================================================================================ SOURCE: eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf ================================================================================ A Complete Guide to the Futures mArket The Wiley Trading series features books by traders who have survived the market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional or some- where in-between, these books will provide the advice and strategies needed to prosper today and well into the future. For more on this series, visit our website at www.WileyTrading.com. Founded in 1807, John Wiley & Sons is the oldest independent publishing com- pany in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. A Complete Guide to the Futures mArket Technical Analysis and Trading Systems, Fundamental Analysis, Options, Spreads, and Trading Principles seCond edition Jack d. schwager mark etzkorn Cover images: Stock Chart © Adam Kazmierski/iStockphoto; Abstract Background © Olga Altunina/ iStockphoto Cover design: Wiley Copyright © 2017 by Jack D. Schwager. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. The first edition of A Complete Guide to the Futures Market was published by John Wiley & Sons in 1984. Published simultaneously in Canada. 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Description: Second edition. | Hoboken, New Jersey : John Wiley & Sons, Inc., [2017] | Series: Wiley trading series | Includes index. Identifiers: LCCN 2016034802 (print) | LCCN 2016047999 (ebook) | ISBN 9781118853757 (pbk.) | ISBN 9781118859599 (pdf) | ISBN 9781118859544 (epub) Subjects: LCSH: Futures market. | Commodity exchanges. | Hedging (Finance) Classification: LCC HG6046 .S39 2017 (print) | LCC HG6046 (ebook) | DDC 332.64/52-dc23 LC record available at https://lccn.loc.gov/2016034802 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 In memory of Stephen Chronowitz, my mentor and friend. vii Contents About the Authors xv PArt I PrelImInArIes ChAPter 1 For Beginners only 3 Purpose of This Chapter 3 The Nature of Futures Markets 3 Delivery 4 Contract Specifications 5 V olume and Open Interest 9 Hedging 11 Trading 15 Types of Orders 16 Commissions and Margins 19 Tax Considerations 19 ChAPter 2 the Great Fundamental versus technical Analysis Debate 21 PArt II ChArt AnAlysIs AnD teChnICAl InDICAtors ChAPter 3 Charts: Forecasting tool or Folklore? 27 ChAPter 4 types of Charts 35 Bar Charts 35 Linked Contract Series: Nearest Futures versus Continuous Futures 39 Close-Only (“Line”) Charts 40 viii Contents Point-and-Figure Charts 42 Candlestick Charts 43 ChAPter 5 linking Contracts for long-term Chart Analysis: nearest versus Continuous Futures 45 The Necessity of Linked-Contract Charts 45 Methods of Creating Linked-Contract Charts 46 Nearest versus Continuous Futures in Chart Analysis 48 Conclusion 51 ChAPter 6 trends 57 Defining Trends by Highs and Lows 57 TD Lines 66 Internal Trend Lines 73 Moving Averages 78 ChAPter 7 trading ranges 83 Trading Ranges: Trading Considerations 83 Trading Range Breakouts 86 ChAPter 8 support and resistance 91 Nearest Futures or Continuous Futures? 91 Trading Ranges 92 Prior Major Highs and Lows 94 Concentrations of Relative Highs and Relative Lows 101 Trend Lines, Channels, and Internal Trend Lines 106 Price Envelope Bands 107 ChAPter 9 Chart Patterns 109 One-Day Patterns 109 Continuation Patterns 122 T op and Bottom Formations 134 ChAPter 10 Is Chart Analysis still Valid? 149 ChAPter 11 technical Indicators 155 What Is an Indicator? 155 The Basic Indicator Calculations 157 Comparing Indicators 157 Moving Average Types 165 Oscillators and Trading Signals 167 Indicator Myths 170 Indicator “Types” 172 Conclusion 173 ixCONTENTS PArt III APPlyInG ChArt AnAlysIs to trADInG ChAPter 12 midtrend entry and Pyramiding 177 ChAPter 13 Choosing stop-loss Points 183 ChAPter 14 setting objectives and other Position exit Criteria 189 Chart-Based Objectives 189 Measured Move 190 Rule of Seven 194 Support and Resistance Levels 196 Overbought/Oversold Indicators 198 DeMark Sequential 199 Contrary Opinion 203 Trailing Stops 204 Change of Market Opinion 204 ChAPter 15 the most Important rule in Chart Analysis 205 Failed Signals 205 Bull and Bear Traps 205 False Trend Line Breakouts 211 Return to Spike Extremes 213 Return to Wide-Ranging Day Extremes 216 Counter-to-Anticipated Breakout of Flag or Pennant 219 Opposite Direction Breakout of Flag or Pennant Following a Normal Breakout 222 Penetration of T op and Bottom Formations 225 Breaking of Curvature 229 The Future Reliability of Failed Signals 229 Conclusion 231 PArt IV t rADInG systems AnD PerFormAnCe meAsurement ChAPter 16 technical trading systems: structure and Design 235 The Benefits of a Mechanical Trading System 236 Three Basic Types of Systems 236 Trend-Following Systems 237 T en Common Problems with Standard Trend-Following Systems 244 Possible Modifications for Basic Trend-Following Systems 247 Countertrend Systems 254 Diversification 256 T en Common Problems with Trend-Following Systems Revisited 259 x Contents ChAPter 17 examples of original trading systems 261 Wide-Ranging-Day System 261 Run-Day Breakout System 268 Run-Day Consecutive Count System 273 Conclusion 278 ChAPter 18 selecting the Best Futures Price series for system testing 279 Actual Contract Series 279 Nearest Futures 280 Constant-Forward (“Perpetual”) Series 281 Continuous (Spread-Adjusted) Price Series 282 Comparing the Series 285 Conclusion 287 ChAPter 19 testing and optimizing trading systems 289 The W ell-Chosen Example 289 Basic Concepts and Definitions 291 Choosing the Price Series 293 Choosing the Time Period 293 Realistic Assumptions 295 Optimizing Systems 297 The Optimization Myth 298 T esting versus Fitting 310 The Truth about Simulated Results 312 Multimarket System T esting 313 Negative Results 314 T en Steps in Constructing and T esting a Trading System 315 Observations about Trading Systems 316 ChAPter 20 how to evaluate Past Performance 319 Why Return Alone Is Meaningless 319 Risk-Adjusted Return Measures 323 Visual Performance Evaluation 335 Investment Insights 343 PArt V FunDAmentAl AnAlysIs ChAPter 21 Fourteen Popular Fallacies, or What not to Do Wrong 347 Five Short Scenes 347 The Fourteen Fallacies 349 xiCONTENTS ChAPter 22 supply-Demand Analysis: Basic economic theory 359 Supply and Demand Defined 359 The Problem of Quantifying Demand 362 Understanding the Difference between Consumption and Demand 363 The Need to Incorporate Demand 366 Possible Methods for Incorporating Demand 368 Why Traditional Fundamental Analysis Doesn’t W ork in the Gold Market 371 ChAPter 23 types of Fundamental Analysis 373 The “Old Hand” Approach 373 The Balance Table 373 The Analogous Season Method 374 Regression Analysis 375 Index Models 376 ChAPter 24 the role of expectations 379 Using Prior- Y ear Estimates Rather Than Revised Statistics 379 Adding Expectations as a Variable in the Price-Forecasting Model 380 The Influence of Expectations on Actual Statistics 380 Defining New-Crop Expectations 381 ChAPter 25 Incorporating Inflation 383 ChAPter 26 seasonal Analysis 389 The Concept of Seasonal Trading 389 Cash versus Futures Price Seasonality 389 The Role of Expectations 390 Is It Real or Is It Probability? 390 Calculating a Seasonal Index 391 ChAPter 27 Analyzing market response 403 Evaluating Market Response for Repetitive Events 403 ChAPter 28 Building a Forecasting model: A step-by-step Approach 413 ChAPter 29 Fundamental Analysis and trading 417 Fundamental versus T echnical Analysis: A Greater Need for Caution 417 Three Major Pitfalls in Fundamental Analysis 418 Combining Fundamental Analysis with T echnical Analysis and Money Management 426 Why Bother with Fundamentals? 427 Are Fundamentals Instantaneously Discounted? 428 xii Contents Fitting the News to Price Moves 431 Fundamental Developments: Long- T erm Implications versus Short- T erm Response 432 Summary 435 PArt VI Futures sPreADs AnD oPtIons ChAPter 30 the Concepts and mechanics of spread trading 439 Introduction 439 Spreads—Definition and Basic Concepts 440 Why Trade Spreads? 440 Types of Spreads 441 The General Rule 443 The General Rule—Applicability and Nonapplicability 443 Spread Rather Than Outright—An Example 445 The Limited-Risk Spread 446 The Spread Trade—Analysis and Approach 448 Pitfalls and Points of Caution 449 ChAPter 31 Intercommodity spreads: Determining Contract ratios 453 ChAPter 32 spread trading in stock Index Futures 461 Intramarket Stock Index Spreads 461 Intermarket Stock Index Spreads 462 ChAPter 33 spread trading in Currency Futures 471 Intercurrency Spreads 471 Intracurrency Spreads 473 ChAPter 34 An Introduction to options on Futures 477 Preliminaries 477 Factors That Determine Option Premiums 480 Theoretical versus Actual Option Premiums 483 Delta (the Neutral Hedge Ratio) 484 ChAPter 35 option trading strategies 487 Comparing Trading Strategies 487 Profit/Loss Profiles for Key Trading Strategies 489 PArt VII PrACtICAl trADInG GuIDelInes ChAPter 36 the Planned trading Approach 559 Step 1: Define a Trading Philosophy 559 Step 2: Choose Markets to Be Traded 560 xiii CONTENTS Step 3: Specify Risk Control Plan 560 Step 4: Establish a Planning Time Routine 563 Step 5: Maintain a Trader’s Spreadsheet 563 Step 6: Maintain a Trader’s Diary 565 Step 7: Analyze Personal Trading 565 ChAPter 37 seventy-Five trading rules and market observations 567 Entering Trades 568 Exiting Trades and Risk Control (Money Management) 569 Other Risk-Control (Money Management) Rules 570 Holding and Exiting Winning Trades 570 Miscellaneous Principles and Rules 571 Market Patterns 572 Analysis and Review 573 ChAPter 38 50 market Wizard lessons 575 APPenDIx A Introduction to regression Analysis 589 Basics 589 Meaning of Best Fit 591 A Practical Example 593 Reliability of the Regression Forecast 593 APPenDIx B A review of elementary statistics 597 Measures of Dispersion 597 Probability Distributions 599 Reading the Normal Curve (Z) Table 604 Populations and Samples 606 Estimating the Population Mean and Standard Deviation from the Sample Statistics 607 Sampling Distribution 608 Central Limit Theorem 609 Standard Error of the Mean 612 Confidence Intervals 612 The t- T est 614 APPenDIx C Checking the significance of the regression equation 619 The Population Regression Line 619 Basic Assumptions of Regression Analysis 620 T esting the Significance of the Regression Coefficients 620 Standard Error of the Regression 627 Confidence Interval for an Individual Forecast 627 Extrapolation 630 Coefficient of Determination (r2) 630 Spurious (“Nonsense”) Correlations 634 xiv Contents APPenDIx D the multiple regression model 637 Basics of Multiple Regression 637 Applying the t- T est in the Multiple Regression Model 640 Standard Error of the Regression 641 Confidence Intervals for an Individual Forecast 642 R2 and Corrected R2 642 F- T est 643 Analyzing a Regression Run 644 APPenDIx e Analyzing the regression equation 649 Outliers 649 The Residual Plot 650 Autocorrelation Defined 651 The Durbin-Watson Statistic as a Measure of Autocorrelation 651 The Implications of Autocorrelation 654 Missing Variables and Time Trend 655 Dummy Variables 658 Multicollinearity 663 Addendum: Advanced T opics 666 APPenDIx F Practical Considerations in Applying regression Analysis 673 Determining the Dependent Variable 673 Selecting the Independent Variables 675 Should the Preforecast Period Price Be Included? 675 Choosing the Length of the Survey Period 676 Sources of Forecast Error 677 Simulation 678 Stepwise Regression 679 Sample Step-by-Step Regression Procedure 680 Summary 681 references and recommended readings 683 Index 685 xv About the A utho RS Jack Schwager is a co-founder and Chief Research Officer of FundSeeder, a firm that seeks to find undiscovered trading talent worldwide via its trader platform (FundSeeder.com), and a co-founder of FundSeeder Investments (FundSeederinvest.com), which seeks to connect properly regulated traders with sources of investment capital. Mr. Schwager is a recognized industry expert in futures and hedge funds and the author of a number of widely acclaimed financial books. Previously, Mr. Schwager was a partner in the Fortune Group (2001–2010), a London-based hedge fund advisory firm. His prior experience also includes 22 years as Director of Futures research for some of Wall Street’s leading firms, most recently Prudential Securities. Mr. Schwager has written extensively on the futures industry and great traders in all financial mar- kets. He is perhaps best known for his best-selling series of interviews with the greatest hedge fund managers of the last three decades: Market Wizards (1989), The New Market Wizards (1992), Stock Market Wizards (2001), Hedge Fund Market Wizards (2012), and The Little Book of Market Wizards (2014). His other books include Market Sense and Nonsense (2012), a compendium of investment miscon- ceptions, and the three-volume series Schwager on Futures, consisting of Fundamental Analysis (1995), T echnical Analysis (1996), and Managed T rading (1996). He is also the author of Getting Started in T echnical Analysis (1999), part of Wiley’s popular Getting Started series. Mr. Schwager is a frequent seminar speaker and has lectured on a range of analytical topics includ- ing the characteristics of great traders, investment fallacies, hedge fund portfolios, managed accounts, technical analysis, and trading system evaluation. He holds a BA in Economics from Brooklyn College (1970) and an MA in Economics from Brown University (1971). Mark etzkorn is founder of FinCom Media. He was formerly Editor-in-Chief of Active T rader maga- zine, editor at Futures magazine, and a member of the Chicago Mercantile Exchange. He has authored, edited, and contributed to more than 10 books on the financial markets. PreliMinaries Part I 3 Cha P ter 1 If a little knowledge is dangerous, where is the man who has so much as to be out of danger? —Thomas Henry Huxley ■ Purpose of This Chapter The focus of this book is on analysis and trading. although these subjects are explored in far greater depth than in most general commodity texts, the presentation in the following chapters does not assume any prior knowledge except for a familiarity with the basic concepts of futures markets. This chapter is intended to provide a sketch of the background information necessary to make this book accessible to the novice reader. The title of this chapter should be taken literally. Traders who are already familiar with futures markets should proceed directly to Chapter 2. The introductory discussion provided by this chapter is deliberately brief and does not purport to cover all background subjects. T opics such as the history of exchanges, choosing a broker, and operation of the clearinghouse are not covered because a familiarity with these subjects is unnecessary for the analysis and trading of futures markets. readers who desire a more detailed discussion of com- modity market basics can refer to a wide range of introductory commodity texts. ■ The Nature of Futures Markets a futures contract is a commitment to deliver or receive a standardized quantity and quality of a com- modity or financial instrument at a specified future date. The price associated with this commitment is the trade entry level. For Beginners Only 4 A Complete Guide to the Futures mArket The essence of a futures market is in its name: Trading involves a commodity or financial instrument for a future delivery date, as opposed to the present time. Thus, if a cotton farmer wished to make a current sale, he would sell his crop in the local cash market. However, if the same farmer wanted to lock in a price for an anticipated future sale (e.g., the marketing of a still unharvested crop), he would have two options: He could locate an interested buyer and negotiate a contract specifying the price and other details (quantity, quality, delivery time, location, etc.). alternatively, he could sell futures. some of the major advantages of the latter approach are the following: 1. The futures contract is standardized; hence, the farmer does not have to find a specific buyer. 2. The transaction can be executed virtually instantaneously online. 3. The cost of the trade (commissions) is minimal compared with the cost of an individualized forward contract. 4. The farmer can offset his sale at any time between the original transaction date and the final trading day of the contract. The reasons this may be desirable are discussed later in this chapter. 5. The futures contract is guaranteed by the exchange. Until the early 1970s, futures markets were restricted to commodities (e.g., wheat, sugar, copper, cattle). since that time, the futures area has expanded to incorporate additional market sec- tors, most significantly stock indexes, interest rates, and currencies (foreign exchange). The same basic principles apply to these financial futures markets. Trading quotes represent prices for a future expiration date rather than current market prices. For example, the quote for December 10-year T -note futures implies a specific price for a $100,000, 10-year U. s. Treasury note to be delivered in December. Financial markets have experienced spectacular growth since their introduction, and today trading volume in these contracts dwarfs that in commodities. nevertheless, futures markets are still commonly, albeit erroneously, referred to as commodity markets, and these terms are synonymous. ■ Delivery shorts who maintain their positions in deliverable futures contracts after the last trading day are obligated to deliver the given commodity or financial instrument against the contract. similarly, longs who maintain their positions after the last trading day must accept delivery. in the com- modity markets, the number of open long contracts is always equal to the number of open short contracts (see section V olume and Open interest). Most traders have no intention of making or accepting delivery, and hence will offset their positions before the last trading day. (The long offsets his position by entering a sell order, the short by entering a buy order.) it has been estimated that fewer than 3 percent of open contracts actually result in delivery. some futures contracts (e.g., stock indexes, eurodollar) use a cash settlement process whereby outstanding long and short positions are offset at the prevailing price level at expiration instead of being physically delivered. 5FOr Beginners Only ■ Contract Specifications Futures contracts are traded for a wide variety of markets on a number of exchanges both in the United states and abroad. The specifications for these contracts, especially details such as daily price limits, trading hours, and ticker symbols, can change over time; exchange web sites should be con- sulted for up-to-date information. Table 1.1 provides the following representative trading details for six futures markets ( e-mini s&P 500, 10-year T -note, euro, Brent crude oil, corn, and gold):  1. exchange. note that some markets are traded on more than one exchange. in some cases, different contracts for the same commodity (or financial instrument) may even be traded on the same exchange. 2. ticker symbol. The quote symbol is the letter code that identifies each market (e.g., es for the e-mini s&P 500, C for corn, eC for the euro), combined with an alphanumeric suffix to represent the month and year. 3. Contract size. The specification of a uniform quantity per contract is one of the key ways in which a futures contract is standardized. By multiplying the contract size by the price, the trader can determine the dollar value of a contract. For example, if corn is trading at $4.00/bushel (bu), the contract value equals $20,000 ($4 × 5,000 bu per contract). if Brent crude oil is trading at $48.30, the contract value is $48,300 ($48.30 × 1,000 barrels). although there are many impor- tant exceptions, very roughly speaking, higher per-contract dollar values will imply a greater potential/risk level. (The concept of contract value has no meaning for interest rate contracts.) 4. Price quoted in. This row indicates the relevant unit of measure for the given market. 5. Minimum price fluctuation (“tick”) size and value. This row indicates the minimum increment in which prices can trade, and the dollar value of that move. For example, the mini- mum fluctuation for the e-mini s&P 500 contract is 0.25 index points. Thus, you can enter an order to buy December e-mini s&P futures at 1,870.25 or 1,870.50, but not 1,870.30. The minimum fluctuation for corn is 1 4 ¢/bu, which means you can enter an order to buy December corn at $4.01 1 2 or $4.01 3 4 , but not $4.01 5 8 per bushel. The tick value is obtained by multiply- ing the minimum fluctuation by the contract size. For example, for Brent crude oil, one cent ($0.01) per barrel × 1,000 barrels = $10. For corn, 1 4 50 00 12 50¢/bu ×=,$ .. 6. Contract months. each market is traded for specific months. For example, the e-mini s&P 500 futures contract is traded for March, June, september, and December. Corn is traded for March, May, July, september, and December. Table 1.2 shows the letter designations for each month of the year, which are added (along with the contract year) to a market’s base ticker symbol to create a contract-specific ticker symbol. For example, December 2017 e-mini s&P 500 futures have a ticker symbol of esZ17, while the symbol for the March 2018 contract is esH18. The symbol for May 2017 corn is CK17. The last trading day for a contract typically occurs on a specified date in the contract month, although in some markets (such as crude oil), the last trading day falls in the month preceding the contract month. For most markets, futures are listed for contract months at least one year forward from the current date. However, trading activity is normally heavily concentrated in the nearest two contracts. 6 A Complete Guide to the Futures mArket table 1.1 Sample Futures Contract Specifications e-Mini S&P 500 10-Y ear t-Note euro FX brent Crude Oil Corn Gold exchange CMe group CM e group/CBOT CM e group intercontinental exchange (iCe Futures europe) CMe group/CBOT CM e group/nyMeX ticker Symbol es Ty eC B C gC Contract Size $50 × s&P 500 index U.s. Treasury note with a face value at maturity of $100,000. 125,000 euros 1,000 barrels 5,000 bushels (∼ 127 metric tons) 100 troy ounces Price Quoted In index points Points ($1,000) and halves of 1/32 of a point (e.g., 126-16 represents 126 16/32 and 126-165 represents 126 16.5/32). U. s. dollars per euro U.s. dollars and cents Cents per bushel U. s. dollars and cents per troy ounce Minimum Price Fluctuation (“tick”) Size and Value 0.25 index points = $12.50 One-half of 1/32 of one point ($15.625, rounded to the nearest cent per contract). $0.00005 per euro increments ($6.25/contract) One cent ($0.01) per barrel = $10 1/4 cent per bushel = $12.50 $0.10 per troy ounce = $10 Contract Months Mar, Jun, sep, Dec Mar, Jun, sep, Dec Mar, Jun, sep, Dec all months of the year Mar, May, Jul, sep, Dec The current month; the next two months; any Feb, apr, aug, and Oct within a 23- month period; and any June and Dec within a 72-month period beginning with the current month. trading hours Mon–Fri, 5:00 p.m. previous day to 4:15 p.m.; trading halt from 3:15 p.m. to 3:30 p.m. 5:00 p.m. to 4:00 p.m., sun–Fri. sun–Fri. 5 p.m. to 4 p.m. CT with a 60-min. break each day beginning at 4:00 p.m. 1 a.m. to 11 p.m. london time sun–Fri, 7:00 p.m. to 7:45 a.m. CT and Mon–Fri, 8:30 a.m. to 1:20 p.m. CT . sun–Fri, 6:00 p.m. to 5:00 p.m. (5:00 p.m. to 4:00 p.m. Chicago time/CT) with a 60-minute break each day beginning at 5:00 p.m. (4:00 p.m. CT). 6 7FOr Beginners Only Daily Price limit 7%, 13%, and 20% limits are applied to the futures fixing price, effective 8:30 a.m. to 3 p.m. CT , Mon–Fri. 7%, 13%, and 20% limits are applied to the futures fixing price, effective 8:30 a.m. to 3 p.m. CT , Mon–Fri. ( see exchange for specifics.) n/a n/a $0.25 n/a Settlement type Cash settlement Deliverable Deliverable Physical delivery based on eFP delivery, with an option to cash settle against the iCe Brent index price for the last trading day of the futures contract. Deliverable Deliverable First Notice Day n/a Final business day of the month preceding the contract month. n/a n/a last business day of month preceding contract month. The last business day of the month preceding the delivery month. last Notice Day n/a Final business day of the contract month. n/a n/a The business day after the last contract’s last trading day. The second-to-last business day of the delivery month. last trading Day Until 8:30 a.m. on the 3rd Friday of the contract month. 12:01 p.m. on the 7th business day preceding the last business day of the delivery month. 9:16 a.m. CT on the second business day immediately preceding the third W ed of the contract month. The last business day of the second month preceding the relevant contract month. Business day prior to the 15th calendar day of the contract month. The third-to-last business day of the delivery month. Deliverable Grade n/a U.s. T -notes with a remaining term to maturity of 6.5 to 10 years from the first day of the delivery month. n/a n/a #2 yellow at contract price, #1 yellow at a 1.5 cent/bushel premium, #3 yellow at a 1.5 cent/bushel discount. gold delivered under this contract shall assay to a minimum of 995 fineness. 7 8 A Complete Guide to the Futures mArket 7. trading hours. Trading hours are listed in terms of the local times for the given exchange. (all U.s. exchanges are currently located in either the eastern or Central time zones.) 8. Daily price limit. exchanges normally specify a maximum amount by which the contract price can change on a given day. For example, if the December corn contract closed at $4.10 on the previous day, and the daily price limit is 25¢/bu, corn cannot trade above $4.35 or below $3.85. some markets employ formulas for increasing the daily limit after a specified number of consecutive limit days. in cases in which free market forces would normally seek an equilibrium price outside the range boundaries implied by the limit, the market will simply move to the limit and virtually cease to trade. For example, if after the market close the U. s. Department of agriculture (UsDa) releases a very bullish corn crop production estimate, which hypothetically would result in an immediate 30¢/bu price rise in an unrestricted market, prices will be locked limit up (25¢/bu) the next day. This means that the market will open and stay at the limit, with virtually no trading tak- ing place. The reason for the absence of trading activity is that the limit rule restriction maintains an artificially low price, leading to a deluge of buy orders at that price but few if any sell orders. in the case of a very severe surprise event (e.g., sudden major crop damage), a market could move several limits in succession, although such moves are less common than in the days before near-24-hour electronic trading. in such situations, traders on the wrong side of the fence might not be able to liquidate their positions until the market trades freely. The new trader should be aware of, but not be overly frightened by, this possibility, since such events of extreme volatility rarely come as a complete surprise. in most cases, markets vulnerable to such volatile price action can be identified. some examples of such markets would include commodities in which the UsDa is scheduled to release a major report, coffee or frozen concentrated orange juice during their respective freeze seasons, and markets that have exhibited recent extreme trading volatility. For some markets, the limit on the nearby contract is removed at some point table 1.2 Contract Month Designations Month ticker Designation January F February g March H april J May K June M July n august Q september U October V november X December Z 9FOr Beginners Only approaching expiration (frequently first notice day—see item 10). Daily price limits can change frequently, so traders should consult the exchange on which their products trade to ensure they are aware of current thresholds. 9. Settlement type. Markets are designated either as physically deliverable or cash settled. in Table 1.1, the e-mini s&P 500 futures are cash settled, while all the other markets can be physi- cally delivered. 10. First notice day. This is the first day on which a long can receive a delivery notice. First notice day presents no problem for shorts, since they are not obligated to issue a notice until after the last trading day. Furthermore, in some markets, first notice day occurs after last trading day, presenting no problem to the long either, since all remaining longs at that point presumably wish to take delivery. However, in markets in which first notice day precedes last trading day, longs who do not wish to take delivery should be sure to offset their positions in time to avoid receiving a delivery notice. (Brokerage firms routinely supply their clients with a list of these important dates.) although longs can pass on an undesired delivery notice by liquidating their position, this transaction will incur extra transaction costs and should be avoided. Last notice day is the final day a long can receive a delivery notice. 11. last trading day. This is the last day on which positions can be offset before delivery becomes obligatory for shorts and the acceptance of delivery obligatory for longs. as indicated previously, the vast majority of traders will liquidate their positions before this day. 12. Deliverable grade. This is the specific quality and type of the underlying commodity or finan- cial instrument that is acceptable for delivery. ■ Volume and Open Interest V olume is the total number of contracts traded on a given day. V olume figures are available for each traded month in a market, but most traders focus on the total volume of all traded months. Open interest is the total number of outstanding long contracts, or equivalently, the total number of outstanding short contracts—in futures, the two are always the same. When a new contract begins trading (typically about 12 to 18 months before its expiration date), its open interest is equal to zero. if a buy order and sell order are matched, then the open interest increases to 1. Basically, open interest increases when a new buyer purchases from a new seller and decreases when an existing long sells to an existing short. The open interest will remain unchanged if a new buyer purchases from an existing long or a new seller sells to an existing short. V olume and open interest are very useful as indicators of a market’s liquidity. not all listed futures mar- kets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading activity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the trader will often have to accept very poor trade execution prices if he wants to get in or out of a position. generally speaking, markets with open interest levels below 5,000 contracts, or average daily volume levels below 1,000 contracts, should be avoided, or at least approached very cautiously. new markets will usually exhibit volume and open interest figures below these levels during their 10a COMPleTe gUiDe TO THe FUTUres MarKeT initial months (and sometimes even years) of trading. By monitoring the volume and open interest fi gures, a trader can determine when the market’s level of liquidity is suffi cient to warrant participa- tion. Figure 1.1 shows February 2016 gold (top) and april 2016 gold (bottom) prices, along with their respective daily volume fi gures. February gold’s volume is negligible until november 2015, at which point it increases rapidly into December and maintains a high level through January (the February contract expires in late February). Meanwhile, april gold’s volume is minimal until Janu- ary, at which point it increases steadily and becomes the more actively traded contract in the last two days of January—even though the February gold contract is still a month from expiration at that point. The breakdown of volume and open interest fi gures by contract month can be very useful in determining whether a specifi c month is suffi ciently liquid. For example, a trader who prefers to initiate a long position in a nine-month forward futures contract rather than in more nearby con- tracts because of an assessment that it is relatively underpriced may be concerned whether its level of trading activity is suffi cient to avoid liquidity problems. in this case, the breakdown of volume and open interest fi gures by contract month can help the trader decide whether it is reasonable to enter the position in the more forward contract or whether it is better to restrict trading to the nearby contracts. Traders with short-term time horizons (e.g., intraday to a few days) should limit trading to the most liquid contract, which is usually the nearby contract month. FIGURE  1.1 V olume shift in gold Futures Chart created using Tradestation. ©Tradestation T echnologies, inc. all rights reserved. 11FOr Beginners Only ■ Hedging a sell hedge is the sale of a futures contract as a temporary substitute for an anticipated future sale of the cash commodity.1 similarly, a buy hedge is a temporary substitute for an anticipated forward purchase of the cash commodity. in essence, the goal of the hedger is to lock in an approximate future price in order to eliminate exposure to interim price fluctuations. The concept of hedging is perhaps best explained through illustration. let’s look at several examples of hedging. hedging examples for a Commodity Cotton Producer Sell Hedge The date is april 1. a cotton farmer estimates his potential production at approximately 200,000 lbs, assuming average yields. The current cash price is 95¢/ lb—an extremely attractive price, but one the producer cannot take advantage of, since his crop will not be harvested until november. December futures are trading at 85¢/lb, reflecting market expecta- tions for an interim price decline. The producer believes the December price may actually be overly optimistic. He expects that a large increase in U. s. production, in response to high prices, will result in a major price collapse by the time the new crop is harvested. given his bearish expectations, the producer is eager to lock in a price on his anticipated production. Historical comparisons indicate the november–December cash prices in the producer’s region tend to average approximately 2–4¢ below the December futures price. (The difference between cash and futures is called the basis. in this case, the november–December basis is said to be “2–4¢ under.”) Thus, by selling December futures at the current price of 85¢/lb, the farmer can lock in an approxi- mate cash price of 81–83¢. Because the producer believes prices will be significantly below 80¢/lb by harvest time, he decides to sell three December futures contracts against the expected post-harvest sale of his crop. This is called a sell hedge. note that three contracts represent 150,000 lbs of cotton, an amount equivalent to three-quarters of the producer’s anticipated crop. The farmer does not hedge his entire crop, because his eventual output is still open to considerable uncertainty. if weather conditions are extremely poor, his yields could be reduced by more than 25 percent. Consequently, to avoid the possibility of overhedging his crop, an action that would leave him with a net short position, he prudently decides to sell only three contracts. Table 1.3 illustrates two hypothetical outcomes of this hedge. in case 1, the producer is entirely correct in his expectations, and cash prices decline to 72¢/lb by December 1. in line with the normal historical basis relationship, December futures are simultaneously trading at 75¢/lb. The producer sells his cash crop at 72¢/lb, but also realizes a profit of 10¢/lb on his futures position. Thus, on the 150,000 lbs of crop that he has hedged, his effective price is 82¢/lb. (Commissions have not been included in this or the following illustrations in order to keep exposition as simple as possible. The adjustment for commissions would not meaningfully alter the results.) as a result of hedging, the 1 The sell hedge may also be used as a proxy for temporary inventory reduction (see example of stock portfolio manager later in this section). 12 A Complete Guide to the Futures mArket table 1.3 Cotton Producer Sell hedge Case 1: Severely W eakening Cash Price Case 2: relatively Firm Cash Price apr. 1 Dec. 1 apr. 1 Dec. 1 Cash price 95¢ 72¢ Cash price 95¢ 92¢ Futures price 85¢ 75¢ Futures price 85¢ 95¢ results: results: Cash sale price: 72¢ Cash sale price: 92¢ Profit on futures: 10¢ loss on futures: 10¢ effective sale price: 82¢ effective sale price: 82¢ farmer has locked in a much better price than he would have realized had he waited until his crop was harvested before taking any marketing action. in dollar terms, the producer’s income is $15,000 higher than it would have been without the hedge: 31 05 00 00 15 000×× =¢/lb lbs,$ , a hedge will not always be profitable. in the situation illustrated by case 2, Table 1.3, the producer’s projections proved wrong as cash prices remained firm, declining a mere 3¢/lb from their lofty april 1 levels. in this case, the farmer is able to sell his crop at a much better than expected 92¢/lb, but he experiences a loss of 10¢/lb on his futures position. His effective sales price is once again 82¢/lb. Of course, in this instance, with the benefit of hindsight, the producer would have been much better off had he had not hedged. nonetheless, note that even though he has sacrificed the opportunity for a windfall profit by hedging, he still realizes his target sales price of 82¢/lb. The value of hedging is that it provides the producer with a much wider range of marketing strate- gies. remember, if he prefers to take his chances and wait until after the harvest to market his crop, he can do so. Futures widen the range of possibilities by allowing the producer to lock in any futures- implied price during the interim. Thus, although he will not always make the right choice, presumably, over the long run, the increased marketing flexibility provided by futures should prove advantageous. Cotton Mill Buy Hedge The date is June 1. a cotton mill has forward contracted to supply a fabric order for the following March. T o meet this production order, the mill will need 1 million lbs of cotton on hand by December. The current cash price is 77¢/lb, and December futures are trading at 80¢/lb. assuming the same −3¢/lb basis established in the aforementioned cotton producer example, the December futures price quote implies cash prices will be unchanged in December relative to their current levels. although the mill has plenty of time to purchase the actual cotton, it is concerned that cash prices will rise significantly in the coming months. since the end-product sales price has already been nego- tiated, the company must lock in its input price in order to guarantee a satisfactory profit margin. given this scenario, the mill has two choices: 1. i ncrease its inventory sufficiently to cover its anticipated December–March requirements. 2. Hedge its forward requirements by buying December cotton futures. 13FOr Beginners Only given the price structure in this example, the mill will be much better off buying futures. Why? Because the purchase of futures covers the forward commitment without incurring any storage costs. (This is true since the December futures price implies an unchanged cash price relative to current levels.) in contrast, the purchase of actual cotton would incur storage-related costs for the six-month period. The most important of these expenses would be borrowing costs, or lost interest, if the firm was using its own funds. Table 1.4 illustrates two alternative outcomes for this hedge. in both cases, it is assumed the firm purchases the actual cotton on December 1, simultaneously offsetting its long hedge position in futures. in the first situation, cash prices increase between June and December, and the actual cash market purchase price on December 1 is 87¢/lb. However, as a result of a 10¢/lb profit on the futures hedge, the effective price to the firm is 77¢ (the cash price on June 1). in the second illustration, cash prices decline, and the firm’s actual purchase price is 67¢/lb. However, as a result of a 10¢/lb loss in futures, the effective price is once again 77¢/lb. although in this case the mill would have been better off not hedging, it is still purchasing the cotton at the previously desired locked-in price. since most companies will be more concerned about locking in adequate profit margins than about giving up windfall profits, hedging should provide a useful tool for business management. Furthermore, it should be emphasized that the firm always has the option not to hedge if, for any reason, the price implied by futures is not considered attractive. in short, users of commodities who incorporate hedging should have an advantage over their competitors, because they have a much wider range of purchasing strategies. hedging in Financial Futures The previous examples illustrate the buy-and-sell hedge for a commodity. The same basic principles apply to the financial markets, as shown by the following examples. a corporation expecting the need for a loan in six months and concerned about rising borrowing costs in the interim could lock in an approximate fixed rate by selling short-term interest rate futures (e.g., eurodollars). ( an increase in interest rates will cause the price of interest rate instruments to decline.) table 1.4 Cotton Mill buy hedge Case 1: rising Cash Price Case 2: Declining Cash Price June 1 Dec. 1 June 1 Dec. 1 Cash price 77¢ 87¢ Cash price 77¢ 67¢ Futures price 80¢ 90¢ Futures price 80¢ 70¢ results: results: Cash purchase price: 87¢ Cash purchase price: 67¢ Profit on futures: 10¢ loss on futures: 10¢ effective purchase price: 77¢ effective purchase price: 77¢ 14 A Complete Guide to the Futures mArket a bond fund manager anticipating a cash influx in three months and an imminent decline in interest rates could lock in a rate of return by going long T -note futures. a stock portfolio manager concerned about the possibility of a sharp, temporary break in stock prices could reduce market exposure by selling stock index futures (e-mini s&P 500, e-mini nasdaq 100, russell 2000 index Mini). such action would be far more cost effective (i.e., would incur much lower commission costs) than liquidating part or all of his portfolio and reinstating the position at a later date. a U.s. company that knew it would require 10 million euros in three months to pay for an import transaction could lock in the exchange rate by purchasing euro futures. General Observations regarding hedging 1. i n all the preceding examples, the hedger offsets either an anticipated future transaction in the actual market or a current position with an equal but opposite transaction in futures. Thus, for the hedger, participation in futures can reduce risks associated with price changes. in effect, the true speculators among producers and users of commodities (or the financial markets) are those who do not hedge. For example, the farmer who does not hedge is speculating on the direction of prices during the interim before his crop is harvested. 2. s ome written discussions of hedging almost seem to imply that producers and users of exchange-traded commodities should automatically hedge. This is ridiculous—hedging should be considered only if the futures-implied price is desirable. Otherwise, one is merely exchang- ing the futures-implied price for the subsequent actual cash price. Over the long run, this type of hedging should be a break-even process in terms of trades and a net loss generator because of commissions. 3. Hedging should be viewed as an important marketing tool, because it provides the producer and user with a wide range of purchase and sale strategies. Hedgers can always choose not to hedge, but nonhedgers eliminate the possibility of enhancing their profits through futures- related opportunities. 4. The hedger need not wait until the time of the actual transaction to lift the hedge. For example, reconsider the case of the cotton producer who sells December futures at 85¢/lb. if by October, futures have declined to 70¢/lb, the hedger might very well decide to cover his short hedge position. although at a price of 85¢/lb the farmer was eager to protect against the possibility of declining prices, at a price of 70¢/lb he might well prefer to take his chances. if prices were subsequently to rally, the producer might decide to reinstate his hedge. in fact, sophisticated hedgers will often use such a trading approach in hedging. The key point is that, contrary to most textbook illustrations, a hedge should be maintained only as long as the implied price protection is deemed desirable. 5. i t is important to keep the time differential and expectations in mind when comparing a current cash price with the cash price implied by futures. For example, in the hedge illustrated in case 1, Table 1.3, the futures-implied cash price is 13¢/lb below the current cash price. yet, despite 15FOr Beginners Only this wide discount, the hedge is still very profitable because the price differential is ultimately far outweighed by the intervening price decline. Thus, the relevant question is not whether the futures-implied cash price is attractive relative to the current cash price, but rather whether it is attractive relative to the expected future cash price. 6. The hedger does not precisely lock in a transaction price. His effective price will depend on the basis. For example, if the cotton producer sells futures at 85¢/lb, assuming a −3¢ basis, his effective sales price will be 80¢/lb, rather than the anticipated 82¢/lb, if the actual basis at the time of offset is −5¢. However, it should be emphasized that this basis-price uncertainty is far smaller than the outright price uncertainty in an unhedged position. Furthermore, by using reasonably conservative basis assumptions the hedger can increase the likelihood of achieving, or bettering, the assumed locked-in price. 7. a lthough a hedger plans to buy or sell the actual commodity, it will usually be far more efficient to offset the futures position and use the local cash market for the actual transaction. Futures should be viewed as a pricing tool, not as a vehicle for making or taking delivery. 8. Most standard discussions of hedging make no mention whatsoever of price forecasting. This omission seems to imply that hedgers need not be concerned about the direction of prices. although this conclusion may be valid for some hedgers (e.g., a middleman seek- ing to lock in a profit margin between the purchase and sales price), it is erroneous for most hedgers. There is little sense in following an automatic hedging program. rather, the hedger should evaluate the relative attractiveness of the price protection offered by futures. Price forecasting would be a key element in making such an evaluation. in this respect, it can easily be argued that price forecasting is as important to many hedgers as it is to speculators. ■ Trading The trader seeks to profit by anticipating price changes. For example, if the price of December gold is $1,150/oz, a trader who expects the price to rise above $1,250/oz will go long. The trader has no intention of actually taking delivery of the gold in December. right or wrong, the trader will offset the position sometime before expiration. For example, if the price rises to $1,275 and the trader decides to take profits, the gain on the trade will be $12,500 per contract (100 oz × $125/ oz). if, on the other hand, the trader’s forecast is wrong and prices decline to $1,075/oz, with the expiration date drawing near, the trader has little choice but to liquidate. in this situation, the loss would be equal to $7,500 per contract. note that the trader would not take delivery even given a desire to maintain the long gold position. in this case, the trader would liquidate the December contract and simultaneously go long in a more forward contract. (This type of transaction is called a rollover and would be implemented with a spread order—defined in the next section.) Traders should avoid taking delivery, since it can often result in substantial extra costs without any com- pensating benefits. 16 A Complete Guide to the Futures mArket novice traders should caution against the securities-based bias of trading only from the long side. in futures trading, there is no distinction between going short and going long. 2 since prices can go down as well as up, the trader who takes only long positions will eliminate approximately half the potential trading opportunities. also, it should be noted that futures frequently command a premium to current prices; consequently, the inflation argument for a long-side bias is frequently erroneous. The successful trader must employ some method for forecasting prices. The two basic analytical approaches are: 1. technical analysis. The technical analyst bases projections on non-economic data. Price data are by far the most important—and often only—input in technical analysis. The basic assump- tion of technical analysis is that prices exhibit repetitive patterns and that the recognition of these patterns can be used to identify trading opportunities. T echnical analysis can also include other data, such as volume, open interest, and sentiment measures. 2. Fundamental analysis. The fundamental analyst uses economic data (e.g., production, consumption, exports) to forecast prices. in essence, the fundamentalist seeks to uncover trad- ing opportunities by identifying potential transitions to significantly more ample or tighter supply-demand balances. as discussed in Chapter 2, technical and fundamental analysis are not mutually exclusive approaches. Many traders use both in the decision-making process or as components of automated trading systems. ■ Types of Orders Day versus Good till Canceled (GtC) Unless specified otherwise, orders are assumed to be good only for the day of entry. if the trader wants the order to remain open until canceled, he must specify that it is a good-till-canceled (gTC) order. Market This instruction directs the broker to execute the order upon receipt at the prevailing price level. Market orders are used when the trader is more concerned with initiating or liquidating a position immediately than with trying to achieve a specific execution price. Market orders ensure the trade will be executed unless prices are locked in at the daily limit or the order is entered too close to the end of the trading session. 2 some beginners are confused about how it is possible for a trader to sell a commodity he does not own. The key to the answer lies in the fact that the trader is selling a futures contract, not the cash commodity. even though the trader who stays short past the last trading day must acquire the actual commodity to fulfill his contractual obligation, there is no need for him to own the commodity before that time. The short sale is simply a bet that prices will go down before the last trading day. right or wrong, the trader will offset his short position before the last trading day, eliminating any need for actual ownership of the commodity. 17FOr Beginners Only limit The limit order, also called an or-better order, is used when the trader wants to ensure that the execu- tion price will be no worse than a certain level. For example, an order to buy December gold at a $1,150/ounce limit can only be executed at a price equal to or below $1,150. if the market is trading higher than that level when the brokerage receives the order, it must wait for the price to decline to $1,150 before it can execute the trade. if the price fails to return to that level, the brokerage is unable to fill the order. similarly, an order to sell December gold at a $1,190/ ounce limit would indicate that the order can only be filled at a price equal to or above $1,190. limit orders will normally provide better fills than will market orders, but the trade-off is that they may not be executed. a trader whose primary concern is to get the order filled, particularly if it is an order to liquidate a losing position, should not use a limit order. Stop a stop order is not executed until the market reaches the given price level. The indicated price on a buy stop must always be above the market, while the indicated price on a sell stop must always be below the market. in effect, a stop order will always be filled at a price worse than the market price. Why then would a trader use a stop order? There are two very important reasons: First, stop orders are used to limit losses or protect open profits. For example, a trader who buys March sugar at 14.50¢/lb might place an order to sell March sugar at 13.50¢/lb stop, gTC. if the market subsequently declines to 13.50¢/lb or lower, the stop order becomes a market order. in this way, the trader limits his risk on the trade to approximately 100 points. The reason for the word approximately is that markets often move beyond the stop price before the order can be executed. in the case of a short position, the protective stop order would be placed at a higher price. For example, if the trader went short March sugar at 14.50¢/lb, an order might be placed to buy March sugar at 15.50¢/lb stop, gTC. second, a stop order may be used if a trader views the market’s ability to reach a certain level as a price signal. For example, if March sugar has been trading between 12.00¢ and 15.00¢/lb for several months, a trader might believe that the ability of the market to significantly penetrate the high of this range would be a sign of strength, suggesting a potential bull move. in this case, the trader might enter an order to buy March sugar at 15.50¢/lb stop. Thus, even though March sugar can be purchased more cheaply at the current price, the trader prefers to use the stop order because he only wants to be long if the market is able to demonstrate a specified degree of strength. Stop-limit a stop-limit order is a stop order in which the actual execution price is limited. For example, an order to “buy March 10-year T -notes at 124'16 stop, 124'24 limit, gTC” means that if March 10-year T -note futures advance to 124'16, the buy order is activated but cannot be executed at a price above 124'24. similarly, an order to “sell March T -notes at 122 stop, 121'22 limit, gTC” is a sell stop that is activated if the market declines to 122, but which cannot be filled at a price below 121'22. The stop and limit portions of the order need not necessarily be at different prices. 18 A Complete Guide to the Futures mArket Stop Close-Only a stop close-only is a stop order that is activated only if any portion of the closing price range is beyond the indicated price. (This type of order is not accepted on all exchanges.) Market If touched a market-if-touched (M iT) order is similar to a limit order except that it becomes a market order anytime the limit price is reached. For example, given the following sequence of prices—79.40, 79.35, 79.25, 79.20, 79.25, 79.30, 79.40, 79.50 . . .—a 79.20 M iT buy order would become a market order once 79.20 was reached, but a 79.20 limit order could be filled only at a price of 79.20 or better. in this illustration, the market decline to 79.20 is so fleeting that the limit order might very well not be filled, while the M iT order would be executed (probably at some price above 79.20). The MiT is a hairsplitting type of order that is largely superfluous. Over the long run, a trader will achieve equivalent results by using slightly higher buy limits (lower sell limits) instead of M iT orders. Fill or Kill as the name implies, a fill-or-kill (FOK) order is a limit order that must be filled immediately or canceled. Scale a scale order is used for multicontract positions in which the trader wants to enter different contracts at different prices. For example, if June British pound futures are trading at 153.00, a trader who wants to sell 10 contracts on a possible rally to the 155.00–157.00 zone might enter a scale order to sell 10 June British pound contracts, one at 155.20 limit and one contract every 0.20 points higher, with the last contract having a limit price of 157.00. One Cancels Other The one-cancels-other (OCO) order is a two-sided order in which the execution of one side cancels the other. For example, a trader who is long February live cattle at 117.00, with an objective of 125.00 and a stop point at 109.00, might enter the following order: sell 1 February cattle 125.00 limit/109.00 stop, OCO, gTC. Contingent in this type of order the execution instruction for one contract is contingent on another contract. an example would be: sell October sugar at the market if March sugar trades at 13.00 or lower. (This type of order is not accepted on all exchanges.) 19FOr Beginners Only Spread a spread involves the simultaneous purchase of one futures contract against the sale of another futures contract, either in the same market or in a related market. in essence, a spread trader is primarily concerned with the difference between prices rather than the direction of price. an example of a spread trade would be: Buy 1 July cotton/sell 1 December cotton, July 200 points premium December. This order would be executed if July could be bought at a price 200 points or less above the level at which December is sold. such an order would be placed if the trader expected July cotton to widen its premium relative to December cotton. not all brokerages will accept all the order types in this section (and may offer others not listed here). Traders should consult with their brokerage to determine which types of orders are available to them. ■ Commissions and Margins in futures trading, commissions are typically charged on a per-contract basis. in most cases, large traders will be able to negotiate a reduced commission rate. although commodity commissions are relatively moderate, commission costs can prove substantial for the active trader—an important rea- son why position trading is preferable unless one has developed a very effective short-term trading method. Futures margins are basically good-faith deposits and represent only a small percentage of the con- tract value (roughly 5 percent with some significant variability around this level). Futures exchanges will set minimum margin requirements for each of their contracts, but many brokerage houses will frequently require higher margin deposits. since the initial margin represents only a small portion of the contract value, traders will be required to provide additional margin funds if the market moves against their positions. These additional margin payments are referred to as maintenance. Many traders tend to be overly concerned with the minimum margin rate charged by a broker- age house. if a trader is adhering to prudent money management principles, the actual margin level should be all but irrelevant. as a general rule, the trader should allocate at least three to five times the minimum margin requirement to each trade. Trading an account anywhere near the full margin allowance greatly increases the chances of experiencing a severe loss. Traders who do not maintain at least several multiples of margin requirements in their accounts are clearly overtrading. ■ Tax Considerations Tax laws change over time, but for the average speculator in the United states, the essential elements of the futures contract tax regulations can be summarized in three basic points: 1. There is no holding period for futures trades (i.e., all trades are treated equally, regardless of the length of time a position is held, or whether a position is long or short). 20 A Complete Guide to the Futures mArket 2. s ixty percent of futures trading gains are treated as long-term capital gains, and the remaining 40 percent are treated as short-term capital gains. since current maximum tax rates on long- and short-term capital gains are 20 percent and 50 percent, respectively, this formula suggests a maximum tax rate of 32 percent on futures trades. 3. g ain (loss) in a given year is calculated as the total of realized gain (loss) plus unrealized gain (loss) as of December 31. 21 Chapter 2 The Great Fundamental versus T echnical Analysis Debate Curiously, however, the broken technician is never apologetic about his method. If anything, he is more enthusiastic than ever. If you commit the social error of asking him why he is broke, he will tell you quite ingeniously that he made the all-too-human error of not believing his own charts. T o my great embarrassment, I once choked conspicuously at the dinner table of a chartist friend of mine when he made such a comment. I have since made it a rule never to eat with a chartist. It’s bad for digestion. —Burton G. Malkiel One evening, while having dinner with a fundamentalist, I accidentally knocked a sharp knife off the edge of the table. He watched the knife twirl through the air, as it came to rest with the pointed end sticking into his shoe. “Why didn’t you move your foot?” I exclaimed. “I was waiting for it to come back up, ” he replied. —Ed Seykota (an avowed technician) F undamental analysis involves the use of economic data (e.g., production, consumption, disposable income) to forecast prices, whereas technical analysis is based primarily (and often solely) on the study of patterns in the price data itself. Which method is better? This question is the subject of great 22 A Complete Guide to the Futures mArket debate. Interestingly, the experts are no less divided on this matter than are novices. In a series of books in which I interviewed some of the world’s best traders,1 I was struck by the sharply divergent views on this issue. Jim Rogers was characteristic of one extreme of the spectrum. During the 1970s, Jim Rogers and George Soros were the two principals of the Quantum Fund, perhaps the most successful Wall Street fund of its day. In 1980, Rogers left the fund to escape managerial responsibilities and devote all his time to managing his own investments—an endeavor at which he again proved spectacularly success- ful. (The Quantum Fund maintained its excellent performance in the ensuing years under George Soros’s directorship.) Over the years, Rogers has been on record with a high percentage of accurate market forecasts. As but one example, in my 1988 interview with him, Rogers correctly predicted both the massive collapse in the Japanese stock market and the continued multiyear downtrend in gold prices. Clearly, Jim Rogers is a man whose opinion merits serious attention. When I queried Rogers about his opinion on chart reading (the classic method of technical analy- sis), he replied: “I haven’t met a rich technician. Excluding, of course, the technicians who sell their services and make a lot of money.” That cynical response succinctly summarized Rogers’s views about technical analysis. Marty Schwartz is a trader whose opinion lies at the other extreme. At the time of our interview , Schwartz, an independent stock index futures trader, was considering managing outside money. In conjunction with this undertaking, he had just had his personal track record audited, and he allowed me to view the results. During the prior 10-year period, he had achieved an average return of 25 percent—monthly! Equally impressive, during this 120-month period, he witnessed only two losing months—minuscule declines of 2 percent and 3 percent. Again, here was an individual whose opinion on the market warranted serious respect. Although I did not mention Rogers’s comments to Schwartz, when I asked Schwartz whether he had made a complete transition from fundamental to technical analysis (Schwartz had started his financial career as a stock analyst), his response almost sounded like a direct rebuttal to Jim Rogers: “Absolutely. I always laugh at people who say, ‘I’ve never met a rich technician. ’ I love that! It is such an arrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician.” There you have it. Two extraordinarily successful market participants holding polar-opposite views regarding the efficacy of fundamental versus technical analysis. Whom do you believe? In my own assessment, both Rogers’s and Schwartz’s viewpoints contain elements of truth. It is possible to succeed as a trader by being a pure fundamentalist, a pure technician, or a hybrid of the two. The two methods are certainly not mutually exclusive. In fact, many of the world’s most suc- cessful traders use fundamental analysis to determine the direction to trade a market and technical analysis to time the entry and exit of such trades. One virtually universal trait I found among successful traders was that they had gravitated to an approach that best fit their personality. Some traders prefer very long-term approaches, while others 1 Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012 [orig. pub. 1989]); The New Market Wizards (Hoboken, NJ: John Wiley & Sons, 2008); Stock Market Wizards (New Y ork, NY: HarperBusiness, 2003); and Hedge Fund Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012). 23THE GREAT FuNDAMENTAl vERSuS TECHNICAl ANAlYSIS DEBATE are inclined toward day trading; some traders feel comfortable only when following signals gener- ated by an automated system, while others find such a mechanical method anathema; some traders thrive in the near-bedlam atmosphere of a trading room, while others succeed only if their decisions are made in the calm of a quiet office; and some traders find fundamental analysis a natural approach, while others instinctively lean to technical methods, and still others a blend of the two. Essentially, then, there is no universal answer to the question, which is better, fundamental analy- sis or technical analysis? Quite simply, it depends on the individual, who must determine his or her natural approach. The relative popularity of fundamental analysis versus technical analysis tends to wax and wane in broad cyclical fashion. When I first became a market analyst in the 1970s, fundamental analysis was considered a solid approach, while technical analysis was regarded by most as some sort of hocus-pocus or black magic. The situation changed, however, because the huge price trends that developed during the com- modity inflation period of the 1970s were ideally suited to the trend-following techniques widely favored by technical analysts. Even the simplest trend-following strategies tended to perform extremely well during this period, while sophisticated fundamental methodologies often proved to be highly misleading. In this environment, the popularity of technical analysis grew enormously, while fundamental analysis declined in favor. This basic trend extended into the 1980s, as technical analysis became the primary method of choice and fundamental analysis a minority technique. By the end of the 1980s, a significant majority of money managers in the futures industry (known as commodity trading advisors, or CTAs) employed technical analysis exclusively or at least for the bulk of their trading decisions. Thus, whereas at the beginning of the 1970s few market participants would even consider technical analysis, by the late 1980s few would consider fundamental analysis. By this time, however, general market behavior had become increasingly erratic, with fewer sus- tained trends and an increasing percentage of false price breakouts (i.e., price moves above or below trading ranges that are followed by price reversals rather than price extensions). Simultaneously, the spectacular performance of some technical trend followers deteriorated substantially, or at the very least their results exhibited periodic deep equity retracements. At the same time, it appeared that many of the traders and money managers with the best performance were those who were primar- ily fundamentally oriented, or at least relied on fundamentals as a significant input in their trading decisions. T o summarize, there is no “right” side to the great fundamental versus technical debate: the appro- priate method depends on the individual. Moreover, even for individual traders, the perceived answer may change dramatically, or even completely reverse, over the years. Also, combining fundamental analysis with technical analysis can provide a particularly effective approach and is indeed descriptive of the general methodology used by some of the world’s most successful traders. The bottom line is that each trader must explore both approaches and select the methodology or blend that feels the most comfortable and appropriate. The relative pros and cons of using fundamental and technical analysis for trading, as well as practical considerations about combining the two methods, are examined in greater detail in Chapter 29. Chart aNalysis aNd teChNiCal iNdiCators Part II 27 Cha P ter 3 Charts: Forecasting tool or Folklore? Common sense is not so common. —V oltaire t here is a story about a speculator whose desire to be a winner was intensified by each successive failure. initially he tried basing his trading decisions on fundamental analysis. he constructed intricate models that provided price forecasts based on an array of supply/demand statistics. Unfor- tunately, his models’ predictions were invariably upset by some unexpected event, such as a drought or a surprise export sale. Ultimately, in exasperation, he gave up on the fundamental approach and turned to chart analysis. he scrutinized price charts, searching for patterns that would reveal the secrets of trading success. he was the first to discover such unusual formations as shark-tooth bottoms and Grand teton tops. But alas, the patterns always seemed reliable until he started basing his trades on them. When he went short, top formations proved to be nothing more than pauses in towering bull markets. equally dis- tressing, steady uptrends had an uncanny tendency to reverse course abruptly soon after he went long. “the problem,” he reasoned, “is that chart analysis is too inexact. What i need is a computerized trad- ing system.” so he began testing various schemes to see if any would have been profitable as a trading sys- tem in the past. after exhaustive research, he found that buying cattle, cocoa, and eurodollars on the first tuesday of months with an odd number of days and then liquidating these positions on the third thursday of the month would have yielded extremely profitable results during the preceding five years. inexpli- cably, this carefully researched pattern failed to hold once he began trading. another stroke of bad luck. the speculator tried many other approaches— elliott waves, Fibonacci numbers, Gann squares, the phases of the moon—but all proved equally unsuccessful. it was at this point that he heard of a famous guru who lived on a remote mountain in the himalayas and who answered the questions of all pilgrims who sought him out. the trader boarded a plane to Nepal, hired guides, and set out on a two-month trek. Finally, completely exhausted, he reached the famous guru. 28 A Complete Guide to the Futures mArket “oh, Wise one,” he said, “i am a frustrated man. For many years i have sought the key to successful trading, but everything i have tried has failed. What is the secret?” the guru paused for only a moment, and, staring at his visitor intently, answered, “B lash.” he said no more. “Blash?” the trader did not understand the answer. it filled his mind every waking moment, but he could not fathom its meaning. he repeated the story to many, until finally one listener interpreted the guru’s response. “it’s quite simple,” he said. “Buy low and sell high.” the guru’s message is apt to be disappointing to readers seeking the profound key to trading wis- dom. Blash does not satisfy our concept of an insight because it appears to be a matter of common sense. however, if, as V oltaire suggested, “Common sense is not so common,” neither is it obvious. For example, consider the following question: What are the trading implications of a market reaching new highs? the “common-sense” Blash theory would unambiguously indicate that subsequent trad- ing activity should be confined to the short side. V ery likely, a large percentage of speculators would be comfortable with this interpretation. Per- haps the appeal of the B lash approach is tied to the desire of most traders to demonstrate their brilliance. after all, any fool can buy the market after a long uptrend, but it takes genius to fade the trend and pick a top. in any case, few trading responses are as instinctive as the bias toward buying when prices are low and selling when prices are high. as a result, many speculators have a strong predilection toward favoring the short side when a market trades in new high ground. there is only one thing wrong with this approach: it doesn’t work. a plausible explanation is readily available. a market’s ability to reach and sustain new highs is usually evidence of powerful underlying forces that often push prices much higher. Common sense? Certainly. But note that the trading implications are exactly opposite to those of the “common-sense” B lash approach. the key point of all of this is that many of our common-sense instincts about market behavior are wrong. Chart analysis provides a means of acquiring common sense in trading—a goal far more elu- sive than it sounds. For example, if prior to beginning trading an individual exhaustively researched historical price charts to determine the consequences of a market’s reaching new highs, he would have a strong advantage in avoiding one of the common pitfalls that await the novice trader. similarly, other market truths can be gleaned through a careful study of historical price patterns. it must be acknowledged, however, that the usefulness of charts as an indicator of future price direction is a fiercely contested subject. rather than list the pros and cons of this argument, we found an episode of a financial markets tV series that was very popular in the 1980s and 1990s, which succinctly highlighted some of the key issues in this debate. the transcript from this program is presented: Moderator: hello, i’m louis Puneyser of Wallet Street Week. tonight we will depart from our normal interview format to provide a forum for a debate on the usefulness of commodity price charts. Can all those wiggly lines and patterns really predict the future? or is shake- speare’s description of life also appropriate to chart analysis: “. . . a tale told by an idiot, full of 29 Charts: ForeCasting tool or Folklore? sound and fury, signifying nothing”? our guests tonight are Faith N. trend, a renowned techni- cal analyst with the Wall street firm of Churnum & Burnum, and Phillip a. Coin, a professor at ivory tower University and the author of The Only Way to Beat the Market—Become a Broker. Mr. Coin, you belong to a group called the random Walkers. is that some sort of hiking club that decides its destinations by throwing darts at a trail map? (He smiles smugly into the camera.) ProFessor CoiN: W ell, no, Mr. Puneyser. the random Walkers are a group of economists who believe that market price movements are random. that is, one can no more devise a system to predict market prices than one can devise a system to predict the sequence of colors that will turn up on a roulette wheel. Both events are strictly a matter of chance. Prices have no memory, and what happened yesterday has nothing to do with what will happen tomorrow . in other words, charts can only tell you what has happened in the past; they are useless in predicting the future. Ms. treNd: Professor, you overlook a very important fact: daily prices are not drawn out of a bowl, but rather are the consequence of the collective activity of all market participants. human be- havior may not be as predictable as the motion of planets as governed by the laws of physics, but neither is it totally random. if this is not the case, your profession—economics—is doomed to the same fate as alchemy. (Professor Coin squirms uncomfortably in his seat upon this reference.) Charts reveal basic behavioral patterns. insofar as similar interactions between buyers and sellers will result in similar price patterns, the past can indeed be used as a guideline for the future. ProFessor CoiN: if past prices can be used to predict future prices, why have a myriad of academic studies concluded that tested technical rules failed to outperform a simple buy- and-hold policy once commissions were taken into account? M s. treNd: the rules used in those studies are generally oversimplified. the studies demonstrate that those particular rules don’t work. they don’t prove that a richer synthesis of price infor- mation, such as chart analysis, or a more complex technical system, cannot be successfully exploited for making trading decisions. P roFessor CoiN: Why then are there no studies that conclusively demonstrate the viability of chart analysis as a forecasting tool? Ms. treNd: your argument merely reflects the difficulties of quantifying chart theories rather than the deficiencies of the chartist approach. one man’s top formation is another man’s congestion area. an attempt to define anything but the simplest chart pattern mathematically will be unavoidably arbitrary. the problems become even more tangled when one realizes that at any given time, the chart picture may exhibit conflicting patterns. thus, in a sense, it is not really possible to test many chart theories objectively. ProFessor CoiN: that’s rather convenient for you, isn’t it? if these theories can’t be rigorously tested, of what use are they? how do you know that trading on charts will lead to better than a 50/50 success rate—that is, before commissions? 30 A Complete Guide to the Futures mArket Ms. treNd: if you mean that blindly following every chart signal will only make your broker rich, i don’t disagree. however, my point is that chart analysis is an art, not a science. a familiarity with basic chart theories is only the starting point. the true usefulness of charts depends on the individual trader’s ability to synthesize successfully his own experience with standard concepts. in the right hands, charts can be extremely valuable in anticipating ma- jor market trends. there are many successful traders who base their decisions primarily on charts. What would you attribute their success to—a lucky streak? ProFessor CoiN: yes. exactly that, a lucky streak. if there are enough traders, some of them will be winners, whether they reach their decisions by reading charts or throwing darts at the commodity price page. it’s not the method, just the laws of probability. even in a casino, some percentage of the people are winners. you wouldn’t say that their success is due to any insights or system. Ms. treNd: all that proves is that superior performance by some chartists could be due to chance. it doesn’t disprove the contention that the skillful chartist is onto something that gives him an edge. Moderator: i sense a lot of resistance here, and i think we could use some more support. have either of you brought any evidence along that would tend to substantiate your positions? ProFessor CoiN: yes! (At this point, Professor Coin pulls a thick manuscript from his briefcase and thrusts it into Mr. Puneyser’s hands. The moderator flips through the pages and shakes his head as he notices a profusion of funny little Greek letters.) M oderator: i had something a little less mathematical in mind. even educational tV is not ready for this. ProFessor CoiN: W ell, i also have this. (He pulls out a sheet of paper and hands it to Ms. T rend.) how would you interpret this chart, Ms. trend? (He unsuccessfully attempts to suppress a smirk.) Ms. treNd: i’ d say this looks like a chart based on a series of coin tosses. you know , heads one box up, tails one box down. ProFessor CoiN: (Whose smirk has turned into a very visible frown.) how did you know that? Ms. treNd: lucky guess. ProFessor CoiN: W ell, anyway, that doesn’t affect my argument. look at this chart. here’s a trend. and this here—isn’t that what you people call a head-and-shoulders formation? Moderator: speaking of head and shoulders, do either of you have an opinion on Procter & Gamble? ProFessor CoiN: (Continuing.) the same chart patterns you are so quick to point to on your price charts also show up in obviously random series. Ms. treNd: yes, but that line of reasoning can lead to some odd conclusions. For instance, would you agree that the fact that working economists tend to have advanced degrees is not a chance occurrence? 31Charts: ForeCastiNG tool or FolKlore? ProFessor CoiN: of course. Ms. treNd: W ell then, a random sample of the population is also likely to turn up some people with advanced degrees. do you then conclude that the fact that an economist has an advanced degree is a coincidence? ProFessor CoiN: i still don’t see any diff erence between price charts and my randomly gener- ated chart. Ms. treNd: y ou don’t? does this look like a randomly generated chart? (Ms. T rend holds up a July 1980 silver chart—see Figure 3.1 .) ProFessor CoiN: W ell, not exactly, but . . . Ms. treNd: ( On the attack .) or this. ( She holds up the December 1994 coff ee chart—see Figure 3.2 .) i could go on. Moderator: ( T o Professor Coin .) Ms. trend really seems to be percolating. are there any grounds for dismissing her examples? ProFessor CoiN: W ell, i admit those examples are pretty extreme, but they still don’t prove that past prices can predict future prices. Moderator: Before our time reaches limit-up, so to speak, i would like to rechart our course. i wonder what your opinions are about fundamental analysts? FIGURE /uni00A03.1 July 1980 silver Chart created using tradestation. ©tradestation t echnologies, inc. all rights reserved. 32a CoMPlete GUide to the FUtUres MarKet FIGURE /uni00A03.2 december 1994 Coff ee Chart created using tradestation. ©tradestation t echnologies, inc. all rights reserved. ProFessor CoiN: W ell, they’re better than chartists since they can at least explain price moves. But i’m afraid their attempts to forecast prices are equally futile. y ou see, at any given moment, the market discounts all known information, so there is no way they can project prices unless they can anticipate unforeseen future developments such as droughts or export embargoes. Ms. treNd: W ell, fi rst i would like to address the implication that chart analysts ignore funda- mentals. actually we believe that the price chart provides an unambiguous and immediate summary of the net impact of all fundamental and psychological factors. in contrast, accurate fundamental models, if they could be constructed at all, would be extremely complex. Fur- thermore, the fundamental data for the forecast period would have to be estimated, thereby making the price projections extremely vulnerable to error. Moderator: then you might say you both agree with the statement that fundamentalists end up with holes in their shoes. Ms. treNd: y es. ProFessor CoiN: y es. Moderator: W ell, on that upbeat note of agreement, we end tonight’s program. in a sense, the argument between the “random walkers” and the chartists can never be clearly resolved. it must be understood that it is impossible to prove randomness; all that one can prove is 33 Charts: ForeCasting tool or Folklore? that a given pattern does not exist. since there is no consensus as to the precise mathematical defini- tion of many chart patterns, the viability of these patterns as price indicators can be neither proven nor disproven. For example, if one wanted to test the contention that breakouts from trading ranges represent valid trade signals, the first requirement would be to formulate concise definitions of a trading range and a breakout. assume that the following definitions are adopted: (1) that the trading range is a price band that completely encloses all daily price changes during the past six-week period and that is no wider than 5 percent of the median price during that period, 1 and (2) that a breakout is a closing price above or below the six-week trading range. although the validity of breakouts as trading signals could be tested for these specific definitions, the definitions themselves will be challenged by many. some of the objections might be the following: 1. t he price band is too narrow . 2. t he price band is too wide. 3. t he six-week period is too long. 4. t he six-week period is too short. 5. No allowance is made for isolated days beyond the confines of the range—an event that most chart analysts would agree does not disturb the basic pattern. 6. t he direction of the trend prior to the trading range is not considered—a factor many chartists would view as a critical input in interpreting the reliability of a breakout. 7. t he breakout should be required to exceed the boundary of the trading range by a minimum amount (e.g., 1 percent of the price level) in order to be viewed as valid. 8. s everal closes above the trading range should be required to indicate a breakout. 9. a time lag should be used to test the validity of the breakout; for example, are prices still beyond the trading range one week after the initial penetration of the range? the preceding list represents only a partial itemization of the possible objections to our hypotheti- cal definitions of a trading range and breakout, and all of this for one of the most basic chart patterns. imagine the ambiguities and complications in specifically defining a pattern such as a confirmed head and shoulders. For their part, the chartists cannot win the argument, either. although chart analysis is based on gen- eral principles, its application depends on individual interpretation. the successful chart-oriented trader might not have any doubts about the viability of chart analysis, but the “random walk” theoreticians would dismiss his success as a consequence of the laws of probability, since even a totally random trade selection process would yield a percentage of winners. in short, the debate is not about to be concluded. it is also important to realize that even if conclusive tests were possible, the conflicting claims of the random walkers and the chartists need not necessarily be contradictory. one way of viewing the situation is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. thus, even if the price series as a whole appears random, it 1 the specification of maximum price width is deliberately intended to exclude periods of wide-swinging prices from being defined as trading ranges. 34 A Complete Guide to the Futures mArket is entirely possible that there are periods within the data that exhibit definite patterns. the goal of the chart analyst is to identify those periods (i.e., major trends). the time has come to admit my own biases. Personal experience has convinced me that charts are a valuable, if not essential, trading tool. however, such perceptions do not prove anything. the random walkers would argue that my conclusions could be based on selective memory—that is, a tendency to remember the successes of chart analysis and forget the failures—or just pure luck. and they are right. such explanations could indeed be correct. the bottom line is that each trader must evaluate chart analysis independently and draw his own conclusions. however, it should be strongly emphasized that charts are considered to be an extremely valuable trading tool by many successful traders, and therefore the new trader should be wary of rejecting this approach simply on the basis of intuitive skepticism. the following are some of the principal potential benefits of using charts. Note that a number of these uses remain valid even if one totally rejects the possibility that charts can be used to forecast prices. 1. Charts provide a concise price history—essential information for any trader. 2. Charts can provide the trader with a good sense of the market’s volatility—an important con- sideration in assessing risk. 3. Charts are a very useful tool to the fundamental analyst. long-term price charts enable the fun- damentalist to isolate quickly the periods of major price moves. By determining the fundamen- tal conditions or events that were peculiar to those periods, the fundamentalist can identify the key price-influencing factors. this information can then be used to construct a price behavior model. 4. Charts can be used as a timing tool, even by traders who formulate their trading decisions on the basis of other information (e.g., fundamentals). 5. Charts can be used as a money management tool by helping to define meaningful and realistic stop points. 6. Charts reflect market behavior that is subject to certain repetitive patterns. Given sufficient experience, some traders will uncover an innate ability to use charts successfully as a method of anticipating price moves. 7. a n understanding of chart concepts is probably an essential prerequisite for developing profit- able technical trading systems. 8. Cynics take notice: under specific circumstances, a contrarian approach to classical chart signals can lead to very profitable trading opportunities. the specifics of this approach are detailed in Chapter 15. in short, charts have something to offer everyone, from cynics to believers. the remaining chapters of Part ii review and evaluate the key concepts of classical chart theory, as well as addressing the all-important question of how charts can be used as an effective trading tool. 35 Chapter 4 Types of Charts You don’t need a weatherman to know which way the wind blows. —Bob Dylan ■ Bar Charts Bar charts are by far the most common type of price chart. In a daily bar chart, each day is represented by a vertical line that ranges from the daily low to the daily high. The day’s closing value is indicated by a horizontal protrusion to the right of the bar, while the opening price is represented by a protrusion to the left of the bar. Figure 4.1 is a daily bar chart of the July 2015 soybean contract. The daily (or intraday for short-term traders) bar chart is most useful for trading purposes, but bar charts for longer data periods provide extremely important perspective. These longer-period bar charts (e.g., weekly, monthly) are entirely analogous to the daily bar chart, with each vertical line representing the price range and final price level for the period. Figure 4.2 is a weekly bar chart for soybean futures. The segment within the rectangle corresponds to the period depicted in Figure  4.1. Figure 4.3 is a monthly bar chart for soybean futures, and the two rectangles enclose the periods depicted in Figures 4.2 and 4.1. The change in time perspective can go in the other direction as well; intraday charts can provide greater detail of the price action than daily charts. Figure 4.4 is a 30-minute chart of the July soybean futures that covers the same time period as the last eight daily bars in Figure 4.1. Used in combination, the monthly, weekly, daily, and intraday bar charts provide a telephoto-type effect. The monthly and weekly charts would be used to provide a broad market perspective and to formulate a technical opinion regarding the potential long-term trend. The daily chart—and, for 36A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  4.1 Daily Bar Chart: July 2015 Soybeans FIGURE  4.2 W eekly Bar Chart: Soybeans (Continuous Futures) Note: Continuous futures will be defi ned in the next section. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 37TYPES OF CHARTS FIGURE  4.3 Monthly Bar Chart: Soybeans (Continuous Futures) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  4.4 30-Minute Bar Chart: July 2015 Soybeans Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 38A COMPLETE GUIDE TO THE FUTURES MARKET shorter-term traders, intraday charts—would then be employed to determine the timing of trades. If the long-term technical picture is suffi ciently decisive, by the time the trader gets to the daily or intra- day charts, he may already have a strong market bias. For example, if a trader interprets the monthly and weekly charts as suggesting the likelihood that the market has witnessed a major long-term top, he will only monitor the daily and intraday charts for sell signals. The diff erence in perspective between short-term and long-term charts can be striking. For exam- ple, in the daily bar chart shown in Figure 4.5 , the technical picture for coff ee seemed quite bearish, with prices in late October 2013 having just pushed below a period of sideways price action while in the midst of a longer-term downtrend that showed no evidence of abating. The weekly futures chart (Figure 4.6 ), however, provided a strikingly diff erent perspective. Although this multiyear chart also showed the market in an unbroken downtrend, it revealed that prices had fallen to the vicinity of the 2008 and 2009 lows—a signifi cant price level that had supported the market in the past, and which, in late 2013, implied the potential for a major trend reversal in that vicinity. Indeed, as the inset chart for the December 2014 coff ee contract shows, prices subsequently embarked on a huge rally from November 2013 into early October 2014. Although in late October 2013 it may not have been apparent which of these confl icting interpretations would prevail, the basic point is that longer- term charts may suggest very diff erent interpretations of price patterns than those indicated by daily charts. Hence, both types of charts should be examined. FIGURE  4.5 Daily Bar Chart Perspective: December 2013 Coff ee Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 39TYPES OF CHARTS FIGURE  4.6 W eekly Bar Chart Perspective: Coff ee Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. ■ Linked Contract Series: Nearest Futures versus Continuous Futures The time period covered by the typical weekly or monthly bar chart requires the use of a series of contracts. Normally, these contracts are combined using the nearest futures approach: a contract is plotted until its expiration and then the subsequent contract is plotted until its expiration, and so on. Traders should be aware that a nearest futures chart may refl ect signifi cant distortions due to the price gaps between the expiring month and the subsequent contract. Figure 4.7 provides two clear examples of this type of distortion. The top chart is a live cattle weekly nearest futures chart; the bottom chart is a live cattle weekly continuous futures chart, which will be defi ned momentarily. The nearest futures chart implies a large 7.175-cent (6 percent) one- week gain in the price of cattle from the August 31 close to the September 7, 2012 close. However, this price jump never really took place because the price gap represented nothing more than the expi- ration of the lower-priced August 2012 cattle contract and the switch to the higher-priced October 2012 cattle contract. In contrast, the continuous futures chart, which, as will be explained shortly, refl ects actual price movements, showed that price had rallied only 0.45 cents from August 31 to September 7, 2012. Almost exactly a year later the same relationship between the prices in diff erent contract months produced an even more noteworthy discrepancy: While the nearest futures chart showed a 3.15-cent gain from August 30 to September 6, 2013, the continuous futures chart shows cattle prices actually declined 1.125 cents between these dates. 40A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  4.7 Distortion in Nearest Futures Chart: Cattle W eekly Nearest Futures (top) and Cattle W eekly Continuous Futures (bottom) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. The fact that a nearest futures chart is vulnerable to great distortion, in the sense that price moves depicted in the chart may contrast dramatically with the results realized by an actual trader (as was the case in the cattle example), makes it necessary to consider an alternate linked-contract representation that does not share this defect. The continuous futures chart provides such an alternative approach. Continuous futures is a series that links together successive contracts in such a way that price gaps are eliminated at rollover points. Although continuous futures will precisely refl ect price swings, past continuous levels will not match actual historical levels. (In contrast, nearest futures will accurately refl ect actual historical levels, but not price swings.) The appropriate series depends on the intended purpose. Nearest futures should be used to indicate the actual price levels at which a market traded in the past. However, continuous futures should be used to illustrate the results that would have been realized by a trader. Continuous futures will be discussed in greater detail in Chapters 5 and 18. ■ Close-Only (“Line”) Charts As the name implies, close-only charts ignore high and low price information and refl ect only closing values. Some price series can be depicted only in close-only chart formats because intraday data are not readily available. Two examples are cash price series (Figure 4.8 ) and spreads (Figure 4.9 ), which represent the price diff erence between two contracts, in this case the July 2015 and November 2015 soybean futures prices. 41TYPES OF CHARTS FIGURE  4.8 Cash Price Chart: Crude Oil FIGURE  4.9 Spread Chart: July–November 2015 Soybeans Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Some chart traders may prefer close-only charts even when high/low/close data are available because they feel a clearer price picture can be obtained by using only the close. In their view , the inclusion of high/low data only serves to obfuscate the price chart. There is much to be said 42A COMPLETE GUIDE TO THE FUTURES MARKET for the emphasis on the closing value as the embodiment of the day’s essential price information. Nevertheless, many important chart patterns depend on the availability of high/low data, and one should think twice before ignoring this information. ■ Point-and-Figure Charts The essential characteristic of the point-and-fi gure chart is that it views all trading as a single continuous stream and hence ignores time. A point-and-fi gure chart is illustrated in Figure 4.10 . As can be seen, a point-and-fi gure chart consists of a series of columns of X ’s and O ’s. Each X rep- resents a price move of a given magnitude called the box size. As long as prices continue to rise, X ’s are added to a column for each increment equal to the box size. However, if prices decline by an amount equal to or greater than the reversal size (usually quoted as a multiple of the box size), a new column of O ’s is initiated and plotted in descending fashion. The number of O ’s will depend on the magnitude of the reversal, but by defi nition must at least equal the reversal size. By conven- tion, the fi rst O in a column is always plotted one box below the last X in the preceding column. An analogous description would apply to price declines and upside reversals. The choice of box and reversal size is arbitrary. FIGURE  4.10 Point-and-Figure Chart: December 2014 Gold Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 43TYPES OF CHARTS Figure 4.10 is a point-and-fi gure chart of December 2014 gold futures with a box size of $3 and a reversal size of three boxes, or $9. In other words, as long as a price decline of $9 or more does not occur, X ’s continue to be added in a single column. When a price decline of $9 or more occurs, a new column of O ’s is begun, with the fi rst O placed one box below the last X . As stated previously, the point-and-fi gure chart does not refl ect time. One column may represent one day or two months. For example, Figure 4.11 is a bar chart corresponding to the point-and-fi gure chart in Figure 4.10 . The period captured in the rectangle corresponds to the similarly highlighted column in the point-and-fi gure chart. Note that this seven-day period occupies only one column on the point-and-fi gure chart. ■ Candlestick Charts Candlestick charts add dimension and color to the simple bar chart. The segment of the bar that represents the range between the open and close is represented by a two-dimensional “real body,” while the extensions beyond this range to the high and low are shown as lines (called “shadows”). A day on which the open and close are near opposite extremes of the daily range will have a large real body, whereas a day on which there is little net change between the open and close will have a small real body. The color of the real body indicates whether the close was higher than the open (white— Figure 4.12 ) or lower than the open (black—Figure 4.13 ). Figure 4.14 shows a daily candlestick chart corresponding to the price action displayed in Figures 4.10 and 4.11 . FIGURE  4.11 Bar Chart Corresponding to Point-and-Figure Chart in Figure 4.10 : December 2014 Gold Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 44A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  4.12 Candlestick Chart: White Real Body High Close Open Low FIGURE  4.13 Candlestick Chart: Black Real Body High Open Close Low FIGURE  4.14 Candlestick Chart Corresponding to Figures 4.10 and 4.11 : December 2014 Gold Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 45 Chapter 5 ■ The Necessity of Linked-Contract Charts Many of the chart analysis patterns and techniques detailed in Chapters 6 through 9 require long- term charts—often charts of multiyear duration. This is particularly true for the identification of top and bottom formations, as well as the determination of support and resistance levels. A major problem facing the chart analyst in the futures markets is that most futures contracts have relatively limited life spans and even shorter periods in which these contracts have significant trading activity. For many futures contracts (e.g., currencies, stock indexes) trading activity is almost totally concentrated in the nearest one or two contract months. For example, in Figure 5.1, there were only about two months of liquid data available for the March 2016 Russell 2000 Index Mini futures contract when it became the most liquid contract in this market as the December 2015 con - tract expiration approached. This market is not particularly unusual in this respect. In many futures markets, almost all trading is concentrated in the nearest contract, which will have only a few months (or weeks) of liquid trading history when the prior contract approaches expiration. Linking Contracts for Long- T erm Chart Analysis: Nearest versus Continuous Futures 46A COMPLETE GUIDE TO THE FUTURES MARKET The limited price data available for many futures contracts—even those that are the most actively traded contracts in their respective markets—makes it virtually impossible to apply most chart analy- sis techniques to individual contract charts. Even in those markets in which the individual contracts have a year or more of liquid data, part of a thorough chart study would still encompass analyzing multiyear weekly and monthly charts. Thus, the application of chart analysis unavoidably requires linking successive futures contracts into a single chart. In markets with very limited individual con- tract data, such linked charts will be a necessity in order to perform any meaningful chart analysis. In other markets, linked charts will still be required for analyzing multiyear chart patterns. ■ Methods of Creating Linked-Contract Charts Nearest Futures The most common approach for creating linked-contract charts is typically termed nearest futures. This type of price series is constructed by taking each individual contract series until its expiration and then continuing with the next contract until its expiration, and so on. Although, at surface glance, this approach appears to be a reasonable method for constructing linked-contract charts, the problem with a nearest futures chart is that there are price gaps between expiring and new contracts—and quite frequently, these gaps can be very substantial. For exam- ple, assume the September coff ee contract expires at 132.50 cents/lb and the next nearest con- tract (December) closes at 138.50 cents/lb on the same day. Further assume that on the next day FIGURE  5.1 March 2016 Russell 2000 Mini Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 47 Linking ContraCts for Long-term Chart anaLysis December coffee falls 5 cents/lb to 133.50—a 3.6 percent drop. A nearest futures price series will show the following closing levels on these two successive days: 132.50 cents, 133.50 cents. In other words, the nearest futures contract would show a one-cent (0.75 percent) gain on a day on which longs would actually have experienced a huge loss. This example is by no means artificial. Such distortions— and indeed more extreme ones—are quite common at contract rollovers in nearest futures charts. The vulnerability of nearest futures charts to distortions at contract rollover points makes it desir- able to derive alternative methods of constructing linked-contract price charts. One such approach is detailed in the next section. Continuous (Spread-adjusted) price Series The spread-adjusted price series known as “continuous futures” is constructed by adding the cumulative dif- ference between the old and new contracts at rollover points to the new contract series. 1 An example should help clarify this method. Assume we are constructing a spread-adjusted continuous price series for gold using the June and December contracts. 2 If the price series begins at the start of the calendar year, initially the values in the series will be identical to the prices of the June contract expiring in that year. Assume that on the rollover date (which need not necessarily be the last trading day) June gold closes at $1,200 and December gold closes at $1,205. In this case, all subsequent prices based on the December contract would be adjusted downward by $5—the difference between the December and June contracts on the rollover date. Assume that at the next rollover date December gold is trading at $1,350 and the subsequent June contract is trading at $1,354. The December contract price of $1,350 implies that the spread-adjusted continuous price is $1,345. Thus, on this second rollover date, the June contract is trading $9 above the adjusted series. Consequently, all subsequent prices based on the second June contract would be adjusted downward by $9. This procedure would continue, with the adjustment for each contract dependent on the cumulative total of the present and prior transition point price differences. The resulting price series would be free of the distortions due to spread differences that exist at the rollover points between contracts. The construction of a continuous futures series can be thought of as the mathematical equivalent of taking a nearest futures chart, cutting out each individual contract series contained in the chart, and pasting the ends together (assuming a continuous series employing all contracts and using the same rollover dates as the nearest futures chart). Typically, as a last step, it is convenient to shift the scale of the entire series by the cumulative adjustment factor, a step that will set the current price of the series equal to the price of the current contract without changing the shape of the series. The construction of a continuous futures chart is discussed in greater detail in Chapter 18. 1 T o avoid confusion, readers should note that some data services use the term continuous futures to refer to linking together contracts of the same month (e.g., linking from March 2015 corn when it expires to March 2016 corn, and so on). Such charts are really only a variation of nearest futures charts—one in which only a single contract month is used—and will be as prone to wide price gaps at rollovers as nearest futures charts, if not more so. These types of charts have absolutely nothing in common with the spread-adjusted continuous futures series described in this section—that is, nothing but the name. It is unfortunate that some data services have decided to use this same term to describe an entirely different price series than the original meaning described here. 2 The choice of a combination of contracts is arbitrary. One can use any combination of actively traded months in the given market. 48 A Complete Guide to the Futures mArket Comparing the Series It is important to understand that a linked futures price series can only accurately reflect either price levels, as does nearest futures, or price moves, as does continuous futures, but not both—much as a coin can land on either heads or tails, but not both. The adjustment process used to construct continu- ous series means that past prices in a continuous series will not match the actual historical prices that prevailed at the time. However, a continuous series will accurately reflect the actual price movements of the market and will exactly parallel the equity fluctuations experienced by a trader who is continu- ally long (rolling over positions on the same rollover dates used to construct the continuous series), whereas a nearest futures price series can be extremely misleading in these respects. ■ Nearest versus Continuous Futures in Chart Analysis Given the significant differences between nearest and continuous futures price series, the obvious question in the reader's mind is probably: Which series—nearest futures or continuous futures— would be more appropriate for chart analysis? T o some extent, this is like asking which factor a consumer should consider before purchasing a new car: price or quality. The obvious answer is both—each factor provides important information about a characteristic that is not measured by the other. In terms of price series, considering nearest futures versus continuous futures, each series pro- vides information that the other doesn't. Specifically, a nearest futures price series provides accurate information about past price levels, but not price swings, whereas the exact reverse statement applies to a continuous futures series. Consider, for example, Figure 5.2. What catastrophic event caused the instantaneous 165- cent (24 percent) collapse in the nearest futures chart for corn from July 12 to July 15, 2013? Answer: absolutely nothing. This “phantom” price move reflected nothing more than a transition from the old crop July contract to the new crop December contract. Figure 5.3, which depicts the continuous futures price for the same market (and by definition eliminates price gaps at con - tract rollovers), shows that no such price move existed—corn was actually little changed from July 12 to July 15. Clearly, the susceptibility of nearest futures charts to distortions caused by wide gaps at rollovers can make it difficult to use nearest futures for chart analysis that focuses on price swings. On the other hand, the continuous futures chart achieves accuracy in depicting price swings at the sacrifice of accuracy in reflecting price levels. In order to accurately show the magnitude of past price swings, historical continuous futures prices can end up being very far removed from the actual historical price levels. In fact, it is not even unusual for historical continuous futures prices to be negative (see Figure 5.4). Obviously, such “impossible” historical prices can have no relevance as guidelines to prospective support and resistance levels. The fact that each type of price chart—nearest and continuous—has certain significant intrin- sic weaknesses argues for combining both types of charts in a more complete analysis. Often these two types of charts will provide entirely different price pictures. For example, consider the nearest futures chart for lean hogs depicted in Figure 5.5. Looking at this chart, it would be tempting to 49LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS FIGURE  5.2 Corn Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  5.3 Corn Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 50A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  5.4 RBOB Gasoline Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE   5.5 Lean Hog Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 51LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS conclude that hogs were experiencing a period of severe price dislocation and volatility in 2013, peaking sometime in early July. Now look at Figure 5.6 , which shows the continuous version of the same market. This chart shows that hog prices were in a consistent uptrend that began in April and peaked at the end of October. It is no exaggeration to say that, without the benefi t of the chart labels, it would be virtually impossible to recognize that Figures 5.5 and 5.6 depict the same market. ■ Conclusion In summary, the brevity of liquid trading periods for futures contracts in many markets makes the use of linked-contract charts essential. Continuous futures charts, which remove the distortions caused by price gaps at contract rollovers, are probably the most meaningful type of longer-term chart and, on balance, are far preferable to the more conventional nearest futures chart—although the latter can still be a useful supplement in identifying long-term support and resistance levels. Continuous futures are even more critical for testing trading systems—a topic that will be discussed in Chapter 18 . Figures 5.7 through 5.16 provide comparisons between long-term nearest and continuous charts for various futures mar- kets. Note how strikingly diff erent nearest and continuous futures charts for the same market can be. Readers are reminded that continuous futures charts generated in the future will show diff erent price scales than those shown in the following pages (although the price moves will remain the same), since it is assumed that the scales will be adjusted to match the prevailing current contract. FIGURE  5.6 Lean Hog Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 52A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE 5.7 10- Y ear T -Note Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  5.8 10- Y ear T -Note Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 53LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS FIGURE 5.9 Soybean Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 5.10 Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 54A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE 5.11 Soybean Meal Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 5.12 Soybean Meal Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 55LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS 30 28 26 24 22 20 18 16 14 12 Feb VIX nearest futures (VX), daily MarNov Oct 2013 year 2014 year 2015 year 14 15Apr MayJ un JulA ug Sep Oct No vF eb 16 FebMar Apr MayJ un JulA ug Sep Oct Nov FIGURE 5.13 VIX Nearest Futures Chart created using TD Ameritrade’s thinkorswim. FIGURE 5.14 VIX Continuous Futures Chart created using TD Ameritrade’s thinkorswim. 30 32 34 36 38 28 26 24 22 20 18 16 14 12 Feb VIX continuous futures (VX), daily MarNov Oct 2013 year 2014 year 2015 year 14 15Apr MayJ un JulA ug Sep Oct No vF eb 16 FebMar Apr MayJ un JulA ug Sep Oct Nov 56A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE 5.15 Live Cattle Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 5.16 Live Cattle Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 57 Chapter 6 The trend is your friend except at the end when it bends. —Ed Seykota ■ Defining Trends by Highs and Lows One standard definition of an uptrend is a succession of higher highs and higher lows. For example, during the May 2014–March 2015 period in Figure 6.1, each relative high (RH) is higher than the preceding high, and each relative low (RL) is higher than the preceding low . In essence, an uptrend can be considered intact until a previous reaction low point is broken. A violation of this condition serves as a warning signal that the trend may be over. For example, in Figure 6.1, the late April penetration of the early April relative low confirmed the end of the nearly yearlong rally, after which the market entered an extended trading range (see weekly chart inset). Figure 6.2 provides an intraday example of an uptrend defined by successively higher highs and higher lows. It should be emphasized, however, that the disruption of the pattern of higher highs and higher lows (or lower highs and lower lows) should be viewed as a clue, not a conclusive indicator, of a possible long-term trend reversal. In similar fashion, a downtrend can be defined as a succession of lower lows and lower highs (see Figure 6.3). A downtrend can be considered intact until a previous reaction high is exceeded. Uptrends and downtrends are also often defined in terms of trend lines. An uptrend line is a line that connects a series of higher lows (see Figures 6.4 through 6.6); a downtrend line is a line that con- nects a series of lower highs (see Figure 6.7). Trend lines can sometimes extend for many years. For example, Figure 6.8 is a weekly chart with a trend line reflecting a multiyear uptrend in the E-mini Nasdaq 100 futures that included the daily timeframe uptrend from Figure 6.4. Figure 6.9 illustrates a trend line defining a 33-year uptrend in 10-year U.S. T -note futures. Trends 58A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  6.1 Uptrend as Succession of Higher Highs and Higher Lows: Dollar Index Continuous Futures Note: RH = relative high; RL = relative low . Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.2 Uptrend as Succession of Higher Highs and Higher Lows: December 2014 10- Y ear T -Note Note: RH = relative high; RL = relative low . Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 59TRENDS FIGURE  6.3 Downtrend as Succession of Lower Highs and Lower Lows: Euro Continuous Futures Note: RH = relative high; RL = relative low . Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.4 Uptrend Line: E-Mini Nasdaq 100 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 60A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  6.5 Uptrend Line: Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 6.6 Uptrend Line: June 2016 E-Mini Dow Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 61TRENDS FIGURE 6.7 Downtrend Line: WTI Crude Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 6.8 Uptrend Line: E-Mini Nasdaq 100 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 62A COMPLETE GUIDE TO THE FUTURES MARKET It is not uncommon for reactions against a major trend to begin near a line parallel to the trend line. Sets of parallel lines that enclose a trend are called trend channels. Figure 6.10 shows an uptrend channel on a daily chart, while Figure 6.11 shows a downtrend channel on a weekly chart. FIGURE  6.9 Uptrend Line: 10- Y ear U.S. T -Note Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.10 Uptrend Channel: Soymeal Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 63TRENDS The following rules are usually applied to trend lines and channels: 1. Declines approaching an uptrend line and rallies approaching a downtrend line are often good opportunities to initiate positions in the direction of the major trend. 2. The penetration of an uptrend line (particularly on a closing basis) is a sell signal; the penetra- tion of a downtrend line is a buy signal. Normally, a minimum percentage price move or a minimum number of closes beyond the trend line is required to confi rm a penetration. 3. The lower end of a downtrend channel and the upper end of an uptrend channel represent potential profi t-taking zones for short-term traders. Trend lines and channels are useful, but their importance is often overstated. It is easy to overesti- mate the reliability of trend lines when they are drawn with the benefi t of hindsight. A consideration that is frequently overlooked is that trend lines often need to be redrawn as a bull or bear market is extended. Thus, although the penetration of a trend line will sometimes off er an early warning signal of a trend reversal, it is also common that such a development will merely require a redrawing of the trend line. For example, Figure 6.12 shows an uptrend line connecting the November and December 2012 lows in the Russell 2000 Mini futures. Prices remained above this line until February 2013, when prices closed below it, signaling an end to this move. Figure 6.13 extends Figure 6.12 by two months and shows that the February penetration of the original (dashed) trend line was a pullback that preceded a rally to a higher high. Prices remained above the revised (solid) trend line connecting the November and February lows until early April, at which point the market posted a more signifi - cant correction. Figure 6.14 , however, shows the larger uptrend extended for almost another year, prompting three additional revisions to the uptrend line, each of which was necessitated by a closing penetration of the preceding trend line. FIGURE  6.11 Downtrend Channel: Soybean Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 64A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  6.12 Uptrend Line: Russell 2000 Mini Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.13 Uptrend Line Redefi ned: Russell 2000 Mini Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 65TRENDS Figure 6.15 provides a similar example for a downtrend. The initial downtrend line connecting the December 2014 and March 2015 highs (gray dotted line) was penetrated to the upside in June, but after a few weeks of sideways price action, the market resumed its decline. The revised trend line (thicker dashed line) connecting the December 2014 and June 2015 highs extended until November 2015, when prices again pushed higher—enough to require a third revision to the downtrend line (solid line), but not enough to end the longer-term downtrend. FIGURE  6.14 Uptrend Line Redefi ned: Russell 2000 Mini Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.15 Downtrend Line Redefi ned: Oat Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 66 A Complete Guide to the Futures mArket The preceding examples are meant to drive home the point that the penetration of trend lines is more the rule than the exception. The simple fact is that trend lines tend to be penetrated, sometimes repeatedly, during their evolution, which is equivalent to saying that trend lines are frequently redefined as they extend. The important implications of this observation are that trend lines work much better in hindsight than in real time and that penetrations of trend lines often prove to be false signals. ■ TD Lines In his book The New Science of T echnical Analysis,1 Thomas DeMark accurately notes that the drawing of trend lines is a highly arbitrary process. Presented with the same chart, different people will draw different trend lines. In fact, presented with the same chart at different times, even the same person might well draw the trend line differently. It is easy to see the reason for this lack of precision. A trend line is typically intended to connect several relative highs or relative lows. If there are only two such points, the trend line can be drawn precisely. If, however, the trend line is intended to connect three or more points—as is frequently the case—a precise line will exist in only the rare circumstance that the relationship between all the points is exactly linear. In most cases, the trend line that is drawn will exactly touch at most one or two of the relative highs (or lows), while bisecting or missing the other such points. The trend line that provides the best fit is truly in the eye of the beholder. DeMark recognizes that in order for a trend line to be defined precisely and unambiguously, it must be based on exactly two points. DeMark also notes that, contrary to convention, trend lines should be drawn from right to left because “recent price activity is more significant than historical movement.” These concepts underlie his approach of drawing trend lines. DeMark’s TD methodology for defining trend lines is explained by the following definitions: 2 Relative high. A daily high that is higher than the high on the N prior and N succeeding days, where N is a parameter value that must be defined. For example, if N = 5, the relative high is defined as a high that is higher than any high in the prior five days and succeeding five days. (An analogous definition could be applied for data expressed in any time interval. For example, in a 60-minute bar chart, the relative high would be a high that is higher than the high on the prior or succeeding N 60-minute bars.) Relative low. A daily low that is lower than the low on the N prior and N succeeding days. TD downtrend line. The prevailing downtrend line is defined as the line connecting the most recent relative high and the most recent preceding relative high that is also higher than the most recent relative high. The latter condition is essential to assure the trend line connecting the two relative highs slopes down. Figure 6.16 illustrates the prevailing TD downtrend line, assuming an N = 5 parameter value is used to define relative highs. 1 Thomas DeMark, The New Science of T echnical Analysis (New Y ork, NY: John Wiley & Sons, 1994). 2 The following definitions and terminology differ from those used by DeMark, but the implied method of identify- ing trend lines is equivalent. I simply find the following approach clearer and more succinct than DeMark’s presen- tation of the same concept. 67TRENDS TD uptrend line . The prevailing uptrend line is defi ned as the line connecting the most recent relative low and the most recent preceding relative low that is also lower than the most recent relative low . Figure 6.17 illustrates the prevailing TD uptrend line, assuming an N = 8 parameter value is used to defi ne relative lows. By basing trend line defi nitions on the most recent relative highs and relative lows, trend lines will be continually redefi ned as new relative highs and relative lows are defi ned. For example, Figure 6.18 FIGURE  6.16 TD Downtrend Line ( N = 5): E-Mini Nasdaq 100 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.17 TD Uptrend Line ( N = 8): Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 68A COMPLETE GUIDE TO THE FUTURES MARKET shows the succession of TD uptrend lines that would be implied as new relative lows are defi ned ( N = 10) until a trend reversal signal is received. In this chart it is assumed that a trend reversal signal is defi ned as three consecutive closes below the prevailing uptrend line. In similar fashion, Figure 6.19 FIGURE  6.18 Succession of TD Uptrend Lines ( N = 10): U.S. Dollar Index Continuous Futures Note: Lines 1–3 are successive TD uptrend lines that use N = 10 to defi ne relative lows (RL). Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.19 Succession of TD Downtrend Lines ( N = 10): June 2015 Euro Futures Note: Lines 1 and 2 are successive TD downtrend lines that use N = 10 to defi ne relative highs (RH). Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 69TRENDS FIGURE  6.20 Succession of TD Uptrend Lines ( N = 10): August 2015 Gasoline Note: Lines 1–3 are successive TD uptrend lines, using N = 10 to defi ne relative lows (RL). Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. illustrates TD downtrend lines that would be implied as new relative highs are defi ned ( N = 10) until a trend reversal signal is received (again, based on three consecutive closes beyond the trend line). Diff erent values for N will yield very diff erent trend lines. For example, Figures 6.20 through 6.22 contrast the TD uptrend lines implied by three diff erent values of N for the same chart. The lower the value of N , the more frequently the trend line is redefi ned and the more sensitive the line is to penetration. For example, contrast the 21 trend lines generated by the N = 2 defi nition in Figure 6.22 , versus the mere three trend lines that result when an N = 10 defi nition is used in Figure 6.20 . In analogous fashion, Figures 6.23 through 6.25 contrast the TD downtrend lines implied by three diff erent values of N for the same chart. Similar to Figures 6.20 through 6.22 , these charts also show that when the value of N is low , the prevailing downtrend line is redefi ned frequently and tends to be very sensitive. In Figure 6.23 , which shows TD lines for N = 10, there are only three downtrend lines. For N = 5 the number of trend lines increases to fi ve during the same period (Figure 6.24 ). Finally, for N = 2, 18 diff erent trend lines are generated (Figure 6.25 ). As these illustrations make clear, the choice of a value for N will make a tremendous diff erence in the trend lines that are gener- ated and the resulting trading implications. DeMark’s basic defi nition of trend lines is equivalent to the aforementioned defi nitions with N = 1. Although he acknowledges that trend lines can be defi ned using higher values of N —“TD lines of higher magnitude,” in his terminology—his stated preference is for trend lines drawn using the basic defi nition. Personally, my own preference is quite the opposite. Although it is a truism that 70A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE 6.21 Succession of TD Uptrend Lines (N = 5): August 2015 Gasoline Note: Lines 1–6 are successive TD uptrend lines, using N = 5 to defi ne relative lows (RL). Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.22 Succession of TD Uptrend Lines ( N = 2): August 2015 Gasoline Note: Lines 1–21 are successive TD uptrend lines, using N = 2 to defi ne relative lows (RL). Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 71TRENDS FIGURE  6.23 Succession of TD Downtrend Lines ( N = 10): Gold Continuous Futures Note: Lines 1–3 are successive TD downtrend lines, using N = 10 to defi ne relative highs (RH). Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 6.24 Succession of TD Downtrend Lines (N = 5): Gold Continuous Futures Note: Lines 1–5 are successive TD downtrend lines, using N = 5 to defi ne relative highs (RH) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 72A COMPLETE GUIDE TO THE FUTURES MARKET using an N = 1 defi nition for trend lines will yield earlier signals for valid trend line breakouts, the critical trade-off is that such an approach will tend to provide very tight trend lines that are prone to far more false breakout signals. As a general principle, I think it is far more critical to avoid bad signals than to get the jump on good signals; hence, I strongly favor using higher values of N (e.g., N = 3 to N = 12) to defi ne trend lines. There is, however, no “right” or “wrong” choice for a value for N ; it is strictly a matter of subjective preference. The reader is encouraged to experiment drawing trend lines using diff erent values of N . Each trader will feel comfortable with certain values of N and uncomfortable with others. Generally speaking, short-term traders will gravitate to low values of N and long-term traders to higher values. As a fi ne-tuning point, which becomes particularly important if trend lines are defi ned using N = 1, it is preferable to defi ne relative highs and relative lows based on true highs and true lows rather than nominal highs and lows. These terms are defi ned as: T rue high . The high or previous close, whichever is higher. T rue low. The low or previous close, whichever is lower. For most days, the true high will be identical to the high and the true low will be identical to the low . The diff erences will occur on downside gap days (days on which the entire trading range is below the previous day’s close) and upside gap days (days on which the entire trading range is above the previous day’s close). Although such gaps are much rarer (and, generally, smaller) than in the days FIGURE  6.25 Succession of TD Downtrend Lines ( N = 2): Gold Continuous Futures Note: Lines 1–18 are successive TD downtrend lines, using N = 2 to defi ne relative highs (RH). Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 73TRENDSbefore nearly 24-hour electronic trading, they do occasionally still occur, and can thus impact the identifi cation of relative highs and lows. The use of true highs and true lows yields relative highs and relative lows that are more in line with our intuitive concept of what these points should represent. For example, in Figure 6.26 , using an N = 3 defi nition, bar A would be identifi ed as a relative low based on the nominal low . This point is identifi ed as a relative low , however, only because of the upside gap that occurred three days earlier; it hardly fi ts the intuitive concept of a relative low . In this case, using the true low instead of the nominal low would eliminate the low of Bar A as a relative low . ■ Internal Trend Lines Conventional trend lines are typically drawn to encompass extreme highs and lows. An argument can be made, however, that extreme highs and lows are aberrations resulting from emotional excesses in the market, and that, as such, these points may be unrepresentative of the dominant trend in the market. An internal trend line does away with the implicit requirement of having to draw trend lines based on extreme price excursions. An internal trend line is a trend line drawn so as to best approxi- mate the majority of relative highs or relative lows without any special consideration being given to extreme points. In a rough sense, an internal trend line can be thought of as an approximate best-fi t line of relative highs and relative lows. Figures 6.27 through 6.34 provide a wide range of examples of internal uptrend and downtrend lines. For comparison, most of these charts also depict conventional trend lines, which are shown as dashed lines. (T o avoid cluttering the charts, only one or two of the conventional trend lines that would have been implied in the course of a price move are shown.) FIGURE  6.26 Nominal Low versus True Low: Lean Hog Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 74A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  6.27 Internal Trend Line versus Conventional Trend Line: Euro Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 6.28 Internal Trend Line versus Conventional Trend Line: E-Mini S&P 500 Index Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 75TRENDS FIGURE 6.29 Alternate Internal Trend Lines: Coff ee Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 6.30 Internal Trend Line: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 76A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE 6.31 Internal Trend Line versus Conventional Trend Line: Wheat Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE 6.32 Internal Trend Line versus Conventional Trend Line: Live Cattle Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 77TRENDS FIGURE 6.33 Internal Trend Line versus Conventional Trend Lines: Platinum Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.34 Internal Trend Line versus Conventional Trend Lines: Soybean Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 78 A Complete Guide to the Futures mArket One shortcoming of internal trend lines is that they are unavoidably arbitrary, perhaps even more so than conventional trend lines, which at least are anchored by the extreme highs or lows. In fact, there is often more than one plausible internal trend line that can be drawn on a chart—see, for example, Figure 6.29. Nevertheless, in my experience, internal trend lines are far more useful than conventional trend lines in defining potential support and resistance areas. An examination of Figures 6.27 through 6.34 will reveal the internal trend lines depicted in these charts generally provided a better indication of where the market would hold in declines and stall in advances than did the conventional trend lines. Of course, this sample of illustrations does not prove the superiority of internal trend lines over conventional trend lines, since it is always possible to find charts that appear to validate virtually any contention, and such a proof is certainly not intended or implied. Rather, the comparisons in these charts are intended only to give the reader a sense of how internal trend lines might provide a better indication of potential support and resistance areas. The fact that I personally find internal trend lines far more useful than conventional trend lines proves nothing—the anecdotal observation of a single individual hardly represents scientific proof. In fact, given the subjective nature of internal trend lines, a scientific test of their validity would be very difficult to construct. My point, however, is that internal trend lines are a concept that should certainly be explored by the serious chart analyst. I am sure that by doing so many readers will also find internal trend lines more effective than conventional trend lines, or at least a worthwhile addition to the chart analyst’s tool kit. ■ Moving Averages Moving averages provide a very simple means of smoothing a price series and making any trends more discernible. A simple moving average is defined as the average close of the past N days, ending with the current day. For example, a 40-day moving average would be equal to the average of the past 40 closes, including the current day. (Typically, moving averages are calculated using daily closes. How- ever, moving averages can also be based on opens, highs, lows, or an average of the daily open, high, low , and close. Also, moving averages can be calculated for time intervals of data other than daily, in which case the “close” would refer to the final price quote in the given time interval.) The term moving average refers to the fact that the set of numbers being averaged is continuously moving through time. Figure 6.35 illustrates a 40-day moving average superimposed on a price series. Note that the moving average clearly reflects the trend in the price series and smooths the meaningless fluctuations in the data. In choppy markets moving averages will tend to oscillate in a general sideways pattern, as illustrated in Figure 6.36. One very simple method of using moving averages to define trends is based on the direction of change in a moving average’s value relative to the previous day. For example, a moving average (and by implication the trend) would be considered to be rising if today’s value was higher than yesterday’s value and declining if today’s value was lower. Note that the basic definition of a rising moving average is equivalent to the simple condition that today’s close is higher than the close N days ago. Why? Because yesterday’s moving average is identical 79TRENDS FIGURE  6.35 Moving Average (40-Day) in Trending Market: Canadian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  6.36 Moving Average (40-Day) in Sideways Market: Oat Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. to today’s moving average with the exception that yesterday’s moving average includes the close N days ago and does not include today’s close. Therefore, if today’s close is higher than the close of N days ago, then today’s moving average will be higher than yesterday’s moving average. Similarly, a declin- ing moving average is equivalent to the condition that today’s close is lower than the close N days ago. 80A COMPLETE GUIDE TO THE FUTURES MARKET The smoothing properties of moving averages are achieved at the expense of introducing lags in the data. By defi nition, since moving averages are based on an average of past prices, turning points in moving averages will always lag the corresponding transitions in the raw price series. This character- istic is readily evident in both Figures 6.35 and 6.36 . In trending markets, moving averages can provide a very simple and eff ective method of identify- ing trends. Figure 6.37 duplicates Figure 6.35 , denoting buy signals at points at which the moving average reversed to the upside by at least 10 ticks and sell signals at points at which the moving average turned down by the same minimum amount. (The reason for using a minimum threshold reversal to defi ne turns in the moving average is to keep trend signals from fl ipping back and forth— “whipsawing”—repeatedly at times when the moving average is near zero.) As Figure 6.37 shows, this extremely simple technique generated good trading signals. During the 24-month period shown, this method generated only seven signals. The fi rst signal (long) was exited with a small profi t in August. The short position triggered at this point captured a signifi cant portion of the July 2014–March 2015 decline. The April 2015 buy was exited with a small loss in June 2015, but the ensuing short trade was exited profi tably in October. The subsequent buy was reversed in late November at a loss, and the fi nal short trade was exited with a profi t in February 2016. The problem is that while moving averages will do well in trending markets, in choppy, sideways markets they are apt to generate many false signals. For example, Figure 6.38 duplicates Figure 6.36 , indicating buy signals at points where the moving average turned up by at least 10 ticks and sell sig- nals at points witnessing equivalent downside reversals in the moving average. The same method that worked so well in Figure 6.37 —buying on upturns in the moving average and selling on downturns in the moving average—proves to be a disastrous strategy in this market, yielding six losses and one essentially break-even trade. FIGURE  6.37 Moving-Average-Based Signals in Trending Market: Canadian Dollar Continuous Futures Notes: Buy (B) = 10-tick rise in moving average off its low . Sell (S) = 10-tick decline in moving average off its high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 81TRENDS There are many other ways of calculating a moving average besides the simple moving average described in this section. Some of these other methods, as well as the application of moving averages in trading systems, are discussed in Chapter 16 . FIGURE  6.38 Moving-Average-Based Signals in Sideways Market: Oat Continuous Futures Notes: Buy (B) = 10-tick rise in moving average off its low . Sell (S) = 10-tick decline in moving average off its high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 83 Chapter 7 Trading Ranges There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time. —Edwin Lefèvre ■ Trading Ranges: Trading Considerations A trading range is a horizontal corridor that contains price fluctuations for an extended period. Gen- erally speaking, markets tend to spend most of their time in trading ranges. Unfortunately, however, trading ranges are very difficult to trade profitably. In fact, most technical traders will probably find that the best strategy they can employ for trading ranges is to minimize their participation in such markets—a procedure that is easier said than done. Although there are methodologies that can be profitable in trading ranges, the problem is that these same approaches are disastrous for trending markets, and while trading ranges are easily iden- tifiable for the past, they are nearly impossible to predict. Also, it should be noted that most chart patterns (e.g., flags, pennants) are relatively meaningless if they occur within a trading range. (Chart patterns are discussed in Chapter 9.) Trading ranges can often last for years. For example, the silver market remained in a trading range for much of the 1990s (see Figure 7.1). Figures 7.2, 7.3, and 7.4 show a multiyear crude oil trading range represented in continuous futures, nearest futures, and the December 2014 contract. These three charts illustrate that the trading range boundaries and periods will differ depending on whether depicted as continuous futures, nearest futures, or an individual contract, although there will typi- cally be significant overlap between these alternative representations. Trading ranges also show up in shorter-term charts. Figure 7.5 shows an example on a 15-minute chart of euro futures. 84A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  7.1 Multiyear Trading Range: Silver Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  7.2 Multiyear Trading Range: Crude Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 85TRADING RANGES FIGURE  7.3 Multiyear Trading Range: Crude Oil Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  7.4 Multiyear Trading Range: December 2014 Crude Oil Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 86A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  7.5 Intraday Trading Range: December 2013 Euro Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Once a trading range is established, the upper and lower boundaries tend to defi ne support and resistance areas. This topic is discussed in greater detail in the next chapter. Breakouts from trading ranges can provide important trading signals—an observation that is the subject of the next section. ■ Trading Range Breakouts A breakout from a trading range suggests an impending price move in the direction of the breakout. The signifi cance and reliability of a breakout are often enhanced by the following three factors: 1. Duration of the trading range. The longer the duration of a trading range, the more poten- tially signifi cant the eventual breakout. This point is illustrated using a weekly chart example in Figure 7.6 and a daily chart example in Figure 7.7 . 2. Narrowness of range. Breakouts from narrow ranges tend to provide particularly reliable trade signals (see Figures 7.8 , 7.9 , and 7.10 ). Furthermore, such trades can be especially attrac- tive since the meaningful stop point implies a relatively low dollar risk. 3. Confi rmation of breakout. It is rather common for prices to break out from a trading range by only a small amount, or for only a few days, and then fall back into the range. One reason for this tendency is that stop orders are frequently clustered in the region beyond a 87TRADING RANGES FIGURE  7.6 Downside Breakout from Extended Trading Range: W eekly Heating Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  7.7 Upside Breakout from Extended Trading Range: December 2010 Coff ee Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. trading range. Consequently, a move slightly beyond the range can sometimes trigger a string of stops. Once this initial fl urry of orders is fi lled, the breakout will fail unless there are solid fundamental reasons and underlying buying (or overhead selling in the case of a downside breakout) to sustain the trend. 88A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  7.8 Downside Breakout from Narrow Trading Range: Japanese Y en Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  7.9 Downside Breakout from Narrow Trading Range: Australian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 89TRADING RANGES In view of these behavioral considerations, the reliability of a breakout from a trading range as a signal for an impending trend is signifi cantly improved if prices are still beyond the range after a num- ber of days (e.g., fi ve). Other types of confi rmation can also be used—minimum percent penetration, a given number of thrust days (discussed in Chapter 9 ), and so on. Although waiting for a confi rma- tion following breakouts will lead to worse fi lls on some valid signals, it will help avoid many “false” signals. The net balance of this trade-off will depend on the confi rmation condition used and must be evaluated by the individual trader. The key point, however, is that the trader should experiment with diff erent confi rmation conditions, rather than blindly follow all breakouts. FIGURE  7.10 Upside Breakout from Narrow Trading Range: U.S. Dollar Index Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 91 Chapter 8 In a narrow market, when prices are not getting anywhere to speak of but move in a narrow range, there is no sense in trying to anticipate what the next big movement is going to be—up or down. —Edwin Lefèvre ■ Nearest Futures or Continuous Futures? For any application of technical analysis in which the accurate representation of price moves is essen- tial, continuous futures, as opposed to nearest futures, are the only viable choice for depicting price series that extend across multiple contracts. However, in the case of support and resistance, actual past price levels, which are accurately represented by only the nearest futures, are also important. This consideration raises the question of which type of longer-term chart—nearest or continuous futures—should be used to determine support and resistance levels. There is no correct answer. Insofar as the accurate measurement of prior price moves is important in determining support and resistance, continuous futures charts should be used. Insofar as past actual price levels are important in determining support and resistance, nearest futures charts should be used. Essentially, strong arguments can be made for using both types of charts for defining support and resistance levels. Traders need to experiment with whether they find nearest or continuous futures charts more useful in identifying support and resistance levels, or, for that matter, if they find consulting both of these charts the most effective method. Support and Resistance 92A COMPLETE GUIDE TO THE FUTURES MARKET ■ Trading Ranges Once a trading range is established (at least one to two months of sideways price movement on the daily time frame), prices will tend to meet resistance at the upper end of the range and support at the lower end of the range. Although chart analysis is best suited as a tool to signal trend-following trades, some agile traders adopt a strategy of selling rallies and buying declines in a trading range situation. Generally speaking, such a trading approach is diffi cult to pull off successfully. Further- more, it should be emphasized that fading minor trends within a trading range can lead to disaster unless losses are limited (e.g., by liquidating the position if prices penetrate the range boundary by a specifi ed minimum amount, or the market trades beyond the range for a minimum number of bars, or both). After prices break out from a trading range, the interpretation of support and resistance is turned on its head. Specifi cally, once prices witness a sustained breakout above a trading range, the upper boundary of that range becomes a zone of price support. The extended lines in Figures 8.1 and 8.2 indicate the support levels implied by the upper boundaries of the prior trading ranges. In the case of a sustained breakout below a trading range, the lower boundary of that range becomes a zone of price resistance. The extended lines in Figures 8.3 and 8.4 indicate the resistance levels implied by the lower boundaries of preceding trading ranges. FIGURE  8.1 Support Near T op of Prior Trading Range: Euro Stoxx 50 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 93SUPPORT AND RESISTANCE FIGURE  8.2 Support Near T op of Prior Trading Range: British Pound Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.3 Resistance Near Bottom of Prior Trading Range: Palladium Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 94A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  8.4 Resistance Near Bottom of Prior Trading Range: Platinum Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. ■ Prior Major Highs and Lows Normally, resistance will be encountered in the vicinity of previous major highs and support in the vicinity of major lows. Figures 8.5 , 8.6 , and 8.7 illustrate both behavioral patterns. For example, in Figure 8.5 the late 2003 low acted as a support level for subsequent lows in 2004, 2007, and 2008, while the 2005 high provided a resistance level for the 2009 highs. In Figure 8.6 the late 2009 and early 2010 highs formed near the resistance level of the 2008 high, while the late 2011 low provided support for the 2012 and 2013 lows. Subsequently, the 2014 high functioned as resistance for the 2015 highs, while the early 2016 low formed just above the support level of the early 2015 low . Although the concept of resistance near prior peaks and support near prior lows is perhaps most important for weekly or monthly charts, such as Figures 8.5 and 8.6 , the principle also applies to daily charts, such as Figure 8.7 . In this chart, the June and August 2013 highs occurred near the March 2013 peak. It should be emphasized that a prior high does not imply subsequent rallies will fail at or below that point, but rather that resistance can be anticipated in the general vicinity of that point. Similarly, a prior low does not imply that subsequent declines will hold at or above that point, but rather that support can be anticipated in the general vicinity of that point. Some practitioners of technical analysis treat prior highs and lows as points endowed with sacrosanct signifi cance: If a prior high was 1,078, then they consider 1,078 to be major resistance, and if, for example, the market rallies to 1,085, they consider resistance to be broken. This is nonsense. Support and resistance should be considered approximate areas, not precise points. Note that although prior major highs and lows proved highly 95SUPPORT AND RESISTANCE FIGURE  8.5 Resistance at Prior High and Support at Prior Low: Euro Bund Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.6 Resistance at Prior Highs and Support at Prior Lows: Cocoa Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 96A COMPLETE GUIDE TO THE FUTURES MARKET signifi cant as resistance and support in all three of the preceding charts, reversals mostly occurred before price reached a given level or after penetrating it by a notable amount (although usually not closing beyond it); reversals that occur very near the precise levels of prior highs or lows are the exception rather than the rule. The penetration of a previous high can be viewed as a buy signal, and the penetration of a prior low can be viewed as a sell signal. Similar to the case of breakouts from trading ranges, to be viewed as trading signals penetrations of highs and lows should be signifi cant in terms of price magnitude, time duration, or both. Thus, for example, as should be clear from the preceding dis- cussion regarding Figures 8.6 and 8.7 , a one-period (one-day for daily chart, one-week for weekly chart, etc.) penetration of a prior high or low would not prove anything. A stronger confi rmation than a mere penetration of a prior high or low should be required before assuming such an event represents a buy or sell signal. Some examples of possible confi rmation conditions include a mini- mum number of closes beyond the prior high or low , a minimum percent price penetration, or both requirements. Figures 8.8 and 8.9 illustrate examples of penetrations of previous highs as buy signals, assum- ing a confi rmation condition of three closes above the high. Similarly, Figures 8.10 and 8.11 provide examples of penetrations of previous lows as sell signals, using an analogous confi rmation condition. In Figure 8.9 price turned lower in late 2012 a little above the resistance level of the early 2012 high. In January 2014 the market posted its third weekly close above the late 2012 high (dashed line), triggering a buy signal. Incidentally, this chart also provides a good example of a prior low (formed in 2013) holding as support more than two years later. Following a sustained penetration of a prior high or low , the interpretation of support and resis- tance is turned on its head. In other words, the area of a prior high becomes support and the area of FIGURE  8.7 Resistance at Prior High: Cotton Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Resistance at Prior High: Cotton Nearest Futures 97SUPPORT AND RESISTANCE FIGURE  8.8 Penetration of Previous High as Buy Signal: Russell 2000 Mini Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Penetration of Previous High as Buy Signal: Russell 2000 Mini Nearest FIGURE  8.9 Penetration of Previous High as Buy Signal: Live Cattle Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. a previous low becomes resistance. For example, in Figure 8.12 the resistance level from Figure 8.9 subsequently became support in April 2014 when the market pulled back temporarily before rallying to new highs. In Figure 8.13 , which extends the support line of Figure 8.10 , the September 2011 98A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  8.10 Penetration of Previous Low as Sell Signal: Silver Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.11 Penetration of Previous Low as Sell Signal: Mexican Peso Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. low provides a support area for the December 2011 and June 2012 lows. When this support level is subsequently penetrated in April 2013, this same level then proves to be a resistance area for the June–August 2013 rebound. Figure 8.14 shows a remarkably similar pattern unfolding on the daily silver chart: The late June 2013 low provided support for subsequent lows between November 2013 99SUPPORT AND RESISTANCE FIGURE  8.12 Previous Resistance Becomes Support: Live Cattle Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Previous Resistance Becomes Support: Live Cattle Nearest Futures and June 2014. This support level subsequently functioned as resistance in January and May 2015 after the market rallied off its late 2014 lows. In Figure 8.15 , the support level that was penetrated to the downside in August 2015 functioned as resistance for the October 2015 rebound as well as the rally that peaked in March 2016. FIGURE  8.13 Previous Support Becomes Resistance: Silver Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Previous Support Becomes Resistance: Silver Nearest Futures 100A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  8.15 Previous Support Becomes Resistance: Live Cattle Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.14 Previous Support Becomes Resistance: Silver Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 101 SUPPORT AND RESISTANCE ■ Concentrations of Relative Highs and Relative Lows The previous section dealt with support and resistance at prior major highs and lows—single peaks and nadirs. In this section we are concerned with support and resistance at price zones with concen- trations of relative highs and relative lows rather than absolute tops and bottoms. Specifi cally, there is often a tendency for relative highs and relative lows to be concentrated in relatively narrow zones. These zones imply support regions if current prices are higher and resistance areas if current prices are lower. This approach is particularly useful for anticipating support and resistance areas in long- term nearest futures charts, which, as the reader will recall, accurately refl ect past price levels (in contrast to continuous futures, which accurately refl ect past price swings ). Figures 8.16 through 8.21 provide weekly chart examples of support or resistance occurring at prior concentrations of relative lows and relative highs (or relative lows alone). In Figure 8.21 , a support zone initially defi ned by multiple relative highs from 2007 to 2010 subsequently functions as a resistance zone in 2013–2014 after the market sells off . The approach of using concentrations of prior relative highs and lows to defi ne support and resis- tance can also be applied to daily continuous or nearest futures charts of suffi cient duration—for example, two years. (The life span of most individual futures contracts is too short for this method to be eff ectively applied on such charts.) Figures 8.22 through 8.24 provide daily chart examples of support and resistance occurring at prior concentrations of relative highs and relative lows. Figure 8.24 is similar to Figure 8.21 in that a support zone transforms into a resistance zone. FIGURE  8.16 Support Zone Defi ned by Concentration of Prior Relative Lows and Highs: Swiss Franc Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Support Zone Defi ned by Concentration of Prior Relative Lows and 102A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  8.17 Support Zone Defi ned by Concentration of Prior Relative Lows and Highs: Gasoline Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.18 Support Zone Defi ned by Concentration of Prior Relative Highs and Lows: Soybean Meal Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 103 SUPPORT AND RESISTANCE FIGURE  8.19 Support Zone Defi ned by Concentration of Prior Relative Highs and Lows: British Pound Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.20 Support Zone Defi ned by Concentration of Prior Relative Lows: Copper Nearest Futures Note: /uni2191 = relative low . Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 104A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  8.21 Support and Resistance Zones Defi ned by Concentration of Prior Relative Highs and Lows: Australian Dollar Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.22 Support Zone Defi ned by Concentration of Prior Relative Lows and Highs: Cocoa Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 105 SUPPORT AND RESISTANCE FIGURE  8.23 Resistance Zone Defi ned by Concentration of Prior Relative Highs and Lows: Mexican Peso Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  8.24 Support and Resistance Zones Defi ned by Concentration of Prior Relative Highs and Lows: Sugar Nearest Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 106A COMPLETE GUIDE TO THE FUTURES MARKET Although best suited to longer-term charts, the technique of using prior concentrations of relative highs and lows as support and resistance zones can also be applied to shorter-term charts. Figure 8.25 provides an intraday example: a support zone defi ned by a series of prior relative highs and lows on a 30-minute chart. ■ Trend Lines, Channels, and Internal Trend Lines The concept that trend lines, channel lines, and internal trend lines indicate areas of potential support and resistance was detailed in Chapter 6 . Again, as previously discussed, based on personal experi- ence, I believe that internal trend lines are more reliable in this regard than conventional trend lines. However, the question of which type of trend line is a better indicator is a highly subjective matter, and some readers may well reach the opposite conclusion. In fact, there is not even a mathematically precise defi nition of a trend line or an internal trend line, and how these lines are drawn will vary from individual to individual. FIGURE  8.25 Support Zone Defi ned by Concentration of Prior Relative Highs and Lows: Euro Continuous Futures Note: /uni2191 = relative low; /uni2193 = relative high. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 107 SUPPORT AND RESISTANCE ■ Price Envelope Bands A price envelope band can be derived from a moving average. The upper band of the price envelope is defi ned as the moving average plus a given percentage of the moving average. Similarly, the lower band of the price envelope is defi ned as the moving average minus a given percentage of the moving average. For example, if the current moving average value is 600 and the percentage value is defi ned as 3 percent, the upper band value would be 618 and the lower band value would be 582. By selecting an appropriate percent boundary for a given moving average, a trader can defi ne an envelope band so that it encompasses most of the price activity, with the upper boundary approximately coinciding with relative highs and the lower boundary approximately coinciding with relative lows. Figure 8.26 illustrates a price envelope band for the Australian dollar continuous futures using a 20-day moving average and a 2.5 percent value. The price envelope provides a good indication of support and resistance for much of the period captured in the chart, especially when the market is moving sideways (e.g., February–April 2015 and September 2015–January 2016). An alternative way of expressing the same concept is that the price envelope indicates “overbought” and “oversold” levels. Price envelope bands can also be applied to data for other than daily time intervals. For example, Figure 8.27 illustrates a 1.25 percent price envelope band applied to 60-minute bars of the March 2016 E-mini S&P 500 contract. FIGURE  8.26 Price Envelope Band as Indication of Support and Resistance in Daily Bar Chart: Australian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 108A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  8.27 Price Envelope Band as Indication of Support and Resistance on 60-Minute Bar Chart: March 2016 E-Mini S&P 500 Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. It should be noted, however, that the price envelope is not as eff ective a tool as it might appear to be. Although it provides a reasonably good indication of when the market may be nearing a turning point, prices can continue to hug one end of the price envelope during extended trends. This pattern, for example, is evident at the beginning of Figure 8.26 (November–December 2014), as well as the middle of the chart (July and August–September 2015). Thus, while it is true that price excursions beyond the price envelope band tend to be limited and temporary, the fact that prices are near one of the boundaries of the envelope does not necessarily mean that a price turning point is imminent. On balance, the price envelope provides one means of gauging potential areas of support and resistance, but it is also susceptible to multiple false signals. 109 Never confuse brilliance with a bull market. —Paul Rubink ■ One-Day Patterns Spikes A spike high is a day whose high is sharply above the highs of the preceding and succeeding days. Frequently, the closing price of a spike high day will be near the lower end of the day’s trading range. A spike high is meaningful only if it occurs after a price advance, in which case it can often signify at least a temporary climax in buying pressure, and hence can be viewed as a potential relative high. Sometimes spike highs will prove to be major tops. Generally speaking, the significance of a spike high will be enhanced by the following factors: 1. A wide difference between the spike high and the highs of the preceding and succeeding days. 2. A close near the low of the day’s range. 3. A substantial price advance preceding the spike’s formation. The more extreme each of these conditions, the greater the likelihood that a spike high will prove to be an important relative high or even a major top. In analogous fashion, a spike low is a day whose low is sharply below the lows of the preceding and succeeding days. Frequently, the closing price on a spike low day will be near the upper end of the day’s trading range. A spike low is meaningful only if it occurs after a price decline, in which case it can often signify at least a temporary climax in selling pressure and hence can be viewed as a potential relative low . Sometimes spike lows will prove to be a major bottom. Chart Patterns Chapter 9 110A COMPLETE GUIDE TO THE FUTURES MARKET Generally speaking, the signifi cance of a spike low will be enhanced by these three factors: 1. A wide diff erence between the lows of the preceding and succeeding days and the spike low . 2. A close near the high of the day’s range. 3. A substantial price decline preceding the spike’s formation. The more extreme each of these conditions, the greater the likelihood that a spike low will prove to be an important relative low or even a major bottom. Figures 9.1 through 9.4 contain several examples of spike highs and spike lows on daily and weekly charts. The massive spike high in Figure 9.3 marked a multiyear top in the Swiss franc futures. Figure 9.4 contains two examples of spike lows that marked swing bottoms. The preceding descriptions of spike highs and lows listed three essential characteristics that typify such days. However, the defi nition of these conditions was somewhat imprecise. Specifi cally, how great must the diff erence be between a day’s high (low) and the highs (lows) of the preceding and succeeding days in order for it to qualify as a spike high (low)? How close must the close be to the low (high) for a day to be considered a spike high (low)? How large must a preceding advance (decline) be for a day to be viewed as a possible spike high (low)? The answer to these questions is that there are no precise specifi cations; in each case, the choice of a qualifying condition is a subjec- tive one. However, Figures 9.1 through 9.4 should provide an intuitive sense of the types of days that qualify as spikes. FIGURE  9.1 Spike High: Cotton Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 111 CHART PATTERNS FIGURE  9.2 Spike High: Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.3 Spike High: Swiss Franc Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 112A COMPLETE GUIDE TO THE FUTURES MARKET It is possible, though, to construct a mathematically precise defi nition for spike days. An example of such a defi nition for a spike high might be a day that fulfi lled all three of the following conditions (the defi nition for a spike low day would be analogous): 1. H t − Max( H t −1 , H t +1 ) > k · ADTR 10 , where H t = high on given day H t −1 = high on preceding day H t +1 = high on succeeding day k = multiplicative factor that must be defi ned (e.g., k = 0.75) ADTR 10 = average daily true range during past 10 days 1 2. H t − C t > 3 · ( C t − L t ), where C t = close on given day L t = low on given day 3. H t > maximum high during past N days, where N = constant that must be defi ned (e.g., N = 50) The first of the preceding conditions assures us that the spike high will exceed the surround- ing highs by an amount at least equal to three-quarters of the past 10-day average true range (assuming the value of k is defined as 0.75). The second condition assures us that the spike day’s close will be in the lower quartile of its range. The third condition, which requires that the spike day’s high exceed the highest high during the past 50 days (assuming N = 50), guarantees that FIGURE  9.4 Spike Lows: British Pound Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 1 The true range is equal to the true high minus the true low . The true high is the maximum of the current day’s high and the previous day’s close. The true low is the minimum of the current day’s low and the previous day’s close. 113 CHART PATTERNS the day was preceded by an upswing. (Generally speaking, higher values of N will require larger prior advances.) The three-part definition just provided for a spike high day is only intended to offer an example of how a mathematically precise definition can be constructed. Many other definitions are possible. reversal Days The standard defi nition of a reversal high day is a day that makes a new high in an upmove and then reverses to close below the preceding day’s close. Analogously, a reversal low day is a day that makes a new low in a decline and then reverses to close above the preceding day’s close. The following dis- cussion focuses on reversal high days, but mirror-image comments would apply to reversal low days. Similar to spike highs, a reversal high day is generally interpreted as suggesting a buying climax and hence a relative high. However, the condition required for a reversal high day by the standard defi ni- tion is a relatively weak one, meaning that reversal high days are fairly common. Hence, while many market highs are reversal days, the problem is that the majority of reversal high days are not market highs. Figure 9.5 , which illustrates this point, is fairly typical. It shows the fi nal leg of the crude oil market’s historic rally to its all-time high in July 2008 and its equally impressive sell-off in the follow- ing months. Note that although a reversal high day occurred just a few days before the July top, it had been preceded by eight other reversal days since late February, only one of which (the seventh, in late FIGURE  9.5 Reversal Days: WTI Crude Oil Continuous Futures Note: R = reversal day. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 114A COMPLETE GUIDE TO THE FUTURES MARKET May) was followed by a downswing of any signifi cance. The reversal low days that occurred from late July to December paint a similar picture: Given crude oil futures fell another $20 before bottoming in February 2009 (not shown), even the fi nal signal in December 2008 was extremely premature. Figure 9.6 depicts another example of the commonplaceness of premature reversal day signals. In this case, a reversal day actually occurred at the exact peak of a major rally dating back to the beginning of 2009. This incredible sell signal, however, was preceded by eight other reversal days, the majority of which occurred far earlier in the advance. Anyone who might have traded this market based on rever- sal signals would probably have thrown in the towel well before the valid signal fi nally materialized. In the examples just provided, at least a reversal day signal occurred at or near the actual high. Frequently, however, an uptrend will witness a number of reversal highs that prove to be false signals and then fail to register a reversal high near the actual top. It can be said that reversal high days suc- cessfully call 100 out of every 10 highs. In other words, reversal days provide occasional excellent signals, but far more frequent false signals. In my opinion, the standard defi nition of reversal days is so prone to generating false signals that it is worthless as a trading indicator. The problem with the standard defi nition is that merely requir- ing a close below the prior day’s close is much too weak a condition. Instead, I suggest defi ning a reversal high day as a day that witnesses a new high in an upmove and then reverses to close below the preceding day’s low . (If desired, the condition can be made even stronger by requiring that the close be below the low of the prior two days.) This more restrictive defi nition will greatly reduce the number of false reversal signals, but it will also knock out some valid signals. For example, this FIGURE  9.6 Reversal Days: Copper Continuous Futures Note: R = reversal day. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 115 CHART PATTERNS revised defi nition would have eliminated all but the fourth signal in Figure 9.5 . In Figure 9.6 the more restrictive defi nition for a reversal day would have avoided all but the fourth signal and the ninth (fi nal and valid) signal. A reversal day may sound somewhat similar to a spike day, but the two patterns are not equiva- lent. A spike day will not necessarily be a reversal day, and a reversal day will not necessarily be a spike day. For example, a spike high day may not close below the previous day’s low (or even below the previous day’s close, as specifi ed by the standard defi nition), even if the close is at the day’s low . As an example of the reverse case, a reversal high day may not signifi cantly exceed the prior day’s high, as required by the spike high defi nition, or exceed the subsequent day’s high at all, since the subsequent day’s price action is not part of the reversal day defi nition. Also, it is possible that a rever- sal day’s close may not be near the low , a standard characteristic of a spike day, even if it is below the previous day’s close. Occasionally, a day will be both a reversal day and a spike day. Such days are far more signifi cant than days that are only reversal days. An alternative to using the more restrictive defi nition for a reversal day is using the standard defi nition, but requiring that the day also fulfi ll spike day conditions. (Although a day that met both the strong reversal day condition and the spike day conditions would be most meaningful of all, such days are fairly rare.) Figure 9.7 provides an example of a day that met both spike and reversal low day conditions. Figure 9.8 highlights three days: a spike and reversal high day that marked the high of the rally, a spike and reversal low day several days later that was followed by a few days of sideways price action, and a spike and reversal low day that was followed by a correc- tion within the prevailing downtrend. FIGURE  9.7 Spike and Reversal Day: July 2008 Soybeans Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 116A COMPLETE GUIDE TO THE FUTURES MARKET thrust Days An upthrust day is a day with a close above the previous day’s high, while a downthrust day is a day with a close below the previous day’s low . The signifi cance of thrust days is tied to the concept that the close is by far the most important price of the day. A single thrust day is not particularly meaningful, since thrust days are quite common. However, a series of upthrust days (not necessarily consecutive) would refl ect pronounced strength. Similarly, a series of downthrust days would refl ect pronounced market weakness. During bull markets upthrust days signifi cantly outnumber downthrust days—see, for example, the especially bullish mid-May to early July period in Figure 9.9 . Conversely, in bear markets down- thrust days signifi cantly outnumber upthrust days—see the July–September period in Figure 9.10 . And, as should come as no surprise, in sideways markets, upthrust and downthrust days tend to be in rough balance—for example, the March to mid-April period in Figure 9.9 and the October–November period in Figure 9.10 . run Days A run day is a strongly trending day. Essentially, a run day is a more powerful version of a thrust day (although it is possible for a run day to fail to meet the thrust day condition). Run days are defi ned as follows: FIGURE  9.8 Spike and Reversal Days: Mexican Peso Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 117 CHART PATTERNS FIGURE  9.9 Upthrust and Downthrust Days in Bull Market: E-Mini S&P 500 Continuous Futures Note: /uni2191 = upthrust day; /uni2193 = downthrust day. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.10 Upthrust and Downthrust Days in Bear Market: December 2014 Euro Note: /uni2191 = upthrust day; /uni2193 = downthrust day. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 118A COMPLETE GUIDE TO THE FUTURES MARKET Up run day. A day that meets the following two conditions: 1. The true high of the run day is greater than the maximum true high of the past N days (e.g., N = 5). 2. The true low on the run day is less than the minimum true low on the subsequent N days. Down run day. A day that meets the following two conditions: 1. The true low of the run day is less than the minimum true low of the past N days. 2. The true high on the run day is greater than the maximum true high on the subsequent N days. As can be seen by these defi nitions, run days cannot be defi ned until N days after their occurrence. Also, note that although most run days are also thrust days, it is possible for the run day conditions to be met on a day that is not a thrust day. For example, it is entirely possible for a day’s low to be lower than the past fi ve-day low , its high to be higher than the subsequent fi ve-day high, and its close to be higher than the previous day’s low . Figures 9.11 and 9.12 provide examples of run days (based on a defi nition of N = 5). As these charts show , run days tend to occur when a market is in a trend run—hence the name. The materialization of up run days, particularly in clusters, can be viewed as evidence the market is in a bullish phase (see Figure 9.11 ). Similarly, a predominance of down run days provides evidence the market is in a bearish state (see Figure 9.12 ). In Chapter 17 , we use the concept of run days to construct trading systems. FIGURE  9.11 Run Days in Bull Market: Euro Stoxx 50 Continuous Futures Note: /uni2191 up run day; /uni2193 down run day. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 119 CHART PATTERNS Note: Although the basic premise of thrust days and run days would apply to longer time frames, it does not hold on intraday charts. The closing prices of intraday bars—especially on very short time frames, such as one or two minutes—do not carry the same weight as the closing prices of daily and weekly bars, which mark the end of signifi cant trading periods. Wide-ranging Days A wide-ranging day is a day whose volatility signifi cantly exceeds the average volatility of recent trad- ing days. Wide-ranging days are defi ned as follows: Wide-ranging day . A day the volatility ratio (VR) is greater than k (e.g., k = 2.0). The VR is equal to today’s true range divided by the average true range of the past N -day period (e.g., N = 15). Wide-ranging days can have special signifi cance. For example, a wide-ranging day with a strong close that materializes after an extended decline often signals an upside trend reversal. Similarly, a wide-ranging day with a weak close that occurs after an extended advance can signal a downside reversal. In Figure 9.13 , strong-closing wide-ranging days marked the reversals of two downswings in euro futures. (Note that although the back-to-back wide-ranging days in July did not close in the upper reaches of their respective ranges, both closed near or above the previous days’ highs.) Figure 9.14 features two sets of consecutive weak-closing wide-ranging days that FIGURE  9.12 Run Days in Bear Market: March 2015 Sugar Note: /uni2191 = up run day; /uni2193 = down run day. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 120A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.13 Wide-Ranging Up Days: Euro Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.14 Wide-Ranging Down Days: Silver Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. ended rallies in silver in dramatic fashion. The weekly chart inset shows these events marked the eff ective end of the market’s longer-term uptrend, ushering in an extended period of sideways- to-lower price action. 121 CHART PATTERNS Figures 9.15 and 9.16 highlight days that satisfy the previously described example of wide-ranging day criteria: The true range of each wide-ranging day is greater than twice the average true range of the preceding 15 days. In Figure 9.15 , the fi rst of these days, a weak-closing wide-ranging day in May 2012 marked the defi nitive end of a WTI crude oil rally following the consolidation that had formed near the market highs. The second downside wide-ranging day had no special signifi cance, as it formed after a large decline had already occurred. The third (strong-closing) wide-ranging day signaled a major market reversal to the upside. In Figure 9.16 there are four wide-ranging days, the fi rst three of which were the start of major trend reversals; the fourth failed to witness any follow-through price action. However, there is an important caveat: The “wide-ranging day” in early May, which signaled a reversal near the market top, did not, in fact, strictly meet the wide-ranging day criteria based on the parameters we used as an example (2.0 multiple and 15 days)—its true range was only 1.94 times the size of the 15-day average true range. Had we instead chosen a multiple of 1.9 instead of 2.0 to defi ne wide-ranging days, this day would have represented a wide-ranging day without any qualifi cation. There is noth- ing special about the parameter values of 2.0 and 15 days chosen in our example. Moderate shifts of these values up or down would still preserve the spirit of the wide-ranging day, as was indeed the case with the early May wide-ranging day, which had a larger-than-normal range with a very weak close following a major uptrend. There is a trade-off in choosing the parameter value for the multiple: The lower the multiple chosen to defi ne wide-ranging days, the greater the probability of capturing valid wide-ranging day reversal signals, but the greater the chance of identifying wide-ranging days that are meaningless. In this context, it may make sense for a trader to use more than one set of parameter values to defi ne wide-ranging days to be aware of days that just miss the selected defi nition. Of course, days defi ned by higher multiples would carry greater weight. FIGURE  9.15 Wide-Ranging Up and Down Days: October 2012 WTI Crude Oil Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 122A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.16 Wide-Ranging Up and Down Days: September 2011 Coff ee Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.` Figures 9.17 and 9.18 show instances of wide-ranging bars on diff erent timeframes. The wide- ranging weeks in Figure 9.17 marked the beginning of an uptrend in Japanese yen futures that extended into early 2012, as shown in the monthly chart inset. In Figure 9.18 the weak-closing wide-ranging hourly bar reversed a seven-day advance. In Chapter 17 , we will use the concept of wide-ranging days as the primary element in constructing a sample trading system. ■ Continuation Patterns Continuation patterns are various types of congestion phases that materialize within long-term trends. As the name implies, a continuation pattern is expected to be resolved by a price swing in the same direction that preceded its formation. triangles There are three basic types of triangle patterns: symmetrical (see Figures 9.19 through 9.21 ), ascend- ing (Figures 9.22 and 9.23 ), and descending (Figures 9.24 and 9.25 ). A symmetrical triangle is usually followed by a continuation of the trend that preceded it, as in Figures 9.19 through 9.21 . Conven- tional chart wisdom suggests that nonsymmetrical triangles will yield to a trend in the direction of the slope of the hypotenuse, as is the case in Figures 9.22 through 9.25 . However, the direction of the breakout from a triangle formation is more important than the type. For example, in Figure 9.26 , although the two congestion patterns are descending triangles—and the second is preceded by a price decline—both break out to the upside and are followed by rallies. 123 CHART PATTERNS FIGURE  9.17 Wide-Ranging Up W eeks: Japanese Y en Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.18 Wide-Ranging Down Bar: September 2015 E-Mini Nasdaq 100 Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 124A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.19 Symmetrical Triangle: Japanese Y en Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.20 Symmetrical Triangle: March 2015 DAX Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 125 CHART PATTERNS FIGURE  9.21 Symmetrical Triangle: Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.22 Ascending Triangle: Euro Stoxx 50 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 126A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.24 Descending Triangle: Euro Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.23 Ascending Triangle: Euro Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 127 CHART PATTERNS FIGURE  9.26 Descending Triangles with Upside Breakouts: 10- Y ear T -Note Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.25 Descending Triangle: September 2015 E-Mini Dow Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 128A COMPLETE GUIDE TO THE FUTURES MARKET Flags and pennants Flags and pennants are narrow-band, short-duration (e.g., one to three weeks) congestion phases within trends. The formation is called a fl ag when it is enclosed by parallel lines and a pennant when the lines converge. Figures 9.27 through 9.31 illustrate both types of patterns. Figure 9.29 shows fl ags forming on a weekly chart, while Figure 9.30 shows fl ags and pennants on an intraday chart. Pennants may appear to be similar to triangles, but they diff er in terms of time: the triangle has a longer duration. Similarly, the diff erence between a horizontal fl ag and a trading range is a matter of duration. Among the many fl ags and pennants in Figure 9.27 , for example, there are two congestion patterns (in August–September 2011 and January–February 2012) that could be classifi ed as either long fl ags or pennants or short trading ranges or triangles. Regardless of which name these patterns are given, their implication is the same: fl ags and pennants typically represent pauses in a major trend. In other words, these patterns are usually followed by price swings in the same direction as the price swings that preceded their formation. A breakout from a fl ag or pennant can be viewed as a confi rmation the trend is continuing and a trading signal in the direction of the trend. Since breakouts are usually in the direction of the main trend, however, I prefer to enter positions during the formation of the fl ag or pennant, anticipating the probable direction of the breakout. This approach allows for more advantageous trade entries, without a signifi cant deterioration in the percentage of correct trades, since reversals following breakouts from fl ags and pennants are about as common as breakouts in the counter-to-anticipated direction. Following a breakout from a fl ag or pennant, the opposite extreme of the formation can be used as an approximate stop-loss point. FIGURE  9.27 Flags and Pennants: Natural Gas Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 129 CHART PATTERNS FIGURE  9.28 Flags and Pennants: March 2015 Wheat Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.29 Flags and Pennants: Soymeal Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 130A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.30 Flags and Pennants: September E-Mini Nasdaq 100 Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.31 Flags and Pennants: Euro Schatz Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 131 CHART PATTERNS A signifi cant penetration of a fl ag or pennant in the opposite-to-anticipated direction—that is, counter to the main trend—can be viewed as a signal of a potential trend reversal. For example, in Figure 9.31 note that after a strong rally that included pennant breakouts in the direction of the main trend, downside breakouts from the two fl ags that formed in June and August–September marked short-term and longer-term highs. Flags and pennants typically point in the opposite direction of the main trend. This characteristic is exhibited by the majority of fl ags and pennants illustrated in Figures 9.27 through 9.31 . The direc- tion in which a fl ag or pennant points, however, is not an important consideration. In my experience, I have not found any signifi cant diff erence in reliability between fl ags and pennants that point in the same direction as the main trend as opposed to the more usual opposite slope. Flags or pennants that form near the top or just above a trading range can be particularly potent bullish signals. In the case where a fl ag or pennant forms near the top of a trading range, it indicates that the market is not backing off despite having reached a major resistance area—the top of the range. Such price action has bullish implications and suggests that the market is gathering strength for an eventual upside breakout. In the case where the fl ag or pennant forms above the trading range, it indicates that prices are holding above a breakout point, thereby lending strong confi rmation to the breakout. Generally speaking, the more extended the trading range, the greater the potential signifi cance of a fl ag or pennant that forms near or above its top. Figures 9.32 through 9.34 provide examples of fl ags or pennants that materialized near the top or above trading ranges and proved to be precursors of price advances. FIGURE  9.32 Flag Near T op of Trading Range as Bullish Signal: U.S. Dollar Index Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 132A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.33 Flag Above T op of Trading Range as Bullish Signal: Live Cattle Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.34 Flag Near T op of Trading Range as Bullish Signal: June 2011 Heating Oil Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 133 CHART PATTERNS For similar reasons, fl ags or pennants that form near the bottom or just below trading ranges are particularly bearish patterns. Figures 9.35 through 9.37 provide examples of fl ags or pennants that materialized near the bottom or below trading ranges and proved to be harbingers of price declines. FIGURE  9.35 Flag Near Bottom of Trading Range as Bearish Signal: October 2015 WTI Crude Oil Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.36 Flag Near Bottom of Trading Range as Bearish Signal: Japanese Y en Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 134A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.37 Flag Near Bottom of Trading Range as Bearish Signal: Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. ■ Top and Bottom Formations V tops and Bottoms The “V” formation is a turn-on-a-dime type of top (see Figure 9.38 ) or bottom (see Figure 9.39 ). One problem with a V top or bottom is that it is frequently diffi cult to distinguish from a sharp correction unless accompanied by other technical indicators (e.g., prominent spike, signifi cant reversal day, wide gap, wide-ranging day). The V top in Figure 9.38 did contain such a clue—a spike day—whereas the V bottom in Figure 9.39 was unaccompanied by any other evidence of a trend reversal. Double tops and Bottoms Double tops and bottoms are exactly what their names imply. Of course, the two tops (or bottoms) that make up the pattern need not be exactly the same, only in the same general price vicinity. Double tops and bottoms that materialize after large price moves should be viewed as strong indicators of a major trend reversal. Figure 9.40 illustrates a major double top in weekly Euro Bobl futures, while Figure 9.41 shows a double top on the daily chart for Canadian dollar futures. (Continuous futures are used for most of the charts illustrating double tops and bottoms because the liquid trading period for most individual contracts is usually not long enough to display the time span encompassing these 135 CHART PATTERNS patterns and the preceding and succeeding trends.) Figure 9.42 shows a major double bottom in the E-mini Nasdaq 100 futures. Figure 9.43 depicts a double bottom on a two-minute chart: In this case the pattern preceded an explosive upmove (nearly 1 percent in less than an hour) in the June 2015 Mini Russell 2000 futures. FIGURE  9.38 “V” T op: Wheat Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.39 “V” Bottom: Euro Stoxx 50 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 136A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.40 Double T op: Euro Bobl W eekly Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.41 Double T op: Canadian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 137 CHART PATTERNS FIGURE  9.42 Double Bottom: E-Mini Nasdaq 100 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.43 Double Bottom: June 2015 Mini Russell 2000 Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 138A COMPLETE GUIDE TO THE FUTURES MARKET As illustrated in Figures 9.40 through 9.43 , a double top (bottom) is considered completed when prices move below (above) the reaction low (high) between the two tops (bottoms) of the forma- tion. When the intervening reaction is relatively deep, as for example in Figure 9.44 , it is impractical to wait for such an “offi cial” confi rmation, and a trader may have to anticipate that the pattern has formed based on other evidence. For example, in Figure 9.44 , the confi rmation of the double top did not occur until the market had dropped nearly 20 percent from the May 2008 high (the second peak of the double top). However, the pennant pattern that formed after the initial downswing from that high implied the next price swing would also be down. Based on this clue, a trader could have reasonably concluded a double top was in place, even though the pattern had not yet been completed according to the standard defi nition. T op and bottom formations with more repetitions (e.g., triple top or bottom) occur rather infrequently but would be interpreted in the same fashion. Figure 9.45 shows a triple top in weekly DAX futures. head and Shoulders The head-and-shoulders pattern is one of the best-known chart formations. The head-and-shoulders top is a three-part formation in which the middle high is above the high points on either side (see Figure 9.46 ). Similarly, the head-and-shoulders bottom is a three-part formation in which the mid- dle low is below the low point on either side (see Figures 9.47 and 9.48 ). Perhaps one of the most common mistakes made by novice chartists is the premature anticipation of the head-and-shoulders formation. The head-and-shoulders pattern is not considered complete until the neckline—a line FIGURE  9.44 Double T op: Platinum Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 139 CHART PATTERNS FIGURE  9.45 Triple T op: DAX Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.46 Head-and-Shoulders T op: Sugar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. connecting the reaction lows or highs separating the shoulders from the head—is penetrated, as illustrated in these charts. Furthermore, a valid head-and-shoulders pattern is formed only after a major price move has occurred. Patterns that bear the shape of a head-and-shoulders formation but lack this requirement can be misleading. 140A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.47 Head-and-Shoulders Bottom: Euro Stoxx 50 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.48 Head-and-Shoulders Bottom: November 2012 Soybeans Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 141 CHART PATTERNS Figure 9.48 is noteworthy in that the “head” of the head-and-shoulders bottom consists of twin lows that constitute a double bottom, a pattern that would have been confi rmed when price traded above the early December high (short dashed line), as discussed in the previous section. The penetra- tion of the head-and-shoulders neckline occurred approximately six weeks later. Sometimes the distinction between a head-and-shoulders pattern and a triple top (or bottom) pattern is not clear-cut. For example, Figure 9.49 shows a major long-term top in the U.S. Dol- lar Index futures in which the ultimate high has slightly lower highs on either side. This formation could reasonably be categorized as either pattern—regardless, its implication as a top pattern is the same. rounding tops and Bottoms Rounding tops and bottoms (also called saucers ) occur somewhat infrequently, but are among the most reliable top and bottom formations. Figure 9.50 shows a Nikkei 225 continuous futures chart with a rounding top that formed at the apex of a multiyear high and was followed by a sharp sell-off . Ideally, the pattern would not contain any “jags,” as this chart does (e.g., the sharply lower low in late June); however, I consider the main criterion to be whether the outer perimeter conforms to a rounding shape. Figure 9.51 depicts a rounding top pattern that formed a major peak in soybean continuous futures in 2014. Although the late-April to early-May price dip prevented a perfect rounding top pattern, the outer boundary of the March–May price action conformed well to a rounding pattern. FIGURE  9.49 Head-and-Shoulders or Triple T op? Dollar Index Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 142A COMPLETE GUIDE TO THE FUTURES MARKET Figure 9.52 provides a textbook instance of a rounding bottom pattern in lean hog continuous futures. Notice that in this example the price action during the bottoming process was relatively smooth and mostly free of the occasional jagged moves that were present in the previous examples. This rounding bot- tom was followed by an explosive upmove that began in mid-February 2014. Figure 9.53 shows a briefer rounding bottom in the Swiss franc that marked the transition from a downturn to an uptrend. FIGURE  9.50 Rounding T op: Nikkei 225 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.51 Rounding T op: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 143 CHART PATTERNS FIGURE  9.52 Rounding Bottom: Lean Hog Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.53 Rounding Bottom: Swiss Franc Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. triangles Triangles, which are among the most common continuation patterns, can be top and bottom forma- tions as well. Figures 9.54 through 9.57 illustrate triangle tops and bottoms. As in the case of the continuation pattern, the key consideration is the direction of the breakout from the triangle. 144A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  9.54 Triangle T op: Platinum Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.55 Triangle T op: Orange Juice Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 145 CHART PATTERNS FIGURE  9.56 Triangle Bottom: DAX Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  9.57 Triangle Bottom: Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 146A COMPLETE GUIDE TO THE FUTURES MARKET The tops in Figures 9.54 and 9.55 took the form of large descending triangles. The downside breakouts out of both patterns were followed by energetic sell-off s. (Notice also in Figure 9.55 the two fl ags that formed during the March–May downtrend that followed the penetration of the tri- angle’s lower boundary. Each would have given traders who missed the initial breakout a chance to capture at least some of the downmove.) Figure 9.56 shows a triangle bottom in DAX continuous futures that was followed by a major uptrend. The symmetrical triangle bottom that formed on the daily copper chart in 2010 (Figure 9.57 ) is shown in the weekly inset to be part of a correction in the market’s longer-term uptrend. Major tops and bottoms may often be consistent with more than one type of pattern. For example, a case could have been made for defi ning the preceding triangular tops and bottoms as head-and- shoulders formations with, generally speaking, similar pattern confi rmation points. W edge In a rising wedge, prices edge steadily higher in a converging pattern (see Figure 9.58 ). In instances when the successive highs form in a relative tight band, as they do here, the inability of prices to accelerate on the upside, despite continued probes into new high ground, suggests the existence of strong scale-up selling pressure. A sell signal occurs when prices break below the lower wedge line. Figure 9.59 provides an example of a declining wedge. W edge patterns can sometimes take an extremely long time to complete. The wedge in Figure 9.59 formed over the course of a year, and even longer-term wedges have been known to occur. FIGURE  9.58 Rising W edge: Euro Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 147 CHART PATTERNS FIGURE  9.59 Declining W edge: Sugar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Spikes and reversal Days These one-day patterns, which often mark relative highs and relative lows, and sometimes major peaks and bottoms, were discussed in an earlier section of this chapter. 149 I always laugh at people who say, “I’ve never met a rich technician. ” I love that! It is such an arrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician. —Marty Schwartz M ost traders who have never used chart analysis (and even some who have) are quite skeptical about this approach. Some of the commonly raised objections include: “How can such a simple analytical approach work?” “Since key chart points are hardly a secret, won’t large professional traders sometimes push the market enough to trigger chart stops artificially?” “Even if chart analysis worked before it was detailed in scores of websites, books, and magazines, isn’t the method too well publi- cized to still be effective?” Although the points raised by these questions are basically valid, a number of factors explain why chart analysis remains an effective trading approach: 1. Trading success does not depend on being right more than half the time—or, for that matter, even half the time—as long as losses are rigidly controlled and profitable trades are permitted to run their course. For example, consider a trader who in March 1991 assumed that September 1992 eurodollars had entered another trading range (see Figure 10.1) and decided to trade in the direction of any subsequent closing breakout. Figure 10.2 shows the initial trade signals and liqui- dation points that would have been realized as a result of this strategy. The implicit assumption is that stops are placed at the midpoint of the trading range. (The relevant considerations in choos- ing a stop point are discussed in detail in Chapter 13.) As can be seen in Figure 10.2, the first two trades would have resulted in immediate losses. Figure 10.3, however, shows the third signal was the real thing—a long position that would have occurred in time to benefit from a major price advance that far exceeded the combined price swings on the prior two adverse trades. (Note the relevant trading range is redefined— that is, widened—after each of the false breakouts.) Is Chart Analysis Still Valid? Chapter 10 150A COMPLETE GUIDE TO THE FUTURES MARKET It is noteworthy that although two out of three trades were losers, on balance the trader would have realized a large net profi t. The key point is that a disciplined adherence to money management principles is an essential ingredient in the successful application of chart analysis. 2. Chart analysis can be made much more eff ective by requiring confi rmation conditions for trade entry, rather than blindly following all technical signals. There is a natural trade-off in the choice of confi rmation rules: the less restrictive the conditions, the greater the number of false signals; the more restrictive the conditions, the greater the potential surrendered profi t due to late entry. Some of the key methods that can be used to construct confi rmation conditions might include the following: time delays, minimum percent penetration, and specifi c chart patterns (e.g., the trade must be confi rmed by two subsequent thrust days in the direction of the signal). There is no such thing as a best set of confi rmation conditions. In any list of tested alterna- tives, the indicated best strategy will vary from market to market as well as over time. Thus, the ultimate choice of confi rmation rules will depend on the trader’s analysis and experience. In fact, the specifi c choice of confi rmation conditions is one of the pivotal ways in which chart analysis is individualized. As an illustration of how confi rmation conditions might be used, consider the following set of rules: a. Wait three days after signal is received. b. For a buy signal, enter trade if the close is above the high since signal was received, or on the fi rst subsequent day fulfi lling this condition. An analogous condition would apply to sell signals. FIGURE /uni00A010.1 Trading Range Market: September 1992 Eurodollar Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 151 IS CHART ANALYSIS STILL VALID? As can be seen in Figure 10.2 , these rules would have fi ltered out the losing March and May signals while only modestly delaying the entry point for the subsequent highly profi table buy signal. Of course, one could also construct examples in which the use of confi rmation condi- tions is detrimental to the trading results. However, the key point is that the use of confi rmation rules is one of the primary means of transforming classical chart concepts into a more powerful trading approach. 3. Chart analysis is more than just the recognition and interpretation of individual patterns. One of the earmarks of the successful chart trader is an ability to synthesize the various components of the overall picture. For example, the trader who recognizes just a trading range in September 1992 Eurodollars (see Figure 10.1 ) would treat upside and downside breakouts equivalently. However, the more experienced chartist will also consider the broader picture. For example, by examining the long-term weekly continuous futures chart in early 1991 (see Figure 10.4 ), the analyst could have noted that the market had just formed a fl ag pattern near the top of a fi ve-year trading range. This extremely bullish long-term chart picture would have strongly cau- tioned against accepting any apparent sell signals on the daily chart. Such a more comprehensive chart analysis could therefore have helped the analyst avert the false sell signal in March (see Figure 10.2 ) and adopt a much more aggressive trading stance from the long side than would have been warranted if the situation were viewed as just another trading range. Figures 10.5 and 10.6 illustrate a similar example in June 2012 natural gas futures. In ear- ly 2011 a trader who decided to trade in the direction of a breakout of the October 2010– January 2011 trading range (again, assuming a stop point in the middle of the range) would have FIGURE /uni00A010.2 False Breakout Signals: September 1992 Eurodollar Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 152A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE /uni00A010.3 Winning Breakout Signal after Two False Signals: September 1992 Eurodollar Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE /uni00A010.4 Long- T erm Chart as Part of Comprehensive Analysis: Eurodollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 153 IS CHART ANALYSIS STILL VALID? experienced fi ve losing trades (three buys and two sells) before the August 2011 sell signal that was followed by an extended downmove. The context provided by the weekly chart (Figure 10.6 ), however, suggests a trader who was aware of the longer-term downtrend that preceded the consolidation could have reasonably chosen to ignore upside breakouts and focus exclusively on downside breakouts in expectation of a continuation of that trend. Of course, the preceding examples benefi t from hindsight. However, the point is not to prove the application of chart analysis would have conclusively indicated the probable continua- tion of a long-term bull market in eurodollar futures in early 1991 or the likely perpetuation of the extended downtrend in natural gas futures in 2011, but rather to illustrate the multifaceted analytical process of the experienced chart trader. It should be clear that the skill and subjectiv- ity implied in this approach place chart analysis in the realm of an art that cannot be mimicked by merely following a set of textbook rules. This is a crucial point in understanding how the chartist approach can remain valid despite widespread publicity. 4. Assuming some skill in fundamental forecasting (i.e., a better than 50/50 accuracy rate), chart analysis can be combined with fundamental projections to provide a more eff ective approach. Spe- cifi cally, if the long-term fundamental forecast indicates the probability of much higher (lower) prices, only bullish (bearish) chart signals would be accepted. If the fundamental projection was neutral, both buy and sell signals would be accepted. Thus, the chart analyst who is also a competent fundamental analyst would have a decided edge over the majority of traders basing their trading decisions solely on chart-oriented input. FIGURE /uni00A010.5 False and Winning Breakout Signals: June 2012 Natural Gas Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 154A COMPLETE GUIDE TO THE FUTURES MARKET 5. The failure of a market to follow through in the direction of a key chart signal is a crucial item of information often overlooked by novice chartists. Recognizing and acting on these situations can greatly enhance the eff ectiveness of the chartist approach. This subject is discussed in detail in Chapter 15 . In conclusion, the skeptics are probably correct in claiming that a Pavlovian response to chart sig- nals will not lead to trading success. However, this assertion in no way contradicts the contention that a more sophisticated utilization of charts, as suggested by the cited factors, can indeed provide the core of an eff ective trading plan. In any case, chart analysis remains a highly individualistic approach, with success or failure critically dependent on the trader’s skill and experience. It would be unreason- able to expect to play the violin well without some degree of practice and innate talent. Chart analysis is no diff erent—the sour notes of novice practitioners notwithstanding. FIGURE /uni00A010.6 Long- T erm Chart as Part of Comprehensive Analysis: June 2012 W eekly Natural Gas Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 155 Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius—and a lot of courage to move in the opposite direction. — Ernst F. Schumacher ■ What Is an Indicator? T echnical indicators are mathematical formulas based on market data—most often prices, but also occasionally volume and open interest. (In the equity market, other data, such as the number of advancing or declining issues, are sometimes incorporated in these calculations.) The implicit goal of most technical indicators is to signal potential changes in market direction that might not be apparent through direct price analysis or fundamental analysis. The implicit assumption underlying this approach is that indicators extract or distill useful forecasting information from market data. Most indicators attempt to translate price action into directional signals in one of two ways: 1. Comparing current price levels to past price levels to determine the prevailing direction and magnitude of price change. 2. Using a smoothing function, such as a moving average, to filter out what are deemed to be ran- dom fluctuations (“noise”), thus revealing a market’s prevailing trend. There are any number of ways to accomplish either of these goals, or to combine them. Consider the simple case of comparing today’s closing price with the most recent 20 days of price action to determine how much price has changed and whether the close is relatively strong or weak. The fol- lowing are only some of the possible approaches: 1. Calculate the difference between the current close and the close 20 days ago. 2. Calculate the percentage change (ratio) of the current close and the close 20 days ago. T echnical Indicators Chapter 11 156 A Complete Guide to the Futures mArket 3. Determine the current closing price’s position within the 20-day high-low range, or its position within the range of the highest and lowest closing prices of the past 20 days. 4. Measure how much the current closing price varies from the “typical” price of the past 20 days by comparing it (as either a difference or a ratio) to the average (or median) of the other closing prices during this period. 5. Alternatively, a shorter-term moving average (or median) value could be substituted for the closing price in the previous calculation, in which case the indicator would become the differ- ence between (or ratio of), say, a 3-day moving average and the 20-day moving average. 6. Use a statistical measurement, such as percentile rank, to determine where the current close places among the 20 most recent closes, or within the 20-day range. 7. Rather than using the most recent closing price as the reference point, the direction and pace of price changes over the past 20 days could alternatively be measured by comparing the period’s aggregate (or average) gains to its aggregate (or average) losses. One example: Divide the sum (or average) of the positive close-to-close changes over the past 20 days by the sum (or average) of the absolute negative close-to-close changes over the past 20 days. All these calculations provide some gauge of how far, and in what direction, a market has moved over the past 20 days. Moreover, any of the foregoing indicators could be based on values other than 20, expanding the list of possible indicators by another dimension. If this list of possible indicators seems excessive (or redundant), peruse any trading website, app, or analysis platform, and you are likely to be confronted by dozens—sometimes in excess of 100—technical indicators, all purport- edly designed to help interpret and forecast market activity. Grappling with the sheer number of indicators, and their often cryptic formulas and names, can be a daunting prospect for the new trader or analyst, who might understandably assume each of these tools has unique properties and specific purposes. The truth, however, is that despite the wide array of indicators and the properties ascribed to them by various proponents and followers, the majority of these tools are based on a handful of basic mathematical formulas. In fact, variations and combinations of the previously listed seven calculations provide the basis for a surprisingly large percentage of the most widely referenced technical tools. One critical consequence of this observation is that there is a high degree of correlation among tech- nical indicators, even if they might seem to be unrelated at a glance. Rather than risking a descent down the rabbit hole of comparing the supposed applications and idiosyncrasies of dozens of technical indicators, the following discussion instead focuses on the basic types of calculations underlying these indicators and what they can and cannot convey about market behavior. The goal is to provide the reader with a logical foundation for objectively interpreting and analyzing technical indicators. In short, readers looking for answers to questions such as “What’s the best technical indicator?” or “What are the best settings for indicator xyz?” or “Which indicators are best for trading currency (or grain, or stock index) futures?” should look elsewhere. These are, in fact, meaningless questions because they presuppose a degree of differentiation among indicators that does not exist and assume a stability in the performance of individual indicators that is unsup- ported by empirical evidence. 157 TEChnICAl InDICATORS ■ The Basic Indicator Calculations Most technical indicators incorporate one or more of the following five calculations: 1. A smoothing function, such as a moving average or moving median. 2. A comparison of the current data point to a specific past data point, as either a difference (e.g., today’s close minus the close 10 days ago) or a ratio (today’s close divided by the close 10 days ago). 3. A comparison of the current data point to an average (e.g., today’s close minus the average close of the past 10 days). 4. A comparison of an average to another average of a different length (e.g., the 10-day moving average minus the 30-day moving average). 5. A comparison of the current data point to a past range (e.g., the difference between today’s close and the lowest low of the past 10 days divided by the difference between the highest high of the past 10 days and the lowest low of the past 10 days). Beyond the number of price bars used (the “look-back period”), these calculations allow for a great deal of variation without altering the basic characteristics of the indicator. For example, a smoothing function could take the form of a simple moving average, a weighted moving average, an exponen- tial moving average, or an “adaptive average” that adjusts its length according to changes in market volatility. Moreover, any of these averages could be based on a bar’s closing price, high, low , open, or midpoint. ■ Comparing Indicators Figures 11.1 through 11.5 illustrate the five types of indicator calculations defined in the previous sec- tion and highlight the relationships between them. For reference, we’ll use the following shorthand to identify these formulas: Indicator 1: M a (moving average). Indicator 2: Close – Close (difference) or Close/Close (ratio). Indicator 3: Close – M a (difference between close and moving average) or Close/Ma (ratio of close and moving average). Indicator 4: Ma – Ma (difference between two moving averages) or Ma/Ma (ratio of two moving averages). Indicator 5: CS (closing strength). In all cases, subscripts are used to denote the look-back period—for example, “MA 30” refers to a 30-bar moving average, “Close – Close10” refers to the difference between the current close and the close 10 bars ago, and so on. In Figure 11.1, a daily price chart of WTI crude oil from August 2015 to May 2016 is overlaid with 10- and 30-day simple moving averages (thin and thick lines, respectively). The lower portion of the chart contains two indicators. The first is the difference between the most recent close and the close 158A COMPlETE GUIDE TO ThE FUTURES MARKET 10 days earlier (Close – Close 10 ), while the second is the diff erence between the close and the 10-day moving average (Close – MA 10 ). Both calculations provide a snapshot of the price movement over the most recent 10 days—how much price has moved relative to each indicator’s respective reference price. For the fi rst indicator, positive values occur when the current close is above the close 10 days ago; negative values occur when the current close is below the close 10 days ago. For the second indica- tor, positive or negative values refl ect closing prices above or below the 10-day average price. notice that although the two indicators have minor diff erences, their fl uctuations closely mirror each other. The indicators in Figure 11.2 are the ratio versions of the indicators in Figure 11.1 —that is, the result of dividing the current close by the close 10 days ago (Close/Close 10 ), and dividing the cur- rent close by the 10-day moving average (Close/MA 10 ). note that they appear to be the same as the indicators in Figure 11.1 except for their scaling. In fact, the indicators in Figure 11.2 are perfectly correlated to their counterparts in Figure 11.1 . In other words, in terms of trading signal generation, there is absolutely no diff erence between the two sets of indicators. Figure 11.3 returns to the diff erence calculations used in Figure 11.1 , except the look-back period for both is 30 days instead of 10 days. Again, the indicators appear very similar, although each is signifi cantly diff erent from its counterpart in Figure 11.1 because of the longer look-back period: The 30-day indicators in Figure 11.3 highlight far fewer of the shorter-term price highs and lows and instead trace the contour of the intermediate-term price action. For example, during the FIGURE  11.1 Diff erence Indicators: Close – Close vs. Close – MA Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 159 TEChnICAl InDICATORS FIGURE  11.2 Ratio V ersions of Diff erence Indicators Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  11.3 30-Day V ersions of Close – Close and Close – MA Indicators Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 160A COMPlETE GUIDE TO ThE FUTURES MARKET October–December 2015 period, both indicators are smoother and have a more pronounced down- ward bias than their 10-day counterparts in Figure 11.1 . Figure 11.4 compares the Close – MA 30 indicator from Figure 11.3 with the MA 10 – MA 30 indica- tor, which represents the diff erence between the 10-day moving average and 30-day moving average. The use of two moving averages produces an indicator that is closely related to the Close − MA indicator, but is smoother and a bit less timely (e.g., note the delay between the MA 10 – MA 30 and the Close – MA 30 indicator in refl ecting the early-April price low). Finally, Figure 11.5 compares the Close/Close 10 indicator from Figure 11.2 with the CS 10 indicator, which shows where the current close falls within the range (high–low) of the most recent 10 days (e.g., if the close is the highest price of the most recent 10 days, the indicator reading is 1.00, or 100 percent). The similarities between the indicators in Figures 11.1 through 11.5 are substantial and not specifi c to the time window represented in these charts. Table 11.1 shows the correlation coeffi cients 1 for all six pair combinations of the four 10-day indicator calculations (Close – Close, Close – MA, CS, and MA – MA 2 ) FIGURE  11.4 Price – MA vs. MA – MA Indicators Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 1 The correlation coeffi cient, which measures the linear relationship between two data samples, ranges from –1.00 to +1.00, with –1.00 representing a perfect negative correlation (values moving in exact opposition) and +1.00 representing perfect positive correlation (values moving exactly in tandem). 2 The MA – MA calculations in Table 11.1 use three days for the short-term moving average and 10 days for the long-term moving average. 161 TEChnICAl InDICATORS FIGURE  11.5 Close/Close vs. Closing Strength Indicators Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. table 11.1 10-Day Indicator Correlations, Crude Oil Close – Close vs. Close – Ma Close – Close vs. Ma – Ma Close – Close vs. CS Close – Ma vs. Ma – Ma Close – Ma vs. CS Ma – Ma vs. CS aug. 2015– May 2016 0.81 0.83 0.81 0.89 0.93 0.83 May 2005– May 2016 0.84 0.86 0.77 0.90 0.87 0.78 during two periods: August 14, 2015 through May 5, 2016 (the period shown in Figures 11.1 through 11.5 ); and a much longer period, May 5, 2005 through May 5, 2016. The lowest correlation between any two indicators during the August 2015–May 2016 period was 0.81. The correlations for the 2005– 2016 period were similar, with some pairs registering modestly higher correlations and other pairs modestly lower correlations. Even the lowest fi gure in Table 11.1 (0.77, for the May 2005–May 2016 Close – Close vs. CS indicator comparison) refl ects a signifi cant level of positive correlation. 162 A Complete Guide to the Futures mArket Table 11.2 extends the same analysis to three additional markets—corn, E-mini S&P 500, and euro futures—and from 6 to 10 indicator-pair combinations, based on adding a sixth calculation: the Up/Down Average (“U/D Avg.”), which is defined as the average positive close-to-close change over the past N days divided by the average (absolute) negative close-to-close change over the past N days, normalized so that it fluctuates in a range from zero to 1.00. 3 Table 11.2 also differs from Table 11.1 in that it is based on 20-day look-back periods (instead of 10), except for the MA – MA indicator, which uses a short-term moving average length of 10 days and a long-term moving average length of 30 days. Although Table 11.2 contains some readings well below the lowest correlation figure in Table 11.1 (mostly for pairs involving the Up/Down Average indicator), the average and median correlations for the ten indicator combinations shown are still uniformly strong, ranging from a low of 0.54 to a high of 0.87. Table 11.3, which replicates the analysis of Table 11.2 using 60-day look-back periods instead of 20 (and 20-day and 60-day moving average lengths for the MA – MA indicator), demonstrates very similar results, with the average/median correlations ranging from a low of 0.49 to a high of 0.90. The significance of the similarity between the indicator formulas discussed thus far is that they are the building blocks of a host of popular indicators, especially those known as momentum indicators, or “oscillators.” This group includes, but is by no means limited to, momentum, rate- of-change (ROC), the stochastic oscillator, the relative strength index (RSI), %R, moving average table 11.2 20-Day Indicator Correlations Close – Close vs. Close – Ma Close – Close vs. Ma – Ma Close – Close vs. CS Close – Close vs. U/D avg. Close – Ma vs. Ma – Ma Close – Ma vs. CS Close – Ma vs. U/D avg. Ma – Ma vs. CS Ma – Ma vs. U/D avg. CS vs. U/D avg. Crude oil Aug. ’15–May ’16 0.84 0.81 0.84 0.88 0.72 0.95 0.72 0.68 0.69 0.72 May ’05–May ’16 0.88 0.88 0.79 0.57 0.80 0.87 0.52 0.69 0.51 0.53 Corn Aug. ’15–May ’16 0.77 0.84 0.71 0.33 0.53 0.91 0.15 0.45 0.34 0.19 May ’05–May ’16 0.86 0.90 0.71 0.59 0.69 0.80 0.52 0.55 0.53 0.51 S&p 500 Aug. ’15–May ’16 0.90 0.84 0.81 0.81 0.71 0.68 0.79 0.90 0.64 0.66 May ’05–May ’16 0.88 0.84 0.74 0.51 0.67 0.57 0.44 0.86 0.43 0.48 euro Aug. ’15–May ’16 0.80 0.86 0.77 0.77 0.58 0.90 0.74 0.55 0.61 0.75 May ’05–May ’16 0.86 0.90 0.76 0.65 0.70 0.87 0.59 0.61 0.57 0.62 average: 0.85 0.86 0.77 0.64 0.68 0.82 0.56 0.66 0.54 0.56 Median: 0.86 0.85 0.77 0.62 0.69 0.87 0.55 0.64 0.55 0.58 3 The formula for normalizing the indicator values between 0 and 1.00 is: 1 – {1/[1 + (UA/DA)]}, where UA is the average positive close-to-close change over the past n bars and DA is the absolute value of the average nega- tive close-to-close change over the past n bars. 163 TEChnICAl InDICATORS table 11.3 60-Day Indicator Correlations Close – Close vs. Close – Ma Close – Close vs. Ma – Ma Close – Close vs. CS Close – Close vs. U/D avg Close – Ma vs. Ma – Ma Close – Ma vs. CS Close – Ma vs. U/D avg Ma – Ma vs. CS Ma – Ma vs. U/D avg CS vs. U/D avg Crude oil Aug. ’15–May ’16 0.85 0.90 0.82 0.60 0.88 0.95 0.83 0.83 0.67 0.75 May ’05–May ’16 0.91 0.92 0.76 0.27 0.90 0.86 0.43 0.74 0.26 0.50 Corn Aug. ’15–May ’16 0.23 0.05 0.42 0.53 0.56 0.90 0.07 0.46 0.22 0.22 May ’05–May ’16 0.87 0.85 0.76 0.68 0.84 0.82 0.61 0.66 0.59 0.58 S&p 500 Aug. ’15–May ’16 0.62 0.13 0.57 0.22 0.82 0.96 0.70 0.81 0.77 0.66 May ’05–May ’16 0.64 0.18 0.60 0.24 0.83 0.88 0.44 0.70 0.40 0.41 euro Aug. ’15–May ’16 0.80 0.74 0.78 0.79 0.70 0.93 0.90 0.60 0.73 0.85 May ’05–May ’16 0.85 0.86 0.78 0.62 0.84 0.88 0.59 0.72 0.53 0.64 average: 0.72 0.58 0.69 0.49 0.80 0.90 0.57 0.69 0.52 0.58 Median: 0.82 0.80 0.76 0.56 0.84 0.89 0.60 0.71 0.56 0.61 convergence-divergence (MACD), the price (or moving average) oscillator, the commodity chan- nel index (CCI), and the money flow index (MFI). (Note: There is little consistency in the technical indicator lexicon, especially with regard to more generic indicators. T erms such as momentum, rate of change, and price oscillator sometimes refer to different calculations in different sources. The names used here are widely applied, but may conflict with other sources. The calculations, not the names, are what are important.) Figure 11.6 compares five popular indicators: momentum, the “fast” stochastic oscillator, CCI, RSI, and the MFI. “Momentum” is simply the Close – Close indicator. The fast stochastic is a three-day moving average of the CS indicator. (The second, thinner line in the stochastic plot in Figure 11.6 is a three-day moving average of the primary indicator line.) The CCI divides the difference between price and a moving average (similar to the Close – MA indicator) by a measure of the absolute total price deviation during the look-back period. The RSI is essentially the U/D Average indicator, except it uses an exponential smoothing function instead of a simple moving average and is scaled from zero to 100 instead of zero to 1. The MFI is basically a volume-weighted version of the RSI that magnifies indicator readings that are accompanied by high trade volume. The precise formulas for these indica- tors (which are readily available online) are less important than the fact that they are all derived from our basic indicator calculations and are all highly correlated to each other. Table 11.4 summarizes the average correlations for 20-day versions of the 10 pair combinations of these five common indica- tors for the same periods shown in Tables 11.2 and 11.3. As Table 11.4 clearly demonstrates, these five popular indicators are all highly correlated, with correlations ranging from a low of 0.67 to a high of 0.94. The takeaway from this analysis is that all technical indicators that measure the magnitude and direction of prices over a given time period must inevitably compare at least two price points or 164A COMPlETE GUIDE TO ThE FUTURES MARKET groups of prices, which means they must incorporate at least one of the indicator formulas we have outlined, or a closely related calculation. Figures 11.1 through 11.6 and Tables 11.1 through 11.4 suggest the specifi c type of calculation used is far less important than the time period it surveys in terms of diff erentiating one indicator from another. This characteristic of indicators is starkly illus- trated in Figure 11.7 , which compares three indicator calculations (top to bottom): Close – Close 10 , MA 3 – MA 10 , and MA 20 – MA 100 . Although the upper and middle indicators use a diff erent type of calculation, they are very similar. In contrast, the middle and lower indicators use the same type of calculation but are radically diff erent. The key point is that the upper and middle indicators are similar because they both track a similar trend length, while the middle and lower indicators are very diff erent because the time length surveyed by the lower indicator is much longer. In short, it’s the time length, not the indicator, that matters. table 11.4 Correlations of Common Indicators, Daily Crude Oil Mom vs. Stoch Mom vs. CCI Mom vs. rSI Mom vs. MFI Stoch vs. CCI Stoch vs. rSI Stoch vs. MFI CCI vs. rSI CCI vs. MFI rSI vs. MFI Aug. ’15–May ’16 0.81 0.77 0.87 0.82 0.94 0.87 0.68 0.86 0.69 0.82 May ’05–May ’16 0.78 0.71 0.84 0.82 0.93 0.87 0.72 0.83 0.67 0.81 FIGURE  11.6 Popular Indicator Comparison Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 165 TEChnICAl InDICATORS FIGURE  11.7 Indicator length vs. Calculation Type Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. ■ Moving Average Types Moving averages, which are incorporated in many indicators, can be calculated in diff erent ways. Whereas a simple moving average (SMA) weights all prices equally (i.e., a 10-day average is the sum of the closing prices of the past 10 days divided by 10), the weighted moving average (WMA) and exponential moving average (EMA) use multipliers to increase the infl uence of more recent data in the calculation (see Chapter 16 for details). The logic behind weighting a moving average is based on an implicit assumption (not necessarily true) that recent price action is more important than more distant price action when attempting to forecast future price direction. The intent of weight- ing a moving average is to reduce lag by creating an indicator that is more responsive to directional changes—a seemingly logical goal, but one that can have drawbacks as well as advantages. Table 11.5 shows the results of testing the same basic trading system using simple, weighted, and exponential moving averages. The system goes long when prices close above the moving average and goes short when prices close below the moving average. The system was tested on three markets: the E-mini S&P 500 futures (ES), WTI crude oil futures (Cl), and euro futures (EC), using daily data from January 30, 2006, through January 28, 2016. In all cases, one contract was traded per signal, and the moving average length was set to 60 days. The results, while based on a small sample of markets, are illustrative. In each market, a diff erent type of moving average produced the highest net profi t and highest profi t factor (gross profi t/ gross loss). 166A COMPlETE GUIDE TO ThE FUTURES MARKET The implication is that the search for the “best” smoothing approach is likely to be a fruitless one. Over time, applied across multiple markets and parameter values, a particular smoothing calculation is unlikely to demonstrate a meaningful advantage over another. Figure 11.8 helps illustrate why. The daily crude oil prices in this chart are overlaid with 60-day simple (dashed line), weighted (thick solid line), and exponential (thin solid line) moving averages. In just a single roughly six-month period, there are multiple instances of the varying degrees of lag among the three moving averages helping or FIGURE  11.8 Moving Average Comparison Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. table 11.5 Simple, W eighted, and exponential Moving average Signals Net profit a No. trades Win % profit Factor b eS Exponential $5,440 163 23.31% 0.98 Simple –$1,635 163 19.63% 0.92 W eighted –$30,860 209 23.44% 0.76 Cl Simple $175,050 161 24.22% 1.87 Exponential $113,870 178 23.03% 1.42 W eighted $102,010 225 20.44% 1.3 eC W eighted $59,763 186 24.19% 1.36 Exponential $46,350 202 21.78% 1.29 Simple $29,325 154 21.43% 1.18 a Closed trades plus open trade profit/loss (P/l) at end of test period. b Reflects closed trades only. 167 TEChnICAl InDICATORS hurting performance. For example, in March 2015, the market closed above both the WMA and SMA (triggering long positions) before reversing to close below both averages the next day (triggering short positions)—a classic example of a “whipsaw” loss that occurs in trend-following strategies dur- ing congested or volatile market conditions. The EMA escaped this loss. however, in other instances of whipsaw trades evident in the chart, it was the WMA or SMA that avoided the losing trade, while the other two averages did not. Also, note that after the WMA suffered a whipsaw loss in early June while the SMA did not, in late June the WMA then provided a better short entry as the market turned sharply lower. Multiply the offsetting benefits and drawbacks illustrated in this chart by similar occur- rences in multiple markets over many years, and it is easy to see why one smoothing approach is unlikely to significantly outperform another, other than by chance. Ultimately, the look-back period will be more important than the particular smoothing tech- nique. Over time, the difference between using a 40-period EMA and a 40-period SMA will be much less significant than the difference between using a 40-period EMA and an 80-period EMA. Once again, it is the time length used in the calculation rather than the calculation type that matters. ■ Oscillators and Trading Signals The most common type of indicator by far is the one commonly referred to as the momentum indicator or oscillator, which is a calculation designed to highlight shorter-term swing points and so-called overbought and oversold levels. All the basic calculations and indicators in Figures 11.1 through 11.7 (using shorter-term look-back periods) could be placed in this category. The popularity of oscillators is probably driven by the desire of many traders to capture as many of a market’s twists and turns as possible. The popularity of oscillators, however, is arguably inversely correlated to their usefulness. T o see why, let’s examine a few examples of applying oscillators as trading tools. Figure 11.9 depicts the 10-year T -note futures with a 10-day fast stochastic oscillator line (i.e., a three-day moving average of the CS calculation). The indicator’s two horizontal lines at 80 and 20 are default overbought and oversold levels that, according to oscillator conventional wisdom, are used to indicate points at which price moves are overextended and likely to correct. Thus, over - bought readings (above 80) signal selling opportunities, and oversold readings (below 20) signal buying opportunities. Although the oscillator does seem to signal all the price turning points, it does so prematurely. The astute reader might argue that the simplistic use of the oscillator to signal trades whenever it enters overbought/oversold zones may be a suboptimal application of the indicator. What if, instead, we waited for the indicated reversal to be confirmed before generating a trade signal? For example, a buy signal might be triggered by the following dual conditions: 1. The oscillator declines into oversold territory (<20), suggesting an environment potentially conducive to long positions. 2. The oscillator then rises back above the oversold threshold (>20), confirming the anticipated trend reversal from down to up. 168A COMPlETE GUIDE TO ThE FUTURES MARKET A trade would be signaled only after the second condition is met. An analogous set of dual condi- tions would apply to sell signals. Figure 11.10 is the same chart as Figure 11.9 except it illustrates signals based on adding the confi rmation condition. now , the oscillator seems to perform spectacu- larly well as a trading tool, generating sells near relative highs and buys near relative lows! Many novice traders will see a chart such as Figure 11.10 and think they have discovered the perfect trading system. In fact, it is not uncommon for some vendors to market systems using similar approaches, illustrating the purported wonderful performance of their system with charts that look very much like Figure 11.10 . So what is wrong with such a dual-condition oscillator application for generating trading signals? nothing, as long as you can predict that the market will stay in a trading range in the future . The period shown in Figure 11.10 (late January to mid-June 2016) represents nearly ideal conditions for short-term indicators such as oscillators to track price swings: the market moved sideways and the price swings were relatively similar in magnitude. In such environments oscillators can appear to be almost foolproof trading tools. If, however, the same approach is applied to a trending market—and keep in mind it’s impossible to know whether a trending or trading range market will prevail in the future—the results can be disastrous. Figure 11.11 shows the signals that would have resulted from applying the same dual-condition trade rules in a trending market. In this case, during an eight- month period when the euro futures declined approximately 16 percent, the same oscillator trig- gered exactly one sell signal while issuing nine buy signals, including seven consecutive losing buys from August 2014 to January 2015. FIGURE  11.9 Oscillator Signals: Initial Penetration Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Oscillator Signals: Initial Penetration 169 TEChnICAl InDICATORS FIGURE  11.10 Oscillator Dual-Condition Signals Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  11.11 Oscillator Signals in Trending Market Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 170 A Complete Guide to the Futures mArket The bottom line is that oscillators will work well as contrarian trading tools if we can assume the market will move in a trading range. If the market instead embarks on an extended trend, oscillator- based signals can lead to huge losses. And while it is easy to identify past trading ranges for which an oscillator-based trading strategy will produce magnificent hypothetical results, we don’t know whether a trading range or trending market will prevail in the immediate future. In other words, we don’t know whether the upcoming market environment will be conducive or adverse to the use of oscillators. As a subjective observation, on balance, oscillators have probably harmed traders more than helped them. however, if a trader fully understands their limitations, these tools could still provide reasonable trading signals. For example, if a trader has good reason to expect that a trading range market is more likely to prevail—and uses rigorous risk management to control losses if this projection proves wrong—then an oscillator could be used as a trading tool. ■ Indicator Myths Through repetition over decades, certain bits of “common wisdom” regarding technical indicators have become entrenched in trading literature, despite the ability of traders to disprove such mislead- ing ideas through testing. The following list is far from exhaustive, but it touches upon some of the most dangerously misleading, and easily refutable, examples of such myths. the Confirmation Myth Traders are often exhorted to consult multiple technical indicators to “confirm” a potential trade signal. This advice may sound sensible, but given the high correlation among so many indicators, such confirmation is often an illusion. Unless the indicators being consulted are uncorrelated—say, if they use radically different look-back periods (which is usually not the case)—they are probably simply repeating the same information, with any apparent variations between the indicators likely meaning- less. The similarities between the indicators shown in Figures 11.1 through 11.7 illustrate how easy it is to generate false “confirmation” from calculations that are, more or less, the same indicator. the “Magic Number” Myth This misconception revolves around the belief that a specific indicator parameter (typically, the look- back period) provides universally optimal performance or otherwise possesses special properties. Popular examples include the nearly ubiquitous use of a 14-day look-back period as the default setting for short-term countertrend indicators and references in the financial media regarding the impor- tance of the penetration of a 200-day moving average. The reality is that such parameter values will be optimal only in isolated markets as a function of chance. The question of what values work best for a specific portfolio over a specific time range can be answered only by computer testing. And even then, the answer would apply only to past data and could not be presumed to be indicative of the optimal values for the future. Chapter 19, which addresses the issue of optimization, provides a more in-depth discussion of this point. 171 TEChnICAl InDICATORS the leading Indicator Myth Some technical tools are commonly referred to as “leading” indicators for their supposed ability to sig- nal a market move before the price series itself gives any indication of a change in direction. Although it might be fair to say that a price-based indicator could (to some eyes) highlight an aspect of price action with predictive properties, the inescapable fact is that an indicator can never “lead” price action because, by defi nition, it is based on historical prices. If a certain indicator reading or pattern proves (through testing) to have predictive value, that information must be present in the price series itself. the Divergence Signal Myth This belief is a subset of the leading indicator myth. Divergence is most commonly used to describe the phenomenon of an indicator (usually one designated as a “countertrend” tool) moving in opposition to a price series, and thus supposedly giving advance warning of vulnerability in the prevailing price trend. For example, prices might make a new high in an uptrend, while the countertrend indicator makes a lower high, suggesting the new price peak has been established on weaker momentum, which in turn implies that a correction or reversal is imminent. Such patterns are, in fact, quite common at market turning points. Unfortunately, though, they are also quite common at other times as well, often generating one false reversal signal after another during extended market trends. Figure 11.12 , which depicts crude oil prices during the market’s extended sell-off in 2014 and into early 2015, highlights FIGURE  11.12 Price-Indicator Divergences Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 172A COMPlETE GUIDE TO ThE FUTURES MARKET a series of successive price lows that were accompanied by higher lows in the MA 5 – MA 20 and Close – Close 20 indicators. These divergences between price and the indicators began signaling the potential for a signifi cant correction or reversal as soon as the trend began—approximately six months and $50/bl. before the market staged a modest bounce in late January 2015. The situation is even worse than it looks because Figure 11.12 omits some smaller false divergences that were left unmarked to avoid cluttering the chart. ■ Indicator “Types” Indicators are typically categorized according to whether they are intended to identify longer-term trends or emphasize shorter-term price swings and countertrend moves. While it is true that smoothing functions, such as moving averages, lend themselves to trend analysis because they simplify price action, such classifi cations usually have more to do with an indicator’s look-back period than any inherent characteristic of the calculation. For example, although moving average crossovers are “classic” trend- following signals, an MA 3 – MA 10 calculation (three-day moving average minus 10-day moving aver- age), which conforms to the standard moving-average crossover form, could hardly be described as a long-term trend-following indicator (see Figure 11.13 ). By contrast, the basic C – C momentum calculation, most often used to highlight short-term price swings, will nonetheless refl ect longer-term trends as its look-back period increases, as evidenced by the C – C 100 calculation shown in Figure 11.13 . FIGURE  11.13 length vs. Indicator Type Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 173 TEChnICAl InDICATORS ■ Conclusion Because they are derivatives of price, it can be argued that technical indicators—when used to gener- ate trading signals—actually distance traders and analysts from the data they are attempting to under- stand. Although indicators can, perhaps, highlight certain aspects of market action that might not be immediately evident by looking at a chart or a spreadsheet, they cannot create information that is not already present in the market data itself. Simplicity is generally a virtue with regard to technical indicators. There are only so many ways to measure the direction and magnitude of price changes, and the slight differences between approaches are unlikely to produce meaningful differences in trading signals. The more inputs an indicator has (and the more arcane those inputs are), the more likely that either it is obscuring, rather than clarifying, the market action it is intended to interpret, or it is merely a more complex version of a simpler calculation. Perhaps the most important insight the reader can take away from this chapter is that indicators that tend to work well in nontrending conditions will unavoidably perform miserably in trending conditions, whereas tools designed for trends will fare poorly in trendless markets. Unfortunately, markets do not ring bells when they are switching from one phase to the other. As a result, no single indicator or parameter input (such as the look-back period) can be expected to perform consistently well across multiple markets and time frames. APPlyiNg ChArt ANAlysis to trAdiNg Part III 177 Cha P ter 12 Nobody can catch all the fluctuations. —Edwin lefèvre F or many reasons, you may find yourself considering whether to enter a new position after the market has already made a substantial price move. Examples include: (1) you were not previously following the market; (2) in an effort to get a better price, you futilely waited for a price correction that never developed; (3) you were previously skeptical about the sustainability of the trend, but have now changed your opinion. Faced with such a situation, many traders will be extremely reluctant to trade the market. this attitude can be easily explained in psychological terms. the act of entering a new position after a trend is already well underway in a sense represents an admission of failure. Even if the trade is prof- itable, traders know their gains would have been much greater if they had acted earlier. thus, even when you have a strong sense of probable market direction, you might be tempted to think: “ i've missed so much of the move, why bother?” As an example, consider chart-oriented traders examining the coffee market in mid-February 2014 (see Figure 12.1) after not having participated in the sharp price advance prior to that time. such traders would have noted the market had broken out above the resistance level defined by the January 2014 and october 2013 highs, with prices remaining in new high ground for two weeks—a very bullish chart configuration. in addition, prices had just formed a flag pattern after an upmove— price action indicative of another imminent upswing. however, observing that prices had already advanced more than 37 percent since the November 2013 low (and more than 25 percent in just seven days in late January and early February), traders might have been reluctant to enter a new long position belatedly, reasoning the market was overextended. Midtrend Entry and Pyramiding 178A CoMPlEtE gUidE to thE FUtUrEs MArKEt Figure 12.2 vividly illustrates the folly of this conclusion. incredibly, as of mid-February 2014, coff ee prices had completed only about 35 percent of their ultimate advance to the March high. the moral of this tale is provided by an observation in Reminiscences of a Stock Operator by Edwin lefèvre: “[Prices] are never too high to begin buying or too low to begin selling.” the key question is how one enters the market in the midst of a major trend. Actually, the goals in implementing a midtrend position are the same as those for initiating any position: favorable timing FIGURE /uni00A012.1 Missed Price Move? (May 2014 Coff ee) Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. FIGURE /uni00A012.2 how it turned out (May 2014 Coff ee) Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. 179 MidtrENd ENtry ANd PyrAMidiNg of entry and risk control. the following are four key strategies that could be employed to achieve these objectives: 1. Percent retracement. this approach attempts to capitalize on the natural tendency of a market to partially retrace prior price swings. generally speaking, one might initiate the position anytime the market retraces a given percentage of the price swing from the last relative low or relative high. A reasonable choice for this percentage would be a fi gure in the 35 to 65 percent range. Figure 12.3 illustrates the entry points using this approach, assuming a 50 percent retracement criterion. Notice two of these retracements are based on rallies (A–d and C–d, respectively) that are defi ned by the same relative high but diff erent rela- tive lows. the main advantage of this method is that it is capable of providing superior entry points. however, it is also subject to a major disadvantage: frequently, the necessary retrace- ment condition may not be fulfi lled until the trend has carried much further, or possibly even reversed. 2. reversal of minor reaction. this approach is based on waiting for a minor reaction to mate- rialize and then entering on the fi rst signs of a resumption of the major trend. of course, the precise method would depend on how a reaction and trend resumption were defi ned. the choices are virtually limitless. For illustration purposes, we will provide one possible set of defi nitions. A “reaction” is identifi ed whenever the reaction count reaches 4. the reaction count is initially set to 0. in a rising market, the count would be raised to 1 any day in which the high and low were equal or lower than the corresponding points on the day on which the high of the move was set. the count would be increased by 1 each day the high and low are equal to or lower than the high FIGURE /uni00A012.3 Buy signals on 50 Percent retracements (E-Mini s&P MidCap 400 Continuous Futures) Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. 180A CoMPlEtE gUidE to thE FUtUrEs MArKEt and low of the most recent day on which the count was increased. the count would be reset to 0 anytime the market moved to new highs. Analogous conditions would apply to a declining market. the resumption of the major trend would be indicated whenever the thrust count reached 3. the thrust count would initially be set to 0 and would begin being monitored after a reaction was defi ned. in the case of a reaction in a rising market, the thrust count would increase by 1 on each upthrust day and would be reset to 0 anytime the reaction low was penetrated. (thrust days were defi ned in Chapter 9.) once a signal was received, the reaction low could be used as a stop-loss reference point. For example, the position might be liquidated anytime the market closed below the reaction low . once again, an analogous set of conditions could be used for defi ning a resumption of the trend in a declining market. Figure 12.4 illustrates the reversal of minor reaction approach using the specifi c defi nitions just detailed. the points at which reactions are defi ned are denoted by the symbol RD, with the numbers prior to these points indicating the reaction count values. Buy signals are indicated at the points at which the thrust count equals 3, with the letters prior to these points indicating the thrust count values. For any given entry point, stop-loss liquidation would be signaled by a close below the most recent stop level, which in this case is the lowest relative low between the identifi cation of the reaction and the completion of the thrust count. 3. Continuation pattern and trading range breakouts. the use of continuation pat- terns and trading ranges for entry signals was discussed in Chapter 9 . since to some extent chart patterns are in the eye of the beholder, this approach will reflect a degree of subjec- tivity. Figure 12.5 offers one interpretation of continuation patterns (implicit assumption: FIGURE /uni00A012.4 reversal of Minor reaction (Australian dollar Continuous Futures) Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. 181 MidtrENd ENtry ANd PyrAMidiNg at least five trading days are required to form a continuation pattern), and the correspond- ing sell points reflect closes below these consolidations. it should be noted, however, that once a trend is considered established, it is not absolutely necessary to wait for penetra- tions of continuation patterns as confirmation of trade entry signals. By definition, these patterns are expected to be resolved by price swings in the same direction as the price moves that preceded their formation. thus, for example, in a downtrend, short positions could be established within consolidation patterns based on an expectation of an eventual downside breakout. the high prices in the patterns depicted in Figure 12.5 could be used as reference points for the placement of protective stops (as marked on the chart) follow- ing the downside breakouts of these patterns. 4. reaction to long-term moving average. Price retracements to a moving average of the price series can be viewed as signals that the reaction to the main trend is near an end. specifi - cally, if a trader believed that an uptrend was in place, long positions could be entered anytime prices declined to below a specifi ed moving average. similarly, if a downtrend were believed to be in eff ect, short positions could be initiated on rallies above the moving average. Figure 12.6 , which superimposes a 40-day moving average over continuous E-mini s&P 500 futures, provides an illustration of this approach. For example, traders who were bullish on the stock market during the period depicted and looking to enter on a correction could have used price pullbacks below the 40-day moving average as entry signals for long positions. the arrows in Figure 12.6 indicate potential buy entry levels based on this approach. FIGURE/uni00A012.5 Continuation Pattern Breakouts as Entry signals (February Wti Crude oil) Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. 182A CoMPlEtE gUidE to thE FUtUrEs MArKEt FIGURE /uni00A012.6 reaction to long- t erm Moving Average (E-Mini s&P 500 Futures) Note: /uni2191 = buy entry signal based on a reaction to below the 40-day moving average. Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. Chapter 16 illustrates how crossovers of moving averages can be used as trend-reversal signals. in the application just described, we have used moving average crossover points to signal countertrend trade entry signals. there is no contradiction. When moving average crossovers are employed for generat- ing trend reversal signals, typically, two moving averages are used so that the smoothing of both data series will reduce false trend-reversal signals. in the method just detailed, we deliberately defi ned crossover points based on the price series itself, which is more sensitive than a moving average since it contains no smoothing of the data, and one moving average. in other words, we would use more sensitive defi nitions of moving average crossovers for countertrend applications than we would for trend-identifi cation applications. it should be noted that the problem of midtrend entry is identical to the problem of pyramiding , which is the implementation of additional units to an existing position. Both transactions involve implementing a position after the market has already witnessed a substantial move in a given direc- tion. Consequently, the strategies discussed in this chapter for a midtrend entry could also be applied to the timing of pyramid positions. A few additional guidelines are necessary for pyramiding. First, one should not add to any existing position unless the last unit placed shows a profi t. second, one should not add to an existing position if the intended stop point would imply a net loss for the entire position. third, pyramid units should be no greater than the base (initial) position size. 183 It was the same with all. They would not take a small loss at first but had held on, in the hope of a recovery that would “let them out even. ” And prices had sunk and sunk until the loss was so great that it seemed only proper to hold on, if need be a year, for sooner or later prices must come back. But the break “shook them out, ” and prices just went so much lower because so many people had to sell, whether they would or not. —Edwin Lefèvre T he success of chart-oriented trading is critically dependent on the effective control of losses. A precise stop-loss liquidation point should be determined before initiating a trade. The most disciplined approach would be to enter a good-till-canceled (GTC) stop order at the same time the trade is implemented. However, if the trader knows he can trust himself, he could predeter- mine the stop point and then enter a day order at any time this price is within the permissible daily limit. How should stop points be determined? A basic principle is that the position should be liquidated at or before the point at which price movement causes a transition in the technical picture. For exam- ple, assume a trader decides to sell September natural gas after the mid-October downside breakout has remained intact for five days (see Figure 13.1). In this case, the protective buy stop should be placed no higher than the upper boundary of the July–October trading range, since the realization of such a price would totally transform the chart picture. Some of the technical reference points com- monly used for placing protective stops include: 1. Trend lines. A sell stop can be placed below an uptrend line; a buy stop can be placed above a downtrend line. One advantage of this approach is that the penetration of a trend line will Choosing Stop-Loss Points Chap T er 13 184A COMPLETE GUIDE TO THE FUTURES MARKET usually be one of the fi rst technical signals in a trend reversal. Thus, this type of stop point will strongly limit the magnitude of the loss or the surrendered open profi t. However, this attribute comes at a steep price: trend line penetrations are prone to false signals. As dis- cussed in Chapter 6 , it is common for trend lines to be redefi ned in the course of a bull or bear market. 2. Trading range. As illustrated in the preceding natural gas example, the opposite side of a trading range can be used as a stop point. Frequently, the stop can be placed closer (particu- larly in the case of broader trading ranges) because if the breakout is a valid signal, prices should not retreat too deeply into the range. Thus, the stop might be placed somewhere in the zone between the midpoint and the more distant boundary of the range. The near end of the trading range, however, would not be a meaningful stop point. In fact, retracements to this area are so common that many traders prefer to wait for such a reaction before initiating a position. (The advisability of this delayed entry strategy following breakouts is a matter of personal choice. In many instances it will provide better fi lls, but it will also cause the trader to miss some major moves.) 3. Flags and pennants. After a breakout in one direction of a fl ag or pennant formation, the return to the opposite end (or some point beyond) can be used as a signal of a price reversal, and by implication a point for placing stops. For example, in Figure 13.2 the downside penetration of a fl ag pattern in mid-August was quickly followed by a rebound above the same formation. This price action proved to be a precursor of a signifi cant price advance. FIGURE /uni00A013.1 Stop Placement Following Trading Range Breakout: September 2015 Natural Gas Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 185 CHOOSING STOP-LOSS POINTS 4. Wide-ranging days. Similar to fl ags and pennants, after a breakout in one direction, the return to the opposite end can be used as a signal of a price reversal, and hence a point for plac- ing stops. For example, in Figure 13.3 note how the return of prices back above the true high of the wide-ranging down day that formed in mid-March (after initially trading below this pattern) led to a strong rally. 5. relative highs and relative lows. If the implied risk is not too great, the most recent relative high or relative low can be used as a stop point. 1 For example, assume a trader initiated a long position in December corn in response to the breakout above resistance in June (see Figure 13.4 ). In this case, the sell stop could be placed below either the May low or the June low . Sometimes the risk implied by even the closest technically signifi cant points may be excessive. In this case, the trader may decide to use a money stop— that is, a protective stop-loss point with no tech- nical signifi cance that is determined by the desired dollar risk level. For example, consider the plight of a trader in July 2008 who after the swift, steep (nearly $18/barrel) price break during the week ending July 18 is convinced the crude oil market has put in a major top (see Figure 13.5 ). The closest 1 The specifi c defi nition of a relative low or relative high is somewhat arbitrary. (The following description is in terms of the relative low , but analogous commentary would apply to the relative high.) The general defi nition of a relative low is a day whose low is below the lows of the preceding and succeeding N days. The specifi c defi nition of a relative low will depend on the choice of N . A reasonable range for N is 5 to 15. FIGURE /uni00A013.2 Stop Placement Following Flag Pattern Breakout: December 2010 RBOB Gasoline Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 186A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE /uni00A013.3 Stop Placement Following Wide-Ranging Day Breakout: June 2012 10- Y ear T -Note Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE /uni00A013.4 Stop Placement at Relative Lows: December 2012 Corn Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 187 CHOOSING STOP-LOSS POINTS FIGURE /uni00A013.5 Example of Market Where Money Stop Is Appropriate: December 2008 WTI Crude Oil Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. meaningful stop point—the contract high (which is the nearest relative high)—would imply a risk of $17,850 per contract (assuming entry at the July 18 closing price)! Although risk can sometimes be reduced if the trader waits for a reaction before entering the market, such a retracement may not occur until the market moves substantially lower. Thus, in a situation in which the nearest meaningful stop point implies a very large risk, a market order accompanied by a money stop may represent the most viable trading approach. Stops should be used not only to limit losses but also to protect profi ts. In the case of a long posi- tion, the stop should be raised intermittently as the market rises. Similarly, in a declining market, the stop should be lowered as the market declines. This type of stop is called a trailing stop. Figure 13.6 illustrates the use of a trailing stop. Assume a trader implements a long position on the breakout above the upper boundary of the trading range, with a stop-loss liquidation plan keyed to relative lows. Specifi cally, the trader plans to liquidate the long position following a close below the most recent relative low with the reference point being revised each time the market moves to new high ground. (Of course, the stop condition may often be more restrictive. For example, the trader might require a specifi ed number of closes below a previous low , or a minimum penetration of that low to activate the stop.) The initial stop-loss point would be a close below Stop 1, which is set at a level in the lower half of the trading range—a point that represents less risk than a stop at the more distant March 2009 relative low . Following the early June 2009 advance to new highs, the stop-loss reference point would be raised to the May low (Stop 2). Similarly, the stop reference points would be raised successively to the levels indicated by Stops 3 to 11. The position would have been stopped out on the decline below Stop 11 in March 2010. 188A COMPLETE GUIDE TO THE FUTURES MARKET As a general rule, stops should be changed only to reduce risk. Some traders who can’t stand the thought of getting stopped out at the bottom of a move (top if short) may be diligent in placing a GTC stop order upon initiating the position, but then cancel the order when the market gets within range. This type of order has been derisively, albeit appropriately, referred to as a CIC (cancel if close) order. Revising the stop to allow greater risk defeats the entire purpose of the stop. FIGURE /uni00A013.6 Trailing Stop: E-Mini Nasdaq 100 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 189 It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. —Edwin Lefèvre A trade is like the army—getting in is a lot easier than getting out. Provided the trader is adhering to money management principles, a losing trade presents little ambiguity; that is, liquidation would be indicated by a predetermined stop point. However, the profitable trade presents a problem (albeit a desirable one). How should the trader decide when to take profits? Myriad solutions have been proposed to this dilemma. The following sections explore some of the primary approaches. ■ Chart-Based Objectives Many chart patterns are believed to provide clues regarding the magnitude of the potential price move. For example, conventional chart wisdom suggests that once prices penetrate the neckline of a head-and-shoulders formation, the ensuing price move will at least equal the distance from the top (or bottom) of the head to the neckline. As another example, many point-and-figure chartists claim that the number of columns that compose a trading range provides an indication of the potential num- ber of boxes in a subsequent trend. (See discussion in Chapter 4 for an explanation of point-and-figure charting.) Generally speaking, chart patterns are probably considerably less reliable as indicators of price objectives than as trade signals. Setting Objectives and Other Position Exit Criteria Chapter 14 190A COMPLETE GUidE TO THE FUTUrES MArKET ■ Measured Move This method is the essence of simplicity. The underlying premise is that markets will move in approxi- mately equal-size price swings. Thus, if a market rallies 30 cents and then reacts, the implication is that the rally from the reaction low will approximate 30 cents. Although the measured move concept is so simple that it strains credibility, the approach off ers reasonable guidelines more frequently than one might expect. When two or more of these objectives nearly coincide, it tends to enhance the reli- ability of the price area as an important objective zone. Since price swings often span several contracts, it is useful to apply the measured move technique to longer-term price charts that link several contracts. Generally speaking, continuous futures charts are more appropriate than nearest futures charts for measured move analysis because, as was noted in Chapter 4 and further detailed in Chapter 5 , continuous futures accurately refl ect price swings, whereas nearest futures do not. in Figure 14.1 , the measured move objective that was fulfi lled in july 2012 was the result of adding the amount of the december 2011–May 2012 rally (404.75¢) to the early june 2012 low of 667.25¢. Figure 14.2 shows two measured moves on a weekly chart. The fi rst measured move target at 0.2711 (MM1), which was very close to the March 2015 relative low , was derived by subtract- ing the june–december 2014 decline of 0.0752 from the january 2015 high of 0.3462. The second measured move objective at 0.2297 (MM2), which was fairly close to the September 2015 low , was obtained by subtracting the january–March 2015 decline of 0.0818 from the late April high of FIGURE  14.1 Measured Move: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 191 SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA 0.3115. Figure 14.3 shows four measured move targets, three of which (MM1, MM3, and MM4) implied targets very near swing point highs. Figure 14.4 illustrates a series of reasonably accurate measured move targets in frozen orange juice futures from mid-2012 to late 2013. Price didn’t reach three of the targets (MM2, MM6, and MM9, represented by dashed lines), but missed only MM2 by a notable margin. Of the other six targets, all but MM4 represented quite advantageous exit points. Also, note that MM3 and MM5 signaled exit points at around the same level, reinforcing the target objective in that price vicinity. Figure 14.5 provides another example of successive reasonably accurate measured move targets over a roughly two-year period. Note that the same price point can serve as the terminus of two diff erent price swings (see October 2014 high with stacked 8 and 4), which can lead to two diff erent measured move objectives based on that point (MM4 and MM8). This chart also provides an example of coincident measured move objectives: MM6, which is a projection based on the january–March 2014 upswing off the May low , occurred one tick away from MM8, which was the result of adding the june–October 2013 rally to the November low . MM4 and MM5 also signaled exits at approximately the same price level. As Figures 14.4 and 14.5 illustrate, when there is more than one relevant price swing for deriv- ing a measured move objective, there will be more than one measured move objective for the same projected low or high. When two or more of these objectives nearly coincide, it tends to enhance the reliability of the projected price area as an important target zone. Figure 14.6 provides a perfect example of two coinciding measured move price targets. The measured move objectives implied by the july 2014–March 2015 decline (MM5) and the May–October 2015 decline (MM6) coincided just above the actual market bottom formed in january 2016. FIGURE  14.2 Measured Moves: brazilian real Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 192A COMPLETE GUidE TO THE FUTUrES MArKET FIGURE  14.3 Measured Moves: Soymeal Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. FIGURE  14.4 Measured Moves: Orange juice Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 193 SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA FIGURE  14.5 Concentration of Measured Move Targets: Cocoa Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. FIGURE  14.6 Concentration of Measured Move Targets: Canadian dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 194A COMPLETE GUidE TO THE FUTUrES MArKET ■ Rule of Seven This method of setting objectives is an interesting and easy-to-use approach detailed in T echniques of a Professional Commodity Chart Analyst by Arthur Sklarew (Windsor books, 1980). The rule of seven refers to a common set of multipliers used to determine objectives, which are derived by dividing 7 by 5, 4, 3, and 2, respectively. Thus, the multipliers are: 7 ÷ 5 = 1.4, 7 ÷ 4 = 1.75, 7 ÷ 3 = 2.33, and 7 ÷ 2 = 3.5. The products of each of these multipliers and the magnitude of the fi rst price swing in a bull market are added to the low to obtain a set of price objectives. in a bear market, the products are subtracted from the high. Sklarew suggests using the latter three multipliers (1.75, 2.33, and 3.5) for fi nding objectives in bull markets and the fi rst three multipliers (1.4, 1.75, and 2.33) for deriving objectives in a bear market. in addition, he indicates objectives based on the lower multipliers are more meaningful if the reference price move (the price swing multiplied by the multipliers) is of extended duration (i.e., several months) and objectives based on the higher multipliers are more signifi cant if a short-term price swing is used in the calculations. Of course, there will be some degree of subjectivity in this approach, since the percep- tion of what constitutes the fi rst price swing in a trend could vary from trader to trader. The rule of seven is illustrated in Figure 14.7 . (Note that this is the same chart that was used as Figure 14.3 to illustrate measured move objectives. readers may fi nd it instructive to compare the FIGURE  14.7 rule of Seven: Soymeal Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 195 SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA implications of these two approaches.) The fi rst wave of the bull market that began in April 2013 was 94.30 points, measured from the April low to the june high. Following Sklarew’s guidelines, because this is a bull market, we skip the fi rst objective and use the second through fourth objec- tives, obtained using the multipliers 1.75, 2.33, and 3.5. The April 11 low , which is used to cal- culate all the objectives, was 123.90. The second objective is 288.90 [123.90 + (1.75 × 94.30)]. The third objective is 343.60 [123.90 + (2.33 × 94.30)]. The fourth objective is 454 [123.90 + (3.5 × 94.30)]. Note that objective 2 was just below the december 2013 relative high of 294.80, while objective 3 was just below the February 27 relative high of 346.10. The market failed to reach objective 4. Figure 14.8 (which repeats Figure 14.6 ) illustrates the rule of seven for an extended bear market in Canadian dollar continuous futures. The chart intentionally shows two sets of objectives based on using diff erent lows (A and b) to defi ne the initial leg of the downtrend. in both cases, the Sep- tember 2012 high was used as the initial high reference price. The fi rst wave of this bear market using low A in March 2013 was 0.0674 points, while using low b in March 2014 the fi rst wave was 0.1407 points. Following Sklarew’s guidelines, since this is a bear market, we use the fi rst through third objectives (obtained using the multipliers 1.4, 1.75, and 2.33). The products of these three multipliers and the two initial price swings are subtracted from the high of the move to obtain the two sets of downside objectives. Of the three objectives that referenced low A, only Objective 2 was FIGURE  14.8 rule of Seven: Canadian dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 196A COMPLETE GUidE TO THE FUTUrES MArKET fairly close to a relative low (during the january–March 2014 consolidation). Among the objectives using low b, Objective 2 was just below the March 2015 relative low , while Objective 3 was just above the january 2016 low . ■ Support and Resistance Levels Points near support levels provide a reasonable choice for setting initial objectives on short positions. For example, the indicated objective zone in Figure 14.9 is based on support anticipated in the area of two prior relative lows. Similarly, prices near resistance levels can be used for setting initial objec- tives on long positions. For example, the indicated objective in Figure 14.10 is based on resistance implied by the two previous highs in late 2009 and early 2010. in Figure 14.11 , an upside objective for british pound prices after the early 2009 bottom was implied by the late 2005 relative low , a level that continued to function as a ceiling for prices over the next several years (a case of former support becoming resistance, as discussed in Chapter 8 ). Generally speaking, support and resistance levels usually represent only temporary rather than major objectives. Consequently, in using this approach, it is advisable to seek to reenter the position at a better price if a reaction does develop. FIGURE  14.9 downside Objective at Support Zone: Australian dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 197 SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA FIGURE  14.10 Upside Objective at resistance Level: Cocoa Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. FIGURE  14.11 Upside Objective at Former Support Turned resistance: british Pound Nearest Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 198A COMPLETE GUidE TO THE FUTUrES MArKET ■ Overbought/Oversold Indicators Overbought/oversold indicators are technical measures intended to refl ect when prices have risen or fallen too sharply and are thus vulnerable to a reaction. Figure 14.12 illustrates the relative strength index (rSi), which provides an example of an overbought/oversold indicator. 1 The rSi has a range of values between 0 and 100. based on the standard interpretation, levels above 70 suggest an over- bought condition, while levels below 30 suggest an oversold condition. The choice of specifi c overbought/oversold boundaries is a subjective one. For example, instead of 70 and 30, one might use 75 and 25, or 80 and 20. The more extreme the selected threshold lev- els, the closer the overbought/oversold signals will be to market turning points, but the greater the number of such points that will be missed. The buy (up) arrows in Figure 14.12 denote points at which the rSi crosses below 30—that is, reaches an oversold condition that can be viewed as a signal to liquidate short positions. The sell (down) arrows denote points at which the rSi crosses above 70—that is, reaches an overbought con- dition that can be viewed as a signal to liquidate long positions. Although the overbought/oversold signals in Figure 14.12 provide some reasonably good position liquidation signals in the latter half of the chart (mid-April 2015 forward), the signals before that FIGURE  14.12 relative Strength index in Trend and Trading range Conditions: U.S. dollar index Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. 1 The rSi was originally introduced in j. W elles Wilder, jr., New Concepts in T echnical T rading Systems (Winston- Salem, NC: Hunter Publishing, 1978). 199 SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA point—when the market was in a strong uptrend—were almost all terrible. The 27 percent rally off the july 2014 low that ultimately extended into March 2015 generated 10 overbought signals, four of which occurred in rapid succession in the first two months of the rally. Only the final two signals during this period, in late january and early March 2015, could be considered relatively timely. This example hints at both the benefits and drawbacks of using overbought/oversold indicators as liquida- tion signals. The approach will usually work well when the market is in a trading range, but will fail miserably during strong trending phases. The derivation and interpretation of various technical indicators are discussed in detail in Chapter 11. ■ DeMark Sequential As discussed in Chapter 11, all the popular overbought/oversold indicators (e.g., rSi, moving aver- age convergence-divergence [MACd], stochastic) are very highly correlated with each other. T om deMark’s sequential, which is intended to signal points where the market is fully extended and vul- nerable to a major trend reversal, represents a completely different and original overbought/oversold indicator. The sequential methodology falls within the domain of pattern recognition. The sequential is fully described in a 48-page chapter in T om deMark’s book The New Science of T echnical Analysis (john Wiley & Sons, 1994). The following brief summary of the technique is intended to give a general sense of the approach. readers interested in a fully detailed explanation of the sequential, which includes several additional qualifying conditions and a discussion of various alternative trade entry and exit rules, are referred to deMark’s text. The fulfillment of the sequential buy condition involves three basic stages: 1. Setup. The setup requires nine or more consecutive closes that are lower than the correspond- ing closes four trading days earlier. 2. Intersection. This condition requires that the high of any day on or after the eighth day of the setup exceed the low of any day three or more trading days earlier. Essentially, this is a minimal qualifying condition that ensures that the buy setup will not be deemed complete in a “waterfall” price slide. 3. Countdown. The countdown stage begins once the previous two conditions have been ful- filled. Starting from 0, the countdown increases by one on each day with a close lower than the low two days earlier. A sequential buy signal is generated once the countdown reaches 13. in contrast to the setup stage, countdown days do not need to be consecutive. The countdown is canceled if any of the following three conditions arise: a. There is a close that exceeds the highest intraday high during the setup stage. b. A sell setup occurs (i.e., nine consecutive closes above the corresponding closes four days earlier). c. Another buy setup occurs before the buy countdown is complete. in this situation, the new buy setup takes precedence, and the countdown restarts from 0 once the intersection condi- tion is met. 200 A Complete Guide to the Futures mArket The fulfillment of the sequential sell conditions are analogous: 1. Setup. The setup requires nine or more consecutive closes that are higher than the correspond- ing closes four trading day earlier. 2. Intersection. This condition requires that the low of any day on or after the eighth day of the setup is lower than the high of any day three or more trading days earlier. Essentially, this is a minimal qualifying condition that ensures that the sell setup will not be deemed complete in a “runaway” rally. 3. Countdown. The countdown stage begins once the previous two conditions have been ful- filled. Starting from 0, the countdown increases by one on each day with a close higher than the high two days earlier. A sequential sell signal is generated once the countdown reaches 13. in contrast to the setup stage, countdown days do not need to be consecutive. The countdown is canceled if any of the following three conditions arise: a. There is a close that is below the lowest intraday low during the setup stage. b. A buy setup occurs (i.e., nine consecutive closes below the corresponding closes four days earlier). c. Another sell setup occurs before the sell countdown is complete. in this situation, the new sell setup takes precedence, and the countdown restarts from 0 once the intersection condi- tion is met. Figures 14.13 through 14.17 provide illustrations of markets that fulfilled the complete sequential process. in each case, the setup, intersection, and countdown stages are marked on the charts; the final bar of the setup stage is highlighted with a boldfaced 9, while the final bar of the countdown phase is marked with a boldfaced 13. The preceding description will be clearer if read in conjunction with an examination of these charts. Figure 14.13 provides an illustration of a sequential sell signal in june 2016 10-year T -note futures. Note that in this case, the first day of the countdown stage (which occurred three days after the end of the setup stage) also fulfilled the intersection requirement (a bar with a low below the high of a day three or more days earlier). The countdown phase completed on February 11, the day that marked the highest high and close of the upmove. Figure 14.14, which shows the june 2016 gold contract, pro- vides an example of a sequential buy. As was the case in Figure 14.13, the first day of the countdown stage also marked the fulfillment of the intersection requirement. The completion of the countdown stage coincided with the mid- december 2015 low . Figure 14.15 provides another example of a sequential buy, this time in the May 2016 soybean contract. in this case the intersection requirement occurred on the eighth bar of the setup phase, while the countdown phase didn’t begin until nine days after the end of the setup phase. The count- down completed in early March 2016, the day with the lowest low of the move and one day after the lowest close. (Note: Figures 14.14 and 14.15 reflect day-session-only data.) The sequential rules can also be applied to bar charts for time periods other than daily. Figure 14.16 illustrates a sequential sell on a monthly copper continuous futures chart. Here, the end of the setup stage, the beginning of the countdown stage, and the fulfillment of the intersection requirement all occur on the same bar (month). The market peaked at month 11 of the countdown phase, but the real 201 SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA FIGURE  14.13 deMark Sequential: june 2016 10- Y ear T -Note Continuous Futures Source for sequential signals: deMark Analytics ( www .demark.com ) Chart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. deMark Sequential: june 2016 10- Y ear T -Note Continuous Futures FIGURE  14.14 deMark Sequential: june 2016 Gold Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. Countdown begins/ Intersection fulfilled Setup complete Countdown complete 12000 11800 11600 11400 11200 11000 10800 10600 10400 10200 01 Feb 04 11 19 25 2016 2801 07 14 21 Dec 02 26 09 16 23 Nov 13 9 12 1110 98 6 7 54 32 187 65 4 3 2 1 June 2016 gold (GCM16), daily (day-session) 202A COMPLETE GUidE TO THE FUTUrES MArKET Countdown begins Setup complete Countdown complete 9400 9300 9200 9100 9000 8900 8800 8700 8600 8400 8500 11 Apr 14 21 28 01 Mar 0708 16 22 01 Feb 0421 28 11 19 0125 2016 Intersection fulfilled 32 1 13 9 1211109 8 6 7 1 5 4 3 2 1 8 76 54 May 2016 soybeans (SK16), daily (day-session) FIGURE  14.15 deMark Sequential: May 2016 Soybeans Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. Copper continuous futures (HG), monthly Setup complete/ Countdown begins Countdown complete 47500 42500 45000 37500 35000 30000 40000 32500 27500 25000 22500 20000 17500 15000 2016 JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul Jan 12500 20152012 2013 201420112009 20 10 Intersection fulfilled 3 21 13 9 12 11109 8 6 7 5 4 32 1 876 54 FIGURE  14.16 deMark Sequential: Copper Continuous Futures Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. 203 SETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA FIGURE  14.17 deMark Sequential: june 2016 E-Mini Nasdaq 100 Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com Chart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. reversal did not occur until after the completion of countdown six months later. Figure 14.17 shows completed sequential sell and buy setups on an intraday chart (15-minute bars). The sell setup com- pleted during a consolidation near the top of the rally, while the buy setup completed a bit above the low of the subsequent decline, but right at the start of the fi rst extended rally after the low . The preceding examples were obviously selected with hindsight to illustrate the methodology. Of course, in real-life trading, the accuracy of the deMark sequential approach will not approach the uniformly near-perfect signals provided by the previous set of examples. if it did, all anyone would need to do would be to trade all sequential signals and retire a multimillionaire. Nevertheless, these examples should demonstrate that sequential can be a very powerful tool, with the capability of pro- viding extraordinary timing signals. Sequential also has the advantage of being inversely correlated to trend-following approaches that typically dominate the technical tool bag. For these reasons, many traders might fi nd deMark’s sequential a very useful addition to their overall trading methodology. ■ Contrary Opinion The theory of contrary opinion suggests that whenever a large majority of speculators are bullish, those who want to be long are already long. Consequently, there will be a paucity of potential new buyers, and the market will be vulnerable to a downside reaction. An analogous interpretation would apply when the majority of traders are bearish. Contrary opinion measures are based on either surveys 204 A Complete Guide to the Futures mArket of market advisory recommendations or surveys of traders and implicitly assume these opinions rep- resent a reasonable proxy for overall market sentiment. The overbought and oversold thresholds in contrary opinion indexes will vary with the source. Although contrary opinion is undoubtedly a sound theoretical concept, the Achilles’ heel of this approach is the difficulty of measuring market sentiment accurately. Contrary opinion measures pro- vided by existing services have frequently signaled major turning points. On the other hand, it is also not unusual for a contrary opinion index to stay high while the market continues to climb, or to stay low as the market continues to slide. On balance, this method provides useful information as long as it is not used as the sole trading guideline. ■ Trailing Stops The use of trailing stops may be among the least glamorous, but most sensible, methods of determin- ing a trade exit point. Although one will never sell the high or buy the low using this method, the approach comes closest to the ideal of permitting a profitable trade to run its course. Trailing stops were detailed in Chapter 13. ■ Change of Market Opinion This method of exiting trades represents another approach with very little flash, but lots of common sense. in this case, the trader sets no predetermined objectives at all, but rather maintains the position until her market opinion changes to at least neutral. 205 Chapter 15 The Most Important Rule in Chart Analysis The market is like a flu virus—as soon as you think you have it pegged, it mutates into something else. —Wayne H. Wagner ■ Failed Signals A failed signal is among the most reliable of all chart signals. When a market fails to follow through in the direction of a chart signal, it very strongly suggests the possibility of a significant move in the opposite direction. For example, in Figure 15.1 note how the market abruptly reversed course after breaking out above the high of the July–August 2013 consolidation in WTI crude oil. If the upside penetration signal were valid, the market should not have retreated back to the lower portion of the consolidation and certainly not below its lower boundary. The fact that such a retracement occurs almost immediately following the breakout strongly suggests a “bull trap.” Such price action is con- sistent with the market’s rising just enough to activate stop orders lying beyond the boundary of the range, but uncovering no additional buying support after the breakout—an indication of a very weak underlying technical picture. In effect, the immediate failure of the apparent buy signal can be viewed as a strong indication the market should be sold. Now that we have established the critical importance of failed signals, the following sections detail various types of failed signals, along with guidelines as to their interpretation and trading implications. ■ Bull and Bear Traps Bull and bear traps are major breakouts that are soon followed by abrupt, sharp price reversals, in stark contrast to the price follow-through that is expected to follow breakouts. In my experience, this type of counter-to-anticipated price action is among the most reliable indicators of major tops and bottoms. 206A CoMPleTe GuIDe To THe FuTuReS MARKeT An example of a bull trap was provided in the previous section (Figure 15.1 ). Another instance of a bull trap was the June 2015 peak in RBoB gasoline (see Figure 15.2 ). After rallying from January to May 2015, the market consolidated for roughly one month before breaking out to new highs in mid- June. However, the market quickly reversed back into the trading range, and by mid-July prices had broken below the range’s lower boundary, setting the stage for a multimonth downtrend. Analogous to the bull trap, in the case of a bear trap, the market falls just enough to trigger resting stops below the low end of a trading range, but fails to uncover any additional selling pressure after the breakout—an indication of substantial underlying strength. In eff ect, the immediate failure of a sell signal can be viewed as a signal the market should be bought. Figure 15.3 shows a bear trap that marked the 2014 low in u.S. Dollar Index futures. In May the market broke below the lower boundary of a long-standing trading range but reversed two days later to close back above that threshold. This price action proved to be the beginning of the market’s largest rally in more than a decade. Figure 15.4 provides another example of a bear trap. Corn prices, which had been trending lower since late summer 2012, entered a trading range in November–December 2013. The market broke below the downside of the range in early January 2014, falling more than 2 percent over the next two days before reversing sharply and returning to the midpoint of the range. May corn futures subse- quently surged approximately 25 percent over the next three months. FIGURE  15.1 Bull Trap: WTI Crude oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 207 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.2 Bull Trap: RBoB Gasoline Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.3 Bear Trap: u.S. Dollar Index Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 208A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.4 Bear Trap: May 2014 Corn Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. How much of a pullback is required to indicate a bull or bear trap has occurred? The following are several possible confi rmation conditions: Initial price confi rmation. A price retracement to the midpoint of the consolidation that preceded the breakout. Strong price confi rmation. A price retracement to the more distant boundary (lower for bull trap; upper for bear trap) of the consolidation that preceded the breakout. time confi rmation. The failure of the market to return to the extreme price witnessed follow- ing the breakout within a specifi ed amount of time (e.g., four weeks). The trade-off between initial and strong price confi rmations is that the former will provide better entry levels in trading bull and bear traps, whereas the latter will provide more reliable signals. The time confi rmation condition can be used on its own or in conjunction with the two price confi rma- tion conditions. Figures 15.5 through 15.8 repeat Figures 15.1 through 15.4 , adding each of the three confi rmation conditions (using four weeks for the time confi rmation condition). Note the time confi rmation can occur before both price confi rmation conditions, after both price confi rmation conditions (as is the case in Figures 15.6 and 15.8 ), or between the price confi rmations (Figures 15.5 and 15.7 ). 209 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.5 Bull Trap Confi rmation Conditions: WTI Crude oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.6 Bull Trap Confi rmation Conditions: RBoB Gasoline Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 210A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.7 Bear Trap Confi rmation Conditions: u.S. Dollar Index Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.8 Bear Trap Confi rmation Conditions: May 2014 Corn Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 211 THe MoST IMPoRTANT Rule IN CHART ANAlySIS A bull trap signal would be invalidated if the market returned to the breakout high. Similarly, a bear trap signal would be invalidated if the market returned to the breakout low . More sensitive conditions could be used to invalidate bull or bear trap signals once the market has moved sufficiently in the direction of the signal or a specified amount of time has elapsed. An example of such a condition would be the return of prices to the opposite boundary of a consolidation once a strong price confir- mation signal was received (e.g., in the case of a bull trap, a return to the top of the consolidation after prices broke to below the low end of the consolidation). An example of a more sensitive combined price/time invalidation signal would be the return of prices to the median of a consolidation (i.e., the initial price confirmation point for bull and bear trap signals) at any time four or more weeks after a strong price confirmation was received. The more sensitive the selected invalidation condition, the smaller the loss on an incorrect call of a bull or bear trap, but the greater the chance that a correct trade will be abandoned prematurely. If the selected invalidation condition does not occur, a trade implemented on a bull or bear trap signal would be held until a price objective or other trade liquidation condition was met or until there was evidence of an opposite direction trend reversal. ■ False Trend Line Breakouts As discussed in Chapter 6, trend lines are particularly prone to false breakouts. Such false break- outs can be used as signals for trading in the direction opposite to the breakout. In fact, in my opinion, false trend line breakout signals are considerably more reliable than conventional trend line breakout signals. In the case of a downtrend, a false trend line breakout would be confirmed if the market closed below the trend line a specified number of times (e.g., two, three) follow- ing an upside breakout. Similarly, in the case of an uptrend, a false trend line breakout would be confirmed if the market closed above the trend line a specified number of times following a downside breakout. Figure 15.9 provides an example of a false breakout of an uptrend line in 10-year T -note futures. The September downside breakout of the uptrend line was soon followed by a break above the line. The indicated failure signal is based on an assumed requirement of two closes above the line for confirmation. Figure 15.10 provides a similar example in the e-mini Nasdaq 100 futures. It is quite possible for a chart to yield multiple successive false trend breakout signals in the process of a trend line being redefined. In Figure 15.11 the initial upside penetration of the prevail - ing downtrend line occurred in mid-March. Prices quickly retreated back below the line, with the indicated failure signal assumed to be triggered by the second close below the line. Another false breakout occurred about a month later based on the redefined trend line using the March relative high. Prices retreated below this downtrend line several days later, yielding another false trend breakout signal. 212A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.10 False Breakout of uptrend line: e-Mini Nasdaq Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.9 False Breakout of uptrend line: 10- y ear T -Note Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 213 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.11 Multiple False Breakouts of Downtrend lines: euro Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. ■ Return to Spike Extremes As was detailed in Chapter 9 , price spikes frequently occur at important price reversals. Conse- quently, the return of prices to a prior spike extreme can be viewed as transforming the original spike into a failed signal. The more extreme the spike (i.e., the greater the magnitude by which the spike high or low exceeds the highs or lows on the prior and subsequent days), the more signifi cant its pen- etration. The signifi cance of such failed signals is also enhanced if at least several weeks, and preferably several months, have elapsed since the original spike. In Figure 15.12 , the January 2016 return to both the August and october 2015 spike highs was followed by a sharp rally well above the prior spike highs. In Figure 15.13, the october 2010 penetra- tion of the early 2008 spike high was followed by a sharp rally. Figures 15.14 and 15.15 provide two illustrations of downside penetrations of spike lows being followed by steep sell-off s. 214A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.12 Penetration of Spike Highs: 30- y ear T -Bond Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.13 Penetration of Spike High: Cotton Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 215 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.14 Penetration of Spike Highs: Soybean oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.15 Penetration of Spike low: Australian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 216A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.16 Spike Penetration Signals Negated: 5- y ear T -Note Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Generally speaking, a close beyond the opposite extreme of the spike can be viewed as negat- ing the failed signal. For example, in Figure 15.16 the price briefl y exceeded the August spike high, forming a second spike high in early october, but then immediately retreated, falling below the low of the August spike day—a failed failed signal, so to speak. This pattern repeated itself in early 2016 when the market penetrated the october spike, rallied for about a week (forming a spike high in the process), but then reversed to close below the low of the october spike day in early March. ■ Return to Wide-Ranging Day Extremes As explained in Chapter 9 , wide-ranging days (WRDs) with particularly strong or weak closes tend to lead to price extensions in the same direction. Consequently, a close above the high price of a downside WRD or below the low price of an upside WRD can be viewed as confi rming such days as failed signals. In Figure 15.17 the WRD that formed in mid-April 2015 is penetrated to the downside about 10 weeks later, leading to a signifi cant decline. In Figure 15.18 a huge WRD formed in early July 2013 in the vicinity of the May swing high. Three days later, the uptrend was reversed by a downside WRD, which was followed three days later by a close below the low of the fi rst WRD, confi rming a failed signal and leading to an extended market slide. Figure 15.19 shows an example of an up-closing WRD in late April that was reversed by a down- closing WRD 12 days later. A closing penetration of the April WRD occurred four days later and was followed by a large, sustained downtrend. Figure 15.20 shows a massive down-closing WRD that was eclipsed to the upside a little more than a month later and followed by a strong rally to new high ground. 217 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.17 Penetration of upside Wide-Ranging Day: Canadian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.18 Penetration of upside Wide-Ranging Day: u.S. Dollar Index Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 218A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.19 Penetration of upside Wide-Ranging Day: Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.20 Penetration of Downside Wide-Ranging Day: Bund Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 219 THe MoST IMPoRTANT Rule IN CHART ANAlySIS ■ Counter-to-Anticipated Breakout of Flag or Pennant As was explained in Chapter 9 , typically, fl ag or pennant consolidations tend to be followed by price swings in the same direction as the price swings that preceded their formation. Therefore, if a fl ag or pennant formation is followed by a breakout in the opposite direction of the preceding price swing, it would qualify the pattern as a failed signal. In Figure 15.21 , just as would have been implied by the chart interpretation guidelines presented in Chapter 9 , the fl ag formations that evolved during the 2014 downtrend in soybean prices were generally followed by downswings. The one exception, however, was the fl ag that formed in late September and early october. In this instance, the fl ag was followed by an upside breakout. This counter-to-anticipated price action was followed by a rally of more than 13 percent to the mid-November high. Figures 15.22 , 15.23 , and 15.24 provide three examples where counter-to-anticipated downside breakouts of fl ag pat- terns signaled major trend reversals. Note that Figure 15.24 is, in fact, the same reversal depicted in Figure 15.19 , which focused on the downside penetration of the strong-closing WRD that immediately preceded the fl ag. In Figure 15.25 heating oil prices rallied more than 33 percent in one month after the counter-to-anticipated upside breakout of the fl ag that formed in early 2015. A counter-to-anticipated breakout does not need to be followed by an immediate extension of the price move in order to be a valid confi rmation of a failed signal. How much of a retracement can be allowed before the interpretation of a failed signal is abandoned? one reasonable approach is to FIGURE  15.21 Counter-to-Anticipated Breakout of Flag Pattern: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 220A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.22 Counter-to-Anticipated Breakout of Flag Pattern: Canadian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.23 Counter-to-Anticipated Breakout of Flag Pattern: orange Juice Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 221 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.24 Counter-to-Anticipated Breakout of Flag Pattern: Copper Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.25 Counter-to-Anticipated Breakout of Flag Pattern: Heating oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 222A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.26 Counter-to-Anticipated Flag Breakout and opposite Direction Flag Breakout Following Normal Breakout: Cocoa Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. consider the confi rmation of a failed signal in force as long as prices do not close beyond the oppo- site end of the relevant fl ag or pennant. The retracement in Figure 15.21 provides a good example: after the breakout above the top of the September–october fl ag, prices pulled back but held at the approximate midpoint of the fl ag before pushing higher, thereby leaving the failed signal intact. Figure 15.26 highlights two fl ag patterns. The fi rst formed in July when prices were rallying and was followed by a sharp sell-off after a counter-to-anticipated breakout to the downside. The second fl ag occurred in September when the market was rebounding. The market initially broke out of this fl ag in the expected direction—to the upside—but after a few days prices dropped back into the fl ag’s range and, eventually, penetrated the bottom of the fl ag, confi rming a failed signal pattern. The mar- ket subsequently dropped more than 5 percent over the next two weeks. This type of reversal after a normal breakout is the subject of the next section. ■ Opposite Direction Breakout of Flag or Pennant Following a Normal Breakout In some cases, fl ags and pennants are followed by breakouts in the anticipated direction, but prices then reverse to close beyond the opposite extreme of the fl ag or pennant, as was the case with the September 2015 pattern in Figure 15.26 . This combined price action provides another example of 223 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.27 opposite Direction Breakout of Flag Following Normal Breakout: Platinum Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. a failed signal, since the anticipated breakout of the fl ag or pennant is followed by a price reversal instead of a price follow-through. Note that a close beyond the opposite end of the fl ag or pennant is required to confi rm a failed signal, rather than a mere intraday penetration. Although this more restrictive condition will yield slightly less timely confi rmations of failed signals in cases when such a conclusion proves valid, it will reduce the number of inaccurate calls of failed signals. In Figure 15.27 the fl ag consolidation that formed in January–February 2013 after an upswing off support near the November–December lows was followed by an upside breakout, as might have been anticipated. Instead of witnessing a further sustained advance, however, prices moved higher for only two days, and less than two weeks later the market had retreated to below the low end of the fl ag consolidation. This price action qualifi ed the earlier upside breakout above the fl ag pattern as a failed signal. (Note this type of signal could also be termed a bull or bear trap if it occurs at a major high or low .) In April a counter-to-anticipated upside breakout of a pennant formation was followed by a sharp bounce and consolidation before the market dropped to new lows in June. In Figure 15.28 the fl ag that formed during an upswing in natural gas prices was also followed by an upside breakout and then a retreat below the low end of the fl ag. In this instance, the market pushed back into the fl ag’s range several days later but did not reach the pattern’s upper boundary, leaving the failed signal confi rmation intact. Figure 15.29 illustrates a fl ag pattern that formed during an extended downtrend in sugar futures. The market fi rst broke out of the fl ag in the anticipated direction but reversed in a few days after 224A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.28 opposite Direction Breakout of Flag Following Normal Breakout: April 2016 Natural Gas Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.29 opposite Direction Breakout of Flag Following Normal Breakout: Sugar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 225 THe MoST IMPoRTANT Rule IN CHART ANAlySIS FIGURE  15.30 opposite Direction Breakout of Flag Following Normal Breakout: euro Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. forming a spike low . The subsequent upside penetration of the fl ag confi rmed the failed signal. After a partial pullback toward the middle of this upward-sloping fl ag, prices staged a huge upmove. Note this failed signal is also a perfect example of a bear trap bottom. In Figure 15.30 an expected downside breakout of the fl ag was followed by an upswing above its upper boundary, confi rming a failed fl ag signal that was followed by a brisk rally. ■ Penetration of Top and Bottom Formations The penetration of patterns that are normally associated with major tops and bottoms represents another important type of failed signal. For example, Figure 15.31 illustrates the double top that formed in u.S. 30-year T -bond futures in late 2010 and the penetration of this top several months later. The monthly chart inset shows the extent of the market’s subsequent rally. Pen- etrations of double tops and double bottoms can be significant failure signals even if the top or bottom formation is not confirmed. For example, Figure 15.32 shows the downside penetration of an unconfirmed double bottom—that is, prices did not exceed the pattern’s october 2013 intermediate high. Nonetheless, penetration of the pattern’s July 2013 and January 2014 lows represented the violation of an important support level, as evidenced by the continued sell-off that followed. 226A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.31 Penetration of Double T op: 30- y ear u.S. T -Bond Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.32 Penetration of Double Bottom: Australian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 227 THe MoST IMPoRTANT Rule IN CHART ANAlySIS Penetrations of double-top and double-bottom patterns provide good signals but are rela- tively rare. Failed signals involving head-and-shoulders patterns are more common and often provide excellent trading indicators. Although the choice of what condition constitutes a confi r- mation of a failed head-and-shoulders pattern is somewhat arbitrary, I would use the criterion of prices exceeding the most recent shoulder. For example, in Figure 15.33 the rebound above the shoulder that peaked at the beginning of November 2012 would represent a confi rmation of a failed head-and-shoulders top pattern. Sometimes prices will fi rst dip back after penetrating the shoulder, even when a substantial advance ultimately ensues, as is the case in Figure 15.34 , which shows a long-term example on a weekly chart of the e-mini S&P 500 futures. As long as prices don’t close below the relative low formed between the head and right shoulder, the failed signal would remain intact. Figure 15.35 provides another example of a strong rally following a failed head-and-shoulders top. Figure 15.36 illustrates a failed head-and-shoulders bottom pattern. In analogous fashion to the head-and-shoulders top case, the downside penetration of the more recent shoulder is used as the confi rmation condition of a failed signal. The trader may often benefi t by waiting for a retracement before implementing a position based on the confi rmation of a failed head-and-shoulders pattern, as illustrated by Figure 15.34 . The trade- off is that such a strategy will result in missing very profi table trades in those cases where there is no retracement or only a very modest retracement (e.g., Figures 15.35 and 15.36 ). FIGURE  15.33 Failed Head-and-Shoulders T op Pattern: Soymeal Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 228A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.34 Failed Head-and-Shoulders T op Pattern: e-Mini S&P 500 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.35 Failed Head-and-Shoulders T op Pattern: Nikkei 225 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 229 THe MoST IMPoRTANT Rule IN CHART ANAlySIS ■ Breaking of Curvature As was discussed in Chapter 9 , rounding patterns often provide very reliable trading signals. In this sense, the breaking of a curved price pattern can be viewed as transforming the pattern into a failed signal. Figure 15.37 actually contains two examples where the breaking of the curvature of what had been an apparent rounding-top pattern represented a bullish signal. In Figure 15.38 , the breaking of the curvature of an apparent rounding-bottom pattern led to a steep decline in corn prices in 2014. Note the downthrust in January 2014 (the low of the curved pattern) was the bear trap illustrated in Figures 15.4 and 15.8 . So, in eff ect, this chart illustrates two successive failure patterns, the fi rst sig- naling a near-two-month rebound, and the second the subsequent reversal into a major downtrend. ■ The Future Reliability of Failed Signals There is an inverse relationship between the popularity of an indicator and its effi ciency. For example, decades ago, when technical analysis was used by fewer market practitioners, chart breakouts (price moves above or below prior trading ranges) tended to work relatively well, providing many excellent signals without an abundance of false signals. In my observation, as technical analysis became increasingly popular and breakouts a commonly used tool, the effi ciency of this pattern seemed to deteriorate. In fact, it now seems that price reversals following breakouts may more often be the rule than the exception. FIGURE  15.36 Failed Head-and-Shoulders Bottom Pattern: Sugar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 230A CoMPleTe GuIDe To THe FuTuReS MARKeT FIGURE  15.37 Breaking of Curvature: e-Mini Nasdaq 100 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  15.38 Breaking of Curvature: Corn Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 231 THe MoST IMPoRTANT Rule IN CHART ANAlySIS As stated earlier, I find failed signals considerably more reliable than conventional chart patterns. Although the concept of failed signals is certainly not new , I don’t believe its usage is widely empha- sized. If the use of failed signals were to become significantly more widespread, however, their long- term reliability could be adversely affected. As a final comment, it should be emphasized that the concept of failed signals in this chapter has been presented in the context of conventional chart analysis as it exists today. In the future—particu- larly the distant future—what passes for popular chart interpretation may well change. The concept of failed signals, however, can be made dynamic by pegging it to the conventional wisdom. In other words, if a new chart pattern became popular as a technical signal in the future (e.g., in the way breakouts are widely used today), a failure of the pattern could be viewed as more significant than the pattern itself. In this more general sense, the concept of failed signals could prove timeless. ■ Conclusion The novice trader will ignore a failed signal, riding a position into a large loss while hoping for the best. More experienced traders, having learned the importance of money management, will exit quickly once it is apparent they have made a bad trade. However, the truly skilled trader will be able to do a 180-degree turn, reversing a position at a loss if market behavior (e.g., confirmation of a failed signal) points to such a course of action. In other words, it takes great discipline to capitalize on failed signals, but such flexibility is essential to the effective synthesis of chart analysis and trading. TraDing SySTeMS anD PerforMance MeaSureMenT Part IV 235 Cha P ter 16 There are only two types of trend-following systems: fast and slow. —Jim orcutt B e forewarned. if you are expecting to find the blueprint for a heretofore secret trading system that consistently makes 100 percent plus per year in real-life trading with minimal risk, you’ll have to look elsewhere. for one thing, i have not yet discovered such a “sure thing” money machine. But, in a sense, that is beside the point. Quite frankly, i have always been somewhat puzzled by advertisements for books or computer software promising to reveal the secrets of systems that make 100 percent, 200 percent, and more! Why are they selling such valuable information for $99, or even $2,999? The primary goal of this chapter is to provide readers with the background knowledge necessary to develop their own trading systems. The discussion focuses on the following five areas: 1. a n overview of some basic trend-following systems 2. The key weaknesses of these systems 3. g uidelines for transforming “generic” systems into more powerful systems 4. c ountertrend systems 5. Diversification as a means of improving performance chapter 17 provides additional examples of trading systems, using original systems as illustra- tions. The essential issues of appropriate data selection, system testing procedures, and performance measurement are discussed in chapters 18, 19, and 20. T echnical Trading Systems: Structure and Design 236 A Complete Guide to the Futures mArket ■ The Benefits of a Mechanical Trading System is paper trading easier than real trading? Most speculators would answer yes, even though both tasks require an equivalent decision process. This difference is explained by a single factor: emotion. over- trading, premature liquidation of good positions because of rumors, jumping the gun on market entry to get a better price, riding a losing position—these are but a few of the negative manifestations of emotion in actual trading. Perhaps the greatest value of a mechanical system is that it eliminates emo- tion from trading. in so doing, it allows the speculator to avoid many of the common errors that often impede trading performance. furthermore, removing the implied need for constant decision making substantially reduces trading-related stress and anxiety. another benefit of a mechanical system is that it ensures a consistent approach—that is, the trader follows all signals indicated by a common set of conditions. This is important, since even profitable trading strategies can lose money if applied selectively. T o illustrate this point, consider the example of a market advisory whose recommendations yield a net profit over the long run (after allowances for commissions and poor executions). Will the advisory’s subscribers make money if they only imple- ment trades in line with its recommendations? not necessarily. Some people will pick and choose trades, invariably missing some of the biggest winners. others will stop following the recommenda- tions after the advisor has a losing streak, and as a result may miss a string of profitable trades. The point is that a good trading strategy is not sufficient; success also depends on consistency. a third advantage of mechanical trading systems is they normally provide the trader with a method for controlling risk. Money management is an essential ingredient of trading success. Without a plan for limiting losses, a single bad trade can lead to disaster. any properly constructed mechanical system will either contain explicit stop-loss rules or specify conditions for reversing a position given a sufficient adverse price move. as a result, following signals generated by a mechanical trading system will nor- mally prevent the possibility of huge losses on individual trades (except in extreme circumstances when one is unable to liquidate a position because the market is in the midst of a string of locked-limit moves). Thus, the speculator using a mechanical system may end up losing money due to the cumulative effect of a number of negative trades, but at least his account will not be decimated by one or two bad trades. of course, money management does not necessarily require the use of a trading system. risk control can also be achieved by initiating a good-till-canceled stop order whenever a new position is taken, or by predetermining the exit point upon entering a trade and sticking to that decision. However, many trad- ers lack sufficient discipline and will be tempted to give the market just a little more time once too often. ■ Three Basic Types of Systems The categories used to classify trading systems are completely arbitrary. The following three-division classification is intended to emphasize a subjective interpretation of the key conceptual differences in possible trading approaches: trend-following. a trend-following system waits for a specified price move and then initiates a position in the same direction based on the implicit assumption that the trend will continue. Countertrend. a countertrend system waits for a significant price move and then initiates a position in the opposite direction on the assumption that the market is due for a correction. 237 Technical Trading SySTemS: STrucTure and deSign Pattern recognition. in a sense, all systems can be classified as pattern recognition systems. after all, the conditions that signal a trend or a countertrend trade are a type of pattern (e.g., close beyond the 20-day high or low). However, the implication here is that the chosen patterns are not based primarily on directional moves, as is the case in trend-following and counter- trend systems. for example, a pattern-recognition system might generate signals on the basis of “spike days” (see chapter 9). in this case, the key consideration is the pattern itself (e.g., spike) rather than the extent of any preceding price move. of course, this example is overly simplistic. in practice, the patterns used for determining trading signals will be more complex, and several patterns may be incorporated into a single system. Systems of this type may sometimes employ probability models in making trading decisions. in this case the researcher would try to identify patterns that appeared to act as precursors of price advances or declines in the past. an underlying assumption in this approach is that such past behavioral patterns can be used to estimate current probabilities for rising or declining markets given certain specified conditions. This chapter does not elaborate on this approach of trading system design since it lies beyond the scope of the overall discussion. it should be emphasized that the lines dividing the preceding categories are not always clear-cut. as modifications are incorporated, a system of one type may begin to more closely approximate the behavioral pattern of a different system category. ■ Trend-Following Systems By definition, trend-following systems never sell near the high or buy near the low , because a meaningful opposite price move is required to signal a trade. Thus, in using this type of system, the trader will always miss the first part of a price move and may surrender a significant portion of profits before an opposite signal is received (assuming the system is always in the market). There is a basic trade-off involved in the choice of the sensitivity, or speed, of a trend-following system. a sensitive system, which responds quickly to signs of a trend reversal, will tend to maximize profits on valid signals, but it will also gener- ate far more false signals. a nonsensitive, or slow , system will reflect the reverse set of characteristics. Many traders become obsessed with trying to catch every market wiggle. Such a predilection leads them toward faster and faster trend-following systems. although in some markets fast systems con- sistently outperform slow systems, in most markets the reverse is true, as the minimization of losing trades and commission costs in slow systems more than offsets the reduced profits in the good trades. This observation is only intended as a cautionary note against the natural tendency toward seeking out more sensitive systems. However, in all cases, the choice between fast and slow systems must be determined on the basis of empirical observation and the trader’s subjective preferences. There is a wide variety of possible approaches in constructing a trend-following system. in this chapter we focus on two of the most basic methods: moving average systems and breakout systems. Moving average Systems The moving average for a given day is equal to the average of that day’s closing price and the closing prices on the preceding N − 1 days, where N is equal to the number of days in the moving average. 238 A Complete Guide to the Futures mArket for example, in a 10-day moving average, the appropriate value for a given day would be the average of the 10 closing prices culminating with that day. The term moving average refers to the fact that the set of numbers being averaged is continuously moving through time. Because the moving average is based on past prices, in a rising market the moving average will be below the price, while in a declining market the moving average will be above the price. Thus, when a price trend reverses from up to down, prices must cross the moving average from above. Similarly, when the trend reverses from down to up, prices must cross the moving average from below . in the most basic type of moving average system, these crossover points are viewed as trade signals: a buy signal is indicated when prices cross the moving average from below; a sell signal is indicated when prices cross the moving average from above. The crossover should be determined based on closing prices. Table 16.1 illustrates the calculation of a 10-day simple moving average and indicates the cor- responding crossover signal points. table 16.1 Calculating a Moving average Day Closing Price 10-Day Moving average Crossover Signal 1 80.50 2 81.00 3 81.90 4 81.40 5 83.10 6 82.60 7 82.20 8 83.10 9 84.40 10 85.20 82.54 11 84.60 82.95 12 83.90 83.24 13 84.40 83.49 14 85.20 83.87 15 86.10 84.17 16 85.40 84.45 17 84.10 84.64 Sell 18 83.50 84.68 19 83.90 84.63 20 83.10 84.42 21 82.50 84.21 22 81.90 84.01 23 81.20 83.69 24 81.60 83.33 25 82.20 82.94 26 82.80 82.68 Buy 27 83.40 82.61 28 83.80 82.64 29 83.90 82.64 30 83.50 82.68 239 TecHnicaL TraDing SySTeMS: STrucTure anD DeSign figure 16.1 shows the June 2015 WTi crude oil contract with a 35-day moving average. The non- circled buy and sell signals on the chart are based on the simple moving average system just described. (for now ignore the circled signals; they are explained later.) note that although the system catches the major downtrend, it also generates several false signals. of course, this problem can be mitigated by increasing the length of the moving average, but the tendency toward excessive false signals is a characteristic of the simple moving average system. The reason for this is that temporary, sharp price fl uctuations, suffi cient to trigger trade signals, are commonplace events in futures markets. one school of thought suggests the problem with the simple moving average system is that it weights all days equally, whereas more recent days are more important and hence should be weighted more heavily. Many diff erent weighting schemes have been proposed for constructing moving aver- ages. Two of the most common weighting approaches are the linearly weighted moving average (LWMa) and the exponentially weighted moving average (eWMa). 1 The LWMa assigns the oldest price in the moving average a weight of 1, the second oldest price a weight of 2, and so on. The weight of the most recent price would be equal to the number of days FIGURE  16.1 June 2015 WTi crude oil and 35-Day Moving average Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell signal: prices cross moving average from above and close below line; = buy signal not eliminated by fi lter; = sell signal not eliminated by fi lter. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 1 The following two sources were used as reference for the remainder of this section: (1) Perry Kaufman, T rading Systems and Methods (Hoboken, nJ: John Wiley & Sons, 2013), and (2) T echnical Analysis of Stocks & Commodities, bonus issue 1995, sidebar, page 66. 240 A Complete Guide to the Futures mArket in the moving average. The LWMa is equal to the sum of the weighted prices divided by the sum of the weights: LWMA = Pt t t t n t n ⋅ = = ∑ ∑ 1 1 where t = time indicator (oldest day = 1, second oldest = 2, etc.) Pt = price at time t n = number of days in moving average for example, for a 10-day LWM a, the price of 10 days ago would be multiplied by 1, the price of 9 days ago by 2, and so on through the most recent price, which would be multiplied by 10. The sum of these weighted prices would then be divided by 55 (the sum of 1 through 10) to obtain the LWM a. The eWMa is calculated as the sum of the current price multiplied by a smoothing constant between 0 and 1, denoted by the symbol a, and the previous day’s eWMa multiplied by 1 − a: EWMA EWMAtt taP a=+ − −()1 1 This linked calculation wherein each day’s value of the eWMa is based on the previous day’s value means that all prior prices will have some weight, but the weight of each day drops exponentially the further back in time it is. The weight of any individual day would be: aa k()1 − where k = number of days prior to current day (for current day, k = 0 and term reduces to a). Since a is a value between 0 and 1, the weight of each given day drops sharply moving back in time. for example, if a = 0.1, yesterday’s price would have a weight of 0.09, the price two days ago would have a weight of 0.081, the price 10 days ago would have a weight of 0.035, and the price 30 days ago would have a weight of 0.004. an eWMa with a smoothing constant, a, corresponds roughly to a simple moving average of length n, where a and n are related by the following formula: an=+21/( ) or na a=−() / 2 Thus, for example, an eWMa with a smoothing constant equal to 0.1 would correspond roughly to a 19-day simple moving average. as another example, a 40-day simple moving average would cor- respond roughly to an eWMa with a smoothing constant equal to 0.04878. 241 TecHnicaL TraDing SySTeMS: STrucTure anD DeSign in my view , there is no strong empirical evidence to support the idea that linearly or exponentially weighted moving averages provide a substantive and consistent improvement over simple moving averages. Sometimes weighted moving averages will do better; sometimes simple moving averages will do better. (See chapter 11 for an illustration of this point.) The question of which method will yield better results will be entirely dependent on the markets and time periods selected, with no rea- son to assume that past relative superiority will be indicative of the probable future pattern. in short, experimentation with diff erent weighted moving averages probably does not represent a particularly fruitful path for trying to improve the simple moving average system. a far more meaningful improvement is provided by the crossover moving average approach. in this system, trade signals are based on the interaction of two moving averages, as opposed to the interaction between a single moving average and price. The trading rules are very similar to those of the simple moving average system: a buy signal is generated when the shorter moving average crosses above the longer moving average; a sell signal is generated when the shorter moving average crosses below the lon- ger moving average. (in a sense, the simple moving average system can be thought of as a special case of the crossover moving average system, in which the short-term moving average is equal to 1.) Because trade signals for the crossover system are based upon two smoothed series (as opposed to one smoothed series and price), the number of false signals is substantially reduced. figures 16.2 , 16.3 , and 16.4 compare trade signals generated by a simple 12-day moving average system, a simple 48-day moving average system, and the crossover system based on these two averages. generally speaking, the crossover moving average system is far superior to the simple moving average. (However, it should be noted that FIGURE  16.2 e-Mini nasdaq 100 continuous futures with 12-Day Moving average Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell signal: prices cross moving average from above and close below line. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 242a coMPLeTe guiDe To THe fuTureS MarKeT FIGURE  16.3 e-Mini nasdaq 100 continuous futures with 48-Day Moving average Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell signal: prices cross moving average from above and close below line. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. FIGURE  16.4 e-Mini nasdaq 100 continuous futures with Moving average crossover Note: /uni2191 = buy signal: short-term moving average (12-day) crosses long-term moving average (48-day) from below; /uni2193 = sell signal: short-term moving average crosses long-term moving average from above. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 243 TecHnicaL TraDing SySTeMS: STrucTure anD DeSign by including some of the trend-following-system modifi cations discussed in a later section, even the simple moving average system can provide the core for a viable trading approach.) The weaknesses of the crossover moving average system and possible improvements are discussed later. breakout Systems The basic concept underlying breakout systems is very simple: the ability of a market to move to a new high or low indicates the potential for a continued trend in the direction of the breakout. The following set of rules provides an example of a simple breakout system: 1. cover short and go long if today’s close exceeds the prior N -day high. 2. cover long and go short if today’s close is below the prior N -day low . The value chosen for N will defi ne the sensitivity of the system. if a short-duration period is used for comparison to the current price (e.g., N = 7), the system will indicate trend reversals fairly quickly, but will also generate many false signals. in contrast, the choice of a longer-duration period (e.g., N = 40) will reduce false signals, but at the cost of slower entry. figure 16.5 compares the trade signals generated by the preceding simple breakout system in silver continuous futures using N = 7 and N = 40. The following three observations, which are evidenced in figure 16.5 , are also valid as generalizations describing the trade-off s between fast and slow breakout systems: 1. a fast system will provide an earlier signal of a major trend transition (e.g., the october 2012 sell signal). FIGURE  16.5 Breakout System Signals, fast versus Slow Systems: Silver continuous futures Note: B, S = signals for N = 7; , = signals for N = 40. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 244 A Complete Guide to the Futures mArket 2. a fast system will generate far more false signals. 3. The loss per trade in the slower system will be greater than the loss for the corresponding trade in the faster system. in some cases, a fast system might even realize a small profit on a minor trend that results in a loss in a slower system. for example, the N = 40 system’s august buy signal that was liquidated in november resulted in a net loss of approximately $2.54 (exclud- ing commissions). The corresponding buy signal for the N = 7 version—triggered in July and exited in September—resulted in a net gain of around $2.46. as indicated by the preceding illustration, fast and slow systems will each work better under dif- ferent circumstances. in the case of the chosen illustration, on balance, the slow system was much more successful. of course, one could just as easily have chosen an example in which the reverse observation was true. However, empirical evidence suggests that, in most markets, slower systems tend to work better. in any case, the choice between a fast and a slow system must be based on up- to-date empirical testing. The previous example of a breakout system was based on the current day’s close and prior period’s high and low . it should be noted that these choices were arbitrary. other alternative combinations might include current day’s high or low versus prior period’s high or low; current day’s close versus prior period’s high close or low close; and current day’s high or low versus prior period’s high close or low close. although the choice of the condition that defines a breakout will affect the results, the differences between the variations just given (for the same value of N) will be largely random and not overwhelming. Thus, while each of these definitions might be tested, it probably makes more sense to focus research efforts on more meaningful modifications of the basic system. The pitfalls of breakout-type systems are basically the same as those of moving average systems and are detailed in the following section. ■ Ten Common Problems with Standard Trend-Following Systems 1. too many similar systems. Many different trend-following systems will generate similar signals. Thus, it is not unusual for a number of trend-following systems to signal a trade during the same one- to five-day period. Because many speculators and futures funds base their deci- sions on basic trend-following systems, their common action can result in a flood of similar orders. under such circumstances, traders using these systems may find their market and stop orders filled well beyond the intended price, if there is a paucity of offsetting orders. 2. Whipsaws. Trend-following systems will signal all major trends; the problem is that they will also generate many false signals. a major frustration experienced by traders using trend- following systems is that markets will frequently move far enough to trigger a signal and then reverse direction. This unpleasant event can even occur several times in succession; hence, the term whipsaw. for example, figure 16.6, which indicates the trade signals generated by a break- out system (close beyond prior N-day high-low) for N = 10, provides a vivid illustration of the dark side of trend-following systems. 245 TecHnicaL TraDing SySTeMS: STrucTure anD DeSign 3. Failure to exploit major price moves. Basic trend-following systems always assume an equal-unit-size position. as a result, given an extended trend, the best such a system can do is to indicate a one-unit position in the direction of the trend. for example, in figure 16.7 a breakout system with N = 40 would signal a long position in December 2012 and remain long throughout the entire uptrend until february 2014. although this outcome is hardly unfavor- able, profi tability could be enhanced if the trend-following system were able to take advantage of such extended trends by generating signals indicating increases in the base position size. 4. Nonsensitive (slow) systems can surrender a large percentage of profi ts. although slow variations of trend-following systems may often work best, one disturbing feature of such systems is that they may sometimes surrender a large portion of open profi ts. in figure 16.8 , for example, a breakout system with N = 40 catches a major portion of the october–December 2014 price advance in silver, but then surrenders more than the entire gain before an opposite signal occurs. The June buy signal is initially profi table, but then realizes a much larger loss by the time a sell signal is received. 5. Cannot make money in trading range markets. The best any trend-following system can do during a period of sideways price action is to break even—that is, generate no new trade sig- nals. in most cases, however, trading range markets will be characterized by whipsaw losses. This is a particularly signifi cant consideration since sideways price action represents the predominant state of most markets. 6. temporary large losses. even an excellent trend-following system may witness transitory peri- ods of sharp equity retracement. Such events can be distressing to the trader who enjoys a profi t cushion, but they can be disastrous to the trader who has just begun following the system’s signals. FIGURE  16.6 Breakout Signals in Trading range Market: october 2015 natural gas futures Note: B = buy signal: close above prior 10-day high; S = sell signal: close below 10-day low . chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 246a coMPLeTe guiDe To THe fuTureS MarKeT FIGURE  16.7 failure of System to exploit Major Price Move: russell 2000 Mini futures chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. FIGURE  16.8 Surrender of Profi ts by nonsensitive System: Silver continuous futures Note: B = buy signal: close above prior 40-day high; S = sell signal: close below 40-day low . chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 247 Technical Trading SySTemS: STrucTure and deSign 7. extreme volatility in best-performing systems. in some cases, the trader may find that the most profitable trend-following systems are also subject to particularly sharp retracements, thereby implying an unacceptable level of risk. 8. System works well in testing but then bombs. This scenario is perhaps the most common tale of woe among traders who have used mechanical trading systems. 9. Parameter shift.2 frequently, the trader may perform an exhaustive search to find the best variation of a system based on past data (e.g., the optimum value of N in a breakout system), only to find that the same variation performs poorly (relative to other variations) in the ensuing period. 10. Slippage. another common experience: the system generates profits on paper, but simultaneously loses money in actual trading. Slippage is discussed in chapter 19. ■ Possible Modifications for Basic Trend-Following Systems even simple systems, such as moving average or breakout systems, will probably prove profitable if traded consistently over a broad range of markets for a sufficient length of time (e.g., three to five years or longer). However, the simplicity of these systems is a vice as well as a virtue. in essence, the rules of these systems are perhaps too simple to adequately account for the wide variety of pos- sible market situations. even if net profitable over the long run, simple trend-following systems will typically leave the trader exposed to periodic sharp losses. in fact, the natural proclivity of many, if not most, users of such systems to abandon the approach during a losing period will lead them to experience a net loss even if the system proves profitable over the longer run. in this section, we discuss some of the primary ways to modify basic trend-following systems in an effort to improve their performance. for simplicity, most of the examples will use the previously described simple breakout system. However, the same types of modifications could also be applied to other basic trend-following systems (e.g., crossover moving average). Confirmation Conditions an important modification that can be made to a basic trend-following system is the requirement for additional conditions to be met before a signal is accepted. if these conditions are not realized before an opposite direction signal is received, no trade occurs. confirmation rules are designed specifi- cally to deal with the nemesis of trend-following systems: false signals. The idea is that valid signals will fulfill the confirmation conditions, while false signals generally will not. The range of possible 2 The meaning of the term parameter as it is used in trading systems is detailed in chapter 19. 248a coMPLeTe guiDe To THe fuTureS MarKeT choices for confi rmation conditions is limited only by the imagination of the system designer. Here are three examples: 1. Penetration. a trade signal is accepted only if the market moves a specifi ed minimum amount beyond a given reference level (e.g., signal price). This confi rming price move can be measured in either nominal or percentage terms. figure 16.9 compares the trade signals generated by a standard breakout system with N = 12 and the corresponding system with a confi rmation rule requiring a close that exceeds the prior N -day high or low by at least 3 percent. 3 note that in this example, although the confi rmation rule results in moderately worse entry levels for valid signals, it eliminates fi ve of six losing buy signals. (The sell signals following the nonconfi rmed buy signals are also eliminated, since the system is already short at these points.) 2. time delay. in this approach, a specifi ed time delay is required, at the end of which the signal is reevaluated. for example, a confi rmation rule may specify that a trade signal is taken if the mar- ket closes beyond the signal price (higher for a buy, lower for a sell) at any time six or more days beyond the original signal date. figure 16.10 compares the signals generated by a basic breakout system with N = 12, and the corresponding system with the six-day time delay confi rmation condition. again, the confi rmation rule eliminates fi ve of the six losing buy signals. 3 Because figure 16.9 depicts a continuous futures series, percentage price changes would be equal to the price changes shown on this chart divided by the corresponding nearest futures price, which is not shown. recall from chapter 5 that continuous futures accurately refl ect price swings but not price levels. conse- quently, continuous futures cannot be used as the divisor to calculate percentage changes. FIGURE  16.9 Penetration as confi rmation condition: coff ee continuous futures Note: B, S = signals for breakout system with N = 12; , = signals for breakout system with N = 12 and 3 percent closing penetration confi rmation. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 249 TecHnicaL TraDing SySTeMS: STrucTure anD DeSign 3. Pattern. This is a catch-all term for a wide variety of confi rmation rules. in this approach, a specifi ed pattern is required to validate the basic system signal. for example, the confi rmation rule might require three subsequent thrust days beyond the signal price. 4 figure 16.11 com- pares the signals generated by the basic breakout system, with N = 12 and the signals based upon the corresponding system using the three-thrust-day validation condition. The thrust-day count at confi rmed signals is indicated by the numbers on the chart. Here, too, the confi rmation rule eliminates fi ve of six losing buy signals. The design of trading systems is a matter of constant trade-off s. The advantage of confi rmation conditions is that they will greatly reduce whipsaw losses. However, it should be noted that confi rma- tion rules also have an undesirable side eff ect—they will delay entry on valid signals, thereby reducing gains on profi table trades. for example, in figures 16.9 through 16.11 , note that the confi rmation rules result in worse entry prices for all the valid trade signals. The confi rmation condition will be benefi cial as long as reduced profi ts due to delayed entry are more than off set by avoided losses. a sys- tem that includes confi rmation conditions will not always outperform its basic system counterpart, but if properly designed it will perform signifi cantly better over the long run. 4 a thrust day, which was originally defi ned in chapter 9 , is a day with a close above the previous day’s high or below the previous day’s low . FIGURE  16.10 Time Delay as a confi rmation condition: coff ee continuous futures Note: B, S = signals for breakout system with N = 12; , = signals for breakout system with N = 12 and six-day time delay confi rmation. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 250a coMPLeTe guiDe To THe fuTureS MarKeT Filter The purpose of a fi lter is to eliminate those trades that are deemed to have a lower probability of suc- cess. for example, the technical system might be combined with a fundamental model that classifi es the market as bullish, bearish, or neutral. T echnical signals would then be accepted only if they were in agreement with the fundamental model’s market designation. in cases of disagreement, a neutral position would be indicated. in most cases, however, the fi lter condition(s) will also be technical in nature. for example, if one could derive a set of rules that had some accuracy in defi ning the pres- ence of a trading range market, signals that were received when a trading range market was indicated would not be accepted. in essence, in developing a fi lter, the system designer is trying to fi nd a com- mon denominator applicable to the majority of losing trades. W e will use the frequently unsatisfactory simple moving average system to provide a specifi c example of a fi lter condition. The noncircled signals in figure 16.1 illustrate the typical tendency of the simple moving average system to generate many false signals—even in trending markets. These whipsaw trades can be substantially reduced by applying a fi lter rule that requires trade signals to be consistent with the trend of the moving average. for example, price crossing the moving average from below and closing above the moving average would be accepted as a buy signal only if the moving average was up relative to the previous day’s level. This fi lter condition makes intuitive sense because it adheres to the basic technical concept of trading with the major trend. FIGURE  16.11 example of a Pattern confi rmation condition: coff ee continuous futures Note: B, S = signals for breakout system with N = 12; , = signals for breakout system with N = 12 and three-thrust-day confi rmation. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 251 Technical Trading SySTemS: STrucTure and deSign Two points should be clarified regarding the application of this rule: 1. a rejected signal could be activated later if the moving average subsequently turned in the direc- tion of the signal before an opposite-direction crossover of the price and moving average. 2. Signals that occur after rejected signals are ignored because the net position is already consistent with the implied trade. This observation is true because the simple moving average system is always in the market. The circled signals in figure 16.1 indicate the trades that would have been accepted if the filter rule just described were applied. (in both instances these trades occurred after delays, as previously described, rather than upon immediate penetration of the moving average.) as can be seen, the rule substantially reduces the number of false signals. although in some cases the application of the filter condition results in adversely delayed trade entries (for example, the July sell signal), on balance the benefits clearly outweigh the disadvantages. of course, a single illustration doesn’t prove anything. However, the implication of figure 16.1 does have a more general applicability. Most empirical testing would reveal that, more often than not, the inclusion of the type of filter rule depicted in figure 16.1 tends to improve performance. in fact, a crossover between price and the moving average that is opposite to the direction of the moving average trend can often provide a good signal to add to rather than reverse the original position. for example, in figure 16.1 the March and May 2014 downside penetrations of the moving average could be viewed as buy rather than sell signals because the moving average trend was still up in those instances. The rationale behind this interpretation is that in a trending market, reactions often carry to the vicinity of a moving average before prices resume their longer-term trend (see chapter 12). Thus, in effect, such rejected signals could actually provide the basis for a method of pyramiding. it should be noted that, in a sense, the confirmation conditions detailed in the previous section represent one type of filter, insofar as signals that fulfill a subsequent set of conditions are accepted, while those that do not are eliminated. However, the distinction here is that a filter implies a set of screening rules applied at the time the base system signal is received. in other words, the sorting procedure occurs without any dependency on subsequent developments (although, to be perfectly accurate, subsequent developments could still permit a delayed acceptance of a rejected signal). con- sequently, as we have defined the terms, a system can include both a filter and a confirmation rule. in such a system, only signals that were accepted based on the filter definition and subsequently validated by the confirmation rule(s) would actually result in trades. Market Characteristic adjustments one criticism of simple trend-following systems is that they treat all markets alike. for example, in a breakout system, with N = 20, both highly volatile and very quiet markets will require the same condi- tions for a buy signal—a 20-day high. Market characteristic adjustments seek to compensate for the fact that a system’s optimum parameter value settings will depend on market conditions. for example, in the case of a breakout system, instead of using a constant value for N, the relevant value for N might be contingent on the market’s volatility classification. as a specific illustration, the average two-day price 252 A Complete Guide to the Futures mArket range during the past 50-day period might be used to place the market into one of five volatility classifications.5 The value of N used to generate signals on any given day would then depend on the prevailing volatility classification. V olatility appears to be the most logical choice for classifying market states, although other cri- teria could also be tested (e.g., fundamentally based conditions, average volume level). in essence, this type of modification seeks to transform a basic trend-following system from a static to a dynamic trading method. Differentiation between buy and Sell Signals Basic trend-following systems typically assume analogous conditions for buy and sell signals (e.g., buy on close above 20-day high, sell on close below 20-day low). However, there is no reason to make this assumption automatically. it can be argued that bull and bear markets behave differently. for example, a survey of a broad spectrum of historical price data would reveal that price breaks from major tops tend to be more rapid than price rallies from major bottoms. 6 This observation suggests a rationale for using more sensitive conditions to generate sell signals than those used to generate buy signals. However, the system designer using such an approach should be particularly sensitive to the danger of overfitting the system—a pitfall discussed in detail in chapter 19. Pyramiding one inherent weakness in basic trend-following systems is that they automatically assume a constant unit position size for all market conditions. it would seem desirable to allow for the possibility of larger position sizes in the case of major trends, which are almost entirely responsible for the success of any trend-following system. one reasonable approach for adding units to a base position in a major trend is to wait for a specified reaction and then initiate the additional unit(s) on evidence of a resump- tion of the trend. Such an approach seeks to optimize the timing of pyramid units, as well as to provide exit rules that reasonably limit the potential losses that could be incurred by such added positions. an 5 a two-day price range is used as a volatility measure instead of a one-day range since the latter can easily yield a distorted image of true market volatility. for example, on a limit day, the one-day range would equal zero, in extreme contrast to the fact that limit days reflect highly volatile conditions. of course, many other measures could be used to define volatility. 6 The reverse statement would apply to short-term interest rate markets, which are quoted in terms of the instrument price, a value that varies inversely with the interest rate level. in the interest rate markets, interest rates rather than instrument prices are analogous to prices in standard markets. for example, there is no upper limit to a commodity’s price or interest rates, but the downside for both of these items is theoretically limited. as another example, commodity markets tend to be more volatile when prices are high, while short-term interest rate markets tend to be more volatile when interest rates are high (instrument prices are low). The situation for long-term (i.e., bond) markets is ambiguous since although interest rates can fall no lower than approximately zero, the pricing mathematics underlying these instruments result in an accelerated price advance (for equal interest rate changes) as interest rates fall. 253 Technical Trading SySTemS: STrucTure and deSign example of this type of approach was detailed in chapter 12. another example of a possible pyramid strategy would be provided by the following set of rules: Buy Case 1. a reaction is defined when the net position is long and the market closes below the prior 10-day l ow. 2. o nce a reaction is defined, an additional long position is initiated on any subsequent 10-day high if the following conditions are met: a. The pyramid signal price is above the price at which the most recent long position was initiated. b. The net position size is less than three units. (This condition implies that there is a limit of two pyramid units.) Sell Case 1. a reaction is defined when the net position is short and the market closes above the prior 10-day high. 2. o nce a reaction is defined, an additional short position is initiated on any subsequent 10-day low if the following conditions are met: a. The pyramid signal price is below the price at which the most recent short position was initiated. b. The net position size is less than three units. (This condition implies that there is a limit of two pyramid units.) figure 16.12 illustrates the addition of this pyramid plan to a breakout system with N = 40 applied to the 2012–2013 gold market. ( for now , ignore the “stop level” signals; they are explained shortly.) risk control becomes especially important if a pyramiding component is added to a system. gen- erally speaking, it is usually advisable to use a more sensitive condition for liquidating a pyramid posi- tion than the condition required to generate an opposite signal. The following is one example of a set of stop rules that might be employed in a system that uses pyramiding. Liquidate all pyramid positions whenever either condition is fulfilled: 1. a n opposite trend-following signal is received. 2. The market closes above (below) the high (low) price since the most recently defined reaction that was followed by a pyramid sell (buy). figure 16.12 illustrates the stop levels implied by this rule in the case of the 2012–2013 gold market. trade exit The existence of a trade exit rule in a system (e.g., a stop rule) would permit the liquidation of a position prior to receiving an opposite trend-following signal. Such a rule would serve to limit losses 254a coMPLeTe guiDe To THe fuTureS MarKeT on losing trades as well as limit the amount of open profi ts surrendered on winning trades. although these are highly desirable goals, the trade-off implied by using a trade exit rule is relatively severe. if a trade exit rule is used, rules must be specifi ed for reentering the position; otherwise, the system will be vulnerable to missing major trends. The danger in using a trade exit rule is that it may result in the premature liquidation of a good trade. although the reentry rule will serve as a backstop, the combination of an activated trade exit rule and a subsequent reentry is a whipsaw loss. Thus, it will not be at all uncommon for the addition of a trade exit rule (and implied reentry rule) to have a negative impact on performance. neverthe- less, although it is not easy, for some systems it will be possible to structure trade exit rules that improve performance on balance. (in terms of return, and usually in terms of return/risk measures as well, if a trade exit rule helps performance, the use of the trade exit rule as a reversal signal—as opposed to just a liquidation signal—will help performance even more.) Trade exit rules can also be made dynamic. for example, the trade exit condition can be made increasingly sensitive as a price move becomes more extended in either magnitude or duration. ■ Countertrend Systems General Considerations regarding Countertrend Systems countertrend systems often appeal to many traders because their ultimate goal is to buy low and sell high. unfortunately, the diffi culty of achieving this goal is inversely proportional to its desirability. FIGURE  16.12 Pyramid Signals: gold continuous futures Note: S = base position sell signal; = pyramid sell signal; rD = reaction defi ned. chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 255 Technical Trading SySTemS: STrucTure and deSign a critical distinction to keep in mind is that whereas a trend-following system is basically self- correcting, a countertrend system implies unlimited losses. Therefore, it is essential to include some stop-loss conditions in any countertrend system (unless it is traded simultaneously with trend-following systems). otherwise, the system could end up being long for the duration of a major downtrend or short for the duration of a major uptrend. (Stop-loss conditions are optional for most trend-following systems, since an opposite signal will usually be received before the loss on a position becomes extreme. 7) one important advantage of using a countertrend system is that it provides the opportunity for excellent diversification with simultaneously employed trend-following systems. in this regard, it should be noted that a countertrend system might be desirable even if it was a modest net loser, the reason being that if the countertrend system was inversely correlated to a simultaneously traded trend-following system, trading both systems might imply less risk than trading the trend-following system alone. Therefore, it is entirely possible that the two systems combined might yield a higher percent return (at the same risk level), even if the countertrend system alone lost money. types of Countertrend Systems The following are some types of approaches that can be used to try to construct a countertrend system: Fading minimum move. This is perhaps the most straightforward countertrend approach. a sell signal is indicated each time the market rallies by a certain minimum amount above the low point since the last countertrend buy signal. Similarly, a buy signal is indicated whenever the market declines by a minimum amount below the high point since the last countertrend sell signal. The magnitude of the price move required to generate a trade signal can be expressed in either nominal or percentage terms. figure 16.13 illustrates the trade signals that would be generated by this type of countertrend system for a 7.5 percent threshold level in the January– September 2015 natural gas market. it is no accident this chart depicts the same market that was previously used in this chapter to illustrate whipsaw losses for a sensitive trend-following system (see figure 16.6). countertrend systems will tend to work best under those types of market conditions in which trend-following systems fare poorly. Fading minimum move with confirmation delay. This is similar to the preceding counter- trend system, with the exception that some minimum indication of a trend reversal is required before the countertrend trade is initiated. for example, a one-thrust-day confirmation might be required to validate countertrend signals based on fading a given percent price move. Oscillators. a countertrend system could use oscillators to generate trade signals. However, as discussed in chapters 11 and 12, although using oscillators to signal countertrend trades may work well in a trading-range market, in a trending market such an approach can be disastrous. 7 Stop-loss rules, however, might be mandatory for an extremely nonsensitive trend-following system—for example, a breakout system with N = 150. 256a coMPLeTe guiDe To THe fuTureS MarKeT Contrary opinion. a countertrend system might use contrary opinion as an input in timing trades. for example, once the contrary opinion rose above a specifi ed level, a short position would be indicated contingent on confi rmation by a very sensitive technical indicator. (con- trary opinion was discussed in chapter 14 .) ■ Diversifi cation The standard interpretation attached to the term diversifi cation is that trading is spread across a broad range of markets. although this is the single most important type of diversifi cation, assuming the availability of suffi cient funds, there are two additional levels of possible diversifi cation. first, each market can be traded with several systems. Second, several variations of each system can be used. for example, if two contracts of cocoa are being traded using the breakout system, each contract can be traded using a diff erent value of N (i.e., the number of days whose high or low must be penetrated to trigger a signal). in the following discussion, the term single market system variation (SMSV) will refer to the concept of a specifi c variation of a given system traded in a single market. Thus, the simple breakout system, with N = 20, traded in the cocoa market would be an example of an SMSV . in the simplest case in FIGURE  16.13 countertrend Signals: october 2015 natural gas futures Note: Percentages are calculated as price changes in continuous futures divided by corresponding nearest futures price levels. B = buy signal: 7.5% decline from prior high; S = sell signal: 7.5% advance from prior low . chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 257 Technical Trading SySTemS: STrucTure and deSign which a single system is used for all markets, and a single system variation is used in each market, there would be only one SMSV for each market traded. This simplified case represents the typical application of trading systems and employs only the standard diversification across markets. However, if sufficient funds are available, additional benefits can be obtained by also diversifying across different systems and different variations of each system. There are three important benefits to diversification: 1. Dampened equity retracements. Different SMSVs will not witness their losses at precisely the same periods. Thus, by trading a wide variety of SMSVs, the trader can achieve a smoother equity curve. This observation implies that trading 10 SMSVs with equivalent profit/risk char- acteristics could provide lower risk at the same return level than trading 10 units of a single SMSV . or, alternatively, by trading larger size, 10 SMSVs with equivalent profit/risk character- istics could provide higher return at the same risk level than trading 10 units of a single SMSV . up to a point, diversification would be beneficial even if the portfolio included SMSVs with poorer expected performance. a key consideration would be a given SMSV’s correlation with the other SMSVs in the portfolio. 2. ensured participation in major trends. Typically, only a few of the actively traded futures markets will witness substantial price trends in any given year. Because the majority of trades in most trend-following systems will lose money, 8 it is essential that the trader participate in the large-profit trades—that is, major trends. This is a key reason for the importance of diversifica- tion across markets. 3. bad luck insurance. futures systems trading, like baseball, is a game of inches. given the right combination of circumstances, even a minute difference in the price movement on a sin- gle day could have an extraordinary impact on the profitability of a specific SMSV . T o illustrate this point, we consider a breakout system (N = 20) with a confirmation rule requiring a single thrust day that penetrates the previous day’s high or low by a minimum amount. in system a this amount is 0.05 cents; in system B it is 0.10 cents. This is the only difference between the two systems. figure 16.14 compares these two systems for the December 1981 coffee market and represents the most striking instance i have ever encountered of the sensitivity of system performance to minute changes in system values. The basic system buy signal (i.e., close above the 20-day high) was received on July 16. This buy was confirmed by system a on July 17 as the close was 0.09 cents above the previous day’s high (point a1). System B, however, which required a 0.10-cent penetration, did not confirm the signal until the following day (point B1). The buy signal for system a would have been executed at approximately $0.97 (point a2). However, due to the ensuing string of limit moves, the buy signal for system B could not be filled until prices surpassed $1.22 (point B2). Thus, during this short interim, system a gained 8 Such systems can still be profitable because the average gain significantly exceeds the average loss. 258a coMPLeTe guiDe To THe fuTureS MarKeT 25¢/lb ($9,375 per contract), while system B, which was unable to reverse its short position, lost a similar amount. The failure of the market to close 0.01 cent higher on a given day (a price move equivalent to less than $4) resulted in an incredible $18,750 per contract diff erence in the performance of the two nearly identical system variations! it should be emphasized this example refl ects the randomness in commodity price movements rather than the instability of the tested system. any system, other than a day trading system, could refl ect the same degree of instability, since the performance diff erence was due to just a single trade in which the signals were separated by only one day. This example should explain how it is possible for a trader to lose money in a given market using a system that generally performs well—he may just have chosen a specifi c variation that does much worse than most other variations (even very similar ones). By trading several varia- tions of a system, the speculator could mitigate the impact of such isolated, abnormally poor results. 9 of course, in so doing, the trader would also eliminate the possibility of gains far exceed- ing the average performance of the system. on balance, however, this prospect represents a desir- able trade-off , since it is assumed that the basic trading goal is consistent performance rather than windfall profi ts. FIGURE  16.14 System Trading: a game of inches (December 1981 coff ee) chart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. 9 in the preceding example, system a and system B were deliberately chosen to be nearly identical in order to make the point about the potential impact of chance in its strongest possible form. However, in practice, the trader should choose system variations that are substantially more diff erentiated. 259 Technical Trading SySTemS: STrucTure and deSign ■ Ten Common Problems with Trend-Following Systems Revisited W e are now ready to consider possible solutions to the previously enumerated problems with stan- dard trend-following systems. The problems and the possible solutions are summarized in Table 16.2. table 16.2 Problems with Standard trend-Following Systems and Possible Solutions Problems with Standard trend- Following Systems Possible Solutions 1. T oo many similar systems 1a. Try to construct original systems in order to avoid the problem of “trading with the crowd.” 1b. if trading more than one contract, spread out entry. 2. Whipsaws 2a. employ confirmation conditions. 2b. Develop filter rules. 2c. employ diversification. 3. failure to exploit major price moves 3. add pyramiding component. 4. nonsensitive (slow) systems can surrender a large percentage of profits. 4. employ trade exit rules. 5. cannot make money in trading-range markets 5. Trade trend-following systems in conjunction with countertrend systems. 6. T emporary large losses 6a. if funds permit, trade more than one system in each market. 6b. When beginning to trade a system, trade more lightly if entering positions at a point after the signal has been received. 7. extreme volatility in best-performing systems 7. By employing diversification, the trader can allocate some funds to a high-profit-potential system that is too risky to trade on its own. 8. System works well in testing but then bombs. 8. The danger of such a development can be reduced if systems are properly tested. This subject is discussed in detail in chapter 19. 9. Parameter shift 9a. if funds permit, diversify by trading several variations of each system. 9b. experiment with systems that incorporate market characteristic adjustments. 10. Slippage 10. use realistic assumptions (discussed in chapter 19). 261 Nothing works at all times in all kinds of markets. —Adam Smith T he previous chapter provided two examples of generic trading systems—moving averages and breakouts. This chapter details several original trading systems that are based on some of the pat- terns introduced in Chapter 9. Although the systems detailed here represent fully automated trading strategies, the primary goal of this chapter is not to offer specific trading systems, but rather to give read- ers a feel for how technical concepts can be utilized to construct a mechanical trading approach. Study- ing these examples should provide readers with ideas as to how to design their own trading systems. ■ Wide-Ranging-Day System Basic Concept A wide-ranging day, which was introduced in Chapter 9, is a day with a much wider true range 1 than recent trading sessions. The high volatility inherent in wide-ranging days gives these days special significance. Typically, the market will tend to extend in the direction of the initial price move beyond Examples of Original Trading Systems Chapter 17 1 The true range is equal to the true high minus the true low. The true high is the maximum of the current day’s high and the previous day’s close. The true low is the minimum of the current day’s low and the previous day’s close. 262 A Complete Guide to the Futures mArket the boundaries of the wide-ranging day. However, situations in which the market originally penetrates one side of the wide-ranging day and then reverses to penetrate the other side also have significance. The wide-ranging-day system defines trading ranges based on wide-ranging days. Signals are generated when prices close above or below these trading ranges. In the simplest case, the trading range is defined as the wide-ranging day itself. However, we make the system more general by defining the trading range as the price range encompassing all the true highs and true lows during the period extending from N1 days before the wide-ranging day to N2 days after, where N1 and N2 are parameter values that must be defined. For example, if both N1 and N2 equal 0, the trading range would be defined by the wide-ranging day itself (i.e., the range between the true high and true low of the wide-ranging day). If N1 = 2 and N2 = 4, the trading range would be defined as the range between the highest true high and lowest true low in the interval beginning two days before the wide-ranging day and ending four days after it. Definitions Wide-ranging day. A day on which the volatility ratio (VR) is greater than k (e.g., k = 2). The VR is equal to today’s true range divided by the average true range of the past N-day period (e.g., N = 10). price trigger range (ptr). The range defined by the highest true high and lowest true low in the interval between N1 days before the most recent wide-ranging day to N2 days after. Note that the PTR cannot be defined until N2 days after a wide-ranging day. (If N2 = 0, the PTR would be defined as of the close of the wide-ranging day itself.) The PTR will be redefined each time there is a new wide-ranging day (i.e., N2 days after such an event). trading Signals Buy case. On a close above the high of the PTR, reverse from short to long. Sell case. On a close below the low of the PTR, reverse from long to short. Daily Checklist T o generate trading signals, perform the following steps each day: 1. If short and today’s close is above the high of the PTR, liquidate short and go long. 2. If long and today’s close is below the low of the PTR, liquidate long and go short. 3. Check whether exactly N2 days have elapsed since the most recent wide-ranging day. If this condition is met, redefine the PTR. The order of these steps is very important. Note that the check for new trading signals precedes the check whether the PTR should be redefined. Thus, if the day a new PTR is defined also signals a trade based on the prevailing PTR going into that day, a signal would be generated. If step 3 preceded steps 1 and 2, trade signals could get delayed each time a signal occurred on the day a new PTR is defined (N2 days after the most recent wide-ranging day, which would be the wide-ranging day itself when N2 = 0). For example, assume the system is long, N2 = 0, and the close on a new wide-ranging day is below the low of the preceding wide-ranging day. According to the listed step order, the new wide-ranging day would signal a reversal from long to short. If steps 1 and 2 followed step 3, no signal 263 ExAMPlES OF ORIgINAl TRADINg SySTEMS would occur, since the PTR would be redefined, and the market would have to close below the new wide-ranging day to trigger a signal. System parameters N1. The number of days prior to the wide-ranging day included in the PTR period. N2. The number of days after the wide-ranging day included in the PTR period. k. The value the volatility ratio (VR) must exceed in order to define a wide-ranging day. Note: N, the number of past days used to calculate the VR, is assumed to be fixed (e.g., N = 10). parameter Set List Table 17.1 provides a sample parameter set list. Readers can use this list as is or adjust it as desired. The subject of testing multiple parameter sets and deciding which one to use in actual trading is addressed in Chapter 19. taBLe 17.1 parameter Set List k N1 N2 1. 1.6 0 0 2. 1.6 2 0 3. 1.6 4 0 4. 1.6 0 2 5. 1.6 2 2 6. 1.6 4 2 7. 1.6 0 4 8. 1.6 2 4 9. 1.6 4 4 10. 2.0 0 0 11. 2.0 2 0 12. 2.0 4 0 13. 2.0 0 2 14. 2.0 2 2 15. 2.0 4 2 16. 2.0 0 4 17. 2.0 2 4 18. 2.0 4 4 19. 2.4 0 0 20. 2.4 2 0 21. 2.4 4 0 22. 2.4 0 2 23. 2.4 2 2 24. 2.4 4 2 25. 2.4 0 4 26. 2.4 2 4 27. 2.4 4 4 264A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  17.1 Wide-Ranging Day System, Chart 1: Copper Continuous Futures Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. an Illustrated example T o illustrate how the system works, Figures 17.1 through 17.5 superimpose trading signals on copper charts spanning late October 2013 to November 2015, a period the weekly chart inset in Figure 17.1 shows consisted mostly of a choppy, longer-term price descent, interspersed with short-term uptrends in mid-2014 and early 2015. Note these charts are continuous futures to coincide with the price series used to generate signals. As will be fully detailed in the next two chapters, continuous futures are usu- ally the most suitable price series to use in trading systems. T o help provide continuity between charts, each chart overlaps one to two months of the preceding chart. Two types of signals are indicated on the accompanying charts: 1. The noncircled signals are generated by the system when both N 1 and N 2 are set to zero. In other words, the PTR is defi ned by the true high and true low of the wide-ranging day. 2. The circled signals are generated by the system when N 1 = 2 and N 2 = 4. (In other words, the PTR is defi ned by the true price range encompassing the interval beginning two days before the wide-ranging day and ending four days after it.) Occasionally, both sets of parameter values will yield identical signals. In most cases, however, the second system version will trigger signals later or not at all. (The reverse can never occur, since the PTR based on N 1 = 2 and N 2 = 4 must be at least as wide as the PTR based on N 1 = 0 and N 2 = 0. Therefore any penetration of the former PTR must also be a penetration of the latter PTR, but not vice versa.) 265 ExAMPlES OF ORIgINAl TRADINg SySTEMS FIGURE  17.3 Wide-Ranging Day System, Chart 3: Copper Continuous Futures Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  17.2 Wide-Ranging Day System, Chart 2: Copper Continuous Futures Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 266A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  17.4 Wide-Ranging Day System, Chart 4: Copper Continuous Futures Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  17.5 Wide-Ranging Day System, Chart 5: Copper Continuous Futures Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 267 ExAMPlES OF ORIgINAl TRADINg SySTEMS First, we examine the trading signals generated for the system version when both N1 and N2 equal zero (the noncircled signals). Therefore, for now , ignore the circled signals, which are based on the parameter set consisting of N1 = 2 and N2 = 4. W e will subsequently examine the instances in which the two parameter sets yield different signals. The first signal occurs in December 2013 when a close above the high of the December 4 wide- ranging day triggers a buy (Figure 17.1). The system then reverses to short modestly higher in January 2014 when the market closes below the low of the wide-ranging day formed in late December. The January short position profits from the ensuing downtrend and remains intact until late April when the market closes above the high of the second wide-ranging day that formed in March, triggering a buy signal. The April 2014 long position remains intact for several months, capturing a portion of the ensuing uptrend, until it is reversed in early August when the market closes below the low of the early July wide-ranging day (Figure 17.2). The early August short position is short-lived and results in the first losing trade when a subsequent market bounce forms a wide-ranging day that is exceeded by a closing price two days later, triggering a buy signal. This August buy signal proves to be a whipsaw trade as the system reverses back to short in September 2014 (Figure 17.3). The next buy signal materializes near the same level in late October 2014 when the market closes above the true high of the October wide-ranging day. This buy signal proves to be another whipsaw loss as the market immediately turns lower and eventually closes below the same October wide- ranging day, triggering a sell signal in November. Note, as is the case here, a single wide-ranging day can trigger multiple trades (in opposite directions) in the absence of intervening wide-ranging days. The November sell signal yields a small profit before leading to a third successive losing buy signal in December 2014. The January 2015 sell signal is exited at a profit in February 2015 when the market closes above the high of the second wide-ranging day formed in January (Figure 17.4). Additional trades are shown in Figures 17.4 and 17.5. Next we examine how the signals generated by the second parameter set (N 1 = 2, N 2 = 4; circled on charts) differ from those that result from the first parameter set (N 1 = 0, N 2 = 0). One pattern the reader will notice is that whenever both parameter sets had signals in the same cycle—a signal in the same direction before the first parameter set triggered an opposite signal— the delay caused by using the second parameter set almost invariably resulted in a less favorable entry level. In most cases the differences in entry levels were moderate (e.g., the signals shown in Figure 17.1). In some instances, however, the difference in entry levels was quite substantial. For example, in Figure 17.2, the second parameter set went long in late June, more than two months after the first parameter set, because prices needed to close not just above the high of the March 11 wide-ranging day, but above the high of the two days preceding that day. Occasionally, both parameter sets may trigger signals on the same day (e.g., the September 2015 buy in Figure 17.5), but there are no instances where the second parameter set has a better entry. The poorer entry levels generated by the second parameter set are no accident, since the wider PTRs defined by the nonzero N 1 and N 2 values will always result in equal or higher buy signals and equal or lower sell signals. 268 A Complete Guide to the Futures mArket The reader might well wonder why one would ever want to use nonzero values for N1 and N2, since the resulting delayed entries are invariably equal to or worse than entries based on keeping N1 and N2 equal to zero. The answer lies in the fact that the broader PTRs that result from nonzero N1 and N2 values will tend to filter out some losing signals—a characteristic that can have a major impact on the system’s profitability. For example, following the August 2014 sell signal, the second parameter set avoids the three successive losing buy signals generated by the first parameter set (Figure 17.3). As a result, the second parameter set generates a substantial profit during this period while the series of trades generated by the first parameter set results in a net loss, despite the pre- vailing major downtrend. On balance, in the market example illustrated in Figures 17.1 through 17.5, the benefit of filtering out some losing trades far outweighs the cumulative negative impact of the worse entries that result from using nonzero values for N1 and N2: For the entire period, the second parameter set generates a cumulative profit of $0.488 per pound ($12,200 per contract) versus a cumulative loss of –$0.379 per pound (–$9,475 per contract) for the first parameter set. Although in some cases parameter sets with more sensitive entry conditions will experience the better performance, the outcome in our example is more typical. generally speaking, the parameter sets with more restrictive entry conditions will do better, as the benefit of reducing whipsaw trades outweighs the disadvantage of worse entries. Ironically, human nature will lead most traders, espe- cially novices, to choose more sensitive parameter sets because they will be attracted by the better entries and smaller surrender of open profits on individual trades offered by these sets, failing to fully appreciate the cumulative impact of reduced bad trades—a trait characteristic of more restrictive parameter sets. It should be emphasized the selected example was intended to illustrate the mechanics of the wide- ranging day system across varied market conditions, not to put the system in the best light. Therefore, this example deliberately contained both intervals of strong wins as well as whipsaw losses. Note that I could easily have made the system look much more impressive by selecting a market and time period with much smoother trends. Such cherry-picked illustrations are all too common in trading books, articles, web sites, and—especially—advertisements. W e return to this subject in the discussion of “the well-chosen example” in Chapter 19. ■ Run-Day Breakout System Basic Concept Up and down run days were defined in Chapter 9. As was explained, run days tend to occur in strongly trending markets. In this system, buy reversal signals are generated when the market closes above the maximum true high of a specified number of prior down run days. Similarly, sell reversal signals are generated when the market closes below the minimum true low of a specified number of prior up run days. The idea is that the ability of the market to close opposite the extreme point defined by one or more such strongly trending days implies a trend reversal has occurred. 269 ExAMPlES OF ORIgINAl TRADINg SySTEMS trading Signals Buy case. Reverse to long whenever both of the following two conditions are met: 1. The close is above the maximum true high of the most recent N2 down run days. (Note: Only the run day true highs are considered, not the true highs on the interim days.) 2. The most recent run day is an up run day. (Without this second condition, in some cases, the first condition in the sell case would result in an automatic reversal back to a short position.) Sell case. Reverse to short whenever both of the following two conditions are met: 1. The close is below the minimum true low of the most recent N2 up run days. (Note: Only the run day true lows are considered, not the true lows on the interim days.) 2. The most recent run day is a down run day. (Without this second condition, in some cases, the first condition in the buy case would result in an automatic reversal back to a long position.) Daily Checklist T o generate trading signals, perform the following three steps each day: 1. Check whether the trading day N1 days prior to the current day can be defined as an up or a down run day. 2 (Recall that a run day cannot be defined until the close N1 days after the run day.) Keep track of all run days and their true highs and true lows. 2. If short, check whether today’s close is above the maximum true high of the past N2 down run days. If it is, check whether the most recent run day was an up run day. If it was, reverse from short to long. 3. If long, check whether today’s close is below the minimum true low of the past N2 up run days. If it is, check whether the most recent run day was a down run day. If it was, reverse from long to short. parameters N1. The parameter used to define run days. For example, if N = 3, a day would be defined as an up run day if its true high was greater than the maximum true high of the prior three days and its true low was less than the minimum true low of the following three days. N2. The number of prior down run days used to compute the maximum true high that must be exceeded by a close for a buy signal. (Also, the number of prior up run days used to compute the minimum true low that must be penetrated by a close for a sell signal.) 2 Although uncommon, a day can be both an up run day and down run day. This unusual situation will occur if a day’s true high is greater than the true highs during the prior and subsequent N1 days, and its true low is lower than the true lows during the prior and subsequent N1 days. Days that fulfill both the up and down run day defini- tions are not considered run days. 270 A Complete Guide to the Futures mArket parameter Set List Table 17.2 provides a sample parameter set list. Readers can use this list as is or adjust it as desired. an Illustrated example T o illustrate the mechanics of the run-day breakout system, Figures 17.6 through 17.9 show the buy and sell signals generated by the system for the parameter set N1 = 5 and N2 = 4 in the WTI crude oil market. Down run days are denoted by downward-pointing arrows and up run days by upward- pointing arrows. A close below the minimum true low of the four most recent up run days triggers a sell signal in January 2014 (Figure 17.6). Note the second condition for a sell signal—that is, the most recent run day is a down run day—was fulfilled on the day of the signal. Had the signal occurred one day earlier, no trade would have been taken because the December 31, 2013, down run day (the first in the string of four) would not yet have been confirmed, and the most recent run day would have been the December 19 up run day. (Remember that each run day marked with an arrow can be confirmed only after five days have passed.) A buy signal occurs in February 2014 when the market closes above the true high of the December 31 down run day (the maximum true high of that string of four down run days). The second condition is also met as the most recent run day is an up run day. The market drifts higher into June (note the predominance of up run days versus down run days) and then begins to sag into July (Figure 17.7). The system next goes short in July when the market closes below the minimum true low of the prior four up run days. The system stays short through the entire ensuing downtrend, which is characterized by a tremendous predominance of down run days, eventually reversing nearly nine months later (in April 2015) on the close above the true high of the cluster of down run days in March (Figure 17.8). The system holds this position through June as the market moves sideways to slightly higher. The downturn in July generates a flurry of down run days, and the system turns short on July 22 with a close below the March 25 low (Figure 17.9). Note that taBLe 17.2 parameter Set List N1 N2 1. 3 2 2. 3 3 3. 3 4 4. 3 5 5. 5 2 6. 5 3 7. 5 4 8. 7 2 9. 7 3 10. 7 4 271 ExAMPlES OF ORIgINAl TRADINg SySTEMS FIGURE  17.7 Run-Day Breakout System ( N 1 = 5; N 2 = 4), Chart 2: WTI Crude Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  17.6 Run-Day Breakout System ( N 1 = 5; N 2 = 4), Chart 1: WTI Crude Oil Continuous Futures Note: The direction of the arrows indicates the direction of the run day. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 272A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  17.8 Run-Day Breakout System ( N 1 = 5; N 2 = 4), Chart 3: WTI Crude Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  17.9 Run-Day Breakout System ( N 1 = 5, N 2 = 4), Chart 4: WTI Crude Oil Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 273 ExAMPlES OF ORIgINAl TRADINg SySTEMS although the sharp rebound in late August is large enough to rally the market above the maximum true high of the four most recent down run days, there is no buy signal because there is no interven- ing up run day. Overall, the system successfully exploits the major downtrend (July 2014 to August 2015) that occurs during the two-year survey period, capturing about half of the total profit that would be realized by a hypothetical trader who goes short at the high of the two-year period and covers the position at the low of the period. Readers, however, are cautioned against generalizing the system’s performance based on this single market/single parameter set example. In most cases, the system will not attain the level of performance exhibited in this illustration. ■ Run-Day Consecutive Count System Basic Concept This system also uses run days as the key input in generating trading signals. In this system, reversal signals occur whenever there are a specified number of up run days without any intervening down run days, or vice versa. Definitions The system uses the following definitions: Buy count. The buy count is activated whenever a sell signal is received. The count starts at zero and increases by one whenever a new up run day is defined. The count is reset to zero whenever there is a down run day. In effect, the buy count represents the number of up run days that occur without any intervening down run days. The buy count is closed when a buy signal is received. Sell count. The sell count is activated whenever a buy signal is received. The count starts at zero and increases by one whenever a new down run day is defined. The count is reset to zero whenever there is an up run day. In effect, the sell count represents the number of down run days that occur without any intervening up run days. The sell count is closed when a sell signal is received. trading Signals Buy case. Reverse to long whenever the buy count reaches N2. Keep in mind that the fulfill- ment of this condition will not be known until N1 days after the N2th consecutive up run day. (Consecutive here means that there are no intervening down run days, not that the up run days occur on consecutive days.) 274 A Complete Guide to the Futures mArket Sell case. Reverse to short whenever the sell count reaches N2. Keep in mind that the fulfill- ment of this condition will not be known until N1 days after the N2th consecutive down run day. (Consecutive here means that there are no intervening up run days, not that the down run days occur on consecutive days.) Daily Checklist T o generate trading signals, perform the following three steps each day: 1. Check whether the trading day N1 days prior to the current day can be defined as an up or a down run day. (Recall that a run day cannot be defined until the close N1 days after the run day.) If the day is an up run day, increase the buy count by one if the buy count is active (i.e., if the current position is short); otherwise, reset the sell count to zero. (Either the buy or sell count is always active, depending on whether the current position is short or long.) If the day is defined as a down run day, increase the sell count by one if the sell count is active (i.e., if current posi- tion is long); otherwise, reset the buy count to zero. 2. If the buy count is active, check whether it is equal to N2 after step 1. If it is, cover short, go long, close buy count, and activate sell count. 3. If the sell count is active, check whether it is equal to N2 after step 1. If it is, cover long, go short, close sell count, and activate buy count. parameters N1. The parameter used to define run days. N2. The number of consecutive run days required for a signal. parameter Set List Table 17.3 provides a sample parameter set list. Readers can use this list as is or adjust it as desired. taBLe 17.3 parameter Set List N1 N2 1. 3 1 2. 3 2 3. 3 3 4. 3 4 5. 5 1 6. 5 2 7. 5 3 8. 7 1 9. 7 2 10. 7 3 275 ExAMPlES OF ORIgINAl TRADINg SySTEMS an Illustrated example Figures 17.10 through 17.14 illustrate the signals generated by the run day consecutive count system for N 1 = 5 and N 2 = 3. In other words, the system reverses from long to short whenever there are three consecutive down run days and from short to long whenever there are three consecutive up run days. (Consecutive here means that there are no intervening run days in the opposite direction; not consecutive days.) Keep in mind that the actual trade signal will not be received until the fi fth close after the third consecutive run day, since a run day is not defi ned until N1 days after its occurrence (N1 = 5 in this example). The fi rst signal in Figure 17.10 —a buy in December 2013—occurs during a brief trading range and is reversed by a sell signal that occurs near the January 2014 low—a good example of how even profi table systems can generate terrible individual trade signals. The three consecutive up run days that start off February trigger a long position on February 12 (fi ve days after the third up run day). Figure 17.11 shows this position remains intact until June 12, when the system reverses to short. Note that although the signal occurs on the fi fth consecutive down run day in the sequence, it is the fact that this day is fi ve days after the third consecutive down run day that triggers the trade. The downtrend that begins in June witnesses 18 down run days with no intervening up run days. In contrast, the preceding February–May uptrend contained 12 up run days and only one down run day. The system reverses to the upside at the start of November 2014 (Figure 17.12 ), one week into a two-and-a-half-month trading range. The three consecutive down run days, which lead to the down- side breakout of this range, turn the system short in January 2015. The next signal is the worst trade in the survey period, as the system reverses to long in February, shortly before the March 2 relative FIGURE  17.10 Run-Day Consecutive Count System, Chart 1: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 276A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  17.11 Run-Day Consecutive Count System, Chart 2: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  17.12 Run-Day Consecutive Count System, Chart 3: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 277 ExAMPlES OF ORIgINAl TRADINg SySTEMS FIGURE  17.13 Run-Day Consecutive Count System, Chart 4: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  17.14 Run-Day Consecutive Count System, Chart 5: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 278 A Complete Guide to the Futures mArket high (Figure 17.13). The system does not generate a sell signal until late May, just before a relative low . Fortunately, the system reverses back to long two weeks later in June 2015 just before a sharp, but short-lived, rally (Figure 17.14). The subsequent downside reversal is equally abrupt, and the system surrenders most of its profit on the long position by the time the next sell signal is gener- ated in July. The final two signals occur in October and November 2015 within a relatively narrow consolidation phase. It should be noted that our intention was to select a realistic market illustration of the system and not to cherrypick an example in which the system performed particularly well, as is typical in most books on trading. The foregoing example provided a market with both favorable (two 4-month trends) and unfavorable (a more than yearlong wide-swing trading range) price environments. On balance, the system was net profitable (a cumulative gain of 76.25 cents per bushel, or $3,812.50 per contract) as the profits during the two trending periods outweighed the losses during the extended trading range period. ■ Conclusion In this chapter we have introduced some original trading systems. Although they are viable as described, readers may wish to experiment with modifications that use the concepts of these systems as the core of more complex approaches. The ultimate goal of this chapter was not to present specific trading systems, but rather to illustrate how basic chart concepts can be transformed into trading systems. The number of possible systems that can be constructed from the technical patterns and concepts already discussed in this volume are limited only by the imagination of the reader. 279 Chapter 18 Garbage in, garbage out. —Anonymous S ystem traders wishing to test their ideas on futures prices have always faced a major obstacle: the transitory life span of futures contracts. In contrast to the equities market, where a given stock is represented by a single price series spanning the entire test period, in futures each market is repre­ sented by a string of expiring contracts. Proposed solutions to this problem have been the subject of many articles and a great deal of discussion. In the process, substantial confusion has been generated, as evidenced by the use of identical terms to describe different types of price series. Even worse, so much misinformation has been provided on this subject that many market participants now believe the equivalent of “the earth is flat” theory. There are four basic types of price series that can be used. The definition, advantages, and dis­ advantages of each are discussed in turn. ■ Actual Contract Series At a surface glance, the best route might seem to be simply to use the actual contract series. How­ ever, there are two major problems with this approach. First, if you are testing a system over a meaningful length of time, each market simulation will require a large number of individual price Selecting the Best Futures Price Series for System T esting 280 A Complete Guide to the Futures mArket series. For example, a 15­year test run for a typical market would require using approximately 60 to 90 individual contract price series. Moreover, using the individual contract series requires an algo­ rithm for determining what action to take at the rollover points. As an example of the type of problem that may be encountered, it is entirely possible for a given system to be long in the old contract and short in the new contract or vice versa. These problems are hardly insurmountable, but they make the use of individual contract series a somewhat unwieldy approach. The awkwardness involved in using a multitude of individual contracts is not, however, the main problem. The primary drawback in using individual contract series is that the period of meaningful liquidity in most contracts is very short—much shorter than the already limited contract life spans. T o see the scope of this problem, examine a cross section of futures price charts depicting the price action in the one ­year period prior to expiration. In many markets, contracts don’t achieve meaning­ ful liquidity until the final five or six months of trading, and sometimes even less. This problem was illustrated in Chapter 5. The limited time span of liquid trading in individual contracts means that any technical system or method that requires looking back at more than about six months of data—as would be true for a whole spectrum of longer ­term approaches—cannot be applied to individual contract series. Thus, with the exception of short­term system traders, the use of individual contract series is not a viable alternative. It’s not merely a matter of the approach being difficult but, rather, its being impossible because the necessary data simply do not exist. ■ Nearest Futures The problems in using individual contract series as just described has led to the construction of vari­ ous linked price series. The most common approach is almost universally known as nearest futures. This price series is constructed by taking each individual contract series until its expiration and then continuing with the next contract until its expiration, and so on. This approach may be useful for constructing long ­term price charts for purposes of chart analysis, but it is worthless for providing a series that can be used in the computer testing of trading systems. The problem in using a nearest futures series is that there are price gaps between expiring and new contracts—and quite frequently these gaps can be very substantial. For example, assume the July corn contract expires at $4 and that the next nearest contract (September) closes at $3.50 on the same day. Assume that on the next day September corn moves from $3.50 to $3.62. A nearest futures price series will show the following closing levels on these two successive days: $4, $3.62. In other words, the near­ est futures contract would imply a 38 ­cent loss on a day on which longs would have enjoyed (or shorts would have suffered) a price gain of 12 cents. This example is by no means artificial. In fact, it would be easy to find a plethora of similarly extreme situations in actual price histories. Moreover, even if the typical distortion at rollover is considerably less extreme, the point is that there is virtually always some distortion, and the cumulative effect of these errors would destroy the validity of any computer test. Fortunately, few traders are naive enough to use the nearest futures type of price series for computer testing. The two alternative linked price series described in the next sections have become the approaches employed by most traders wishing to use a single price series for each market in computer testing. 281 SElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg ■ Constant-Forward (“Perpetual”) Series The constant­forward (also known as “perpetual”) price series consists of quotes for prices a constant amount of time forward. The interbank currency market offers actual examples of constant­forward price series. For example, the three­month forward price series for the euro represents the quote for the euro three months forward from each given day in the series. This is in contrast to the standard u.S. futures contract, which specifies a fixed expiration date. A constant ­forward series can be constructed from futures price data through interpola­ tion. For example, if we were calculating a 90 ­day constant ­forward (or perpetual) series and the 90­day forward date fell exactly one ­third of the way between the expirations of the nearest two contracts, the constant ­forward price would be calculated as the sum of two ­thirds of the nearest contract price and one ­third of the subsequent contract price. As we moved forward in time, the nearer contract would be weighted less, and the weighting of the subsequent contract would increase proportionately. Eventually, the nearest contract would expire and drop out of the calculation, and the constant ­forward price would be based on an interpolation between the subsequent two contracts. As a more detailed example, assume you want to generate a 100­day forward price series based on euro futures, which are traded in March, June, September, and December contracts. T o illustrate the method for deriving the 100 ­day constant­forward price, assume the current date is January 20. In this case, the date 100 days forward is April 30. This date falls between the March and June contracts. Assume the last trading dates for these two contracts are March 14 and June 13, respectively. Thus, April 30 is 47 days after the last trading day for the March contract and 44 days before the last trad­ ing day for the June contract. T o calculate the 100 ­day forward price for January 20, an average price would be calculated using the quotes for March and June euro futures on January 20, weighting each quote in inverse proportion to its distance from the 100 ­day forward date (April 30). Thus, if on Janu­ ary 20 the closing price of March futures is 130.04 and the closing price of June futures is 130.77, the closing price for the 100 ­day forward series would be: 44 91 1300 4 130 77 130 42(. )( .) .+=47 91 Note that the general formula for the weighting factor used for each contract price is: W CF CC W FC CC1 2 21 2 1 21 = − − = − − where C1 = number of days until the nearby contract expiration C2 = number of days until the forward contract expiration F = number of days until forward quote date W1 = weighting for nearby contract price quote W2 = weighting for forward contract price quote 282 A Complete Guide to the Futures mArket So, for example, the weightings of the March and June quotes that would be used to derive a 100­day forward quote on March 2 would be as follows: Weighting for March quot e Weighting for = − − =1031 00 103 12 3 91 JJune quote = − − =100 12 103 12 88 91 As we move forward in time, the nearer contract is weighted less and less, but the weighting for the subsequent contract increases proportionately. When the number of days remaining until the expiration of the forward contract equals the constant ­forward time (100 days in this example), the quote for the constant ­forward series would simply be equal to the quote for the forward contract (June). Subsequent price quotes would then be based on a weighted average of the June and Septem­ ber prices. In this manner, one continuous price series could be derived. The constant ­forward price series eliminates the problem of huge price gaps at rollover points and is certainly a significant improvement over a nearest futures price series. However, this type of series still has major drawbacks. T o begin, it must be stressed that one cannot literally trade a constant ­ forward series, since the series does not correspond to any real contract. An even more serious deficiency of the constant ­forward series is that it fails to reflect the effect of the evaporation of time that exists in actual futures contracts. This deficiency can lead to major distortions—particularly in carrying ­charge markets. T o illustrate this point, consider a hypothetical situation in which spot gold prices remain stable at approximately $1,200/ounce for a one­year period, while forward futures maintain a constant pre­ mium of 1 percent per two­month spread. given these assumptions, futures would experience a steady downtrend, declining $73.82/ounce1 ($7,382 per contract) over the one­year period (the equivalent of the cumulative carrying­charge premiums). Note, however, the constant­forward series would com­ pletely fail to reflect this bear trend because it would register an approximate constant price. For example, a two ­month constant­forward series would remain stable at approximately $1,212/ounce (1.01 × $1,200 = $1,212). Thus, the price pattern of a constant ­forward series can easily deviate substantially from the pattern exhibited by the actual traded contracts—a highly undesirable feature. ■ Continuous (Spread-Adjusted) Price Series The spread­adjusted futures series, commonly known as continuous futures, is constructed to elimi­ nate the distortions caused by the price gaps between consecutive futures contracts at their transi­ tion points. In effect, the continuous futures price will precisely reflect the fluctuations of a futures position that is continuously rolled over to the subsequent contract N days before the last trading day, where N is a parameter that needs to be defined. If constructing their own continuous futures data series, traders should select a value of N that corresponds to their actual trading practices. 1 This is true since, given the assumptions, the one­year forward futures price would be approximately $1,273.82 (1.016 × $1,200 = $1,273.82) and would decline to the spot price ($1,200) by expiration. 283 SElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg For example, if a trader normally rolls a position over to a new contract approximately 20 days before the last trading day, N would be defined as 20. The scale of the continuous futures series is adjusted so the current price corresponds to a currently traded futures contract. Table 18.1 illustrates the construction of a continuous futures price for the soybean market. For simplicity, this example uses only two contract months, July and November; however, a continuous price could be formed using any number of traded contract months. For example, the continuous futures price could be constructed using the January, March, May, July, August, September, and November soybean contracts. table 18.1 Construction of a Continuous Futures price Using July and November Soybeans (cents/bushel)* Date Contract actual price Spread at rollover (Nearby Forward) Cumulative adjustment Factor Unadjusted Continuous Futures (Col. 3 + Col. 5) Continuous Futures price (Col. 6 – 772.5) 6/27/12 Jul ­12 1,471 1,471 698.5 6/28/12 Jul ­12 1,466 1,466 693.5 6/29/12 Jul ­12 1,512.75 1,512.75 740.25 7/2/12 Nov ­12 1,438 85 85 1,523 750.5 7/3/12 Nov ­12 1,474.75 85 1,559.75 787.25 *** 10/30/12 Nov ­12 1,533.75 85 1,618.75 846.25 10/31/12 Nov ­12 1,547 85 1,632 859.5 11/1/12 Jul ­13 1,474 86.25 171.25 1,645.25 872.75 11/2/12 Jul ­13 1,454 171.25 1,625.25 852.75 *** 6/27/13 Jul ­13 1,548.5 171.25 1,719.75 947.25 6/28/13 Jul ­13 1,564.5 171.25 1,735.75 963.25 7/1/13 Nov ­13 1,243.25 312.5 483.75 1,727 954.5 7/2/13 Nov ­13 1,242.5 483.75 1,726.25 953.75 *** 10/30/13 Nov ­13 1,287.5 483.75 1,771.25 998.75 10/31/13 Nov ­13 1,280.25 483.75 1,764 991.5 11/1/13 Jul ­14 1,224.5 45.5 529.25 1,753.75 981.25 11/4/13 Jul ­14 1,227.75 529.25 1,757 984.5 *** 6/27/14 Jul ­14 1,432 529.25 1,961.25 1,188.75 6/30/14 Jul ­14 1,400.5 529.25 1,929.75 1,157.25 7/1/14 Nov ­14 1,147.5 243.25 772.5 1,920 1,147.5 7/2/14 Nov ­14 1,141.5 772.5 1,914 1,141.5 *Assumes rollover on last day of the month preceding the contract month. 284 A Complete Guide to the Futures mArket For the moment, ignore the last column in Table 18.1 and focus instead on the unadjusted con­ tinuous futures price (column 6). At the start of the period, the actual price and the unadjusted continuous futures price are identical. At the first rollover point, the forward contract (November 2012) is trading at an 85 ­cent discount to the nearby contract (July 2012). All subsequent prices of the November 2012 contract are then adjusted upward by this amount (the addition of a positive nearby/forward spread), yielding the unadjusted continuous futures prices shown in column 6. At the next rollover point, the forward contract (July 2013) is trading at an 86.25 ­cent discount to the nearby contract (November 2012). As a result, all subsequent actual prices of the July 2013 contract must now be adjusted by the cumulative adjustment factor—the total of all rollover gaps up to that point (171.25 cents)—in order to avoid any artificial price gaps at the rollover point. This cumulative adjustment factor is indicated in column 5. The unadjusted continuous futures price is obtained by adding the cumulative adjustment factor to the actual price. The preceding process is continued until the current date is reached. At this point, the final cumu­ lative adjustment factor is subtracted from all the unadjusted continuous futures prices (column 6), a step that sets the current price of the series equal to the price of the current contract (November 2014 in our example) without changing the shape of the series. This continuous futures price is indi­ cated in column 7 of Table 18.1. Note that although actual prices seem to imply a net price decline of 329.50 cents during the surveyed period, the continuous futures price indicates a 443 ­cent increase— the actual price change that would have been realized by a constant long futures position. In effect, the construction of the continuous series can be thought of as the mathematical equiva­ lent of taking a nearest futures chart, cutting out each individual contract series contained in the chart, and pasting the ends together (assuming a continuous series employing all contracts and using the same rollover dates as the nearest futures chart). In some markets, the spreads between nearby and forward contracts will range from premiums to discounts (e.g., cattle). However, in other markets, the spread differences will be unidirectional. For example, in the gold market, the forward month always trades at a premium to the nearby month. 2 In these types of markets, the spread­adjusted continuous price series can become increasingly disparate from actual prices. It should be noted that when nearby premiums at contract rollovers tend to swamp nearby dis ­ counts, it is entirely possible for the series to eventually include negative prices for some past periods as cumulative adjustments mount, as illustrated in the soybean continuous futures chart in Figure 18.1. The price gain that would have been realized by a continuously held futures position during this period 2 The reason for this behavioral pattern in gold spreads is related to the fact that world gold inventories exceed annual usage by many multiples, perhaps even by as much as a hundredfold. Consequently, there can never ac­ tually be a “shortage” of gold—and a shortage of nearby supplies is the only reason why a storable commodity would reflect a premium for the nearby contract. (Typically, for storable commodities, the fact that the forward contracts embed carrying costs will result in these contracts trading at a premium to more nearby months.) gold prices fluctuate in response to shifting perceptions of gold’s value among buyers and sellers. Even when gold prices are at extremely lofty levels, it does not imply any actual shortage, but rather an upward shift in the market’s perception of gold’s value. Supplies of virtually any level are still available—at some price. This is not true for most commodities, in which there is a definite relevant limit in total supplies. 285 SElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg far exceeded the net price gain implied by nearest futures, and the subtraction of the cumulative adjust­ ment factor from the most recent (2015) prices would result in negative prices for the majority of the time before 2009. Such an outcome is unavoidable if the continuous futures price series is to refl ect the net gain in a continually held long position and if the series is shifted by the constant factor necessary to set the current continuous futures price equal to the current contract actual price. Although the fact that a continuous futures price series could include negative prices may sound disconcerting, it does not present any problems in using the series for testing systems. The reason for this is that in measuring the profi ts or losses of trades, it is critical that the price series employed accurately refl ects price changes, not price levels. However, it also will often be useful to generate the actual prices that correspond to the continuous futures prices in order to facilitate such applications as checking trading signals against actual contract charts. It should also be noted that the transition between contracts need not occur on the last trading day, as is the conventional assumption in the nearest futures price series. In fact, because physically delivered contracts are particularly vulnerable to distortions in their fi nal weeks of trading due to technical concerns regarding delivery, it probably makes sense to avoid these prices in constructing a continuous series. It follows, then, that one should use a rollover date before the last trading day (e.g., 20 days prior to the last trading day). ■ Comparing the Series It is important to understand that a linked futures price series can only accurately refl ect either price levels, as do nearest futures, or price moves , as do continuous futures, but not both—much as a coin can land on either heads or tails but not both. The adjustment process used to construct continuous FIGURE  18.1 “Negative” Prices in a Continuous Futures Chart: Soybean Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 286 A Complete Guide to the Futures mArket series means that past prices in a continuous series will not match the actual historical prices that prevailed at the time. However, the essential point is that the continuous series is the only linked futures series that will exactly reflect price swings and hence equity fluctuations in an actual trading account. Consequently, it is the only linked series that can be used to generate accurate simulations in computer testing of trading systems. The preceding point is absolutely critical! Mathematics is not a matter of opinion. There is one right answer and there are many wrong answers. The simple fact is that if a continuous futures price series is defined so that rollovers occur on days consistent with rollovers in actual trading, results implied by using this series will precisely match results in actual trading (assuming, of course, accu­ rate commission and slippage cost estimates). In other words, the continuous series will exactly paral­ lel the fluctuations of a constantly held (i.e., rolled over) long position. All other types of linked series will not match actual market price movements. T o illustrate this statement, we compare the implications of various price series using the sideways gold market example cited earlier in this chapter (i.e., gold hovering near $1,200 and a forward/ nearby contract premium equal to 1 percent per two ­month spread). A trader buying a one­year for­ ward futures contract would therefore pay approximately $1,273.82 (1.016 × $1,200 = $1,273.82). The spot price would reflect a sideways pattern near $1,200. As previously seen, a 60­day constant­ forward price would reflect a sideways pattern near $1,212 (1.01 × $1,200). A nearest futures price series would exhibit a general sideways pattern, characterized by extended minor downtrends (reflecting the gradual evaporation of the carrying charge time premium as each nearby contract approached expiration), interspersed with upward gaps at rollovers between expiring and subsequent futures contracts. Thus the spot, constant ­forward, and nearest futures price series would all suggest that a long position would have resulted in a break­even trade for the year. In reality, however, the buyer of the futures contract pays $1,273.82 for a contract that eventually expires at $1,200. Thus, from a trading or real ­world viewpoint, the market actually witnesses a downtrend. The continuous futures price is the only price series that reflects the market decline—and real dollar loss—a trader would actually have experienced. I have often seen comments or articles by industry “experts” arguing for the use of constant ­ forward (perpetual) series instead of continuous series in order to avoid distortions. This argument has it exactly backwards. Whether these proponents of constant ­forward series adopt their stance because of naïveté or self ­interest (i.e., they are vendors of constant ­forward­type data), they are simply wrong. This is not a matter of opinion. If you have any doubts, try matching up fluctuations in an actual trading account with those that would be implied by constant ­forward­type price series. you will soon be a believer. Are there any drawbacks to the continuous futures time series? of course. It may be the best solution to the linked series problem, but it is not a perfect answer. A perfect alternative simply does not exist. one potential drawback, which is a consequence of the fact that continuous futures accurately reflect only price swings, not price levels, is that continuous futures cannot be used for any type of percentage calculations. This situation, however, can be easily remedied. If a system requires the calculation of a percentage change figure, use continuous futures to calculate the nominal price 287 SElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg change and nearest futures for the divisor. Also, there is some unavoidable arbitrariness involved in constructing a continuous series, since one must decide which contracts to use and on what dates the rollovers should occur. However, this issue is not really a problem since these choices should merely mirror the contracts and rollover dates used in actual trading. Moreover, there is arbitrariness involved in the use of any of the price series discussed. Finally, in some markets, the contracts being linked together may have very different past price patterns (as is often the case in livestock markets). However, this problem would exist in any kind of linked series. ■ Conclusion For the purpose of computer testing of trading systems, there are only two types of valid price series: (1) individual contract series and (2) continuous futures series. Individual contract series are a viable approach only if the methodologies employed do not require looking back more than four or five months in time (a restriction that rules out a vast number of technical approaches). In addition, the use of individual contract series is far clumsier. Thus, for most purposes, the continuous futures price series provides the best alternative. As long as one avoids using continuous prices for percent­ age calculations, this type of price series will yield accurate results (i.e., results that parallel actual trading) as well as provide the efficiency of a single series per market. Again, I would strongly caution data users to avoid being misled by those who argue for the use of constant ­forward­type series in computer testing applications. If your goal is a price series that will accurately reflect futures trading, the constant ­forward series will create distortions rather than avoid them. over the years more—but not all—data vendors and system­testing platforms have embraced the continuous futures series described here as the default data type for long ­term analysis and system testing. Traders should nonetheless confirm with the vendor that long­term futures data series link­ ing different contracts are indeed constructed using the continuous futures (i.e., spread ­adjusted) methodology. Traders should also be cognizant of the contracts and rollover dates used by the vendor so that they can match their contract selection and rollover dates accordingly. V endors should be able to provide a clear explanation of the methodology they employ for constructing long ­term (i.e., linked­contract) futures data series. 289 Chapter 19 Every decade has its characteristic folly, but the basic cause is the same: people persist in believing that what has happened in the recent past will go on happening into the indefinite future, even while the ground is shifting under their feet. —George J. Church ■ The Well-Chosen Example1 Y ou’ve plunked down your $895 to attend the 10th annual “Secret of the Millionaires” futures trading seminar. At that price, you figure the speakers will be revealing some very valuable information. The current speaker is explaining the Super-Razzle-Dazzle (SRD) commodity trading system. The slide on the huge screen reveals a price chart with “B” and “S” symbols representing buy and sell points. The slide is impressive: All of the buys seem to be lower than the sells. This point is brought home even more dramatically in the next slide, which reveals the equity stream that would have been realized trading this system—a near-perfect uptrend. Not only that but the system is also very easy to keep up. As the speaker says, “All it takes is 10 minutes a day and a knowledge of simple arithmetic.” Y ou never realized making money in futures could be so simple. Y ou could kick yourself for not having attended the first through ninth annual seminars. T esting and Optimizing Trading Systems 1 The following section is adapted from an article that first appeared in Futures magazine in September 1984. 290 A Complete Guide to the Futures mArket Once you get home, you select 10 diversified markets and begin trading the SRD system. Each day you plot your equity. As the months go by, you notice a strange development. Although the equity in your account exhibits a very steady trend, just as the seminar example did, there is one small difference: The trend on your equity chart is down. What went wrong? The fact is you can find a favorable illustration for almost any trading system. The mistake is in extrap- olating probable future performance on the basis of an isolated and well-chosen example from the past. A true-life example may help illustrate this point. Back in 1983, when I had been working on trading systems for only a couple of years, I read an article in a trade magazine that presented the following very simple trading system: 1. If the six-day moving average is higher than the previous day’s corresponding value, cover short and go long. 2. If the six-day moving average is lower than the previous day’s corresponding value, cover long and go short. The article used the Swiss franc in 1980 as an illustration. Without going into the details, suffice it to say that applying this system to the Swiss franc in 1980 would have resulted in a profit of $17,235 per contract after transaction costs. Even allowing for a conservative fund allocation of $6,000 per contract, this implied an annual gain of 287 percent! Not bad for a system that can be summarized in two sentences. It is easy to see how traders, presented with such an example, might eagerly abandon their other trading approaches for this apparent money machine. I couldn’t believe such a simple system could do so well. So I decided to test the system over a broader period—1976 to mid-1983 2—and a wide group of markets. Beginning with the Swiss franc, I found that the total profit during this period was $20,473. In other words, excluding 1980, the system made only $3,238 during the remaining 6½ years. Thus, assuming that you allocated $6,000 to trade this approach, the average annual percent return for those years was a meager 8 percent—quite a comedown from 287 percent in 1980. But wait. It gets worse. Much worse. When I applied the system to a group of 25 markets from 1976 through mid-1983, the system lost money in 19 of the 25 markets. In 13 of the markets—more than half of the total survey—the loss exceeded $22,500, or $3,000 per year, per contract! In five markets, the loss exceeded $45,000, equivalent to $6,000 per year, per contract! Also, it should be noted that, even in the markets where the system was profitable, its performance was well below gains exhibited for these markets during the same period by most other trend-following systems. There was no question about it. This was truly a bad system. Y et if you looked only at the well- chosen example, you might think you had stumbled upon the trading system Jesse Livermore used in his good years. Talk about a gap between perception and reality. This system witnessed such large, broadly based losses that you may well wonder why fading the signals of such a system might not provide an attractive trading strategy. The reason is that most of the 2 The start date was chosen to avoid the distortion of the extreme trends witnessed by many commodity markets during 1973–1975. The end date merely reflected the date on which I tested this particular system. 291 TESTING AND OPTIMIzING TRADING SYSTEMS losses are the result of the system being so sensitive that it generates large transaction costs. (Trans- action costs include commission costs plus slippage. The concept of slippage is discussed later in this chapter.) This sensitivity of the system occasionally is beneficial, as was the case for the Swiss franc in 1980. However, on balance, it is the system’s major weakness. Losses due to transaction costs would not be realized as gains by fading the system. Moreover, doing the opposite of all signals would generate equivalent transaction costs. Thus, once transac- tion costs are incorporated, the apparent attractiveness of a contrarian approach to using the system evaporates. Because the related episode and the system testing it inspired occurred many years ago, some readers might justifiably wonder whether the system has been a viable strategy in more recent years. T o answer this question, we tested the same system on a portfolio of 31 U.S. futures contracts for the 10 years ending November 30, 2015, and produced similar results: Only 12 of the 31 markets gener- ated a net gross profit—that is, a profit before accounting for commissions or slippage. Incorporating a $25 commission and slippage assessment reduced the number of profitable markets to nine, and the total losses of the unprofitable markets outweighed the profits of the winning markets by a factor of more than 4 to 1, with a total cumulative loss of −$940,612 for the entire 10-year period (assuming a trade size of one contract per market). The moral is simple: Don’t draw any conclusions about a system (or indicator) on the basis of isolated examples. The only way you can determine if a system has any value is by testing it (without benefit of hindsight) over an extended time period for a broad range of markets. ■ Basic Concepts and Definitions A trading system is a set of rules that can be used to generate trade signals. A parameter is a value that can be freely assigned in a trading system in order to vary the timing of signals. For example, in the basic breakout system, N (the number of prior days whose high or low must be exceeded to indicate a signal) is a parameter. Although the operation of the rules in the system will be identical whether N = 7 or N = 40, the timing of the signals will be vastly different. (For an example, see Figure 16.5 in Chapter 16.) Most trading systems will have more than one parameter. For example, in the crossover moving average system there are two parameters: the length of the short-term moving average and the length of the long-term moving average. Any combination of parameter values is called a parameter set. For example, in a crossover moving average system, moving averages of 10 and 40 would represent a specific parameter set. Any other combination of moving average values would represent another parameter set. In systems with only one parameter (e.g., breakout), the parameter set would consist of only one element. 3 3 Note that the terms parameter set and system variation (the latter was used in Chapter 16) refer to identical con- cepts. The introduction of the term parameter set was merely deferred until this chapter because doing so allowed for a more logically ordered presentation of the material. 292 A Complete Guide to the Futures mArket Most “generic” systems are limited to one or two parameters. However, the design of more creative and flexible systems, or the addition of modifications to basic systems, will usually imply the need for three or more parameters. For example, adding a confirmation time delay rule to the cross- over moving average system would imply a third parameter: the number of days in the time delay. As a general principle, it is wise to use the simplest form of a system (i.e., the least number of parameters) that does not imply any substantial deterioration in performance relative to the more complex versions. However, one should not drop parameters that are deemed important simply to reduce the number of implied parameter sets. In this case, a more reasonable approach would be to limit the number of parameter sets actually tested. It should be noted that even for a simple one- or two-parameter-set system, it is not necessary to test all possible combinations. For example, in a simple breakout system in which one wishes to test the performance for values of N = 1 to N = 100, it is not necessary to test each integer in this range. A more efficient approach would be to first test the system using spaced values for N (e.g., 10, 20, 30, . . . , 100), and then, if desired, the trader could focus on any areas that appeared to be of particular interest. For example, if the system exhibited particularly favorable performance for the parameter values N = 40 and N = 50, the trader might want to also test some other values of N in this narrower range. Such an additional step, however, is probably unnecessary, since, as is discussed later in this chapter, performance differences in parameter set values—particularly values in such close proximity—are probably a matter of chance and lack any significance. As a more practical real-life example, assume we wish to test a crossover moving average system that includes a time-delay confirmation rule. If we were interested in the performance of the system for parameter values 1 to 50 for the shorter-term moving average, 2 to 100 for the longer-term mov- ing average, and 1 to 20 for the time delay, there would be a total of 74,500 parameter sets. 4 Note that we cannot reduce the number of parameters without severely damaging the basic structure of the system. However, we can test a far more limited number of parameter sets and still produce a very good approximation of the system’s overall performance. Specifically, we might use increments of 10 for the shorter-term moving average (10, 20, 30, 40, and 50), increments of 20 for the longer-term moving average (20, 40, 60, 80, and 100), and three selected values for the time delay (e.g., 5, 10, and 20). This approach would limit the number of parameter sets to be tested to 57. 5 Once these param- eter sets are tested, the results would be analyzed, and a moderate number of additional parameter sets might be tested as suggested by this evaluation. For example, if a time delay of 5—the smallest value tested—seemed to work best for most favorably performing parameter sets, it would also be reasonable to test smaller values for the time delay. Conceptually, it might be useful to define four types of parameters: Continuous parameter. A continuous parameter can assume any value within a given range. A percentage price penetration would be an example of a continuous parameter. Because a 4 T o avoid double counting, each “short-term” moving average can only be combined with a “long-term” moving average for a longer period. Thus, the total number of combinations is given by (99 + 98 + 97 + … + 50) (20) = 74,500. 5 (5 + 4 + 4 + 3 + 3)(3) = 57. 293 TESTING AND OPTIMIzING TRADING SYSTEMS continuous parameter can assume an infinite number of values, it is necessary to specify some interval spacing in testing such a parameter. For example, a percent penetration parameter might be tested over a range of 0.05 percent to 0.50 percent, at intervals of 0.05 (i.e., 0.05, 0.10, . . . , 0.50). It is reasonable to expect performance results to change only moderately for an incremental change in the parameter value (assuming a sufficiently long test period). Discrete parameter. A discrete parameter can assume only integer values. For example, the number of days in a breakout system is a discrete parameter. Although one can test a discrete parameter for every integer value within the specified range, such detail is often unnecessary, and wider spacing is frequently employed. As with continuous parameters, it is reasonable to expect performance results to change only moderately for a small change in the parameter value. Code parameter. A code parameter is used to represent a definitional classification. Thus, there is no significance to the cardinal value of a code parameter. For example, assume we wish to test a simple breakout system using three different definitions of a breakout (buy case): close above previous N-day high, high above previous N-day high, and close above previous N-day high close. W e could test each of these systems separately, but it might be more efficient to use a parameter to specify the intended definition. Thus, a parameter value of 0 would indicate the first definition, a value of 1 the second definition, and a value of 2 the third definition. Note that there are only three possible values for this parameter, and that there is no significance to incremental changes in parameter values. Fixed or nonoptimized parameter. Normally, any type of parameter will be allowed to assume different values in testing a system. However, in systems with a large number of parameters, it may be necessary to fix some parameter values in order to avoid an excessive number of parame- ter sets. Such parameters are called nonoptimized parameters. For example, in a nonsensitive (slow) trend-following system, we might wish to include a backup stop rule to prevent catastrophic losses. By definition, in this situation, the stop rule would be activated on only a few occasions. Consequently, any parameters implicit in the stop rule could be fixed, since variation in these parameter values would not greatly affect the results. ■ Choosing the Price Series The first step in testing a system in a given market is choosing the appropriate price series. The issues related to this selection were fully detailed in Chapter 18. Generally speaking, a continuous futures series is the preferred choice, although actual contract data could be used for short-term trading systems. ■ Choosing the Time Period Generally speaking, the longer the test period, the more reliable the results. If the time period is too short, the test will not reflect the system’s performance for a reasonable range of market situations. For example, a test of a trend-following system on the Canadian dollar market that used only the three 294A COMPLETE GUIDE TO THE FUTURES MARKET years of data from roughly October 2012 to October 2015—a period dominated by a sustained bear market (see Figure 19.1 )—would yield highly misleading results in terms of the system’s probable long-term performance, as evidenced by the monthly chart inset, which shows the market’s price action dating back to 2004. Although testing over only the recent past is almost always undesirable, longer periods are not always necessarily better for testing than shorter ones. In some markets, if too long a period is used for testing a system, the earlier years in the survey period might be extremely unrepresentative of current market conditions. Although it is impossible to provide a decisive answer as to the optimum number of years to be used in testing, 10 to 20 years is a reasonable range. For short-term trading systems (average duration of trades equal to a few weeks or less), a shorter test period (e.g., 5 to 10 years) would probably be suffi cient. Trading system test results based on time periods signifi cantly shorter than these guidelines should be suspect. In fact, it is rather incredible that some published studies on trading systems are based on test periods of two years or less. Trading systems that use intraday data do not need to be tested over as long a time period as is the case for daily data because any time period will contain far more data points. For example, in the case of fi ve-minute bars, a stock-index futures contract—just during the stock market’s cash trading session—will generate the equivalent of a year’s worth of daily price bars (252) in a little more than three days. A year’s worth of this fi ve-minute data would contain approximately as many price bars as 78 years of daily data. However, the far greater amount of data inherent in intraday data does not mean the test period can be reduced proportionally—not even close. The governing principle will always be to select FIGURE  19.1 Major Trending Phase as Unrepresentative Price Sample: Canadian Dollar Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 295 TESTING AND OPTIMIzING TRADING SYSTEMS enough data to expose the system to a wide range of market conditions. A trader testing a system based on five-minute bars should run the test on far more than 30 days of data, even though this data contains more bars than 10 years of daily price bars, since the larger-scale market conditions can often be relatively static over such brief time periods. For example, the intraday price action during a very strong 30-day trending period will likely differ dramatically from the typical intraday price action during a 30-day trading range. The necessity that any meaningful system test span bull, bear, and sideways markets means that even intraday systems will need to be tested over a period of at least several years, if not more. In fact, given the current speed of computer processing, if the data are available, there is no compelling reason to run intraday systems tests for significantly shorter periods than daily systems. Sure, such tests will include dramatically more data, but that is a good thing. Ideally, one should test a system using a longer time period (e.g., 15 years) and then evaluate the results for the period as a whole and various shorter time intervals (e.g., individual years). Such an approach is important in determining the system’s degree of time stability—the relative performance consistency from one period to the next. Time stability is important because it enhances confidence regarding a system’s potential for maintaining consistently favorable performance in the future. Most people would be quite hesitant about using a system that generated significant net profits over a 15-year period due to three spectacularly performing years but then witnessed losses or near break- even results in the remaining 12 years—and rightly so. In contrast, a system that registered moderate net gains during the 15-year period and was profitable in 14 of the 15 years would undoubtedly be viewed as more attractive by most traders. ■ Realistic Assumptions System traders often discover that their actual results are substantially worse than the paper trad- ing results implied by the system. In fact, this situation is so common that it even has its own name: slippage. Assuming that the divergence in the results is not due to errors in the program, slippage is basically a consequence of a failure to use realistic assumptions in testing the system. Basically, there are two types of such faulty assumptions: 1. transaction costs. Most traders don’t realize that merely adjusting for actual commission costs in testing a system is not a sufficiently rigid assumption. The reason for this is that commis- sions account for only a portion—and usually a minor portion—of transaction costs. Another less tangible, but no less real, cost is the difference between the theoretical execution price and the actual fill price. For example, if one is testing a system assuming order entry on the close, the use of the midpoint of the closing range might not be a realistic assumption. For some reason, buys near the upper end of the closing range and sells near the lower end of the clos- ing range seem to be far more common than their reverse counterparts. There are two ways of addressing this problem. First, use the worst possible fill price (e.g., high of the closing range for buys). Second, use a transaction cost per trade assumption much greater than the actual 296A COMPLETE GUIDE TO THE FUTURES MARKET historical commission costs (e.g., $25 per side, per trade). The latter approach is preferable because it is more general. For example, how would one decide the worst possible fi ll price for an intraday stop order? 2. limit days. Unless it is programmed otherwise, an automated trading system will indicate executions on the receipt of each signal. However, in the real world, things are not quite so simple. Occasionally, execution will not be possible because the market is locked at the daily permissible limit. Or even if execution is possible, it could occur at a much worse level than the intended price because the market gaps far beyond the signal trigger price. Although nearly continuous trading hours have made these events less common than in decades past, they still occur, especially in less liquid markets. If one assumes execution in such a situ- ation, the paper results may dramatically overstate actual performance. Figure 19.2 illus- trates the diff erence even a single locked-limit day can have on trade results. September 2011 corn futures closed limit down at 648 cents on June 30. A trader who wanted— or worse, needed—to sell on this close but did not receive a fi ll would have had to wait for the next session to execute the trade. The market opened 41.25 cents lower the next day, representing a $2,062.50 loss per contract, assuming the trade was fi lled exactly at the opening price. The potential systems trader may discover that seemingly attractive trading systems disintegrate once realistic assumptions are employed. This characteristic is particularly true for very active sys- tems, which generate very large transaction costs. However, it is far better to make this discovery in the analytical testing stage than in actual trading. FIGURE  19.2 Wide Gap between Signal Price and Actual Entry: Impact of Limit Days (September 2011 Corn) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 297 TESTING AND OPTIMIzING TRADING SYSTEMS ■ Optimizing Systems Optimization refers to the process of finding the best-performing parameter set(s) for a given system applied to a specific market. The underlying premise of optimization is that parameter sets that worked best in the past have a greater probability of superior performance in the future. (The question of whether this assumption is valid is addressed in the next section.) A basic question that must be considered in optimization is what criteria should be used for defin- ing best performance. Frequently, best performance is simply interpreted as largest equity gain. However, such a definition is incomplete. Ideally, four factors should be considered in performance comparisons: 1. percent return. Return measured relative to funds needed to trade the system. The impor- tance of using percent return rather than nominal gain is detailed in Chapter 20. 2. risk measure. In addition to percent gain, it is also important to employ some measure of equity fluctuations (e.g., variability in rate of gain, retracements in equity). Besides the obvious psychological reasons for wishing to avoid parameter sets and systems with high volatility, a risk measure is particularly significant because one might pick an unfavorable starting date for trading the system. Chapter 20 discusses several performance measures that incorporate both percent return and risk. 3. parameter stability. It is not sufficient to find a parameter set that performs well. It is also necessary to ascertain the parameter set does not reflect a fluke in the system. In other words, we wish to determine that similar parameter sets also exhibit favorable performance. In fact, the goal of optimization should be to find broad regions of good performance rather than the single best-performing parameter set. For example, if in testing a simple breakout system one found that the parameter set N = 7 exhibited the best percent return/risk characteristics but that performance dropped off very sharply for parameter sets N < 5 and N > 9, while all sets in the range N = 25 to N = 54 performed relatively well, it would make much more sense to choose a parameter set from the latter range. Why? Because the exceptional performance of the set N = 7 appears to be a pecu- liarity of the historical price data, which is not likely to be repeated. The fact that surrounding parameter sets performed poorly suggests that there is no basis for confidence in trading the parameter set N = 7. In contrast, the broad range of performance stability for sets in the region N = 25 to N = 54 suggests that a set drawn from the center of this range would have a better prospect for success. 4. time stability. As detailed in a previous section, it is important to ascertain that favorable performance for the period as a whole is truly representative of the total period rather than a reflection of a few isolated intervals of extraordinary performance. For comparisons involving different parameter sets for the same system, the preceding factors tend to be highly correlated. Generally, the parameter sets with the best gains will also be the sets that exhibit the smallest equity retracements. Consequently, for the optimization of a single system, the use of a basic return/risk measure (e.g., the Sharpe ratio or the gain-to-pain ratio) will usually yield 298 A Complete Guide to the Futures mArket similar results to a complex performance evaluation that incorporates multiple performance mea- sures. Thus, although the multifactor performance evaluation is theoretically preferable, it is often not essential. However, if one is comparing parameter sets from completely different systems, the explicit consideration of risk, parameter stability, and time stability is more important. The foregoing represents a theoretical discussion of optimization concepts and procedures, and implicitly assumes that optimization enhances a system’s future performance. As discussed in the next section, however, the viability of optimization is open to serious question. ■ The Optimization Myth It is ironic that optimization receives so much attention while its underlying premise is rarely considered. In other words, do the better performing parameter sets of the past continue to exhibit above-average performance in the future? As an empirical test of the validity of optimization we examine the historical rankings of a range of parameter set values for a breakout system: reverse from short to long if today’s close is higher than the highest close during the past N days; reverse from long to short if today’s close is lower than the lowest close during the past N days. Nine values of N for this system were tested: 20, 30, 40, 50, 60, 70, 80, 90, and 100. Tables 19.1 to 19.10 compare the profit/loss rankings of these parameter sets in 10 markets for three 2-year test periods (2009–2010, 2011–2012, and 2013–2014), with parameter sets listed in the order of their performance during the respective prior eight-year periods. (All markets were traded with one contract per signal.) In other words, the top-performing parameter set of the prior eight-year period (2001–2008, 2003–2010, or 2005–2012) is listed first, the second-best parameter set of the prior period is listed second, and so on. For example, if the top number in a column is 6, it means that the best-performing parameter set for that market in the prior eight-year period was the sixth-ranked parameter set (out of nine) during the given test period. table 19.1 breakout System (10-Y ear t-Notes): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 9 9 7 2 8 6 5 3 7 7 3 4 2 8 1 5 5 4 4 6 6 5 6 7 1 3 2 8 3 1 9 9 4 2 8 299 TESTING AND OPTIMIzING TRADING SYSTEMS table 19.2 breakout System (euro): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 4 2 1 2 9 1 7 3 5 4 2 4 6 5 5 5 7 6 8 6 3 3 3 7 8 7 9 8 2 8 6 9 1 9 4 table 19.3 breakout System (Japanese Y en): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 9 5 4 2 2 3 1 3 8 7 6 4 1 6 2 5 3 1 7 6 4 4 8 7 7 9 9 8 6 2 5 9 5 8 3 table 19.4 breakout System (Gold): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 7 2 2 2 3 4 3 3 4 5 4 4 9 1 9 5 6 6 1 6 8 9 7 7 1 8 5 8 2 7 6 9 5 3 8 300 A Complete Guide to the Futures mArket table 19.5 breakout System (Natural Gas): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 8 3 1 2 4 5 4 3 5 1 2 4 1 6 3 5 6 8 9 6 2 9 5 7 9 4 8 8 7 7 6 9 3 2 7 table 19.6 breakout System (WtI Crude Oil): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 3 6 1 2 2 7 6 3 7 9 8 4 4 1 2 5 5 3 5 6 1 5 4 7 9 8 9 8 6 2 3 9 8 4 7 table 19.7 breakout System (Corn): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 3 7 3 2 4 1 7 3 2 3 5 4 1 8 8 5 9 4 1 6 5 9 6 7 6 2 2 8 8 5 4 9 7 6 9 301 TESTING AND OPTIMIzING TRADING SYSTEMS table 19.8 breakout System (Soybeans): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 6 4 5 2 3 5 3 3 4 7 1 4 1 2 4 5 2 3 2 6 8 1 7 7 7 6 6 8 9 8 8 9 5 9 9 table 19.9 breakout System (Coffee): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 3 1 9 2 8 2 1 3 1 6 6 4 7 8 3 5 9 9 2 6 2 5 4 7 6 7 8 8 5 4 7 9 4 3 5 table 19.10 breakout System (e-Mini Nasdaq 100): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 2009–2010 rank of Same parameter Set in 2011–2012 rank of Same parameter Set in 2013–2014 1 5 3 9 2 7 1 7 3 4 2 8 4 2 8 4 5 6 6 6 6 9 5 1 7 3 9 2 8 8 4 5 9 1 7 3 302 A Complete Guide to the Futures mArket As a visual aid to help see if there is any consistency between past and future performance, the two top-performing parameter sets in each test period are denoted by circles and the two bottom parameter sets by squares. If the basic premise of optimization were valid—that is, that the best- performing parameter sets of the past were likely to be the best-performing parameter sets in the future—then Tables 19.1 through 19.10 should reflect a pattern of circles consistently near column tops and squares consistently near column bottoms. However, this is not the case. Both circles and squares are sometimes near column tops, sometimes near column bottoms, and sometimes near column midpoints. The apparent randomness in the vertical placement of the circles and squares in Tables 19.1 through 19.10 implies the correlation between past and future performance is highly tenuous. Table 19.11 further highlights the weakness of the relationship between past and future per- formance. In addition to showing the average rank of the best-performing parameter sets from the eight-year sample periods in the subsequent two-year test periods (second column), Table 19.11 also shows how often the best- and worst-performing sets in a prior eight-year period repeated their positions in the subsequent two-year period versus completely reversing their rank order. Note the initially best- and worst-performing parameter sets repeated in subsequent two-year periods a total of eight times, which is only one time more than the number of times the best set became the worst set or the worst set became the best set. Also notice that the best-performing parameter set became the worst-performing set one more time (5) than the best-performing set repeated as the top set. This instability in the values of the best-performing parameter sets from period to period means gauging a system’s performance by the best past parameter sets will grossly overstate the system’s performance potential. T o illustrate this point, Tables 19.12 through 19.15 compare the performance of the best parameter set in each test period versus the average of all param- eter sets and the performance of the parameter sets that had the best and worst results in the table 19.11 Stability of best- and W orst-performing parameter Sets Market avg. rank of best parameter Set best parameter Set repeated W orst parameter Set repeated best Set becomes W orst Set W orst Set becomes best Set 10-yr. T -note 4.70 0 0 2 0 Euro 4.30 1 1 0 1 Japanese yen 4.77 0 0 1 0 Gold 4.27 0 0 0 0 Natural gas 5.10 1 0 0 0 WTI crude oil 5.13 1 0 0 0 Corn 6.00 0 1 0 0 Soybeans 5.43 0 2 0 0 Coffee 5.30 1 0 1 0 E-mini Nasdaq 100 4.70 0 0 1 1 total 4 4 5 2 303 TESTING AND OPTIMIzING TRADING SYSTEMS prior period. In this example, based on the all-market totals, selecting the worst parameter set in the prior period would have outperformed a strategy of picking the best past parameter set in one of the three test periods (see Table 19.12), as well as the three-period total (see Table 19.15). The penultimate column of these tables marks the instances the worst-performing parameter set in a prior eight-year period outperformed the prior best-performing set in the subsequent two-year period. The final column shows how often the average parameter set per- formance in the subsequent two-year period outperformed the best-performing set of the prior eight-year period. table 19.12 profit/loss ($) Comparisons for 2009–2010 test period: actual best parameter Set vs. period average and best and W orst parameter Sets in prior period Market best parameter Set in period best parameter Set in prior period W orst parameter Set in prior period avg. of all parameter Sets W orst prior > best prior avg. > best prior 10-yr. T -note $7,453 –$7,188 $2,391 $253 X X Euro $47,575 $18,963 $47,575 $22,511 X X Japanese yen $5,438 –$23,825 –$9,638 –$8,967 X X Gold $50,740 $7,420 $19,020 $25,084 X X Natural gas $46,960 –$7,360 $34,120 $16,522 X X WTI crude oil –$11,670 –$26,030 –$45,150 –$33,041 Corn $8,875 $6,913 –$338 $3,188 Soybeans $34,188 $11,875 $22,350 $16,944 X X Coffee $25,650 $12,075 $11,963 $6,713 E-Mini Nasdaq 100 $12,330 $4,820 $12,330 $5,417 X X total $227,538 –$2,338 $94,623 $54,625 7 7 table 19.13 profit/loss ($) Comparisons for 2011–2012 test period: actual best parameter Set vs. period average and best and W orst parameter Sets in prior period Market best parameter Set in period best parameter Set in prior period W orst parameter Set in prior period avg. of all parameter Sets W orst prior > best prior avg. > best prior 10-yr. T -note $13,172 –$3,750 $9,234 $3,516 X X Euro $10,900 $10,900 –$11,550 $1,938 Japanese yen –$1,538 –$7,963 –$12,913 –$8,157 Gold $16,310 $7,300 $3,170 –$5,672 Natural gas $16,050 $2,590 $10,930 –$712 X WTI crude oil $12,330 –$30,950 –$11,920 –$19,537 X X Corn –$963 –$8,563 –$8,538 –$9,138 X Soybeans $24,013 –$3,113 –$16,413 –$2,590 X Coffee $48,563 $48,563 $20,963 $8,308 E-Mini Nasdaq 100 $1,540 –$7,630 –$20,870 –$13,506 total $140,377 $7,385 –$37,906 –$45,550 4 3 304 A Complete Guide to the Futures mArket table 19.14 profit/loss ($) Comparisons for 2013–2014 test period: actual best parameter Set vs. period average and best and W orst parameter Sets in prior period Market best parameter Set in period best parameter Set in prior period W orst parameter Set in prior period avg. of all parameter Sets W orst prior > best prior avg. > best prior 10-yr. T -note $2,922 –$2,328 –$3,359 –$1,557 X Euro $19,963 $19,963 $5,013 $2,568 Japanese yen $39,713 $38,138 $39,713 $27,339 X Gold $25,840 $21,160 –$4,340 $11,042 Natural gas $6,250 $6,250 –$1,590 –$2,077 WTI crude oil $39,060 $39,060 $18,070 $23,379 Corn $9,750 $3,675 –$1,150 $2,661 Soybeans $8,663 $488 –$12,863 $1,211 X Coffee $28,313 –$9,113 $2,963 $7,677 X X E-Mini Nasdaq 100 $29,640 –$8,780 $16,505 $10,635 X X total $210,112 $108,512 $58,961 $82,878 3 4 table 19.15 profit/loss ($) Comparisons for three test periods Combined: actual best parameter Sets vs. period averages and best and W orst parameter Sets in prior periods Market best parameter Set in period total best parameter Set in prior period total W orst parameter Set in prior period total avg. of all parameter Sets total W orst prior > best prior avg. > best prior 10-yr. T -note $23,547 –$13,266 $8,266 $2,212 X X Euro $78,438 $49,825 $41,038 $27,017 Japanese yen $43,613 $6,350 $17,163 $10,215 X X Gold $92,890 $35,880 $17,850 $30,454 Natural gas $69,260 $1,480 $43,460 $13,733 X X WTI crude oil $39,720 –$17,920 –$39,000 –$29,199 Corn $17,663 $2,025 –$10,025 –$3,289 Soybeans $66,863 $9,250 –$6,925 $15,565 X Coffee $102,525 $51,525 $35,888 $22,698 E-Mini Nasdaq 100 $43,510 –$11,590 $7,965 $2,546 X X total $578,027 $113,559 $115,678 $91,953 4 5 Our example used a very small list of only nine parameter sets. Many system developers run opti- mizations across hundreds or even thousands of parameter sets. Imagine the degree of performance overstatement that would occur by representing a system’s performance by the best parameter sets in these cases! For comparison, Tables 19.16 through 19.19 show the same information as Tables 19.12 through 19.15 except they reflect tests of the same system conducted 20 years earlier on a slightly different 305 TESTING AND OPTIMIzING TRADING SYSTEMS portfolio (30-year U.S. T -bonds, Deutsche marks, Japanese yen, gold, silver, heating oil, corn, soybeans, live cattle, and sugar). In this case, the three 8-year sample periods were 1981–1988, 1983–1990, and 1985–1992 and the three 2-year test periods were 1989–1990, 1991–1992, and 1993–1994. table 19.16 profit/loss ($) Comparisons for 1989–1990 test period: actual best parameter Set vs. period average and best and W orst parameter Sets in prior period Market best parameter Set in period best parameter Set in prior period W orst parameter Set in prior period avg. of all parameter Sets W orst prior > best prior avg. > best prior T -bond 6,670 −9,090 1,420 −2,180 X X Deutsche mark 7,780 3,020 6,340 5,390 X X Japanese yen 11,840 9,240 8,420 8,130 Gold 3,390 1,700 −320 1,080 Silver 5,850 5,330 1,630 3,050 Heating oil 7,650 1,760 6,430 3,380 X X Corn 1,640 −2,190 −2,730 −590 X Soybeans 4,970 −7,160 4,740 −740 X X Cattle 2,090 850 −3,290 −20 Sugar 4,240 4,170 −5,560 −840 total 56,120 7,630 17,080 16,030 4 5 table 19.17 profit/loss ($) Comparisons for 1991–1992 test period: actual best parameter Set vs. period average and best and W orst parameter Sets in prior period Market best parameter Set in period best parameter Set in prior period W orst parameter Set in prior period avg. of all parameter Sets W orst prior > best prior avg. > best prior T -bond 3,710 −1,820 −2,920 −420 X Deutsche mark 9,180 1,680 9,180 4,770 X X Japanese yen 3,340 −240 −3,620 −1,670 Gold 1,370 90 1,370 −1,050 X Silver −720 −1,890 −1,780 −1,640 X X Heating oil 5,510 −980 4,290 1,540 X X Corn 560 −480 340 −440 X X Soybeans −2,420 −6,090 −3,190 −4,650 X X Cattle 1,380 −160 1,380 −340 X Sugar 810 −1,690 −1,850 −1,410 X total 22,700 −11,570 3,200 −5,010 7 7 306 A Complete Guide to the Futures mArket table 19.18 profit/loss ($) Comparisons for 1993–1994 test period: actual best parameter Set vs. period average and best and W orst parameter Sets in prior period Market best parameter Set in period best parameter Set in prior period W orst parameter Set in prior period avg. of all parameter Sets W orst prior > best prior avg. > best prior T -bond 11,600 3,500 7,910 7,180 X X Deutsche mark 6,210 −3,660 −1,410 −3,300 X X Japanese yen 3,620 2,460 −3,060 260 Gold 490 −1,900 −930 −1,460 X X Silver 1,600 −3,650 −790 −2,690 X X Heating oil 2,200 2,200 −890 −1,700 Corn 1,910 1,910 −1,030 640 Soybeans 2,120 1,570 −2,060 −240 Cattle 1,600 950 1,600 500 X Sugar 880 570 −240 −550 total 32,230 3,950 −900 −1,360 5 4 table 19.19 profit/loss ($) Comparisons for three test periods Combined: actual best parameter Sets vs. period averages and best and W orst parameter Sets in prior periods Market best parameter Sets in test periods total best parameter Sets in prior periods total W orst parameter Sets in Prior periods total period parameter Set averages total W orst prior > best prior avg. > best prior T -bond 21,980 −7,410 6,410 3,950 X X Deutsche mark 23,170 1,040 14,110 6,860 X X Japanese yen 18,800 11,460 1,740 6,720 Gold 5,250 −110 120 −1,430 X Silver 6,730 −210 −940 −1,280 Heating oil 15,360 2,980 9,830 3,220 X X Corn 4,110 −760 −3,420 −390 X Soybeans 4,670 −11,680 −510 −5,330 X X Cattle 5,070 1,640 −310 140 Sugar 5,930 3,060 −7,650 −2,800 total 111,070 10 19,380 9,660 5 5 Based on the combined three-period, all-market totals from this second set of tests, selecting the worst parameter set in the prior period actually would have outperformed a strategy of picking the best past parameter set in two of the three test periods, as well as the three-period total! This observation is not intended to imply that the prior-period worst-performing parameter set is likely to outperform the prior-period best-performing set. If similar empirical tests were conducted for other systems, the prior-period best-performing parameter set would probably outperform the prior-period worst-performing set more often than the other way around (although the types of results witnessed in our example are far from uncommon). The key point, however, is that invariably, as was the 307 TESTING AND OPTIMIzING TRADING SYSTEMS case in Tables 19.12 through 19.15 and 19.16 through 19.19, the prior-period best-performing parame- ter sets would fall far short of the actual best-performing parameter sets for the given periods and would often fail to provide any statistically significant improvement over the average of all parameter sets. Although optimization seemed to have little, if any, value when applied market by market, optimiza- tion does appear to be a bit more useful if applied to a portfolio. In other words, instead of picking the best past parameter set for each market, the best past single parameter set applied across all markets is selected. Table 19.20 shows the two-year test period parameter set rankings for a portfolio consisting of the 10 markets that provided the results for Tables 19.16 through 19.19. 6 The one striking correla- tion between past and future performance is that the worst parameter set in the prior eight-year period is also the worst parameter set in the subsequent two-year period in all three test intervals! Although the worst past parameter set also seems likely to be the worst future parameter set, other past ranking placements seem to imply little predictive value. The average ranking for all three test periods of the remaining eight prior-period ranking placements (i.e., all rankings excluding the worst one) is 4.5. While the average test period ranking of the best parameter set in the prior eight- year period (3.3) is somewhat better than this average, the fourth-ranked parameter set in the prior period has by far the best average ranking in the future test periods (2.3). Also note that the second- best prior-period parameter set has an average test period rank almost identical to the corresponding average for the second worst prior-period parameter set (4.7 vs. 5.0). T o gain some insight as to why the worst prior-period ranking seems to be such an excellent predictor of future performance (namely, continued poor performance for that parameter set), while other ranking placements seem to have little predictive value, we examine performance rankings based on parameter set value. Table 19.21 indicates parameter set rankings in each of the three tests periods based on parameter set values (as opposed to prior-period rankings as was the case in Table 19.20). The parameter set values are listed in ascending order. 6 In this case the portfolio consisted of one contract in each market, with the exception of corn, which was traded with two contracts because of its low volatility. table 19.20 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods parameter Set rank prior eight-Y ear period rank of Same parameter Set in 1989–1990 rank of Same parameter Set in 1991–1992 rank of Same parameter Set in 1993–1994 avg. rank 1 1 7 2 3.3 2 5 1 8 4.7 3 3 6 4 4.3 4 2 4 1 2.3 5 4 8 6 6.0 6 6 3 7 5.3 7 7 5 3 5.0 8 8 2 5 5.0 9 9 9 9 9.0 308 A Complete Guide to the Futures mArket table 19.21 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test periods based on N-Values parameter Set N-Value rank of parameter Set in 1989–1990 rank of parameter Set in 1991–1992 rank of parameter Set in 1993–1994 avg. rank 20 9 9 9 9.0 30 8 2 5 5.0 40 7 5 3 5.0 50 6 3 1 3.3 60 4 6 6 5.3 70 5 7 8 6.7 80 1 1 2 1.3 90 2 4 4 3.3 100 3 8 7 6.0 Table 19.21 reveals that the worst-performing parameter set in each of the test periods was actually the same parameter set! (Since Table 19.20 indicated the test period worst parameter set was the same as the prior-period worst parameter set in all three cases, the implication is that this same parameter set was also the worst-performing parameter set in all three prior eight-year periods.) This consistently worst-performing parameter set is at one extreme end of the parameter set range tested: N = 20. Although N = 20—the most sensitive parameter set value tested—is consistently the worst per- former (when applied across a portfolio), the other values tested (N = 30 to N = 100) show no consistent pattern. It is true that the parameter set N = 80 was by far the best-performing set with an incredible average rank of 1.3. However, the average rankings of the two surrounding N-values (6.7 and 3.3) suggest that the stellar performance of N = 80 was probably a statistical fluke. As was explained earlier in this chapter, a lack of parameter stability suggests that the past superior perfor- mance of a parameter set probably reflects a peculiarity in the historical data tested rather than a pattern that is likely to be repeated in the future. Tables 19.22 and 19.23 show analogous portfolio optimization statistics for the portfolios in the more recent test periods that were reviewed in Tables 19.12 through 19.15. Note in Table 19.23 that the same N = 20 parameter set once again exhibited inferior performance, registering as the worst- performing set in two of the three periods. It is instructive to review the observations revealed by the foregoing optimization experiments: ■ Optimization appeared to have no value whatsoever when applied on a market-by-market basis. ■ When applied to a portfolio, however, optimization in the earlier (1981–1994) example appeared useful in predicting the parameter set most likely to witness inferior future performance, although it still showed no reliable pattern in predicting the parameter set most likely to witness superior future performance. ■ Upon closer examination it appeared this pattern of consistent inferior performance was not so much a consequence of the prior-period ranking as the parameter value. In other words, the 309 TESTING AND OPTIMIzING TRADING SYSTEMS parameter set range tested began at a value that was clearly suboptimal for the given system: N = 20. This same parameter value remained suboptimal, on average, in the more recent test period as well. Although not indicated in the parameter set ranking tables, lower values of N would have shown even worse performance—in fact, strikingly worse—as the value of N was decreased. These observations, which are consistent with the results of other similar empirical tests I have conducted in the past, suggest the following five key conclusions regarding optimization:7 table 19.22 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test periods vs. rankings in prior eight-Y ear periods (2000–2014) parameter Set rank prior eight-Y ear period parameter Set rank in 2009–2010 parameter Set rank in 2011–2012 parameter Set rank in 2013–2014 average rank 1 9 1 1 3.7 2 2 7 5 4.7 3 3 2 3 2.7 4 7 3 9 6.3 5 6 4 4 4.7 6 8 5 8 7.0 7 4 8 2 4.7 8 5 6 7 6.0 9 1 9 6 5.3 table 19.23 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test periods based on N-Values (2000–2014) parameter Set N-Value rank of parameter Set in 2009–2010 rank of parameter Set in 2011–2012 rank of parameter Set in 2013–2014 average rank 20 9 3 9 7.0 30 7 5 8 6.7 40 6 8 7 7.0 50 8 9 6 7.7 60 5 6 2 4.3 70 3 7 3 4.3 80 4 4 4 4.0 90 1 2 5 2.7 100 2 1 1 1.3 7 Although a single empirical experiment cannot be used to draw broad generalizations, I am willing to do so here because the results of the optimization test just described are fairly typical of many similar tests I have conducted in the past. In this sense, the optimization tests detailed in the text are not intended as a proof of the severe limita- tions of optimization, but rather as illustrations of this point. 310 A Complete Guide to the Futures mArket 1. Any system—repeat, any system—can be made to be very profitable through optimization (i.e., over its past performance). If you ever find a system that can’t be optimized to show good profits in the past, congratulations, you have just discovered a money machine (by doing the opposite, unless transaction costs are exorbitant). Therefore, a wonderful past performance for a system that has been optimized may be nice to look at, but it doesn’t mean very much. 2. Optimization will always, repeat always, overstate the potential future performance of a system—usually by a wide margin (say, three trailer trucks’ worth). Therefore, optimized results should never, repeat never, be used to evaluate a system’s merit. 3. For many if not most systems, optimization will improve future performance only marginally, if at all. 4. If optimization has any value, it is usually in defining the broad boundaries for the ranges from which parameter set values in the system should be chosen. Fine-tuning of optimization is at best a waste of time and at worst self-delusion. 5. In view of the preceding items, sophisticated and complex optimization procedures are a waste of time. The simplest optimization procedure will provide as much meaningful information (assuming that there is any meaningful information to be derived). In summary, contrary to widespread belief, there is some reasonable question as to whether opti- mization will yield meaningfully better results over the long run than randomly picking the param- eter sets to be traded. Lest there be any confusion, let me explicitly state that this statement is not intended to imply that optimization is never of any value. First, as indicated previously, optimization can be useful in defining the suboptimal extreme ranges that should be excluded from the selection of parameter set values (e.g., N ≤ 20 in our breakout system example). Also, it is possible that, for some systems, optimization may provide some edge in parameter set selection, even after suboptimal extreme ranges are excluded. However, I do mean to imply that the degree of improvement provided by optimization is far less than generally perceived and that traders would probably save a lot of money by first proving any assumptions they are making about optimization rather than taking such assumptions on blind faith. ■ Testing versus Fitting Perhaps the most critical error made by users of futures trading systems is the assumption the per- formance of the optimized parameter sets during the test period provides an approximation of the potential performance of those sets in the future. As was demonstrated in the previous section, such assumptions will lead to grossly overstated evaluations of a system’s true potential. It must be under- stood that futures market price fluctuations are subject to a great deal of randomness. Thus, the “ugly truth” is that the question of which parameter sets will perform best during any given period is largely a matter of chance. The laws of probability indicate that if enough parameter sets are tested, even a meaningless trading system will yield some sets with favorable past performance. Evaluating a system based on the optimized parameter sets (i.e., the best-performing sets during the survey period) 311 TESTING AND OPTIMIzING TRADING SYSTEMS would be best described as fitting the system to past results rather than testing the system. If optimiza- tion can’t be used to gauge performance, how then do you evaluate a system? The following sections describe two meaningful approaches. blind Simulation In the blind simulation approach the system is optimized using data for a time period that deliber- ately excludes the most recent years. The performance of the system is then tested using the selected parameter sets for subsequent years. Ideally, this process should be repeated several times. Note that the error of fitting results is avoided because the parameter sets used to measure per- formance in any given period are selected entirely on the basis of prior rather than concurrent data. In a sense, this testing approach mimics real life (i.e., one must decide which parameter sets to trade on the basis of past data). The optimization tests of the previous section used this type of procedure, stepping through time in two-year intervals. Specifically, system results for the 2001–2008 period were used to select the best-performing parameter sets, which were then tested for the 2009–2010 period. Next, the system results for the 2003–2010 period were used to select the best-performing parameter sets, which were then tested for the 2011–2012 period. Finally, the system results for the 2005–2012 period were used to select the best-performing parameter sets, which were then tested for the 2013–2014 period. The essential point is that simulation and optimization periods should not be allowed to overlap. Simulations that are run over the same period as the optimization are worthless. average parameter Set performance Finding the average parameter set performance requires defining a complete list of all parameter sets you wish to test before running any simulations. Simulations are then run for all the parameter sets selected, and the average of all sets tested is used as an indication of the system’s potential per- formance. This approach is valid because you could always throw a dart to pick a parameter from a broad range of parameter set values. If you throw enough darts, the net result will be the average. The important point is that this average should be calculated across all parameter sets, not just those sets that prove profitable. Note that the trader might still choose to trade the optimized parameter sets for the future (instead of randomly selected ones), but the evaluation of the system’s performance should be based on the average of all sets tested (which is equivalent to a random selection process). The blind simulation approach probably comes closest to duplicating real-life trading circumstances. However, the average parameter set performance is probably as conservative and has the advantage of requiring far less calculation. Both approaches represent valid procedures for testing a system. One important caveat: In the advertised claims for given systems, the term simulated results is often used loosely as a euphemism for optimized results (instead of implying the results are based on a blind simulation process). If this is the case, the weight attached to the results should equal the amount of money invested in the system: zero. The commonplace misuse and distortion of simulated results is examined in detail in the next section. 312 A Complete Guide to the Futures mArket ■ The Truth about Simulated Results Although the value of optimization in improving a system’s future performance is open to debate, there is absolutely no question the use of optimized results will greatly distort the implied future performance of a system. As was demonstrated earlier in this chapter, there is very little, if any, correlation between the best-performing parameters in a system for one period and the best- performing parameters in a subsequent period. Hence, assuming that the performance implied by the best-performing parameters could have been achieved in the past is totally unrealistic. After years of experience, my attitude toward simulated results is summarized by what I call Schwager’s simulations corollary to Gresham’s law of money. As readers may recall from Economics 101, Gresham’s proposition was that “bad money drives out good.” Gresham’s contention was that if two types of money were in circulation (e.g., gold and silver) at some arbitrarily defined ratio (e.g., 16:1), the bad money (i.e., the money overvalued at the fixed rate of exchange) would drive out the good. Thus, if gold were worth more than 16 ounces of silver, a 16:1 ratio would result in silver driving gold out of circulation (as people would tend to hoard it). My corollary is “bad simulations drive out good.” The term bad means simulations derived based on highly tenuous assumptions, not bad in terms of indicated performance. On the contrary, truly “bad” simulations will show eye-popping results. I frequently see ads hawking systems that supposedly make 200 percent, 400 percent, or even 600 percent a year. Let’s be conservative—and I use the term loosely—and assume a return of only 100 percent per year. At this level of return, $100,000 would grow to over $1 billion in just over 13 years! How can such claims possibly be true, then? The answer is they can’t. The point is that, given enough hindsight, it is possible to construct virtually any type of past-performance results. If anyone tried to sell a system or a trading program based on truly realistic simulations, the results would appear laughably puny relative to the normal promotional fare. It is in this sense that I believe that bad (unrealistic) simulations drive out good (realistic) simulations. How are simulated results distorted? Let us count the ways: 1. the well-chosen example (revisited). In constructing a well-chosen example, the system promoter selects the best market, in the best time period, using the best parameter set. Assum- ing a system is tested on 25 markets for 15 years and uses 100 parameter set variations, there would be a total of 37,500 (25 × 15 × 100) one-year results. It would be difficult to construct a system in which not one of these 37,500 possible outcomes showed superlative results. For example, if you tossed a group of 10 coins 37,500 times, don’t you think you would get 10 out of 10 heads sometimes? Absolutely. In fact, you would get 10 out of 10 heads on the average of one out of 1,024 times. 2. Kitchen sink approach. By using hindsight to add parameters and create additional system rules that conveniently take care of past losing periods, it is possible to generate virtually any level of past performance. 3. Ignoring risk. Advertised system results frequently calculate return as a percent of margin or as a percent of an unrealistically low multiple of margin. This return measurement approach 313 TESTING AND OPTIMIzING TRADING SYSTEMS alone can multiply the implied returns severalfold. Of course, the risk would increase commen- surately, but the ads don’t provide those details. 4. Overlooking losing trades. It is hardly uncommon for charts in system websites or adver- tisements to indicate buy and sell signals at the points at which some specified rules were met, but fail to indicate other points on the same chart where the same conditions were met and the resulting trades were losers. 5. Optimize, optimize, optimize. Optimization (i.e., selecting the best-performing param- eter sets for the past) can tremendously magnify the past performance of a system. Virtually any system ever conceived by man would look great if the results were based on the best parameter set (i.e., the parameter set that had the best past performance) for each market. The more parameter sets tested, the wider the selection of past results, and the greater the potential simu- lated return. 6. Unrealistic transaction costs. Frequently, simulated results only include commissions but not slippage (the difference between the assumed entry level and the actual fill that would be realized by using a market or stop order). For short-term systems (e.g., those using intraday data), ignoring slippage can make a system that would wipe out an account in real life look like a money machine. 7. Fabrication. Even though it is remarkably easy to construct system rules with great perfor- mance for the past, some promoters don’t even bother doing this much. For example, one infamous individual for years repeatedly promoted $299 systems that were outright frauds. The preceding is not intended to indict all system promoters or those using simulated results. Certainly, there are many individuals who construct simulated results in appropriately rigorous fashion. However, the sad truth is that the extraordinary misuse of simulations over many years has made simulated results virtually worthless. Advertised simulated results are very much like restaurant reviews written by the proprietors—you would hardly expect to ever see a bad review . I can assure you that you will never see any simulated results for a system that show the system long the S&P as of the close of October 16, 1987, September 10, 2001, or March 5, 2010. Can simulated results ever be used? Y es, if you are the system developer and you know what you’re doing (e.g., use the simulation methods detailed in the previous section), or, equivalently, if you have absolute faith in the integrity and competence of the system developer. ■ Multimarket System Testing Although it is probably unrealistic to expect any single system to work in all markets, generally speaking, a good system should demonstrate profitability in a large majority of actively traded markets (e.g., 85 percent or more). There are, of course, some important exceptions. A system employing fundamental input would, by definition, be applicable to only a single market. In addition, the behavior of some markets is so atypical (e.g., stock indexes) that systems designed for trading such markets might well perform poorly over the broad range of markets. 314 A Complete Guide to the Futures mArket In testing a system for a multimarket portfolio, it is necessary to predetermine the relative number of contracts to be traded in each market. This problem is frequently handled by simply assuming the system will trade one contract in each market. However, this is a rather naive approach, for two reasons. First, some markets are far more volatile than other markets. For example, a portfolio that included one contract of coffee and one contract of corn would be far more dependent on the trading results in coffee. Second, it may be desirable to downgrade the relative weightings of some markets because they are highly correlated with other markets (e.g., 10-year T -notes and 30-year T -bonds). 8 In any case, the percentage allocation of available funds to each market should be determined prior to testing a system. These relative weightings can then be used to establish the number of contracts to be traded in each market. ■ Negative Results One should not overlook the potential value of negative results. Analyzing the conditions under which a system performs poorly can sometimes reveal important weaknesses in the system that have been overlooked and thus provide clues as to how the system can be improved. Of course, the fact that the implied rule changes improve results in the poorly performing case does not prove anything. However, the validity of any suggested rule changes would be confirmed if such revisions generally tended to improve the results for other parameter sets and markets as well. The potential value of negative results as a source of ideas for how a system can be improved cannot be overstated. The con- cept that disorder is a catalyst for thought is a general truth that was perfectly expressed by the late novelist John Gardner: “In a perfect world, there would be no need for thought. W e think because something goes wrong.” The idea of learning from poor results is basically applicable to a system that works in most mar- kets and for most parameter sets but performs badly in isolated cases. However, systems that exhibit disappointing results over a broad range of markets and parameter sets are likely to be lost causes, unless the results are spectacularly poor. In the latter case, a system that exactly reverses the trade signals of the original system might be attractive. For example, if tests of a new trend-following system reveal that the system consistently loses money in most markets, the implication is that one might have accidently stumbled upon an effective countertrend system. Such discoveries may be difficult on the ego, but they should not be ignored. Of course, the fact that a system exhibits stable poor performance does not imply that the reverse system would perform favorably, since transaction costs may account for a significant por - tion of losses. Thus, the reverse system might also perform badly once these costs are taken into account, as was the case for the aforementioned well-chosen example described at the start of 8 For purposes of future trading (as opposed to historical testing), historical performance might be a third relevant factor in determining contract weightings. However, this factor cannot be included as an input in the testing procedure because it would bias the results. 315 TESTING AND OPTIMIzING TRADING SYSTEMS this chapter. As another example, at surface glance, reversing the signals generated by a system that loses an average of $3,000 per year may appear to be an attractive strategy. If, however, two-thirds of the loss can be attributed to transaction costs, fading the signals of this system will result in a loss of $1,000 per year, assuming a continuation of the same performance. (The preceding assumptions imply that transaction costs equal $2,000 per year and that the trades lose $1,000 per year net of these costs. Thus, reversing the signals would imply a $l,000-per-year gain on the trades, but the $2,000-per year transaction costs would imply a net loss of $1,000 per year.) Moral: If you are going to design a bad system, it should be truly terrible if it is to be of value. ■ Ten Steps in Constructing and Testing a Trading System 1. Obtain all data needed for testing. Again, with the exception of short-term trading systems, which may be able to use actual contract data, the use of continuous futures (not to be confused with nearest futures or perpetual prices) is highly recommended. 2. Define the system concept. 3. Program rules to generate trades in accordance with this concept. 4. Select a small subset of markets and a subset of years for these markets. 5. Generate system trading signals for this subset of markets and time for a given parameter set. 6. Check to see that the system is doing what was intended. Almost invariably, a careful check will reveal some inconsistencies due to either or both of the following reasons: a. There are errors in the program. b. Rules in program do not anticipate some circumstances, or they create unforeseen repercussions. Some examples of the latter might include the system failing to generate a signal, given an event at which a signal is intended; system generating a signal when no signal is intended; system rules inadvertently creating a situation in which no new signals can be generated or in which a position is held indefinitely. In essence, these types of situations arise because there will often be some missed nuances. The system rules need to be modified to correct both programming errors as well as unforeseen inconsistencies. It should be emphasized that corrections of the latter type are only concerned with making the system operate consistently with the intended concept and should be made without any regard as to whether the changes help or hurt performance in the sample cases used in the developmental process. 7. After making necessary corrections, repeat step 6. Pay particular attention to changes in the indicated signals versus those from previous runs for two reasons: a. T o check whether the program changes achieved the desired fix. b. T o make sure the changes did not have unintended effects. 8. Once the system is working as intended, and all rules and contingencies have been fully defined, and only after such a point, test the system on the entire defined parameter set list across the full database. Be sure the intended trading portfolio has been defined before this test is run. 316 A Complete Guide to the Futures mArket 9. As detailed earlier in this chapter, evaluate performance based on the average of all parameter sets tested or a blind simulation process. (The former involves far less work.) 10. Compare these results with the results of a generic system (e.g., breakout, crossover moving average) for the corresponding portfolio and test period. The return/risk of the system should be measurably better than that of the generic system if it is to be deemed to have any real value. The preceding steps represent a rigorous procedure that is designed to avoid generating results that are upwardly biased by hindsight. As such, expect most system ideas to fail the test of merit in step 10. Designing a system with a truly superior performance is more difficult than most people think. ■ Observations about Trading Systems 1. In trend-following systems, the basic method used to identify trends (e.g., breakout, crossover moving average) may well be the least important component of the system. In a sense, this contention is merely a restatement of Jim Orcutt’s observation that “There are only two types of trend-following systems: fast and slow .” Thus, in designing trend-following systems, it may make more sense to concentrate on modifications (e.g., filters and confirmation rules to reduce bad trades, market characteristic adjustments, pyramiding rules, stop rules) than on trying to discover a better method for defining trends. 2. Complexity for its own sake is no virtue. Use the simplest form of a system that does not imply a meaningful sacrifice in performance relative to more complex versions. 3. The well-publicized and very valid reason for trading a broad range of markets is risk control through diversification. However, there is a very important additional reason for trading as many markets as possible: insurance against missing any of the sporadic giant price moves in the futures markets. The importance of catching all such major trends cannot be overstressed—it can make the difference between mediocre performance and great performance. The 2008– 2011 gold market and the 2007–2009 and 2014–2016 crude oil markets are three spectacular examples of markets that were critical to portfolio performance. 4. If trading funds are sufficient, diversification should be extended to systems as well as markets. Trading several systems rather than a single system could help smooth overall performance. Ideally, the greatest degree of diversification would be achieved if the mix of systems included countertrend and pattern-recognition systems as well as trend-following systems. (However, this goal may be difficult to achieve because countertrend and pattern-recognition systems are generally significantly harder to design than trend-following systems.) 5. If sufficient funds are available, it is better to trade a number of diversified parameter sets than to trade a single optimized set. 6. Generally speaking, the value of parameter optimization is far overstated. 7. The previous observation strongly suggests that optimized results should never be used for evaluating the relative performance of a system. Two meaningful methods for testing systems were discussed in the text. 317 TESTING AND OPTIMIzING TRADING SYSTEMS 8. So-called simulated results are frequently optimized results (i.e., derived with the benefi t of hindsight) and, as such, virtually meaningless. This caveat is particularly pertinent in regard to promotions for trading systems, which invariably use very well-chosen examples. 9. An analysis of the results of successful systems will almost invariably reveal the presence of many markets with one or more years of very large profi ts, but few instances of very large single-year losses. The implication is that a key reason for the success of these systems is that their rules adhere to the critical, albeit clichéd principle of letting profi ts run and cutting losses short. 10. A market should not be avoided because its volatility increases sharply. In fact, the most volatile markets are often the most profi table. 11. Isolating negative results for a system that performs well on balance can provide valuable clues as to how the system can be improved. 12. A frequently overlooked fact is that trading results may often refl ect more information about the market than the system. For example, in Figure 19.3 , the fact that a trend-following system that was short in mid-January 2015 would have witnessed the transformation of a large open profi t into a large loss before the system provided a liquidation or reversal signal would not necessarily refl ect inadequate risk control. Virtually any trend-following system would have experienced the same fate. This example illustrates how the value of a system cannot be judged in a vacuum. In some cases, poor performance may refl ect nothing more than the fact that market conditions would have resulted in poor results for the vast majority of systems. Similarly, favorable results may also refl ect the conditions of the market rather than any degree of superiority in the tested FIGURE  19.3 Trading Results Refl ect Market, Not System: Short Swiss Franc Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 318 A Complete Guide to the Futures mArket system. These considerations suggest that a meaningful assessment of a new system’s perfor- mance should include a comparison to a benchmark (e.g., the corresponding performance of standard systems, such as a crossover moving average or a simple breakout, during the same period for the same markets). 13. Use continuous futures prices for testing systems. 14. Use only a small portion of the database (i.e., some markets for only a segment of the full time period) for developing and debugging a system. 15. Use charts with superimposed signal annotations as an aid to debugging systems. 16. In checking the accuracy and completeness of the signals generated by a system, make changes dictated by deviations from the intended operation of the system (due to oversights related to the full implications of the rules employed or unforeseen situations) with complete disregard for whether such changes increase or decrease profits in the sample tests. 319 ■ Why Return Alone Is Meaningless Y ou are looking for a London hotel room on the Internet. Y ou find the same hotel room at two differ- ent sites (both including taxes) at two different prices: ■ Site A: 300 ■ Site B: 250 Which is the better deal? The answer may seem obvious, but it’s not. On one occasion, when I posed this question to a conference audience, one attendee shouted the response, “It depends whether they both include breakfast.” “That would have to be a very expensive breakfast,” I answered. But at least he had the right idea. The question I posed contained incomplete information. I didn’t specify what currency the prices were quoted in. What if the 300 price was in dollars and the 250 price was in pounds (let’s say when the pound was at $1.40)? Changes everything, doesn’t it? “W ell,” you are probably thinking, “no rational person will ignore the currency denomination in comparing two prices, so what’s the point?” The point is that investors make this type of error all the time when selecting investments by focusing only on returns. Comparing returns without risk is as meaningless as comparing international hotel prices without the currency denomination. Risk is the denomination of return. How to Evaluate Past Performance* Chapter 20 * This chapter is adapted from Jack D. Schwager, Market Sense and Nonsense: How the Markets Really Work (and How They Don’t) (Hoboken, NJ: John Wiley & Sons, 2012). 320 A Complete Guide to the Futures mArket Consider the two managers in Table 20.1. Assuming the two managers are considered qualitatively equivalent, which is the better-performing manager? 1 Many investors would opt for Manager B, reasoning, “I am willing to accept the higher risk to get the higher return potential.” But is this reasoning rational? In Table 20.2 we add a third investment alternative—leveraging an investment with Manager A at 300 percent. 2 The leveraged investment with Manager A now has both a higher return and lower risk than Manager B. So even risk-seeking investors should prefer Manager A, using a leverage factor that raises return to the desired level. One can picture risk as a hole—the deeper the hole, the greater the risk—and return as a pile of sand. Leverage is the shovel that, if desired, allows transferring some of the sand from the risk hole to the return pile, thereby increasing return in exchange for accepting greater risk—a trade-off that may be preferred if the risk level is lower than desired. Continuing the analogy, by using negative leverage (i.e., holding more cash), it is also possible to transfer sand from the return pile to the risk hole, thereby reducing risk in exchange for accepting lower return. In this sense, risk and return are entirely interchangeable through leverage (that is, through varying exposure). table 20.1 a Comparison of two Managers return risk (Standard Deviation) return/risk ratio Manager A 10% 5 2:1 Manager B 25% 25 1:1 table 20.2 a Comparison of two Managers revisited return risk (Standard Deviation) return/risk ratio Manager A 10% 5 2:1 Manager B 25% 25 1:1 Manager A 3× 30% 15 2:1 2 For strategies that use margin (e.g., futures, foreign exchange, options), managers need only a small percent- age of the nominal investment to meet margin requirements. In these instances, investors can often use notional funding—that is, funding an account with a smaller amount of cash than the nominal level. For example, an investor might notionally fund an account with $300,000 cash to be traded as a $900,000 investment, implicitly leveraging the cash investment 300 percent vis-à-vis an investment that is not notionally funded. T echnically speaking, although notional funding increases the exposure per dollar invested, it does not actually imply leverage, since there is no borrowing involved. Our example assumes notional funding. Nevertheless, in the ensuing discus- sion, we use the term leverage to indicate increased exposure (even if there is no borrowing involved). For strate- gies that must be fully funded, the leveraged portion of returns would have to be reduced by borrowing costs. 1 Although this chapter is written from the perspective of an investor comparing investments with two different managers, exactly analogous comments would apply to a trader comparing two different systems or two differ- ent trading strategies. 321 HOW TO EVALUATE PAST PERFORMANCE As a practical example to illustrate this concept, in Figure 20.1 we compare two actual manag- ers. Assuming we consider past performance indicative of potential future performance—at least in a relative sense—which manager provides a better investment? It would appear the answer is indetermi- nate: Manager C clearly achieves a superior return, but Manager D displays considerably lower risk, as evidenced by much smaller equity drawdowns throughout the track record. The seeming inability to determine which manager exhibits better performance is true only in a superfi cial sense, however. In Figure 20.2 , we again compare Managers C and D, but this time we assume the exposure to Manager D is doubled. 3 Now it is clear that Manager D is superior in terms of both return and risk, achieving a signifi cantly higher ending net asset value (NAV) and still doing so with visibly lower equity drawdowns (despite the doubling of exposure). Even though Manager C ended up with a higher return in Figure 20.1 , investors could have achieved an even higher return with a 2× investment in Manager D while still maintaining less risk. The lesson is that return is a faulty gauge; it is the return/risk ratio that matters. 3 Managers C and D are commodity trading advisors (CTAs) who trade futures, so increased exposure could have been achieved through notional funding (i.e., without leverage through borrowing). The returns depicted in Figure 20.1 were adjusted to remove interest income, so that doubling exposure (whether through notional funding or through borrowed leverage) would multiply all the returns by a near-exact factor of 2.0. (If returns included interest income, then doubling the exposure would not fully double the returns because there would be no interest income on the additional exposure.) FIGURE  20.1 Two Paths to Return April January 4,000 2,000 3,000 1,000 July October April January July October April January July October April January July October April January January July October April January July October April January July October Manager C Manager D April January July October 322A COMPLETE GUIDE TO THE FUTURES MARKET What if leverage is not available as a tool? For example, what if investors have a choice between Managers C and D in Figure 20.1 but there are practical impediments to increasing the exposure of Manager D? Now return and risk are inextricably bundled, and investors must choose between the higher-return/higher-risk profi le of Manager C and the lower-return/lower-risk profi le of Manager D. It might seem that risk-tolerant investors would always be better off with Manager C. Such inves- tors might say, “I don’t care if Manager C is riskier, as long as the end return is higher.” The fl aw in this premise is that investors who start with Manager C at the wrong time—and that is easy to do—may actually experience signifi cant losses rather than gains, even if they maintain the investment, and espe- cially if they don’t. The more volatile the path of returns, the more likely investors will abandon the investment during one of the equity plunges and, as a result, never realize the higher return. After all, investors in real time do not know the investment will eventually recover. Thus, even though Manager C ends up ahead of Manager D, many investors will never survive the ride to see the eventual suc- cessful outcome (and even those who do may have initiated their investment on an upside excursion, reducing or even eliminating their net return). The greater the volatility, the larger the percentage of investors who will close out their investments at a loss. Clearly, there is a need to use risk-adjusted returns rather than returns alone to make valid perfor- mance comparisons. In the next section we consider some alternative risk-adjusted return measures. April January 4,000 5,000 6,000 7,000 8,000 2,000 3,000 1,000 July October April January July October April January July October April January July October April January January July October April January July October April January July October Manager C Manager D 2× April January July October FIGURE  20.2 Doubling the Exposure of the Lower-Risk Manager 323 How to EvaluatE Past PErformancE ■ Risk-Adjusted Return Measures Sharpe ratio The Sharpe ratio is the most widely used risk-adjusted return measure. The Sharpe ratio is defined as the average excess return divided by the standard deviation. Excess return is the return above the risk-free return (e.g., the Treasury bill rate). For example, if the average return is 8 percent per year and the T -bill rate is 3 percent, the excess return would be 5 percent. (It should be noted that during certain periods, such as the years following the 2008 financial crisis, zero, or near-zero, interest rates can effectively eliminate the expectation of a meaningful “risk-free” return. For reference, the average three-month T -bill rate from 2009 through 2015 was only 0.08 percent. In contrast, from 2002 to 2008 the average three-month T -bill rate was 2.58 percent, and during 1995–2001 it was 5.03 percent.) The standard deviation is a measure of the variability of return. In essence, the Sharpe ratio is the average excess return normalized by the volatility of returns: SR AR RF SD= − where SR = Sharpe ratio AR = average return (used as proxy for expected return) RF = risk-free interest rate (e.g., Treasury bill return) SD = standard deviation The standard deviation is calculated as follows: SD XX N iI N = − − ∑ () 2 1 where X = mean Xi = individual returns N = number of returns Assuming monthly data is used to calculate the Sharpe ratio, as is most common, the Sharpe ratio would be annualized by multiplying by the square root of 12. Note that the return is an arithmetic average return, not the compounded return. There are two basic problems with the Sharpe ratio: 1. the return measure is based on average rather than compounded return. The return an investor realizes is the compounded return, not the average return. The more volatile the return series, the more the average return will deviate from the actual (i.e., compounded) return. For example, a two-year period with a 50 percent gain in one year and a 50 percent loss in the other would represent a zero percent average return, but the investor would actually realize a 25 percent loss (150% × 50% = 75%). The average annual compounded return of –13.4 percent, however, would reflect the reality (86.6% × 86.6% = 75%). 324A COMPLETE GUIDE TO THE FUTURES MARKET 2. the Sharpe ratio does not distinguish between upside and downside volatility. The risk measure inherent in the Sharpe ratio—the standard deviation—does not refl ect the way most investors perceive risk. Investors care about loss, not volatility. They are averse to downside volatility, but actually like upside volatility. I have yet to meet any investors who complained because their managers made too much money in a month. The standard deviation, and by inference the Sharpe ratio, however, makes no distinction between upside and downside volatility. This characteristic of the Sharpe ratio can result in rankings that would contradict most investors’ perceptions and preferences. 4 Figure 20.3 compares two hypothetical managers that have identical returns over the period depicted, but very diff erent return profi les. Which manager appears riskier? Decide on an answer before reading on. 4 T o be fair, in some cases, high upside volatility can be indicative of a greater potential for downside volatility, and in these instances the Sharpe ratio will be an appropriate measure. The Sharpe ratio, however, will be particularly misleading in evaluating strategies that are designed to achieve sporadic large gains while strictly controlling downside risk (that is, “right-skewed” strategies). FIGURE  20.3 Which Manager Is Riskier? February April June August October December February April June August October December February April June August October December February April June August October December February April June August October December December February April June August October December 2,000 1,800 1,600 1,400 1,200 2,400 2,200 1,000 800 Manager A Manager B 325 How to EvaluatE Past PErformancE Most likely you chose Manager A as being riskier. Manager A has three drawdown episodes in excess of 20 percent, with the largest being 28 percent. In contrast, Manager B’s worst peak-to-valley decline is a rather moderate 11 percent. Y et the standard deviation—the risk component of the Sharpe ratio—is 30 percent higher for Manager B. As a result, even though both Managers A and B have equal cumulative returns and Manager A has much larger equity retracements, Manager A also has a signifi- cantly higher Sharpe ratio: 0.71 versus 0.58 (assuming a 2 percent risk-free rate). Why does this occur? Because Manager B has a number of very large gain months, and it is these months that strongly push up Manager B’s standard deviation, thereby reducing the Sharpe ratio. Although most investors would clearly prefer the return profile of Manager B, the Sharpe ratio decisively indicates the reverse ranking. The potential for a mismatch between Sharpe ratio rankings and investor preferences has led to the creation of other return/risk measures that seek to address the flaws of the Sharpe ratio. Before we review some of these alternative measures, we first consider the question: What are the implica- tions of a negative Sharpe ratio? Although it is commonplace to see negative Sharpe ratios reported for managers whose returns are less than the risk-free return, negative Sharpe ratios are absolutely meaningless. When the Sharpe ratio is positive, greater volatility (as measured by the standard deviation), a negative characteristic, will reduce the Sharpe ratio, as it logically should. When the Sharpe ratio is negative, however, greater volatility will actually increase its value—that is, the division of a negative return by a larger number will make it less negative. Comparisons involving negative Sharpe ratios can lead to absurd results. Table 20.3 provides an example. Manager B has a negative excess return twice the size of Manager A’s (–10 percent versus –5 percent) and four times the volatility of Manager A. Even though Manager B is much worse than Manager A in terms of both return and volatility, Manager B has a higher (less negative) Sharpe ratio. This preposterous result is a direct consequence of higher volatility resulting in higher (less negative) Sharpe ratios when the Sharpe ratio is in negative territory. What should be done with negative Sharpe ratios? Ignore them. 5 They are always worthless and frequently misleading. Sortino ratio The Sortino ratio addresses both of the Sharpe ratio’s previously cited problems. First, it uses the compounded return, which is representative of the actual realized return over any period of time, 5 What if some value must be used, as in an application such as ranking a list of managers based on the ratio? In this case, a dual rank criterion makes much more sense: ranking managers based on the Sharpe ratio when excess returns are positive and on excess returns when Sharpe ratios are negative. table 20.3 a Comparison of two Managers with Negative Sharpe ratios average annual return risk-Free return excess return annualized Standard Deviation Sharpe ratio Manager A –3% 2% –5% 5 –1.0 Manager B –8% 2% –10% 20 –0.5 326 A Complete Guide to the Futures mArket instead of the arithmetic return. Second, and most important, the Sortino ratio focuses on defining risk in terms of downside deviation, considering only deviations below a specified minimum accept- able return (MAR) instead of a standard deviation (used in the Sharpe ratio), which includes all devia- tions, upside as well as downside. Specifically, the Sortino ratio is defined as the compounded return in excess of the MAR divided by the downside deviation, as follows: SR ACRM AR DD= − where SR = Sortino ratio ACR = annual compounded return MAR = minimum acceptable return (e.g., zero, risk-free, average) DD = downside deviation where DD is defined as: DD XM AR N ii N = −∑ (min (, ))0 2 where Xi = individual returns MAR = minimum acceptable return (e.g., zero, risk-free, average) N = number of data values For example, if we define MAR = 0, then DD calculations will include only deviations for months with negative returns (the other months will equal zero). The MAR in the Sortino ratio can be set to any level, but one of the following three definitions is normally used for the MAR: 1. Zero. Deviations are calculated for all negative returns. 2. risk-free return. Deviations are calculated for all returns below the risk-free return. 3. average return. Deviations are calculated for all returns below the average of the series being analyzed. This formulation is closest to the standard deviation, but considers deviations for only the lower half of returns. Frequently, the fact that a manager has a higher Sortino ratio than Sharpe ratio is cited as evidence that returns are positively skewed—that is, there is a tendency for larger deviations on the upside than on the downside. This type of comparison is incorrect. The Sortino and Sharpe ratios cannot be compared, and as formulated, the Sortino ratio will invariably be higher, even for managers whose worst losses tend to be larger than their best gains. The reason for the upward bias in the Sortino ratio is that it calculates deviations for only a portion of returns—those returns below the MAR— but uses a divisor based on the number of all returns to calculate the downside deviation. Because it distinguishes between upside and downside deviations, the Sortino ratio probably comes closer to reflecting investor preferences than does the Sharpe ratio and, in this sense, may be a better tool for 327 How to EvaluatE Past PErformancE comparing managers. But the Sortino ratio should be compared only with other Sortino ratios and never with Sharpe ratios. Symmetric Downside-risk Sharpe ratio The symmetric downside-risk (SDR) Sharpe ratio, which was introduced by William T . Ziemba,6 is similar in intent and construction to the Sortino ratio, but makes a critical adjustment to remove the inherent upward bias in the Sortino ratio vis-à-vis the Sharpe ratio. The SDR Sharpe ratio is defined as the compounded return minus the risk-free return divided by the downside deviation. The down- side deviation is calculated similarly to the downside deviation in the Sortino ratio with one critical exception: a multiplier of 2.0 is used to compensate for the fact that only returns below a specified benchmark contribute to the deviation calculation. 7 The benchmark used for calculating the down- side deviation can be set to any level, but the same three choices listed for the MAR in the Sortino ratio would apply here as well: zero, risk-free return, and average return. (In his article, Ziemba uses zero as the benchmark value.) Unlike the Sortino ratio, the SDR Sharpe ratio (with the benchmark set to the average) can be directly compared with the Sharpe ratio. 8 SDRSR ACRR F DD = − ×2 where SDRSR = symmetric downside-risk Sharpe ratio ACR = annual compounded return RF = risk-free interest rate (e.g., T -bill return) DD = downside deviation 6 William T . Ziemba, “The Symmetric Downside-Risk Sharpe Ratio,” Journal of Portfolio Management (Fall 2005): 108–121. 7 Ziemba used the term benchmark instead of MAR in defining downside deviation. If the median were used as the benchmark, only half the returns would be used to calculate the downside deviation, and a multiplier of 2.0 would then provide an exact compensating adjustment. For other choices for the benchmark (e.g., zero, risk- free return, average), the number of points below the benchmark would not necessarily be exactly half, and a multiplier of 2.0 would provide an approximate adjustment. 8 T o be perfectly precise, there would be a tendency for the SDR Sharpe ratio to be slightly lower for a symmetric distribution of returns because the SDR Sharpe ratio uses the compounded return rather than the arithmetic return used in the Sharpe ratio, and the arithmetic return will always be equal to or higher than the compounded return. If, however, zero or the risk-free return is used as the benchmark in the downside deviation calculation, assuming the manager’s average return is greater than the risk-free return, there would be a tendency for the SDR Sharpe ratio to be higher than the Sharpe ratio for a symmetric distribution of returns for two reasons:  1. There will be fewer than half the returns below the benchmark, so the multiplication by 2.0 will not fully compensate. 2. Downside deviations from the risk-free return (and especially zero) would be smaller than deviations from the average. These two factors would cause the downside deviation to be smaller than the standard deviation, implying a higher SDR Sharpe ratio than Sharpe ratio. 328 A Complete Guide to the Futures mArket where DD is defined as: DD XX N ii N = − − ∑ (min (, ))0 1 2 where Xi = individual returns X = benchmark return (e.g., mean, zero, risk-free) Since the SDR Sharpe ratio includes only the downside deviation, multiplying by the square root of 2 (a consequence of doubling the squared deviations) is equivalent to assuming the upside deviation is equal (i.e., symmetric) to the downside deviation. This proxy replacement of the upside deviation is what makes it possible to compare SDR Sharpe ratio values with Sharpe ratio values. The SDR Sharpe ratio (with any of the standard choices for a benchmark value) is preferable to the Sharpe ratio because it accounts for the very significant difference between the risk implications of downside deviations versus upside deviations as viewed from the perspective of the investor. The SDR Sharpe ratio is also preferable to the Sortino ratio because it is an almost identical calculation, 9 but with the important advantage of being directly comparable with the widely used Sharpe ratio. Also, by comparing a manager’s SDR Sharpe ratio versus the Sharpe ratio, an investor can get a sense of whether the manager’s returns are positively or negatively skewed. Gain-to-pain ratio The gain-to-pain ratio (GPR) is the sum of all monthly returns divided by the absolute value of the sum of all monthly losses. 10 This performance measure indicates the ratio of cumulative net gain to the cumulative loss realized to achieve that gain. For example, a GPR of 1.0 would imply that, on average, an investor has to experience an amount of monthly losses equal to the net amount gained. The GPR penalizes all losses in proportion to their size, and upside volatility is beneficial since it impacts only the return portion of the ratio. 9 Besides the essential introduction of the 2.0 multiplier term, which allows unbiased comparisons between the SDR Sharpe ratio and the Sharpe ratio, the only difference between the SDR Sharpe ratio and the Sortino ratio is that it subtracts the risk-free return from the compounded return instead of the MAR (which may or may not be the risk-free return). 10 The gain-to-pain ratio (GPR) is a performance statistic I have been using for many years. I am not aware of any prior use of this statistic, although the term is sometimes used as a generic reference for return/risk measures or a return/drawdown measure. The GPR is similar to the profit factor, which is a commonly used statistic in evaluating trading systems. The profit factor is defined as the sum of all profitable trades divided by the absolute value of the sum of all losing trades. The profit factor is applied to trades, whereas the GPR is applied to interval (e.g., monthly) returns. Algebraically, it can easily be shown that if the profit factor calculation were applied to monthly returns, the profit factor would equal GPR + 1 and would provide the same performance ordering as the GPR. For quantitatively oriented readers familiar with the omega function, note that the omega function evaluated at zero is also equal to GPR + 1. 329 How to EvaluatE Past PErformancE GPR X X ii N ii N= =∑ ∑ 1 0|m in(, )| where Xi = individual returns A key difference between the GPR and measures such as the Sharpe ratio, the SDR Sharpe ratio, and the Sortino ratio is that the GPR will be indifferent between five 2 percent losses and one 10 percent loss, whereas the other ratios discussed so far will be impacted far more by the single larger loss. This difference results because the standard deviation and downside deviation calcula- tions used for the other ratios involve squaring the deviation between the reference return level (e.g., average, zero, risk-free) and the loss. For example, if the reference return is zero percent, the squared deviation for one 10 percent loss would be five times greater than the squared devia- tion for five 2 percent losses (10 2 = 100; 5 × 2 2 = 20). In the GPR calculation, by contrast, both cases will add 10 percent to the denominator. If an investor is indifferent as to whether a given magnitude of loss is experienced over multiple months or in a single month, then the GPR would be a more appropriate measure than the SDR Sharpe ratio and Sortino ratio. However, an investor who considers a single larger loss worse than multiple losses totaling the same amount would have the opposite preference. Although the GPR would typically be applied to monthly data, it can also be calculated for other time intervals. If daily data are available, the GPR can provide a statistically very significant measure because of the large amount of sample data. The longer the time frame, the higher the GPR because many of the losses visible on a shorter time interval will be smoothed out over a longer period. In my experience, on average, daily GPR values tend to be about one-sixth as large as the monthly GPR for the same manager, although the ratio between daily and monthly GPR values can range widely. For monthly data, roughly speaking, GPRs greater than 1.0 are good and those above 1.5 are very good. For daily data, the corresponding numbers would be approximately 0.17 and 0.25. One advantage of the GPR over the other ratios is that rankings remain consistent even for nega- tive returns—that is, a smaller negative GPR is always better than a larger negative GPR (a relation- ship that is not necessarily true for the other ratios). A GPR of zero means that the sum of all wins is equal to the sum of all losses. The theoretical minimum GPR value is –1.0 and would occur if there were no winning months. The closer the GPR is to –1.0, the smaller the ratio of the sum of all wins to the sum of all losses. 11 tail ratio An important question for the investor is whether a manager’s extreme returns tend to be larger on the upside or the downside. Managers with frequent small gains and occasional large losses (negatively skewed managers) are more risky and less desirable than managers with frequent small 11 The ratio of the sum of wins to the sum of losses is equal to GPR + 1. So, for example, a GPR of −0.25 would imply that the ratio of the sum of wins to the sum of losses is 0.75. 330 A Complete Guide to the Futures mArket losses and occasional large gains (positively skewed managers). Although there is a statistic that mea- sures skewness—the degree to which a return distribution has longer tails (extreme events) on the right (positive) or left (negative) side than the symmetric normal distribution—it is difficult to attach intuitive meaning to specific values (beyond the value of the sign). The tail ratio measures the tendency for extreme returns to be skewed to the positive or negative side in a statistic whose value is intuitively clear. TR X N X N pp pT pT ppT p pT = = = < =− = >−∑ ∑ 0 100 100 100 where Xp = return at percentile p T = threshold percentile to calculate numerator of tail ratio (Implicit assumption: Lower percentile rankings represent higher return. For example, the top 10% of returns would be all returns less than T, where T = 10.) Np100−T = number of returns above percentile 100−T The tail ratio requires one parameter input: the upper and lower percentile threshold used to calculate the statistic. If the threshold is set to 10, for example, the tail ratio would be equal to the average of all returns in the top decile of returns divided by the absolute value of the average of all returns in the bottom decile of returns. (Note: If the average of bottom decile returns is positive, the tail ratio would have no meaning and cannot be calculated.) If returns were normally distributed, the tail ratio would equal 1.0. A ratio significantly less than 1.0 would indicate a tendency for the largest losses to be of greater magnitude than the largest gains, while a ratio significantly greater than 1.0 would indicate the reverse tendency. For example, if the tail ratio was equal to 0.5, it would imply that the magnitude of the average loss in the bottom decile was twice as large as the average gain in the top decile—a reading indicative of a potentially very risky manager. Mar and Calmar ratios The MAR ratio is the annualized compounded return divided by the maximum drawdown. MAR ACR NAV NAV j i = −      1m in where ACR = annual compounded return (expressed in decimal form) NAV = net asset value j > i 331 How to EvaluatE Past PErformancE The Calmar ratio is exactly the same except the calculation is specifically restricted to the past three years of data. Although these ratios are useful in that they are based on a past worst-case situa- tion, the fact that the risk measure divisor is based on only a single event impedes their statistical sig- nificance. Also, if applied over entire track records, the MAR will be strongly biased against managers with longer records, because the longer the record, the greater the potential maximum drawdown. (This bias does not exist in the Calmar ratio because, by definition, it is based on only the past three years of data.) Manager comparisons should be limited to common time periods, a restriction that is especially critical when using the MAR ratio. return retracement ratio The return retracement ratio (RRR) is similar to the MAR and Calmar ratios in that it is a measure of the average annual compounded return divided by a retracement measure. The key difference, however, is that instead of being based on a single retracement (the maximum retracement), the RRR divides return by the average maximum retracement (AMR), which is based on a maximum retrace- ment calculation for each month. The maximum retracement for each month is equal to the greater of the following two numbers: 1. The largest possible cumulative loss that could have been experienced by any existing investor in that month (the percentage decline from the prior peak NAV to the current month-end NAV). 2. The largest loss that could have been experienced by any new investor starting at the end of that month (the percentage decline from the current month-end NAV to the subsequent lowest NAV). RRR ACRR F AMR= − where ACR = annual compounded return RF = risk-free return AMR = average maximum retracement = MRi/N where N = number of months MRi = max(MRPNHi, MRSNLi) where MRPNHi is the maximum retracement from prior NAV high, and is defined as: MRPN HP NH NA VP NHii ii=−() / where PNHi = prior NAV high (prior to month i) NAVi = NAV at end of month i MRSNLi is the maximum retracement to a subsequent NAV low , and is defined as: MRSN LN AV SN LN AVii ii=−() / where SNLi is the subsequent NAV low (subsequent to month i). 332 A Complete Guide to the Futures mArket The reason for using both metrics to determine a maximum retracement for each month is that each of the two conditions would be biased to show small retracement levels during a seg- ment of the track record. The first condition would invariably show small retracements for the early months in the track record because there would not have been an opportunity for any large retracements to develop. Similarly, the second condition would inevitably show small retrace- ments during the latter months of the track record for analogous reasons. By using the maximum of both conditions, we assure a true worst-case number for each month. The average maximum retracement is the average of all these monthly maximum retracements. The return retracement ratio is statistically far more meaningful than the MAR and Calmar ratios because it is based on multiple data points (one for each month) as opposed to a single statistic (the maximum drawdown in the entire record). Comparing the risk-adjusted return performance Measures Table 20.4 compares Managers A and B shown in Figure 20.3 in terms of each of the risk-adjusted return performance measures we discussed. Interestingly, the Sharpe ratio, which is by far the most widely used return/risk measure, leads to exactly the opposite conclusion indicated by all the other measures. Whereas the Sharpe ratio implies that Manager A is significantly superior in return/risk terms, all the other performance measures rank Manager B higher—many by wide margins. Recall that both Managers A and B had identical cumulative returns, so the only differ- ence between the two was the riskiness implied by their return paths. The Sharpe ratio, which uses the standard deviation as its risk metric, judged Manager B as being riskier because of higher vola- tility, as measured across all months. Most of Manager B’s volatility, however, was on the upside—a table 20.4 a Comparison of risk-adjusted return Measures Manager a Manager b b as percent of a Sharpe ratio 0.71 0.58 82% Sortino ratio (zero) 1.27 1.44 113% Sortino ratio (risk-free) 1.03 1.15 112% Sortino ratio (average) 0.87 0.94 107% SDR Sharpe ratio (zero) 0.75 0.85 113% SDR Sharpe ratio (risk-free) 0.73 0.81 112% SDR Sharpe ratio (average) 0.62 0.66 107% Gain-to-pain ratio (GPR) 0.70 0.71 101% Tail ratio (10%) 1.13 2.86 253% Tail ratio (5%) 1.10 2.72 247% MAR ratio 0.41 1.09 265% Calmar ratio 0.33 1.70 515% Return retracement ratio (RRR) 0.77 1.67 218% 333 How to EvaluatE Past PErformancE characteristic most investors would consider an attribute, not a fault. Although Manager A had lower volatility overall, the downside volatility was significantly greater than Manager B’s—a char- acteristic that is consistent with most investors’ intuitive sense of greater risk. The Sharpe ratio does not distinguish between downside and upside volatility, while the other risk-adjusted return measures do. Although all the risk-adjusted return measures besides the Sharpe ratio penalize only downside volatility, they do so in different ways that have different implications: ■ Sortino ratio and SD r Sharpe ratio. These ratios penalize returns below a specified level (e.g., zero) with the weight assigned to downside deviations increasing more than proportionately as their magnitude increases. Thus, one larger downside deviation will reduce the ratio more than multiple smaller deviations that sum to the same amount. These ratios are unaffected by the order of losing months. Two widely separated losses of 10 percent will have the same effect as two con- secutive 10 percent losses, even though the latter results in a larger equity retracement. ■ Gpr. The GPR penalizes downside deviations in direct proportion to their magnitude. In contrast to the Sortino and SDR Sharpe ratios, one large deviation will have exactly the same effect as multiple smaller deviations that sum to the same amount. This difference explains why Managers A and B are nearly equivalent based on the GPR, but Manager A is significantly worse based on the Sortino and SDR Sharpe ratios: Manager A has both larger and fewer losses, but the sum of the losses is nearly the same for both managers. The GPR is similar to the Sortino and SDR Sharpe ratios in terms of being indifferent to the order of losses; that is, it does not penalize for consecu- tive or proximate losses. ■ tail ratio. The tail ratio focuses specifically on the most extreme gains and losses. The tail ratio will be very effective in highlighting managers whose worst losses tend to be larger than their best gains. In terms of the tail ratio, Manager B, who achieves occasional very large gains but whose worst losses are only moderate, is dramatically better than Manager A, who exhibits the reverse pattern. ■ Mar and Calmar ratios. In contrast to all the foregoing performance measures, these ratios are heavily influenced by the order of returns. A concentration of losses will have a much greater impact than the same losses dispersed throughout the track record. Both of these measures, how- ever, focus on only the single worst equity drawdown. Therefore losses that occur outside the interim defined by the largest peak-to-valley equity drawdown will not have any impact on these ratios. Because the maximum drawdown for Manager A is much greater than for Manager B, these ratios show a dramatic difference between the two managers. ■ return retracement ratio (rrr). The RRR is the only return/risk measure that both penal- izes all downside deviations and also penalizes consecutive or proximate losses. In contrast to the MAR and Calmar ratios, which reflect only those losses that define the maximum drawdown, the RRR calculation incorporates all losses. Table 20.5 summarizes and compares the properties of the different risk-adjusted return measures. 334 A Complete Guide to the Futures mArket Which return/risk Measure Is best? T o some extent, the choice of which return/risk measures to use depends on the performance mea- sure properties favored by the individual investor. The major advantages and disadvantages of these performance measures can be summarized as follows: ■ Sharpe ratio. Although the Sharpe ratio is the most widely used risk-adjusted metric, it provides rankings that are least consistent with most people’s intuitive sense of risk because it penalizes upside gains. ■ Sortino ratio. This ratio corrects the main deficiency of the Sharpe ratio by focusing on down- side risk instead of total volatility as the measure of risk. In addition, the Sortino ratio uses a com- pounded return, which matches actual return over the entire period, whereas the Sharpe ratio uses an arithmetic average return, which does not. One disadvantage of the Sortino ratio is that it is not directly comparable with the Sharpe ratio because its calculation is biased to delivering higher values. ■ SDr Sharpe ratio. This ratio provides the same fix as the Sortino ratio, and it has the advan- tage of an additional adjustment that allows for direct comparisons of its values with Sharpe ratio values. Similar to the Sortino ratio, the SDR Sharpe ratio also uses the compounded return instead of the arithmetic average return. Since the SDR Sharpe ratio will provide nearly identical rankings as the Sortino ratio and has the advantage of allowing for comparisons with the Sharpe ratio for the same manager, it seems the better choice for any investor. Using both ratios would be redundant. ■ Gain-to-pain ratio (Gpr). Similar to the Sortino and SDR Sharpe ratios, the GPR penalizes a manager only for losses (zero percent is also a common choice for minimum acceptable return or benchmark in the Sortino and SDR Sharpe ratios). The GPR weights losses proportionately to their table 20.5 properties of risk-adjusted performance Measures property Sharpe ratio SDr Sharpe ratio Sortino ratio G pr tail ratio Mar and Calmar rrr Is impacted by upside volatility X Is impacted only by downside volatility X X X X X X Reflects all downside volatility X X X X X Gives more than proportionate weight to large losses X X X X Is impacted by proximity of losses X X Focuses on extreme returns only X Rankings remain consistent for net negative returns X X 335 How to EvaluatE Past PErformancE magnitude, whereas the Sortino and SDR Sharpe ratios magnify the weight of larger losses. Investors who view one 10 percent monthly loss the same as five 2 percent losses might prefer the GPR, whereas investors who consider the single 10 percent monthly loss to be worse might prefer the SDR Sharpe ratio. ■ tail ratio. Since, by definition, the tail ratio considers only a small percentage of all returns (20 percent or less), it is not intended as a stand-alone risk-adjusted return measure. Its focus on extreme returns, however, makes it a very useful supplemental metric to one of the other measures. ■ Mar and Calmar ratios. These ratios will penalize for losses that occur with sufficient proximity to be part of the same drawdown. The other ratios (with the exception of the RRR) are unaffected by the sequence of returns. The drawback of these ratios is that the risk is defined by only a single event (the maximum drawdown), impeding their statistical significance and representativeness. ■ return retracement ratio ( rrr). This ratio is both based on downside deviations and im- pacted by proximate losses. Its big advantage vis-à-vis the MAR and Calmar ratios is that it reflects all retracements, with the risk number based on all monthly numbers, rather than just a single event and single statistic: the maximum drawdown. Although the MAR and Calmar ratios might still be consulted as supplemental measures reflecting a worst-case situation, the RRR is prefer- able as a return/drawdown ratio. ■ Visual Performance Evaluation Many people will find that the performance charts in this section provide a better intuitive sense of relative performance (in both return and risk terms) than do performance statistics. Net asset Value (NaV) Charts An NAV chart, such as was illustrated in Figure 20.3, provides an extremely useful way of evaluating a track record. The NAV chart depicts the compounded growth of $1,000 over time. For example, an NAV of 2,000 implies that the original investment has doubled from its starting level as of the indicated time. The NAV chart can offer a good intuitive sense of past performance in terms of both return and risk. In fact, if an investor were to examine only a single performance gauge, the NAV chart would probably be the most informative. The way we visually perceive conventionally scaled NAV charts that depict longer-term periods, however, may result in misleading inferences. Consider Figure 20.4, and answer the following three questions before reading on: 1. Was return higher in the first half of the track record or the second? 2. Was the manager riskier during the first half of the track record or the second? 3. Was the return/risk performance better during the first half of the track record or the second? 336A COMPLETE GUIDE TO THE FUTURES MARKET If you picked the fi rst half as the answer to any of these three questions, you are wrong. If you picked the second half for any answer, you are also wrong. The two halves are exactly the same. In fact, all four quarters of the track record are the same. Figure 20.4 was created by copying the returns of Manager A in Figure 20.3 and pasting the sequence three times to the end to create an extended NAV that repeats the same return pattern, displaying it four times in all. Looking at Figure 20.4 , however, it seems as if both the return and the volatility are increasing sharply over time. They are not. The illusion is an artifact of depicting NAV charts on a conventional arithmetic scale. On an arithmetic scale, an NAV decline of 1,000 when the NAV is at 16,000 looks the same as an NAV decline of 1,000 when the NAV is 2,000. The two declines, however, are radically diff erent: a modest 6 percent decline in the fi rst instance and a huge 50 percent drop in the second. The distortion on an arithmetic scale chart will get magnifi ed when the NAV range is wide, which is frequently a serious problem for long-term charts. The ideal way to depict an NAV chart is on a logarithmic scale. On a log scale chart, the increments for a fi xed amount of movement (e.g., 1,000) become proportionately smaller as the level increases, and as a result, equal percentage price moves will appear as equal size moves on the vertical scale. Figure 20.5 depicts the same NAV as Figure 20.4 , but on a log scale. The self-replicating nature of the chart is now evident as equal percentage changes now look identical wherever they appear. The moral is that a log scale is always the correct way to represent an NAV chart and is especially critical when there is a wide NAV range (more likely on long-term charts). A log scale was used for Figures 20.1 and 20.2 earlier in this chapter to allow for an accurate representation of relative volatility across time. FIGURE  20.4 How Has Performance Changed over Time? 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December December June 0 337 HOW TO EVALUATE PAST PERFORMANCE rolling Window return Charts The rolling window return chart shows the return for the specifi ed time length ending in each month. For example, a 12-month rolling window return chart would show the 12-month return ending in each month (beginning with the 12th month of the track record). The rolling window return chart provides a clear visual summary of the results of investing with a manager for a specifi ed length of time and answers such questions as: What would have been the range of outcomes with a manager for investments held for 12 months? 24 months? What was the worst loss for investments held for 12 months? 24 months? For any December, the rolling 12-month return would be the same as the annual return. The important diff erence is that the rolling window return chart would show the analogous returns for all the other months as well. There is only a one-out-of-12 chance that December will be the worst 12-month return for the year. By showing all 12-month returns ending in any month, the rolling win- dow chart will encompass worst-case events likely to be missed by annual returns and will provide a much more representative performance picture for one-year holding periods. The rolling window return chart can be calculated for other time intervals as well (e.g., 24 months, 36 months). T o illustrate the use of the rolling window return chart as a graphic analysis tool, we compare the two managers shown in Figure 20.6 , who diff er only moderately in terms of return (Manager E’s annual compounded return is 1.3 percent higher), but diff er widely in terms of the stability of returns. As shown in Figure 20.7 , Manager E’s 12-month returns range enormously from a severe FIGURE  20.5 Log Scale: Equal Percentage Price Moves Appear Equal 20,000 10,000 5,000 4,000 3,000 2,000 1,000 500 December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December June December December June 338A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  20.6 Small Diff erence in Return; Wide Diff erence in Stability of Return March December 2,000 3,000 4,000 1,000 500 June September December March June September December March June September December March June September December March June September December March June September December March June September December September December March June Manager F Manager E FIGURE  20.7 12-Month Rolling Return: Manager E March December –60% –40% –20% 20% 40% 60% 80% 100% 120% 140% 160% 0% June September December March June September December March June September December March June September December March June September December March June September December September December March June 339 HOW TO EVALUATE PAST PERFORMANCE loss of 49 percent to a spectacular gain of 142 percent. In contrast, manager F’s 12-month returns are contained in a far more moderate range of –10 percent to +29 percent (see Figure 20.8 ). Investors who were patient enough to stay with Manager F for at least 12 months would have experienced only a handful of investment initiation months that would have resulted in a net loss. Such patience, however, would not have provided any solace to investors with Manager E, who would have witnessed more than one-quarter of all 12-month holding periods resulting in net losses exceeding 15 percent, with several in excess of 40 percent. Even investors who committed to a 24-month holding period with Manager E would still have been subject to nearly one-fi fth of all intervals with losses in excess of 15 percent (see Figure 20.9 ). In contrast, the worst-case outcome for investors with Manager F for a 24-month holding period would have been a positive return of 4 percent (see Figure 20.10 ). Investors can use the rolling window return chart to assess the potential frequency and magnitude of worst-case outcomes as an aid in selecting investments consistent with their holding period toler- ance for a losing investment. For example, an investor who is unwilling to maintain a losing invest- ment for more than 12 months should avoid managers who have a meaningful percentage of negative 12-month returns, regardless of how favorable all the other performance statistics may be. Rolling charts can also be used to depict other statistics besides return. For example, a rolling chart of annualized volatility (using daily data and a window of several months) can be used as a tool to monitor both managers and portfolios for early evidence of a possible increase in risk. FIGURE  20.8 12-Month Rolling Return: Manager F March December 40% –20% –10% 20% 30% 10% 0% June September December March June September December March June September December March June September December March June September December March June September December September December March June 340A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  20.9 24-Month Rolling Return: Manager E December February April June August October December February April June August October December February April June August October December February April June August October December February April June August October December February April June August October 300% 280% 260% 240% 220% 200% 180% 160% 140% 120% 100% 80% 60% 40% 20% –20% –40% –60% 0% December FIGURE  20.10 24-Month Rolling Return: Manager F 35% 20% 25% 30% 10% 5% 0% 15% December February April June August October December February April June August October December February April June August October December February April June August October December February April June August October December February April June August October December 341 HOW TO EVALUATE PAST PERFORMANCE Underwater Curve and 2DUC Charts The underwater chart shows the worst possible cumulative percentage loss any investor could have experienced as of the end of each month—an assumption that implies an investment started at the prior NAV peak. The low point in the NAV chart is the maximum retracement (the risk measure used in the MAR and Calmar ratios). The underwater chart, however, provides far more informa- tion because it shows not only the worst possible loss for the entire track record (the maximum retracement), but the worst possible loss as of the end of every other month in the track record as well. Figure 20.11 illustrates the underwater chart for the same two managers with widely disparate stability of returns depicted in Figure 20.6 . The diff erence between the two could hardly be starker. Manager F’s retracements are very shallow and relatively short-lived (a rise to the 0 percent level indicates a new NAV high); Manager E’s retracements are both deep and protracted. The underwater chart provides an excellent visual representation of an investment’s relative risk in a way that is very consistent with the way most investors perceive risk. One shortcoming of the underwater curve is that it will understate risk for months in the early portion of the track record because there is an insuffi cient look-back period for a prior NAV peak. For these earlier months, there is no way of assessing a true worst-case loss representa- tion, because a prior track record of suffi cient length simply does not exist. Also, the underwater curve is constructed from the perspective of the worst cumulative loss that could have been FIGURE  20.11 Underwater Curve: Manager E vs. Manager F 0% −10% −20% −30% −40% Manager E Manager F −50% −60% January April July October January April July October January April July October January April July October January April July October January April July October January April July October January April July October 342A COMPLETE GUIDE TO THE FUTURES MARKET experienced by an existing investor. Arguably, the worst loss suff ered by new investors may be an even more relevant measure. One solution to these inadequacies in the underwater curve calcula- tion is to also consider the worst loss that could have been experienced by any investor starting in each month, assuming the investment was exited at the subsequent lowest NAV point. W e can then create a two-direction underwater curve (2DUC) that for each month would show the maxi- mum of the following two losses: 1. The cumulative loss of an existing investor starting at the prior NAV peak. 2. The cumulative loss of an investor starting that month-end and liquidating at the subsequent NAV low. The average of all the points in the 2DUC chart would, in fact, be the risk measure used in the return retracement ratio (the average maximum retracement). The underwater excursions for Man- ager E become signifi cantly more extreme in the 2DUC chart (Figure 20.12 ), widening from an average monthly value of 21 percent to 30 percent (the AMR). The underwater curve for Manager F remains subdued in the 2DUC chart with a still very low average value of 3 percent. The 2DUC chart implies that the average worst-case scenario for investors with Manager E is 10 times worse than with Manager F; that is a lot of extra risk for a 1.3 percent diff erence in the average annual compounded return. Based on performance, it would be diffi cult to justify choosing Manager E over Manager F, even for the most risk-tolerant investor. FIGURE  20.12 2DUC: Manager E vs. Manager F 2DUC: Manager E vs. Manager F 0% −10% −20% −30% −40% Manager E Manager F −50% −60% January April July October January April July October January April July October January April July October January April July October January April July October January April July October January April July October 343 How to EvaluatE Past PErformancE ■ Investment Insights Many investors place too much emphasis on return. Since return can always be improved by increas- ing exposure (i.e., taking on greater risk), the return/risk ratio is a far more meaningful performance measure. An investment with higher return/risk and lower return than an alternative investment with the reverse characteristics can be brought up to the same higher return level with lower risk by using leverage. The Sharpe ratio is by far the most widely used return/risk metric. The Sharpe ratio, however, penalizes upside volatility the same as downside volatility, which is not consistent with the way most investors view risk. Other return/risk measures detailed in this chapter, which focus on losses as the proxy for risk, more closely reflect the way most investors perceive risk. Investors can use Table 20.5, which summarizes the properties of different return/risk measures, to select the performance measures that best fit their criteria. Return/risk statistics can be supplemented with the performance charts detailed in this chapter, which provide a tremendous amount of information in an intuitive and accessible format and should be at the core of any performance analysis. I recommend using the following performance charts in any manager or fund evaluation: ■ An NAV chart ■ Both 12-month and 24-month rolling window return charts ■ A 2DUC chart ■ ■ ■ Note: Some of the statistics and chart analytics described in this chapter are my own invention and hence not yet available on any existing software. Many of these statistics and analytical charts can be accessed for free on FundSeeder.com. FuNdaMeNtal aNalysis Part V Fourteen Popular Fallacies, or What Not to do Wrong Cha P ter 21 347 The fault, dear trader, is not in the fundamentals, but in ourselves. (With apologies to shakespeare) ■ Five Short Scenes Scene 1 the u.s. treasury announces a new plan to sell stockpiled gold. Not surprisingly, the market opens with near-limit losses the following day. you reason that the new gold sales will sharply increase sup- ply and that, therefore, the market still offers a good selling opportunity, even given the decline. you are somewhat concerned about expectations for continued increasing inflation and dollar weakness but decide the gold sale will dominate market action over the near term. after going short, the market hovers for two days and then, as you expected, breaks sharply. One week later, your trade is substantially in the plus column and convinced that you have caught a new bear market in its infancy, you resolve to hold the position as a long-term trade. the next week, however, the market begins to rally inexplicably, and your profits evaporate. Paradoxically, despite an absence of any meaningful bullish news, the rally continues and prices even surpass the levels they were at before the u.s. treasury announcement. your losses continue to grow , and finally you bail out, promising yourself, “that’s the last time i trade on fundamentals.” 348 A Complete Guide to the Futures mArket Scene 2 you’ve done your homework and feel confident the u.s. department of agriculture’s 50-state Hogs and Pigs report, which will be released in the afternoon, will reflect a large expansion in hog produc- tion. you anticipate that hog numbers will be up at least 7 percent over the year-ago level. Hog prices have already sold off sharply in recent weeks, but you reason that a report in line with your expecta- tions will push prices still lower. although you are quite familiar with the dangers of riding a position into a major report, this is one time you cannot resist. at the report release time, eyes glued to your computer screen and your heart pounding, you read the critical figure. a smile crosses your face as you see the number. “i knew it!” you shout triumphantly. the report shows hog numbers up 8 percent. the next day the market opens limit down, and you begin to calculate what your profits will be after three limit-down days—a conservative assumption. But before you can even finish calculating your profits, a strange thing happens: the market begins to rally. By the end of the session, hog prices are actually 100 points higher! the uptrend continues in subsequent trading sessions, and one week later you liquidate your position with a sizable loss. you feel cheated. you were right in your expecta- tions: the report was bearish, wasn’t it? Scene 3 you’ve been long corn for three weeks and it’s been one of your best trades ever. the market has moved steadily and sharply higher with export rumors flying in all directions. that evening on the news, the lead story is the official announcement of an additional large grain sale to Japan. daydream- ing, you wonder if this is the trade you will retire on. Next morning you call your broker. “Corn is due 8 to 10 cents a bushel higher,” he says. Not as good as you thought, but it will do. However, by the time corn is ready to open, the call has dropped to unchanged, and the market actually opens 2 cents lower. several days later, corn has fallen more than 40 cents, and your profits have virtually evaporated. Scene 4 Cattle futures have rallied to near all-time record highs. you are well aware that cattle supplies are down and expected to remain low , but upon closer examination, you have discovered that supplies were lower in a number of other past situations when prices were lower. you reason the current rally is overdone and go short. When cattle rallies an additional 10¢/lb, you figure the market is an even better short, and add to your position. Prices are still moving higher when you finally throw in the towel on the trade. Scene 5 you have read that sugar prices are below costs of production, a factor that seems to suggest that prices have overdone the down side. you go long. Not only does the price fail to rise, but it actually 349 FOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg continues to slide steadily lower. you can’t understand why producers continue to sell sugar at a loss. you are both confused and frustrated at the seemingly logic-defying market price action as your losses continue to mount. ■ ■ ■ these five scenes appear to provide proof that fundamental analysis just does not work. at least, that is the conclusion a great many futures traders have drawn from such experiences. the simple truth, however, is that much that passes for fundamental analysis is either incomplete or incorrect—and frequently both. the trader who ignores fundamentals completely is almost cer- tainly better off than the trader who uses fundamentals incorrectly. However, this in no way alters the fact that good fundamental analysis is a useful, and even powerful, tool. Before turning to how to do things right, it is essential to first cover what not to do wrong. W e begin by exploring 14 common fallacies in fundamental analysis. incidentally, these fallacies do not represent mistakes made solely by the novice trader. in fact, virtually all these errors have been repeated numerous times in the most respected financial news outlets and in myriad commodity research publications. there is no significance to the order of the list. ■ The Fourteen Fallacies 1. Viewing Fundamentals in a Vacuum “the fundamentals are bearish” is often thought to be synonymous with an abundant supply situation. such an interpretation might seem plausible, but it can lead to inaccurate conclusions. For example, assume the sugar market is trading at 30¢/lb. and in transition from tightness to surplus. given this scenario, the fundamentals can indeed be termed “bearish,” and an expectation of lower prices would be reasonable. assume that prices begin to move lower. are the fundamentals still bearish at 25¢? V ery likely. at 20¢? Maybe. at 15¢? at 10¢? at 5¢? the point is that at some price level, the fundamentals are no longer bearish, no matter how large the projected supply. in fact, it is entirely possible that the fundamentals could be bullish in a surplus situation if prices have overdone the downside—a situation that is far from infrequent. thus, fundamentals are not bullish or bearish in themselves; they are only bullish or bearish relative to price. the failure of many analysts to realize or acknowledge this fact is the reason why the fundamentals are so often termed bullish at market tops and bearish at market bottoms. 2. Viewing Old Information as New Financial news outlets frequently report old information and new information in much the same manner. For example, a story with the headline “W orld Cotton Production Projected to rise 10 Percent” may sound very bearish. However, what the story is not likely to indicate is that this may be the fourth or fifth such estimate released. V ery likely, the previous month’s estimate also projected 350 A Complete Guide to the Futures mArket an approximate 10 percent increase in world production. For that matter, the previous month’s esti- mate might have forecast a 12 percent increase, and the current estimate actually represents a price- constructive development. the main point to keep in mind is that much information that sounds new is actually old news, long discounted by the market. 3. One-Y ear Comparisons the use of one-year comparisons is fairly widespread, probably because it offers a simple means of instant analysis. this approach is overly simplistic, however, and should be avoided. For example, consider the following market commentary: “the december Hogs & Pigs report indicates that large pork supplies are around the corner. Market hogs on all farms are up 10 percent. the projected 10 percent increase in hog slaughter should push prices lower. . . .” although this type of analysis could be right on target in some situations, it will be susceptible to error if used consistently. sharp-eyed readers may already be citing fallacy number 1—that is, large supplies do not neces- sarily imply lower prices, since the market may already be discounting such a development. How- ever, some additional potential errors pertain specifically to the one-year comparison. First, just because the december report indicated a 10 percent increase in hog numbers does not mean it implies large supplies. Perhaps hog numbers were extremely low the previous year. second, the rela- tionship between hog slaughter and market hogs can vary significantly. it is possible that the preceding year the ratio of slaughter to market hogs was abnormally high. in this case, a 10 percent increase in market hogs would imply a smaller increase in slaughter. although one-year comparisons can be used sparingly for illustrative purposes, they should never represent the sole basis of fundamental analysis. 4. Using Fundamentals for timing if this list of fallacies were ordered on the basis of frequency of occurrence, this item would be a strong contender for the number 1 spot. Fundamental analysis is a method for gauging what price is right under given statistical conditions and can be used in constructing annual, quarterly, and in some instances monthly price projections. However, it is ludicrous to attempt to boil supply-demand statistics down to the point at which they provide an instantaneous price signal, which is exactly what some traders do when they rely on fundamentals for timing. trading on the basis of market websites, newspaper articles, and newswire stories, falls into this category. it is no surprise that speculators who base their trades on such items are usually spectacu- larly unsuccessful. the only major exception are those traders who use this type of information in a contrary way, such as viewing the failure of the market to rally after the release of a bullish newswire story as a signal to go short. the fundamental researcher must also guard against the natural instinct of wanting to take a market position right after completing an analysis that indicates either an underpriced or overpriced situation. the market is not aware of the timing of a researcher’s personal price discovery. even if the analysis is correct, the right time may be three weeks or even three months off. in short, for purposes of timing, even the fundamental analyst should use some form of technical input. 351 FOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg 5. Lack of Perspective assume the following scenario: scanning the financial pages one day, you notice the following headline: “government Officials estimate 10,000 Head of Cattle Killed in recent Midwest Winter storm.” does such a large production loss suggest a major buying opportunity? Wait a minute. What large production loss? ten thousand cattle might sound like a very big number if you were to picture them on your front lawn, but viewed in terms of a total u.s. cattle population of about 90 million head (and many times that globally), the loss does not even equal the proverbial drop in the bucket. this example is based on supply, but cases involving domestic consumption or exports could be illustrated just as easily. in each instance, the same question should be asked: How important is the event (e.g., production loss, new export sales) in terms of the total picture? 6. Ignoring relevant time Considerations true or false: Higher grain prices imply higher meat prices. No cheating—think before reading on. actually, this is not a fair question, because the answer depends on the time frame. Most peo- ple would probably answer true, since rising grain prices do suggest increased costs of production for feedlot operators, a development that would lead to reduced meat production and higher meat prices. (Cost of production is itself a primary source of misconception and is discussed separately.) However, this reasoning is true only for the very long run (2½ years plus). Over the short to intermediate term—the time frame that is really of primary concern to futures traders—the effect might be exactly the opposite. if high grain prices are effective in influencing cattle feeders to reduce production, the preliminary impact will be increased marketings and lower prices as a result of breeding herd liquidation. Higher grain prices might reduce the weight to which cattle are fed, but this effect is relatively minor. increased feeding costs would only imply a shift in the flow of supply (since cattle gain weight more slowly on grass) rather than a change in total actual supplies over the longer run. in the world of economics, the cause-and-effect relationship is not necessarily instantaneous. in some cases, an event will trigger a very quick price response; in other instances, such as the cattle situation, the effect will not occur for many years. 7. assuming that Prices Cannot Decline Significantly Below the Cost of Production No matter how many times this old saw is disproved by actual events, it never seems to be laid to rest. the cost of production is not—repeat, not—a price-supporting factor, especially for nonstorable commodities. Once a commodity is produced, the market does not care about the cost of production. Prices will be determined on the basis of existing supply and demand. if prices fall to the cost of production and there is still a surplus, prices will continue to decline until an equilibrium price level is reached. Why should producers sell a commodity below the cost of production? the fact is they don’t have much choice. agricultural markets are highly competitive, with literally thousands of sellers. Conse- quently, any individual is powerless to pass on production costs to the marketplace. instead, individu- als must accept the price that the market will bear. after all, a low price is better than no price. 352 A Complete Guide to the Futures mArket Of course, an unprofitable situation will lead to production cutbacks, but this will not happen overnight. the minimum time lag might be one year, but in many instances, it will take several years before prices below the cost of production actually result in reduced output. in this sense, fallacy number 7 is a corollary of fallacy number 6—ignoring relevant time considerations. Many commod- ity markets have witnessed periods in which prices have fallen and stayed below cost of production for years at a time. Keep this empirical reality in mind the next time you read a recommendation to purchase a commodity because it is at or below the cost of production. 8. Improper Inferences Fallacy number 8 might be best explained by citing some examples. First, cattle-on-feed numbers do not necessarily provide an indication of potential future slaughter. reason: cattle on feed do not include grass-fed cattle. as long as grass-fed cattle account for a stable percentage of total slaughter, there is no problem. But if the percentage varies widely over time (as has tended to be the case), the straightforward use of cattle-on-feed numbers to predict slaughter can lead to a totally erroneous con- clusion. if, for instance, high feed prices influence a shift toward increased grass feeding of cattle, the total number of cattle could be higher, even if the cattle-on-feed figure shows a significant reduction. Much market analysis and commentary naively ignores the preceding complication in projecting cattle slaughter. How bad is this error? table 21.1 shows the relationship between percentage changes in cattle on feed and total slaughter. there is a great deal of variability between the two sets of figures. in fact, from 1995 through 2014 there were 34 quarters when the deviation in percentage changes between cattle on feed and total slaughter exceeded 5 percent and seven quarters with deviations greater than 10 percent! it is not an overstatement to say that one can achieve far more accurate slaughter projections using the naive assumption that slaughter in any given quarter will equal the corresponding previous year’s level. this is a clear example of no information being far preferable to incorrectly used information. taBLe 21.1 Percentage Changes in Cattle on Feed Numbers V ersus Percentage Changes in Slaughter Quarter Cattle on Feed as Percentage of Previous Y ear Cattle Slaughter as Percentage of Previous Y ear Discrepancy between two Percentagesa Jan-2015 94.48% 100.98% 6.50% Oct-2014 91.17% 99.49% 8.31% Jul-2014 91.72% 97.61% 5.89% apr-2014 94.14% 99.53% 5.39% Jan-2014 94.77% 94.79% 0.02% Oct-2013 97.01% 92.31% –4.70% Jul-2013 99.85% 96.81% –3.05% apr-2013 100.19% 95.01% –5.18% Jan-2013 96.95% 94.37% –2.58% Oct-2012 98.66% 97.40% –1.26% Jul-2012 95.37% 102.66% 7.28% apr-2012 96.18% 102.00% 5.82% 353 FOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg Quarter Cattle on Feed as Percentage of Previous Y ear Cattle Slaughter as Percentage of Previous Y ear Discrepancy between two Percentagesa Jan-2012 96.53% 103.02% 6.49% Oct-2011 97.00% 104.86% 7.85% Jul-2011 99.84% 103.74% 3.90% apr-2011 99.54% 104.92% 5.39% Jan-2011 101.85% 104.83% 2.99% Oct-2010 105.02% 102.91% –2.10% Jul-2010 102.74% 103.26% 0.52% apr-2010 100.89% 96.46% –4.42% Jan-2010 102.36% 97.99% –4.37% Oct-2009 100.78% 100.57% –0.22% Jul-2009 96.14% 94.73% –1.41% apr-2009 94.99% 95.53% 0.54% Jan-2009 96.44% 92.90% –3.53% Oct-2008 95.30% 94.97% –0.33% Jul-2008 101.84% 95.88% –5.96% apr-2008 102.58% 100.34% –2.24% Jan-2008 101.42% 101.03% –0.39% Oct-2007 103.22% 96.33% –6.89% Jul-2007 99.60% 98.76% –0.84% apr-2007 100.25% 98.58% –1.67% Jan-2007 103.97% 101.44% –2.53% Oct-2006 103.73% 108.61% 4.89% Jul-2006 102.94% 104.60% 1.66% apr-2006 106.22% 108.64% 2.41% Jan-2006 103.25% 104.47% 1.22% Oct-2005 100.45% 99.81% –0.64% Jul-2005 101.69% 102.57% 0.88% apr-2005 97.22% 100.99% 3.77% Jan-2005 96.43% 100.41% 3.98% Oct-2004 98.28% 102.73% 4.45% Jul-2004 87.31% 101.96% 14.65% apr-2004 90.09% 100.33% 10.24% Jan-2004 94.33% 105.58% 11.26% Oct-2003 91.22% 98.05% 6.83% Jul-2003 103.14% 94.62% –8.51% apr-2003 103.37% 92.45% –10.92% Jan-2003 99.29% 91.60% –7.70% Oct-2002 100.62% 93.63% –6.99% taBLe 21.1 (Continued) (Continued) 354 A Complete Guide to the Futures mArket Quarter Cattle on Feed as Percentage of Previous Y ear Cattle Slaughter as Percentage of Previous Y ear Discrepancy between two Percentagesa Jul-2002 103.08% 95.24% –7.84% apr-2002 101.37% 100.47% –0.90% Jan-2002 98.93% 98.03% –0.91% Oct-2001 100.65% 100.99% 0.34% Jul-2001 97.13% 105.89% 8.76% apr-2001 98.22% 102.87% 4.65% Jan-2001 94.41% 102.81% 8.40% Oct-2000 98.64% 107.20% 8.56% Jul-2000 99.18% 108.61% 9.43% apr-2000 100.26% 107.58% 7.33% Jan-2000 103.09% 107.57% 4.48% Oct-1999 102.15% 104.96% 2.81% Jul-1999 102.89% 104.30% 1.41% apr-1999 102.03% 102.63% 0.60% Jan-1999 100.62% 95.63% –4.99% Oct-1998 98.42% 97.83% –0.59% Jul-1998 97.99% 102.27% 4.28% apr-1998 96.69% 97.27% 0.58% Jan-1998 97.54% 105.65% 8.11% Oct-1997 99.57% 112.69% 13.12% Jul-1997 101.46% 114.26% 12.80% apr-1997 97.00% 105.90% 8.90% Jan-1997 99.19% 102.05% 2.86% Oct-1996 100.12% 96.94% –3.17% Jul-1996 98.32% 85.05% –13.27% apr-1996 105.91% 99.50% –6.42% Jan-1996 106.58% 107.92% 1.34% Oct-1995 103.04% 101.63% –1.41% Jul-1995 105.14% 106.00% 0.85% apr-1995 105.48% 100.17% –5.31% Jan-1995 103.14% 94.61% –8.53% avg. (abs) 4.73% Med. (abs) 4.40% Max. (abs) 14.65% Min. (abs) 0.02% Qtrs. w/ abs discrepancy ≥ 5% 34 Qtrs. w/ abs discrepancy ≥ 10% 7 aColumn 2 minus column 3 percentages. taBLe 21.1 (Continued) 355 FOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg another example of an improper inference is provided by the projection of production from acreage figures. a given percentage change in acreage does not necessarily imply a similar change in production (even assuming equivalent yields). For most crops, the distribution of production is a critically important variable. For example, average cotton yields in some states, such as California, are approximately three times as high as average yields in other states, such as texas. although consider- ably more time consuming, production projections should be based on a breakdown of acreage by area (region or state) rather than on a total acreage figure. 9. Comparing Nominal Price Levels it is inaccurate to compare current prices with the actual recorded prices of previous years. in draw- ing comparisons with past seasons, it is necessary to adjust historical prices for inflation. even though u.s. inflation has been subdued since the mid-1980s, over broad periods of time, even low inflation can have a significant cumulative effect. Moreover, in the future, higher inflation levels could recur, making this factor a critical consideration. as an example, assume that an exhaustive survey of the statistical data for commodity x in past years indicates that 1997 and 2003 were very similar to the current season in terms of overall funda- mentals. does this observation imply that current-season prices will be about in line with the price levels of 1997 and 2003? Of course not. in real dollar terms, the prices may be roughly equivalent, but because of the impact of inflation, current nominal prices are likely to be higher. inflation cannot be considered in a vacuum, however. For example, a protracted downshift in demand for most physical commodities (resulting from reduced inventory requirements) begin- ning around 1980 provided a counterbalancing force to inflation. Because demand is very difficult to quantify—as will be discussed in detail in Chapter 22—the net effect is that inflation-adjusted forecasts can be biased to the high side. in other words, ironically, in some cases it is possible that a naive analyst who ignores both demand shifts and inflation adjustments may derive a more accurate forecast than the analyst who adjusts for inflation. such accidental accuracy is likely to be a temporary phenomenon. the correct procedure would be to incorporate inflation adjustments in the model and then infer and include demand shifts in the model as well. 10. Ignoring expectations Markets often place greater emphasis on expectations for the following year (or season) than on pre- vailing fundamentals. this pattern is especially true in transitional periods when the supply situation is moving from surplus to tightness, or vice versa. the 1990 wheat market provided an excellent example. in the 1989–1990 season, the winter wheat crop proved very disappointing because of below-average yields. as a result, carryover stocks (measured as a percent of utilization) fell to their lowest level in 15 years. Moreover, winter wheat seedings for the 1990 crop increased only slightly, thereby seeming to suggest the extension of a tight supply situation into the new season. despite the apparent bullish scenario, wheat prices moved steadily and sharply lower from the very beginning of 1990. this price slide cannot be explained in terms of prevailing fundamentals, but only in terms of expectations. as the year progressed, it became increasingly evident that the 356 A Complete Guide to the Futures mArket 1990–1991 hard red winter wheat crop would result in extremely good yields. as it turned out, the yield of the 1990–1991 winter wheat crop increased by an imposing 16 percent over the previous season’s level, and the percentage of planted acreage harvested rose from 75 percent to 88 percent. as a result of excellent yields and sharply lower acreage abandonment, 1990–1991 winter wheat production increased by a huge 39 percent, despite the fact that planted acreage was only marginally higher, and carryover stocks returned to comfortable levels. although the fundamental transition just described was reflected by data available after mid-spring 1990, during early 1990 such changes would have fallen into the category of expectations. thus, price action in the wheat market during the first half of 1990 provided a classic example of expectations dominating prevailing fundamentals. 11. Ignoring Seasonal Considerations almost every commodity exhibits one or more seasonal patterns. ignoring seasonal factors can easily lead to the misinterpretation of fundamental data. For example, a 5 percent increase in hog slaughter during the fourth quarter relative to the third-quarter level would actually be indicative of a trend toward reduced production—not expanded production. the explanation behind this apparent paradoxical statement lies in the fact that hog production is highly seasonal. Producers breed hogs so that the largest pig crop is born during the spring and the smallest in winter. Because it takes approximately six months for hogs to reach market weight, slaughter tends to be heaviest during the fall and lightest during the summer. thus, it is essential to adjust for the seasonal pro- duction pattern in drawing slaughter comparisons between the current period and the preceding month or quarter. Comparisons of production and consumption figures with the corresponding figures of previous years obviously do not require any consideration of seasonal factors. However, if comparisons of fun- damental data involve different time periods during the year, it is essential to examine historical data carefully for possible seasonal behavior and to make any necessary adjustments. 12. expecting Prices to Conform to target Levels in World trade agreements the history of commodities is replete with examples of world trade agreements that totally failed to achieve their stated goals. trade agreements typically attempt to support prices through export controls and stockpiling plans. although these provisions provide some underlying support to the market and occa- sionally even spark temporary rallies, they are usually not sufficiently restrictive to maintain prices signifi- cantly above equilibrium levels for any extended period of time. the international sugar agreement and the international Cocoa agreement are two examples of world trade agreements that ultimately failed to support prices above the lower end of their respective stated target ranges (in the years when these agree- ments attempted to support prices; they no longer even attempt to do so). Perhaps the most effective price-supporting organization has been the Organization of the Petroleum exporting Countries (OPeC), but even the oil cartel has frequently seen prices fall below their target level—often by a wide margin. it should be noted that world trade agreements are even more impotent in terms of restraining a price advance. in the case in which prices approach the upper end of a target range, the most powerful 357 FOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg action that any agreement could take would be the elimination of all restrictions—in other words, a return to a free market. 13. Drawing Conclusions on the Basis of Insufficient Data sometimes it is virtually impossible to construct a fundamental forecasting model for a market because of a lack of sufficient comparative historical data. a perfect case in point was provided in the august 1972 issue of Commodities magazine (now called Modern T rader), which ran a detailed study of fundamentals in the cotton market. the article ultimately came to the valid conclusion that only two seasons since 1953 could truly be termed free markets. as the article explained, during the 1950s and 1960s, government programs had maintained cotton prices above the levels that would have been realized had prices been determined by the interaction of supply and demand. so far, so good. the proper and very worthwhile conclusion would have been that existing data were insufficient to permit the use of fundamentals in forecasting prices. after all, how can you interpret the price impli- cations of a projected statistical balance if there are only two previous years to use as a comparison? unfortunately, the author went on to sketch an entire set of price forecasting conclusions on the basis of admittedly very limited relevant information. Quoting the first item, “Final stock levels under 3½ million bales imply a very tight supply situation and suggest a likelihood of a price rise well above 30¢ in such seasons.” although this statement certainly proved true, by implication it severely understated the upside potential in the cotton market. Only a little more than one year after the article was published, cotton prices reached an all-time peak of 99¢/lb. incidentally, i was the author of that article. 14. Confusing the Concepts of Demand and Consumption demand is probably one of the two most misused words in futures literature and analysis (parameter being the other; see Chapter 19). the confusion between demand and consumption is not a matter of semantics; the two terms represent very different concepts, and their frequent interchangeable use leads to many major analytical errors. an adequate explanation of this statement requires a diversion into a short review of basic supply-demand theory, which is the subject of the next chapter. at this point, it might be instructive to return to the five scenes depicted at the beginning of this chapter to try to determine which of the 14 fallacies were responsible for the incorrect trading con- clusions. Note that each scene reflects two or more fallacies. the answers can be found in table 21.2. taBLe 21.2 Fallacies Committed in the Five Scenes Scene Fallaciesa 1 4, 5, 10 2 1, 3, 4 3 2, 4 4 9, 10 5 7 athe inclusion of additional items is not necessarily incorrect. Other fallacies might also be applicable (e.g., fallacy number 1 in any of the scenes), but are not listed because the text provides insufficient information to make such a determination. 359There are in the fields of economics no consistent relations, and consequently, no measurement is possible. —Ludwig Edler von Mises ■ Supply and Demand Defined Supply curves slope upward, meaning more is offered to the market at higher prices (Figure 22.1). 1 Assuming that the time unit shown on the horizontal axis in Figure 22.1 equals one season, the sup- ply that can be offered to the market will be limited to total production plus stocks, regardless of the price. At high prices, however, producers will be willing to hold smaller inventories and therefore offer greater quantities to the market. Conversely, at lower prices, producers will prefer to store Supply-Demand Analysis: Basic Economic Theory Chapter 22 1 The supply and demand curves in this section are drawn as straight lines for simplicity of exposition. It also seemed desirable to avoid the unnecessary digression of discussing the factors that determine the precise shapes of these curves. Although the straight-line assumption may often be adequate within normal boundaries, supply and demand curves will not be linear over the entire price range. For example, as prices rise and the quantity consumed declines, it will usually take greater and greater increases in price to induce a given further reduction in the amount consumed. As another example, over the short run, at some point the supply curve must begin to rise asymptotically, since the supply offered to the market cannot exceed the existing total supply (i.e., stocks plus current production). 360A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  22.1 Supply Curve Quantity (per unit time) Price larger quantities rather than marketing their goods at prevailing depressed levels. The slope of the supply curve will refl ect this tradeoff between the options of sale and storage. 2 For perishable (e.g., eggs, potatoes 3 ) or nonstorable (e.g., cattle, hogs) commodities, supply is approximately fi xed and can be represented by a vertical line (Figure 22.2 ). For example, if a supply curve is drawn for the hog market for a time unit of one-half year, the amount off ered to the market during that period will be relatively independent of market prices. Low prices will not reduce the quantity supplied, because once hogs reach market weight, with the exception of temporary delays, producers have little choice but to bring those hogs to market, regardless of the price. However, since there is a lag of nearly one year between producers’ breeding decisions and the time that resulting 2 For longer time units (e.g., 10 years), the supply curve will also refl ect the potential for an expansion in pro- duction beyond current levels. For example, high prices may encourage shifts in acreage to the high-priced com- modity and increased usage of fertilizer in new crops. From the vantage point of futures trading, however, it is most useful to limit the discussion of supply and demand to short time units (i.e., season or fraction of a season). 3 These commodities are no longer traded as futures markets, but provide perfect illustrations of perishable goods. FIGURE  22.2 Fixed Supply Quantity (per unit time) Price 361 SUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY off spring reach market weight, high prices cannot induce an increase in the quantity supplied. In fact, if anything, the supply curve in such a market exhibits a perverse behavior; that is, high prices will reduce the quantity supplied. The reason is that high prices will infl uence producers to withhold hogs from the market for breeding, thereby reducing current supplies. However, for simplicity’s sake, we will assume a vertical supply curve in the case of perishable or nonstorable commodities. Demand can be defi ned as a schedule of the various quantities of a commodity that will be con- sumed at each price level. In a sense, demand is a barometer of consumer buying pressure. Demand curves slope downward, meaning more will be demanded at lower prices (Figure 22.3 ). Elasticity of demand can be defi ned as the percentage increase in the amount demanded divided by the percentage decrease in price. If the demand for a commodity is inelastic, it means that a relatively large percentage change in price will only induce a small percentage change in the amount demanded. Figure 22.4 presents illustrations of elastic and inelastic demand curves. 4 The elasticity of demand is primarily determined by two basic factors: 1. availability of substitutes. The elasticity of demand will vary directly with the availability of substitutes. For example, the demand for salt is highly inelastic, but the demand for a given brand of salt is very elastic. 2. percentage of total income spent on the good. The elasticity of demand will vary directly with the percentage of expenditures allocated to a good. For example, the demand for automobiles is far more elastic than the demand for salt, even though there are no close substitutes for either item. Generally speaking, the demand curves for most commodities tend to be inelastic; that is, a given percentage change in price will induce a smaller opposite percentage change in the amount demanded. This is a signifi cant consideration, since prices of goods with inelastic demand curves are more subject to wide price swings in times of shortage. FIGURE  22.3 Demand Curve Quantity (per unit time) Price 4 Elasticity is not constant along each demand curve. Elasticity is a concept that relates to a given point, not to the entire curve. As we move rightward along a line or demand curve (in both the elastic and inelastic cases), the elasticity of demand will decrease, since any given change in price will represent a larger percentage change, and will infl uence the same absolute, but smaller percentage, change in the quantity demanded. In other words, as can be verifi ed in Figure 22.4 , rightward movement along the demand curve will increase the denominator and decrease the numerator of the elasticity of demand. 362A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  22.4 Elasticity of Demand Quantity (per unit time) Price ELASTIC INELASTIC A B OC D Quantity (per unit time) CD= OD AB OB Price A B OC D ■ The Problem of Quantifying Demand As all students of Economics 101 know , price is determined by the intersection of the supply and demand curves (Figure 22.5 ). However, there is one major problem in using supply-demand analysis to project prices: Demand is not readily quantifi able—that is, there is no way of determining how much will be consumed at any given price level. Whereas in most cases supply can be either approxi- mately fi xed as in the case of perishable and nonstorable commodities, or at least roughly estimated using production and stock statistics, 5 demand is entirely intangible. It is hardly feasible to query all 5 The precious metal markets provide an important exception. See the section, Why Traditional Fundamental Analysis Doesn’t W ork in the Gold Market, at the end of this chapter. 363 SUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY FIGURE  22.5 Equilibrium Quantity (per unit time) Price Supply Demand P OQ potential consumers as to the amount of a good they would purchase at various price levels. Even if a sampling procedure were used—presumably an impractical and prohibitively expensive approach for the analyst—there is no reason to assume that consumers could even describe their demand curves. The only theoretically acceptable means of quantifying demand is to infer demand curves through a detailed analysis of historical consumption and price data. Although this is an easy task if demand is relatively stable, unfortunately, it is either diffi cult or impossible if demand is subject to frequent wide shifts. ■ Understanding the Difference between Consumption and Demand Perhaps the most commonly employed solution to the problem of quantifying demand is the use of consumption as a proxy for demand. This approach, however, has one major drawback: It is totally incorrect. The synonymous use of consumption and demand represents a confusion of two entirely diff erent concepts. Consumption is the amount of a good used and is determined by price, which in turn is determined by supply and demand factors. Demand refers to the amount of a good that will be used at any given price level and, along with supply, determines price. An increase in demand means that more will be consumed at any given price level (Figure 22.6 ). Factors that might aff ect demand include disposable income, consumer tastes, and the price of substi- tute goods but, by defi nition, not price. For most commodities, a rise in disposable income will result in an increase in demand; that is, at each given price, more will be consumed than before. A price decline will lead to increased consumption, showing movement along the same demand curve, but it does not imply anything about demand. In other words, all else being equal, the same amount will be consumed at each given price level unless there is a change in demand. 364A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  22.6 Increase in Demand Quantity (per unit time) Price Figure 22.7 summarizes the relationship between demand and consumption. Consumption (i.e., the amount consumed) is directly dependent on price, where price is determined by the interaction of supply and demand. The key point to keep in mind: Consumption is a consequence of price, not a determinant of price. Thus the concept that consumption mirrors demand is totally erroneous; con- sumption is determined by both supply and demand. FIGURE  22.7 Supply-Demand Interaction Production Stock levels Marketing policy (the percentage of total supply which will be offered at each given price)* Cunsumer tastes Level of disposable income Inflation *For perishable of nonstorable commodities, such as hogs and cattle, the entire amount will be offered during the season, regardless of price level. In this case, supply for the season is fixed, that is, equal to total production. Population size Price of substitute goods Means influences Supply Demand Price Consumption 365 SUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY In fact, for perishable and nonstorable commodities, consumption primarily refl ects supply, not demand. For example, assume that pork consumption has increased sharply. Does this mean that pork demand has suddenly improved dramatically? Absolutely not. The consumption increase is merely the result of increased hog slaughter. Recalling that the supply curve for hogs (and therefore pork) can be approximated by a vertical line, Figure 22.8 demonstrates the consumption level will be determined by supply and will be the same, no matter which demand curve prevails. Thus, an increase in con- sumption would merely refl ect an increase, or rightward shift, in supply—a bearish development— and not an increase in demand, which would be a bullish development. It is entirely possible for a demand increase and a consumption decrease to occur simultaneously. Figure 22.9 illustrates how this is possible for both the variable supply and fi xed supply cases. At the FIGURE  22.8 Consumption Refl ects Supply (in Fixed Supply Case) Quantity (per unit time) OQ Supply Demand curves Price FIGURE  22.9 Higher Demand, Lower Consumption: Variable Supply (a) and Fixed Supply (b) Quantity (per unit time) (a) Quantity (per unit time) (b) OO BA BA 1 1 1 1 2 2 2 2 Price Price 366 A Complete Guide to the Futures mArket start, in period 1, the equilibrium consumption level is at point A. Although demand increases in period 2, the equilibrium consumption level declines to B as a result of the decline in supply. Even the U.S. Department of Agriculture (USDA), one of the nation’s leading employers of econ- omists, has misused the term demand. The popularly termed supply-demand reports are in reality sup- ply-disappearance reports (with disappearance defined as total domestic consumption plus exports). Quite frequently, when the USDA changes its estimates for items that are sometimes discussed under the label of “demand” (domestic consumption, exports), 6 the revision reflects a change in sup- ply, not demand. For example, if the projected carryover for a commodity is already at estimated minimum pipeline requirements, a reduced production forecast will mean that the USDA has to lower either the domestic consumption estimate, the export estimate, or both. Otherwise, the USDA might find itself in the absurd position of projecting a near-zero or even negative carryover. However, the key point is that such revisions do not imply that demand has been reduced—a bearish conclu- sion—but rather that high prices will ration scarce supplies, thereby resulting in reduced usage. ■ The Need to Incorporate Demand Because of the difficulties involved in quantifying demand, there is often a temptation to concentrate solely on supply factors in constructing a fundamental price-forecasting model. This can be a grave error, because a demand shift can often be the dominant force in a major price move. The 1980–1982 copper market provided a classic example of the dangers of ignoring demand. T o focus in on this example, we will examine a 21-year segment of the copper market (1973–1993) that contains three major bull-bear price cycles, with the bear phase of the middle cycle containing the 1980–1982 mar- ket that is the center of our attention. Consider the following copper price-forecasting model: Pf S C=     where P = average deflated copper price during the period S = copper stock level (U.S. plus foreign refined copper stocks) C = copper consumption level during the period (annualized refined copper deliveries, United States plus foreign) f( ) is read as “is a function of,” which basically means “is dependent on.” At surface glance, this model seems reasonably plausible. In essence, the model implies that prices will be low when copper stocks are large relative to the usage level and high in the reverse case. This model certainly seems logical enough. Figure 22.10, which illustrates the relationship between cop- per prices and the stock/consumption ratio during a 21-year segment (1973–1993) that is centered near the 1980–1982 bear market that we wish to focus on, appears to confirm this expected market behavior. The strong inverse correlation between the stock/consumption ratio and copper prices is 6 USDA report tables, however, correctly label these items as components of “disappearance.” 367 SUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY FIGURE  22.10 Average Monthly Copper Nearest Futures Price vs. Copper Stock/Consumption Ratio Jan-73 20 40 60 80 ¢/Lb. Ratio 100 120 140 160 180 0 4 10 15 20 25 30 35 40 Jul-73 Jan-74 Jul-74 Jan-75 Jul-75 Jan-76 Jul-76 Jan-77 Jul-77 Jan-78 Jul-78 Jan-79 Jul-79 Jan-80 Jul-80 Jan-81 Jul-81 Jan-82 Jul-82 Jan-83 Jul-83 Jan-84 Jul-84 Jan-85 Jul-85 Jan-86 Jul-86 Jan-87 Jul-87 Jan-88 Jul-88 Jan-89 Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Price broadly evident across the entire period shown. However, note the seemingly puzzling 1980 to mid- 1982 price behavior. During this period, prices plunged dramatically despite a slide in the stock/ consumption ratio to a major low . How can this counter-to-expected price action be explained? There is no mystery. Although the stock/consumption ratio is an important price-infl uencing factor, it only refl ects supply. The apparent paradoxical behavior from 1980 to mid-1982 is explained by the fact that the model does not incorporate demand. During this period, the anticipation and ultimate realization of a severe recession combined with high real interest rates (interest rate minus infl ation rate) drastically reduced the inventories users wished to hold at each given price level. In other words, there was a sharp downward shift in the demand curve. This crucial fundamental devel- opment simply could not be refl ected by the model just described. The moral is that it is always necessary to take demand into account. The next section discusses several methods for incorporating demand in the price-forecasting model. But even when this type of analysis is not possible, demand must still be considered. If demand is not part of the model because of the inherent diffi culties in quantifying demand, then the analysis should be divided into two steps: 1. Model projection 2. Informal evaluation of the potential impact of demand factors 368 A Complete Guide to the Futures mArket ■ Possible Methods for Incorporating Demand How can the problem of nonquantifiable demand be circumvented? The answer depends on the mar- ket. The following types of markets permit various solutions to the problem of quantifying demand: Stable Demand For some markets, the supposition that demand is stable is a reasonable simplifying assumption. In effect, in this type of market, fundamental price forecasts can be based strictly on supply statistics. Growth pattern in Demand Change For other markets, although demand changes from year to year, the pattern of change can be described by a simplified assumption (e.g., demand increases by 3 percent annually). For markets of this type, demand can be represented by an index that changes in a manner consistent with the assumed growth pattern for demand. Identification of Demand-Influencing Variables For some markets, although changes in demand cannot be described by any consistent growth pat- tern, the factors that affect demand can be identified. For example, beef demand increases in some years and decreases in others. Nevertheless, it can easily be demonstrated that these shifts are depen- dent on other identifiable factors, such as availability of competitive meat supplies. In such cases, one can bypass the problem of precisely specifying the demand curve by directly formulating a price- forecasting model that uses supply statistics and the factors determining demand as inputs. An exam- ple of such a model is given by the following equation: QCPf CS HS BS T= (, ,, ) where QCP = average quarterly cattle price CS = quarterly cattle slaughter HS = quarterly hog slaughter BS = quarterly broiler slaughter T = time trend In the preceding example, CS represents a supply variable, while HS, BS, and T represent variables that affect demand. Trend affects demand through inflation (more will be demanded at each nominal price level because of inflation) and possible other factors that have a trending characteristic. As another example, in attempting to forecast copper prices, one of the ways we could incorpo- rate the demand effect would be by focusing on the level of activity in the key copper-using indus- tries. Figure 22.11 illustrates the relationship between copper prices and an index of new housing for the same 21-year period that was surveyed in Figure 22.10. Figure 22.12 illustrates the rela- tionship between copper prices and domestic auto sales during the same period. Note how the 369 SUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY FIGURE  22.11 Average Monthly Copper Nearest Futures Price vs. Index of New Private Housing Jan-73 20 40 60 80 ¢/Lb. Index 100 120 140 160 180 40 60 80 100 120 140 160 180 200 Jul-73 Jan-74 Jul-74 Jan-75 Jul-75 Jan-76 Jul-76 Jan-77 Jul-77 Jan-78 Jul-78 Jan-79 Jul-79 Jan-80 Jul-80 Jan-81 Jul-81 Jan-82 Jul-82 Jan-83 Jul-83 Jan-84 Jul-84 Jan-85 Jul-85 Jan-86 Jul-86 Jan-87 Jul-87 Jan-88 Jul-88 Jan-89 Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Price Index FIGURE  22.12 Average Monthly Copper Nearest Futures Price vs. Annualized Seasonally Adjusted Auto Sales Jan-73 Jul-73 Jan-74 Jul-74 Jan-75 Jul-75 Jan-76 Jul-76 Jan-77 Jul-77 Jan-78 Jul-78 Jan-79 Jul-79 Jan-80 Jul-80 Jan-81 Jul-81 Jan-82 Jul-82 Jan-83 Jul-83 Jan-84 Jul-84 Jan-85 Jul-85 Jan-86 Jul-86 Jan-87 Jul-87 Jan-88 Jul-88 Jan-89 Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 4 5 6 7 8 9 10 Price 11 12 20 40 60 80 100 ¢/Ld. 120 140 160 180 Million Sales 370A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE  22.13 Consumption as Proxy for Inelastic Demand Quantity (per unit time) Price S1 S1 S2 S2 D1 D2 D3 D4 D1 D2 D3 D4 declines in housing starts and automobile sales preceded downturns in copper prices, including the 1980 to mid-1982 decline. Recall from the previous section that the imposing 1980 to mid-1982 bear market seemed somewhat puzzling when viewed solely relative to the stock/consumption ratio. Figure 22.11 and 22.12 illustrate how this seeming paradox can be resolved once demand factors are considered. Of course, the specifi c demand factors included would change over time. For example, our copper illustration focused on the 1973–1993 time segment. In a current copper price model, indicators of emerging market demand would be far more critical than they were then. highly Inelastic Demand (and Supply elastic relative to Demand) Although conceptually incorrect, practically speaking, for markets of this type it is possible to use consumption as a proxy for demand. Since by defi nition in these markets consumption in a given year will not vary widely, regardless of price level, one can assume the prevailing consumption level roughly refl ects the demand level. For example, Figure 22.13 illustrates a series of inelastic demand curves and two diff erent supply curves. Note how the quantity consumed at the equilibrium price level is primarily dependent on the prevailing demand curve. Hence, consumption can serve as a proxy indicator for the unknown demand curve. 371 Supply -DemanD analySiS: BaSic economic Theory An example of this approach is provided by the following model: DASP f IS P C= +    where DASP = deflated average annual sugar price IS = initial stocks P = production C = consumption Note that initial stocks plus production is a proxy for supply, and consumption is a proxy for demand. ■ Why Traditional Fundamental Analysis Doesn’t Work in the Gold Market Unfortunately, the approaches we have enumerated for dealing with the elusiveness of demand do not encompass all cases. For some markets, not only is demand highly erratic, it is also difficult or nearly impossible to define a stable relationship that describes the precise dependence of demand on other variables. Gold is a perfect example of such a market. Gold demand is basically dependent on the market’s psychological perception of the value of gold, which in turn is dependent on a myriad of interrelated variables, including relative inflation rates, world interest rates, currency fluctuations, trade balance figures, OPEC actions, and political turmoil. The problem of specifying gold demand is further com- plicated by the fact that the relative importance of any of these factors in influencing gold demand is subject to considerable variation. For example, during some periods, currency fluctuations may become the pivotal price-influencing factor, while at other times developments in this area exert only a minor price impact. In the case of gold, even the supply side of the equation cannot be readily approximated. Similar to demand, supply is subject to wide, erratic shifts that are also dependent on market psychology. This instability of the supply curve is primarily attributable to shifts in dishoarding rather than to changes in commercial supply. The combination of highly erratic, intangible supply and demand curves makes the gold market a fundamental analyst’s nightmare. Some analysts attempt to construct a fundamental model for gold by focusing on such statistics as mine production and industrial usage. This approach represents true folly, since these figures are equal to only a minuscule fraction of total gold supply. Gold prices are dependent on the psychological considerations detailed earlier, and there is no way to avoid this fact. In effect, for a market such as gold, the traditional fundamental approach just does not work. Constructing an econometric model to predict gold prices is like trying to write a computer program that will predict a photographer’s next picture on the basis of her past shots—the answer may be somewhat better than a blind guess but is hardly worth the effort. 373 Chapter 23 Types of Fundamental Analysis When you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind: it may be the beginnings of knowledge, but you have scarcely, in your thoughts, advanced to the stage of science. —William Thomson, Lord Kelvin ■ The “Old Hand” Approach The “old hand” approach refers to the analytical method used by analysts whose familiarity with the market is so finely honed that they have developed a virtual sixth sense with respect to its price fluctuations. By talking to a variety of commercial participants, they get a feel for market tone. They are also well tuned in to the flow of market news and are constantly assessing the market’s behavior in response to this information. This is strictly a nonscientific approach, with the individual acting as the computer. It is not intrinsically inferior to more sophisticated approaches; its value is strictly dependent on the skills and intuition of the practitioner. In fact, it is hardly unusual for some analysts of this school to consistently outperform their econometrically oriented counterparts. This approach is strictly individualistic, however, and by definition can only be acquired by personal experience. ■ The Balance Table The balance table summarizes the key components of current-season supply and disappearance, along with prior-season comparisons. The balance between supply and disappearance will indicate a season- ending carryover; it is the relative magnitude of this figure that is considered the primary price- determining statistic. Table 23.1 illustrates a U.S. Department of Agriculture (USDA) balance table 374 A Complete Guide to the Futures mArket table 23.1 U.S. Wheat Supply/Disappearance balance, June–May Crop Y ear (million bushels) 1988–1989 1989–1990 1990–1991 1991–1992 1992–1993 1993–1994 a Beginning stocks 1,261 702 536 366 472 529 Imports 23 23 37 41 70 75 Production 1,812 2,037 2,736 1,981 2,459 2,493 total supply 3,096 2,762 3,309 2,888 3,001 3,097 Food use 726 749 786 789 829 845 Seed use 103 100 90 94 93 94 Feed/Residual 146 143 500 254 196 325 T otal domestic use 975 992 1,376 1,137 1,118 1,264 Exports 1,419 1,233 1,068 1,280 1,354 1,125 total disappearance 2,394 2,225 2,444 2,416 2,472 2,389 ending stocks 702 536 866 472 529 708 Ending stocks as % of total use 29 24 35 20 21 30 aProjected. Source: USDA. for the wheat market. The analyst who relies heavily on the balance table will focus on possible shifts in the various components of supply and disappearance in an effort to anticipate the probable direc- tion of price change. The balance table is a valuable aid that succinctly summarizes the key market statistics. By itself, however, the balance table is insufficient in answering the critical question of what price is right under the given conditions. In fact, the analyst who uses only the balance-table approach to forecast prices will be guilty of fallacy number 1 detailed in Chapter 21 (i.e., viewing fundamentals in a vacuum). ■ The Analogous Season Method In the analogous season method, the analyst finds past seasons that shared the same fundamental charac- teristics of a current season and then uses the price profiles of those analogous seasons as a “road map” in projecting current season price swings. For example, if in the current season production is up, usage is down, and the ending stocks/usage ratio is down, the analyst might find all past seasons that also exhibited these conditions. Next, the analyst would identify key price turning points in the analo- gous seasons (e.g., harvest low , postharvest high, winter low , crop-scare high). The timing and relative magnitude of price swings between these key turning points would then be calculated for each past analogous season. Finally, price swing ranges and turning point time windows would be projected for the current season, based on the assumption that the current season price patterns would be at least roughly similar to the price action of prior analogous seasons. 375 TyPES oF FUNDAMENTAL ANALySIS ■ Regression Analysis How can you determine which fundamental factors are most important in determining price levels? Even assuming you can make a reasonable conjecture as to what are the key fundamental factors influencing prices, how can you translate the current levels of these factors into a price forecast? Say, for example, you are trying to forecast hog futures prices. you assume that hog prices will be inversely correlated with hog slaughter levels and also inversely correlated with competitive meat supplies (e.g., broiler slaughter, cattle slaughter). you also assume that for any combination of supply levels for these various meats, prices will be higher in the current year than in past years because of the influence of inflation. Even if all these assumptions are correct, how can you determine the price implications for any given combination of the various meat supplies? Simply comparing current supply levels to past year levels will not yield any price forecast. For example, what are the price implications of hog slaughter being 3 percent lower than in some prior year while broiler slaughter and cattle slaughter are each 2 percent higher? How does one reconcile the multiple comparisons of the current year to each of the past years examined? How much differ- ence does a given time separation make when drawing comparisons between different years? All of these questions seem impossible to answer by simply comparing current and past data. Regression analysis provides a statistical procedure that can be used to translate fundamental data into price projections. The assumptions we just made regarding the plausible key influences on hog prices could be formalized into the following equation: Pa bH bB bC bT=+ ++ +12 34 where P = average price H = hog slaughter B = broiler slaughter C = cattle slaughter T = time trend The values of a, b1, b2, b3, and b4 are determined by the regression analysis procedure (explained in the appendices). Given projections for hog slaughter, broiler slaughter, and cattle slaughter, we can plug those values and the time trend value for the current year into the preceding equation and obtain a precise price forecast. Even if you are not mathematically inclined, think twice before dismissing the regression-analysis approach. Regression analysis embeds a number of important attributes: 1. Regression analysis makes it possible to combine multiple fundamental inputs, compared across multiple years, to derive a price forecast. 2. Regression analysis can be used to test the relative significance of each of the price-influencing variables (called independent variables) as well as the forecasting equation as a whole. 3. Regression analysis provides an efficient learning tool for understanding the interrelationships between various fundamental factors and price. 376 A Complete Guide to the Futures mArket Regression analysis is probably the single most useful analytical tool in fundamental analysis. Appendices A through F provide an in-depth discussion of regression analysis. ■ Index Models Sometimes we may wish to construct a fundamental model that uses scores of explanatory variables as indicators of a market’s price. For example, we might postulate that bond prices are inversely related to a variety of inflation indicators (e.g., gold prices, S&P Goldman Sachs Commodity Index, con- sumer price index), economic indicators (e.g., employment, industrial production, housing starts), and monetary indicators (e.g., yield spread). Given the wide range of such indicators, and allowing that each indicator can be used with multiple time lags (as the relationship between bond rates and an indicator will frequently not be contemporaneous), it is easy to see how the number of possible explanatory variables could reach 50 or even higher. Regression analysis cannot handle situations that involve large numbers of explanatory (inde- pendent) variables. Typically, a regression equation will employ five or fewer independent variables. There are two primary reasons why regression analysis cannot be applied to cases involving a multi- tude of variables: 1. If large numbers of independent variables are used, there is a great danger of overfitting (i.e., deriving a model that is tailored to fit past data but will be useless as a tool for projecting future prices or price trends). 2. When large numbers of independent variables are employed it is virtually inevitable that a num- ber of such variables will be closely related to each other. High correlations among independent variables in a regression model will result in a statistical problem called multicollinearity, which destroys the reliability of the derived forecasting equation. (This problem is discussed in greater detail in Appendix E.) one method of handling a large number of explanatory variables is to combine them all in an index model. The following step-by-step approach illustrates one possible procedure: 1. Assign each indicator a value of +1 if its current status is considered bullish for the price of the given market and a value of −1 if it is considered bearish. (How such a determination is made will be discussed momentarily.) 2. Add all the assigned indicator values to obtain an index value. 3. Normalize the index by multiplying by 100 divided by number of indicators. This step will yield an index with a theoretical range of −100 (if all the indicators are bearish) to +100 (if all the indicators are bullish). For example, if there are 50 indicators, and 30 are bullish and 20 bearish, the preceding procedure would yield a normalized index value of +20. of course, an equal split between bullish and bearish indicators would yield an index value of 0, as is intuitively desirable. This procedure sounds simple enough. The key question, however, is: how does one determine if a current indicator value is bullish or bearish? Deciding on some value as the division line between 377 TyPES oF FUNDAMENTAL ANALySIS bullish and bearish values is highly undesirable for two key reasons: (1) many variables trend over time; and (2) due to structural changes over time, the definition of “high” and “low” will tend to shift for many, if not most, variables. Hence, it is far more practical to categorize a variable as bullish or bearish based on its direction of movement (i.e., trend) rather than its level. Trend categorization, however, falls more within the realm of technical analysis than fundamental analysis. Indeed, some of the very basic tools of technical analysis (e.g., crossover moving average) can be applied to defining the assigned indicator values in an index model of the type described in this section. For example, if using a crossover moving average to define the trend direction of the indicators, an indicator would be assigned a value of +1 if the short-term moving average was greater than the long-term moving average, and a value of −1 in the reverse case. 379 Chapter 24 The Role of Expectations What we anticipate seldom occurs; what we least expect generally happens. —Benjamin Disraeli ■ Using Prior-Year Estimates Rather Than Revised Statistics Historical data are based on final revised estimates rather than the estimates that were available at the time. For example, the historical levels of U.S. corn production are revised throughout the season with the final revision occurring after the end of the season. These final revised estimates for each season (the actual levels) can differ substantially from the crop estimates that prevailed during each season (the expected levels). Similarly, historical corn consumption and export levels (the actual levels based on final revised estimates) can be very different from the expected levels that prevailed during each season. Typically, fundamental models would use actual historical data as inputs. But is this default approach the best procedure? A strong argument can be made that the data levels expected at the time are more relevant to explaining price behavior than actual data levels that only became known after the price forecast period in question. Thus, it may be possible to build a more accurate model using past estimates rather than actual statistics as the price-explanatory variables. For example, if we are trying to construct a model to explain and predict September–November corn prices, we might well find that the past production and usage estimates released during the September–November period are more helpful than the actual supply statistics in explaining the year-to-year historical variation in September–November prices. Such price behavior would merely reflect that what the market thought was true in the past was more important in determining prices than what was actually true (as defined by the final revised estimates)—a reasonable outcome given that market participants have no way of determining actual statistics and must rely on prevailing estimates for their marketing, purchasing, and trading decisions. The key point is that using past expected data rather than actual statistics might be theoretically sounder and may well yield better price-forecasting models. Of course, using past expected statistics in 380 A Complete Guide to the Futures mArket a model will require considerably more work in terms of data gathering, which may explain why such data are far less frequently used than the final revised numbers. As is true for most of life’s endeavors, creating a better product (price-forecasting model in this case) requires more effort. There are no shortcuts in doing things right. ■ Adding Expectations as a Variable in the Price-Forecasting Model Thus far, we have discussed the choice between using anticipated versus actual data for explaining past price variation. Regardless of which is used, one can also consider adding a variable to represent expectations for a key statistic in a following season. T o clarify this distinction, we list the four possible variations in the extent to which expectations are incorporated in a model: 1. Price is a function of concurrent-season actual statistics (no use of expectations). 2. Price is a function of estimates for concurrent-season statistics (expectations used for concurrent- season data). 3. Price is a function of concurrent-season actual statistics and expectations for the following sea- son (expectations used for following-season data). 4. Price is a function of concurrent-season estimates and expectations for the following season (expectations used for both concurrent- and following-season data). The expectations for a coming season can often exert a more pronounced price impact than do prevailing fundamentals. This observation is especially true during the latter half of a season—a time at which the fundamentals for the given season are usually well defined and not subject to large variation. In fact, frequently, when there is a dichotomy between the implications of old-crop funda- mentals and new-crop expectations, the latter tend to dominate the price picture. Why should expectations for a coming season affect current-season prices? Expectations influence current selling and buying psychology. For example, if supplies are burdensome and a shift toward supply tightness is anticipated, sellers will have an incentive to hold back the commodity and will offer less to the market at each given price level (the supply curve will shift upward in response to reduced supply). At the same time, buyers will attempt to build inventories and therefore will pur- chase increased quantities at any given price level (the demand curve will shift upward). These two effects reinforce each other, and the net result will be higher prices in the current season. ■ The Influence of Expectations on Actual Statistics Ironically, bullish new-crop expectations can actually cause current-season fundamentals to appear more bearish. The following cause-and-effect diagram illustrates this point: Bullish expectations forn ew crop pr iced uringo ld-c rops eason o →↑ → lld-crop consumpt iona nd export so ld-c rops tock s↓→ ↑ 381 THE ROlE OF ExPEcTATIONS As a result of this string of events, seasons that experience bullish new-crop expectations are likely to appear inexplicably overpriced based on old-crop fundamentals—another reason why new-crop expectations should be incorporated in the price-forecasting model wherever possible. ■ Defining New-Crop Expectations On the supply side, new-crop expectations can be based on planting intentions and subsequently on acreage estimates. In using these estimates to define expectations, one usually assumes a trend yield (the yield implied by a regression-derived best-fit line of past yields) or an average yield (e.g., five- year average for each state or region) if there is no pronounced trend. Such neutral projections would then be adjusted upward in the case of very favorable growing weather, or downward if conditions were adverse. On the usage side, expectations are defined by the historical behavior pattern. For example, if in recent years consumption changes for a given commodity have tended to range from −2 percent to +4 percent, as a function of the direction and magnitude of price change, in the absence of any additional information, one might use a 1 percent consumption increase as a representative figure for expected new-crop consumption. Historical expectation statistics can be generated in a similar manner or by surveying past com- mentaries in U.S. Department of Agriculture situation reports, trade reports, and industry market reports. Unfortunately, there is some unavoidable arbitrariness in the latter approach, since the expec- tation figures depend on the sources chosen and on the weights assigned to each source. However, this ambiguity is not a critical drawback, since at any given time, new-crop projections by various sources tend to cluster in the same general area. 383Nothing so weakens government as persistent inflation. —John Kenneth Galbraith I n designing price-forecasting models, it is essential to keep in mind that the measure of prices—the dollar—is itself a variable. Thus, using nominal prices to compare widely separated years makes as much sense as comparing the dollar price of a commodity in one season to the euro price in another season. It is safe to say that any model that does not adjust for inflation is critically flawed. Figures 25.1 through 25.4 illustrate the difference between nominal and inflation-adjusted prices in different futures markets from 1995 to 2015. These charts illustrate that adjusting for the effect of inflation can alter the relationship between past highs and lows, as well as the relative magnitudes of prior past moves. For example, in Figure 25.1, the 2004 highs in lumber nearest futures were above the 1996 and 1999 highs in nominal terms (solid line), but lower than these previous peaks on an inflation-adjusted basis (dashed line). In Figure 25.2, in March 2004 soybean nearest futures eclipsed their March 1997 high on a nominal basis, but the inflation-adjusted series made a lower high in March 2004. Figure 25.3 compares nominal and inflation-adjusted copper nearest futures. Successively higher highs in 2007 and 2008 in the nominal series were slightly lower highs in the deflated series. Also note that although nominal prices were substantially higher at the end of the period than at the start, inflation-adjusted prices were near unchanged for period as a whole. Finally, in Figure 25.4, the nominal price graph reflects a strong uptrend in live cattle prices dur- ing 1995 through 2011 (the sharp correction in 2008 notwithstanding), while the inflation-adjusted Incorporating Inflation Chapter 25 384A CoMPlETE GUIDE To THE FUTUrES MArKET FIGURE /uni00A025.1 lumber: Nearest Futures, Nominal vs. Defl ated by PPI* *Monthly closing prices defl ated by PPI indexed to June 2005 = 100. FIGURE /uni00A025.2 Soybeans: Nearest Futures, Nominal vs. Defl ated by PPI* *Monthly closing prices defl ated by PPI indexed to June 2005 = 100. 385 INCorPorATING INFlATIoN FIGURE /uni00A025.3 Copper: Nearest Futures, Nominal vs. Defl ated by PPI* *Monthly closing prices defl ated by PPI indexed to June 2005 = 100. FIGURE /uni00A025.4 live Cattle: Monthly Nearest Futures, Nominal V ersus Defl ated by PPI* *Monthly closing prices defl ated by PPI indexed to June 2005 = 100. 386 A Complete Guide to the Futures mArket price series moved essentially sideways during the same period, with little net change for the period as a whole. In other words, the entire rise in nominal prices during this 17-year period was nothing more than the inflation effect. Some of the ways inflation can be incorporated into the price-forecasting model include the fol- lowing: 1. A representative inflation index is chosen, such as the producer price index (PPI), consumer price index (CPI), or the gross domestic product (GDP) deflator, and each historical price is divided by the contemporaneous index value, yielding a deflated price series. (Actually, the reported index value is divided by 100, since the index figures are quoted as a percent of a base of 100.) The inflation-adjusted price series in Figure 25.1 through 25.4 were deflated in this manner, using monthly PPI data with June 2005 as the base month (i.e., June 2005 PPI = 100). Table 25.1 applies this method to corn futures price data. A price forecast derived using this approach would be translated into current dollar terms by multiplying the projection by an estimate of the inflation index for the forecast period. 2. Alternately, all historical prices can be transformed into current dollar equivalents by mul- tiplying each past price by the ratio of the estimated inflation index for the forecast period to the index value during the given past period. Table 25.2 illustrates this approach for a September–November 2015 forecast period, based on the assumption that PPI numbers are available only through August 2015. The table estimates the average September–November 2015 PPI by assuming the year-to-year percentage PPI change for this period will be the same as the known year-to-year percentage change in the June–August 2015 average PPI. (The estimated 7.5 percent decrease in PPI using this approach compared with an actual decrease of 7.3 percent.) Note that even when the PPI estimate used for the forecast period proves somewhat out of line, the distortion to the price analysis will be limited for two reasons. First, any reasonable inflation estimate will almost invariably be within a few percentage points of the actual figure and usually much closer. Second, all past prices will be overstated or understated equivalently (in percentage terms), thereby maintaining their relative relationship and leaving any price- explanatory model virtually unaffected. In any case, the forecast error attributable to an inac- curate inflation projection would be minuscule compared with the distortion that would result from the use of nominal rather than inflation-adjusted prices. 3. The inflation influence can be incorporated through its impact on the demand curve. Inflation implies an upward shift in the demand curve. All else being equal, the amount consumed at each given price level will increase over time, since each nominal price level represents a lower real price. However, because of the previously discussed problems in quantifying demand curves, this method represents more of a theoretical concept than a practical approach. The actual method used to adjust for inflation is of secondary importance. The key point is that inflation is a critical input that should be incorporated in any fundamental price-forecasting model. 387 INCorPorATING INFlATIoN table 25.1 Corn Monthly Nearest Futures prices: Nominal and Deflated Y ear avg. Dec Futures price, Sep–Nov avg. Sep–Nov ppIa Inflation-adjusted avg. price 1995 325.00 81.21 400.20 1996 277.83 83.04 334.57 1997 269.67 82.78 325.77 1998 215.58 80.23 268.70 1999 198.42 82.96 239.18 2000 204.17 87.51 233.31 2001 209.42 84.99 246.41 2002 246.42 86.11 286.17 2003 237.50 90.02 263.83 2004 200.17 97.02 206.32 2005 196.42 106.31 184.76 2006 320.08 106.33 301.03 2007 377.67 113.89 331.61 2008 412.83 121.00 341.19 2009 370.92 113.78 325.99 2010 535.92 120.80 443.63 2011 613.58 130.96 468.54 2012 753.33 131.71 571.95 2013 428.33 131.26 326.33 2014 357.75 131.93 271.17 areported index values would be divided by 100.0, since reported figures are quoted as a percentage of June 2005 base = 100.0. Ironically, in the post-1979 period there were some instances when naïve price-forecasting mod- els that totally ignored the effect of inflation may actually have provided more accurate projections than models incorporating this important factor. This apparent paradox can be explained by the extraordinarily high real interest rates (nominal rates minus inflation) witnessed in 1979–1980, which triggered a permanent change in inventory psychology. The high cost of holding commod - ity inventories provided a strong incentive to reduce inventories all along the pipeline (from raw product to retail). In effect, this widespread decision to hold lower inventories represented a classic example of a downshift in the demand curve. once set in motion by the shock of the high inflation/ high interest rate environment of 1979–1980, and abetted by technological advances and new inven- tory theories (e.g., “just-in-time”), inventory demand continued to contract even when inflation and interest rates fell sharply. The resulting sustained downshift in demand tended to counterbalance the influence of inflation. The preceding discussion certainly is not intended to imply that inflation can be safely ignored, but rather that major shifts in the demand for commodities, which can run counter to the inflation 388 A Complete Guide to the Futures mArket effect, as was the case for the pronounced downward shift in demand evident in the 1980s and early 1990s, must also be incorporated. Some examples of ways the latter factor can be included (assuming a regression model) are the addition of a trend variable 1 and the use of a dummy variable to segment the data by different periods. (Dummy variables are discussed in Appendix E.) 1 Note that a trend variable need not increase for the entire period used in the analysis, but can be assumed to level off if the trending variable (the downward shift in demand in our example) is assumed to dissipate at some point. table 25.2 average September–November price of December Corn Futures: Nominal and estimated 2015 Dollar equivalent terms Y ear avg. Dec Futures price, Sep–Nov avg. Sep– Nov ppIa estimated avg. Sep–Nov 2015 ppI Multiplier to Convert past Season prices into 2015 terms Dec Futures avg. Sep–Nov price in 2015 $ terms 1995 325.00 81.31 120.16 1.478 480.35 1996 277.83 83.24 120.16 1.444 401.19 1997 269.67 82.63 120.16 1.454 392.10 1998 215.58 80.02 120.16 1.502 323.80 1999 198.42 82.91 120.16 1.449 287.51 2000 204.17 87.84 120.16 1.368 279.30 2001 209.42 83.86 120.16 1.433 300.10 2002 246.42 86.24 120.16 1.393 343.26 2003 237.50 90.24 120.16 1.332 316.35 2004 200.17 97.56 120.16 1.232 246.61 2005 196.42 106.48 120.16 1.128 221.56 2006 320.08 106.37 120.16 1.130 361.69 2007 377.67 114.99 120.16 1.045 394.67 2008 412.83 115.38 120.16 1.041 429.76 2009 370.92 114.65 120.16 1.048 388.72 2010 535.92 121.84 120.16 0.986 528.42 2011 613.58 130.11 120.16 0.923 566.33 2012 753.33 131.09 120.16 0.917 690.80 2013 428.33 130.85 120.16 0.918 393.21 2014 357.75 129.90 120.16 0.925 330.92 aPPI indexed to June 2005 = 100. 389 Chapter 26 The freeze may come in winter, but the seasonal rally comes in fall. —Jack D. Schwager ■ The Concept of Seasonal Trading Various markets exhibit seasonal tendencies. Sometimes these seasonal patterns can be attributed to obvious fundamental causes, such as harvest selling or buying in front of potential freeze danger periods for some agricultural markets. Financial markets can also exhibit seasonal patterns tied to fundamental causes (e.g., Treasury refundings, year-end book squaring). Sometimes, however, sea- sonal patterns will not be associated with any apparent fundamental factors. The concept of utilizing seasonal patterns in making trading decisions is based on the assumption that seasonal influences will cause biases in the movements of market prices. Of course, such correla- tions will be far from perfect. It is hardly uncommon for markets to move opposite to their normal seasonal trends. The key question is whether, on balance, there is enough positive correlation between future price movements and past seasonal patterns for such information to be useful. Because (as will be detailed later) apparent seasonal patterns would be expected to appear even in random series, it is difficult to determine to what extent seasonal price patterns reflect true biases as opposed to random occurrences. Hence, there is an unavoidable degree of subjectivity in deciding how much weight to give past seasonal patterns. A reasonable approach is to use seasonal analysis as a supplement to fun- damental and technical analysis in making trading decisions, but never as a sole input. ■ Cash versus Futures Price Seasonality It is important to understand that seasonal patterns in futures and cash prices may not be equivalent. For example, even if cash prices move lower for a given crop during harvest time with great con- sistency, it doesn’t mean this pattern will provide a trading opportunity. It is entirely possible the Seasonal Analysis 390 A Complete Guide to the Futures mArket futures market will discount harvest-time weakness in the cash market, thereby eliminating any profit opportunity. Because we are concerned with trading futures, not the cash commodities or financial instruments, the key question is whether a seasonal pattern exists in futures. Therefore, futures data should be used for all seasonality calculations. ■ The Role of Expectations Because markets tend to discount expected events, such as changes in the seasons, true seasonal patterns often differ radically from conventional beliefs regarding such patterns. For example, it is widely believed that markets that are vulnerable to severe cold weather, such as heating oil, frozen concentrated orange juice, and coffee, exhibit strength during the winter. (For coffee, the relevant winter period is June through August.) However, these markets often exhibit seasonal strength prior to the advent of winter and tend to decline with the onset of winter. ■ Is It Real or Is It Probability? Even if a market exhibits a seemingly pronounced seasonal pattern, this does not mean a true seasonal pattern exists. If enough markets are examined for enough periods of time, the emergence of some apparent seasonal patterns will be a virtual certainty even if all the examined price series are random. In other words, past seasonal patterns could simply be due to normal probability and not suggest any potential bias for future price behavior. T o illustrate how patterns can occur—in fact, are likely to occur—even if the distribution of price movements is random, we can use coin tosses to represent up or down price changes: heads repre- sents a week with a net price gain; tails a week with a net price loss. Assume we flip a coin 10 times to represent the price movement in a given market in each of the past 10 years. W e then repeat this 10-flip trial for a total of 52 times (one corresponding to each week in the year). Although an equal number of heads and tails (i.e., an equal number of years of up and down price movement) will be the most common event, more than 75 percent of the trials will yield an unequal num- ber of heads and tails (an unequal number of up and down years). In fact, some of these trials will result in a highly unbalanced number of heads and tails. It can be shown through probability theory that in 52 trials (weeks) there is a better than 75 percent chance of getting one or more 10-flip trials with at least 9 out of 10 heads or tails (one or more weeks with at least 9 out of 10 years of up or down price movements). If the preceding process of 52 ten-flip trials is repeated a total of 25 times (to represent 25 dif- ferent markets), then the probability of getting one or more 10-flip trials with at least 9 of 10 heads or tails is a virtual certainty (99.999999998 percent). In fact, there is a better than 99 percent prob- ability there will be more than 15 ten-flip trials with at least 9 out of 10 heads or tails. T o state this in market equivalent terms, even if the distribution of up and down price movements is random in all markets, in a group of 25 markets, there is a better than 99 percent chance of finding more than 15 instances in which a market moved higher (or lower) in at least 9 out of the past 10 years during a 391 SEASONAl ANAlySIS given week. Thus, it is important to understand that a certain number of apparent seasonal patterns are inevitable even if the distribution of price movements is random. ■ Calculating a Seasonal Index There are many methods for calculating a seasonal index. This section examines two basic approaches. average percentage Method The average percentage method is by far the simplest way to calculate a seasonal index. This method involves the following steps: 1. Calculate an annual average for each year or season. 2. Express each data item (daily, weekly, or monthly value) as a percentage of the corresponding annual average. Either daily, weekly, or monthly data can be used in constructing seasonal indi- ces. A daily or weekly seasonal index is obviously preferable to a monthly index, particularly for trading purposes, but it also requires far more data manipulation. This section uses monthly indices solely for simplicity of illustration. 3. Average the percentage values for each period (month, week, or day). The resulting figures are the seasonal index. T o illustrate this method, we will calculate the seasonal index for heating oil. Table 26.1 lists the average monthly prices for the 1996–2015 December heating oil contracts (which expire in Novem- ber). Note the first column of data (November) is listed for later use and is not included in calculating the annual average. The final column in Table 26.1 indicates the 12-month average for each contract. Table 26.2 expresses each monthly price as a percentage of the annual average. These percentage figures are then averaged for each month to yield a seasonal index at the bottom of the table. In calculating a seasonal index, it is wise to check for any extreme years that might distort the results. The question of what constitutes an extreme year can only be answered subjectively. With regard to the heating oil market from 1996 through 2015, one year stands out: 2008. As Table 26.1 shows, the December 2008 heating oil contract traversed an extraordinarily wide range. It is usually best to exclude such uncharacteristic years when calculating a seasonal index, unless some adjustment scheme is used to modify their exaggerated influence. However, there are no concrete rules, and the ultimate decision must depend on the judgment of the researcher. Although a sense of the seasonal pattern can be gained by examining the seasonal index at the bot- tom of Table 26.2, a graphic presentation is far more convenient and informative. Figure 26.1 shows the seasonal index, both with and without the inclusion of 2008. In this case, the extreme year does not have a significant impact on the basic seasonal pattern. As is readily apparent, there is a seasonal tendency for prices to reach relative highs around September –October and to bottom around December–January. It is important to note the average percentage method does not remove any trend from the data. Thus, what appears to be a seasonal pattern might partially reflect a long-term trend in prices. In fact, 392 table 26.1 December heating Oil Contract: average Monthly prices Y ear of Contract expiration Nova Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov Dec–Nov avg 1996 0.507 0.515 0.510 0.509 0.527 0.543 0.538 0.543 0.572 0.601 0.672 0.711 0.701 0.579 1997 0.587 0.591 0.610 0.586 0.584 0.574 0.591 0.574 0.567 0.573 0.575 0.600 0.564 0.582 1998 0.572 0.553 0.528 0.514 0.495 0.500 0.489 0.458 0.435 0.398 0.417 0.416 0.358 0.463 1999 0.444 0.418 0.411 0.386 0.427 0.469 0.466 0.475 0.535 0.570 0.609 0.589 0.641 0.500 2000 0.563 0.570 0.601 0.651 0.686 0.647 0.720 0.794 0.794 0.877 0.977 1.016 1.004 0.778 2001 0.771 0.725 0.722 0.750 0.734 0.754 0.803 0.789 0.733 0.760 0.739 0.643 0.568 0.727 2002 0.600 0.596 0.597 0.596 0.665 0.702 0.707 0.685 0.709 0.735 0.787 0.778 0.720 0.690 2003 0.669 0.702 0.748 0.805 0.779 0.722 0.738 0.781 0.808 0.841 0.780 0.842 0.841 0.782 2004 0.760 0.785 0.828 0.841 0.899 0.916 1.018 1.036 1.120 1.219 1.272 1.491 1.402 1.069 2005 1.282 1.189 1.225 1.324 1.533 1.622 1.498 1.655 1.789 1.956 2.047 1.992 1.716 1.629 2006 1.807 1.857 1.934 1.959 1.949 2.128 2.135 2.171 2.239 2.177 1.916 1.729 1.725 1.993 2007 1.940 1.943 1.788 1.861 1.947 2.004 2.011 2.072 2.156 2.065 2.192 2.352 2.604 2.083 2008 2.445 2.477 2.531 2.624 2.897 3.115 3.634 3.902 3.917 3.383 3.001 2.438 1.926 2.987 2009 2.140 1.695 1.710 1.481 1.528 1.575 1.685 1.961 1.810 1.951 1.818 1.963 1.985 1.763 2010 2.261 2.213 2.209 2.118 2.231 2.378 2.234 2.162 2.090 2.140 2.163 2.279 2.343 2.213 2011 2.441 2.521 2.700 2.984 3.115 3.299 3.123 3.027 3.076 2.987 2.937 2.904 3.059 2.978 2012 2.971 2.919 3.000 3.160 3.276 3.214 2.988 2.657 2.811 3.019 3.139 3.122 3.014 3.027 2013 2.966 2.974 3.015 3.065 2.977 2.912 2.875 2.911 2.983 3.073 3.047 2.982 2.950 2.980 2014 2.904 2.963 2.915 2.921 2.937 2.917 2.921 2.986 2.952 2.879 2.763 2.558 2.374 2.840 2015 2.375 2.073 1.813 1.903 1.897 1.922 2.015 1.959 1.791 1.583 1.613 1.547 1.452 1.797 aNovember of year preceding the contract year. This column is needed to calculate Table 26.3. 393 table 26.2 December heating Oil Contract: Monthly price as a percentage of the December–November average Y ear of Contract expiration Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov 1996 88.98 88.23 88.03 91.14 93.87 92.90 93.92 98.87 103.79 116.20 122.85 121.21 1997 101.58 104.71 100.63 100.21 98.54 101.46 98.50 97.29 98.46 98.71 103.09 96.82 1998 119.36 113.98 111.00 106.75 107.83 105.46 98.76 93.94 85.97 89.97 89.80 77.18 1999 83.77 82.32 77.32 85.38 93.79 93.27 95.04 107.05 114.11 121.92 117.81 128.22 2000 73.26 77.23 83.67 88.15 83.09 92.53 102.08 102.05 112.71 125.60 130.58 129.07 2001 99.76 99.44 103.16 101.02 103.82 110.46 108.63 100.83 104.54 101.72 88.50 78.11 2002 86.40 86.59 86.45 96.42 101.80 102.44 99.28 102.74 106.53 114.13 112.80 104.43 2003 89.80 95.63 102.86 99.60 92.25 94.41 99.82 103.24 107.49 99.76 107.59 107.56 2004 73.41 77.43 78.72 84.08 85.72 95.26 96.92 104.80 114.03 119.00 139.49 131.12 2005 72.99 75.22 81.29 94.12 99.56 91.94 101.64 109.82 120.06 125.69 122.28 105.39 2006 93.16 97.01 98.28 97.76 106.75 107.12 108.92 112.35 109.23 96.14 86.73 86.54 2007 93.28 85.82 89.37 93.47 96.21 96.54 99.48 103.50 99.13 105.23 112.94 125.01 2008 82.92 84.73 87.84 96.98 104.28 121.65 130.65 131.13 113.26 100.47 81.63 64.47 2009 96.14 96.95 83.98 86.64 89.31 95.56 111.19 102.64 110.63 103.11 111.31 112.57 2010 100.00 99.80 95.71 100.82 107.42 100.93 97.69 94.44 96.68 97.71 102.96 105.84 2011 84.67 90.67 100.21 104.60 110.78 104.88 101.66 103.31 100.33 98.62 97.54 102.73 2012 96.44 99.13 104.41 108.23 106.17 98.74 87.79 92.87 99.76 103.71 103.16 99.58 2013 99.77 101.17 102.83 99.89 97.72 96.47 97.68 100.08 103.11 102.25 100.05 98.98 2014 104.33 102.61 102.82 103.38 102.69 102.83 105.12 103.91 101.36 97.29 90.06 83.59 2015 115.31 100.86 105.88 105.53 106.95 112.14 108.97 99.66 88.07 89.77 86.08 80.77 averages: all Y ears 92.77 92.98 94.22 97.21 99.43 100.85 102.19 103.23 104.46 105.35 105.36 101.96 excl. 2008 93.28 93.41 94.56 97.22 99.17 99.75 100.69 101.76 104.00 105.61 106.61 103.93 394A COMPlETE GUIDE TO THE FUTURES MARKET for data exhibiting a strong trend, the eff ect of the trend will often totally swamp any true seasonal pattern. (By this we mean the seasonal pattern that remains after the trend has been removed from the data.) An unadjusted seasonal index, such as the average percentage method, is relevant because it more directly refl ects the past results of implementing a position on a given date and exiting it on another given date. However, because secular trends may change, it can be argued that the detrended seasonal index might be more relevant in refl ecting seasonal patterns. The next section describes one method for deriving a detrended seasonal index. link relative Method The link relative method involves the following steps: 1. Express each data value as a percentage of the previous month’s value. 2. Average these percentage values for each month. 3. Set the fi rst month’s value at 100.0 and reexpress all the other monthly averages as relative percentages of the fi rst month’s value. 4. Adjust the resulting values for trend. 5. Multiply each of these values by the appropriate common factor so that the average monthly seasonal index value equals 100.0. These steps will be clearer if we work through an example. Table 26.3 indicates each month’s price as a percentage of the previous month’s price. (These fi gures are derived from Table 26.1 .) The monthly averages for all these percentages are listed at the bottom of the table. FIGURE  26.1 December Heating Oil Contract Seasonal Index: Average Percentage Method December Heating Oil Contract Seasonal Index: Average Percentage 395 table 26.3 December heating Oil Contract: Monthly average price as a percentage of the previous Month’s price Y ear of Contract expiration Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov 1996 101.51 99.16 99.77 103.53 103.00 98.97 101.10 105.26 104.98 111.95 105.73 98.66 1997 100.70 103.09 96.10 99.58 98.33 102.96 97.08 98.78 101.20 100.25 104.44 93.92 1998 96.74 95.50 97.39 96.17 101.01 97.80 93.65 95.11 91.52 104.65 99.82 85.94 1999 94.23 98.27 93.93 110.42 109.85 99.45 101.90 112.64 106.59 106.84 96.63 108.84 2000 101.21 105.43 108.33 105.35 94.26 111.37 110.31 99.97 110.45 111.43 103.97 98.84 2001 93.95 99.68 103.74 97.93 102.77 106.39 98.35 92.82 103.68 97.30 87.01 88.26 2002 99.38 100.23 99.83 111.53 105.59 100.63 96.91 103.49 103.68 107.13 98.84 92.58 2003 104.99 106.50 107.56 96.82 92.62 102.34 105.74 103.43 104.12 92.80 107.85 99.97 2004 103.24 105.47 101.67 106.81 101.95 111.13 101.74 108.14 108.81 104.36 117.22 94.00 2005 92.72 103.06 108.07 115.79 105.77 92.35 110.54 108.05 109.33 104.69 97.29 86.18 2006 102.77 104.13 101.31 99.48 109.20 100.34 101.69 103.15 97.22 88.02 90.21 99.78 2007 100.16 92.01 104.13 104.58 102.94 100.34 103.05 104.04 95.78 106.15 107.33 110.69 2008 101.31 102.18 103.67 110.41 107.52 116.65 107.40 100.37 86.38 88.71 81.24 78.98 2009 79.23 100.84 86.63 103.16 103.08 106.99 116.36 92.31 107.78 93.21 107.95 101.13 2010 97.90 99.80 95.91 105.33 106.55 93.96 96.79 96.67 102.38 101.06 105.38 102.79 2011 103.30 107.09 110.52 104.38 105.91 94.67 96.93 101.62 97.11 98.29 98.91 105.32 2012 98.24 102.79 105.32 103.66 98.10 92.99 88.92 105.79 107.41 103.97 99.47 96.52 2013 100.26 101.40 101.64 97.14 97.84 98.72 101.25 102.46 103.03 99.17 97.85 98.93 2014 102.05 98.35 100.21 100.54 99.33 100.13 102.23 98.85 97.55 95.98 92.57 92.82 2015 87.27 87.46 104.98 99.67 101.34 104.85 97.18 91.46 88.37 101.93 95.88 93.84 average 98.06 100.62 101.54 103.61 102.35 101.65 101.46 101.22 101.37 100.89 99.78 96.40 396 A Complete Guide to the Futures mArket As the next step, in Table 26.4 we express each month’s value relative to the first month (December), which is set at 100.0. Thus, since the average ratio of January to December prices is 100.62 percent from Table 26.3, its value is set to 100.62 (i.e., 100.62 percent of 100.0). Similarly, since the average ratio of February to January prices is 101.54 percent, the February value would be set to 101.54 percent of 100.62 or 102.17. The value for March would be 103.61 percent of 102.17, or 105.86, and so on. Note that the entry for the second value of December is equal to 98.06 percent of the November value (98.06 is the average December value from Table 26.3). The higher value for the second December entry reflects the trend in the data. T o remove this trend, we must find the constant factor that will increase to 109.10 (the ratio of the second Decem- ber value to the first) when multiplied by itself 12 times. In other words, we want to find a constant monthly growth factor X. This can be expressed as X 12 = 109.10. The derivation of this value requires the use of logarithms (readers unfamiliar with logarithms can skip to the immediately following description of an alternative approach for detrending the data): X X X X 12 10 91 12 1 091 11 21 091 00 031 = = = = (. ) logl og(. ) logl og(. ) log. / 552 00 03152 10 07284antilogo fr ounded to1.0073.. ,= In other words, (1.0073)12 = 1.091. W e assume a constant growth trend. The first month’s (December) value will still equal 100.0; the second month’s value will be divided by 1.0073; the third month’s value will be divided by (1.0073)2; the fourth by (1.0073) 3, and so on. These calculations are illustrated in Table 26.5. The final month (the second December entry) will be divided by (1.0073)12, thereby transforming its value to 100.0. Since both December values are equal after the adjustment of the data by the constant growth factor, the trend has been removed from the data. alternative approach The following steps, which do not require the use of logarithms, can be used to derive a reasonably good approximation of the last column in Table 26.5. table 26.4 December heating Oil Contract 1996–2015: Monthly average price as a percentage of the prior December average price Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov Dec 100 100.62 102.17 105.86 108.35 110.14 111.74 113.10 114.65 115.67 115.42 111.26 109.10 397 SEASONAl ANAlySIS 1. Find the difference between the two December values in Table 26.4 (9.10). 2. Multiply this difference by 1/12 and subtract the product from the second month’s (January) value (100.62 − 0.76 = 99.86). 3. Multiply the difference found in step 1 by 2/12 and subtract the product from the third month’s value. Multiply the difference found in step 1 by 3/12 and subtract the product from the fourth month’s value. Continue this progression for the remaining months. Using this method, the adjusted values would be: Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov 100 99.86 100.65 103.59 105.32 106.35 107.19 107.79 108.58 108.85 107.84 102.92 These approximated figures are very close to the precise adjusted values shown in Table 26.5. For the sake of uniformity, it is desirable that the average of the monthly seasonal index values equal 100, or equivalently, that the sum of the monthly index values equal 1200. Table 26.5 shows the sum of the index values in this case is more than 1200, which makes it necessary to adjust the figures by a multiplier: Multiplier == 1200 1256 71 09 549. . Dividing each of the values in Table 26.5 by 0.9549 produces the seasonal index values in Table 26.6, which are plotted in Figure 26.2. The average percentage method and link relative method indices are compared in Figure 26.3. Note there is a great deal of similarity between the two methods. The basic table 26.5 trend adjustment for Monthly Index Values Month Values from table 26.4 trend-adjustment Divisor trend-adj. Divisor Numerical equivalent adjusted Value Dec 100 100 Jan 100.62 (1.007284)1 1.007284 99.89 Feb 102.17 (1.007284)2 1.014621 100.69 Mar 105.86 (1.007284)3 1.022012 103.58 Apr 108.35 (1.007284)4 1.029456 105.25 May 110.14 (1.007284)5 1.036954 106.21 Jun 111.74 (1.007284)6 1.044508 106.98 Jul 113.10 (1.007284)7 1.052116 107.50 Aug 114.65 (1.007284)8 1.059779 108.18 Sep 115.67 (1.007284)9 1.067499 108.36 Oct 115.42 (1.007284)10 1.075275 107.34 Nov 111.26 (1.007284)11 1.083107 102.73 total 1256.71 398A COMPlETE GUIDE TO THE FUTURES MARKET table 26.6 Seasonal Index for December heating Oil Contract Using the link relative Method Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov 95.49 95.38 96.15 98.91 100.50 101.42 102.15 102.65 103.30 103.47 102.50 98.09 FIGURE  26.2 December Heating Oil Contract Seasonal Index: link Relative Method December Heating Oil Contract Seasonal Index: link Relative Method FIGURE  26.3 December Heating Oil Seasonal Index: Comparison of Average Percentage Method and link Relative Method December Heating Oil Seasonal Index: Comparison of Average Percentage 399 SEASONAl ANAlySIS diff erence is that the average percentage method index refl ects the long-term trend, whereas the link relative method does not. Both approaches indicate a relative low in the December–January period and a relative high in September. Figures 26.4 through 26.9 Illustrate the seasonal graphs for specifi c contract months in several futures markets, both unadjusted (average percentage method) and detrended (link relative method), FIGURE  26.4 December WTI Crude Oil Seasonal Index: Comparison of Average Percentage Method and link Relative Method FIGURE  26.5 December E-Mini S&P 500 Seasonal Index: Comparison of Average Percentage Method and link Relative Method December E-Mini S&P 500 Seasonal Index: Comparison of Average 400A COMPlETE GUIDE TO THE FUTURES MARKET FIGURE  26.6 December Gold Seasonal Index: Comparison of Average Percentage Method and link Relative Method FIGURE  26.7 September Coff ee Seasonal Index: Comparison of Average Percentage Method and link Relative Method 401 SEASONAl ANAlySIS FIGURE  26.8 November Frozen Concentrated Orange Juice Seasonal Index: Comparison of Average Percentage Method and link Relative Method November Frozen Concentrated Orange Juice Seasonal Index: FIGURE  26.9 December Corn Seasonal Index: Comparison of Average Percentage Method and link Relative Method December Corn Seasonal Index: Comparison of Average Percentage based on data from 1996 through 2015 (with the exception of the E-mini S&P 500 in Figure 26.6 , which used data from 1998 through 2015). It should be stressed that seasonal patterns should never be used as the sole basis for making trad- ing decisions, as they are only one infl uence and can easily be swamped by fundamental and technical forces impacting the market. 403 Chapter 27 Markets are never wrong—opinions often are. —Jesse Livermore ■ Evaluating Market Response for Repetitive Events A market’s response to key fundamental developments can provide important clues about the prob- able future price direction. When these developments are repetitive, such as the release of key eco- nomic numbers or U.S. Department of Agriculture (USDA) reports, a systematic approach can be used to analyze the implications of market response. The general analytic procedure would involve the following steps: 1. Identify the event to be studied (e.g., the Treasury market’s response to the monthly employ- ment report). 2. Construct a table comparing the market’s immediate reaction to a report’s release to subse- quent price trends. 3. Search for consistent patterns. There is no single correct format for analyzing market response. The objective of this chapter is to illustrate the analysis process rather than to provide specific market-response models for trading the markets. The observed responses in the following examples are moderate and there is not enough data to rule out that the results could simply be due to chance. The reader can apply a similar methodology for analyzing market reaction for other situations that may be of interest. Analyzing Market Response 404 A Complete Guide to the Futures mArket example a: t-Note Futures response to Monthly U.S. employment report The U.S. employment situation report released by the Bureau of Labor Statistics is the most closely watched monthly economic release, capable of triggering volatile moves in a wide range of markets. Let’s say our goal is to check whether the direction (and magnitude) of the price move in U.S. Trea- sury futures on the day the monthly employment report is released is indicative of the price action in subsequent weeks. In other words, we want to check the hypothesis that a “bullish” or “bearish” market response to the employment report is an indicator of probable near-term price direction. W e might proceed as follows: 1. Determine the threshold to determine a bullish or bearish initial response to the employment report. 2. Measure the market’s price action in the N days following employment report days that satisfy this criterion. Table 27.1 shows how the U.S. 10-year- T -note futures traded in the first 10 trading days (two weeks) after the monthly employment report between 2006 and 2015 based on whether the move from the close of the day prior to the report to the report day’s close was bullish or bearish. In this case, a bullish initial response was defined as a closing gain (measured from the previous day’s close) of 0.50 points (16/32) or more on the day of the employment report, while a bearish initial response was defined as a 0.50-point or larger decline. (This nominal amount was selected solely for illustra- tion purposes and has no special significance.) Twenty-six employment report days fulfilled the bullish criteria from 2006 through 2015 (top half of table), while 33 fulfilled the bearish criteria (bottom half of table). Table 27.1 shows the cumula- tive average and median gains from the close of the employment report day to the closes of the next 10 days. For comparison, the table also includes the average price changes for all 1- to 10-day periods during the 10-year analysis window . The table also shows the percentage of times the T -note futures contract closed higher than the employment report day close after bullish and bearish initial responses to the report, along with the percentage of higher closes for all 1- to 10-day periods. For example, on the first day after bullish initial reactions to the employment report, 10-year T -note futures closed, on average, –0.054 points lower (–0.039 points median), compared to an average 0.021-point one- day gain for all days. The market closed higher 42.31 percent of the time one day after initial bullish responses, compared to 51.93 percent for all days. Because it is often easier to digest such data visually, Figure 27.1 graphs the results for the bullish initial responses, while Figure 27.2 graphs the results for the bearish initial responses. Surprisingly, the analysis suggests that, if anything, there was a tendency for T -note price action in the near-term period following employment reports to move in the opposite direction of the market’s initial response. Specifically, there seems to be a notable tendency for contrarian price action in the two days following a bullish initial response to the unemployment report (after which trading was mixed), while the price action was more consistently bullish after an initial bearish response. Figure 27.1 shows that after two days T -notes closed below the close of the employment report day 73 percent of the time, with an average decline of 0.205 points (around 6/32nds). This observation suggests that those seeking to enter a position in the direction of the market’s bullish response to the report might 405 AnALyzIng MARkeT ReSPonSe taBLe 27.1 10-Y ear t -Note Futures response to Monthly employment report: Cumulative Change as of Indicated Day (2006–2015) Bullish 26 instances Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10 Median post-report Change -0.039 -0.172 0.016 0.164 0.211 0.063 0.117 0.344 -0.055 0.117 average post-report Change -0.054 -0.205 -0.035 -0.030 0.119 0.214 0.093 0.189 0.082 0.111 average Change all Days 0.021 0.042 0.063 0.084 0.105 0.126 0.147 0.168 0.188 0.208 higher Close than report Day (% times) 42.31% 26.92% 50.00% 53.85% 65.38% 53.85% 53.85% 53.85% 46.15% 57.69% all Days higher Close (%times) 51.93% 53.85% 55.09% 55.24% 54.94% 55.04% 56.09% 57.14% 56.79% 56.79% Bearish 33 instances Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10 Median post-report Change 0.031 0.219 0.141 0.328 0.484 0.422 0.406 0.609 0.313 0.484 average post-report Change 0.081 0.285 0.306 0.401 0.474 0.605 0.707 0.649 0.622 0.603 average Change all Days 0.021 0.042 0.063 0.084 0.105 0.126 0.147 0.168 0.188 0.208 higher Close than report Day (% times) 51.52% 57.58% 57.58% 63.64% 63.64% 72.73% 69.70% 66.67% 72.73% 63.64% all Days higher Close (%times) 51.93% 53.85% 55.09% 55.24% 54.94% 55.04% 56.09% 57.14% 56.79% 56.79% FIGURE  27.1 10- y ear T -note after Bullish Initial Response to Jobs Report (Cumulative) 0.35 75% 50% 25% 0% Post-report average Post-report higher close 12 34 56 78 91 0 All days higher close All days average Post-report median 0.15 −0.05Gain/loss from report day close % higher closes Day −0.25 406A CoMPLeTe gUIDe To THe FUTUReS MARkeT be better off waiting a couple of days before entering a position. In contrast, Figure 27.2 highlights the market’s tendency to move higher after bearish initial responses. It should be noted that the period surveyed was one that witnessed a long-term uptrend. Therefore, the appropriate comparison is to the corresponding changes for all days. Figures 27.3 and 27.4 present a slightly diff erent perspective of the performance of 10-year T -note futures after bullish and bearish initial responses to the monthly employment report. Instead of show- ing the cumulative performance from the close of the employment report day, these charts show each day’s gain or loss. Figure 27.3 highlights the negative average returns in the fi rst two days after bull- ish initial responses, while Figure 27.4 shows a tendency for higher prices in the fi rst two days after bearish report responses. In examining historical patterns (e.g., market response, seasonal tendencies), it is usually impos- sible to say whether apparent proclivities refl ect true market biases (or ineffi ciencies) or whether such results are strictly a function of chance. even clearly random events with a 50 percent expected outcome will sometimes deviate signifi cantly from 50 percent simply by chance. For example, if you fl ipped 10 coins 1,000 times, approximately 17 percent of the time you would get seven or more heads. getting seven or more heads on any individual toss of 10 coins certainly wouldn’t imply the coins have a tendency to land on heads. Two factors should be considered in trying to assess whether a past pattern might be meaningful rather than due to chance: 1. Number of observations. The greater the number of observations, the more likely a past pattern might be signifi cant. 2. theoretical explanation. If there is a logical reason why a past pattern might have occurred, it enhances the potential signifi cance of the observed tendency. 0.85 0.65 0.45 0.25 0.05 75% 50% 25% 0% Post-report average Post-report higher close 12 34 56 78 91 0 All days higher close All days average Post-report median Gain/loss from report day close % higher closes Day FIGURE  27.2 10- y ear T -note after Bearish Initial Response to Jobs Report (Cumulative) 407 AnALyzIng MARkeT ReSPonSe FIGURE  27.3 10- y ear T -note after Bullish Initial Response to Jobs Report (Daily) 0.20 75% 50% 25% 0% Post-report average Post-report higher close 12 34 56 78 91 0 All days higher close Post-report median 0.10 0.00 Gain/loss from prev. day % higher closes Day −0.10 FIGURE  27.4 10- y ear T -note after Bearish Initial Response to Jobs Report (Daily) 0.25 0.20 50% 25% 0% Post-report average Post-report higher close 12 34 56 78 91 0 All days higher close Post-report median 0.15 0.10 0.05 0.00 −0.05Gain/loss from prev. day % higher closes Day 408A CoMPLeTe gUIDe To THe FUTUReS MARkeT FIGURE  27.5 e-Mini S&P Change 500 after Bullish Initial Response to Jobs Report (Cumulative) 20 50% 25% 0% Post-report average Post-report higher close 1 23456789 10 All days higher close Post-report median All days average 15 10 5 0 −5 Gain/loss from report day close % higher closes Day example B: Stock Index Futures response to employment reports Stock index futures also are prone to volatile moves in response to monthly employment reports. Figures 27.5 and 27.6 show the results of an analysis of the e-mini S&P 500 futures contract’s performance in the fi rst 10 trading days following bullish and bearish initial responses to employment reports from 2006 through 2015. In this case, however, bullish and bearish are defi ned not by the price change on the report day, but rather the location of the closing price within the report day’s range: 1. A close within the upper 25 percent of the day’s range is defi ned as a bullish initial response. 2. A close in the bottom 25 percent of the day’s range is defi ned as a bearish initial response. of the 120 employment reports from 2006 through 2015, 42 satisfi ed the bullish response criteria, while 26 satisfi ed the bearish response criteria. Figure 27.5 shows the e-mini S&P’s average and median cumulative gain/loss from the close of bullish response report days to the closes of the next 10 consecutive days, while Figure 27.6 provides an analogous chart for bearish response days. The most noticeable pattern is the tendency for follow-through weakness in the week following bearish response days (Figure 27.6 ). The chart for bullish response days (Figure 27.5 ) is fairly inconclusive. Table 27.2 shows the results of a related analysis. In this case, an initial bullish reaction was defi ned as a close 1.35 percent or more above the previous day’s close and a bearish reaction as a close 1.35 percent or more below the previous day’s close. Initial responses between these thresholds were classifi ed as neutral. These initial responses were then compared to the subsequent moves from the report day’s close to the close of the day immediately preceding the next month’s employment report (approximately 20 days, but ranging from 18 to 25 days for any given month). In this example, the cumulative price changes after bullish and neutral initial reactions were similar (and positive), while the 409 AnALyzIng MARkeT ReSPonSe FIGURE  27.6 e-Mini S&P 500 Change after Bearish Initial Response to Jobs Report (Cumulative) 50% 75% 25% 0% Post-report average Post-report higher close 123456789 10 All days higher close Post-report median All days average 10 5 0 −5 −10Gain/loss from report day close % higher closes Day taBLe 27.2 e-Mini S&p 500 Cumulative Change in Month Following Intitial response to employment report, 2006–2015 Bullish Initial response Bearish Initial response Neutral Initial response average 5.54 –16.05 7.88 Median 18.13 –8.75 14.25 % higher Close 64.29% 35.71% 65.91% performance after bearish initial responses tended to be negative. Because there was a decisive uptrend in place during the survey period, there is a bias toward getting bullish price behavior following any defi ned event—a tendency refl ected by the bullish result following neutral response days. Therefore, the bullish price action following bullish response days may be more a matter of refl ecting the prevailing long-term trend than any meaningful pattern, particularly since the price responses following bullish and neutral response days were similar. The negative price action following bearish response days, how- ever, seems potentially more signifi cant since it runs counter to the prevailing long-term trend. Still, even here, there is the caveat that the results are based on a small number of observations. Isolated events expectations are the key to evaluating market response for any single event. In other words, the failure of a market to respond to a fundamental development as decisively as might have been anticipated could provide an important signal regarding the market’s inherent strength or weakness. 410A CoMPLeTe gUIDe To THe FUTUReS MARkeT A classic example of this principle was the counter-to-anticipated response of the gold market dur- ing the 1991 gulf War. As the United States’ January 17 deadline for starting air strikes approached without any concessions from Iraq, gold prices fi rmed. The start of the air war during nighttime hours in the United States saw gold surge to a three-month high of $410/oz. in the overnight mar- ket. But this rally abruptly fi zzled, and gold prices began to sink rapidly. By the time the gold market opened in the United States the next morning, prices were actually $28/oz. lower than the previ- ous evening’s close. This extremely weak price action in response to an event that could have been expected to rally prices—even allowing for what proved to be the market’s correct anticipation for a quick U.S. victory—suggested that gold prices were vulnerable to further erosion. As can be seen in Figure 27.7 , prices did indeed continue to slide in the ensuing months, falling to new contract lows. The basic principle is that a price response to an important event that is radically diff erent from what might normally have been anticipated may provide an important clue as to the market’s probable near-term direction. Limitations of Market response analysis The following are some of the ambiguities that arise in conducting market response analysis: 1. In any type of market response analysis, the answers we obtain are dependent on the param- eters used in the analysis. For example, the various thresholds used to defi ne bullish and bearish response days in this chapter were representative values selected to illustrate the analysis process; they were not the result of any attempt to fi nd optimal defi nitions of what constitutes strong (bullish) or weak (bearish) reactions. The choice of analysis parameters, which will often FIGURE  27.7 April 1991 gold Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 411 AnALyzIng MARkeT ReSPonSe be subjective, can have a large impact on the results—a reality that provides a strong argument for analyzing a range of parameters. 2. When dealing with market events that occur relatively infrequently, there is the problem of determining the significance of results based on samples that might be too small (or spread out across too long and varied an analysis period) to be considered statistically valid. For example, some of the examples in this chapter were based on only 13 or 14 observations. 3. Response patterns may shift over time. A market’s response to a particular report or event might be consistent for an extended period during one type of economic environment or mar- ket regime, but that tendency could diminish or disappear if conditions change—for example, in the change from a rising interest rate environment to a declining rate environment. In view of the foregoing limitations, market response patterns should be viewed as one potential indicator of near-term market direction, which could be combined with other analysis to support a trading opinion, as opposed to being used as a stand-alone market signal. 413 Chapter 28 Building a Forecasting Model: A Step-by- Step Approach Economics as a positive science is a body of tentatively accepted generalizations about economic phenomena that can be used to predict the consequences of changes in circumstances. —Milton Friedman B ecause of the heterogeneous nature of commodity markets, there is no such thing as a standard fundamental model. Among the key substantive characteristics that differentiate markets are de- gree of storability, availability of substitutes, importance of imports and exports, types of government intervention, and sensitivity to general economic conditions. Consequently, in contrast to technical analysis, in which a specific system or methodology can often be applied to a broad spectrum of mar- kets, the fundamental approach requires a separate analysis for each market. The time-consuming nature of fundamental analysis makes it virtually impossible to cover a large number of markets adequately using this approach. Thus, as a practical matter, a trader wishing to employ fundamental inputs in trading decisions must resort to one of the following alternatives: 1. Restrict fundamental analysis to a superficial examination of the key statistics in a broad range of markets. 2. Employ in-depth fundamental analysis for only a few markets and trade all other markets based on technical input only. 3. Rely on published fundamental analysis. The first alternative is usually a poor compromise. Market knowledge based on a cursory exami- nation of fundamentals is often worse than total ignorance. In fact, next to poor money management, 414 A Complete Guide to the Futures mArket perhaps the most common reason that nonprofessional traders lose money in commodities is that they base their trading decisions on superficial fundamental information (e.g., market blogs, online forums, brokers' two-sentence market summaries). The analytic approach outlined in this chapter implicitly assumes alternative 2. It is a good idea to start by analyzing and following only one or two markets fundamentally, expanding this list only after all research ideas on previously chosen markets have been investigated. The third alternative is a reasonable supplement to individual research, as long as one is selective. Unfortunately, a significant portion of published research is analytically unsound. However, if you have fully grasped the concepts of this section, you should have no difficulty in evalu- ating the analytic merit of available published research. Once a market has been selected for fundamental study, the following step-by-step approach can be employed: 1. read background material. The first step in any analysis must be a familiarization with the given market. Before beginning, an analyst must have a good idea of the key fundamentals that affect the market, as well as the primary sources of statistical information. 2. Gather statistics. Once you have a good understanding of the basic mechanics of a market, list all the statistics that might be relevant in formulating a price analysis. The U.S. Department of Agriculture (USDA), which publishes a wide variety of reports on domestic and foreign agri- cultural products, is an excellent source of information. Another major source of statistics is the CRB Commodity Yearbook, which contains extensive data for the complete range of commodity markets. For many markets, special statistical sources will have to be consulted. The familiariza- tion process described in step 1 should provide the information regarding the primary statistical sources for a given market. 3. adjust price data for inflation. This adjustment is an essential step in fundamental price forecasting. As a caveat, though, if there is a prevailing downward-shifting trend in demand (a circumstance that will offset inflation), then unadjusted prices could yield more accurate forecasts. 4. Construct a model. Select one or more of the approaches discussed in Chapter 23 and attempt to construct a price-explanatory model. Regression analysis, which is perhaps the most powerful and efficient of these approaches, is covered comprehensively in the Appendices. 5. Modify model. After identifying which past years, or seasons, failed to fit the general pattern, try to determine the factors that were responsible for the aberrant behavior. Attempt to incor- porate these factors into the general model. In some cases, highly unusual price action in a past year might reflect the impact of isolated events (e.g., price controls, export embargoes, forced liquidation by huge speculators) that are not relevant to the current market. In such situations, it is often preferable to delete the abnormal year from the model. It should be emphasized, how- ever, that the expedient deletion of a year simply because it does not fit the pattern constitutes improper methodology. The practical decision-making process in the deletion of years from a model is discussed in much greater detail in Appendix E. 6. Incorporate expectations. Check to see whether expectation-based statistics improve the model. 415 Building a Forecasting Model: a step-By -step approach 7. estimate the independent variables. The independent variables are the factors used to explain and forecast prices in the model. These inputs must be estimated for the forecast period. For example, the coming season's corn crop, which would obviously be a key input in any corn price-forecasting model, could be estimated on the basis of planting intentions, historical yields, and weather conditions to date. 8. Forecast a price range. Allowing for a plausible range of values for each of the independent variables, use the model to forecast a price range for the upcoming period. 9. evaluate the potential impact of government regulations. Consider whether existing government programs or international agreements are likely to interfere with the normal free market mechanism. 10. examine seasonal patterns. Using the methods discussed in Chapter 26, determine whether there are any pronounced seasonal patterns for the given market. Furthermore, it is essential to check whether recent price action has violated normal seasonal patterns, since such behavior might reflect underlying weakness or strength. 11. Search for market response patterns. As detailed in Chapter 27, a market response to key fundamental information (e.g., major government reports) might provide important clues regarding the impending price direction. 12. assess the trade opportunity. Compare the potential price range implied by the forego- ing analytic steps with the prevailing price level. A trading opportunity is only indicated if the current price is outside the projected range. (This step will not be applicable for analytical approaches designed to forecast the direction of the market rather than the price level.) 13. time trade entry. Some elements of the fundamental approach, such as seasonal analysis and market response patterns, and some fundamental methods, such as index models, might pro- vide timing clues. Generally speaking, however, the timing of a trade entry should be based on technical input (e.g., chart analysis, technical model). Otherwise, the timing of fundamentally oriented trades is apt to be based on the date on which the analysis is completed—a ludicrous proposition. Furthermore, it should be emphasized that even if the fundamental analysis is cor- rect, prices can always get more out of line before the trend is reversed. The practical aspects of combining fundamental analysis and trading are the subject of Chapter 29. 417 Chapter 29 Fundamental Analysis and Trading All our knowledge brings us nearer to our ignorance. —T . S. Eliot ■ Fundamental versus Technical Analysis: A Greater Need for Caution Virtually every market student who has ever relied on fundamental analysis as the basis of a market opinion can recall instances in which his conclusions proved dead wrong. The same, of course, can be said for the technical analyst. However, there is a critical distinction between them. If the technical analyst’s methodology leads to erroneous projections, the same analytic tools will eventually point to an opposite conclusion. In effect, technical analysis is a self-correcting approach. In contrast, the fundamental analyst treads on far more dangerous ground. If the fundamental analyst’s assessment indicates wheat prices should be $7.00 when the market price is $6.00, by definition, he would be even more bullish if prices were to decline to $5.50—assuming the key economic statistics have remained unchanged. Therein lies the great danger in using fundamental analysis: The more inaccurate the projection, the more adamant practitioners are apt to become regarding the current attractiveness of market positions in line with their original prognostications. Thus, traders who base their decisions strictly on fundamental considerations might find themselves pyramiding positions in those situations they are most incorrect—a blueprint for disaster. In other words, there is a real danger that a sole or near- exclusive reliance on fundamentals will sooner or later transform an error into a major trading loss. 418 A Complete Guide to the Futures mArket In fact, this very experience has caused many fundamentalists to renounce their former analytic beliefs. One is reminded of Mark Twain’s observation: “The cat that sits down on a hot stove lid will never sit down on a hot stove lid again . . . [nor on] a cold one.” The problem lies not in the validity of fundamental analysis as a valuable analytic tool, but rather in the failure to recognize the limitations of this approach. This chapter focuses on these limitations. ■ Three Major Pitfalls in Fundamental Analysis Even fundamental analysts who do everything right will eventually find themselves reaching the wrong conclusion. There are three possible reasons this could occur: 1. the unexpected development. In this case, the model is right, but the assumptions are wrong. The 1972–1973 cotton market provides a classic historical example of such a development. Before that time, the United States did not export any cotton to China. This situation changed dra- matically during the 1972–1973 season, when the United States exported more than one-half million bales, or approximately 11 percent of its total shipments, to the People’s Republic of China (PRC). Table 29.1 shows exports to the PRC further expanded in the 1973–1974 season. The sudden emer- gence of the PRC as a major importer of U.S. cotton was one of the key factors behind the historic 1972–1973 bull market in cotton. W eather often plays the role of the unexpected development in agricultural markets. Figure 29.1 depicts the price impact of the 1989 freeze on the frozen concentrated orange juice (FCOJ) market. Figure 29.2 illustrates the price impact of the 2012 drought on the corn market. Although such devel- opments in the weather are hardly extraordinary, they cannot be anticipated, since allowing for their possible occurrence would lead to inflated price projections in most other years. An example of an impossible-to-predict sequence of events causing a major market reaction was the March 2011 Japanese earthquake, which triggered a tsunami that caused core meltdowns in three of the Fukushima Daiichi nuclear reactors. (Although the possibility that a tsunami could result in a major accident was anticipated by some, the timing of such a tsunami was, of course, unpredictable.) Figure 29.3 shows this disaster resulted in a 20 percent plunge in the Nikkei index futures over the course of four days. table 29.1 early 1970s Shift in U.S. Cotton exports to the people’s republic of China (1,000 bales) Season exports to prC total exports exports to prC as percentage of total 1971–1972 0 3,385 0 1972–1973 585 5,311 11.0 1973–1974 898 6,123 14.7 1974–1975 307 3,926 7.8 1975–1976 9 3,311 0.2 1976–1977 0 4,784 0 419 FUNDAMENTAl ANAlySIS AND TRADINg FIGURE  29.1 March 1990 FCOJ Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  29.2 September 2012 Corn Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 420A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  29.3 Nikkei 225 Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Iraq’s August 1990 invasion of Kuwait is another example of how an unanticipated event can dra- matically alter the supply-demand balance and trigger a huge price shift. As depicted in Figure 29.4 , this event was followed by a huge advance in crude oil prices, as the market’s perceptions about avail- able oil supplies shifted in response to interrupted Kuwaiti output, the embargo against Iraqi crude, and fears that the confl ict would extend to threaten critical Saudi Arabian supplies. Figure 29.5 shows the dramatic impact of the unexpected decision by Switzerland’s central bank to remove a price cap on the Swiss franc that had been in place for approximately three years. This shock event caused an almost immediate 25 percent leap in the Swiss franc’s value on January 15, 2015. Although this price surge was largely reversed over the subsequent two months, the sudden market move had a devastating impact on currency traders with short positions in the Swiss franc. Surprises in government reports, which can trigger sharp price reactions, are a common source of unexpected developments. However, because the release dates of these reports are known, as are the reports that are apt to cause large price moves (typically, the initial planting and production estimates in agricultural markets), the resulting price moves are not completely unexpected in the way an unscheduled event might be (e.g., freeze, nuclear accident, invasion). Sometimes, however, a report that does not typically trigger a major price impact may do so. One such instance was the U.S. Department of Agriculture’s (USDA) quarterly corn stocks report released on March 28, 2013. Dur- ing what was perceived to be an exceptionally tight corn market (as a result of the drought referenced by Figure 29.2 ), the report indicated corn stocks were nearly 8 percent (387 million bushels) higher than previously estimated. In response, corn futures dropped more than 5 percent the next trading day, and more than 8 percent the day after that (see Figure 29.6 ). 421 FUNDAMENTAl ANAlySIS AND TRADINg FIGURE  29.4 December 1990 WTI Crude Oil Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  29.5 Swiss Franc Continuous Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 422A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  29.6 May 2013 Corn Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 2. the missing variable. Quite often, a market whose price behavior has been adequately described by a set of variables for an extended period of time will suddenly be dramatically aff ected by an entirely new factor. The 1972–1973 infl ationary boom, and its associated hoarding psychology, provides an excellent example of a missing key factor. During this period, price behavior in diff erent markets became far more interdependent, and a wide variety of markets far exceeded the price levels suggested by their intrinsic fundamentals. Any fundamental analysis of a specifi c market that failed to take into account the potential price impact of the overall bullish wave would have yielded sharply understated price projections. The 1981–1982 period provided an almost exact opposite example of a missing key variable. In this instance, failure to take into account the pronounced impact of simultaneous defl ation and high real interest rates on inventory psychology would have resulted in overstated price forecasts for virtu- ally any commodity market. It is tempting to think that pivotal events such as the two aforementioned major shifts in com- modity demand curves were so readily apparent they would have been quickly incorporated into any fundamental model. Such major transitions, however, tend to be far more conspicuous in retrospect than at the time of their occurrence. Often by the time such structural changes become evident, prices have already witnessed a major move. 3. poor timing. Even if fundamental analysis is accurate and the assumptions are correct, a mar- ket can still move counter to the fundamental price projection over the short term—or even the intermediate term. In other words, generally speaking, fundamental models do not provide reliable timing information. 423 FUNDAMENTAl ANAlySIS AND TRADINg FIGURE  29.7 Case-Shiller National Home Price Index, Infl ation Adjusted Source: www .econ.yale.edu/~shiller/data.htm. Data refl ect December values for each calendar year. Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. The 2008 fi nancial meltdown and the subsequent great Recession provide an excellent illustra- tion of the disconnect between changes in the fundamentals and the timing of price moves. There were many reasons for the 2008 fi nancial crisis but certainly chief among them was the bursting of the housing bubble that had seen housing prices far exceed historical norms. For more than a century since the starting year of the Case-Shiller Home Price Index, the infl ation-adjusted index level fl uctu- ated in a range of approximately 65 to 130. At the peak of the 2003–2006 housing bubble, the index had nearly doubled its long-term median level (see Figure 29.7 ). The extremes of the housing bubble were fueled by excesses in subprime mortgage lending: loans were made to borrowers with poor credit, requiring little or no money down, and in its later phases no verifi cation of income or assets. An insatiable demand for mortgages to bundle into mortgage-backed securities (MBSs) incentivized mortgage lenders to write as many mortgages as possible. These lenders were unconcerned about whether borrowers could pay back the loans because they passed on the owner- ship of mortgages to other fi nancial institutions for use in securitizations. The competition among mort- gage lenders to fi nd new borrowers seemed like a race to issue the poorest quality mortgages possible. The S&P Case-Shiller Home Price Index peaked in the spring of 2006 (see Figure 29.8 ). At the same time, the rate of delinquencies on subprime adjusted rate mortgages (ARMs) rose steadily throughout 2006 and accelerated in 2007 (see Figure 29.9 ). Despite these ominous developments, U.S. stock prices continued to move higher, ultimately extending to new record levels, as shown in Figures 29.8 and 29.9 . In fact, the extension of the equity bull market after the peak in housing prices in mid-2006 occurred in the face of a more than doubling of sub- 424A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  29.8 The S&P/Case-Shiller Home Price Index (20-City Composite, Seasonally Adjusted) vs. S&P 500 Index Median Monthly Price Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE  29.9 Subprime Arm T otal Delinquencies vs. S&P 500 Median Monthly Price Source: OTS (delinquency data) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 425 FUNDAMENTAl ANAlySIS AND TRADINg prime delinquencies—a fundamental development that not only had very negative implications for housing prices and the economy, but also seriously imperiled the literally trillions of dol - lars of subprime MBS that had been issued. All these factors were bearish for the stock market. Nonetheless, it was not until 18 months after housing prices had peaked and a similar interim of sharply rising delinquencies on subprime mortgages that the stock market finally topped out in October 2007. Assume a fundamental analyst came to the conclusion the prevailing bull market in equities during the mid-2000s was critically dependent on an ongoing housing bubble, which could not be sustained, and whose inevitable reversal would lead to a stock market collapse—a prognostication that would ultimately prove spectacularly correct. Further assume this analyst interpreted the reversal in the Case-Shiller Home Price Index in mid-2006 and the concurrent emerging uptrend in subprime mort- gage delinquencies as early evidence that the housing bubble was unraveling—another correct assess- ment. Now consider the outcome if the analyst acted on this market assessment by implementing a short position in stock index futures in September 2006—the month after subprime delinquencies reached a new multiyear high. A short S&P position initiated at the median price in September 2006 would have been exposed to a 20 percent rise in the index before the stock market ultimately peaked in October 2007. Although the stock market subsequently collapsed, it is highly unlikely the analyst could have survived such a large adverse price move before giving up and liquidating the position at a large loss. The point is not that fundamentally oriented traders should adamantly hold on to positions if they have a strong conviction in their market analysis—a mental attitude that would be almost certain to result in financial ruin, as it would take only one wrong forecast to lead to a devastating loss. Rather, the point is that even accurate fundamental analysis can lead to poor trading results if fundamentals are used for timing. Crude oil prices in 1985 offer another classic example of a market that continued to extend its prior trend after an important fundamental change, only to witness a belated major reversal many months later. In March 1985 the Saudis announced they would no longer be the Organization of the Petroleum Exporting Countries’ (OPEC) “swing supplier” (i.e., the producer that adjusted its output to keep supply and demand in balance). Their decision to abandon their price-supportive role had bearish implications. The Saudis implemented this policy by introducing netback crude oil pricing during the summer of 1985, or guaranteeing buyers of Saudi oil a profit margin. In essence, the Sau- dis were pricing their oil at whatever price was necessary to move all their production. Despite this ominous action, prices still continued to climb (see Figure 29.10). Prices did not collapse until OPEC officially decided to “pursue market share” at their December 1985 meeting, six months after the de facto implementation of such a policy by Saudi Arabia. A fundamental analyst who decided in the summer of 1985 that the world oil market was vulner- able to a collapse would have been absolutely right—eventually. In the interim, any short positions implemented on this analysis would have been subject to a protracted, large loss. Thus, poor timing of trade entry based on the timing of fundamental events could have transformed a potential windfall trade into a major loss. The simple fact is that the timing of price moves is often out of sync with the timing of fundamental developments. 426A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  29.10 March 1986 WTI Crude Oil Futures Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. ■ Combining Fundamental Analysis with Technical Analysis and Money Management As a result of the three pitfalls in fundamental analysis, a buy-and-hold or sell-and-hold trading strat- egy will eventually prove disastrous for virtually any fundamental analyst. Even assuming a price- forecasting model always managed to include all key variables, a fundamental analyst would still be vulnerable to large trading losses as a result of unexpected developments and poor timing. The observations in the previous section suggest the following important trading rule: rUle: Never hold a fundamental opinion with complete rigidity. Clearly, fundamental analysis alone is insuffi cient for making trading decisions. The two missing ingredients are technical analysis and money management. These various inputs can be combined in the following manner. Fundamental analysis is used as the initial step in the decision-making process in order to determine whether the market is underpriced, overpriced, or in line. rUle: View fundamental analysis as a tool for gauging whether the market is out of line. Once a fundamental indication is obtained, technical factors are checked for possible confi rma- tion. This technical input can be in the form of charts or a mechanical system. The main point is that it is necessary to check whether the fundamentally suggested trade appears reasonable in terms of market action. For example, if fundamentals suggest the market is overpriced at a time when prices 427 FUNDAMENTAl ANAlySIS AND TRADINg are in an unbroken uptrend, it would usually be best to delay the implementation of any short posi- tion. However, such a fundamental projection might still provide the motivation for initiating shorts on the first signs the market is faltering. Occasionally, it is reasonable to implement a fundamental trade counter to the prevailing price trend if the market is approaching a major resistance area. For example, assume corn prices are cur- rently $6/bushel and in a virtually unbroken uptrend, while fundamental analysis suggests an equi- librium price level of only $5. If the market is approaching a major resistance area (e.g., a previous high, or the low end of a prior trading range), one might use fundamental analysis as the justification for anticipating a top. However, the trade should only be considered if the trader chooses a predeter- mined exit point. This point introduces the third major element in making trading decisions: money management. Of course, the control of losses is essential even when the trading implications of fundamental and technical analysis are in full agreement. However, money management is particularly critical when one is anticipating a market turn. rUle: An effective trading approach should combine fundamental analysis with technical analysis and money management. ■ Why Bother with Fundamentals? At this point, the reader might well ask: If fundamental input must be used in conjunction with tech- nical analysis, why should the trader even bother with fundamental analysis in the first place? There are several answers to this question: 1. Fundamental analysis provides an extra dimension of information not available to the purely tech- nical trader. Knowing why a market is acting the way it is can be invaluable in trading decisions. For example, a rally in a declining market might be attributable to a news item that does not meaningfully alter a bearish fundamental outlook, or it might reflect that the market is oversold relative to the fundamentals. T echnical analysts cannot distinguish between these two situations— they must treat all similar patterns alike, regardless of the underlying causes. The fundamental analyst, however, can use an awareness of existing market conditions and potential developments as an aid in assessing whether a rally is likely to be the beginning of a new bull market or a bull trap. Of course, such value judgments will not always be accurate, but this consideration is not a problem. For fundamental input to be of value, it is only necessary that profits (or reduced losses) tied to correct decisions exceed the losses (or reduced gains) resulting from incorrect decisions. 2. Fundamentals might sometimes portend a major price move well in advance of any technical signals. The trader who is aware of such a potential transition could have an important advantage over traders who are only following technical signals. 3. A knowledge of fundamentals would permit a trader to adopt a more aggressive stance when the fundamentals suggest the potential for a major move. The strictly technical trader, however, would have to treat all trading signals the same. 428 A Complete Guide to the Futures mArket 4. An understanding of the underlying fundamentals can provide the incentive to stay with a win- ning trade. 5. The way in which a market responds to fundamental news can be used as a trading tool, even by the technical trader. ■ Are Fundamentals Instantaneously Discounted? One aspect of the efficient market hypothesis, a popular theory subscribed to by many economists, can be paraphrased as follows: At any given time, the market discounts all known information. Of course, if this premise were true, all market analysts—and readers of this book as well—would be suffering from mass delusion. However, there are more compelling reasons for contesting this hypothesis. One reason is the fundamental information responsible for a major price transition is frequently available well before the price trend actually develops. Another reason is that price moves often reflect a reaction to a preceding price swing that had carried the market well beyond funda - mentally sustainable equilibrium levels. In both cases, dramatic price moves may materialize in the apparent absence of any significant concurrent change in the basic fundamentals. In fact, in the case in which a market has sharply overshot its equilibrium level, it is not unusual for prices to respond in the opposite direction one would anticipate for certain fundamental news (e.g., a rally following a bearish news item). The aforementioned types of price behavior are inexplicable only if one assumes the market dis- counts all known information at any given time. However, a far more plausible view of market behav- ior is that prices sometimes lag or anticipate the levels implied by existing information. Copper during 2002 through 2006 provides a good example of a market in which price moves occurred well after the fundamental changes responsible for those moves. In 2002, copper invento- ries reached enormous levels. Not surprisingly, the copper market languished at low prices. Inven- tories then embarked upon a long decline, but prices failed to respond for more than a year (see Figure 29.11). Beginning in late 2003, prices finally adjusted upward to a higher plateau, as invento- ries continued to slide. Prices then continued to move sideways at this higher level for about one year (early 2004 to early 2005), even though inventories fell still further. This sideways drift was followed by an explosive rally, which saw prices nearly triple in just over one year’s time. Ironically, this enor- mous price advance occurred at a time when inventories had actually begun to increase moderately. A fundamental analyst who correctly anticipated both the peak and low in copper inventories and traded based on the timing of shifting fundamentals could well have fared poorly. Price responses followed major changes in the fundamentals (inventory levels) with long lags. The market in 2006 traded at dramatically higher price levels on the same fundamentals as it did in early 2005. These long lags between changes in fundamentals and price adjustments contradict the immediate price adjustments implied by the efficient market hypothesis. The more plausible explana- tion is that the shift in market psychology from complacency regarding ample supply availability to heightened sensitivity over supply shortages occurred gradually over time rather than as an immediate response to changing fundamentals. 429 FUNDAMENTAl ANAlySIS AND TRADINg FIGURE  29.11 lME Copper Inventories vs. lME Copper Prices CQg, Inc. © 979030 24232 950000 900000 850000 800000 750000 700000 650000 600000 550000 550000 450000 400000 350000 300000 250000 200000 150000 100000 2002 Jan Jul 50000 411425 2003 Jan Jul 2004 Jan Jul 2005 Jan 2006 JanJul 7170 8500 8000 7500 7000 6500 6000 5500 5000 4500 4000 3500 3000 2500 2000 1500 2002 Jan Jul 2003 Jan Jul 2004 Jan Jul 2005 Jan 2006 JanJul O= 411425 Line E= −2375 L= 411425 I= 411425 H= 411425 430A COMPlETE gUIDE TO THE FUTURES MARKET FIGURE  29.12 March 1986 Corn Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. The 1985–1986 corn market provides another excellent illustration of the nonsynchronous rela- tionship between fundamental information and price movements. Corn prices rose steadily from September through December 1985 (see Figure 29.12 ), despite repeated increases in the production estimate and reductions in the total usage projection, which resulted in a consistent expansion in the forecasted ending stock/usage ratio (see Table 29.2 ). This price action would be completely inexpli- cable if one assumed that prices always responded instantaneously to new fundamental information, a popular academic premise that is subject to frequent empirical contradiction in the real world. Rather, it makes far more sense to view the subsequent price collapse in January/February 1986 as a belated response to the steady deterioration in the fundamental picture in late 1985. table 29.2 Corn: USDa Supply/Disappearance estimates During 1985–1986 Season (million bushels) Month production total Use ending Stocks Stock/Use ratio (%) August 1985 8,266 7,145 2,364 33.1 September 1985 8,469 7,070 2,717 38.4 October 1985 8,603 7,070 2,851 40.3 November 1985 8,717 7,045 3,052 43.3 December 1985 8,717 7,045 3,052 43.3 January 1986 8,717 7,045 3,052 43.3 February 1986 8,865 6,845 3,403 49.7 431 FUNDAMENTAl ANAlySIS AND TRADINg ■ Fitting the News to Price Moves Although day-to-day price moves often reflect ongoing adjustments to background fundamentals and shifting expectations rather than reactions to concurrent events, the media will usually seek to fit the news to market price movements. If the market is up sharply on a given day, some economic news will be found to explain the price strength. Similarly, if the market breaks precipitously, it’s a safe bet that some bearish fundamental explanation will be found. This tailoring of news to fit the price action can sometimes reach absurd lengths, as exemplified by the following two excerpts. The first selection is from an article with the headline, “Strong Economic Reports give a lift to the Dollar”: The dollar closed mostly higher yesterday after what currency traders saw as stronger- than-expected economic reports. “There was good reaction to surprisingly strong num- bers,” said . . . “The biggest one was retail sales.” . . . The Commerce Department reported that retail sales rose three-tenths of 1 percent in November, after remaining unchanged in October. A fall in new weekly claims for unemployment also helped the dollar. The next quotation comes from a story with the headline, “ long- T erm Rates Fall on Reports”: . . . bond prices benefited from a Commerce Department report that showed the Christmas buying season got off to a slow start in November. . . . At first blush, the numbers seemed to suggest that consumer activity had begun to pick up. But analysts said the increase was tainted because of the downward revisions in sales figures for Sep- tember and October. “The revisions showed that consumers are still struggling,” said . . . Both of these stories come from the same newspaper, on the same day, on facing pages! Of course, major unexpected developments will have an immediate market impact when they become known, but for the most part, the efficient market hypothesis assumption that prices instan- taneously adjust to fundamental news has it exactly backwards. It is far more accurate to say the financial news will instantaneously adjust to price changes. Whether the market is up or down on a given day, financial reporters have to find an explanation for the price move. Therefore, an explana- tion will be drawn from the coincident news developments on that day, whether they are pertinent or not. This routine process can lead to the comical situation of the same development being used as both a bullish and bearish explanation on days where the market traverses widely between up and down or vice versa. August 26, 2011, was a perfect example. On that day, the market sold off in the morning, and then rallied sharply into the afternoon. The key focus of market attention was a speech by Federal Reserve Chairman Ben Bernanke. The following two headlines announced stock market news stories issued by the same newswire service on the same day: Wall Street Slides after Bernanke Comments Wall Street Bounces as Bernanke Keeps Hopes Alive 432 A Complete Guide to the Futures mArket The first story read, “Major indexes fell more than 1 percent after Federal Reserve Chairman Ben Bernanke said the U.S. economic recovery was much less robust than hoped but stopped short of signaling further action to boost growth.” The second story saw things a bit differently: “Bernanke raised hope the Fed could consider further stimulus measures for the economy at an extended policy meeting in September.” Now , you could believe the same event was bearish before it was bullish. It seems considerably more plausible, though, to believe that the interpretation of the event was altered to fit the market price action. I can assure you that if the market had failed to rebound, there would not have been any stories about how the market ignored Bernanke’s constructive comments. The market action deter- mines the interpretation of the news, not the other way around. Quite frequently prices move higher on the same longer-term fundamentals that have been known for some time or in reaction to a prior decline that took prices too low based on the underlying funda- mentals. But while these types of longer-term underlying factors are what really move prices, rather than the often minor or irrelevant developments that are coincident on the same day, they apparently do not make acceptable news copy. When was the last time you saw a financial page headline that read, “Market Rallies Sharply because Bullish Fundamentals Unchanged” or “Market Plunges as Prices Correct Recent Speculative Mania”? ■ Fundamental Developments: Long-Term Implications versus Short-Term Response In interpreting new developments, it is necessary to make a distinction between the long term and the short term. The long-term interpretation is fairly straightforward: All else being equal, a bullish news item suggests higher prices. However, the short-term interpretation of new developments is entirely different: The essential consideration is how the market responds to the news. In this regard, as summarized by the following rule, the significant occurrence is a divergence between fundamental news and subsequent price action. rUle: A bullish fundamental development that is followed by a decline or that prompts a rally well below expectations should be viewed as a bearish signal. A bearish fundamental development that is followed by a rally or that prompts a significantly smaller-than-anticipated decline should be viewed as a bullish signal. By no means is this rule sufficient by itself to allow trading decisions. But in conjunction with other market information, such as background fundamentals and the technical picture, an awareness of this rule should help improve a trader’s performance. Some examples of interpreting market response were provided in Chapter 27. Still, another example might help clarify this approach in using fundamental developments as a trading tool. The time was December 24, 1980, and the cotton market finished the holiday-shortened week just below contract highs and only a few cents below record highs. Despite the pronounced price advance over the previous six-month period, the fundamental picture still appeared bullish because supply and 433 FUNDAMENTAl ANAlySIS AND TRADINg usage trends suggested the potential for the lowest ending carryover since the early 1950s. The weekly export report released after the close indicated a huge net sales fi gure in excess of one-half million bales. This export fi gure confi rmed rumors of potential large sales to China and virtually assured a very low season ending carryover. On the basis of her analysis, Stephanie Statistics had been long for some time. After the release of the strikingly bullish December 24 export fi gure, Stephanie had to virtually restrain herself from calculating the potential increase in her open equity as a result of this latest news item. Monday morning the market opened with near limit gains. “Not bad,” she thought, but the fact that the market did not open locked limit-up was disconcerting. As the day progressed, prices began to ease and warning bells went off in her mind. Something was wrong—the market was not really acting right, given the export news. On the basis of this input, Stephanie liquidated one-third of her position that day, one-third the next day, and the remaining third one week later. This scaled liquidation refl ected her reluctance to give up a long position in the cotton market, given what she still perceived to be an extremely bullish fundamental outlook. Stephanie’s fundamental view of the market at that time could not have been more off target. As subsequent events would prove, that Monday was the top of the market (see Figure 29.13 ) and the start of a yearlong slide—the impending extremely low carryover notwithstanding. Eventually, the fundamental explanations for the market’s weakness became evident: high interest rates, a deep recession, and expectations for a large new crop. However, by that time, prices had already moved substantially lower (albeit a large portion of the bear move still remained to be realized). The crucial point is that a contrarian interpretation of a bullish news item provided a long liquidation signal at the FIGURE  29.13 July 1981 Cotton Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 434A COMPlETE gUIDE TO THE FUTURES MARKET market top and prevented an incorrect fundamental market evaluation from transforming a profi table position into a large loss. The preceding story was not a recreation based on artifi cial hindsight. The events described are true, only the names have been changed to protect the guilty. A large price move in response to a seemingly neutral event can also be signifi cant. The FCOJ market’s response to the October 1993 Crop Production report, which was initially interpreted as “neutral,” provides an excellent example. This situation and its implications are nicely described from a trader’s perspective in the following excerpt of an interview of Russell Sands that appeared in Commodity T raders Consumers Report : y esterday there was a crop report. They were expecting between 165 and 180 million boxes of orange juice. The number came out at 172—right in the middle. The early call this morning was unchanged to slightly lower. A few minutes before the open they changed the call to 300 lower. The market opened 700 lower. Now it’s down 900. I have no idea what the fundamentals are. I read the crop report yesterday after- noon, and I thought it would be a quiet day. Maybe the estimates were wrong. Maybe somebody didn’t believe the estimates. I have no clue as to why this happened. All I know is there was a neutral report, there was a close-to-unchanged call, but all of a sudden the market is sharply lower and I didn’t get out. All the fundamental knowl- edge in the world is not going to save me. I’m scrambling to get out and cut my losses. As readers can ascertain in Figure 29.14 , getting out of longs even 900 points lower on the day in question looked awfully good a few days or a few weeks later. The preceding quotation, which FIGURE  29.14 November 1993 FCOJ Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 435 FUNDAMENTAl ANAlySIS AND TRADINg apparently was recorded at the moment of the market event being described, provides a good real- life illustration of how market response to fundamental news can be utilized as an aid in making trading decisions. ■ Summary An awareness of the potential limitations of fundamental analysis is essential to its successful appli- cation. Perhaps the key point to keep in mind is that fundamental analysis is primarily a tool for forecasting intermediate or long-term price swings and should not be used as a timing indicator. The only exception to this basic premise is that a counter-to-anticipated market response to fundamental information could be viewed as a contrarian trading signal (e.g., a bullish fundamental development would have bearish near-term implications if it failed to elicit the anticipated positive price response). Futures spreAds And OptiOns Part VI 439 Cha P ter 30 There was a one-lot trader named Fred, who tried to reduce risk with a spread. But the spread was his demise— He overdid position size, trading not 1 but 10 instead. ■ Introduction despite widespread publicity and extensive information, spreads still remain an often misunderstood and relatively little-used trading vehicle. there is nothing inordinately complicated about spread trad- ing; many traders simply lack the familiarity with the concepts involved. ironically, it is usually the novice trader, for whom spreads can be a particularly useful trading vehicle, who shuns them as an esoteric operation confined to the “pros.” Furthermore, even experienced traders often exhibit a bias against trading spreads, preferring to trade in outright positions because of their greater potential. these traders fail to realize that, at times, spreads may offer a more attractive reward/risk ratio than outright positions. in other words, at a given time, X number of spreads may offer equal potential to a one-contract outright position but imply a smaller risk. (Of course, such a judgment will always be subjective.) the Concepts and Mechanics of spread trading 440 A Complete Guide to the Futures mArket ■ Spreads—Definition and Basic Concepts A spread trade involves the simultaneous purchase of one futures contract against the sale of another futures contract either in the same market or in a related market. normally, the spread trader will initiate a position when he considers the price difference between two futures contracts to be out of line rather than when he believes the absolute price level to be too high or too low . in essence, the spread trader is more concerned with the difference between prices than the direction of price. For example, if a trader buys October cattle and sells February cattle, it would not make any difference to him whether October rose by 500 points and February by only 400 points or October fell by 400 and February fell by 500. in either case, October would have gained 100 points relative to February, and the trader’s profit would be completely independent of the overall market direction. However, this is not to say the spread trader will initiate a trade without having some definitive bias as to the future outright market direction. in fact, very often the direction of the market will determine the movement of the spread. in some instances, however, a spread trader may enter a posi- tion when he has absolutely no bias regarding future market direction but views a given price differ- ence as being so extreme that he believes the trade will work, or at worst allow only a modest loss, regardless of market direction. W e will elaborate on the questions of when and how market direction will affect spreads in later sections. ■ Why Trade Spreads? the following are some advantages to not exclusively restricting one’s trading to outright positions: 1. In highly volatile markets, the minimum outright commitment of one contract may offer excessive risk to small traders. in such markets, one-day price swings in excess of $1,500 per contract are not uncommon, and holding a one-contract position may well be overtrading for many traders. ironically, it is usually these highly volatile markets that provide the best potential trading opportunities. spreads offer a great flexibility in reducing risk to a desirable and manageable level, since a spread trade usually presents only a fraction of the risk involved in an outright position. 1 For example, assume a given spread is judged to involve approximately one-fifth the risk of an outright position. in such a case, traders for whom a one- contract outright position involves excessive risk may instead choose to initiate a one-, two-, three-, or four-contract spread position, depending on their desired risk level and objectives. 2. there are times when spreads may offer better reward/risk ratios than outright positions. Of course, the determination of a reward/risk ratio is a subjective matter. never- theless, given a trader’s market bias, in a given situation spreads may sometimes offer a better means of approaching the market. 1 For some markets, reduced-size contracts are available on one or more exchanges. 441 tHe COnCepts And MeCHAniCs OF spreAd trAding 3. Spreads often offer some protection against sudden extreme losses due to dra- matic events that may spark a string of limit-up or limit-down moves counter to one’s position (e.g., freeze, large export deal). such situations are not all that infrequent, and traders can sometimes lose multiples of the maximum loss they intended to allow (i.e., as reflected by a protective stop) before they can even liquidate their positions. in contrast, during a time of successive limit moves, the value of a spread might not even change as both months may move the limit. Of course, eventually the spread will also react, but when it does, the market may well be past its frenzied panic stage, and the move may be gradual and moderate compared with the drastic price change of the outright position. 4. a knowledge and understanding of spreads can also be a valuable aid in trading outright positions. For example, a failure of the near months to gain sufficiently during a rally (in those commodities in which a gain can theoretically be expected) may signal the trader to be wary of an upward move as a possible technical surge vulnerable to retracement. in other words, the spread action may suggest that no real tightness exists. this scenario is merely one example of how close observation of spreads can offer valuable insights into outright market direction. naturally, at times, the inferences drawn from spread movements may be mislead- ing, but overall they are likely to be a valuable aid to the trader. A second way an understanding of spreads can aid an outright-position trader is by helping identify the best contract month in which to initiate a position. the trader with knowledge of spreads should have a distinct advan- tage in picking the month that offers the best potential versus risk. Over the long run, this factor alone could significantly improve trading performance. 5. trading opportunities may sometimes exist for spreads at a time when none is perceived for the outright commodity itself. ■ Types of Spreads there are three basic types of spreads: 1. the intramarket (or interdelivery) spread is the most common type of spread and con- sists of buying one month and selling another month in the same commodity. An example of an intramarket spread would be long december corn/short March corn. the intramarket spread is by far the most widely used type of spread and will be the focus of this chapter’s discussion. the intercrop spread is a special case of the intramarket spread involving two different crop years (e.g., long an old crop month and short a new crop month). the intercrop spread requires special consideration and extra caution. intercrop spreads can often be highly volatile, and price moves in opposite directions by new and old crop months are not particularly uncom- mon. the intercrop spread may often be subject to price ranges and patterns that distinctly separate it from the intracrop spread (i.e., standard intramarket spread). 2. the intercommodity spread consists of a long position in one commodity and a short position in a related commodity. in this type of spread the trader feels the price of a given 442 A Complete Guide to the Futures mArket commodity is too high or low relative to a closely related commodity. some examples of this type of spread include long december cattle/short december hogs and long July wheat/short July corn. The source/product spread, which involves a commodity and its by-product(s)—for example, soybeans versus soybean meal and/or soybean oil—is a specific type of intercommod- ity spread that is sometimes classified separately. usually, an intercommodity spread will involve the same month in each commodity, but this need not always be the case. ideally, traders should choose the month they consider the strongest in the market they are buying and the month they consider the weakest in the market they are selling. Obviously, these will not always be the same month. For example, assume the following price configuration: December February april Cattle 120.00 116.00 118.00 Hogs 84.00 81.00 81.00 given this price structure, a trader might decide the premium of cattle to hogs is too small and will likely increase. this trading bias would dictate the initiation of a long cattle/short hog spread. However, the trader may also believe February cattle is underpriced relative to other cattle months and that december hogs are overpriced relative to the other hog contracts. in such a case, it would make more sense for the trader to be long February cattle/short decem- ber hogs rather than long december cattle/short december hogs or long February cattle/short February hogs. One important factor to keep in mind when trading intercommodity spreads is that contract sizes may differ for each commodity. For example, the contract size for euro futures is 125,000 units, whereas the contract size for British pound futures is 62,500 units. thus, a euro/British pound spread consisting of one long contract could vary even if the price difference between the two markets remained unchanged. the difference in price levels is another important fac- tor relevant to contract ratios for intercommodity spreads. the criteria and methodology for determining appropriate contract ratios for intercommodity spreads are discussed in the next chapter. 3. the intermarket spread. this spread involves buying a commodity at one exchange and sell- ing the same commodity at another exchange, which will often be another country. An example of this type of spread would be long new Y ork March cocoa/short London March cocoa. trans- portation, grades deliverable, distribution of supply (total and deliverable) relative to location, and historical and seasonal basis relationships are the primary considerations in this type of spread. in the case of intermarket spreads involving different countries, currency fluctuations become a major consideration. intermarket spread trading is often referred to as arbitrage. As a rule, the intermarket spread requires a greater degree of sophistication and comprehensive familiarity with the commodity in question than other types of spreads. 443 tHe COnCepts And MeCHAniCs OF spreAd trAding ■ The General Rule For many commodities, the intramarket spread can often, but not always, be used as a proxy for an outright long or short position. As a general rule, near months will gain ground relative to distant months in a bull market and lose ground in a bear market. the reason for this behavior is that a bull market usually reflects a current tight supply situation and often will place a premium on more imme- diately available supplies. in a bear market, however, supplies are usually burdensome, and distant months will have more value because they implicitly reflect the cost involved in storing the com- modity for a period of time. thus, if a trader expects a major bull move, he can often buy a nearby month and sell a more distant month. if he is correct in his analysis of the market and a bull move does materialize, the nearby contract will likely gain on the distant contract, resulting in a success- ful trade. it is critical to keep in mind that this general rule is just that, and is meant only as a rough guideline. there are a number of commodities for which this rule does not apply, and even in those commodities where it does apply, there are important exceptions. W e will elaborate on the question of applicability in the next section. At this point the question might legitimately be posed, “ if the success of a given spread trade is contingent upon forecasting the direction of the market, wouldn’t the trader be better off with an outright position?” Admittedly, the potential of an outright position will almost invariably be consid- erably greater. But the point to be kept in mind is that an outright position also entails a correspond- ingly greater risk. sometimes the outright position will offer a better reward/risk ratio; at other times the spread will offer a more attractive trade. A determination of which is the better approach will depend upon absolute price levels, prevailing price differences, and the trader’s subjective views of the risk and potential involved in each approach. ■ The General Rule—Applicability and Nonapplicability Commodities to Which the General rule Can Be applied Commodities to which the general rule applies with some regularity include corn, wheat, oats, soybeans, soybean meal, soybean oil, lumber, sugar, cocoa, cotton, orange juice, copper, and heating oil. ( the general rule will also usually apply to interest rate markets.) Although the general rule will usually hold in these markets, there are still important exceptions, some of which include: 1. At a given point in time the premium of a nearby month may already be excessively wide, and consequently a general price rise in the market may fail to widen the spread further. 2. s ince higher prices also increase carrying costs (see section entitled “the Limited-risk spread”), it is theoretically possible for a price increase to widen the discount of nearby months in a surplus market. Although such a spread response to higher prices is atypical, its probability of occurrence will increase in a high-interest-rate environment. 444 A Complete Guide to the Futures mArket 3. s preads involving a spot month near expiration can move independently of, or contrary to, the direction implied by the general rule. the reason is that the price of an expiring position is criti- cally dependent upon various technical considerations involving the delivery situation, and wide distortions are common. 4. A bull move that is primarily technical in nature may fail to influence a widening of the nearby premiums since no real near-term tightness exists. ( such a price advance will usually only be temporary in nature.) 5. g overnment intervention (e.g., export controls, price controls, etc.), or even the expectation of government action, can completely distort normal spread relationships. therefore, it is important that when initiating spreads in these commodities, the trader keep in mind not only the likely overall market direction, but also the relative magnitude of existing spread differences and other related factors. Commodities Conforming to the Inverse of the General rule some commodities, such as gold and silver, conform to the exact inverse of the general rule: in a ris- ing market distant months gain relative to more nearby contracts, and in a declining market they lose relative to the nearby positions. In fact, in these markets, a long forward/short nearby spread is often a good proxy for an outright long position, and the reverse spread can be a substitute position for an outright short. in each of these markets nearby months almost invariably trade at a discount, which tends to widen in bull markets and narrow in bear markets. the reason for the tendency of near months in gold and silver to move to a wider discount in a bull market derives from the large worldwide stock levels of these metals. generally speaking, price fluctuations in gold and silver do not reflect near-term tightness or surplus, but rather the market’s changing perception of their value. in a bull market, the premium of the back months will increase because higher prices imply increased carrying charges (i.e., interest costs will increase as the total value of the contract increases). Because the forward months implicitly contain the cost of carrying the commodity, their premium will tend to widen when these costs increase. Although the preced- ing represents the usual pattern, there have been a few isolated exceptions due to technical factors. Commodities Bearing Little or No relationship to the General rule Commodities in which there is little correlation between general price direction and spread differ- ences usually fall into the category of nonstorable commodities (cattle and live hogs). W e will exam- ine the case of live cattle to illustrate why this there is no consistent correlation between price and spread direction in nonstorable markets. Live cattle, by definition, is a completely nonstorable commodity. When feedlot cattle reach mar- ket weight, they must be marketed; unlike most other commodities, they obviously cannot be placed in storage to await better prices. ( to be perfectly accurate, cattle feeders have a small measure of flexibility, in that they can market an animal before it reaches optimum weight or hold it for a while after. However, economic considerations will place strong limits on the extent of such marketing 445 tHe COnCepts And MeCHAniCs OF spreAd trAding shifts.) As a consequence of the intrinsic nature of this commodity, different months in live cattle are, in a sense, different commodities. June live cattle is a very different commodity from december live cattle. the price of each will be dependent on the market’s perception of the supply-demand picture that it expects to prevail at each given time period. it is not unusual for a key cattle on feed report to carry bullish implications for near months and bearish connotations for distant months, or vice versa. in such a case, the futures market can often react by moving in opposite directions for the near and distant contracts. the key point is that in a bullish (bearish) situation, the market will sometimes view the near-term supply/demand balance as being more bullish (bearish) and sometimes it will view the distant situation as being more bullish (bearish). A similar behavioral pattern prevails in hogs. thus, the general rule would not apply in these types of markets. in these markets, rather than being concerned about the overall price direction, the spread trader is primarily concerned with how he thinks the market will perceive the fundamental situation in dif- ferent time periods. For example, at a given point in time, June cattle and december cattle may be trading at approximately equal levels. if the trader believes that marketings will become heavy in the months preceding the June expiration, placing pressure on that contract, and further believes the market psychology will view the situation as temporary, expecting prices to improve toward year- end, he would initiate a long december/short June cattle spread. note that if he is correct in the development of near-term pressure but the market expects even more pronounced weakness as time goes on, the trade will not work even if his expectations for improved prices toward year-end also prove accurate. One must always remember that a spread’s life span is limited to the expiration of the nearer month, and substantiation of the spread idea after that point will be of no benefit to the trader. thus, the trader is critically concerned, not only with the fundamentals themselves, but also with the market’s perception of the fundamentals, which may or may not be the same. ■ Spread Rather Than Outright—An Example Frequently, the volatility of a given market may be so extreme that even a one-contract position may represent excessive risk for some traders. in such instances, spreads offer the trader an alternative approach to the market. For example, in early 2014, coffee futures surged dramatically, gaining more than 75 percent from late January to early March, with average daily price volatility more than tri- pling during that period. prices swung wildly for the next several months—pushing to a higher high in April, giving back more than half of the rally in the sell-off to the July low , and then rallying to yet another new high in October (see Figure 30.1). At that juncture, assume a low-risk trader believed that prevailing nearest futures prices near $2.22 in mid-October 2014 were unsustainable, but based on the market’s volatility (which was still around three times what it had been early in the year) and his money management rules felt he could not assume the risk of an outright position. such a trader could instead have entered a bear spread (e.g., short July 2015 coffee/long december 2015 coffee) and profited handsomely from the subsequent price slide. Figure 30.1 illustrates the close correspondence between the spread and the market. the fact that an outright position would have garnered a much larger profit is an irrelevant consideration, since the trader’s risk limitations would have prevented him from participating in the bear move altogether had his market view been confined to outright trades. 446A COMpLete guide tO tHe Futures MArKet ■ The Limited-Risk Spread the limited-risk spread is a type of intracommodity spread involving the buying of a near month (relatively speaking) and the selling of a more distant month in a storable commodity in which the process of taking delivery, storing, and redelivering at a later date does not require reinspection or involve major transportation or storage complications. this defi nition would exclude such commodi- ties as live cattle, which by defi nition are nonstorable, and sugar, which involves major complications in taking delivery and storing. Commodities that fall into the limited-risk category include corn, wheat, oats, soybeans, soybean oil, copper, cotton, orange juice, cocoa, and lumber. 2 in a commodity fulfi lling the above specifi cations, the maximum premium that a more distant month can command over a nearby contract is roughly equal to the cost of taking delivery, holding the commodity for the length of time between the two expirations, and then redelivering. the cost for this entire operation is referred to as full carry. the term limited risk will be used only when the nearby month is at a discount. For example, assuming full carry in the October/december cotton FIGURE  30.1 July and december 2015 Coff ee Futures vs. July/december 2015 Coff ee spread Chart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. 2 Although precious metals can easily be received in delivery, stored, and redelivered, they are not listed here because spreads in precious metals are almost entirely determined by carrying charges. thus, the only motivation for implementing an intramarket precious metals spread is an expectation for a change in carrying charges. in contrast, the purpose of a limited-risk spread is to profi t from an expected narrowing of the spread relative to the level implied by carrying charges (which are assumed to remain constant). 447 tHe COnCepts And MeCHAniCs OF spreAd trAding spread is equal to 200 points, a long October/short december spread initiated at October 100 points under might be termed a limited-risk spread. However, the same long October/short december cotton spread would not be termed limited risk if, for example, October were at a 300-point pre- mium. nevertheless, it should be noted that even in this latter case, the maximum risk would still be defined—namely, 500 points—and in this respect the spread would still differ from spreads involving the selling of the nearby contract, or spreads in markets that do not fulfill the limited-risk specifica- tions detailed above. the best way to understand why it is unlikely for the premium of a distant month to exceed car- rying costs is to assume the existence of a situation where this is indeed the case. in such an instance, a trader who bought a nearby month and sold a more distant month would have an opportunity for speculative gain and, at worst, would have the option of taking delivery, storing, and redelivering at a likely profit (since we assumed a situation in which the premium of the distant month exceeded carrying charges). sounds too good to be true? Of course, and for this reason differences beyond full carry are quite rare unless there are technical problems in the delivery process. in fact, it is usually unlikely for a spread difference to even approach full carry since, as it does, the opportunity exists for a speculative trade that has very limited risk but, theoretically, no limit on upside potential. in other words, as spreads approach full carry, some traders will initiate long nearby/short forward spreads with the idea that there is always the possibility of gain, but, at worst, the loss will be minimal. For this reason, spreads will usually never reach full carry. At a surface glance, limited-risk spreads seem to be highly attractive trades, and indeed they often are. However, it should be emphasized that just because a spread is relatively near full carry does not neces- sarily mean it is an attractive trade. V ery often, such spreads will move still closer to full carry, resulting in a loss, or trade sluggishly in a narrow range, tying up capital that could be used elsewhere. How- ever, if the trader has reason to believe the nearby month should gain on the distant, the fact that the spread has a limited risk (the difference between full carry and the current spread differential) makes the trade particularly attractive. the components of carrying costs include interest, storage, insurance, and commission. W e will not digress into the area of calculating carrying charges. ( such information can be obtained either through the exchanges themselves or through commodity brokers or analysts specializing in the given commodity.) However, we would emphasize that the various components of carrying charges are variable rather than fixed, and consequently carrying charges can fluctuate quite widely over time. interest costs are usually the main component of carrying charges and are dependent on interest rates and price levels, both of which are sometimes highly volatile. it is critical to keep changes in carrying costs in mind when making historical comparisons. Can a trader ever lose more money in a limited-risk spread than the amount implied by the differ- ence between full carry and the spread differential at which the trade was initiated? the answer is that although such an occurrence is unlikely, it is possible. For one thing, as we indicated above, carrying charges are variable, and it is possible for the theoretical maximum loss of a spread trade to increase as a result of fluctuations in carrying costs. For example, a trader might enter a long October/short december cotton spread at 100 points October under, at a time when full carry approximates 200 points—implying a maximum risk of 100 points. However, in ensuing months, it is possible higher 448 A Complete Guide to the Futures mArket prices and rising interest rates could cause full carry to move beyond 200 points, increasing the trad- er’s risk correspondingly. in such an instance, it is theoretically possible for the given spread to move significantly beyond the point the trader considered the maximum risk point. Although such an event can occur, it should be emphasized that it is rather unusual, since in a limited-risk spread increased carrying costs due to sharply higher price levels will usually imply larger gains for the nearby months. As for interest rates, changes substantial enough to influence marked changes in carrying costs will usually take time to develop. Another example of a limited-risk spread that might contain hidden risk is the case in which the government imposes price ceilings on nearby contracts but not on the more distant contracts. Although highly unusual, this situation has happened before and represents a possible risk that the spread trader should consider in the unlikely event that the prevailing political environment is condu- cive to the enactment of price controls. Also, for short intervals of time, spread differences may well exceed full carry due to the absence of price limits on the nearby contract. For a number of commodities, price limits on the nearby contract are removed at some point before its expiration (e.g., first notice day, first trading day of the expiring month, etc.). Consequently, in a sharply declining market, the nearby month can move to a discount exceeding full carry as the forward month is contained by price limits. Although this situation will usually correct itself within a few days, in the interim, it can generate a substantial mar- gin call for the spread trader. it is important that spread traders holding their positions beyond the removal of price limits on the nearby contract are sufficiently capitalized to easily handle such possible temporary spread aberrations. As a final word, it should be emphasized that although there is a theoretical limit on the premium that a distant month can command over a nearby contract in carrying-charge markets, there is no similar limit on the premium that a nearby position can command. nearby premiums are usually indicative of a tight current supply situation, and there is no way of determining an upper limit to the premium the market will place on more immediately available supplies. ■ The Spread Trade—Analysis and Approach Step 1: Straightforward historical Comparison A logical starting point is a survey of the price action of the given spread during recent years. Histori- cal spread charts, if available, are ideal for this purpose. if charts (or historical price data that can be downloaded into a spreadsheet) are unavailable, the trader should, if possible, scan historical price data, checking the difference of the given spread on a biweekly or monthly basis for at least the past 5 to 10 years. this can prove to be a time-consuming endeavor, but a spread trade initiated without any concept of historical patterns is, in a sense, a shot in the dark. Although spreads can deviate widely from historical patterns, it is still important to know the normal range of a spread, as well as its “average” level. 449 tHe COnCepts And MeCHAniCs OF spreAd trAding Step 2: Isolation of Similar Periods As a rule, spreads will tend to act similarly in similar situations. thus, the next step would be a refine- ment of step 1 by means of isolating roughly similar periods. For example, in a high-priced year, we might be interested in considering the spread action only in other past bull seasons, or we can cut the line still sharper and consider only bull seasons that were demand oriented or only those that were supply oriented. An examination of the spread’s behavior during different fundamental conditions in past years will usually reveal the relative comparative importance of similar and dissimilar seasons. Step 3: analysis of Spread Seasonality this step is a further refinement of step 1. sometimes a spread will tend to display a distinct seasonal pattern. For example, a given spread may tend to widen or narrow during a specific period. Knowledge of such a seasonality can be critically important in deciding whether or not to initiate a given spread. For example, if in nine of the past 10 seasons the near month of a given spread lost ground to the distant month during the March–June period, one should think twice about initiating a bull spread in March. Step 4: analysis and Implications of relevant Fundamentals this step would require the formulation of a concept of market direction (in commodities where applicable), or equivalent appropriate analysis in those commodities where it is not. this approach is fully detailed in the sections entitled “the general rule” and “the general rule—Applicability and nonapplicability.” Step 5: Chart analysis A key step before initiating a spread trade should be the examination of a current chart of the spread (or the use of some other technical input). As in outright positions, charts are an invaluable informa- tional tool and a critical aid to timing. ■ Pitfalls and Points of Caution ■ do not automatically assume a spread is necessarily a low-risk trade. in some instances, a spread may even involve greater risk than an outright position. specifically, in the case of intercommodity spreads, intercrop spreads, and spreads involving nonstorable commodities, the two legs of the spread can sometimes move in opposite directions. ■ Be careful not to overtrade a spread because of its lower risks or margin. A 5- to 10-contract spread position gone astray can often prove more costly than a bad one-contract outright trade. Overtrading is a very common error in spread trading. 450 A Complete Guide to the Futures mArket ■ As a general rule, traders should avoid trading spreads in markets in which they are unfamiliar with the fundamentals. ■ Check the open interest of the months involved to ensure adequate liquidity, especially in spreads involving distant back months. A lack of liquidity can significantly increase the loss when getting out of a spread that has gone awry. At times, of course, a given spread may be sufficiently attrac- tive despite its less-than-desirable liquidity. nevertheless, even in such a case, it is important that traders be aware of the extra risk involved. ■ place a spread order on a spread basis rather than as two separate outright orders. some traders place their spread orders one leg at a time in the hopes of initiating their position at a better price than the prevailing market level. such an approach is inadvisable not only because it will often backfire, but also because it will increase commission costs. ■ When the two months of the spread are very close in price, extra care should be taken to specify clearly which month is the premium month in the order. ■ do not assume that current price quotations accurately reflect actual spread differences. time lags in the buying and selling of different contracts, as well as a momentary concentration of orders in a given contract month, can often result in outright price quotations implying totally unrepresen- tative spread values. ■ do not liquidate spreads one leg at a time. Failing to liquidate the entire spread position at one time is another common and costly error, which has caused many a good spread trade to end in a loss. ■ Avoid spreads involving soon-to-expire contracts. expiring contracts, aside from usually being free of any price limits, are subject to extremely wide and erratic price moves dependent on technical delivery conditions. ■ do not assume the applicability of prior seasons’ carrying charges before initiating a limited-risk spread. Wide price swings and sharply fluctuating interest costs can radically alter carrying costs. ■ try to keep informed of any changes in contract specifications, since such changes can substan- tially alter the behavior of a spread. ■ properly implemented intercommodity and intermarket spreads often require an unequal num- ber of contracts in each market. the methodology for determining the proper contract ratio be- tween different markets is discussed in the next chapter. ■ do not use spreads to protect an outright position that has gone sour—that is, do not initiate an opposite direction position in another contract as an alternative to liquidating a losing position. in most cases such a move amounts to little more than fooling oneself and often can exacerbate the loss. 451 tHe COnCepts And MeCHAniCs OF spreAd trAding ■ Because it is especially easy to procrastinate in liquidating a losing spread position, the spread trader needs to be particularly vigilant in adhering to risk management principals. it is advisable that the spread trader determine a mental stop point (usually on the basis of closing values) prior to entering a spread and rigidly stick to liquidating the spread position if this mental stop point is reached. ■ Avoid excessively low-risk spreads because transaction costs (slippage as well as commission) will represent a significant percentage of the profit potential, reducing the odds of a net winning out- come. in short, the odds are stacked against the very-low-risk spread trader. ■ As a corollary to the prior item, a trader should choose the most widely spaced intramarket spread consistent with the desired risk level. generally speaking, the wider the time duration in an intramarket spread, the greater the volatility of the spread. this observation is as true for mar- kets conforming to the general rule as for markets unrelated or inversely related to the general rule. traders implementing a greater-than-one-unit intramarket spread position should be sure to choose the widest liquid spread consistent with the trading strategy. For example, it usually would make little sense to implement a two-unit March/May corn spread, since a one-unit March/July corn spread would offer a very similar potential/risk trade at half the transaction cost. 453 . . . many more people see than weigh. —Philip Dormar Stanhope, Earl of Chesterfield B y definition, the intention of the spread trader is to implement a position that will reflect changes in the price difference between contracts rather than changes in outright price levels. T o achieve such a trade, the two legs of a spread must be equally weighted. As an obvious example, long 2 December corn/short 1 March corn is a spread in name only. Such a position would be far more dependent on fluctuations in the price level of corn than on changes in the price difference between December and March. The meaning of equally weighted, however, is by no means obvious. Many traders simply assume that a balanced spread position implies an equal number of contracts long and short. Such an assump- tion is usually valid for most intramarket spreads (although an exception will be discussed later in this chapter). However, for many intermarket and intercommodity 1 spreads, the automatic presumption of an equal number of contracts long and short can lead to severe distortions. Consider the example of a trader who anticipates that demand for lower quality Robusta coffee beans (London contract) will decline relative to higher quality Arabica beans (New Y ork contract) and Intercommodity Spreads: Determining Contract Ratios Chapter 31 1 The distinction between intermarket and intercommodity spreads was defined in Chapter 30. An intermarket spread involves buying and selling the same commodity at two different exchanges (e.g., New Y ork vs. London cocoa); the intercommodity spread involves buying and selling two different but related markets (e.g., wheat vs. corn, cattle vs. hogs). 454 A Complete Guide to the Futures mArket attempts to capitalize on this forecast by initiating a 5-contract long New Y ork coffee/short London coffee spread. Assume the projection is correct, and London coffee prices decline from $0.80/lb to $0.65/lb, while New Y ork coffee prices simultaneously decline from $1.41/lb to $1.31/lb. At sur- face glance, it might appear this trade is successful, since the trader is short London coffee (which has declined by $0.15/lb) and long New Y ork coffee (which has lost only $0.10/lb). However, the trade actually loses money (even excluding commissions). The explanation lies in the fact that the contract sizes for the New Y ork and London coffee contracts are different: The size of the New Y ork coffee contract is 37,500 lb, while the size of the London coffee contract is 10 metric tonnes, or 22,043 lb. (Note: In practice, the London coffee contract is quoted in dollars/tonne; the calculations in this sec- tion reflect a conversion into $/pound for easier comparison with the New Y ork coffee contract.) Because of this disparity, an equal contract position really implies a larger commitment in New Y ork coffee. Consequently, such a spread position is biased toward gaining in bull coffee markets (assuming the long position is in New Y ork coffee) and losing in bear markets. The long New Y ork/short London spread position in our example actually loses $2,218 plus commissions, despite the larger decline in London coffee prices: Profit/los so f co ntractso f units per c ontrac tg ain/loss=× ×## per un it Profit/loss in long New York coffee positio n5 37 5000=× ×−,( $. .) $,10/lb1 8 750=− Profit/loss in short London coffee position = 52 20 43×× +,( $001 5/lb 16 532.) $,=+ Net profit/l oss in sprea d2 218=− $, The difference in contract size between the two markets could have been offset by adjusting the contract ratio of the spread to equalize the long and short positions in terms of units (lb). The gen- eral procedure would be to place U1/U2 contracts of the smaller-unit market (i.e., London coffee) against each contract of the larger-unit contract (i.e., New Y ork coffee). (U1 and U2 represent the number of units per contract in the respective markets—U1 = 37,500 lb and U2 = 22,043 lb.) Thus, in the New Y ork coffee/London coffee spread, each New Y ork coffee contract would be offset by 1.7 (37,500/22,043) London coffee contracts, implying a minimum equal-unit spread of five London coffee versus three New Y ork coffee (rounding down the theoretical 5.1-contract London coffee posi- tion to 5 contracts.) This unit-equalized spread would have been profitable in the above example: Profit/los so f co ntractso f units per c ontrac tg ain/loss=× ×## per un it Profit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10/lb1 1 250=− Profit/loss in short London coffee position 52 20 43 0=× ×+,( $. 115/lb +1 6 532)$ ,= Net profit/l oss in sprea d+ 5 282= $, The unit-size adjustment, however, is not the end of our story. It can be argued that even the equalized-unit New Y ork coffee/London coffee spread is still unbalanced, since there is another signifi- cant difference between the two markets: London coffee prices are lower than New Y ork coffee prices. This observation raises the question of whether it is more important to neutralize the spread against equal price moves or equal-percentage price moves. The rationale for the latter approach is that, all else being equal, the magnitude of price changes is likely to be greater in the higher-priced market. 455 IntercommodIty SpreadS: determInIng contract ratIoS The fact that percentage price change is a more meaningful measure than absolute price change is perhaps best illustrated by considering the extreme example of the gold/silver spread. The equal-unit approach, which neutralizes the spread against equal-dollar price changes in both markets, would imply the rather ludicrous spread position of 50 gold contracts versus 1 silver contract. (The contract size of silver is 5,000 oz; the contract size of gold is 100 oz.) Obviously, such a position would be almost entirely dependent upon changes in the price of gold rather than any movement in the gold/ silver spread. The disparity is due to the fact that since gold is far higher priced than silver (by a ratio of 32-101:1 based on the past 30-year range), its price swings will also be far greater. For example, if gold is trading at $1,400/oz and silver at $20/oz, a $2 increase in silver prices is likely to be accom- panied by far more than a $2 increase in gold prices. Clearly, the relevant criterion in the gold/silver spread is that the position should be indifferent to equal percentage price changes rather than equal absolute price changes. Although less obvious, the same principle would also appear preferable, even for intercommodity or intermarket spreads between more closely priced markets (e.g., New Y ork coffee/London coffee). Thus we adopt the definition that a balanced spread is a spread that is indifferent to equal percentage price changes in both markets. It can be demonstrated this condition will be fulfilled if the spread is initiated so the dollar values of the long and short positions are equal. 2 An equal-dollar-value spread 2 If the spread is implemented so that dollar values are equal, then: NU PN UPtt11 10 22 20,,== = where N1 = number of contracts in market 1 N2 = number of contracts in market 2 U1 = number of units per contract in market 1 U2 = number of units per contract in market 2 P1,t=0 = price of market 1 at spread initiation P2,t=0 = price of market 2 at spread initiation An equal-percentage price change implies that both prices change by the same factor k. Thus, Pk PP kPtt tt11 10 21 20,, ,,== ==== and where Pl,t = 1 = price of market 1 after equal-percentage price move P2,t = 1 = price of market 2 after equal-percentage price move And the equity changes (in absolute terms) are: Equity change in market 1 positio n =− ===NU kP PN UPtt11 10 10 11 1|| ,, ,t t tt k NU kP P = == − =− 0 22 20 20 1 | | ,, | Equity change in market 2 positio n| || ,=− =NU Pkt22 20 1 | Since, by definition, an equal-dollar-value spread at initiation implies that N1U1P1,t = 0 = N2U2P2,t = 0, the equity changes in the positions are equal. It should be noted that the equal-dollar-value spread only assures that equal-percentage price changes will not affect the spread if the percentage price changes are measured relative to the initiation price levels. However, equal-percentage price changes from subsequent price levels will normally result in different absolute dollar changes in the long and short positions (since the position values are not necessarily equal at any post-initiation points of reference). 456 A Complete Guide to the Futures mArket can be achieved by using a contract ratio that is inversely proportional to the contract value (CV) ratio. This can be expressed as follows (see footnote 2 for symbol definitions): N N CV CV UP UP t t 2 1 1 2 11 0 22 0 == = = , , or, NN CV CV21 1 2 =       For example, if New Y ork coffee is trading at $1.41/lb and London coffee at $.80/lb, the equal-dollar- value spread would indicate a contract ratio of 1 New Y ork coffee/3 London coffee: NN CV CV N UP UP t t 21 1 2 1 11 0 22 0 =       =       = = , , If New York coffee contractN1 1= , N2 =× ×=37 5001 41/22 0430 80 3 London contracts,$ ., $. Thus, in an equal-dollar-value spread position, 3 New Y ork coffee contracts would be balanced by 9 (not 5) London contracts. It may help clarify matters to compare the just-defined equal-dollar-value approach to the equal-unit approach for the case of the New Y ork coffee/London coffee spread. Although the equal- unit spread is indifferent to equal absolute price changes, it will be affected by equal-percentage price changes (unless, of course, the price levels in both markets are equal, in which case the two approaches are equivalent). For example, given initiation price levels of New Y ork coffee = $1.41/lb and London coffee = $.80/lb, consider the effect of a 25 percent price decline on a long 3 New Y ork/ short 5 London coffee (equal unit) spread: Profit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,3525 39 656=− Profit/loss in short London coffee position 52 20 43 0=× ×−,( $. 220 +2 20 43)$ ,= Profit/loss in sprea d1 7 613=− $, The equal-dollar-value spread, however, would be approximately unchanged: Profit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,3525 39 656=− Profit/loss in short London coffee position 92 20 43 0=× ×+,( $. 220 +3 96 77)$ ,= Profit/loss in sprea d+ 21= $ Returning to our original example, if the trader anticipating price weakness in London coffee rela- tive to New Y ork coffee had used the equal-dollar-value approach (assuming a 3-contract position for New Y ork coffee), the results would have been as follows: Profit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10 11 250=− Profit/loss in short London coffee position 92 20 43 +0=× ×,( $. 115 29 758) $,=+ Profit/loss in sprea d+ 18 508= $, 457 INTERCOMMODITY SPREADS: DETERMINING CONTRACT RATIOS Thus, while the naive placement of an equal contract spread actually results in a $2,218 loss despite the validity of the trade concept, the more appropriate equal-dollar-value approach results in a $18,508 gain. This example emphasizes the critical importance of determining appropriate contract ratios in intercommodity and intermarket spreads. An essential point to note is that if intercommodity and intermarket spreads are traded using an equal-dollar-value approach—as they should be—the price diff erence between the markets is no longer the relevant subject of analysis. Rather, such an approach is most closely related to the price ratio between the two markets. This fact means that chart analysis and the defi nition of historical ranges should be based on the price ratio, not the price diff erence. Figures 31.1 , 31.2 , and 31.3 illus- trate this point. Figure 31.1 depicts the September 2013 wheat/September 2013 corn spread in the standard form as a price diff erence. Figure 31.2 illustrates the price ratio of September 2013 wheat to September 2013 corn during the same period. Finally, Figure 31.3 plots the equity fl uctuations of the approximate equal-dollar-value spread: 3 wheat versus 4 corn. Note how much more closely the equal dollar position is paralleled by the ratio than by the price diff erence. 3 3 The equal-dollar-value spread would be precisely related to the price ratio only if the contract ratios in the spread were continuously adjusted to refl ect changes in the price ratio. (An analogous complication does not exist in equal-unit spreads, since the contract weightings are determined independent of price levels.) However, unless price levels change drastically during the holding period of the spread, the absence of theoretical readjust- ments in contract ratios will make little practical diff erence. In other words, equity fl uctuations in the equal- dollar-value spread will normally closely track the movements of the price ratio. FIGURE /uni00A031.1 September 2013 Wheat Minus September 2013 Corn Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. 458A COMPLETE GUIDE TO THE FUTURES MARKET FIGURE /uni00A031.2 Price Ratio of September 2013 Wheat to September 2013 Corn Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. FIGURE /uni00A031.3 3 September 2013 Wheat Minus 4 September 2013 Corn 459 INTERCOMMODITY SPREADS: DETERMINING CONTRACT RATIOS In the preceding example, because wheat is a larger contract than corn (in dollar-value terms), a long 1 wheat/short 1 corn spread would be biased in the direction of the general price trend of grains. For example, during November 2012–August 2013, a period of declining grain prices (see Figure 31.4 ), the equal contract spread seems to suggest that wheat prices weakened signifi cantly relative to corn prices (see Figure 31.1 ). In reality, as indicated by Figures 31.2 and 31.3 , the wheat/corn relationship during this period was best characterized by a trading range. T o illustrate the trading implications of the spread ratio, consider a long wheat/short corn spread initiated at the late-November 2012 relative high and liquidated at the August 2013 peak. This trade would have resulted in a near breakeven trade if the spread were implemented on an equal-dollar-value basis (see Figure 31.2 or 31.3 ), but a signifi cant loss if an equal contract criterion were used instead (see Figure 31.1 ). It should now be clear why the standard assumption of an equal contract position is usually valid for intramarket spreads. In these spreads, contract sizes are identical, while price levels are normally close. Thus, the equal-dollar-value approach suggests a contract ratio very close to 1:1. If, however, two contracts in an intramarket spread are trading at signifi cantly diff erent price levels, the argument for using the equal-dollar-value approach (as opposed to equal contract positions) would be analogous to the intercommodity and intermarket case. Wide price diff erences between contracts in an intramarket spread can occur in extreme bull markets that place a large premium on FIGURE /uni00A031.4 September 2013 Wheat and September 2013 Corn 460 A Complete Guide to the Futures mArket nearby supplies (i.e., in markets conforming to the “general rule” defined in Chapter 30). Intercrop spreads (which are a subset of intramarket spreads) can also exhibit wide price differences. In these cases, the greater dollar volatility implicit in the higher-priced month suggests that the spread be initi- ated with a larger number of contracts in the lower-priced month. It should be noted that the concept of equal dollar value is meaningless for interest rate futures. For example, a $1 million eurodollar contract is certainly not 10 times as large as a $100,000 T -bond contract. In fact, because of its much longer maturity, and, hence, much greater volatility, the T -bond contract is a substantially “larger” contract by any reasonable definition. 461 The stock market is but a mirror which . . . provides an image of the underlying or fundamental economic situation. —John Kenneth Galbraith ■ Intramarket Stock Index Spreads Spreads in carrying charge markets, such as gold, provide a good starting point for developing a theo- retical behavioral model for spreads in stock index futures. As is the case for gold, there can never be any near-term shortage in stock indexes, which means spreads will be entirely determined by carrying charges. As was explained in Chapter 30, gold spreads are largely determined by short-term interest rates. For example, since a trader could accept delivery of gold on an expiring contract and redeliver it against a subsequent contract, the price spread between the two months would primarily reflect financing costs and, hence, short-term rates. If the premium of the forward contract were sig- nificantly above the level implied by short-term rates, the arbitrageur could lock in a risk-free profit by performing a cash-and-carry operation. And if the premium were significantly lower, an arbitra- geur could lock in a risk-free profit by implementing a short nearby/long forward spread, borrowing gold to deliver against the nearby contract and accepting delivery at the expiration of the forward contract. These arbitrage forces will tend to keep the intramarket spreads within a reasonably well- defined band for any given combination of short-term interest rates and gold prices. The same arguments could be duplicated substituting a stock index for gold. In a broad sense this is true, but there is one critical difference between stock index spreads and gold spreads: Stocks pay Spread Trading in Stock Index Futures Chapter 32 462 A Complete Guide to the Futures mArket dividends. Thus, the interest rate cost of holding a stock position is offset (partially, or more than totally) by dividend income. The presence of dividends is easily incorporated into the framework of calculating a theoretical spread level. The spread would be in equilibrium if, based on current prices, interest rates, and dividends, there would be no difference between holding the actual equities in the index for the interim between the two spread months versus buying the forward index futures contract. Holding equities would incur an interest rate cost that does not exist in holding futures, but would also accrue the dividend yield the holder of futures does not receive. The theoretical spread level (P 2 − P1) at the expiration of P 1 at which these two alternative means of holding a long equity position—equity and stock index futures—would imply an equivalent outcome can be expressed symbolically as follows: PP P t id21 1 360−=     −() where P1 = price of nearby (expiring) futures contract P2 = price of forward futures contract t = number of days between expiration of nearby contract and expiration of forward contract i = short-term interest rate level at time of P1 expiration d = annualized dividend yield (%) As is evident from this equation, if short-term interest rates exceed dividend yields, forward futures will trade at a premium to nearby contracts. Conversely, if the dividend yield exceeds short- term interest rates, forward futures will trade at a discount. Since the dividend yield is not subject to sharp changes in the short run, for any given index (price) level, intramarket stock index spreads would primarily reflect expected future short-term rates (similar to gold spreads). If short-term interest rates exhibit low volatility, as characterized by the near-zero interest rate environment that prevailed in the years following the 2008 financial crisis, stock index spreads will tend to trade in relatively narrow range—a consequence of both major drivers of stock index spreads (interest rates and dividend yield) being stable. ■ Intermarket Stock Index Spreads As is the case with intercommodity and intermarket spreads trading at disparate price levels, stock index spreads should be traded as ratios rather than differences—an approach that will make the spread position indifferent to equal percentage price changes in both markets (indexes). As a reminder, to trade a ratio, the trader should implement each leg of the spread in approximately equal contract value positions, which, as was shown in Chapter 31, can be achieved by using a contract ratio that is inversely proportional to the contract value ratio. For example, if the E-mini Nasdaq 100 futures contract, which has a contract value of 20 times the index, is trading at 4,300 (a contract value of $86,000), and the Russell 2000 Mini futures contract, 463 SPREAd TRAdING IN SToCK INdEx FuTuRES which has a contract value of 100 times the index, is trading at 1,150 (a contract value of $115,000), the contract value ratio (CVR) of Nasdaq to Russell futures would be equal to: CVR2 04 ,300 /1 00 1,150 07 478=× ×=() () . Therefore, the contract ratio would be equal to the inverse of the contract value ratio: 1/0.7478 = 1.337. Thus, for example, a spread with 3 long (short) Russell contracts would be bal- anced by 4 Nasdaq short (long) contracts: 3 × 1.337 = 4.01. Because some stock indexes are inherently more volatile than other indexes—for example, smaller- cap indexes tend to be more volatile than larger-cap indexes—some traders may wish to make an additional adjustment to the contract ratio to neutralize volatility differences. If this were done, the contract ratio defined by the inverse of the contract value ratio would be further adjusted by multiply- ing by the inverse of some volatility measure ratio. one good candidate for such a volatility measure is the average true range (ATR), which was defined in Chapter 17. As an illustration, if in the aforemen- tioned example of the Nasdaq 100/Russell 2000 ratio, the prevailing ATR of the Nasdaq 100 is 0.8 times the ATR of the Russell 2000, then the Nasdaq/Russell 2000 contract ratio of 1.337 would be further adjusted by multiplying by the inverse of the ATR ratio (1 / 0.8 = 1.25), yielding a contract ratio of 1.671 instead of 1.337. If this additional adjustment is made, then a spread with 3 long (short) Russell contracts would be balanced by 5 short (long) Nasdaq contracts: 3 × 1.671= 5.01. It is up traders to decide whether they wish to further adjust the contract ratio for volatility. For the remainder of this chapter, we assume the more straightforward case of contract ratios being adjusted only for contract value differences (i.e., without any additional adjustment for volatility differences). The four most actively traded stock index futures contracts are the E-mini S&P 500, E-mini Nasdaq 100, E-mini dow , and the Russell 2000 Mini. There are six possible spread pairs for these four markets: ■ E-mini S&P 500 / E-mini dow ■ E-mini S&P 500 / E-mini Nasdaq 100 ■ E-mini S&P 500 / Russell 2000 Mini ■ E-mini Nasdaq 100 / E-mini dow ■ E-mini Nasdaq 100 / Russell 2000 Mini ■ E-mini dow / Russell 2000 Mini Traders who believe a certain group of stocks will perform better or worse than another group can express this view through stock index spreads. For example, a trader who expected large-cap stocks to outperform small-cap stocks could initiate long E-mini S&P 500/short Russell 2000 Mini spreads or long E-mini dow/short Russell 2000 Mini spreads. A trader expecting relative outperfor- mance by small-cap spreads would place the reverse spreads. As another example, a trader expecting relative outperformance by technology stocks might consider spreads that are long the tech-heavy Nasdaq 100 index and short another index, such as long E-mini Nasdaq 100/short E-mini S&P 500 464A CoMPLETE GuIdE To THE FuTuRES MARKET spreads. Again, to trade these types of spreads as price ratios, the spreads would be implemented so the contract values of each side are approximately equal, a condition that will be achieved when the contract ratio between the indexes is equal to the inverse of the contract value ratio. Figures 32.1 through 32.6 illustrate the contract value ratios for these six spread pairs during 2002–2015. In some cases, such as the S&P 500/dow spread, the contract value ratio does not vary much. As can be seen in Figure 32.1 , the contract value ratio for this pair ranged by a factor of only about 1.2 from low to high over the entire period. For other index pairs, however, the contract value ratio ranged widely. For example, Figure 32.4 shows that during the same period, the high Nasdaq/ dow contract value ratio was nearly 2.5 times the low ratio. Since the contract ratio required to keep the trade neutral to equal percentage price changes in both markets is equal to the inverse of the prevailing contract value ratio, the appropriate contract ratio for these spreads can range widely over time. For example, for the aforementioned Nasdaq 100/dow ratio, a three-contract dow position would have been balanced by a seven-contract Nasdaq position when the contract value ratio was at its low versus only a three-contract position (rounding up) when the ratio was at its high. Figures 32.7 through 32.12 illustrate the price ratios for the six stock index pairs during the same period, along with an overlay of one of the indexes to facilitate visually checking of the relationships between the index price ratio and the overall stock market direction. Note that the price ratios in Figures 32.7 through 32.12 are identical in pattern to the contract value ratios in Figures 32.1 through 32.6 , which is a consequence of the contract value ratio being equal to the price ratio times a constant—the constant being equal to the ratio of the multipliers for the indexes. FIGURE  32.1 Contract Value Ratio: S&P 500/dow E-Mini Futures 465 SPREAd TRAdING IN SToCK INdEx FuTuRES FIGURE  32.2 Contract Value Ratio: S&P 500/Nasdaq 100 E-Mini Futures FIGURE  32.3 Contract Value Ratio: S&P 500/Russell 2000 Mini Futures 466A CoMPLETE GuIdE To THE FuTuRES MARKET FIGURE  32.4 Contract Value Ratio: Nasdaq 100/dow E-Mini Futures FIGURE  32.5 Contract Value Ratio: Nasdaq 100/Russell 2000 Mini Futures 467 SPREAd TRAdING IN SToCK INdEx FuTuRES FIGURE  32.6 Contract Value Ratio: dow/Russell 2000 Mini Futures FIGURE  32.7 S&P 500/dow E-Mini Futures Ratio vs. S&P 468A CoMPLETE GuIdE To THE FuTuRES MARKET FIGURE  32.8 S&P 500/Nasdaq 100 E-Mini Futures Ratio vs. S&P FIGURE  32.9 S&P 500/Russell 2000 Mini Futures Ratio vs. S&P 469 SPREAd TRAdING IN SToCK INdEx FuTuRES FIGURE  32.10 Nasdaq 100/dow E-Mini Futures Ratio vs. dow FIGURE  32.11 Nasdaq 100/Russell 2000 Mini Futures Ratio vs. Russell 2000 470A CoMPLETE GuIdE To THE FuTuRES MARKET FIGURE  32.12 dow/Russell 2000 Mini Futures Ratio vs. Russell 2000 Generally speaking, at least during the 14-year period depicted in these charts, Figures 32.7 through 32.12 refl ect a tendency for larger-cap indexes to lose ground to smaller-cap indexes dur- ing market uptrends and to outperform (i.e., decline less) during market downtrends. For example, Figure 32.12 compares the index ratio of the largest cap of the four indexes (dow) to the smallest cap of the four indexes (Russell 2000) with the Russell 2000 index. on balance, there is a clear inverse correlation between the index ratio and the market direction. As another example, in Figure 32.7 , in which both indexes in the spread are large-cap, but in which the smaller-cap of the two (S&P) is in the numerator of the ratio, the ratio is clearly positively correlated with the market direction. Another interesting aspect of Figure 32.7 is that there appears to be some tendency for the S&P/dow ratio to lead major trend reversals in the outright market. 471 Spread Trading in Currency Futures Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. —John Maynard Keynes ■ Intercurrency Spreads Conceptually, intercurrency spreads are identical to outright currency trades. After all, a net long or short currency futures position is also a spread in that it implies an opposite position in the dollar. For example, a net long Japanese yen (JY) position means that one is long the JY versus the U.S. dollar (USD). If the JY strengthens against the USD, the long JY position will gain. If the JY strengthens against the Swiss franc (SF) and euro but remains unchanged against the USD, the long JY position will also remain unchanged. In an intercurrency spread, the implied counterposing short in the USD is replaced by another currency. For example, in a long JY/short euro spread, the position will gain when the JY strengthens relative to the euro, but will be unaffected by fluctuations of the JY relative to the dollar. The long JY/short euro spread is merely the combination of a long JY/short USD and a long USD short euro position, in which the opposite USD positions offset each other. (T o be precise, the implied USD posi- tions will only be completely offset if the dollar values of the JY and euro positions are exactly equal.) There are two possible reasons for implementing an intercurrency spread: 1. The trader believes currency 1 will gain against the USD, while currency 2 will lose against the USD. In this case, a long currency 1/short currency 2 spread is best thought of as two separate outright trades. 2. The trader believes that one foreign currency will gain on another, but has no strong opinion regarding the movement of either currency against the USD. In this case, the intercurrency spread is analogous to an outright currency trade, with the implied short or long in the USD replaced by another currency. If, however, the two currencies are far more closely related to each other than to the USD, the connotation normally attributed to a spread might be at least partially appropriate. Chapter 33 472 A Complete Guide to the Futures mArket If an intercurrency spread is motivated by the second of these factors, the position should be balanced in terms of equal dollar values. (This may not always be possible for the small trader.) Otherwise, equity losses can occur, even if the exchange rate between the two currencies remains unchanged. For example, consider a long 4 December SF/short 4 December euro spread position imple- mented when the December SF = $1.000 and the December euro = $1.250. At the trade initiation, the exchange rate between the SF and euro is 1 euro = 1.25 SF. If the SF rises to $1.100 and the euro climbs to $1.375, the exchange rate between the SF and euro is unchanged: 1 euro = 1.25 SF. However, the spread position will have lost $12,500: Equity change numbe ro fc ontrac ts number of unitsp er contra ct ga=× × iin/loss peru nit Equity change in long SF 41 25 000 01 0= 50 000=× ×,$ .$ , Equity change in short euro 4 125 000 01 25 62 500=× ×− =−,$ .$ , Netp rofit/loss 12 500=− $, The reason the spread loses money even though the SF/euro exchange rate remains unchanged is that the original position was unweighted. At the initiation prices, the spread represented a long SF position of $500,000 but a short euro position of $625,000. Thus, the spread position was biased toward gaining if the dollar weakened against both currencies and losing if the dollar strengthened. If, however, the spread were balanced in terms of equal dollar values, the equity of the position would have been unchanged. For example, if the initial spread position were long 5 December SF/short 4 December euro (a position in which the dollar value of each side = $625,000), the aforementioned price shift would not have resulted in an equity change: Equity change in long SF 51 25 000 01 06 25 00=× ×=,$ .$ , Equity change in short euro 4 125 000 01 25 62 500=× ×− =−,( $. )$ , Netprofit/loss 0= The general formula for determining the equal-dollar-value spread ratio (number of contracts of currency 1 per contract of currency 2) is: Equal-dollar-spread rati o numbe ro f units per contra ct of currenc= yy2 priceo f currenc y2 numbe ro f units per contra ct of currenc y1 () () (() () priceo f currenc y1 For example, if currency 1, the British pound (BP) = $1.50, and currency 2, the euro = $1.20, and the BP futures contract consists of 62,500 units, while the euro futures contract consists of 125,000 units, the implied spread ratio would be: (, )($ .) (, )($ .) .125 0001 20 62 5001 50 16= 473 SPreAD TrADINg IN CUrreNCY FUTUreS Thus, the equal dollar value spread would consist of 1.6 BP contracts per euro contract, or 8 BP to 5 euro. equity fluctuations in an equal-dollar-value intercurrency spread position will mirror the price ratio (or exchange rate) between currencies. It should be emphasized that price ratios (as opposed to price spreads) are the only meaningful means of representing intercurrency spreads. For example, if the BP = $1.50 and SF = $1.00, an increase of $0.50 in both the currencies will leave the price spread between the BP and SF unchanged, even though it would drastically alter the relative values of the two currencies: a decline of the BP vis-à-vis the SF from 1.5 SF to 1.33 SF. ■ Intracurrency Spreads An intracurrency spread—the price difference between two futures contracts for the same currency— directly reflects the implied forward interest rate differential between dollar-denominated accounts and accounts denominated in the given currency. For example, the June/December euro spread indicates the expected relationship between six-month eurodollar and euro rates in June. 1 T o demonstrate the connection between intracurrency spreads and interest rate differentials, we compare the alternatives of investing in dollar-denominated versus euro-denominated accounts: S = spot exchange rate ($/euro) F = current forward exchange rate for date at end of investment period ($/euro) r 1 = simple rate of return on dollar-denominated account for investment period (nonannualized) r2 = simple rate of return on euro-denominated account for investment period (nonannualized) alternative a: Invest in Dollar-Denominated account alternative B: Invest in euro-Denominated account 1. Invest $1 in dollar-denominated account. 1. Convert $1 to euro at spot. 2. Funds at end of period = $1 (1 + r1) exchange rate is S, which yields 1/S euro. (By definition, if S equals dollars per euro, 1/S = euro per dollar.) 2. Invest 1/S euro in euro-denominated account at r 2. 3. Lock in forward exchange rate by selling the anticipated euro proceeds at end of investment period at current forward rate F.2 4. Funds at end of period = 1/S (1 + r2) euro. 5. Converted to dollars at rate F, funds at end of period = $F/S (1 + r2) (since F = dollars per euro). 1 The eurocurrency rates are interest rates on time deposits for funds outside the country of issue and hence free of government controls. For example, interest rates on dollar-denominated deposits in London are eurodollar rates, while rates on sterling-denominated deposits in Frankfurt are eurosterling rates. The quoted eurocurrency rates represent the rates on transactions between major international banks. 2 A short forward position can be established in one of two ways: (1) selling futures that are available for forward dates at three-month intervals; and (2) initiating a long spot/short forward position in the foreign exchange (FX) swap market and simultaneously selling spot. 474 A Complete Guide to the Futures mArket If the proceeds of the two above alternatives are to be equivalent, then: 11 12+= +r F S r() Thus, at this equilibrium level, given values for S, r1, and r2, F would be automatically determined. For example, if S = $0.80/euro, r 1 = 2 percent per six-month period (4.04 percent annualized), and r2 = 1 percent per six-month period (2.01 percent annualized), at equilibrium, the six-month forward rate would be: F Sr r= + + ==() () .( .) (. ) .1 1 0810 2 10 1 08 07921 2 At forward rate of F = 0.80792, both alternatives will yield $1.02. This result is obvious for the dollar-denominated account; for the euro-denominated account: $/ () $. (. ) . $.FS r1 0 80792 10 1 08 0 10 22+= = Consider what would happen if the forward exchange rate F were greater than the equilibrium level (i.e., greater than $0.80792/euro in the above example). For instance, using an assumed value of F = $0.82/euro, the proceeds of Alternative B would be: $. (. ) . $.08 21 01 08 0 10 3525= Thus, if F = $0.82/euro, arbitrageurs could borrow dollars at r1 convert the dollars into euro, invest the euro at r2, and hedge the anticipated six-month forward euro proceeds at $0.82/euro. In doing so, they would pay $1.02 for the dollar loan, but would earn $1.03525, thereby netting a risk-free profit of $0.01525 per dollar borrowed. If such a wonderful opportunity existed (and it will soon be clear why it could not), all arbitrageurs who were awake and could add would rush to implement the above set of transactions. This activity by arbitrageurs would impact both the spot and forward exchange rates. In the spot market, the concentration of conversions of dollars into euros would cause the euro to gain against the dollar, and hence the spot rate S would rise. Similarly, in the forward market, heavy sales of euro against the dollar would cause the euro to weaken against the dollar and hence the forward rate F would fall. 3 These market forces would narrow the gap between the forward and spot rates until: F S r r= + + 1 1 1 2 3 In the futures market, such sales would occur directly. In the cash FX market, downward pressure on the implied forward rate would manifest itself through the initiation of long spot/short forward swaps (spreads). 475 SPreAD TrADINg IN CUrreNCY FUTUreS Of course, the market forces just described would come into play well before the forward/spot ratio increased to 0.82/0.80 = 1.025. The intervention of arbitrageurs will assure the six-month forward/spot ratio would not rise significantly above 1 + r 1/1 + r2 = 1.0099. A similar argument could be used to demonstrate that arbitrage intervention would keep the forward/spot ratio from declining significantly below 1.0099. In short, arbitrage activity will assure that the forward/spot ratio will be approximately defined by the above equation. This relationship is commonly referred to as the interest rate parity theorem. Since currency futures must converge with spot exchange rates at expiration, the price spread between a forward futures contract and a nearby expiring contract must reflect the prevailing interest rate ratio (between the eurodollar rate and the given eurocurrency rate). 4 Hence, a spread between two forward futures contracts can be interpreted as reflecting the market’s expectation for the inter- est rate ratio at the time of the nearby contract expiration. Specifically, if P 1 = price of the more nearby futures expiring at t1 and P2 = price of the forward futures contract expiring at time t 2, then P2/P1 will equal the expected interest rate ratio (expressed as 1+r1/1+r2) for term rates of duration t2 − t1 at time t1. It should be stressed that the forward interest rate ratio implied by spreads in futures will usually differ from the prevailing interest rate ratio. If the market expects the eurodollar rate to be greater than the foreign eurocurrency rate, forward futures for that currency will trade at a premium to more nearby futures—the wider the expected differential, the wider the spread. Conversely, if the foreign eurocurrency rate is expected to be greater than the eurodollar rate, forward futures will trade at a discount to nearby futures. The above relationships suggest that intracurrency spreads can be used to trade expectations regarding future interest rate differentials between different currencies. If a trader expected eurodol- lar rates to gain (move up more or down less) on a foreign eurocurrency rate (relative to the expected interest rate ratio implied by the intracurrency futures spread), this expectation could be expressed as a long forward/short nearby spread in that currency. Conversely, if the trader expected the foreign eurocurrency rate to gain on the eurodollar rate, the implied trade would be a long nearby/short forward intracurrency spread. As a technical point, a 1:1 spread ratio would fluctuate even if the implied forward interest rate ratio were unchanged. For example, if P 2 = $0.81/euro and P1 = $0.80/euro, a 10-percent increase in both rates would result in a 810-point price gain in the forward contract and only a 800-point gain in the nearby contract, even though the implied forward interest rate ratio would be unchanged (since an equal percentage change in each month would leave F/S unchanged). In order for the spread posi- tion to be unaffected by equal percentage price changes in both contracts, a development that would not affect the implied forward interest rate ratio, the spread would have to be implemented so that the dollar value of the long and short positions were equal. This parity will be achieved when the contract ratio is equal to the inverse of the price ratio. For example, given the above case of P 2 = $0.81 and 4 All references to interest rate ratios in this section should be understood to mean (1 + r1)/(l + r2) where r1 and r2 are the nonannualized rates of return for the time interim between S and F. Thus, in the above example, the interest rate ratio for the six-month period given annualized rates of 4.04 percent and 2.01 percent is equal to 1.02/1.01 = 1.0099. The reader should be careful not to misconstrue the intended definition of interest rate ratio with a literal interpretation, which in the above example would suggest a figure of 0.02/0.01 = 2. 476 A Complete Guide to the Futures mArket P1 = $0.80, an 80-contract forward/81-contract nearby spread would not be affected by equal price changes (e.g., a 10-percent price increase would cause a total 64,800-point change in both legs of the spread). As can be seen in this example, a balanced spread will only be possible for extremely large positions. This fact, however, does not present a problem, since the distortion is sufficiently small so that a 1:1 contract ratio spread serves as a reasonable approximation. Intracurrency spreads can also be combined to trade expectations regarding two foreign euro- currency rates. In this case, the trader would implement a long nearby/short forward spread in the currency with the expected relative rate gain, and a long forward/short nearby spread in the other currency. For example, assume that in February the June/December euro spread implies that the June six-month eurodollar rate will be 1 percent above the euro rate, while the June/December JY spread implies that the June eurodollar rate will be 2 percent above the euroyen rate. In combina- tion, these spreads imply that the June euro rate will be higher than the June euroyen rate. If a trader expected euroyen rates to be higher than euro rates in June, the following combined spread positions would be implied: long June JY/short December JY plus long December euro/short June euro. T o summarize, intracurrency spreads can be used to trade interest rate differentials in the follow- ing manner: expectation Indicated trade eurodollar rate will gain on given eurocurrency rate (relative to rate ratio implied by spread). Long forward/short nearby spread in given currency eurodollar rate will lose on given eurocurrency rate (relative to rate ratio implied by spread). Long nearby/short forward spread in given currency eurocurrency rate 1 will gain on eurocurrency rate 2 (relative to rate ratio implied by spreads in both markets). Long nearby/short forward spread in market 1 and long forward/short nearby spread in market 2 477 A put might more properly be called a stick. For the whole point of a put—its purpose, if you will—is that it gives its owner the right to force 100 shares of some godforsaken stock onto someone else at a price at which he would very likely rather not take it. So what you are really doing is sticking it to him. —Andrew T obias Getting By on $100,000 a Year (and Other Sad T ales) ■ Preliminaries There are two basic types of options: calls and puts. The purchase of a call option on futures1 provides the buyer with the right, but not the obligation, to purchase the underlying futures contract at a speci- fied price, called the strike or exercise price, at any time up to and including the expiration date. 2 A put option provides the buyer with the right, but not the obligation, to sell the underlying futures contract at the strike price at any time prior to expiration. (Note, therefore, that buying a put is a bearish trade, while selling a put is a bullish trade.) The price of an option is called the premium, and is quoted in An Introduction to Options on Futures Chapter 34 1 Chapters 34 and 35 deal specifically with options on futures contracts. However, generally speaking, analogous concepts would apply to options on cash (physical) goods or instruments (e.g., bullion versus gold futures). Some of the advantages of basing an option contract on futures as opposed to the cash asset are discussed in the next section. 2 For some markets, the expiration date on the option and the underlying futures contract will be the same; for other markets, the expiration date on the option will be a specified date prior to the expiration of the futures contract. 478 A Complete Guide to the Futures mArket either dollars (or cents) per unit or points. Table 34.1 illustrates how to calculate the dollar value of a premium. As a specific example, a trader who buys a $1,000 August gold call at a premium of $50 pays $50/oz ($5,000 per contract) for the right to buy an August gold futures contract at $1,000 (regardless of how high its price may rise) at any time up to the expiration date of the August option. Because options are traded for both puts and calls and a number of strike prices for each futures contract, the total number of different options traded in a market will far exceed the number of futures contracts—often by a factor of 10 to 1 or more. This broad variety of listed options provides the trader with myriad alternative trading strategies. Like their underlying futures contracts, options are exchange-traded, standardized contracts. Consequently, option positions can be offset prior to expiration simply by entering an order opposite to the position held. For example, the holder of a call could liquidate his position by entering an order to sell a call with the same expiration date and strike price. The buyer of a call seeks to profit from an anticipated price rise by locking in a specific purchase price. His maximum possible loss will be equal to the dollar amount of the premium paid for the option. This maximum loss would occur on an option held until expiration if the strike price were above the prevailing futures price. For example, if August gold futures were trading at $990 upon the expiration of the August option, a $1,000 call would be worthless because futures could be purchased more cheaply at the existing market price. 3 If the futures were trading above the strike price at expira- tion, then the option would have some value and hence would be exercised. However, if the difference table 34.1 Determining the Dollar Value of Option premiums Contracts Quoted on an Index Option premium (in points) × $ value per point = $ value of the option premium Examples: E-mini S&P 500 options 8.50 (option premium) × $50 per point = $425 (option premium $ value) U.S. dollar index options 2.30 (option premium) × $1,000 per point = $2,300 (option premium $ value) Contracts Quoted in Dollars Option premium (in dollars or cents per unit) × No. of units in futures contract = $ value of the option premium Examples: Gold options $42 (option premium) × 100 (ounces in futures contract) = $4,200 (option premium $ value) WTI crude oil options $1.24 (option premium) × 1,000 (barrels in futures contract) = $1,240 (option premium $ value) 3 However, it should be noted that even in this case, the call buyer could have recouped part of the premium if he had sold the option prior to expiration. This is true since the option will maintain some value (i.e., premium greater than zero) as long as there is some possibility of the futures price rising above the strike price prior to the expiration of the option. 479 AN INTrOduCTION TO OPTIONS ON FuTureS between the futures price and the strike price were less than the premium paid for the option, the net result of the trade would still be a loss. In order for the call buyer to realize a net profit, the dif- ference between the futures price and the strike price would have to exceed the premium at the time the call was purchased (after adjusting for commission cost). The higher the futures price, the greater the resulting profit. Of course, if the futures reach the desired objective, or the call buyer changes his market opinion, he could sell his call prior to expiration. 4 The buyer of a put seeks to profit from an anticipated price decline by locking in a sales price. Similar to the call buyer, his maximum possible loss is limited to the dollar amount of the premium paid for the option. In the case of a put held until expiration, the trade would show a net profit if the strike price exceeded the futures price by an amount greater than the premium of the put at purchase (after adjusting for commission cost). While the buyer of a call or put has limited risk and unlimited potential gain, 5 the reverse is true for the seller. The option seller (“writer”) receives the dollar value of the premium in return for undertaking the obligation to assume an opposite position at the strike price if an option is exercised. For example, if a call is exercised, the seller must assume a short position in futures at the strike price (since by exercising the call, the buyer assumes a long position at that price). upon exercise, the exchange’s clearinghouse will establish these opposite futures positions at the strike price. After exercise, the call buyer and seller can either maintain or liquidate their respective futures positions. The seller of a call seeks to profit from an anticipated sideways to modestly declining market. In such a situation, the premium earned by selling a call will provide the most attractive trading oppor- tunity. However, if the trader expected a large price decline, he would usually be better off going short futures or buying a put—trades with open-ended profit potential. In a similar fashion, the seller of a put seeks to profit from an anticipated sideways to modestly rising market. Some novices have trouble understanding why a trader would not always prefer the buy side of an option (call or put, depending on his market opinion), since such a trade has unlimited potential and limited risk. Such confusion reflects the failure to take probability into account. Although the option seller’s theoretical risk is unlimited, the price levels that have the greatest probability of occurring (i.e., prices in the vicinity of the market price at the time the option trade occurs) would result in a net gain to the option seller. roughly speaking, the option buyer accepts a large probability of a small loss in return for a small probability of a large gain, whereas the option seller accepts a small probability of a large loss in exchange for a large probability of a small gain. In an efficient market, neither the consistent option buyer nor the consistent option seller should have any advantage over the long run. 6 4 even if the call is held until the expiration date, it will usually still be easier to offset the position in the options market rather than exercising the call. 5 T echnically speaking, the gains on a put would be limited, since prices cannot fall below zero; but for practical purposes, it is entirely reasonable to speak of the maximum possible gain on a long put position as being unlimited. 6 T o be precise, this statement is not intended to imply that the consistent option buyer and consistent option seller would both have the same expected outcome (zero excluding transactions costs). Theoretically, on average, it is rea- sonable to expect the market to price options so there is some advantage to the seller to compensate option sellers for providing price insurance—that is, assuming the highly undesirable exposure to a large, open-ended loss. So, in effect, option sellers would have a more attractive return profile and a less attractive risk profile than option buyers, and it is in this sense that the market will, on average, price options so that there is no net advantage to the buyer or seller. 480 A Complete Guide to the Futures mArket ■ Factors That Determine Option Premiums An option’s premium consists of two components: Premiu mi ntri nsic v aluet imev alue=+ The intrinsic value of a call option is the amount by which the current futures price is above the strike price. The intrinsic value of a put option is the amount by which the current futures price is below the strike price. In effect, the intrinsic value is that part of the premium that could be realized if the option were exercised and the futures contract offset at the current market price. For example, if July crude oil futures were trading at $74.60, a call option with a strike price of $70 would have an intrinsic value of $4.60. The intrinsic value serves as a floor price for an option. Why? Because if the premium were less than the intrinsic value, a trader could buy and exercise the option, and immediately offset the resulting futures position, thereby realizing a net gain (assuming this profit would at least cover the transaction costs). Options that have intrinsic value (i.e., calls with strike prices below the current futures price and puts with strike prices above the current futures price) are said to be in-the-money. Options with no intrinsic value are called out-of-the-money options. An option whose strike price equals the futures price is called an at-the-money option. The term at-the-money is also often used less restrictively to refer to the specific option whose strike price is closest to the futures price. An out-of-the-money option, which by definition has an intrinsic value of zero, nonetheless retains some value because of the possibility the futures price will move beyond the strike price prior to the expi- ration date. An in-the-money option will have a value greater than the intrinsic value because a position in the option will be preferred to a position in the underlying futures contract. reason: Both the option and the futures contract will gain equally in the event of favorable price movement, but the option’s maximum loss is limited. The portion of the premium that exceeds the intrinsic value is called the time value. It should be emphasized that because the time value is almost always greater than zero, one should avoid exercising an option before the expiration date. Almost invariably, the trader who wants to offset his option position will realize a better return by selling the option, a transaction that will yield the intrinsic value plus some time value, as opposed to exercising the option, an action that will yield only the intrinsic value. The time value depends on four quantifiable factors 7: 1. the relationship between the strike price and the current futures price. As illus- trated in Figure 34.1, the time value will decline as an option moves more deeply in-the-money or out-of-the-money. deeply out-of-the-money options will have little time value, since it is unlikely the futures will move to (or beyond) the strike price prior to expiration. deeply in- the-money options have little time value because these options offer very similar positions to the underlying futures contracts—both will gain and lose equivalent amounts for all but an extreme adverse price move. In other words, for a deeply in-the-money option, the fact that the 7 Theoretically, the time value will also be influenced by price expectations, which are a non-quantifiable factor. 481 AN INTrOduCTION TO OPTIONS ON FuTureS risk is limited is not worth very much, because the strike price is so far away from the prevailing futures price. As Figure 34.1 shows, the time value will be at a maximum at the strike price. 2. time remaining until expiration. The more time remaining until expiration, the greater the time value of the option. This is true because a longer life span increases the probability of the intrinsic value increasing by any specifi ed amount prior to expiration. In other words, the more time until expiration, the greater the probable price range of futures. Figure 34.2 illustrates the standard theoretical assumption regarding the relationship between time value and time remaining until expiration for an at-the-money option. Specifi cally, the time value is FIGURE  34.1 Theoretical Option Premium Curve Source: Chicago Board of Trade, Marketing department. Call Option Strike price Intrinsic value T -bond futures price130 132 134 136 138 140 Time value premium 8 6 4 2 Option premium Strike price Intrinsic value T-bond futures price 124 126 128 130 8 6 4 2 Option premium Put Option Time value premium FIGURE  34.2 Time Value decay Source: Options on Comex Gold Futures, published by Commodity exchange, Inc. (COMeX), 1982. Time value decay 94 10 Time remaining until expiration (months) Time value premium 482 A Complete Guide to the Futures mArket table 34.2 Option prices as a Function of V olatility in e-Mini S&p 500 Futures pricesa annualized V olatility put or Call premium 10 22.88 ($1,144) 20 45.75 ($2,288) 30 68.62 ($3,431) 40 91.46 ($4,573) 50 114.29 ($5,715) a At-the-money options at a strike price of 2000 with 30 days to expiration. 8 James Bowe, Option Strategies T rading Handbook (New Y ork, NY: Coffee, Sugar, and Cocoa exchange, 1983). assumed to be a function of the square root of time. (This relationship is a consequence of the typical assumption regarding the shape of the probability curve for prices of the underlying futures contract.) Thus, an option with nine months until expiration would have 1.5 times the time value of a four-month option with the same strike price (; ;. )93 42 32 15== ÷= and three times the time value of a one-month option (; ;)93 11 31 3== ÷= . 3. V olatility. Time value will vary directly with the estimated volatility of the underlying futures contract for the remaining lifespan of the option. This relationship is the result of the fact that greater volatility raises the probability the intrinsic value will increase by any specified amount prior to expiration. In other words, the greater the volatility, the larger the probable range of futures prices. As Table 34.2 shows, volatility has a strong impact on theoretical option pre- mium values. Although volatility is an extremely important factor in determining option premium values, it should be stressed that the future volatility of the underlying futures contract is never pre- cisely known until after the fact. (In contrast, the time remaining until expiration and the rela - tionship between the current price of futures and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of historical volatility data. As will be explained, this factor is crucial in explaining the deviation between theoretical and actual premium values. 4. Interest rates. The effect of interest rates on option premiums is considerably smaller than any of the above three factors. The specific nature of the relationship between interest rates and premiums was succinctly summarized by James Bowe 8: The effect of interest rates is complicated because changes in rates affect not only the underlying value of the option, but the futures price as well. Taking it in steps, a buyer of any given option must pay the premium up front, and of course the seller receives the money. If interest rates go up and everything else stays constant, the opportunity cost to the option buyer of giving up the use of his money increases, and so he is will- ing to bid less. Conversely, the seller of options can make more on the premiums by 483 AN INTrOduCTION TO OPTIONS ON FuTureS investing the cash received and so is willing to accept less; the value of the options fall. However, in futures markets, part of the value of distant contracts in a carry market reflects the interest costs associated with owning the commodity. An increase in the interest rate might cause the futures price to increase, leading to the value of existing calls going up. The net effect on calls is ambiguous, but puts should decline in value with increasing interest rates, as the effects are reinforcing. ■ Theoretical versus Actual Option Premiums There is a variety of mathematical models available that will indicate the theoretical “fair value” for an option, given specific information regarding the four factors detailed in the previous section. Theoret- ical values will approximate, but by no means coincide with, actual premiums. does the existence of such a discrepancy necessarily imply that the option is mispriced? definitely not. The model-implied premium will differ from the actual premium for two reasons: 1. The model’s assumption regarding the mathematical relationship between option prices (premi- ums) and the factors that affect option prices may not accurately describe market behavior. This is always true because, to some extent, even the best option-pricing models are only theoretical approximations of true market behavior. 2. The volatility figure used by an option-pricing model will normally differ somewhat from the market’s expectation of future volatility. This is a critical point that requires further elaboration. recall that although volatility is a crucial input in any option pricing formula, its value can only be estimated. The theoretical “fair value” of an option will depend on the specific choice of a volatility figure. Some of the factors that will influence the value of the volatility estimate are the length of the prior period used to estimate volatility, the time interval in which volatility is mea- sured, the weighting scheme (if any) used on the historical volatility data, and adjustments (if any) to reflect relevant influences (e.g., the recent trend in volatility). It should be clear that any specific volatility estimate will implicitly reflect a number of unavoidably arbitrary decisions. different assumptions regarding the best procedure for estimating future volatility from past volatility will yield different theoretical premium values. Thus, there is no such thing as a single, well-defined fair value for an option. All that any option pricing model can tell you is what the value of the option should be given the specific assumptions regarding expected volatility and the form of the mathematical relationship between option prices and the key factors affecting them. If a given mathematical model provides a close approximation of market behavior, a discrepancy between the theoretical value and the actual premium means the market expectation for volatility, called the implied volatility, differs from the historically based volatility estimate used in the model. The question of whether the volatility assump- tions of a specific pricing model provide more accurate estimates of actual volatility than the implied volatility figures (i.e., the future volatility suggested by actual premiums) can only be answered empirically. A bias toward buying “underpriced” options (relative to the theoretical model fair value) 484 A Complete Guide to the Futures mArket and selling “overpriced” options would be justified only if empirical evidence supported the conten- tion that, on balance, the model’s volatility assumptions proved to be better than implied volatility in predicting actual volatility levels. If a model’s volatility estimates were demonstrated to be superior to implied volatility estimates, it would suggest, from a strict probability standpoint, a bullish trader would be better off selling puts than buying calls if options were overpriced (based on the fair value figures indicated by the model), and buying calls rather than selling puts if options were underpriced. Similarly, a bearish trader would be better off selling calls than buying puts if options were overpriced, and buying puts rather than selling calls if options were underpriced. The best strategy for any individual trader, however, would depend on the specific profile of his price expectations (i.e., the probabilities the trader assigns to various price outcomes). ■ Delta (the Neutral Hedge Ratio) Delta, also called the neutral hedge ratio, is the expected change in the option price given a one-unit change in the price of the underlying futures contract. For example, if the delta of an August gold call option is 0.25, it means that a $1 change in the price of August futures can be expected to result in a $0.25 change in the option premium. Thus, the delta value for a given option can be used to determine the number of options that would be equivalent in risk to a single futures contract for small changes in price. It should be stressed that delta will change rapidly as prices change. Thus, the delta value cannot be used to compare the relative risk of options versus futures for large price changes. Table 34.3 illustrates the estimated delta values for out-of-the-money, at-the-money, and in-the- money call options for a range of times to expiration. Where did these values come from? They are derived from the same mathematical models used to determine a theoretical value for an option pre- mium given the relationship between the strike price and the current price of futures, time remaining table 34.3 Change in the premium of an e-Mini S&p 500 Call Option for 20.00 ($1000) Move in the Underlying Futures Contracta Increase in the 2000 call option premium if the futures price rises: From 1900 to 1920 From 2000 to 2020 From 2100 to 2120 Time to expiration $ Delta $ Delta $ Delta 1 week $10 0.01 $500 0.5 $1,000 1 1 month $120 0.12 $510 0.51 $870 0.87 3 months $260 0.26 $510 0.51 $750 0.75 6 months $330 0.33 $520 0.52 $690 0.69 12 months $390 0.39 $520 0.52 $650 0.65 aAssumed volatility: 15 percent; assumed interest rate: 2 percent per year. Source: CMe Group (www .cmegroup.com). 485 AN INTrOduCTION TO OPTIONS ON FuTureS until expiration, estimated volatility, and interest rates. For any given set of values for these factors, delta will equal the absolute difference between the option premium indicated by the model and the model-indicated premium if the futures price changes by one point. Table 34.3 illustrates a number of important observations regarding theoretical delta values: 1. Delta values for out-of-the-money options are low. This relationship is a result of the fact that there is a high probability that any given price increase 9 will not make any actual differ- ence to the value of the option at expiration (i.e., the option will probably expire worthless). 2. Delta values for in-the-money options are relatively high, but less than one. In- the-money options have high deltas because there is a high probability that a one-point change in the futures price will mean a one-point change in the option value at expiration. However, since this probability must always be equal to less than one, the delta value will also always be equal to less than one. 3. Delta values for at-the-money options will be near 0.50. Since there is a 50/50 chance that an at-the-money option will expire in-the-money, there will be an approximately 50/50 chance that a one-point increase in the price of futures will result in a one-point increase in the option value at expiration. 4. Delta values for out-of-the-money options will increase as time to expiration increases. A longer time to expiration will increase the probability that a price increase in futures will make a difference in the option value at expiration, since there is more time for futures to reach the strike price. 5. Delta values for in-the-money options will decrease as time to expiration increases. A longer time to expiration will increase the probability that a change in the futures price will not make any difference to the option value at expiration since there is more time for futures to fall back to the strike price by the time the option expires. 6. Delta values for at-the-money options are not substantially affected by time to maturity until near expiration. This behavioral pattern is true because the probability that an at-the-money option will expire in-the-money remains close to 50/50 until the option is near expiration. 9 This section implicitly assumes that the option is a call. If the option is a put, read “price decrease” for all refer- ences to “price increase.” 487 Brokers are fond of pointing out to possible buyers of options that they are a splendid thing to buy, and pointing out to sellers that they are a splendid thing to sell. They believe implicitly in this paradox. Thus the buyer does well, the seller does well, and it is not necessary to stress the point that the broker does well enough. Many examples can be cited showing all three of them emerging from their adventures with a profit. One wonders why the problem of unemployment cannot be solved by having the unemployed buy and sell each other options, instead of mooning around on those park benches. —Fred Schwed Where Are the Customers’ Yachts? ■ Comparing Trading Strategies The existence of options greatly expands the range of possible trading strategies. For example, in the absence of an option market, a trader who is bullish can either go long or initiate a bull spread (in those markets in which spread movements correspond to price direction). However, if option-related trad- ing approaches are included, the bullish trader can consider numerous alternative strategies including: long out-of-the-money calls, long in-the-money calls, long at-the-money calls, short out-of-the-money puts, short in-the-money puts, short at-the-money puts, “synthetic” long positions, combined positions in futures and options, and a variety of bullish option spreads. Frequently, one of these option-related strategies will offer significantly better profit potential for a given level of risk than an outright futures position. Thus, the trader who considers both option-based strategies and outright positions should have a decided advantage over the trader who restricts his trades to only futures. Option Trading Strategies Chapter 35 488 A Complete Guide to the Futures mArket There is no single best trading approach. The optimal trading strategy in any given situation will depend on the prevailing option premium levels and the specific nature of the expected price sce- nario. How does one decide on the best strategy? This chapter will attempt to answer this critical question in two steps. First, we will examine the general profit/loss characteristics (profiles) of a wide range of alternative trading strategies. Second, we will consider how price expectations can be combined with these profit/loss profiles to determine the best trading approach. The profit/loss profile is a diagram indicating the profit or loss implied by a position (vertical axis) for a range of market prices (horizontal axis). The profit/loss profile provides an ideal means of understanding and comparing different trading strategies. The following points should be noted regarding the profit/loss profiles detailed in the next section: 1. All illustrations are based on a single option series, for a single market, on a single date: the August 2015 gold options on April 13, 2015. This common denominator makes it easy to com- pare the implications of different trading strategies. The choice of April 13, 2015, was not arbi- trary. On that date, the closing price of August futures (1,200.20) was almost exactly equal to one of the option strike prices ($1,200/oz), thereby providing a nearly precise at-the-money option—a factor that greatly facilitates the illustration of theoretical differences among out-of- the-money, in-the-money, and at-the-money options. The specific closing values for the option premiums on that date were as follows ($/oz): Strike price august Calls august puts 1,050 155.2 5.1 1,100 110.1 10.1 1,150 70.1 19.9 1,200 38.8 38.7 1,250 19.2 68.7 1,300 9.1 108.7 1,350 4.5 154.1 Option pricing data in this chapter courtesy of OptionVue (www .optionvue.com). The reader should refer to these quotes when examining each of the profit/loss profiles in the next section. 2. In order to avoid unnecessarily cluttering the illustrations, the profit/loss profiles do not include transaction costs and interest income effects, both of which are very minor. (Note the assump- tion that transaction costs equal zero imply that commission costs equal zero and that positions can be implemented at the quoted levels—in this case, the market close.) 3. The profit/loss profiles reflect the situation at the time of the option expiration. This assumption simplifies the exposition, since the value of an option can be precisely determined at that point in time. At prior times, the value of the option will depend on the various factors discussed in the previous chapter (e.g., time until expiration, volatility, etc.). Allowing for an evaluation of each option strategy at interim time stages would introduce a level of complexity that would place the discussion beyond the scope of this book. However, the key point to keep in mind 489 OPTION TrAdINg STrATegIeS is that the profit/loss profile for strategies that include a net long options position will shift upward as the time reference point is further removed from the expiration date. The reason is that at expiration, options have only intrinsic value; at points prior to expiration, options also have time value. Thus, prior to expiration, the holder of an option could liquidate his position at a price above its intrinsic value—the liquidation value assumed in the profit/loss profile. Simi- larly, the profit/loss profile would be shifted downward for the option writer (seller) at points in time prior to expiration. This is true since at such earlier junctures, the option writer would have to pay not only the intrinsic value but also the time value if he wanted to cover his position. 4. It is important to keep in mind that a single option is equivalent to a smaller position size than a single futures contract (see section entitled “ delta—the Neutral Hedge ratio” in the previous chapter). Similarly, an out-of-the-money option is equivalent to a smaller position size than an in-the-money option. Thus, the trader should also consider the profit/loss profiles consisting of various multiples of each strategy. In any case, the preference of one strategy over another should be based entirely on the relationship between reward and risk rather than on the absolute profit (loss) levels. In other words, strategy preferences should be totally independent of posi- tion size. 5. Trading strategies are evaluated strictly from the perspective of the speculator. Hedging applica- tions of option trading are discussed separately at the end of this chapter. ■ Profit/Loss Profiles for Key Trading Strategies Strategy 1: Long Futures exAMPle. Buy August gold futures at $1,200. (See Table 35.1 and Figure 35.1.) Comment. The simple long position in futures does not require much explanation and is included primarily for purposes of comparison to other less familiar trading strategies. As every trader knows, the long futures position is appropriate when one expects a significant price advance. However, as will tabLe 35.1 profit/Loss Calculations: Long Futures Futures price at expiration ($/oz) Futures price Change ($/oz) profit/Loss on position 1,000 –200 –$20,000 1,050 –150 –$15,000 1,100 –100 –$10,000 1,150 –50 –$5,000 1,200 0 $0 1,250 50 $5,000 1,300 100 $10,000 1,350 150 $15,000 1,400 200 $20,000 490A COMPleTe gUIde TO THe FUTUreS MArKeT be illustrated later in this section, for any given price scenario, some option-based strategy will often provide a more attractive trade in terms of reward/risk characteristics. Strategy 2: Short Futures exAMPle . Sell August gold futures at $1,200. (See Table 35.2 and Figure 35.2 .) tabLe 35.2 profit/Loss Calculations: Short Futures Futures price at expiration ($/oz) Futures price Change ($/oz) profit/Loss on position 1,000 200 $20,000 1,050 150 $15,000 1,100 100 $10,000 1,150 50 $5,000 1,200 0 $0 1,250 –50 –$5,000 1,300 –100 –$10,000 1,350 –150 –$15,000 1,400 –200 –$20,000 FIGURE  35.1 Profi t/loss Profi le: long Futures Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 20,000 15,000 10,000 5,000 −5,000 −10,000 −15,000 −20,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 491 OPTION TrAdINg STrATegIeS Comment. Once again, this strategy requires little explanation and is included primarily for com- parison to other strategies. As any trader knows, the short futures position is appropriate when one is expecting a signifi cant price decline. However, as will be seen later in this chapter, for any given expected price scenario, some option-based strategy will often off er a more attractive trading oppor- tunity in terms of reward/risk characteristics. Strategy 3a: Long Call (at-the-Money) exAMPle . Buy August $1,200 gold futures call at a premium of $38.80/oz ($3,880), with August gold futures trading at $1,200/oz. (See Table 35.3 a and Figure 35.3 a.) Comment. The long call is a bullish strategy in which maximum risk is limited to the premium paid for the option, while maximum gain is theoretically unlimited. However, the probability of a loss is greater than the probability of a gain, since the futures price must rise by an amount exceeding the option premium (as of the option expiration) in order for the call buyer to realize a profi t. Two spe- cifi c characteristics of the at-the-money option are the following: 1. The maximum loss will only be realized if futures are trading at or below their current level at the time of the option expiration. 2. For small price changes, each $1 change in the futures price will result in approximately a $0.50 change in the option price. (At-the-money options near expiration, which will change by a greater amount, are an exception.) Thus, for small price changes, a net long futures position is equivalent to approximately two call options in terms of risk. FIGURE  35.2 Profi t/loss Profi le: Short Futures Price of August gold futures at option expiration ($/oz) 1,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Profit/loss at expiration ($) 20,000 15,000 10,000 5,000 −5,000 −10,000 −15,000 −20,000 0 492A COMPleTe gUIde TO THe FUTUreS MArKeT tabLe 35.3a profit/Loss Calculations: Long Call (at-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) $ amount of premium paid Call Value at expiration profit/Loss of position [(4) – (3)] 1,000 38.8 $3,880 $0 –$3,880 1,050 38.8 $3,880 $0 –$3,880 1,100 38.8 $3,880 $0 –$3,880 1,150 38.8 $3,880 $0 –$3,880 1,200 38.8 $3,880 $0 –$3,880 1,250 38.8 $3,880 $5,000 $1,120 1,300 38.8 $3,880 $10,000 $6,120 1,350 38.8 $3,880 $15,000 $11,120 1,400 38.8 $3,880 $20,000 $16,120 FIGURE  35.3a Profi t/loss Profi le: long Call (At-the-Money) Price of August gold futures at option expiration ($/oz) Futures at time of position initiation and strike price Breakeven price = $1,238.80 Profit/loss at expiration ($) 1,000 15,000 17,500 12,500 10,000 7 ,500 2,500 0 −2,500 −5,000 5,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 493 OPTION TrAdINg STrATegIeS Strategy 3b: Long Call (Out-of-the-Money) exAMPle. Buy August $1,300 gold futures call at a premium of $9.10/oz ($910), with August gold futures trading at $1,200/oz. (See Table 35.3b and Figure 35.3b.) Comment. The buyer of an out-of-the-money call reduces his maximum risk in exchange for accept- ing a smaller probability that the trade will realize a profit. By definition, the strike price of an out-of- the-money call is above the current level of futures. In order for the out-of-the-money call position to realize a profit, the futures price (as of the time of the option expiration) must exceed the strike price by an amount greater than the premium ($9.10/oz in this example). Note that in the out-of- the-money call position, price increases that leave futures below the option strike price will still result in a maximum loss on the option. The long out-of-the-money call might be a particularly appropriate position for the trader expecting a large price advance, but also concerned about the possibility of a large price decline. It should be emphasized that the futures price need not necessarily reach the strike price in order for the out-of-the-money call to be profitable. If the market rises quickly, the call will increase in value and hence can be resold at a profit. (However, this characteristic will not necessarily hold true for slow price advances, since the depressant effect of the passage of time on the option premium could more than offset the supportive effect of the increased price level of futures.) For small price changes, the out-of-the-money call will change by less than a factor of one-half for each dollar change in the futures price. Thus, for small price changes, each long futures position will be equivalent to several long out-of-the-money calls in terms of risk. tabLe 35.3b profit/Loss Calculations: Long Call (Out-of-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,300 Call at Initiation ($/oz) $ amount of premium paid Call Value at expiration profit/Loss on position [(4) – (3)] 1,000 9.1 $910 $0 –$910 1,050 9.1 $910 $0 –$910 1,100 9.1 $910 $0 –$910 1,150 9.1 $910 $0 –$910 1,200 9.1 $910 $0 –$910 1,250 9.1 $910 $0 –$910 1,300 9.1 $910 $0 –$910 1,350 9.1 $910 $5,000 $4,090 1,400 9.1 $910 $10,000 $9,090 494A COMPleTe gUIde TO THe FUTUreS MArKeT FIGURE  35.3b Profi t/loss Profi le: long Call (Out-of-the-Money) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Strike price Breakeven price = $1,309.10 Profit/loss at expiration ($) 1,000 10,000 5,000 7 ,500 2,500 −2,500 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Strategy 3c: Long Call (In-the-Money) example . Buy August $1,100 gold futures call at a premium of $110.10 /oz ($11,010), with August gold futures trading at $1,200/oz. (See Table 35.3 c and Figure 35.3 c.) Comment. In many respects, a long in-the-money call position is very similar to a long futures posi- tion. The three main diff erences between these two trading strategies are: 1. The long futures position will gain slightly more in the event of a price rise—an amount equal to the time value portion of the premium paid for the option ($1,010 in the above example). 2. For moderate price declines, the long futures position will lose slightly less. (Once again, the diff erence will be equal to the time value portion of the premium paid for the option.) 3. In the event of a large price decline, the loss on the in-the-money long call position would be lim- ited to the total option premium paid, while the loss on the long futures position will be unlimited. In a sense, the long in-the-money call position can be thought of as a long futures position with a built-in stop. This characteristic is an especially important consideration for speculators who typically employ protective stop-loss orders on their positions—a prudent trading approach. A trader using a protective sell stop on a long position faces the frustrating possibility of the market declining suffi ciently to activate his stop and subsequently rebounding. The long in-the-money call position off ers the spec- ulator an alternative method of limiting risk that does not present this danger. Of course, this benefi t does not come without a cost; as mentioned above, the buyer of an in-the-money call will gain slightly less than the outright futures trader if the market advances, and will lose slightly more if the market declines moderately. However, if the trader is anticipating volatile market conditions, he might very 495 OPTION TrAdINg STrATegIeS well prefer a long in-the-money call position to a long futures position combined with a protective sell stop order. In any case, the key point is that the trader who routinely compares the strategies of buying an in-the-money call versus going long futures with a protective sell stop should enjoy an advantage over those traders who never consider the option-based alternative. FIGURE  35.3c Profi t/loss Profi le: long Call (In-the-Money) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiationStrike price Breakeven price = $1210.10 Profit/loss at expiration ($) 1,000 10,000 −10,000 −15,000 5,000 −5,000 0 15,000 20,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 tabLe 35.3c profit/Loss Calculations: Long Call (In-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,100 Call at Initiation ($/oz) $ amount of premium paid Call Value at expiration profit/Loss on position [(4) – (3)] 1,000 110.1 $11,010 $0 –$11,010 1,050 110.1 $11,010 $0 –$11,010 1,100 110.1 $11,010 $0 –$11,010 1,150 110.1 $11,010 $5,000 –$6,010 1,200 110.1 $11,010 $10,000 –$1,010 1,250 110.1 $11,010 $15,000 $3,990 1,300 110.1 $11,010 $20,000 $8,990 1,350 110.1 $11,010 $25,000 $13,990 1,400 110.1 $11,010 $30,000 $18,990 496 A Complete Guide to the Futures mArket Table 35.3d summarizes the profit/loss implications of various long call positions for a range of price assumptions. Note that as calls move deeper in-the-money, their profit and loss characteristics increasingly resemble a long futures position. The very deep in-the-money $1,050 call provides an interesting apparent paradox: The profit/loss characteristics of this option are nearly the same as those of a long futures position for all prices above $1,050, but the option has the advantage of limited risk for lower prices. How can this be? Why wouldn’t all traders prefer the long $1,050 call to the long futures position and, therefore, bid up its price so that its premium also reflected more time value? (The indicated premium of $15,520 for the $1,050 call consists almost entirely of intrinsic value.) There are two plausible explanations to this apparent paradox. First, the option price reflects the market’s assessment that there is a very low probability of gold prices moving to this deep in- the-money strike price, and therefore the market places a low value on the time premium. In other words, the market places a low value on the loss protection provided by an option with a strike price so far below the market. Second, the $1,050 call represents a fairly illiquid option position, and the quoted price does not reflect the bid/ask spread. No doubt, a potential buyer of the call would have had to pay a higher price than the quoted premium in order to assure an execution. tabLe 35.3d profit/Loss Matrix for Long Calls with Different Strike prices Dollar amount of premiums paid $1,050 $1,100 $1,150 $1,200 $1,250 $1,300 $1,350 Call Call a Call Call a Call Call a Call $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450 position profit/Loss at expiration Futures price at expiration ($/oz) Long Futures at $1,200 In-the-Money at-the-Money Out-of-the-Money $1,050 Call $1,100 Calla $1,150 Call $1,200 Calla $1,250 Call $1,300 Calla $1,350 Call 1,000 –$20,000 –$15,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450 1,050 –$15,000 –$15,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450 1,100 –$10,000 –$10,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450 1,150 –$5,000 –$5,520 –$6,010 –$7,010 –$3,880 –$1,920 –$910 –$450 1,200 $0 –$520 –$1,010 –$2,010 –$3,880 –$1,920 –$910 –$450 1,250 $5,000 $4,480 $3,990 $2,990 $1,120 –$1,920 –$910 –$450 1,300 $10,000 $9,480 $8,990 $7,990 $6,120 $3,080 –$910 –$450 1,350 $15,000 $14,480 $13,990 $12,990 $11,120 $8,080 $4,090 –$450 1,400 $20,000 $19,480 $18,990 $17,990 $16,120 $13,080 $9,090 $4,550 aThese calls are compared in Figure 35.3d. 497 OPTION TrAdINg STrATegIeS Figure 35.3 d compares the three types of long call positions to a long futures position. It should be noted that in terms of absolute price changes, the long futures position represents the largest position size, while the out-of-the-money call represents the smallest position size. Figure 35.3 d suggests the following important observations: 1. As previously mentioned, the in-the-money call is very similar to an outright long futures position. 2. The out-of-the-money call will lose the least in a declining market, but will also gain the least in a rising market. 3. The at-the-money call will lose the most in a steady market and will be the middle-of-the-road performer (relative to the other two types of calls) in advancing and declining markets. Again, it should be emphasized that these comparisons are based upon single-unit positions that may diff er substantially in terms of their implied position size (as suggested by their respective delta values). A comparison that involved equivalent position size levels for each strategy (i.e., equal delta values for each position) would yield diff erent observations. This point is discussed in greater detail in the section entitled “Multiunit Strategies.” FIGURE  35.3d Profi t/loss Profi le: long Futures and long Call Comparisons (In-the-Money, At-the-Money, and Out-of-the-Money) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Long futures At-the-money call (strike price = $1,200) Out-of-the-money call (strike price = $1,300) In-the-money call (strike price = $1,100) Profit/loss at expiration ($) 1,000 10,000 −10,000 −15,000 5,000 −5,000 0 15,000 20,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 498A COMPleTe gUIde TO THe FUTUreS MArKeT Strategy 4a: Short Call (at-the-Money) example . Sell August $1,200 gold futures call at a premium of $38.80 /oz ($3,880), with August gold futures trading at $1,200/oz. (See Table 35.4 a and Figure 35.4 a.) tabLe 35.4a profit/Loss Calculations-Short Call (at-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) $ amount of premium received Call Value at expiration profit/Loss on position [(3) – (4)] 1,000 38.8 $3,880 $0 $3,880 1,050 38.8 $3,880 $0 $3,880 1,100 38.8 $3,880 $0 $3,880 1,150 38.8 $3,880 $0 $3,880 1,200 38.8 $3,880 $0 $3,880 1,250 38.8 $3,880 $5,000 –$1,120 1,300 38.8 $3,880 $10,000 –$6,120 1,350 38.8 $3,880 $15,000 –$11,120 1,400 38.8 $3,880 $20,000 –$16,120 FIGURE  35.4a Profi t/loss Profi le: Short Call (At-the-Money) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation and strike price Breakeven price = $1,238.80 Profit/loss at expiration ($) 1,000 5,000 2,500 −5,000 −2,500 0 −10,000 −7,500 −17,500 −15,000 −12,500 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 499 OPTION TrAdINg STrATegIeS Comment. The short call is a bearish position with a maximum potential gain equal to the premium received for selling the call and unlimited risk. However, in return for assuming this unattractive maximum reward/maximum risk relationship, the seller of a call enjoys a greater probability of realizing a profit than a loss. Note the short at-the-money call position will result in a gain as long as the futures price at the time of the option expiration does not exceed the futures price at the time of the option initiation by an amount greater than the premium level ($38.80/oz in our example). However, the maximum possible profit (i.e., the premium received on the option) will only be real- ized if the futures price at the time of the option expiration is below the prevailing market price at the time the option was sold (i.e., the strike price). The short call position is appropriate if the trader is modestly bearish and views the probability of a large price rise as being very low . If, however, the trader anticipated a large price decline, he would probably be better off buying a put or going short futures. Strategy 4b: Short Call (Out-of-the-Money) example. Sell August $1,300 gold futures call at a premium of $9.10/oz ($910), with August gold futures trading at $1,200/oz. (See Table 35.4b and Figure 35.4b.) Comment. The seller of an out-of-the-money call is willing to accept a smaller maximum gain (i.e., premium) in exchange for increasing the probability of a gain on the trade. The seller of an out-of- the-money call will retain the full premium received as long as the futures price does not rise by an amount greater than the difference between the strike price and the futures price at the time of the option sale. The trade will be profitable as long as the futures price at the time of the option expiration is not above the strike price by more than the option premium ($9.10/oz in this example). The short out-of-the-money call represents a less bearish posture than the short at-the-money call position. Whereas the short at-the-money call position reflects an expectation that prices will either decline or increase only slightly, the short out-of-the-money call merely reflects an expectation that prices will not rise sharply. tabLe 35.4b profit/Loss Calculations: Short Call (Out-of-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,300 Call at Initiation ($/oz) $ amount of premium received Value of Call at expiration profit/Loss on position [(3) – (4)] 1,000 9.1 $910 $0 $910 1,050 9.1 $910 $0 $910 1,100 9.1 $910 $0 $910 1,150 9.1 $910 $0 $910 1,200 9.1 $910 $0 $910 1,250 9.1 $910 $0 $910 1,300 9.1 $910 $0 $910 1,350 9.1 $910 $5,000 –$4,090 1,400 9.1 $910 $10,000 –$9,090 500A COMPleTe gUIde TO THe FUTUreS MArKeT Strategy 4c: Short Call (In-the-Money) example . Sell August $1,100 gold futures call at a premium of $110.10 /oz ($11,010), with August gold futures trading at $1,200/oz. (See Table 35.4 c and Figure 35.4 c.) FIGURE  35.4b Profi t/loss Profi le: Short Call (Out-of-the-Money) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Strike price Breakeven price = $1,309.10 Profit/loss at expiration ($) 1,000 2,500 −5,000 −2,500 0 −10,000 −7,500 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 tabLe 35.4c profit/Loss Calculations: Short Call (In-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,100 Call at Initiation ($/oz) Dollar amount of premium received Value of Call at expiration profit/Loss on position [(3) – (4)] 1,000 110.1 $11,010 $0 $11,010 1,050 110.1 $11,010 $0 $11,010 1,100 110.1 $11,010 $0 $11,010 1,150 110.1 $11,010 $5,000 $6,010 1,200 110.1 $11,010 $10,000 $1,010 1,250 110.1 $11,010 $15,000 –$3,990 1,300 110.1 $11,010 $20,000 –$8,990 1,350 110.1 $11,010 $25,000 –$13,990 1,400 110.1 $11,010 $30,000 –$18,990 501 OPTION TrAdINg STrATegIeS Comment. For most of the probable price range, the profi t/loss characteristics of the short in-the- money call are fairly similar to those of the outright short futures position. There are three basic dif- ferences between these two positions: 1. The short in-the-money call will lose modestly less than the short futures position in an advancing market because the loss will be partially off set by the premium received for the call. 2. The short in-the-money call will gain modestly more than the short futures position in a mod- erately declining market. 3. In a very sharply declining market, the profi t potential on a short futures position is open-ended, whereas the maximum gain in the short in-the-money call position is limited to the total pre- mium received for the call. In eff ect, the seller of an in-the-money call chooses to lock in modestly better results for the prob- able price range in exchange for surrendering the opportunity for windfall profi ts in the event of a price collapse. generally speaking, a trader should only choose a short in-the-money call over a short futures position if he believes that the probability of a sharp price decline is extremely small. Table 35.4 d summarizes the profi t/loss results for various short call positions for a range of price assumptions. As can be seen, as calls move more deeply in-the-money, they begin to resemble FIGURE  35.4c Profi t/loss Profi le: Short Call (In-the-Money) Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Strike price Breakeven price = $1210.10 Profit/loss at expiration ($) 1,000 10,000 15,000 −10,000 5,000 −5,000 0 −20,000 −15,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 502 A Complete Guide to the Futures mArket a short futures position more closely. (Sellers of deep in-the-money calls should be aware that longs may choose to exercise such options well before expiration. early exercise can occur if the poten- tial interest income on the premium is greater than the theoretical time value of the option for a zero interest rate assumption.) Short positions in deep out-of-the-money calls will prove profitable for the vast range of prices, but the maximum gain is small and the theoretical maximum loss is unlimited. Figure 35.4d compares each type of short call to a short futures position. The short at-the-money call position will be the most profitable strategy under stable market conditions and the middle-of- the-road strategy (relative to the other two types of calls) in rising and declining markets. The short out-of-the-money call will lose the least in a rising market, but it will also be the least profitable strategy if prices decline. The short in-the-money call is the type of call that has the greatest potential and risk and, as mentioned above, there is a strong resemblance between this strategy and an outright short position in futures. It should be emphasized that the comparisons in Figure 35.4d are based upon single-unit positions. However, as previously explained, these alternative strategies do not represent equivalent position sizes. Comparisons based on positions weighted equally in terms of some risk measure (e.g., equal delta values) would yield different empirical conclusions. tabLe 35.4d profit/Loss Matrix for Short Calls with Different Strike prices Dollar amount of premium received $1,050 $1,100 $1,150 $1,200 $1,250 $1,300 $1,350 Call Call Call Call Call Call Call $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450 position profit/Loss at expiration Futures price at expiration ($/oz) Short Futures at $1,200 In-the-Money at-the- Money Out-of-the Money $1,050 Call $1,100 Call a $1,150 Call $1,200 Call a $1,250 Call $1,300 Call a $500 Call 1,000 $20,000 $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450 1,050 $15,000 $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450 1,100 $10,000 $10,520 $11,010 $7,010 $3,880 $1,920 $910 $450 1,150 $5,000 $5,520 $6,010 $7,010 $3,880 $1,920 $910 $450 1,200 $0 $520 $1,010 $2,010 $3,880 $1,920 $910 $450 1,250 –$5,000 –$4,480 –$3,990 –$2,990 –$1,120 $1,920 $910 $450 1,300 –$10,000 –$9,480 –$8,990 –$7,990 –$6,120 –$3,080 $910 $450 1,350 –$15,000 –$14,480 –$13,990 –$12,990 –$11,120 –$8,080 –$4,090 $450 1,400 –$20,000 –$19,480 –$18,990 –$17,990 –$16,120 –$13,080 –$9,090 –$4,550 aThese calls are compared in Figure 35.4d. 503 OPTION TrAdINg STrATegIeS Strategy 5a: Long put (at-the-Money) example . Buy August $1,200 gold futures put at a premium of $38.70/oz ($3,870), with August gold futures trading at $1,200/oz. (See Table 35.5 a and Figure 35.5 a.) FIGURE  35.4d Profi t/loss Profi le: Short Futures and Short Call Comparisons (In-the-Money, At-the-Money, and Out-of-the-Money) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Short futures At-the-money call (strike price = $1,200) Out-of-the-money call (strike price = $1,300) In-the-money call (strike price = $1,100) Profit/loss at expiration ($) 1,000 10,000 15,000 −10,000 5,000 −5,000 0 −15,000 −20,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 tabLe 35.5a profit/Loss Calculations: Long put (at-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,200 put at Initiation ($/oz) $ amount of premium paid put Value at expiration profit/Loss on position [(4) – (3)] 1,000 38.7 $3,870 $20,000 $16,130 1,050 38.7 $3,870 $15,000 $11,130 1,100 38.7 $3,870 $10,000 $6,130 1,150 38.7 $3,870 $5,000 $1,130 1,200 38.7 $3,870 $0 –$3,870 1,250 38.7 $3,870 $0 –$3,870 1,300 38.7 $3,870 $0 –$3,870 1,350 38.7 $3,870 $0 –$3,870 1,400 38.7 $3,870 $0 –$3,870 504A COMPleTe gUIde TO THe FUTUreS MArKeT Comment. The long put is a bearish strategy in which maximum risk is limited to the premium paid for the option, while maximum gain is theoretically unlimited. However, the probability of a loss is greater than the probability of a gain, since the futures price must decline by an amount exceeding the option premium (as of the option expiration) in order for the put buyer to realize a profi t. Two specifi c characteristics of the at-the-money option are: 1. The maximum loss will be realized only if futures are trading at or above their current level at the time of the option expiration. 2. For small price changes, each $1 change in the futures price will result in approximately a $0.50 change in the option price (except for options near expiration). Thus, for small price changes, a net short futures position is equivalent to approximately 2 put options in terms of risk. Strategy 5 b: Long put (Out-of-the-Money) example . Buy August $1,100 gold futures put at a premium of $10.10 /oz ($1,010). (The current price of August gold futures is $1,200/oz.) (See Table 35.5 b and Figure 35.5 b.) Comment. The buyer of an out-of-the-money put reduces his maximum risk in exchange for accept- ing a smaller probability that the trade will realize a profi t. By defi nition, the strike price of an out-of- the-money put is below the current level of futures. In order for the out-of-the-money put position Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation and strike price Breakeven price = $1,161.30 Profit/loss at expiration ($) 1,000 10,000 7,500 −5,000 5,000 −2,500 2,500 0 17,500 15,000 12,500 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 FIGURE  35.5a Profi t/loss Profi le: long Put (At-the-Money) 505 OPTION TrAdINg STrATegIeS to realize a profi t, the futures price (as of the time of the option expiration) must penetrate the strike price by an amount greater than the premium ($10.10/oz in the above example). Note that in the out-of-the-money put position, price decreases that leave futures above the option strike price will still result in a maximum loss on the option. The long out-of-the-money put might be a particularly appropriate position for the trader expecting a large price decline, but also concerned about the pos- sibility of a large price rise. tabLe 35.5b profit/Loss Calculations: Long put (Out-of-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,100 put at Initiation ($/oz) $ amount of premium paid Value of put at expiration profit/Loss on position [(4) – (3)] 1,000 10.1 $1,010 $10,000 $8,990 1,050 10.1 $1,010 $5,000 $3,990 1,100 10.1 $1,010 $0 –$1,010 1,150 10.1 $1,010 $0 –$1,010 1,200 10.1 $1,010 $0 –$1,010 1,250 10.1 $1,010 $0 –$1,010 1,300 10.1 $1,010 $0 –$1,010 1,350 10.1 $1,010 $0 –$1,010 1,400 10.1 $1,010 $0 –$1,010 Price of August gold futures at option expiration Futures price at time of position initiation Breakeven price = $1,089.90 Profit/loss at expiration ($) 1,000 7,500 10,000 5,000 −2,500 2,500 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Strike price FIGURE  35.5b Profi t/loss Profi le: long Put (Out-of-the-Money) 506 A Complete Guide to the Futures mArket It should be emphasized that the futures price need not necessarily reach the strike price in order for the out-of-the-money put to be profitable. If the market declines quickly, the put will increase in value, and hence can be resold at a profit. (However, this behavior will not necessarily hold for slow price declines, since the depressant effect of the passage of time on the option premium could well more than offset the supportive effect of the decreased price level of futures.) For small price changes, the out-of-the-money put will change by less than a factor of one-half for each dollar change in the futures price. Thus, for small price changes, each short futures position will be equivalent to several short out-of-the-money puts in terms of risk. Strategy 5c: Long put (In-the-Money) example. Buy August $1,300 gold futures put at a premium of $108.70/oz ($10,870), with August gold futures trading at $1,200/oz. (See Table 35.5c and Figure 35.5c.) Comment. In many respects, a long in-the-money put option is very similar to a short futures posi- tion. The three main differences between these two trading strategies are: 1. The short futures position will gain slightly more in the event of a price decline—an amount equal to the time value portion of the premium paid for the option ($870 in this example). 2. For moderate price advances, the short futures position will lose slightly less. (Once again, the difference will be equal to the time value portion of the premium paid for the option.) 3. In the event of a large price advance, the loss on the in-the-money long put position would be limited to the total option premium paid, while the loss on the short futures position would be unlimited. tabLe 35.5c profit/Loss Calculations: Long put (In-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,300 put at Initiation ($/oz) Dollar amount of premium paid Value of put at expiration profit/Loss on position [(3) – (4)] 1,000 108.7 $10,870 $30,000 $19,130 1,050 108.7 $10,870 $25,000 $14,130 1,100 108.7 $10,870 $20,000 $9,130 1,150 108.7 $10,870 $15,000 $4,130 1,200 108.7 $10,870 $10,000 –$870 1,250 108.7 $10,870 $5,000 –$5,870 1,300 108.7 $10,870 $0 –$10,870 1,350 108.7 $10,870 $0 –$10,870 1,400 108.7 $10,870 $0 –$10,870 507 OPTION TrAdINg STrATegIeS In a sense, the long in-the-money put position can be thought of as a short futures position with a built-in stop. This characteristic is an especially important consideration for speculators who typically employ protective stop loss orders on their positions—a prudent trading approach. A trader using a protective buy stop on a short position faces the frustrating possibility of the market advancing suffi ciently to activate his stop and subsequently breaking. The long in-the-money put position off ers the speculator an alternative method of limiting risk that does not present this danger. Of course, this benefi t does not come without a cost: as mentioned earlier, the buyer of an in-the-money put will gain slightly less than the outright short futures trader if the market declines and lose slightly more if the market advances moderately. However, if the trader is anticipating volatile market conditions, he might very well prefer a long in-the-money put position to a short futures position combined with a protective buy stop order. In any case, the key point is that the trader who routinely compares the strategies of buying an in-the-money put versus going short futures with a protective buy stop should enjoy an advantage over those traders who never consider the option-based alternative. Table 35.5 d summarizes the profi t/loss implications of various long put positions for a range of price assumptions. Note that as puts move deeper in-the-money, their profi t and loss characteristics increasingly resemble a short futures position. FIGURE  35.5c Profi t/loss Profi le: long Put (In-the-Money) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Strike price Breakeven price = $1,191.30 Profit/loss at expiration ($) 1,000 10,000 −10,000 −15,000 5,000 −5,000 0 15,000 20,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 508 A Complete Guide to the Futures mArket tabLe 35.5d profit/Loss Matrix for Long puts with Different Strike prices Dollar amount of premium paid $1,350 put $1,300 put $1,250 put $1,200 put $1,150 put $1,100 put $1,050 put $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510 position profit/Loss at expiration Futures price at expiration ($/oz) Short Futures at $1,200 In-the-Money at-the-Money Out-of-the-Money $1,350 put $1,300 puta $1,250 put $1,200 puta $1,150 put $1,100 puta $1,050 put 1,000 $20,000 $19,590 $19,130 $18,130 $16,130 $13,010 $8,990 $4,490 1,050 $15,000 $14,590 $14,130 $13,130 $11,130 $8,010 $3,990 –$510 1,100 $10,000 $9,590 $9,130 $8,130 $6,130 $3,010 –$1,010 –$510 1,150 $5,000 $4,590 $4,130 $3,130 $1,130 –$1,990 –$1,010 –$510 1,200 $0 –$410 –$870 –$1,870 –$3,870 –$1,990 –$1,010 –$510 1,250 –$5,000 –$5,410 –$5,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510 1,300 –$10,000 –$10,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510 1,350 –$15,000 –$15,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510 1,400 –$20,000 –$15,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510 aThese puts are compared in Figure 35.5d. Figure 35.5d compares the three types of long put positions to a short futures position. It should be noted that in terms of absolute price changes, the short futures position represents the largest position size, while the out-of-the-money put represents the smallest position size. Figure 35.5d sug- gests the following important observations: 1. As previously mentioned, the in-the-money put is very similar to an outright short futures position. 2. The out-of-the-money put will lose the least in a rising market, but will also gain the least in a declining market. 3. The at-the-money put will lose the most in a steady market and will be the middle-of- the-road performer (relative to the other two types of puts) in declining and advancing markets. Again, it should be emphasized that these comparisons are based on single-unit positions that may differ substantially in terms of their implied position size (as suggested by their respective delta values). A comparison that involved equivalent position size levels for each strategy (i.e., equal delta values for each position) would yield different observations. 509 OPTION TrAdINg STrATegIeS example . Sell August $1,200 gold futures put at a premium of $38.70/oz ($3,870), with August gold futures trading at $1,200/oz. (See Table 35.6 a and Figure 35.6 a.) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Short futures At-the-money put (strike price = $1,200) Out-of-the-money put (strike price = $1,100) In-the-money put (strike price = $1,300) Price/loss at expiration ($) 1,000 10,000 −10,000 −15,000 5,000 −5,000 0 15,000 20,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 FIGURE  35.5d Profi t/loss Profi le: Short Futures and long Put Comparisons (In-the-Money, At-the-Money, and Out-of-the-Money) tabLe 35.6a profit/Loss Calculations: Short put (at-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,200 put at Initiation ($/oz) $ amount of premium received put Value at expiration profit/Loss on position [(3) – (4)] 1,000 38.7 $3,870 $20,000 –$16,130 1,050 38.7 $3,870 $15,000 –$11,130 1,100 38.7 $3,870 $10,000 –$6,130 1,150 38.7 $3,870 $5,000 –$1,130 1,200 38.7 $3,870 $0 $3,870 1,250 38.7 $3,870 $0 $3,870 1,300 38.7 $3,870 $0 $3,870 1,350 38.7 $3,870 $0 $3,870 1,400 38.7 $3,870 $0 $3,870 510A COMPleTe gUIde TO THe FUTUreS MArKeT Comment. The short put is a bullish position with a maximum potential gain equal to the premium received for selling the put and unlimited risk. However, in return for assuming this unattractive maximum reward/maximum risk relationship, the seller of a put enjoys a greater probability of real- izing a profi t than a loss. Note that the short at-the-money put position will result in a gain as long as the futures price at the time of the option expiration is not below the futures price at the time of the option initiation by an amount greater than the premium level ($38.70/oz in our example). However, the maximum possible profi t (i.e., the premium received on the option) will only be realized if the futures price at the time of the option expiration is above the prevailing market price at the time the option was sold (i.e., the strike price). The short put position is appropriate if the trader is modestly bullish and views the probability of a large price decline as being very low . If, however, the trader anticipated a large price advance, he would probably be better off buying a call or going long futures. Strategy 6b: Short put (Out-of-the-Money) example . Sell August $1,100 gold futures put at a premium of $10.10 /oz ($1,010), with August gold futures trading at $1,200/oz. (See Table 35.6 b and Figure 35.6 b .) Comment. The seller of an out-of-the-money put is willing to accept a smaller maximum gain (i.e., premium) in exchange for increasing the probability of gain on the trade. The seller of an out-of-the- money put will retain the full premium received as long as the futures price does not decline by an FIGURE  35.6a Profi t/loss Profi le: Short Put (At-the-Money) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation and strike price Breakeven price = $1,161.30 Profit/loss at expiration ($) 1,000 −10,000 −12,500 5,000 2,500 −2,500 −5,000 −7,500 0 −15,000 −17,500 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 511 OPTION TrAdINg STrATegIeS amount greater than the diff erence between the futures price at the time of the option sale and the strike price. The trade will be profi table as long as the futures price at the time of the option expira- tion is not below the strike price by more than the option premium ($10.10/oz in this example). The short out-of-the-money put represents a less bullish posture than the short at-the-money put tabLe 35.6b profit/Loss Calculations: Short put (Out-of-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,100 put at Initiation ($/oz) Dollar amount of premium received Value of put at expiration profit/Loss on position [(3) – (4)] 1,000 10.1 $1,010 $10,000 –$8,990 1,050 10.1 $1,010 $5,000 –$3,990 1,100 10.1 $1,010 $0 $1,010 1,150 10.1 $1,010 $0 $1,010 1,200 10.1 $1,010 $0 $1,010 1,250 10.1 $1,010 $0 $1,010 1,300 10.1 $1,010 $0 $1,010 1,350 10.1 $1,010 $0 $1,010 1,400 10.1 $1,010 $0 $1,010 Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Breakeven price = $1,089.90 Profit/loss at expiration ($) 1,000 −10,000 2,500 −2,500 −5,000 −7,500 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Strike price FIGURE  35.6b Profi t/loss Profi le: Short Put (Out-of-the-Money) 512 A Complete Guide to the Futures mArket position. Whereas the short at-the-money put position reflects an expectation that prices will either rise or decline only slightly, the short out-of-the-money put merely reflects an expectation that prices will not decline sharply. Strategy 6c: Short put (In-the-Money) example. Sell August $1,300 gold futures put at a premium of $108.70/oz ($10,870), with August gold futures trading at $1,200/oz. (See Table 35.6c and Figure 35.6c.) Comment. For most of the probable price range, the profit/loss characteristics of the short in-the- money put are fairly similar to those of the outright long futures position. There are three basic dif- ferences between these two positions: 1. The short in-the-money put will lose modestly less than the long futures position in a declining market because the loss will be partially offset by the premium received for the put. 2. The short in-the-money put will gain modestly more than the long futures position in a moder- ately advancing market. 3. In a very sharply advancing market, the profit potential on a long futures position is open-ended, whereas the maximum gain in the short in-the-money put position is limited to the total pre- mium received for the put. In effect, the seller of an in-the-money put chooses to lock in modestly better results for the probable price range in exchange for surrendering the opportunity for windfall profits in the event of a price explosion. generally speaking, a trader should only choose a short in-the-money put over a long futures position if he believes that the probability of a sharp price advance is extremely small. tabLe 35.6c profit/Loss Calculations: Short put (In-the-Money) (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,300 put at Initiation ($/oz) Dollar amount of premium received put Value at expiration profit/Loss on position [(3) – (4)] 1,000 108.7 $10,870 $30,000 –$19,130 1,050 108.7 $10,870 $25,000 –$14,130 1,100 108.7 $10,870 $20,000 –$9,130 1,150 108.7 $10,870 $15,000 –$4,130 1,200 108.7 $10,870 $10,000 $870 1,250 108.7 $10,870 $5,000 $5,870 1,300 108.7 $10,870 $0 $10,870 1,350 108.7 $10,870 $0 $10,870 1,400 108.7 $10,870 $0 $10,870 513 OPTION TrAdINg STrATegIeS Table 35.6 d summarizes the profi t/loss results for various short put positions for a range of price assumptions. As can be seen, as puts move more deeply in the money, they begin to more closely resemble a long futures position. (As previously explained in the case of calls, sellers of deep in-the- money options should be cognizant of the real possibility of early exercise.) Short positions in deep out-of-the-money puts will prove profi table for the vast range of prices, but the maximum gain is small and the theoretical maximum loss is unlimited. Figure 35.6 d compares each type of short put to a long futures position. The short at-the-money put position will be the most profi table strategy under stable market conditions and the middle-of- the-road strategy (relative to the other two types of puts) in declining and rising markets. The short out-of-the-money put will lose the least in a declining market, but it will also be the least profi table strategy if prices advance. The short in-the-money put is the type of put that has the greatest potential and risk and, as mentioned above, there is a strong resemblance between this strategy and an outright long position in futures. It should be emphasized that the comparisons in Figure 35.6 d are based upon single-unit positions. However, as previously explained, these alternative strategies do not represent equivalent position sizes. Comparisons based on positions weighted equally in terms of some risk measure (e.g., equal delta values) would yield diff erent empirical conclusions. FIGURE  35.6c Profi t/loss Profi le: Short Put (In-the-Money) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Breakeven price =$1,191.30 Profit/loss at expiration ($) 1,000 10,000 15,000 −10,000 5,000 −5,000 −15,000 −20,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Strike price 514A COMPleTe gUIde TO THe FUTUreS MArKeT tabLe 35.6d profit/Loss Matrix for Short puts with Different Strike prices Dollar amount of premium received $1,350 put $1,300 put $1,250 put $1,200 put $1,150 put $1,100 put $1,050 put $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510 position profit/Loss at expiration Futures price at expiration ($/oz) Long Futures at $1,200 In-the- Money at-the- Money Out-of- the-Money $1,350 put $1,300 put a $1,250 put $1,200 put a $1,150 put $1,100 put a $1,050 put 1,000 –$20,000 –$19,590 –$19,130 –$18,130 –$16,130 –$13,010 –$8,990 –$4,490 1,050 –$15,000 –$14,590 –$14,130 –$13,130 –$11,130 –$8,010 –$3,990 $510 1,100 –$10,000 –$9,590 –$9,130 –$8,130 –$6,130 –$3,010 $1,010 $510 1,150 –$5,000 –$4,590 –$4,130 –$3,130 –$1,130 $1,990 $1,010 $510 1,200 $0 $410 $870 $1,870 $3,870 $1,990 $1,010 $510 1,250 $5,000 $5,410 $5,870 $6,870 $3,870 $1,990 $1,010 $510 1,300 $10,000 $10,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510 1,350 $15,000 $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510 1,400 $20,000 $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510 a These puts are compared in Figure 35.6 d. Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Long futures At-the-money put (strike price = $1,200) Out-of-the money put (strike price = $1,100) In-the-money put (strike price = $1,300) Profit/loss at expiration ($) 1,000 10,000 15,000 −10,000 5,000 −5,000 0 −15,000 −20,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 FIGURE  35.6d Profi t/loss Profi le: long Futures and Short Put Comparisons (In-the-Money, At-the-Money, and Out-of-the-Money) 515 OPTION TrAdINg STrATegIeS Strategy 7: Long Straddle (Long Call + Long put) example. Buy August $1,200 gold futures call at a premium of $38.80/oz ($3,880) and simultane- ously buy an August $1,200 gold futures put at a premium of $38.70/oz ($3,870). (See Table 35.7 and Figure 35.7.) Comment. The long straddle position is a volatility bet. The buyer of a straddle does not have any opinion regarding the probable price direction; he merely believes that option premiums are underpriced relative to the potential market volatility. Andrew T obias once offered a some - what more cynical perspective of this type of trade 1: “Indeed, if you haven’t any idea of which way the [market] is headed but feel it is headed someplace, you can buy both a put and a call on it. That’s called a straddle and involves enough commissions to keep your broker smiling all week.” As can be seen in Figure 35.7, the long straddle position will be unprofitable for a wide price range centered at the current price. Since this region represents the range of the most probable price outcomes, the long straddle position has a large probability of loss. In return for accepting a large probability of loss, the buyer of a straddle enjoys unlimited profit potential in the event of either a large price rise or a large price decline. The maximum loss on a long straddle position is equal to the total premium paid for both the long call and long put and will only be experienced if the expiration price is equal to the futures price at the time the options were purchased. (Implicit assumption: both the call and put are at-the-money options.) tabLe 35.7 profit/Loss Calculations: Long Straddle (Long Call + Long put) (1) (2) (3) (4) (5) (6) (7) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) premium of august $1,200 put at Initiation ($/oz) $ amount of total premium paid Call Value at expiration put Value at expiration profit/Loss on position [(5) + (6) – (4)] 1,000 38.8 38.7 $7,750 $0 $20,000 $12,250 1,050 38.8 38.7 $7,750 $0 $15,000 $7,250 1,100 38.8 38.7 $7,750 $0 $10,000 $2,250 1,150 38.8 38.7 $7,750 $0 $5,000 –$2,750 1,200 38.8 38.7 $7,750 $0 $0 –$7,750 1,250 38.8 38.7 $7,750 $5,000 $0 –$2,750 1,300 38.8 38.7 $7,750 $10,000 $0 $2,250 1,350 38.8 38.7 $7,750 $15,000 $0 $7,250 1,400 38.8 38.7 $7,750 $20,000 $0 $12,250 1 Andrew T obias, Getting By on $100,000 a Year (and Other Sad T ales) (New Y ork, NY: Simon & Schuster, 1980). 516A COMPleTe gUIde TO THe FUTUreS MArKeT Strategy 8: Short Straddle (Short Call + Short put) example . Sell August $1,200 gold futures call at a premium of $38.80/oz ($3,880 ) and simultane- ously sell an August $1,200 put at a premium of $38.70/oz ($3,870). (See Table 35.8 and Figure 35.8 .) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation and call and put strike prices Breakeven price = $1,122.50 Breakeven price = 1,277.50 Profit/loss at expiration ($) 1,000 5,000 10,000 15,000 –10,000 –5,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 FIGURE  35.7 Profi t/loss Profi le: long Straddle (long Call + long Put) tabLe 35.8 profit/Loss Calculations: Short Straddle (Short Call + Short put) (1) (2) (3) (4) (5) (6) (7) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) premium of august $1,200 put at Initiation ($/oz) $ amount of total premium received Call Value at expiration put Value at expiration profit/Loss on position [(4) – (5) – (6)] 1,000 38.8 38.7 $7,750 $0 $20,000 –$12,250 1,050 38.8 38.7 $7,750 $0 $15,000 –$7,250 1,100 38.8 38.7 $7,750 $0 $10,000 –$2,250 1,150 38.8 38.7 $7,750 $0 $5,000 $2,750 1,200 38.8 38.7 $7,750 $0 $0 $7,750 1,250 38.8 38.7 $7,750 $5,000 $0 $2,750 1,300 38.8 38.7 $7,750 $10,000 $0 –$2,250 1,350 38.8 38.7 $7,750 $15,000 $0 –$7,250 1,400 38.8 38.7 $7,750 $20,000 $0 –$12,250 517 OPTION TrAdINg STrATegIeSComment. The short straddle position will be profi table over a wide range of prices. The best outcome for a seller of a straddle is a totally unchanged market. In this circumstance, the seller will realize his maximum profi t, which is equal to the total premium received for the sale of the call and put. The short straddle position will remain profi table as long as prices do not rise or decline by more than the combined total premium of the two options. The seller of the straddle enjoys a large probability of a profi table trade, in exchange for accepting unlimited risk in the event of either a very sharp price advance or decline. This strategy is appropriate if the speculator expects prices to trade within a moderate range, but has no opinion regarding the probable market direction. A trader anticipating nonvolatile market con- ditions, but also having a price-directional bias, would be better off selling either calls or puts rather than a straddle. For example, a trader expecting low volatility and modestly declining prices should sell 2 calls instead of selling a straddle. Strategy 9: bullish “texas Option hedge” (Long Futures + Long Call) 2 example . Buy August gold futures at $1,200 and simultaneously buy an August $1,200 gold futures call at a premium of $38.80 /oz ($3,880). (See Table 35.9 and Figure 35.9 .) FIGURE  35.8 Profi t/loss Profi le: Short Straddle (Short Call + Short Put) Profi t/loss Profi le: Short Straddle (Short Call + Short Put) Price of August gold futures at option expiration ($/oz) Breakeven price = $1,122.50 Breakeven price = 1,277.50 Profit/loss at expiration ($) 1,000 5,000 10,000 –10,000 –15,000 –5,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Futures price at time of position initiation and call and put strike prices 2 By defi nition, a hedge implies a futures position opposite to an existing or anticipated actual position. In com- modity trading, T exas hedge is a facetious reference to so-called “hedgers” who implement a futures position in the same direction as their cash position. The classic example of a T exas hedge would be a cattle feeder who goes long cattle futures. Whereas normal hedging reduces risk, the T exas hedge increases risk. There are many option strate- gies that combine off setting positions in options and futures. This strategy is unusual in that it combines reinforcing positions in futures and options. Consequently, the term T exas option hedge seems to provide an appropriate label. 518A COMPleTe gUIde TO THe FUTUreS MArKeT tabLe 35.9 profit/Loss Calculations: bullish “texas Option hedge” (Long Futures + Long Call) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) $ amount of premium paid profit/Loss on Long Futures position Call Value at expiration profit/Loss on position [(4)+(5)–(3)] 1,000 38.8 $3,880 –$20,000 $0 –$23,880 1,050 38.8 $3,880 –$15,000 $0 –$18,880 1,100 38.8 $3,880 –$10,000 $0 –$13,880 1,150 38.8 $3,880 –$5,000 $0 –$8,880 1,200 38.8 $3,880 $0 $0 –$3,880 1,250 38.8 $3,880 $5,000 $5,000 $6,120 1,300 38.8 $3,880 $10,000 $10,000 $16,120 1,350 38.8 $3,880 $15,000 $15,000 $26,120 1,400 38.8 $3,880 $20,000 $20,000 $36,120 FIGURE  35.9 Profi t/loss Profi le: Bullish “T exas Option Hedge” (long Futures + long Call) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation and strike price Breakeven price = $1,219.40 Profit/loss at expiration ($) 1,000 37,500 50,000 25,000 −25,000 −37,500 12,500 −12,500 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Long 2 futures Long futures + long call 519 OPTION TrAdINg STrATegIeS Comment. This strategy provides an interesting alternative method of pyramiding—that is, increas- ing the size of a winning position. For example, a trader who is already long a futures contract at a profit and believes the market is heading higher may wish to increase his position without doubling his risk in the event of a price reaction—as would be the case if he bought a second futures contract. Such a speculator could choose instead to supplement his long position with the purchase of a call, thereby limiting the magnitude of his loss in the event of a price retracement, in exchange for real- izing a moderately lower profit if prices continued to rise. Figure 35.9 compares the alternative strategies of buying two futures versus buying a futures con- tract and a call. (For simplicity of exposition, the diagram assumes that both the futures contract and the call are purchased at the same time.) As can be seen, the long two futures position will always do moderately better in a rising market (by an amount equal to the premium paid for the call), but will lose more in the event of a significant price decline. The difference in losses between the two strate- gies will widen as larger price declines are considered. Strategy 10: bearish “texas Option hedge” (Short Futures + Long put) example. Sell August gold futures at $1,200 and simultaneously buy an August $1,200 gold put at a premium of $38.70/oz ($3,870). (See Table 35.10 and Figure 35.10.) Comment. This strategy is perhaps most useful as an alternative means of increasing a short position. As illustrated in Figure 35.10, the combination of a short futures contract and a long put will gain moderately less than 2 short futures contracts in a declining market, but will lose a more limited amount in a rising market. tabLe 35.10 profit/Loss Calculations: bearish “texas Option hedge” (Short Futures + Long put) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1200 put at Initiation ($/oz) $ amount of premium paid profit/Loss on Short Futures position put Value at expiration profit/Loss on position [(4) + (5) – (3)] 1,000 38.7 $3,870 $20,000 $20,000 $36,130 1,050 38.7 $3,870 $15,000 $15,000 $26,130 1,100 38.7 $3,870 $10,000 $10,000 $16,130 1,150 38.7 $3,870 $5,000 $5,000 $6,130 1,200 38.7 $3,870 $0 $0 –$3,870 1,250 38.7 $3,870 –$5,000 $0 –$8,870 1,300 38.7 $3,870 –$10,000 $0 –$13,870 1,350 38.7 $3,870 –$15,000 $0 –$18,870 1,400 38.7 $3,870 –$20,000 $0 –$23,870 520A COMPleTe gUIde TO THe FUTUreS MArKeT Strategy 11a: Option-protected Long Futures (Long Futures + Long at-the-Money put) example . Buy August gold futures at $1,200/oz and simultaneously buy an August $1200 gold put at a premium of $38.70/oz ($3,870). (See Table 35.11 a and Figure 35.11 a.) Comment. A frequently recommended strategy is that the trader implementing (or holding) a long futures position can consider buying a put to protect his downside risk. The basic idea is that if the market declines, the losses in the long futures position will be off set dollar for dollar by the long put position. Although this premise is true, it should be stressed that such a combined position represents nothing more than a proxy for a long call. The reader can verify the virtually identical nature of these two alternative strategies by comparing Figure 35.11 a to Figure 35.3 a. If prices increase, the long futures position will gain, while the option will expire worthless. On the other hand, if prices decline, the loss in the combined position will equal the premium paid for the put. In fact, if the call and put premiums are equal, a long futures plus long put position will be precisely equivalent to a long call. In most cases, the trader who fi nds the profi t/loss profi le of this strategy attractive would be better off buying a call, because the transaction costs are likely to be lower. However, if the trader already holds a long futures position, buying a put may be a reasonable alternative to liquidating this position and buying a call. Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation and strike price Breakeven price = $1,180.65 Profit/loss at expiration ($) 1,000 37,500 50,000 25,000 −25,000 −37,500 12,500 −12,500 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Short 2 futures Short futures + long put FIGURE  35.10 Profi t/loss Profi le: Bearish “T exas Option Hedge” (Short Futures + long Put) 521 OPTION TrAdINg STrATegIeS tabLe 35.11a profit/Loss Calculations: Option-protected Long Futures—Long Futures + Long at-the- Money put (Similar to Long at-the-Money Call) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 put at Initiation ($/oz) $ amount of premium paid profit/Loss on Long Futures position put Value at expiration profit/Loss on position [(4) + (5) – (3)] 1,000 38.7 $3,870 –$20,000 $20,000 –$3,870 1,050 38.7 $3,870 –$15,000 $15,000 –$3,870 1,100 38.7 $3,870 –$10,000 $10,000 –$3,870 1,150 38.7 $3,870 –$5,000 $5,000 –$3,870 1,200 38.7 $3,870 $0 $0 –$3,870 1,250 38.7 $3,870 $5,000 $0 $1,130 1,300 38.7 $3,870 $10,000 $0 $6,130 1,350 38.7 $3,870 $15,000 $0 $11,130 1,400 38.7 $3,870 $20,000 $0 $16,130 FIGURE  35.11a Profi t/loss Profi le: Option-Protected long Futures—long Futures + long at-the-Money Put (Similar to long At-the-Money Call) Price of August gold futures at option expiration ($/oz) Futures at time of position initiation and strike price Breakeven price = $1,238.70 Profit/loss at expiration ($) 1,000 10,000 7,500 12,500 15,000 17,500 5,000 −5,000 −2,500 2,500 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 522A COMPleTe gUIde TO THe FUTUreS MArKeT Strategy 11b: Option-protected Long Futures (Long Futures + Long Out-of-the-Money put) example . Buy August gold futures at $1,200/oz and simultaneously buy an August $1,100 gold futures put at a premium of $10.10/oz ($1,010). (See Table 35.11 b and Figure 35.11 b.) tabLe 35.11b profit/Loss Calculations: Option-protected Long Futures—Long Futures + Long Out-of- the-Money put (Similar to Long In-the-Money Call) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,100 put at Initiation ($/oz) $ amount of premium paid profit/Loss on Long Futures position put Value at expiration profit/Loss on position [(4) + (5) – (3)] 1,000 10.1 $1,010 –$20,000 $10,000 –$11,010 1,050 10.1 $1,010 –$15,000 $5,000 –$11,010 1,100 10.1 $1,010 –$10,000 $0 –$11,010 1,150 10.1 $1,010 –$5,000 $0 –$6,010 1,200 10.1 $1,010 $0 $0 –$1,010 1,250 10.1 $1,010 $5,000 $0 $3,990 1,300 10.1 $1,010 $10,000 $0 $8,990 1,350 10.1 $1,010 $15,000 $0 $13,990 1,400 10.1 $1,010 $20,000 $0 $18,990 FIGURE  35.11b Profi t/loss Profi le: Option-Protected long Futures—long Futures + long Out-of-the-Money Put (Similar to long In-the-Money Call) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Breakeven price = $1,210.10 Profit/loss at expiration ($) 1,000 10,000 15,000 20,000 5,000 −5,000 −10,000 −15,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Strike price 523 OPTION TrAdINg STrATegIeS Comment. As can be verified by comparing Figure 35.11b to Figure 35.3c, this strategy is virtually equivalent to buying an in-the-money call. Supplementing a long futures position with the purchase of an out-of-the-money put will result in slightly poorer results if the market advances, or declines moderately, but will limit the magnitude of losses in the event of a sharp price decline. Thus, much like the long in-the-money call position, this strategy can be viewed as a long position with a built- in stop. In most cases, it will make more sense for the trader to simply buy an in-the-money call since the transaction cost will be lower. However, if a speculator is already long futures, the purchase of an out-of-the-money put might present a viable alternative to liquidating this position and buying an in-the-money call. Strategy 12a: Option-protected Short Futures (Short Futures + Long at-the-Money Call) example. Sell August gold futures at $1,200/oz and simultaneously buy an August $1,200 gold call at a premium of $38.80/oz ($3,880). (See Table 35.12a and Figure 35.12a.) Comment. A frequently recommended strategy is that the trader implementing (or holding) a short futures position can consider buying a call to protect his upside risk. The basic idea is that if the mar- ket advances, the losses in the short futures position will be offset dollar for dollar by the long call position. Although this premise is true, it should be stressed that such a combined position represents nothing more than a proxy for a long put. The reader can verify the virtually identical nature of these two alternative strategies by comparing Figure 35.12a to Figure 35.5a. If prices decline, the short futures position will gain, while the option will expire worthless. And if prices advance, the loss in the combined position will equal the premium paid for the call. In fact, if the put and call premiums are equal, a short futures plus long call position will be precisely equivalent to a long put. tabLe 35.12a profit/Loss Calculations: Option-protected Short Futures—Short Futures + Long at-the- Money Call (Similar to Long at-the-Money put) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) $ amount of premium paid profit/Loss on Short Futures position Call Value at expiration profit/Loss on position [(4)+ (5) – (3)] 1,000 38.8 $3,880 $20,000 $0 $16,120 1,050 38.8 $3,880 $15,000 $0 $11,120 1,100 38.8 $3,880 $10,000 $0 $6,120 1,150 38.8 $3,880 $5,000 $0 $1,120 1,200 38.8 $3,880 $0 $0 –$3,880 1,250 38.8 $3,880 –$5,000 $5,000 –$3,880 1,300 38.8 $3,880 –$10,000 $10,000 –$3,880 1,350 38.8 $3,880 –$15,000 $15,000 –$3,880 1,400 38.8 $3,880 –$20,000 $20,000 –$3,880 524A COMPleTe gUIde TO THe FUTUreS MArKeT In most cases, the trader who fi nds the profi t/loss profi le of this strategy attractive would be better off buying a put, because the transaction costs are likely to be lower. However, if the trader already holds a short futures position, buying a call may be a reasonable alternative to liquidating this position and buying a put. Strategy 12b: Option-protected Short Futures (Short Futures + Long Out-of-the-Money Call) example . Sell August gold futures at $1,200/oz and simultaneously buy an August $1,300 gold futures call at a premium of $9.10/oz ($910). (See Table 35.12 b and Figure 35.12 b.) Comment. As can be verifi ed by comparing Figure 35.12 b to Figure 35.5 c, this strategy is virtually equivalent to buying an in-the-money put. Supplementing a short futures position with the purchase of an out-of-the-money call will result in slightly poorer results if the market declines or advances moderately, but will limit the magnitude of losses in the event of a sharp price advance. Thus, much as with the long in-the-money put position, this strategy can be viewed as a short position with a built-in stop. Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation and strike priceBreakeven price = $1,161.20 Profit/loss at expiration ($) 1,000 10,000 17,500 15,000 12,500 7,500 5,000 2,500 −5,000 −2,500 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 FIGURE  35.12a Profi t/loss Profi le: Option-Protected Short Futures—Short Futures + long At-the-Money Call (Similar to long At-the-Money Put) 525 OPTION TrAdINg STrATegIeS In most cases, it will make more sense for the trader simply to buy an in-the-money put since the transaction costs will be lower. However, if a speculator is already short futures, the purchase of an out-of-the-money call might present a viable alternative to liquidating this position and buying an in-the-money put. tabLe 35.12b profit/Loss Calculations: Option-protected Short Futures—Short Futures + Long Out- of-the-Money Call (Similar to Long In-the-Money put) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,300 Call at Initiation ($/oz) $ amount of premium paid profit/Loss on Short Futures position Call Value at expiration profit/Loss on position [(4) + (5) – (3)] 1,000 9.1 $910 $20,000 $0 $19,090 1,050 9.1 $910 $15,000 $0 $14,090 1,100 9.1 $910 $10,000 $0 $9,090 1,150 9.1 $910 $5,000 $0 $4,090 1,200 9.1 $910 $0 $0 –$910 1,250 9.1 $910 –$5,000 $0 –$5,910 1,300 9.1 $910 –$10,000 $0 –$10,910 1,350 9.1 $910 –$15,000 $5,000 –$10,910 1,400 9.1 $910 –$20,000 $10,000 –$10,910 FIGURE  35.12b Profi t/loss Profi le: Option-Protected Short Futures—Short Futures + long Out-of-the-Money Call (Similar to long In-the-Money Put) Price of August gold futures at option expiration ($/oz) Futures price at time of position initiation Breakeven price = $1,190.90 Profit/loss at expiration ($) 1,000 10,000 15,000 20,000 5,000 −5,000 −10,000 −15,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 Strike price 526 A Complete Guide to the Futures mArket Strategy 13: Covered Call Write (Long Futures + Short Call) example. Buy August gold futures at $1,200/oz and simultaneously sell an August $1,200 gold futures call at a premium of $38.80/oz ($3,880). (See Table 35.13 and Figure 35.13.) Comment. There has been a lot of nonsense written about covered call writing. In fact, even the term is misleading. The implication is that covered call writing—the sale of calls against long positions—is somehow a more conservative strategy than naked call writing—the sale of calls without any offsetting long futures position. This assumption is absolutely false. Although naked call writing implies unlimited risk, the same statement applies to covered call writing. As can be seen in Figure 35.13, the covered call writer merely exchanges unlimited risk in the event of a market advance (as is the case for the naked call writer) for unlimited risk in the event of a market decline. In fact, the reader can verify that this strategy is virtually equivalent to a “naked” short put position (see Strategy 35.6a). One frequently mentioned motivation for covered call writing is that it allows the holder of a long position to realize a better sales price. For example, if the market is trading at $1,200 and the holder of a long futures contract sells an at-the-money call at a premium of $38.80/oz instead of liquidating his position, he can realize an effective sales price of $1,238.80 if prices move higher (the $1,200 strike price plus the premium received for the sale of the call). And, if prices move down by no more than $38.80/oz by option expiration, he will realize an effective sales price of at least $1,200. Pre- sented in this light, this strategy appears to be a “heads you win, tails you win” proposition. However, there is no free lunch. The catch is that if prices decline by more than $38.80, the trader will realize a lower sales price than if he had simply liquidated the futures position. And, if prices rise substantially higher, the trader will fail to participate fully in the move as he would have if he had maintained his long position. The essential point is that although many motivations are suggested for covered call writing, the trader should keep in mind that this strategy is entirely equivalent to selling puts. tabLe 35.13 profit/Loss Calculations: Covered Call Write—Long Futures + Short Call (Similar to Short put) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) $ amount of premium received profit/Loss on Long Futures position Call Value at expiration profit/Loss on position [(3) + (4) – (5)] 1,000 38.8 $3,880 –$20,000 $0 –$16,120 1,050 38.8 $3,880 –$15,000 $0 –$11,120 1,100 38.8 $3,880 –$10,000 $0 –$6,120 1,150 38.8 $3,880 –$5,000 $0 –$1,120 1,200 38.8 $3,880 $0 $0 $3,880 1,250 38.8 $3,880 $5,000 $5,000 $3,880 1,300 38.8 $3,880 $10,000 $10,000 $3,880 1,350 38.8 $3,880 $15,000 $15,000 $3,880 1,400 38.8 $3,880 $20,000 $20,000 $3,880 527 OPTION TrAdINg STrATegIeS Strategy 14: Covered put Write (Short Futures + Short put) example . Sell August futures at $1,200 and simultaneously sell an August $1,200 gold futures put at a premium of $38.70/oz ($3,870). (See Table 35.14 and Figure 35.14 .) FIGURE  35.13 Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to Short Put) Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 5,000 2,500 0 −2,500 −7 ,500 −10,000 −12,500 −15,000 −5,000 1,050 1,100 1,150 1,200 1,250 Futures price at time of position initiation and strike price Breakeven price = $1,161 .20 1,300 1,350 1,400 −17 ,500 tabLe 35.14 profit/Loss Calculations: Covered put Write—Short Futures + Short put (Similar to Short Call) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 put at Initiation ($/oz) $ amount of premium received profit/Loss on Short Futures position put Value at expiration profit/Loss on position [(3) + (4) – (5)] 1,000 38.7 $3,870 $20,000 $20,000 $3,870 1,050 38.7 $3,870 $15,000 $15,000 $3,870 1,100 38.7 $3,870 $10,000 $10,000 $3,870 1,150 38.7 $3,870 $5,000 $5,000 $3,870 1,200 38.7 $3,870 $0 $0 $3,870 1,250 38.7 $3,870 –$5,000 $0 –$1,130 1,300 38.7 $3,870 –$10,000 $0 –$6,130 1,350 38.7 $3,870 –$15,000 $0 –$11,130 1,400 38.7 $3,870 –$20,000 $0 –$16,130 528A COMPleTe gUIde TO THe FUTUreS MArKeT Comment. Comments analogous to those made for Strategy 13 would apply here. The sale of a put against a short futures position is equivalent to the sale of a call. The reader can verify this by compar- ing Figure 35.14 to Figure 35.4 a. The two strategies would be precisely equivalent (ignoring transac- tion cost diff erences) if the put and call premiums were equal. Strategy 15: Synthetic Long Futures (Long Call + Short put) example . Buy an August $1,150 gold futures call at a premium of $70.10/oz ($7,010) and simultane- ously sell an August $1,150 gold futures put at a premium of $19.90/oz ($1,990). (See Table 35.15 and Figure 35.15 .) Comment. A synthetic long futures position can be created by combining a long call and a short put for the same expiration date and the same strike price. For example, as illustrated in Table 35.15 and Figure 35.15 , the combined position of a long August $1,150 call and a short August $1,150 put is virtually identical to a long August futures position. The reason for this equivalence is tied to the fact that the diff erence between the premium paid for the call and the premium received for the put is approxi- mately equal to the intrinsic value of the call. each $1 increase in price will raise the intrinsic value of the call by an equivalent amount and each $1 decrease in price will reduce the intrinsic value of the FIGURE  35.14 Profi t/loss Profi le: Covered Put Write—Short Futures + Short Put (Similar to Short Call) Price of August gold futures at option expiration ($/oz) 1,000 1,050 1,100 1,150 1,200 1,250 Futures price at time of position initiation and strike price Breakeven price = $1,238.70 1,300 1,350 1,400 Profit/loss at expiration ($) 5,000 2,500 0 −2,500 −7 ,500 −10,000 −12,500 −17 ,500 −15,000 −5,000 529 OPTION TrAdINg STrATegIeS tabLe 35.15 profit/Loss Calculations: Synthetic Long Futures (Long Call + Short put) (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,150 Call at Initiation ($/oz) $ amount of premium paid premium of august $1,150 put at Initiation ($/oz) $ amount of premium received Call Value at expiration put Value at expiration profit/Loss on position [(5) − (3) + (6) − (7)] 1,000 70.1 $7,010 19.9 $1,990 $0 $15,000 −$20,020 1,050 70.1 $7,010 19.9 $1,990 $0 $10,000 −$15,020 1,100 70.1 $7,010 19.9 $1,990 $0 $5,000 −$10,020 1,150 70.1 $7,010 19.9 $1,990 $0 $0 −$5,020 1,200 70.1 $7,010 19.9 $1,990 $5,000 $0 −$20 1,250 70.1 $7,010 19.9 $1,990 $10,000 $0 $4,980 1,300 70.1 $7,010 19.9 $1,990 $15,000 $0 $9,980 1,350 70.1 $7,010 19.9 $1,990 $20,000 $0 $14,980 1,400 70.1 $7,010 19.9 $1,990 $25,000 $0 $19,980 FIGURE  35.15 Profi t/loss Profi le: Synthetic long Futures (long Call + Short Put) Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 20,000 15,000 10,000 5,000 −5,000 −10,000 −15,000 −20,000 0 1,050 1,100 1,150 1,200 1,250 Futures price at time of position initiation Breakeven price = $1,200.20 1,300 1,350 1,400 530 A Complete Guide to the Futures mArket call (or if prices decline below $1,150, increase the value of the put) by an equivalent amount. Thus, as long as the expiration date and strike price of the two options are identical, a long call/short put position acts just like a long futures contract. The futures equivalent price implied by a synthetic position is given by the following formula: Synthetic futures pos itio n prices trike pricec all prem ium=+ − −put premi um It should be noted there will be one synthetic futures position price corresponding to each strike price for which options are traded for the given futures contract. In this example, the synthetic long position is the same price as a long futures contract. (Synthetic futures position price = $1,150 + $70.10 − $19.90 = $1,200.20.) Thus, ignoring transaction costs and interest income effects, buying the August $1,150 call and simultaneously selling the August $1,150 put would be equivalent to buying an August futures contract. Of course, the trader consider- ing this strategy as an alternative to an outright long futures position must incorporate transaction costs and interest income effects into the calculation. In this example, the true cost of the synthetic futures position would be raised vis-à-vis a long futures contract as a result of the following three factors: 1. Because the synthetic futures position involves two trades, in a less liquid market, it is reason- able to assume the execution costs will also be greater. In other words, the option-based strategy will require the trader to give up more points (relative to quoted levels) in order to execute the trade. 2. The synthetic futures position will involve greater commission costs. 3. The dollar premium paid for the call ($7,010) exceeds the dollar premium received for the put ($1,990). Thus, the synthetic futures position will involve an interest income loss on the differ- ence between these two premium payments ($5,020). This factor, however, would be offset by the margin requirements on a long futures position. Once the above differences are accounted for, the apparent relative advantage a synthetic futures position will sometimes seemingly offer will largely, if not totally, disappear. Nonetheless, insofar as some market inefficiencies may exist, the synthetic long futures position will sometimes offer a slight advantage over the direct purchase of a futures contract. In fact, the existence of such discrepancies would raise the possibility of pure arbitrage trades. 3 For example, if the price implied by the synthetic long futures position was less than the futures price, even after accounting for transaction costs and interest income effects, the arbitrageur could lock in a profit by buying the call, selling the put, and selling futures. Such a trade is called a reverse conversion. Alternately, if after adjusting for transaction costs and interest income effects, the implied price of the synthetic long futures position were greater than the futures price, the arbitrageur could lock in a profit by buying futures, selling the call, and buying the put. Such a trade is called a conversion. 3 Pure arbitrage implies a risk-free trade in which the arbitrageur is able to lock in a small profit by exploiting temporary price distortions between two related markets. 531 OPTION TrAdINg STrATegIeS It should be obvious that such risk-free profit opportunities will be limited in terms of both duration and magnitude. generally speaking, conversion and reverse conversion arbitrage will normally only be feasible for professional arbitrageurs who enjoy much lower transac- tion costs (commissions plus execution costs) than the general public. The activity of these arbitrageurs will tend to keep synthetic futures position prices about in line with actual futures prices. Strategy 16: Synthetic Short Futures (Long put + Short Call) example. Buy an August $1,300 gold futures put at a premium of $108.70/oz ($10,870) and simul- taneously sell an August $1,300 gold futures call at a premium of $9.10/oz ($910). (See Table 35.16 and Figure 35.16.) Comment. As follows directly from the discussion of the previous strategy, a synthetic short futures position can be created by combining a long put and a short call with the same expiration date and the same strike price. In this example, the synthetic futures position based upon the $1,300 strike price options is $0.40 higher priced than the underlying futures contract. (Synthetic futures position = $1,300 + $9.10 − $108.70 = $1,200.40.) However, for reasons similar to those discussed in the previous strategy, much of the advantage of an implied synthetic futures position price versus the actual futures price typically disappears once transaction costs and interest income effects are incorporated into the evaluation. An arbitrage employing the synthetic short futures position is called a conversion and was detailed in the previous strategy. tabLe 35.16 profit/Loss Calculations: Synthetic Short Futures (Long put + Short Call) (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,300 Call at Initiation ($/oz) Dollar amount of premium received premium of august $1,300 put at Initiation ($/oz) Dollar amount of premium paid Value of Call at expiration Value of put at expiration profit/Loss on position [(3) − (5) + (7) − (6)] 1,000 9.1 $910 108.7 $10,870 $0 $30,000 $20,040 1,050 9.1 $910 108.7 $10,870 $0 $25,000 $15,040 1,100 9.1 $910 108.7 $10,870 $0 $20,000 $10,040 1,150 9.1 $910 108.7 $10,870 $0 $15,000 $5,040 1,200 9.1 $910 108.7 $10,870 $0 $10,000 $40 1,250 9.1 $910 108.7 $10,870 $0 $5,000 –$4,960 1,300 9.1 $910 108.7 $10,870 $0 $0 –$9,960 1,350 9.1 $910 108.7 $10,870 $5,000 $0 –$14,960 1,400 9.1 $910 108.7 $10,870 $10,000 $0 –$19,960 532A COMPleTe gUIde TO THe FUTUreS MArKeT Strategy 17: the ratio Call Write (Long Futures + Short 2 Calls) example . Buy August gold futures at $1,200 and simultaneously sell two August $1,200 gold futures calls at a premium of $38.80/ oz. ($7,760). (See Table 35.17 and Figure 35.17 .) FIGURE  35.16 Profi t/loss Profi le: Synthetic Short Futures (long Put + Short Call). Futures price at time of position initiation Breakeven price = $1,210.40 Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 20,000 15,000 10,000 5,000 −5,000 −10,000 −15,000 −20,000 0 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 tabLe 35.17 profit/Loss Calculations: ratio Call Write—Long Futures + Short 2 Calls (Similar to Short Straddle) (1) (2) (3) (4) (5) (6) Futures price at expiration ($/oz) premium of august $1,200 Call at Initiation ($/oz) $ amount of total premium received profit/Loss on Long Futures position Value of 2 Calls at expiration profit/Loss on position [(3) + (4) − (5)] 1,000 38.8 $7,760 –$20,000 $0 –$12,240 1,050 38.8 $7,760 –$15,000 $0 –$7,240 1,100 38.8 $7,760 –$10,000 $0 –$2,240 1,150 38.8 $7,760 –$5,000 $0 $2,760 1,200 38.8 $7,760 $0 $0 $7,760 1,250 38.8 $7,760 $5,000 $10,000 $2,760 1,300 38.8 $7,760 $10,000 $20,000 –$2,240 1,350 38.8 $7,760 $15,000 $30,000 –$7,240 1,400 38.8 $7,760 $20,000 $40,000 –$12,240 533 OPTION TrAdINg STrATegIeS Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 10,000 5,000 −5,000 −10,000 0 1,050 1,100 1,150 1,200 1,250 Breakeven price = $1,122.40 Breakeven price = $1,277 .60 1,300 1,350 1,400 −15,000 Futures price at time of position initiation FIGURE  35.17 Profi t/loss Profi le: ratio Call Write—long Futures + Short 2 Calls (Similar to Short Straddle) Comment. The combination of 1 long futures contract and 2 short at-the-money calls is a balanced position in terms of delta values. In other words, at any given point in time, the gain or loss in the long futures contract due to small price changes (i.e., price changes in the vicinity of the strike price) will be approximately off set by an opposite change in the call position. (Over time, however, a mar- ket characterized by small price changes will result in the long futures position gaining on the short call position due to the evaporation of the time value of the options.) The maximum profi t in this strategy will be equal to the premium received for the 2 calls and will occur when prices are exactly unchanged. This strategy will show a net profi t for a wide range of prices centered at the prevailing price level at the time the position was initiated. However, the position will imply unlimited risk in the event of very sharp price increases or declines. The profi t/loss profi le for this strategy should look familiar—it is virtually identical to the short straddle position (see Strategy 35.8). The virtual equivalence of this strategy to the short straddle position follows directly from the previously discussed structure of a synthetic futures position: Ratio call wr itel ong f utures short calls =+ 2 However, from the synthetic futures position relationship, we know that: Long f utures long call short put ≈+ 534 A Complete Guide to the Futures mArket Thus: Ratio call writ el ong c all short put short c alls or Rati ≈+ + 2, oo call wr ite short put short call≈+ The right-hand term of this last equation is, in fact, the definition of a short straddle. In similar fashion, it can be demonstrated that a short put write (short futures + short 2 puts) would also yield a profit/loss profile nearly identical to the short straddle position. Strategy 18: bull Call Money Spread (Long Call with Lower Strike price/Short Call with higher Strike price) example. Buy an August $1,250 gold futures call at a premium of $19.20/oz ($1,920) and simultaneously sell an August $1,300 call at a premium of $9.10 ($910). (See Table 35.18 and Figure 35.18.) Comment. This type of spread position is also called a debit spread because the amount of premium paid for the long call is greater than the amount of the premium received for the short call. The maxi- mum risk in this type of trade is equal to the difference between these two premiums. The maximum possible gain in this spread will be equal to the difference between the two strike prices minus the net difference between the two premiums. The maximum loss will occur if prices fail to rise at least beyond the lowest strike price. The maximum gain will be realized if prices rise above the higher strike price. Note that although the maximum profit exceeds the maximum risk by a factor of nearly 4 to 1, the probability of a loss is significantly greater than the probability of a gain. This condition is true since prices must rise $60.10/oz before the strategy proves profitable. tabLe 35.18 profit/Loss Calculations: bull Call Money Spread (Long Call with Lower Strike price/ Short Call with higher Strike price) (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,250 Call ($/oz) $ amount of premium paid premium of august $1,300 Call ($/oz) Dollar amount of premium received $1,250 Call Value at expiration $1,300 Call Value at expiration profit/Loss on position [(5) − (3) + (6) − (7)] 1,000 19.2 $1,920 9.1 $910 $0 $0 -$1,010 1,050 19.2 $1,920 9.1 $910 $0 $0 -$1,010 1,100 19.2 $1,920 9.1 $910 $0 $0 -$1,010 1,150 19.2 $1,920 9.1 $910 $0 $0 -$1,010 1,200 19.2 $1,920 9.1 $910 $0 $0 -$1,010 1,250 19.2 $1,920 9.1 $910 $0 $0 -$1,010 1,300 19.2 $1,920 9.1 $910 $5,000 $0 $3,990 1,350 19.2 $1,920 9.1 $910 $10,000 $5,000 $3,990 1,400 19.2 $1,920 9.1 $910 $15,000 $10,000 $3,990 535 OPTION TrAdINg STrATegIeS This strategy can perhaps be best understood by comparing it to the long call position (e.g., long August $1,250 gold futures call). In eff ect, the spread trader reduces the premium cost for the long call position by the amount of premium received for the sale of the more deeply out-of-the-money call. This reduction in the net premium cost of the trade comes at the expense of sacrifi cing the pos- sibility of unlimited gain in the event of a large price rise. As can be seen in Figure 35.18 , in contrast to the outright long call position, price gains beyond the higher strike price will cease to aff ect the profi tability of the trade. Strategy 19a: bear Call Money Spread (Short Call with Lower Strike price/Long Call with higher Strike price)—Case 1 example . Buy August $1,150 gold futures call at a premium of $70.10/oz ($7,010) and simultane- ously sell an August $1,100 gold futures call at a premium of $110.10/oz ($11,010), with August gold futures trading at $1,200/oz. (See Table 35.19 a and Figure 35.19 a.) Comment. This type of spread is called a credit spread, since the amount of premium received for the short call position exceeds the premium paid for the long call position. The maximum possible gain on the trade is equal to the net diff erence between the two premiums. The maximum possible loss is equal to the diff erence between the two strike prices minus the diff erence between the two premiums. The maximum gain would be realized if prices declined to the lower strike price. The maximum loss would occur if prices failed to decline to at least the higher strike price. Although FIGURE  35.18 Profi t/loss Profi le: Bull Call Money Spread (long Call with lower Strike Price/ Short Call with Higher Strike Price) Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 3,750 5,000 2,500 0 −1,250 1,250 1,050 1,100 1,150 1,200 1,250 Breakeven price = $1,260.10 1,300 1,350 1,400 −2,500 Futures price at time of position initiation 536A COMPleTe gUIde TO THe FUTUreS MArKeT tabLe 35.19a profit/Loss Calculations: bear Call Money Spread (Short Call with Lower Strike price/ Long Call with higher Strike price); Case 1—both Calls In-the-Money (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,150 Call ($/oz) $ amount of premium paid premium of august $1,100 Call ($/oz) $ amount of premium received $1,150 Call Value at expiration $1,100 Call Value at expiration profit/Loss on position [(5) − (3) + (6) − (7)] 1,000 70.1 $7,010 110.1 $11,010 $0 $0 $4,000 1,050 70.1 $7,010 110.1 $11,010 $0 $0 $4,000 1,100 70.1 $7,010 110.1 $11,010 $0 $0 $4,000 1,150 70.1 $7,010 110.1 $11,010 $0 $5,000 –$1,000 1,200 70.1 $7,010 110.1 $11,010 $5,000 $10,000 –$1,000 1,250 70.1 $7,010 110.1 $11,010 $10,000 $15,000 –$1,000 1,300 70.1 $7,010 110.1 $11,010 $15,000 $20,000 –$1,000 1,350 70.1 $7,010 110.1 $11,010 $20,000 $25,000 –$1,000 1,400 70.1 $7,010 110.1 $11,010 $25,000 $30,000 –$1,000 Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 3,750 5,000 2,500 0 −1,250 1,250 1,050 1,100 1,150 1,200 1,250 Breakeven price = $1,140 1,300 1,350 1,400 Futures price at time of position initiation FIGURE  35.19a Profi t/loss Profi le: Bear Call Money Spread (Short Call with lower Strike Price/long Call with Higher Strike Price); Case 1—Both Calls In-the-Money 537 OPTION TrAdINg STrATegIeS in the above example the maximum gain exceeds the maximum risk by a factor of 4 to 1, there is a greater probability of a net loss on the trade, since prices must decline by $60/oz before a profit is realized. In this type of spread, the trader achieves a bearish position at a fairly low premium cost at the expense of sacrificing the potential for unlimited gains in the event of a very sharp price decline. This strategy might be appropriate for the trader expecting a price decline but viewing the possibility of a very large price slide as being very low . Strategy 19b: bear Call Money Spread (Short Call with Lower Strike price/Long Call with higher Strike price)—Case 2 example. Buy an August $1,300 gold futures call at a premium of $9.10/oz ($9.10) and simultane- ously sell an August $1,200 gold futures call at a premium of $38.80/oz ($3,880), with August gold futures trading at $1,200/oz. (See Table 35.19b and Figure 35.19b.) Comment. In contrast to the previous strategy, which involved two in-the-money calls, this illustra- tion is based on a spread consisting of a short at-the-money call and a long out-of-the-money call. In a sense, this type of trade can be thought of as a short at-the-money call position with built-in stop-loss protection. (The long out-of-the-money call will serve to limit the risk in the short at-the- money call position.) This risk limitation is achieved at the expense of a reduction in the net premium received by the seller of the at-the-money call (by an amount equal to the premium paid for the out- of-the-money call). This trade-off between risk exposure and the amount of net premium received is illustrated in Figure 35.19b, which compares the outright short at-the-money call position to the above spread strategy. tabLe 35.19b profit/Loss Calculations: bear Call Money Spread (Short Call with Lower Strike price/Long Call with higher Strike price); Case 2—Short at-the-Money Call/Long Out-of-the-Money Call (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,300 Call ($/oz) $ amount of premium paid premium of august $1,200 Call ($/oz) $ amount of premium received Value of $1,300 Call at expiration Value of $1,200 Call at expiration profit/Loss on position [(5) − (3) + (6) − (7)] 1,000 9.1 $910 38.8 $3,880 $0 $0 $2,970 1,050 9.1 $910 38.8 $3,880 $0 $0 $2,970 1,100 9.1 $910 38.8 $3,880 $0 $0 $2,970 1,150 9.1 $910 38.8 $3,880 $0 $0 $2,970 1,200 9.1 $910 38.8 $3,880 $0 $0 $2,970 1,250 9.1 $910 38.8 $3,880 $0 $5,000 –$2,030 1,300 9.1 $910 38.8 $3,880 $0 $10,000 –$7,030 1,350 9.1 $910 38.8 $3,880 $5,000 $15,000 –$7,030 1,400 9.1 $910 38.8 $3,880 $10,000 $20,000 –$7,030 538A COMPleTe gUIde TO THe FUTUreS MArKeT Strategy 20a: bull put Money Spread (Long put with Lower Strike price/Short put with higher Strike price)—Case 1 example . Buy an August $1,250 gold futures put at a premium of $68.70/oz ($6,870) and simulta- neously sell an August $1,300 put at a premium of $108.70/oz ($10,870), with August gold futures trading at $1,200/oz. (See Table 35.20 a and Figure 35.20 a.) Comment. This is a net credit bull spread that uses puts instead of calls. The maximum gain in this strategy is equal to the diff erence between the premium received for the short put and the premium paid for the long put. The maximum loss is equal to the diff erence between the strike prices minus the diff erence between the premiums. The maximum gain will be achieved if prices rise to the higher strike price, while the maximum loss will occur if prices fail to rise at least to the lower strike price. The profi t/loss profi le of this trade is very similar to the profi le of the net debit bull call money spread illustrated in Figure 35.18 . Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 5,000 2,500 0 −2,500 −5,000 −7 ,500 −10,000 −12,500 −17 ,500 1,050 1,100 1,150 1,200 1,250 Bear call money spread Short at-the-money call Breakeven price on spread = $1,229.70 Breakeven price on short call = $1,238.80 1,300 1,350 1,400 −15,000 Futures price at time of position initiation FIGURE  35.19b Profi t/loss Profi le: Bear Call Money Spread (Short Call with lower Strike Price/long Call with Higher Strike Price); Case 2—Short At-the-Money Call/long Out-of-the- Money Call with Comparison to Short At-the-Money Call 539 OPTION TrAdINg STrATegIeS tabLe 35.20a profit/Loss Calculations: bull put Money Spread (Long put with Lower Strike price/ Short put with higher Strike price); Case 1—both puts In-the-Money (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,250 put ($/oz) $ amount of premium paid premium of august $1,300 put ($/oz) $ amount of premium received $1,250 put Value at expiration $1,300 put Value at expiration profit/Loss on position [(5) − (3) + (6) −(7)] 1,000 68.7 $6,870 108.7 $10,870 $25,000 $30,000 –$1,000 1,050 68.7 $6,870 108.7 $10,870 $20,000 $25,000 –$1,000 1,100 68.7 $6,870 108.7 $10,870 $15,000 $20,000 –$1,000 1,150 68.7 $6,870 108.7 $10,870 $10,000 $15,000 –$1,000 1,200 68.7 $6,870 108.7 $10,870 $5,000 $10,000 –$1,000 1,250 68.7 $6,870 108.7 $10,870 $0 $5,000 –$1,000 1,300 68.7 $6,870 108.7 $10,870 $0 $0 $4,000 1,350 68.7 $6,870 108.7 $10,870 $0 $0 $4,000 1,400 68.7 $6,870 108.7 $10,870 $0 $0 $4,000 FIGURE  35.20a Profi t/loss Profi le: Bull Put Money Spread (long Put with lower Strike Price/ Short Put with Higher Strike Price); Case 1—Both Puts In-the-Money Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 3,750 5,000 2,500 0 1,250 1,050 1,100 1,150 1,200 1,250 Breakeven price = $1,260 1,300 1,350 1,400 −1,250 Futures price at time of position initiation 540 A Complete Guide to the Futures mArket Strategy 20b: bull put Money Spread (Long put with Lower Strike price/Short put with higher Strike price)—Case 2 example. Buy an August $1,100 gold futures put at a premium of $10.10/oz ($1,010) and simul- taneously sell an August $1,200 put at a premium of $38.70/oz ($3,870), with August gold futures trading at $1,200/oz. (See Table 35.20b and Figure 35.20b.) Comment. In contrast to Case 1, which involved two in-the-money puts, this strategy is based on a long out-of-the-money put versus a short at-the-money put spread. In a sense, this strategy can be viewed as a short at-the-money put position with a built-in stop. (The purchase of the out-of- the-money put serves to limit the maximum possible loss in the event of a large price decline.) This risk limitation is achieved at the expense of a reduction in the net premium received. This trade-off between risk exposure and the amount of premium received is illustrated in Figure 35.20b, which compares the outright short at-the-money put position to this spread strategy. Strategy 21: bear put Money Spread (Short put with Lower Strike price/Long put with higher Strike price) example. Sell an August $1,100 gold futures put at a premium of $10.10/oz ($1,010) and simul- taneously buy an August $1,150 put at a premium of $19.90/oz ($1,990), with August gold futures trading at $1,200/oz. (See Table 35.21 and Figure 35.21.) Comment. This is a debit bear spread using puts instead of calls. The maximum risk is equal to the difference between the premium paid for the long put and the premium received for the short put. The maximum gain equals the difference between the two strike prices minus the difference between the premiums. The maximum loss will occur if prices fail to decline to at least the higher strike price. The maximum gain will be achieved if prices decline to the lower strike price. The profit/loss profile of this spread is approximately equivalent to the profile of the bear call money spread (see Figure 35.19a). tabLe 35.20b profit/Loss Calculations: bull put Money Spread (Long put with Lower Strike price/Short put with higher Strike price); Case 2—Long Out-of-the-Money put/Short at-the-Money put (1) (2) (3) (4) (5) (6) (7) (8) Futures price at expiration ($/oz) premium of august $1,100 put ($/oz) Dollar amount of premium paid premium of august $1,200 put ($/oz) Dollar amount of premium received Value of $1,100 put at expiration Value of $1,200 put at expiration profit/Loss on position [(5) − (3) + (6) − (7)] 1,000 10.1 $1,010 38.7 $3,870 $10,000 $20,000 –$7,140 1,050 10.1 $1,010 38.7 $3,870 $5,000 $15,000 –$7,140 1,100 10.1 $1,010 38.7 $3,870 $0 $10,000 –$7,140 1,150 10.1 $1,010 38.7 $3,870 $0 $5,000 –$2,140 1,200 10.1 $1,010 38.7 $3,870 $0 $0 $2,860 1,250 10.1 $1,010 38.7 $3,870 $0 $0 $2,860 1,300 10.1 $1,010 38.7 $3,870 $0 $0 $2,860 1,350 10.1 $1,010 38.7 $3,870 $0 $0 $2,860 1,400 10.1 $1,010 38.7 $3,870 $0 $0 $2,860 541 OPTION TrAdINg STrATegIeS FIGURE  35.20b Profi t/loss Profi le: Bull Put Money Spread (long Put with lower Strike Price/ Short Put with Higher Strike Price); Case 2—long Out-of-the-Money Put/Short At-the-Money Put with Comparison to Short At-the-Money Put Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 5,000 2,500 0 −2,500 −5,000 −7 ,500 −10,000 −12,500 −15,000 1,050 1,100 1,150 1,200 1,250 Bull put money spread Short at-the-money put Breakeven price on spread = $1,171.40 Breakeven price on short put $1,161.30 1,300 1,350 1,400 −17 ,500 Futures price at time of position initiation tabLe 35.21 profit/Loss Calculations: bear put Money Spread (Short put with Lower Strike price/Long put with higher Strike price) (1) (2) (3) (4) (5) (6) (7) Futures price at expiration ($/oz) premium of august $1,150 put ($/oz) $ amount of premium paid premium of august $1,100 put ($/oz) $ amount of premium received Value of $1,150 put Value of $1,100 put profit/Loss on position [(5) − (3) + (6) − (7)] 1,000 19.9 $1,990 10.1 $1,010 $15,000 $10,000 $4,020 1,050 19.9 $1,990 10.1 $1,010 $10,000 $5,000 $4,020 1,100 19.9 $1,990 10.1 $1,010 $5,000 $0 $4,020 1,150 19.9 $1,990 10.1 $1,010 $0 $0 –$980 1,200 19.9 $1,990 10.1 $1,010 $0 $0 –$980 1,250 19.9 $1,990 10.1 $1,010 $0 $0 –$980 1,300 19.9 $1,990 10.1 $1,010 $0 $0 –$980 1,350 19.9 $1,990 10.1 $1,010 $0 $0 –$980 1,400 19.9 $1,990 10.1 $1,010 $0 $0 –$980 542A COMPleTe gUIde TO THe FUTUreS MArKeT Other Spread Strategies Money spreads represent only one class of option spreads. A complete discussion of option spread strategies would require a substantial extension of this section—a degree of detail beyond the scope of this presentation. The following are examples of some other types of spreads. time spread. A time spread is a spread between two calls or two puts with the same strike price, but a diff erent expiration date. An example of a time spread would be: long 1 August $1,300 gold futures call/short 1 december $1,300 gold futures call. Time spreads are more complex than the other strategies discussed in this section, because the profi t/loss profi le at the time of expiration cannot be precisely predetermined, but rather must be estimated on the basis of theoretical valuation models. Diagonal spread. This is a spread between two calls or two puts that diff er in terms of both the strike price and the expiration date. An example of a diagonal spread would be: long 1 August $1,200 gold futures call/short 1 december $1,250 gold futures call. In eff ect, this type of spread combines the money spread and the time spread into one trade. butterfl y spread. This is a three-legged spread in which the options have the same expiration date but diff er in strike prices. A butterfl y spread using calls consists of two short calls at a given strike price, one long call at a higher strike price, and one long call at a lower strike price. The list of types of option spreads can be significantly extended, but the above examples should be sufficient to give the reader some idea of the potential range of complexity of spread Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 3,750 5,000 2,500 0 −1,250 −2,500 1,250 1,050 1,100 1,150 1,200 1,250 Breakeven price = $1,140.20 1,300 1,350 1,400 Futures price at time of position initiation FIGURE  35.21 Profi t/loss Profi le; Bear Put Money Spread (Short Put with lower Strike Price/ long Put with Higher Strike Price) 543 OPTION TrAdINg STrATegIeS strategies. One critical point that must be emphasized regarding option spreads is that these strategies are normally subject to a major disadvantage: the transaction costs (commissions plus cumulative bid/asked spreads) for these trades are relatively large compared to the profit poten- tial. This consideration means that the option spread trader must be right a large percentage of the time if he is to come out ahead of the game. The importance of this point cannot be overem - phasized. In short, as a generalization, other option strategies will usually offer better trading opportunities. Multiunit Strategies The profit/loss profile can also be used to analyze multiple-unit option strategies. In fact, multiple- unit option positions may often provide the more appropriate strategy for purposes of comparison. For example, as previously detailed, a long futures position is more volatile than a long or short call position. In fact, for small price changes, each $1 change in a futures price will only result in approxi- mately a $0.50 change in the call price (the delta value for an at-the-money call is approximately equal to 0.5). As a result, in considering the alternatives of buying futures and buying calls, it probably makes more sense to compare the long futures position to two long calls (see Table 35.22) as opposed to one long call. Figure 35.22 compares the strategies of long futures versus long two calls, which at the time of initiation are approximately equivalent in terms of delta values. Note this comparison indicates that the long futures position is preferable if prices change only moderately, but that the long two-call position will gain more if prices rise sharply, and lose less if prices decline sharply. In contrast, the comparison between long futures and a long one-call position would indicate that futures provide the better strategy in the event of a price advance of any magnitude (see Figure 35.3d). For most purposes, the comparison employing two long calls will be more meaningful because it comes much closer to matching the risk level implicit in the long futures position. tabLe 35.22 profit/Loss Calculations: Long two at-the-Money Calls (1) (2) (3) (4) (5) Futures price at expiration ($/oz) premium of august $1,200 Call ($/oz) $ amount of total premium paid Value of 2 Calls at expiration profit/Loss on position [(4) − (3)] 1,000 38.8 $7,760 $0 –$7,760 1,050 38.8 $7,760 $0 –$7,760 1,100 38.8 $7,760 $0 –$7,760 1,150 38.8 $7,760 $0 –$7,760 1,200 38.8 $7,760 $0 –$7,760 1,250 38.8 $7,760 $10,000 $2,240 1,300 38.8 $7,760 $20,000 $12,240 1,350 38.8 $7,760 $30,000 $22,240 1,400 38.8 $7,760 $40,000 $32,240 544A COMPleTe gUIde TO THe FUTUreS MArKeT Choosing an Optimal Strategy It the previous sections we examined a wide range of alternative trading strategies. Now what? How does a trader decide which of these alternatives provides the best trading opportunity? This ques- tion can be answered only if probability is incorporated into the analysis. The selection of an optimal option strategy will depend entirely on the trader’s price and volatility expectations. Insofar as these expectations will diff er from trader to trader, the optimal option strategy will also vary, and the success of the selected option strategy will depend on the accuracy of the trader’s expectations. In order to select an optimal option strategy, the trader needs to translate his price expectations into probabilities. The basic approach requires the trader to assign estimated probability levels for the entire range of feasible price intervals. Figure 35.23 illustrates six diff erent types of probability distributions for August gold futures. These distributions can be thought of as representing six diff erent hypothetical expectations. (The charts in Figure 35.23 implicitly assume that the current price of August gold futures is $1,200.) Several important points should be made regarding these probability distributions: 1. The indicated probability distributions only represent approximations of traders’ price expec- tations. In reality, any reasonable probability distribution would be represented by a smooth curve. The stair-step charts in Figure 35.23 are only intended as crude models that greatly sim- plify calculations. (The use of smooth probability distributions would require integral calculus in the evaluation process.) Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 25,000 12,500 −12,500 −25,000 0 1,050 1,100 1,150 1,200 1,250 Breakeven price on long 2 calls = $1,238.80 Long futures Long 2 calls 1,300 1,350 1,400 37 ,500 +37 ,500 Futures price at time of position initiation FIGURE  35.22 Profi t/loss Profi le: Two long Calls vs. long Futures 545 OPTION TrAdINg STrATegIeS 2. The sum of all the probabilities is equal to 1.0. 3. The stair-step type of graph used in Figure 35.23 implicitly assumes an equal probability for each price in the interval. 4. The high and low intervals in each diagram are intended as summary descriptions for all prices beyond the internal border of that interval. For example, in expected Probability distribution 1, the assumption of a 5 percent probability of a price between $1,050 and $1,099.90 (with all prices in that range having an equal probability of occurrence) and a zero probability of a lower price is equivalent to the more realistic assumption of a 5 percent prob- ability of a price below $1,100, with the probability-weighted average of such prices equal to $1,075. FIGURE  35.23 Probability of Futures Price within given range of Option expiration for Various expected Probability distributions (Arrow Indicates Current Price of Futures) .02 .04 .06 .08 .10 .12 .14 .16 .18 .20 Expected probability distribution 3 975 .02 .04 .06 .08 .10 .12 .14 .16 .18 .20 1,025 1,075 1,125 1,175 1,225 Expected probability distribution 1 1,275 1,325 1,375 1,425 975 1,025 1,075 1,125 1,175 1,225 1,275 1,325 1,375 1,425 975 1,025 1,075 1,125 1,175 1,225 1,275 1,325 1,375 1,425 975 1,025 1,075 1,125 1,175 1,225 1,275 1,325 1,375 1,425 975 1,025 1,075 1,125 1,175 1,225 1,275 1,325 1,375 1,425 975 1,025 1,075 1,125 1,175 1,225 1,275 1,325 1,375 1,425 .02 .04 .06 .08 .10 .12 .14 .16 .18 .20 Expected probability distribution 5 .02 .04 .06 .08 .10 .12 .14 .16 .18 .20 Expected probability distribution 4 .02 .04 .06 .08 .10 .12 .14 .16 .18 .20 Expected probability distribution 2 .02 .04 .06 .08 .10 .12 .14 .16 .18 .20 Expected probability distribution 6 546 A Complete Guide to the Futures mArket 5. The probability distributions in Figure 35.23 represent sample hypothetical illustrations of personal price expectations. The indicated optimal strategy in any given situation will depend upon the specific shape of the expected price distribution, an input that will differ from trader to trader. The general nature of the price expectations implied by each of the distributions in Figure 35.23 can be summarized as follows: Expected Probability Distribution 1. Higher prices and low volatility. This interpretation follows from the fact that there is a greater probability of higher prices and that the probabilities are heavily weighted toward intervals close to the current price level. Expected Probability Distribution 2. Higher prices and high volatility. This distribution reflects the same 60/40 probability bias toward higher prices as was the case for distribution 1, but the assumed probability of a substantially higher or lower price is much greater. Expected Probability Distribution 3. lower prices and low volatility. This distribution is the bearish counterpart of distribution 1. Expected Probability Distribution 4. lower prices and high volatility. This distribution is the bearish counterpart of distribution 2. Expected Probability Distribution 5. Neutral price assumptions and low volatility. This distribution is symmetrical in terms of higher and lower prices, and probability levels are heavily weighted toward prices near the current level. Expected Probability Distribution 6. Neutral price assumptions and high volatility. This distribution is also symmetrical in terms of high and low prices, but substantially higher and lower prices have a much greater probability of occurrence than in distribution 5. Figure 35.24 combines expected Probability distribution 1 with three alternative bullish strat- egies. (Since it is assumed that there is a greater probability of higher prices, there is no need to consider bearish or neutral trading strategies.) Insofar as the assumed probability distribution is very heavily weighted toward prices near the current level, the short put position appears to offer the best strategy. Figure 35.25 combines the same three alternative bullish strategies with the bull - ish/volatile price scenario suggested by expected Probability distribution 2. In this case, the long call position appears to be the optimal strategy, since it is by far the best performer for large price advances and declines—price outcomes that account for a significant portion of the overall prob - ability distribution. In analogous fashion, Figure 35.26 suggests the preferability of the short call position given the bearish/nonvolatile price scenario assumption, while Figure 35.27 suggests that the long put position is the optimal strategy given the bearish/volatile price scenario. Finally, two alternative neutral strategies are compared in Figures 35.28 and 35.29 for two neutral price distributions that differ in terms of assumed volatility. The short straddle appears to offer the better strategy in the low volatility distribution assumption, while the reverse conclusion is suggested in the volatile price case. 547 OPTION TrAdINg STrATegIeS FIGURE  35.24 “Bullish/Nonvolatile” expected Probability distribution and Profi t/loss Profi les for Three Alternative Bullish Strategies Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 25,000 12,500 −12,500 −25,000 0 1,050 1,100 1,150 1,200 1,250 Long futures Short 2 puts Long 2 calls .20 .18 .16 .14 .12 .10 Probability .08 .06 .04 .02 1,300 1,350 1,400 FIGURE  35.25 “Bullish/V olatile” expected Probability distribution and Profi t/loss Profi les for Three Alternative Bullish Strategies Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 25,000 12,500 −12,500 −25,000 0 1,050 1,100 1,150 1,200 1,250 Long futures Short 2 puts Long 2 calls .20 .18 .16 .14 .12 .10 Probability .08 .06 .04 .02 1,300 1,350 1,400 548A COMPleTe gUIde TO THe FUTUreS MArKeT FIGURE  35.26 “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss Profi les for Three Alternative Bearish Strategies “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 25,000 12,500 −12,500 −25,000 0 1,050 1,100 1,150 1,200 1,250 Short futures Short 2 calls Long 2 puts .20 .18 .16 .14 .12 .10 Probability .08 .06 .04 .02 1,300 1,350 1,400 FIGURE  35.27 “Bearish/V olatile” expected Probability distribution and Profi t/loss Profi les for Three Alternative Bearish Strategies Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 25,000 12,500 −12,500 −25,000 0 1,050 1,100 1,150 1,200 1,250 .20 .18 .16 .14 .12 .10 Probability .08 .06 .04 .02 1,300 1,350 1,400 Short futures Short 2 calls Long 2 puts 549 OPTION TrAdINg STrATegIeS FIGURE  35.28 “Neutral/Nonvolatile” expected Probability distribution and Profi t/loss Profi les for Two Alternative Neutral Strategies “Neutral/Nonvolatile” expected Probability distribution and Profi t/loss Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 10,000 5,000 −5,000 −10,000 0 1,050 1,100 1,150 1,200 1,250 .20 .18 .16 .14 .12 .10 Probability .08 .06 .04 .02 1,300 1,350 1,400 Long straddle Short straddle FIGURE  35.29 “Neutral/V olatile” expected Probability distribution and Profi t/loss Profi les for Two Alternative Neutral Strategies Price of August gold futures at option expiration ($/oz) Profit/loss at expiration ($) 1,000 10,000 5,000 −5,000 −10,000 −15,000 0 1,050 1,100 1,150 1,200 1,250 .20 .18 .16 .14 .12 .10 Probability .08 .06 .04 .02 1,300 1,350 1,400 Long straddle Short straddle 550 A Complete Guide to the Futures mArket One problem with the graphic approach described thus far is that it may not always be visually clear which is the best strategy for the given price distribution assumption. Obviously, a more precise method of determining the optimal trading strategy would be desirable. Intuitively, it might appear that expected gain would provide such a relative measure. expected gain is the expected gain (or loss) on a trade and can be expressed as follows: Expected g ain = = ∑ () ()PXii i n 1 where Pi = probability of price interval i Xt = average gain (or loss) of interval i n = number of intervals Unfortunately, expected gain has a major defect as a relative measure: it is dependent upon posi- tion size. The expected gain of any strategy that has a positive expected gain could always be improved by trading a multiple of the position. Thus, in comparing alternative strategies with positive expected gains, the indicated optimal strategy would vary depending on the assumed position sizes. Such arbi- trariness in a relative measure is obviously unacceptable. The use of expected gain as a relative measure can lead to some ludicrous conclusions. For exam- ple, a strategy that had a 50 percent probability of a $1,000 gain and a 50 percent probability of a $900 loss would be judged better than an alternative strategy with a 50 percent chance of a $100 gain and a 50 percent chance of a $10 loss (an expected gain of $50 vs. an expected gain of $45). Obvi- ously, virtually any trader would prefer the second strategy, despite its lower expected gain. The dependency of expected gain on position size actually reflects a more fundamental flaw in this measure: expected gain does not incorporate a measure of risk. A measure that included risk would not be dependent upon position size, since doubling the position would not only double the expected gain, but would also double the risk. One such possible measure is the probability-weighted profit/ loss ratio (PWP lr), which can be defined as follows: PWPLR PG PL ii i m jj j n=− = = ∑ ∑ () () () () 1 1 where Pi = probability of interval i, where i represents an interval with a net gain at the average price of the interval Pj = probability of interval j, where j represents an interval with a net loss at the average price of the interval Gi = indicated gain at the average price of the interval Lj = indicated loss at the average price of the interval m = number of intervals with net gain at average price of interval n = number of intervals with net loss at average price of interval 551 OPTION TrAdINg STrATegIeS An implicit assumption in the formulation of the probability-weighted profit/loss ratio is that each price in a given interval has an equal probability of occurrence.4 Note that the PWPlr will be totally unaffected by position size. This is true because increasing the position will affect the numerator and denominator of the PWPlr equally, thereby leaving the ratio unchanged. Tables 35.23 through 35.28 evaluate the strategies graphically analyzed in Figure 35.24 through 35.29. The conclusions are equivalent, but the advantage of this method is that it yields pre- cise, unambiguous results. T o select an optimal strategy, the trader would merely define his estimate of the probability distribution for prices and then calculate the PWP lrs for each alternative trading approach. 4 It is worth noting that the probability-weighted profit/loss ratio will yield the same ordering of strategies as the ratio of the expected gain to the expected loss on losing trades, where the expected loss on losing trades is defined as: () ()PLjj j n = ∑ 1 . This can be demonstrated as follows: Expected g ain Expected gain Expe =− == ∑∑() () () ()PG PLii i m jj j n 11 ccted loss on losing trade s =− = = = ∑ ∑ () () () () PG PL P ii i m jj j n 1 1 1 W WPLR − 1 tabLe 35.23 probability-W eighted profit/Loss ratio Comparisons for “bullish/Nonvolatile” expected probability Distribution Long Futures Long Call Short put price range ($/oz) average price ($/oz) assumed probability Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) 1,050–1,099.9 1,075 0.05 –12,500 –625 –3,880 –194 –8,630 –431.5 1,100–1,149.9 1,125 0.15 –7,500 –1,125 –3,880 –582 –3,630 –544.5 1,150–1,199.9 1,175 0.2 –2,500 –500 –3,880 –776 1,370 274 1,200–1,249.9 1,225 0.2 2,500 500 –1,380 –276 3,870 774 1,250–1,299.9 1,275 0.2 7,500 1,500 3,620 724 3,870 774 1,300–1,349.9 1,325 0.15 12,500 1,875 8,620 1,293 3,870 580.5 1,350–1,399.9 1,375 0.05 17,500 875 13,620 681 3,870 193.5 Probability-weighted profit/loss ratio:4,750/2,250 = 2.11 2,698/1,828 = 1.48 2,596/976 = 2.66 552 A Complete Guide to the Futures mArket tabLe 35.24 probability-W eighted profit/Loss ratio Comparisons for “bullish/V olatile” expected probability Distribution Long Futures Long Call Short put price range ($/oz) average price ($/oz) assumed probability Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) 950–999.9 975 0.04 –22,500 –900 –3,880 –155 –18,630 –745.2 1,000–1,049.9 1,025 0.06 –17,500 –1,050 –3,880 –233 –13,630 –817.8 1,050–1,099.9 1,075 0.08 –12,500 –1,000 –3,880 –310 –8,630 –690.4 1,100–1,149.9 1,125 0.1 –7,500 –750 –3,880 –388 –3,630 –363 1,150–1,199.9 1,175 0.12 –2,500 –300 –3,880 –466 1,370 164.4 1,200–1,249.9 1,225 0.18 2,500 450 –1,380 –248 3,870 696.6 1,250–1,299.9 1,275 0.14 7,500 1,050 3,620 507 3,870 541.8 1,300–1,349.9 1,325 0.12 12,500 1,500 8,620 1,034 3,870 464.4 1,350–1,399.9 1,375 0.1 17,500 1,750 13,620 1,362 3,870 387 1,400–1,449.9 1,425 0.06 22,500 1,350 18,620 1,117 3,870 232.2 Probability-weighted profit/loss ratio:6,100/4,000 = 1.53 4,020/1,800 = 2.23 2,486/2,616 = 0.95 tabLe 35.25 probability-W eighted profit/Loss ratio Comparisons for “bearish/Nonvolatile” expected probability Distribution Short Futures Short Call Long put price range ($/oz) average price ($/oz) assumed probability Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) 1,000–1,049.9 1,025 0.05 17,500 875 3,880 194 13,630 681.5 1,050–1,099.9 1,075 0.15 12,500 1,875 3,880 582 8,630 1,294.5 1,100–1,149.9 1,125 0.2 7,500 1,500 3,880 776 3,630 726 1,150–1,199.9 1,175 0.2 2,500 500 3,880 776 –1,370 –274 1,200–1,249.9 1,225 0.2 –2,500 –500 1,380 276 –3,870 –774 1,250–1,299.9 1,275 0.15 –7,500 –1,125 –3,620 –543 –3,870 –580.5 1,300–1,349.9 1,325 0.05 –12,500 –625 –8,620 –431 –3,870 –193.5 Probability-weighted profit/loss ratio: 4,750/2,250 = 2.11 2,604/974 = 2.67 2,702/1,822 = 1.48 553 OPTION TrAdINg STrATegIeS tabLe 35.26 probability-W eighted profit/Loss ratio Comparisons for “bearish/V olatile” expected probability Distribution Short Futures Short Call Long put price range ($/oz) average price ($/oz) assumed probability Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) 950–999.9 975 0.06 22,500 1,350 3,880 233 18,630 1,117.8 1,000–1,049.9 1,025 0.1 17,500 1,750 3,880 388 13,630 1,363 1,050–1,099.9 1,075 0.12 12,500 1,500 3,880 466 8,630 1,035.6 1,100–1,149.9 1,125 0.14 7,500 1,050 3,880 543 3,630 508.2 1,150–1,199.9 1,175 0.18 2,500 450 3,880 698 –1,370 –246.6 1,200–1,249.9 1,225 0.12 –2,500 –300 1,380 166 –3,870 –464.4 1,250–1,299.9 1,275 0.1 –7,500 –750 –3,620 –362 –3,870 –387 1,300–1,349.9 1,325 0.08 –12,500 –1,000 –8,620 –690 –3,870 –309.6 1,350–1,399.9 1,375 0.06 –17,500 –1,050 –13,620 –817 –3,870 –232.2 1,400–1,449.9 1,425 0.04 –22,500 –900 –18,620 –745 –3,870 –154.8 Probability-weighted profit/loss ratio: 6,100/4,000 = 1.53 2,494/2,614 = 0.95 4,025/1,795 = 2.24 tabLe 35.27 probability-W eighted profit/Loss ratio Comparisons for “Neutral/Nonvolatile” expected probability Distribution Long Straddle Short Straddle price range ($/oz) average price ($/oz) assumed probability Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) 1,000–1,049.9 1,025 0.05 9750 488 –9,750 –488 1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475 1,100–1,149.9 1,125 0.15 –250 –38 250 38 1,150–1,199.9 1,175 0.2 –5,250 –1,050 5,250 1,050 1,200–1,249.9 1,225 0.2 –5,250 –1,050 5,250 1,050 1,250–1,299.9 1,275 0.15 –250 –38 250 38 1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475 1,350–1,399.9 1,375 0.05 9,750 488 –9,750 –488 Probability-weighted profit/loss ratio: 1,925/2,175 = 0.89 2,175/1,925 = 1.13 554 A Complete Guide to the Futures mArket hedging applications The entire discussion in this chapter has been approached from the vantage point of the speculator. However, option-based strategies can also be employed by the hedger. T o illustrate how options can be used by the hedger, we compare five basic alternative strategies for the gold jeweler who anticipates a requirement for 100 ounces of gold in August. The assumed date in this illustration is April 13, 2015, a day on which the relevant price quotes were as follows: spot gold = $1,198.90, August gold futures = $1,200, August $1,200 gold call premium = $38.80, August $1,200 gold put premium = $38.70. The five purchasing alternatives are: 5 1. Wait until time of requirement. In this approach, the jeweler simply waits until August before purchasing the gold. In effect, the jeweler gambles on the interim price movement of gold. If gold prices decline, he will be better off. However, if gold prices rise, his purchase price will increase. If the jeweler has forward-contracted for his products, he may need to lock in his raw material purchase costs in order to guarantee a satisfactory profit margin. Consequently, the price risk inherent in this approach may be unacceptable. tabLe 35.28 probability-W eighted profit/Loss ratio Comparisons for “Neutral/V olatile” expected probability Distribution Long Straddle Short Straddle price range ($/oz) average price ($/oz) assumed probability Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) Gain/Loss at average price ($) probability- W eighted Gain/Loss ($) 950–999.9 975 0.05 14,750 738 –14,750 –738 1,000–1,049.9 1,025 0.08 9,750 780 –9,750 –780 1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475 1,100–1,149.9 1,125 0.12 –250 –30 250 30 1,150–1,199.9 1,175 0.15 –5,250 –788 5,250 788 1,200–1,249.9 1,225 0.15 –5,250 –788 5,250 788 1,250–1,299.9 1,275 0.12 –250 –30 250 30 1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475 1,350–1,399.9 1,375 0.08 9,750 780 –9,750 –780 1,400–1,449.9 1,425 0.05 14,750 738 –14,750 –738 Probability-weighted profit/loss ratio: 3,985/1,635 = 2.44 1,635/3,985 = 0.41 5 There is no intention to imply that the following list of alternative hedging strategies is all-inclusive. Many other option-based strategies are also possible. For example, the jeweler could buy a call and sell a put at the same strike price—a strategy similar to buying a futures contract (see Strategy 15). 555 OPTION TrAdINg STrATegIeS 2. buy spot gold. The jeweler can buy spot gold and store it until August. In this case, he locks in a purchase price of $1,198.90/oz plus carrying costs (interest, storage, and insurance). This approach eliminates price risk, but also removes the potential of benefiting from any possible price decline. 3. buy gold futures. The jeweler can purchase one contract of August gold futures, thereby locking in a price of $1,200/oz. The higher price of gold futures vis-à-vis spot gold reflects the fact that futures embed carrying costs. Insofar as the price spread between futures and spot gold will be closely related to the magnitude of carrying costs, the advantages and disadvantages of this approach will be very similar to those discussed in the above strategy. 4. buy an at-the-money call. Instead of purchasing spot gold or gold futures, the jeweler could instead buy an August $1,200 gold futures call at a premium of $38.80/oz. The disadvantage of this approach is that if prices advance the jeweler locks in a higher purchase price: $1,238.80/ oz. However, by purchasing the call, the jeweler retains the potential for a substantially lower purchase price in the event of a sharp interim price decline. Thus, if, for example, spot prices declined to $1,050/oz by the time of the option expiration, the jeweler’s purchase price would be reduced to $1,088.80/oz (the spot gold price plus the option premium). 6 In effect, the pur- chase of the call can be viewed as a form of price risk insurance, with the cost of this insurance equal to the “premium.” 7 5. buy an out-of-the-money call. As an example, the jeweler could purchase an August $1,300 gold futures call at a premium of $9.10/oz. In this case, the jeweler forgoes protection against moderate price advances in exchange for reducing the premium costs. Thus, the jeweler assures he will have to pay no more than $1,309.10/oz. The cost of this price protection is $910 as opposed to the $3,880 premium for the at-the-money call. In a sense, the purchase of the out-of-the-money call can be thought of as a price risk insurance policy with a “deductible.” As in the case of purchasing an at-the-money call, the jeweler would retain the potential of benefit- ing from any interim price decline. As should be clear from the above discussion, options meaningfully expand the range of choices open to the hedger. As was the case for speculative applications, the choice of an optimal strategy will depend on the trader’s (hedger’s) individual expectations and preferences. It should be stressed that this section is only intended as an introduction to the concept of using options for hedging. A compre- hensive review of hedging strategies would require a far more extensive discussion. 6 T echnically speaking, since gold futures options expire before the start of the contract month, the effective purchase price would be raised by the amount of carrying costs for the remaining weeks until August. 7 The use of futures for hedging is also often described as “insurance.” However, in this context, the term is misapplied. In standard application, the term insurance implies protection against a catastrophic event for a cost that is small relative to the potential loss that is being insured. In using futures for hedging, the potential cost is equivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against a $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on his hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the standard concept of insurance: the magnitude of the potential loss being insured is much greater than the cost of the insurance. Practical tradiNg guideliNes Part VII 559 Cha P ter 36 If making money is a slow process, losing it is quickly done. —ihara saikaku i f the amount of money you risk in futures trading represents a minuscule fraction of your net worth, and your major motivation for speculation is entertainment, the shoot-from-the-hip ap- proach might be fine. However, if your major objective in futures trading is to make money, an organized trading plan is essential. this assertion is not just a platitude. search out successful futures speculators, and you will no doubt find that they all use a well-defined, disciplined trading approach. the following seven steps provide general guidelines for constructing an organized trading plan. ■ Step 1: Define a Trading Philosophy How do you plan to make your trading decisions? if your answer is something vague like, “When my friend gets a hot tip from his broker,” “When i get a trade idea from reading a blog,” or “On market feel while watching the trading screen,” you’re not ready to begin trading. a meaningful strategy would be based on either chart analysis, technical trading systems, fundamental analysis, or some combination of these approaches. the same method will not necessarily be used in all markets. For example, in some markets a trader might use a synthesis of fundamental and chart analyses to make trading decisions, while in other markets decisions may be based on chart analysis only. the more specific the trading strategy, the better. For example, a trader who plans to base his trades on chart analysis should be able to specify the types of patterns that would signal trades, as well as other details, such as confirmation rules. Of course, the most specific trading strategy would be one based on a mechanical trading system; however, such a fully automated approach may not appeal to all traders. the Planned trading approach 560 A Complete Guide to the Futures mArket ■ Step 2: Choose Markets to Be Traded after deciding how to pick trades, you must choose which markets to follow . For most traders, con- straints on time and available funds will significantly limit the number of markets that can be moni- tored and traded. three factors might be considered in selecting markets. Suitability to trading approach traders should choose those markets that appear to have the best potential for satisfactory perfor- mance, given their planned approach. Of course, such a determination can be made only on the basis of either past trading experience or historical testing of a specific trading strategy. Diversification the multiple benefits of diversification were fully discussed in chapter 16. However, the essential point here is that diversification provides one of the most effective means of reducing risk. diversi- fication can be enhanced by choosing markets that are not closely related. For example, if you knew that you wanted to trade gold, then silver and platinum would be poor choices for additional markets, unless your available funds were sufficient to permit you to trade many other markets as well. V olatility a trader with limited funds should avoid extremely volatile markets, since the inclusion of such markets in a portfolio will severely limit the total number of markets that can be traded. (V olatility here refers to dollar volatility per contract. consequently, high volatility could imply relatively large price swings, large-size contracts, or both.) unless your approach is better suited to a given volatile market, you will be better off trading a wider variety of less volatile markets (diversification again). ■ Step 3: Specify Risk Control Plan1 the rigid control of losses is perhaps the most critical prerequisite for successful trading. a risk con- trol plan should include the following elements. Maximum risk per trade traders can substantially increase their probability of long-term success by restricting the percent- age of total funds allocated to any given trade.2 the maximum risk on any trade should be limited to 1 risk control is typically referred to as “money management,” although i believe the former represents the more descriptive label. 2 the implicit assumption here is that the trader’s expected net profit per trade (eNPPt) is positive. if a trader’s eNPPt is negative, the laws of probability will assure failure if he trades long enough. such a situation would be analogous to the roulette player whose expected gain per bet is negative. 561 tHe PlaNNed tradiNg aPPrOacH 2 percent of total equity and, ideally, 1 percent or less. For smaller accounts, adhering to such a guide- line will require restricting trading to less volatile markets, mini contracts, and spreads. speculators who find that they must risk 3 percent or more of their equity on individual trades should seriously reconsider their financial suitability for futures trading. the maximum risk per trade can be used to determine the number of contracts that can be initi- ated in any given trade. For example, if the maximum risk per trade is 1 percent of equity, and the trader’s account size is $200,000, a crude oil trade that required a stop point $1/barrel below the market would imply a maximum position size of two contracts. ( the crude oil contract represents 1,000 barrels, so each $1 move equates to $1,000 per contract.) Stop-Loss Strategy Know where you’re going to get out before you get in. the importance of this rule cannot be over- emphasized. Without a predetermined exit point, you can find yourself vulnerable to procrastinating in the liquidation of a losing position. at the wrong time, one such lapse of trading discipline could literally knock you out of the game. ideally, you should place a good-till-canceled (gtc) stop order when entering a trade. However, if you are fairly certain you can trust yourself, a mental stop point can be determined at trade entry, and thereafter adjusted only to reduce risk. For a more detailed discussion of stop-order placement strategies, see chapter 13. it should be noted that a system trader does not necessarily need to employ stop-loss rules in order to achieve risk control. For example, if a trading system automatically reverses the position given a sufficient trend reversal, the system will inherently perform the major function of a stop-loss rule—the prevention of catastrophic losses on individual trades—without such a rule being explicit. Of course, large cumulative losses can still occur over many trades, but the same vulnerability would also apply if stops were used. Diversification Because different markets will experience adverse moves at different times, trading multiple markets will reduce risk. as a very simple example, assume you have a $100,000 account and you are using a system that experiences average drawdowns of $5,000 in both gold and euro futures. if you traded two contracts of either market, the average drawdown would be equal to 10 percent ($10,000 ÷ $100,000), whereas if you traded one contract of each, the average drawdown would invariably be less (possibly even less than for one contract of a single market if the markets were inversely correlated). in fact, the average drawdown could reach 10 percent (assuming average drawdowns remain at $5,000 for each market) only if the drawdowns in the two markets proved to be exactly synchronized, which is exceedingly unlikely. Of course, the risk-reduction benefit of diversification would increase if more unrelated markets were added to the portfolio. also, as noted in chapter 16, the concept of diversi- fication applies not only to trading multiple markets but also multiple systems (or approaches) and multiple system variations (i.e., parameter sets) for each market, assuming equity is sufficient to do so. 562 A Complete Guide to the Futures mArket although our focus in this section is risk control, it should be noted that diversification can also increase return by allowing the trader to increase the average exposure in each market without increas- ing overall risk. in fact, the addition of markets with a lower average return than other markets in an existing portfolio can actually increase the return of the portfolio if the risk reduction gained by diversifica- tion is greater than the decline in return and the trader adjusts exposure accordingly. two other benefits of diversification—ensuring participation in major trends and “bad luck insurance”—were discussed in chapter 16. reduce Leverage for Correlated Markets although adding markets to a portfolio allows a trader to increase leverage, it is important to make adjustments for highly correlated markets. For example, a currency portfolio, consisting of the eight most active currency futures contracts (euro, Japanese yen, British pound, australian dollar, canadian dollar, u.s. dollar index, Mexican peso, swiss franc), would be subject to much greater risk than a more broadly diversified eight-market portfolio because of the very strong correlations between some of these markets. consequently, the exposure level (as measured by the margin-to-equity ratio or other risk metric) of such an all-currency portfolio should be adjusted downward vis-à-vis a more diversified eight-market portfolio with equivalent individual market volatilities. Market V olatility adjustments the number of contracts traded in each market for any given equity size should be adjusted to account for volatility differences. there are two aspects of this rule. First, fewer contracts would be traded in more volatile markets. second, even for a single market, the number of contracts would vary in con- junction with fluctuations in volatility. Of course, since contracts can’t be traded in fractions, traders with small accounts will be unable to make such volatility adjustments, which is one reason why small accounts will be subject to greater risk. (Other reasons include the unavoidability of the maximum risk per trade exceeding desired levels and an inability to diversify sufficiently.) adjusting Position Size to equity Changes Position size should also be adjusted in accordance with major fluctuations in equity. For example, if a trader’s position size in the corn market was equal to four contracts when the account equity was at $200,000, then a $50,000 decline in the account equity should result in the corn position size being reduced to three contracts. (Of course, if equity rose instead, the position size should be increased.) Losing Period adjustments (Discretionary traders Only) When a trader’s confidence is shaken because of an ongoing losing streak, it is often a good idea to temporarily cut back position size or even take a complete trading break until confidence returns. in this way, the trader can keep a losing phase from steamrolling into a disastrous retracement. this advice would not apply to a system trader, however, since for most viable systems, a losing period 563 tHe PlaNNed tradiNg aPPrOacH enhances the potential for favorable performance in the ensuing period. Or to put it another way, confidence and frame of mind are critical to the performance of a discretionary trader but are not relevant to the performance of a system. ■ Step 4: Establish a Planning Time Routine it is important to set aside some time each evening for reviewing markets and updating trading strategies. in most cases, once the trader has established a specific routine, 30–60 minutes should be sufficient (less if only a few markets are being traded). the primary tasks performed during this time would be: 1. Update trading systems or review charts. at least one of these should be employed as an aid in making trading decisions. in those markets in which fundamental analysis is employed, the trader will also have to reevaluate the fundamental picture periodically after the release of important new information (e.g., government crop report). 2. Plan new trades. determine whether any new trades are indicated for the next day, which could be defined as either including or excluding the preceding night session. if new trades are indicated, decide on a specific entry plan. (this step applies to discretionary trading only, since any systematic approach should include a specific trade entry approach.) in some cases, a trad- ing decision may be contingent on an evaluation of market behavior on the following day. For example, assume a trader is bearish on corn, and a modestly bullish crop report is received after the close. such a trader might decide to go short if the market is trading lower on the day at any point within one hour of the close. 3. Update exit points for existing positions. the trader should review the stops and objec- tives on existing positions to see whether any revisions appear desirable in light of the current day’s price action. in the case of stops, such changes should be made only to reduce trade risk. ■ Step 5: Maintain a Trader’s Spreadsheet the planning routine discussed in the previous section implies some systematic form of record keep- ing. Figure 36.1 provides one sample of a format that might be used for a trader’s spreadsheet. the first four columns simply identify the trade. column 5 would be used to indicate the intended stop point at time of entry. revisions of this stop would be entered in column 6. the reason for main- taining the initial stop point as a separate item is that this information may be useful in any subsequent trade analysis. For example, traders may wish to check whether their initial stops tend to be too wide or too close. columns 7 through 10 provide a summary of the implied risk on open positions. By adding these entries for all open positions, a trader can assess current total exposure—information critical in con- trolling risk and determining whether new positions can be initiated. 564a cOMPlete guide tO tHe Futures MarKet the use of objectives (columns 11 and 12) is a matter of individual preference. although in some cases the use of objectives will permit a better exit price, in other circumstances objectives will result in the premature liquidation of a trade. consequently, some traders may prefer to forgo the use of objectives, allowing the timing of liquidation to be determined by either a trailing stop or a change of opinion. liquidation information is contained in columns 13 through 15. the reason for maintaining the exit date is that it can be used to calculate the duration of the trade, information that may be useful in trade analysis. column 15 would indicate the profi t or loss on the trade after deducting commissions. columns 16 and 17 provide room for capsule comments regarding the reasons for entering the trade (made at that time) and a hindsight evaluation of the trade. (Of course, entries for these two columns would require much greater space than shown in Figure 36.1 .) the observations noted in these two columns can be particularly helpful in detecting any patterns in successes and failures. Fur- thermore, a more extensive description of the trade would be contained in a trader’s diary, which is discussed in the next section. the novice will usually benefi t from a period of paper trading before plunging into actual trading. the trader’s spreadsheet is ideally suited to this purpose, since it would not only provide an indication of potential trading success, but it would also get the new trader into the habit of approaching speculation in a systematic and disciplined fashion. thus, when the transition is made to actual trading, the decision process will have become routine. Of course, the diffi culty of trading decisions will increase dramati- cally once real money is at stake, but at least new traders who have established a routine of maintaining a trader’s spreadsheet will have a decisive advantage over their typically ill-prepared counterparts. FIGURE  36.1 sample Page from a trader’s spreadsheet (1) Trade Entry Date Long or Short Entry Price Exit Date Exit PriceC omment Reasons for Entering Trade Net Profit or LossUnits Mar ketI nitialC urrent Stops Cumulative Implied Risk (2)( 3) (4)( 5) (6)( 7) (8)( 9) (10) (11) (12) (13) (14) (15) (16) (17) InitialC urrent As Percentage of Equity InitialC urrent Objective InitialC urrent 565 tHe PlaNNed tradiNg aPPrOacH ■ Step 6: Maintain a Trader’s Diary the trader’s diary should contain the following basic information for each trade: 1. reasons for trade. it is important that the reasons for the trade are entered at the time the trade is taken so that this summary provides an accurate description of the original trade rationale, unbiased by hindsight and trade outcome. Over time, this information can help traders deter- mine whether any of their trading strategies are particularly prone to success or failure. 2. trade exit comments. trade exit is as important as trade entry. Here, the trader would note both good and bad decisions made in exiting trades. For example, if a close stop was used on the trade, did it result in getting stopped out of a good trade, or did it reduce the loss on what would have been a losing trade even with a wider stop? as another example, if a trailing stop was used, did it result in premature exit or did it avoid a larger surrender of open profits? comments in this section can help the trader determine whether the exit strategies employed are benefiting or hurting performance. 3. Lessons. a trader should itemize the mistakes or correct decisions made in the course of the trade. the mere act of keeping such a written record can greatly help a trader to both rein- force good trading habits and avoid repeating past mistakes—particularly if repeated errors are denoted in bold or in capital letters. the trader’s diary should be reviewed periodically to help reinforce these observations. after a while, the lessons will sink in. speaking from personal experience, this approach can be instrumental in eradicating frequently repeated mistakes. it may also be very useful to augment the written diary with charts illustrating trade entry and exit points. ■ Step 7: Analyze Personal Trading traders must not only analyze the markets, but also their own past trades in order to isolate the strengths and weaknesses of their approach. Besides the trader’s diary, two useful tools in such an analysis are analysis of segmented trades and the equity chart. analysis of Segmented trades the idea behind segmenting trades into different categories is to help identify any patterns of sub- stantially above- or below-average performance. For example, a trader who makes decisions based on chart patterns could segment trades by the type of chart pattern that signaled the trade. this exercise could potentially reveal that some patterns provide much more reliable signals than others, allowing the trader to make appropriate strategy adjustments. as another example, by breaking down trades into buys and sells, a trader might discover a predilec- tion toward taking long side trades, even though past short trades have a higher average profit. such a combined observation would obviously imply the desirability of correcting a bias toward the long side. 566 A Complete Guide to the Futures mArket as a third example, after breaking down performance results by market, a trader might discover a tendency to consistently lose money in a specific market. such evidence might suggest the trader could improve overall performance by not trading this market. segmenting trading results by market can be an extremely important exercise, since many traders have a poor intuitive sense of their rela- tive degree of success in various markets. the cessation of trading in poorer performing markets need not be permanent. the trader could attempt to identify the reasons for the disappointing results in these markets and then research and test possible trading adjustments. as a fourth example, a trader who combines day trading and position trading might find it par- ticularly instructive to compare the net results of each category. My suspicion is that if such analysis were performed by all traders to whom the exercise is relevant, the population of day traders would shrink by 50 percent overnight. Of course, there are many other criteria that can be used to segment trades. two other examples of relevant comparisons are fundamentally versus technically oriented trades, and trades that were in agreement with the position of a given trading system versus those that were not. in each case, the trader would be searching for patterns of success or failure. the process of analyzing segmented trades can be greatly simplified by utilizing the previously described trader’s spreadsheet. equity Chart the equity chart is a close-only type of chart in which the indicated value for each day represents the account equity (including the equity on open positions). the primary purpose of such a chart is to alert the trader when there is a precipitous deterioration of performance. For example, if after an extended, steady climb, the account equity experiences a sudden, steep decline, a trader might well be advised to lighten positions and take time to reassess the situation. such an abrupt shift in per- formance might reflect a transformation of market conditions, a current vulnerability in the trader’s approach, or a recent predilection toward poor trading decisions. a determination of the actual cause is not essential, since any of these factors could be viewed as strong cautionary signals to reduce risk exposure. in short, the equity chart can be an important tool in mitigating equity retracements. traders can create equity charts for their accounts, as well as access other performance charts and statistics, cost-free at fundseeder.com.3 3 For the sake of full disclosure, i have a financial interest in Fundseeder. 567 Live long enough and you will eventually be wrong about everything. —Russell Baker F ew things are easier to ignore than trading advice. Many of the most critical trading rules have been so widely circulated that they have lost their ability to provoke any thought in the new trader. Thus, valid market insights are often dismissed as obvious clichés. Consider the rule “Cut your losses short”—perhaps the single most important trading maxim. Lives there a speculator who has not heard this advice? Y et there is certainly no shortage of specula- tors who have ignored this rule. Not surprisingly, there is also no shortage of speculators whose accounts were virtually obliterated by one or two losing trades. The truth is that most speculators will ignore advice until they have “rediscovered the wheel” through their own trading experience. Moreover, most traders will repeat a mistake many times before the lesson finally sinks in. Thus, I have no illusions that the advice presented in this and the next chapter will spare the reader from committing basic trading errors. However, it is hoped that several readings of these chapters (particularly following periods of negative trading results) will at least help some novice traders reduce the number of times these mistakes are repeated—hardly a trivial achievement. The observations in this chapter are based on personal experience. Thus, the following list of rules should be viewed in their proper perspective: empirically based opinions as opposed to proven facts. Overall, there will be substantial overlap with other published expositions of trading guidelines. This is hardly surprising, since a wide range of rules (many of them mundane) are based on such sound Seventy-Five Trading Rules and Market Observations Chapter 37 568 A Complete Guide to the Futures mArket principles that they are almost universally accepted as trading truths. For example, I have never met a successful trader who did not believe that risk control was essential to profitable trading. However, some of the rules listed below reflect a subjective view that is contradicted by other writers (e.g., using market orders instead of limit orders). In the final analysis, traders must discover their own trading truths. It is hoped that the following list will help speed the process. ■ Entering Trades 1. Differentiate between major position trades and short-term trades. Focus on major position trades, since these are usually far more critical to trading success. The average risk allocated to short-term trades (as implied by number of contracts in position and stop point) should be significantly smaller. A mistake made by many traders is that they become so involved in trying to catch the minor market swings (generating lots of commissions and slippage in the process) that they miss the major price moves. 2. If you believe a major trading opportunity exists, don’t be greedy in trying to get a slightly bet- ter entry price. The lost profit potential of one missed price move can offset the savings from 50 slightly better execution prices. 3. Entry into any major position should be planned and carefully thought out—never an intraday impulse. 4. Find a chart pattern that says the timing is right—now. Don’t initiate a trade without such a confirming pattern. (Of course, this rule applies only to traders who base their trading decisions on charts.) 5. Place orders determined by daily analysis. If the market is not close to the desired entry level, either enter a good-till-canceled (GTC) order at the appropriate price or record the trade idea and review it each day until the trade is entered or the trade idea is no longer deemed attractive. Failure to adhere to this rule can result in missing good trades. One common occurrence is that a trade idea is recalled once the market has moved beyond the intended entry, and it is then dif- ficult to do the same trade at a worse price. 6. When looking for a major reversal in a trend, it is usually wiser to wait for some pattern that suggests that the timing is right rather than fading the trend at projected objectives and support/ resistance points. This rule is particularly important in the case of a market in which the trend has carried prices to long-term highs/lows (e.g., highs/lows beyond a prior 100-day range). Remember, in most cases of an extended trend, the market will not form V-type reversals. Instead prices will normally pull back to test highs and lows—often a number of times. Thus, waiting for a top or bottom to form can prevent getting chopped to pieces during the topping or bottoming process—not to mention the losses that can occur if you are highly premature in picking the top or bottom. Even if the market does form a major V top or V bottom, subsequent consolidations (e.g., flags) can allow favorable reward/risk entries. 7. If you have an immediate instinctive impression when looking at a chart (particularly, if you are not conscious about which market you are looking at), go with that feeling. 569 SEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS 8. Don’t let the fact that you missed the first major portion of a new trend keep you from trading with that trend (as long as you can define a reasonable stop-loss point). 9. Don’t take positions counter to recent price failure patterns (e.g., a long position after a bull trap or a short position after a bear trap), even if there are many other reasons for the trade. 10. Don’t trade counter to the first wide-ranging day (i.e., day with a range far exceeding the recent average range) of a price move. For example, if you are waiting to enter a trade on a correction, and the correction then forms on a wide-ranging day, don’t enter the trade. 11. In most cases, use market orders rather than limit orders. This rule is especially important when liquidating a losing position or entering a perceived major trading opportunity— situations in which traders are apt to be greatly concerned about the market getting away from them. Although limit orders will provide slightly better fills for a large majority of trades, this benefit will usually be more than offset by the substantially poorer fills, or missed profit potential, in those cases in which the initial limit order is not filled. 12. Never double up near the original trade entry point after having been ahead. Often, the fact that the market has completely retraced is a negative sign for the trade. Even if the trade is still good, doubling up in this manner will jeopardize holding power due to overtrading. ■ Exiting Trades and Risk Control (Money Management) 13. Decide on a specific protective stop point at the time of trade entry. 14. Exit any trade as newly developing patterns or market action are contrary to trade—even if stop point has not been reached. Ask yourself, “If I had to have a position in this market, which way would it be?” If the answer is not the position you hold, get out! In fact, if contradictory indica- tions are strong enough, reverse the position. 15. Always get out immediately once the original premise for a trade is violated. 16. If you are dramatically wrong the first day trade is on, abandon trade immediately. 17. In the event of a major breakout counter to the position held, either liquidate immediately or use a very close stop. 18. If a given market suddenly trades far in excess of its recent volatility in a direction opposite to the position held, liquidate your position immediately. For example, if a market that has been trading in approximate 50-point daily ranges opens 100 to 150 points higher, cover immediately if you are short. 19. If you sell into resistance or buy into support, and the market then consolidates instead of reversing, get out. 20. For analysts and market advisors: If your gut feeling is that a recent recommendation or written report is wrong, reverse your opinion. 21. If you’re unable to watch markets for a period of time (e.g., when traveling), either liquidate all positions or be sure to have GTC stop orders on all open positions. (Also, in such situations, limit orders can be used to ensure getting into the market on planned buys at lower prices or planned sells at higher prices.) 570 A Complete Guide to the Futures mArket 22. Do not get complacent about an open position. Always know where you are getting out even if the point is far removed from the current price. Also, an evolving pattern contrary to the trade may suggest the desirability of an earlier-than-intended exit. 23. Fight the desire to immediately get back into the market following a stopped-out trade. Getting back in will usually supplement the original loss with additional losses. The only reason to get back in on a stopped out trade is if the timing seems appropriate based on evolving price patterns—that is, only if it meets all the conditions and justifications of any new trade. ■ Other Risk-Control (Money Management) Rules 24. When trading is going badly: (a) reduce position size (keep in mind that positions in strongly correlated markets are similar to one larger position); (b) use tight stop-loss points; (c) slow up in taking new trades. 25. When trading is going badly, reduce risk exposure by liquidating losing trades, not winning trades. This observation was memorably related by Edwin Lefèvre in Reminiscences of a Stock Operator: “I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit.” 26. Be extremely careful not to change trading patterns after making a profit: a. Do not initiate any trades that would have been deemed too risky at the start of the trading program. b. Do not suddenly increase the number of contracts in a typical trade. (However, a gradual increase as equity grows is O k.) 27. Treat small positions with the same common sense as large positions. Never say, “It’s only one or two contracts.” 28. Avoid holding very large positions into major reports or the release of important government statistics. 29. Apply the same money management principles to spreads as to outright positions. It is easy to be lulled into thinking that spreads move gradually enough so that it is not necessary to worry about stop-loss protection. 30. Don’t buy options without planning at what outright price the trade is to be liquidated. ■ Holding and Exiting Winning Trades 31. Do not take small, quick profits in major position trades. In particular, if you are dramatically right on a trade, never, never take profits on the first day. 32. Don’t be too hasty to get out of a trade with a wide-ranging day in your direction. The wide- ranging day, however, can be used to reset stop to closer point. 571 SEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS 33. Try to use trailing stops, supplemented by developing market action, instead of objectives as a means of getting out of profitable trades. using objectives will often work against fully realizing the potential of major trends. Remember, you need the occasional big winners to offset losers. 34. The preceding rule notwithstanding, it is still useful to set an initial objective at the time of trade entry to allow the application of the following rule: If a very large portion of an objective is realized very quickly (e.g., 50 to 60 percent in one week or 75 to 80 percent in two or three weeks), take partial profits, with the idea of reinstating liquidated contracts on a reaction. The idea is that it is O k to take a quick, sizable profit. Although this rule may often result in missing the remainder of the move on the liquidated portion of the position, holding the entire position, in such a case, can frequently lead to nervous liquidation on the first market correction. 35. If an objective is reached, but you still like the trade, stay with it using a trailing stop. This rule is important in order to be able to ride a major trend. Remember, patience is not only important in waiting for the right trades, but also in staying with trades that are working. The failure to adequately profit from correct trades is a key profit-limiting factor. 36. One partial exception to the previous rule is that if you are heavily positioned and equity is surg- ing straight up, consider taking scale-up profits. Corollary rule: When things look too good to be true—watch out! If everything is going right, it is probably a good time to begin taking scale-up (scale-down) profits and using close trailing stops on a portion of your positions. 37. If taking profits on a trade that is believed to still have long-term potential (but is presumably vulnerable to a near-term correction), have a game plan for reentering the position. If the mar- ket doesn’t retrace sufficiently to allow for reentry, be cognizant of patterns that can be used for timing a reentry. Don’t let the fact that the reentry point would be worse than the exit point keep you from getting back into a trade in which the perception of both the long-term trend and current timing suggest reentering. The inability to enter at a worse price can often lead to missing major portions of large trends. 38. If trading multiple contracts, avoid the emotional trap of wanting to be 100 percent right. For example, if tempted to take profits on a trade that is still acting well, try to keep at least a partial position for the duration of the move—until the market forms a convincing reversal pattern or reaches a meaningful stop-loss point. ■ Miscellaneous Principles and Rules 39. Always pay more attention to market action and evolving patterns than to objectives and support/resistance areas. The latter can often cause you to reverse a correct market bias very prematurely. 40. Whenever you feel action should be taken either entering or exiting a position—act, don’t procrastinate. 41. Never go counter to your own opinion of the long-term trend of the market. In other words, don’t try to dance between the raindrops. 572 A Complete Guide to the Futures mArket 42. Winning trades tend to be ahead right from the start. Along the same line of thought, Peter Brandt, a successful trader with four decades of experience advises: “Never take a losing trade home on a Friday.” 43. Correct timing of entry and exit (e.g., timing entry on a reliable pattern, getting out immedi- ately on the first sign of trade failure), can often keep a loss small even if the trade is dead wrong. 44. Intraday decisions are usually wrong. Most traders would be better off keeping their screens turned off during the day and reviewing markets once daily after the close of the main trading session. 45. Be sure to check markets before the close on Friday. Often, the situation is clearer at the end of the week. In such cases, a better entry or exit can usually be obtained on Friday near the close than on the following Monday opening. This rule is particularly important if you are holding a significant position. 46. Act on market dreams (that are recalled unambiguously). Such dreams are often right because they represent your subconscious market knowledge attempting to break through the barri- ers established by the conscious mind (e.g., “How can I buy here when I could have gone long $2,000 lower last week?”) 47. Y ou are never immune to bad trading habits—the best you can do is to keep them latent. As soon as you get lazy or sloppy, they will return. ■ Market Patterns 48. If the market sets new historical highs and holds, the odds strongly favor a move very far beyond the old highs. Selling a market at new record highs is probably one the amateur trader’s worst mistakes. 49. Narrow market consolidations near the upper end of broader trading ranges are bullish pat- terns. Similarly, narrow consolidations near the low end of trading ranges are bearish. 50. Play the breakout from an extended, narrow range with a stop against the other side of the range. 51. Breakouts from trading ranges that hold 1 to 2 weeks, or longer, are among the most reliable technical indicators of impending trends. 52. A common and particularly useful form of the above rule is: Flags or pennants forming right above or below prior extended and broad trading ranges tend to be fairly reliable continuation patterns. 53. If the market breaks out to a new high or low and then pulls back to form a flag or pennant in the pre-breakout trading range, assume that a top or bottom is in place. A position can be taken using a protective stop beyond the flag or pennant consolidation. 54. A breakout from a trading range followed by a pullback deep into the range (e.g., three-quarters of the way back into the range or more) is yet another significant bull- or bear-trap formation. 55. If an apparent V bottom is followed by a nearby congestion pattern, it may represent a bot- tom pattern. However, if this consolidation is then broken on the downside and the V bottom 573 SEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS is approached, the market action can be read as a sign of an impending move to new lows. In the latter case, short positions could be implemented using protective stops near the top of the consolidation. Analogous comments would apply to V tops followed by nearby consolidations. 56. V tops and V bottoms followed by multimonth consolidations that form in close proximity to the reversal point tend to be major top or bottom formations. 57. Tight flag and pennant consolidations tend to be reliable continuation patterns and allow entry into an existing trend, with a reasonably close, yet meaningful, stop point. 58. If a tight flag or pennant consolidation leads to a breakout in the wrong direction (i.e., a reversal instead of a continuation), expect the move to continue in the direction of the breakout. 59. Curved consolidations tend to suggest an accelerated move in the direction of the curve. 60. The breaking of a short-term curved consolidation, in the direction opposite of the curve path- way, tends to be a good trend-reversal signal. 61. A wide-ranging day that closes counter to the main trend can often provide a reliable early signal of a trend change—particularly if it also triggers a reversal signal (e.g., complete penetration of prior consolidation). 62. Near-vertical, large price moves over a period of 2 to 4 days (coming off of a relative high or low) tend to be extended in the following weeks. 63. Spikes are good short-term reversal signals. The extreme of the spike can be used as a stop point. 64. In spike situations, look at chart both ways—with and without spike. For example, if a flag is evident when a spike is removed, a penetration of that flag is a meaningful signal. 65. The ability of a market to hold relatively firm when other correlated markets are under signifi- cant pressure can be viewed as a sign of intrinsic strength. Similarly, a market acting weak when correlated markets are strong can be viewed as a bearish sign. 66. If a market trades consistently higher for most of the daily trading session, anticipate a close in the same direction. 67. Two successive flags with little separation can be viewed as a probable continuation pattern. 68. View a curved bottom, followed by a shallower, same-direction curved consolidation near the top of this pattern, as a bullish formation (cup-and-handle). A similar pattern would apply to market tops. 69. A failed signal is more reliable than the original signal. Go the other way, using the high (low) before the failure signal as a stop. Some examples of such failure patterns are rule numbers 53, 54, 58, and 60. 70. The failure of a market to follow through on significant bullish or bearish news (e.g., a major u.S. Department of Agriculture report) is often a harbinger of an imminent trend reversal. Pay particular attention to such a development if you have an existing position. ■ Analysis and Review 71. Review charts every day—especially if you are too busy. 72. Periodically review long-term charts (e.g., every 2 to 4 weeks). 574 A Complete Guide to the Futures mArket 73. Religiously maintain a trader’s diary, including a chart for each trade taken and noting the fol- lowing: reasons for trade; intended stop and objective (if any); follow-up at a later point indi - cating how the trade turned out; observations and lessons (mistakes, things done right, or noteworthy patterns); and net profit/loss. It is important that the trade sheet be filled out when a trade is entered so that the reasons for the trade accurately reflect your actual thinking rather than a reconstruction. 74. Maintain a patterns chart book whenever you notice a market pattern that is interesting and you want to note how you think it will turn out, or you want to record how that pattern is eventually resolved (in the case where you don’t have any bias concerning the correct interpretation). Be sure to follow each chart up at a later date to see the actual outcome. Over time, this process may improve skills in chart interpretation by providing some statistical evidence of the forecast- ing reliability of various chart patterns (as recognized in real time). 75. Review and update trading rules, trader’s diary, and patterns chart book on a regular schedule (e.g., three-month rotation for the three items). Of course, any of these items can be reviewed more frequently, whenever it is felt such a review would be useful. 575 There is no such thing as being right or beating the market. If you make money, it is because you understood the same thing the market did. If you lose money, it is simply because you got it wrong. There is no other way of looking at it. —Musawer Mansoor Ijaz T he methods employed by exceptional traders are extraordinarily diverse. Some are pure funda- mentalists; others employ only technical analysis; and still others combine the two methodologies. Some traders consider two days to be long term, while others consider two months to be short term. Y et despite the wide gamut of styles, I have found that certain principles hold true for a broad spec- trum of successful traders. This chapter contains a list of 50 observations regarding success in trading drawn from the lessons I learned and insights I developed in the process of interviewing great traders over several decades—an endeavor chronicled in four Market Wizards books. 1. First things first. First, be sure that you really want to trade. It is common for people who think they want to trade to discover that they really don’t. 2. Examine your motives. Think about why you really want to trade. If you want to trade for the excitement, you might be better off riding a roller coaster or taking up hang gliding. If you are drawn to trading because you think it is an easy way to make a lot of money, the markets are likely to disabuse you of that assumption. 50 Market Wizard Lessons* Chapt E r 38 * This chapter is adapted from the following two sources: Jack Schwager, The New Market Wizards (New Y ork, NY: Harper Business, 1989), pp. 461–478; © 1989 by Harper Collins Publishers. Used with permission. Jack Schwa- ger, Hedge Fund Market Wizards (New Y ork, NY: John Wiley & Sons, 2012), pp. 489–499; © 2012 by John Wiley & Sons Publishers. Used with permission. 576 A Complete Guide to the Futures mArket 3. there is no holy grail in trading. Many traders mistakenly believe there is some single solution to defining market behavior. Not only did the methods used by highly successful traders I interviewed vary widely, they were sometimes polar opposites of each other. 4. Match the trading method to your personality. Trading success is not about finding the one true method but rather about finding the one method that is right for you. It is critical to choose a method that is consistent with your own personality and comfort level. If you can’t stand to give back significant profits, then a long-term trend-following approach—even a very good one—will be a disaster, because you will never be able to follow it. If you don’t want to watch the quote screen all day (or can’t), don’t try a day-trading method. If you can’t stand the emotional strain of making trading decisions, then try to develop a mechanical system for trading the markets. The importance of finding an approach that fits you cannot be overempha- sized. Randy McKay, who met success as both an on-the-floor and off-the-floor trader, asserted: “Virtually every successful trader I know ultimately ended up with a trading style suited to his personality.” Incidentally, the mismatch of trading style and personality is one of the key reasons why pur- chased trading systems rarely make profits for those who buy them, even if the system is a good one. Why? Because every system will have periods of poor performance. And if you are trading someone else’s system, particularly a “black box” system where you have no idea why signals are being generated, you will likely abandon it the first time it does poorly. 5. It is absolutely necessary to have an edge. Y ou can’t win without an edge, even with the world’s greatest discipline and money management skills. If you could, then it would be possible to win at roulette (over the long run) using perfect discipline and risk control. Of course, that is an impossible task because of the laws of probability. If you don’t have an edge, all that money management and discipline will do for you is to guarantee that you will bleed to death gradually. Incidentally, if you don’t know what your edge is, you don’t have one. 6. Derive a method. T o have an edge, you must have a method. The type of method is irrelevant. Some of the supertraders are pure fundamentalists; some are pure technicians; and some are hybrids. Even within each group, there are tremendous variations. For example, within the group of technicians, there are tape readers (or their modern-day equivalent—screen watch- ers), chartists, mechanical system traders, Elliott Wave analysts, Gann analysts, and so on. The type of method is not important, but having one is critical—and, of course, the method must have an edge. 7. Developing a method is hard work. Shortcuts rarely lead to trading success. Developing your own approach requires research, observation, and thought. Expect the process to take lots of time and hard work. Expect many dead ends and multiple failures before you find a successful trading approach that is right for you. Remember that you are playing against tens of thousands of professionals. Why should you be any better? If it were that easy, there would be a lot more millionaire traders. 8. Skill versus hard work. Is trading success dependent on innate skills, or is hard work suf- ficient? There is no question in my mind that many of the supertraders have a special talent for trading. Marathon running provides an appropriate analogy. Virtually anyone can run a 577 50 Market Wizard Lessons marathon, given sufficient commitment and hard work. Y et, regardless of the effort and desire, only a small fraction of the population will ever be able to run a 2:12 marathon (or 2:25 for women). Similarly, anyone can learn to play a musical instrument. But again, regardless of work and dedication, only a handful of individuals possess the natural talent to become concert solo- ists. The general rule is that exceptional performance requires both natural talent and hard work to realize its potential. If the innate skill is lacking, hard work may provide proficiency, but not excellence. In my opinion, the same principles apply to trading. Virtually anyone can become a net prof- itable trader, but only a few have the inborn talent to become supertraders. For this reason, it may be possible to teach trading success, but only up to a point. Be realistic in your goals. 9. Good trading should be effortless. Wait a minute. Didn’t I just list hard work as an ingredient to successful trading? How can good trading require hard work and yet be effortless? There is no contradiction. Hard work refers to the preparatory process—the research and observation necessary to become a good trader—not to the trading itself. In this respect, hard work is associated with such qualities as vision, creativity, persistence, drive, desire, and com- mitment. Hard work certainly does not mean that the process of trading itself should be filled with exertion. It certainly does not imply struggling with or fighting against the markets. On the contrary, the more effortless and natural the trading process, the better the chances for success. One trader quoting Zen and the Art of Archery made the following analogy: “In trading, just as in archery, whenever there is effort, force, straining, struggling, or trying, it’s wrong. Y ou’re out of sync; you’re out of harmony with the market. The perfect trade is one that requires no effort.” Visualize a world-class distance runner, clicking off mile after mile at a five-minute pace. Now picture an out-of-shape, 250-pound couch potato trying to run a mile at a 10-minute pace. The professional runner glides along gracefully—almost effortlessly—despite the long distance and fast pace. The out-of-shape runner, however, is likely to struggle, huffing and puffing like a Yugo going up a 1 percent grade. Who is putting in more work and effort? Who is more success- ful? Of course, the world-class runner puts in his hard working during training, and this prior effort and commitment are essential to his success. 10. trade within your comfort zone. If a position is too large you will be prone to exit good trades on inconsequential corrections because fear will dominate the decision process. 11. Money management and risk control. Almost all the great traders I interviewed felt that money management was even more important than the trading method. Many potentially suc- cessful systems or trading approaches have led to disaster because the trader applying the strat- egy lacked a method of controlling risk. Y ou don’t have to be a mathematician or an expert in portfolio theory to manage risk. Risk control can be as easy as the following four-step approach: 1. Never risk more than 1 to 2 percent of your capital on any trade. (Risking less than 1 percent per trade is even better if this restriction can be met while still being consistent with your methodology.) 2. Predetermine your exit point before you get into a trade. Many of the traders I interviewed cited exactly this rule. 578 A Complete Guide to the Futures mArket 3. Start with a deliberately small trading stake that you can afford to lose without it causing any significant financial or emotional impact. If this equity is lost, stop trading. Once you feel confident and ready to start trading again, begin with another small stake. By rigorously limiting the worst case in this manner, you will never be knocked out of the game because of one disastrous trading experience, as happens to so many novice traders. 4. If you are in an equity drawdown and feel you are out of sync with the markets or your trad- ing confidence is shaky, take a breather, analyze what went wrong, and wait until you feel confident and have a high-probability idea before you begin trading again. For traders with large accounts, trading very small is a reasonable alternative to a complete trading hiatus. The strategy of cutting trading size down sharply during losing streaks is one mentioned by many of the traders I interviewed. 12. the trading plan. Trying to win in the markets without a trading plan is like trying to build a house without blueprints—costly (and avoidable) mistakes are virtually inevitable. A trading plan simply requires combining a personal trading method with specific money management and trade entry rules. Robert Krausz, a hypnotist who made a specialty of working with traders, considered the absence of a trading plan the root of all the principal difficulties traders encoun- ter in the markets. Richard Driehaus, a very successful mutual fund manager I interviewed, stresses that a trading plan should reflect a personal core philosophy. He explains that without a core philosophy, you are not going to be able to hold on to your positions or stick with your trading plan during really difficult times. 13. Don’t confuse the concepts of winning and losing trades with good and bad trades. A good trade can lose money, and a bad trade can make money. Even the best trading process will lose a certain percentage of the time. There is no way of knowing a priori which individual trade will make money. As long as a trade adheres to a process with a positive edge, it is a good trade, regardless of whether it wins or loses, because if similar trades are repeated multiple times, they will come out ahead. Conversely, a trade that is taken as a gamble is a bad trade, regardless of whether it wins or loses, because over time such trades will lose money. 14. Discipline. Discipline was probably the most frequent word used by the exceptional traders that I interviewed. Often, it was mentioned in an almost apologetic tone: “I know you’ve heard this a million times before, but believe me, it’s really important.” There are two basic reasons why discipline is critical. First, it is a prerequisite for maintain- ing effective risk control. Second, you need discipline to apply your method without second- guessing and choosing which trades to take. I guarantee that you will almost always pick the wrong ones. Why? Because you will tend to pick the comfortable trades, and as Bill Eckhardt, a mathematician turned successful commodity trading advisor (CTA), explained, “What feels good is often the wrong thing to do.” 15. Understand that you are responsible. Whether you win or lose, you are responsible for your own results. Even if you lost on your broker’s tip, an advisory service recommendation, or a bad signal from the system you bought, you are responsible because you made the decision to listen and act. I have never met a successful trader who blamed others for his losses. 579 50 Market Wizard Lessons 16. the need for independence. Y ou need to do your own thinking. Don’t get caught up in mass hysteria. Ed Seykota, a futures trader who multiplied the equity in his accounts a thousandfold over an 18-year period, pointed out that by the time a story is making the cover of national periodicals, the trend is probably near an end. Independence also means making your own trading decisions. Never listen to other opin- ions. Even if it occasionally helps on a trade or two, listening to others invariably seems to end up costing you money—not to mention confusing your own market view . As Michael Marcus, a spectacularly successful futures trader, stated in Market Wizards, “Y ou need to follow your own light. If you combine two traders, you will get the worst of each.” A related personal anecdote concerns another trader I interviewed in Market Wizards. Although he could trade better than I if he were blindfolded and placed in a trunk at the bottom of a pool, he still was interested in my view of the markets. One day he called and asked, “What do you think of the yen?” The yen was one of the few markets about which I had a strong opinion at the time. It had formed a particular chart pattern that made me very bearish. “I think the yen is going straight down, and I’m short,” I replied. He proceeded to give me 51 reasons why the yen was oversold and due for a rally. After he hung up, I thought: “I’m leaving on a business trip tomorrow . My trading has not been going very well during the last few weeks. The short yen trade is one of the only positions in my ac- count. Do I really want to fade one of the world’s best traders given these considerations?” I decided to close out the trade. By the time I returned from my trip several days later, the yen had fallen 150 points. As luck would have it, that afternoon the same trader called. When the conversation rolled around to the yen, I couldn’t resist asking, “By the way, are you still long the yen?” “Oh no,” he replied, “I’m short.” The point is not that this trader was trying to mislead me. On the contrary, he firmly believed each market opinion at the time he expressed it. However, he was a very short- term trader and his timing was good enough so that he probably made money on both sides of the trade. In contrast, I ended up with nothing, even though I had the original move pegged exactly right. The moral is that even advice from a much better trader can lead to detrimental results. 17. Confidence. An unwavering confidence in their ability to continue to win in the markets, was a nearly universal characteristic among the traders I interviewed. Dr. Van Tharp, a psychologist who has done a great deal of research on traders and was interviewed in Market Wizards, claims that one of the basic traits of winning traders is that they believe “they’ve won the game before they start.” The trader who has confidence will have the courage to make the right decisions and the strength not to panic. There is a passage in Mark Twain’s Life on the Mississippi that I find remark- ably apropos, even though it has nothing to do with trading. In it, the protagonist—an appren- tice steamboat river pilot—is tricked by his mentor and the crew into panicking in a stretch of 580 A Complete Guide to the Futures mArket river he knows to be the easiest in the entire run. The following exchange then ensues with his mentor: “Didn’t you know there was no bottom in that crossing?” “Y es sir, I did.” “V ery well then, you shouldn’t have allowed me or anybody else to shake your confi- dence in that knowledge. Try to remember that. And another thing, when you get into a dangerous place, don’t turn coward. That isn’t going to help matters any.” 18. Losing is part of the game. The great traders fully realize that losing is an intrinsic element in the game of trading. This attitude seems linked to confidence. Because exceptional traders are confident that they will win over the long run, individual losing trades no longer seem horrible; they simply appear inevitable—which is what they are. As Linda Raschke, a futures trader with a high ratio of winning to losing trades, explained, “It never bothered me to lose because I always knew I would make it right back.” There is no more certain recipe for losing than having a fear of losing. If you can’t stand tak- ing losses, you will either end up taking large losses or missing great trading opportunities—ei- ther flaw is sufficient to sink any chance for success. 19. Lack of confidence and time-outs. Trade only when you feel confident and optimistic. I have often heard traders say: “I just can’t seem to do anything right.” Or “I bet I get stopped out right near the low again.” If you find yourself thinking in such negative terms, it is a sure sign that it is time to take a break from trading. Get back into trading slowly. Think of trading as a cold ocean. T est the water before plunging in. 20. the urge to seek advice. The urge to seek advice betrays a lack of confidence. As Linda Raschke said, “If you ever find yourself tempted to seek out someone else’s opinion on a trade, that’s usually a sure sign that you should get out of your position.” 21. the virtue of patience. Waiting for the right opportunity increases the probability of suc- cess. Y ou don’t always have to be in the market. As Edwin Lefèvre put it in his classic Reminis- cences of a Stock Operator, “There is the plain fool who does the wrong thing at all times anywhere, but there is the Wall Street fool who thinks he must trade all the time.” One of the more colorful descriptions of patience in trading was offered by well-known investor Jim Rogers in Market Wizards: “I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up.” In other words, until he is so sure of a trade that it seems as easy as picking money off the floor, he does nothing. Mark W einstein, who was interviewed in Market Wizards, provided the following apt analogy: “Although the cheetah is the fastest animal in the world and can catch any animal on the plains, it will wait until it is absolutely sure it can catch its prey. It may hide in the bush for a week, waiting for just the right moment. It will wait for a baby antelope, and not just any baby antelope, but preferably one that is also sick or lame. Only then, when there is no chance it can lose its prey, does it attack. That, to me, is the epitome of professional trading.” 22. the importance of sitting. Patience is important not only in waiting for the right trades, but also in staying with trades that are working. The failure to adequately profit from correct trades is a key profit-limiting factor. Quoting again from Lefèvre in Reminiscences, “It never was my 581 50 Market Wizard Lessons thinking that made big money for me. It was always my sitting. Got that? My sitting tight!” Bill Eckhardt offered a particularly memorable comment on this subject: “One common adage . . . that is completely wrongheaded is: Y ou can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits.” 23. Developing a low-risk idea. One of the exercises Dr. Van Tharp uses in his seminars is having the participants take the time to write down their ideas on low-risk trades. The merit of a low-risk idea is that it combines two essential elements: patience (because only a small portion of ideas will qualify) and risk control (inherent in the definition). Taking the time to think through low-risk strategies is a useful exercise for all traders. The specific ideas will vary greatly from trader to trader, depending on the markets traded and methodologies used. At the seminar I attended, the participants came up with a long list of descriptions of low-risk ideas. As one example: a trade in which the market movement required to provide convincing proof that you are wrong is small. Although it had nothing to do with trading, my personal favorite of the low-risk ideas mentioned was: “Open a doughnut shop next door to a police station.” 24. the importance of varying bet size. All traders who win consistently over the long run have an edge. However, that edge may vary significantly from trade to trade. It can be mathemat- ically demonstrated that in any wager game with varying probabilities, winnings are maximized by adjusting the bet size in accordance with the perceived chance for a successful outcome. Optimal blackjack betting strategy provides a perfect illustration of this concept. If the trader has some idea as to which trades have a greater edge—say, for example, based on a higher confidence level (assuming that it is a reliable indicator)—then it makes sense to be more aggressive in these situations. As Stanley Druckenmiller, one of the most consistently prof- itable hedge fund managers ever, expressed it, “The way to build [superior] long-term returns is through preservation of capital and home runs. . . . When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig.” For a number of Market Wizards, keen judgment as to when to really step on the accelerator and the courage to do so have been instrumental to their achieving exceptional (as opposed to merely good) returns. Some of the traders I interviewed mentioned that they varied their trading size in accordance with how they were doing. For example, McKay indicated that it was not uncommon for him to vary his position size by as much as a factor of one hundred to one. He finds this approach helps him reduce risk during losing periods while enhancing profits during the winning periods. 25. Scaling in and out of trades. Y ou don’t have to get in or out of a position all at once. Scaling in and out of positions provides the flexibility of fine-tuning trades and broadens the set of alter- native choices. Most traders sacrifice this flexibility without a second thought because of the innate human desire to be completely right. (By definition, a scaling approach means that some portions of a trade will be entered or exited at worse prices than other portions.) Some traders also noted that scaling out enabled them to stay with at least a portion of long-term winning trades much longer than would otherwise have been the case. 26. trading around a position can be beneficial. Most traders tend to view trading as a two-step process: a decision when to enter and a decision when to exit. It may be better to 582 A Complete Guide to the Futures mArket view trading as a dynamic rather than static process between entry and exit points. The basic idea is that as a trade moves in the intended direction, the position exposure would be gradually reduced. The larger the move and the closer the market gets to a target objective, the more the position would be decreased. After reducing exposure in this manner, the position would be reinstated on a market correction. Any time the market retraced to a correction reentry point, a net profit would be generated that otherwise would not have been realized. The choppier the market, the more excess profits trading around the position will generate. Even a trade in which the market fails to move in the intended direction, on balance, could still be net profitable as a result of gains generated by lightening the total position on favorable trend moves and reinstat- ing liquidated portions of the position on corrections. This strategy will also reduce the chances of being knocked out of a favorable position on a market correction, because if the position has already been reduced, the correction will have less impact and may even be desired to rein- state the liquidated portion of the position. The only time this strategy will have a net adverse impact is if the market keeps going in the intended direction without ever retracing to correc- tion reentry levels. This negative outcome, however, simply means that the original trade was profitable, but the total profits are smaller than they would have been otherwise. In a nutshell, trading around a position will generate extra profits and increase the chances of staying with a good trade the at expense of sometimes giving up a portion of profits when the market moves smoothly in the intended direction. 27. Being right is more important than being a genius. I think one reason why so many people try to pick tops and bottoms is that they want to prove to the world how smart they are. Think about winning rather than being a hero. Forget trying to judge trading success by how close you can come to picking major tops and bottoms, but rather by how well you can pick individual trades with favorable return/risk characteristics. Go for consistency on a trade-to- trade basis, not perfect trades. 28. Don’t worry about looking stupid. Last week, you told everyone at the office, “My analy- sis has just given me a great buy signal in the S&P . The market is going to a new high.” Now as you examine the market action since then, something appears to be wrong. Instead of rally - ing, the market is breaking down. Y our gut tells you that the market is vulnerable. Whether you realize it or not, your announced prognostications are going to color your objectivity. Why? Because you don’t want to look stupid after telling the world that the market was going to a new high. Consequently, you are likely to view the market’s action in the most favorable light possible. “The market isn’t breaking down, it’s just a pullback to knock out the weak longs.” As a result of this type of rationalization, you end up holding a losing position far too long. There is an easy solution to this problem: Don’t talk about your position. What if your job requires talking about your market opinions (as mine once did)? Here the rule is: Whenever you start worrying about contradicting your previous opinion, view that concern as reinforcement to reverse your market stance. As a personal example, in early 1991, I came to the conclusion that the dollar had formed a major bottom. I specifically remember one talk in which an audience member asked me about my outlook for currencies. I responded by boldly predicting that the dollar would head higher for years. Several months later, when the 583 50 Market Wizard Lessons dollar surrendered the entire gain it had realized following the news of the August 1991 Soviet coup before the coup’s failure was confirmed, I sensed that something was wrong. I recalled my many predictions over the preceding months in which I had stated that the dollar would go up for years. The discomfort and embarrassment I felt about these previous forecasts told me it was time to change my opinion. In my earlier years in the business, I invariably tried to rationalize my original market opin- ion in such situations. I was burned enough times so that I eventually learned a lesson. In the preceding example, the abandonment of my original projection was fortunate because the dol- lar collapsed in the ensuing months. 29. Sometimes action is more important than prudence. Waiting for a price correction to enter the market may sound prudent, but it is often the wrong thing to do. When your analysis, methodology, or gut tells you to get into a trade at the market instead of waiting for a correction— do so. Caution against the influence of knowing that you could have gotten in at a better price in recent sessions, particularly in those situations when the market witnesses a sudden, large move (often due to an important surprise news item). These types of trades often work because they are so hard to do. 30. Catching part of the move is just fine. Just because you missed the first major portion of a new trend, don’t let that keep you from trading with that trend (as long as you can define a reasonable stop-loss point). McKay commented that the easiest part of a trend is the middle portion, which implies always missing part of the trend prior to entry. 31. Don’t try to be 100 percent right. Almost every trader has had the experience of the mar- ket moving against the position sufficiently to raise significant concern regarding the potential additional loss, while still believing the position is correct. Staying in the trade risks an uncom- fortably large loss, but liquidating the trade risks abandoning a good position at nearly the worst possible point. In such circumstances, instead of making an all-or-nothing decision, traders can choose to liquidate part of the position. Taking a partial loss is much easier than liquidating the entire position and will avoid the possibility of riding the entire position for a large loss. It will also preserve the potential for a partial recovery if the market turns around. 32. Maximize gains, not the number of wins. Eckhardt explains that human nature does not operate to maximize gain but rather the chance of a gain. The problem with this is that it implies a lack of focus on the magnitudes of gains (and losses)—a flaw that leads to nonoptimal per- formance results. Eckhardt bluntly concludes: “The success rate of trades is the least important performance statistic and may even be inversely related to performance.” Jeff Yass, a very suc- cessful options trader, echoes a similar theme: “The basic concept that applies to both poker and option trading is that the primary object is not winning the most hands, but rather maximizing your gains.” 33. Learn to be disloyal. Loyalty may be a virtue in family, friends, and pets, but it is a fatal flaw for a trader. Never have loyalty to a position. The novice trader will have lots of loyalty to his original position. He will ignore signs that he is on the wrong side of the market, riding his trade into a large loss while hoping for the best. The more experienced trader, having learned the importance of money management, will exit quickly once it is apparent he has made a bad 584 A Complete Guide to the Futures mArket trade. However, the truly skilled trader will be able to do a 180-degree turn, reversing his posi- tion at a loss if market behavior points to such a course of action. Druckenmiller made the awful error of reversing his stock position from short to long on the very day before the October 19, 1987, crash. His ability to quickly recognize his error and, more important, to unhesitatingly act on that realization by reversing back to short at a large loss helped transform a potentially disastrous month into a net profitable one. 34. pull out partial profits. Pull a portion of winnings out of the market to prevent trading discipline from deteriorating into complacency. It is far too easy to rationalize overtrading and procrastination in liquidating losing trades by saying, “It’s only profits.” Profits withdrawn from an account are much more likely to be viewed as real money. 35. hope is a four-letter word. Hope is a dirty word for a trader, not only in regards to pro- crastinating in a losing position, hoping the market will come back, but also in terms of hoping for a reaction that will allow for a better entry in a missed trade. If such trades are good, the hoped-for reaction will not materialize until it is too late. Often, the only way to enter such trades is to do so as soon as a reasonable stop-loss point can be identified. 36. Don’t do the comfortable thing. Eckhardt offers the rather provocative proposition that the human tendency to select comfortable choices will lead most people to experience worse than random results. In effect, he is saying that natural human traits lead to such poor trad- ing decisions that most people would be better off flipping coins or throwing darts. Some of the examples Eckhardt cites of the comfortable choices people tend to make that run counter to sound trading principles include gambling with losses, locking in sure winners, selling on strength and buying on weakness, and designing (or buying) trading systems that have been overfitted to past price behavior. The implied message to the trader is: do what is right, not what feels comfortable. 37. Y ou can’t win if you have to win. There is an old Wall Street adage: “Scared money never wins.” The reason is quite simple: If you are risking money you can’t afford to lose, all the emo- tional pitfalls of trading will be magnified. Early in his career, when the bankruptcy of a key financial backer threatened the survival of his fledgling investment firm, Druckenmiller “bet the ranch” on one trade, in a last-ditch effort to save his firm. Even though he came within one week of picking the absolute bottom in the T -bill market, he still lost all his money. The need to win fosters trading errors (e.g., excessive leverage and a lack of planning in the example just cited). The market seldom tolerates the carelessness associated with trades born of desperation. 38. the road to success is paved with mistakes. Learning from mistakes is essential to improvement and ultimate success. Each mistake, if recognized and acted on, provides an oppor- tunity for improving a trading approach. Most traders would benefit by writing down each mis- take, the important lesson, and the intended change in the trading process. Such a trading log can be periodically reviewed for reinforcement. Trading mistakes cannot be avoided, but repeating the same mistakes can be, and doing so is often the difference between success and failure. 39. think twice when the market lets you off the hook easily. Don’t be too eager to get out of a position you have been worried about if the market allows you to exit at a much better price than anticipated. If you had been worried about an adverse overnight (or over-the-weekend) 585 50 Market Wizard Lessons price move because of a news event or a technical price failure on the previous close, it is likely that many other traders shared this concern. The fact that the market does not follow through much on these fears strongly suggests that there must be some very powerful underlying forces in favor of the direction of the original position. This concept, which was first proposed in Mar- ket Wizards by Marty Schwartz, who compiled an astounding track record trading stock index futures, was illustrated by the manner in which Lipschutz, a large-scale currency trader, exited the one trade he admitted had scared him. In that instance, on Friday afternoon, a time when the currency markets are particularly thin (after Europe’s close), Lipschutz found himself with an enormous short dollar position in the midst of a strongly rallying market. He had to wait over the weekend for the T okyo opening on Sunday evening to find sufficient liquidity to exit his posi- tion. When the dollar opened weaker than expected in T okyo, he didn’t just dump his position in relief; rather, his trader’s instincts told him to delay liquidation—a decision that resulted in a far better exit price. 40. a mind is a terrible thing to close. Open-mindedness seems to be a common trait among those who excel at trading. For example, Gil Blake, a mutual fund timer who has made incred- ibly consistent profits, actually fell into a trading career by attempting to demonstrate to a colleague that prices were random. When he realized he was wrong, he became a trader. In the words of Driehaus, “The mind is like a parachute—it’s only good when it’s open.” 41. the markets are an expensive place to look for excitement. Excitement has a lot to do with the image of trading, but nothing to do with success in trading (except in an inverse sense). In Market Wizards, Larry Hite, the founder of Mint Management, one of the largest CTA firms, described his conversation with a friend who couldn’t understand his absolute adherence to a computerized trading system. His friend asked, “Larry, how can you trade the way you do? Isn’t it boring?” Larry replied, “I don’t trade for excitement; I trade to win.” 42. Beware of trades born of euphoria. Take caution against placing impulsive trades influ- enced by being caught up in market hysteria. Excessive euphoria in the market should be seen as a cautionary flag of a potential impending reversal. 43. If you are on the right side of euphoria or panic, lighten up. Parabolic price moves tend to end abruptly and sharply. If you are fortunate enough to be on the right side of the mar- ket in which the price move turns near vertical, consider scaling out of the position while the trend is still moving in your direction. If you would be petrified to be on the other side of the market, that is probably a good sign that you should be lightening your position. 44. the calm state of a trader. If there is an emotional state associated with successful trading, it is the antithesis of excitement. Based on his observations, Charles Faulkner, a neuro-linguistic programming (NLP) practitioner who works with traders, stated that exceptional traders are able to remain calm and detached regardless of what the markets are doing. He describes Peter Steidlmayer’s (a successful futures trader who is best known as the inventor of the Market Pro- file trading technique) response to a position that is going against him as being typified by the thought, “Hmmm, look at that.” 45. Identify and eliminate stress. Stress in trading is a sign that something is wrong. If you feel stress, think about the cause, and then act to eliminate the problem. For example, let’s say you 586 A Complete Guide to the Futures mArket determine that the greatest source of stress is indecision in getting out of a losing position. One way to solve this problem is simply to enter a protective stop order every time you put in a position. I will give you a personal example. When I was a research director, one of the elements of my job was providing trading recommendations to brokers in my company. This task is very similar to trading, and, having done both, I believe it’s actually more difficult than trading. At one point, after years of net profitable recommendations, I hit a bad streak. I just couldn’t do anything right. When I was right about the direction of the market, my buy recommendation was just a bit too low (or my sell price too high). When I got in and the direction was right, I got stopped out—frequently within a few ticks of the extreme of the reaction. I responded by developing a range of computerized trading programs and technical indica- tors, thereby widely diversifying the trading advice I provided to the firm. I still made my day- to-day subjective calls on the market, but everything was no longer riding on the accuracy of these recommendations. By widely diversifying the trading-related advice and information, and transferring much of this load to mechanical approaches, I was able to greatly diminish a source of personal stress—and improve the quality of the research product in the process. 46. pay attention to intuition. As I see it, intuition is simply experience that resides in the subconscious mind. The objectivity of the market analysis done by the conscious mind can be compromised by all sorts of extraneous considerations (e.g., one’s current market position, a resistance to change a previous forecast). The subconscious, however, is not inhibited by such constraints. Unfortunately, we can’t readily tap into our subconscious thoughts. However, when they come through as intuition, the trader needs to pay attention. As the Zen-quoting trader mentioned earlier expressed it, “The trick is to differentiate between what you want to happen and what you know will happen.” 47. Life’s mission and love of the endeavor. In talking to the traders interviewed in Market Wizards, I had the definite sense that many of them felt that trading was what they were meant to do—in essence, their mission in life. In this context, Charles Faulkner quoted NLP cofounder John Grinder’s description of mission: “What do you love so much that you would pay to do it?” Throughout my interviews, I was struck by the exuberance and love the Market Wizards had for trading. Many used gamelike analogies to describe trading. This type of love for the endeavor may indeed be an essential element for success. 48. the elements of achievement. Faulkner has a list of six key steps to achievement based on Gary Faris’s study of successfully rehabilitated athletes, which appears to apply equally well to the goal of achieving trading success. These strategies include the following: 1. Using both “T oward” and “Away From” motivation; 2. Having a goal of full capability plus, with anything less being unacceptable; 3. Breaking down potentially overwhelming goals into chunks, with satisfaction garnered from the completion of each individual step; 4. Keeping full concentration on the present moment—that is, the single task at hand rather than the long-term goal; 587 50 Market Wizard Lessons 5. Being personally involved in achieving goals (as opposed to depending on others); and 6. Making self-to-self comparisons to measure progress. 49. prices are nonrandom = the markets can be beat. In reference to academicians who believe market prices are random, Monroe Trout, a commodity trading advisor with one of the best risk/return records in the industry, says, “That’s probably why they’re professors and why I’m making money doing what I’m doing.” The debate over whether prices are random is not yet over. However, my experience in interviewing scores of great traders left me with little doubt that the random walk theory is wrong. It is not the magnitude of the winnings registered by the Market Wizards, but the consistency of these winnings in some cases, that underpin my belief. As a particularly compelling example, in his first fund, Edward Thorp, a mathematician best known for his best-selling book Beat the Dealer, compiled a track record of 227 winning months and only 3 losing months (all under 1 percent)—an extraordinary 98.7 winning per- centage. The odds of getting such a result by chance (as would be the case if the markets were random) are less than 1 out of 10 63. T o put this probability in context, the odds of randomly selecting a specific atom in the earth would be about a trillion times better. Certainly, winning at the markets is not easy—and, in fact, it is getting more difficult as professionals account for a constantly growing proportion of the activity—but it can be done! 50. Keep trading in perspective. There is more to life than trading. 589 Introduction to Regression Analysis Theory helps us bear our ignorance of fact. —George Santayana ■ Basics Regression analysis is concerned with describing and evaluating the relationship between a given variable and one or more other variables. For example, we might be interested in describing the relationship between the pig crop (number of pigs born during a given period) and the hog slaughter level in the following six-month period. 1 The relationship between these variables is illustrated in Figure A.1. Each point in Figure A.1 represents a single observation or year. The location of a point along the horizontal axis is determined by the December–May pig crop, while its placement along the vertical axis is determined by the June–November hog slaughter level. Note that there is a clear Appendix A 1 Readers may notice that a predominant number of the examples in the Appendices will be drawn from the hog market. There are three basic reasons for this: (1) Such comparisons will illustrate the advantages of regression analysis in terms of preciseness, efficiency, flexibility, and ease of application. (2) The exposition will be clearer if a limited number of markets are used to provide illustrative examples. (3) Because hogs are nonstorable, the hog market can be represented adequately by simple fundamental models. In any event, it should be stressed that chosen examples are merely intended as vehicles to illustrate the general concepts and techniques of regression analysis, and not as a description of the methodology for analyzing any specific market. Consequently, the illus- trations should be as relevant to the reader interested in applying regression analysis to the interest rate markets as to the reader whose primary focus is the livestock sector. 590APPENDIX A relationship between these two variables: large hog slaughter levels correspond to large pig crop levels. In this example, hog slaughter is the dependent variable in that hog slaughter depends on the pig crop, but not vice versa, and the pig crop is the independent , or explanatory , variable. The primary goal of regression analysis is to defi ne a mathematical relationship between the dependent variable and the independent variable(s). Perhaps the most basic underlying assumption in the standard regression analysis approach is that the relationship between the dependent and independent variables is linear. In the case in which there is only one explanatory variable, the regression equation will be a straight line and can be expressed as Ya bX=+ where a and b are constants determined by the regression procedure. 2 The values derived for a and b by the regression procedure are termed the regression coeffi cients ( a is sometimes simply referred to as the constant term ). By convention, Y is the variable that we are trying to explain or predict—the dependent variable—while X is the explanatory or independent variable. 2 T o be precise, a and b are parameters. A parameter can be thought of as a hybrid between a variable and a constant. If the focus is on the variation of the equation as a whole, then a and b are variables. Given the equa- tion, Y = a + bX , each set of values for a and b will defi ne a diff erent line. However, if we are concerned with the relationship between the variables X and Y , given a specifi c set of values for a and b , as is the case in regression analysis, then a and b can be termed constants. FIGURE  A.1 June–November Hog Slaughter vs. December–May Pig Crop (Thousands) 44 46 48 50 52 54 56 58 60 47 49 51 53 55 57 59 Jun-Nov hog slaughter Dec-May pig crop ’96 ’01 ’97 ’95 ’00 ’03 ’02 ’04 ’05 ’07 ’08 ’12 ’09 ’11 ’13’10 ’14’98 ’06 ’99 591 INTRoDuCTIoN To REGRESSIoN ANAlySIS The constants a and b in the regression equation have special meanings. Constant b is the amount variable Y (e.g., hog slaughter) will change given a one-unit change in variable X (e.g., pig crop). For example, in the simple linear equation Y = 1 + 2 X each unit change in X will result in a two-unit change in Y . Note this relationship will hold regardless of the level of X . In fact, the constancy of the change in Y given a fi xed change in X is a basic characteristic of a linear equation. Constant a is called the Y intercept because it is the value of Y at which the line crosses the Y axis—that is, the value of Y when X equals zero. (See Figure A.2 for a graphic depiction of the preceding points.) Given a set of data points such as those illustrated in Figure A.1 , regression analysis will seek to fi nd the values of a and b in the regression equation that result in the line that best fi ts the observed points. ■ Meaning of Best Fit using Figure A.1 as an example, how would we defi ne the best-fi t line to the scatter of points? Intui- tively, it seems that we would want to pick the line that minimizes the deviations from the individual points to the line. The deviation of any single point or observation can be defi ned as the diff erence FIGURE  A.2 Meaning of a and b for Straight line Y Y = 1 + 2X b = 2 b = 2 a = 1 1 1 X 20 15 10 10 5 } 5 592APPENDIX A between Y i , the observed value, and ˆYi , the Y value predicted by the line for the same value of X . The deviation of a single point is thus equal to YYii − ˆ (see Figure A.3 ). These deviations are also called residuals. W e cannot derive a summary deviation fi gure for a group of points by adding all the individual deviations. Why? Because deviations above and below the line will tend to cancel each other out. Thus, the sum of the residuals can be small even if the line fi ts the data points poorly. In fact, if the deviations below the line are greater than the deviations above the line, the sum of the residuals will be negative—an absurd value for a measure of total deviation. How would one interpret a negative total deviation? In other words, the sum of the residuals does not off er a criterion for determining best fi t. one possible solution is to fi nd the line that minimizes the sum of the absolute deviations, that is, the sum of the residuals measured without regard to sign. Another possible approach would be to square each of the deviations before adding them, thereby assuring that they will all be positive, and then to fi nd the line that minimizes the sum of these squared deviations 3 : ()YYii i n − = ∑ ˆ 2 1 This least-squares approach represents the method employed by regression analysis, and is preferable to the sum of the absolute deviations for several reasons: 1. Theoretically, the least-squares approach will yield the best estimates. 4 2. The least-squares method will place greater weight on large errors as a result of the squaring operation in its computation. This approach is usually advantageous, since it is desirable to avoid large deviations. 3 The symbol /uni03A3 means “the sum of.” The superscript n indicates the number of observations, and the subscript i = 1 indicates the observation number at which the summation begins. In other words, in this term, all the squared deviations are summed, and there are a total of n observations. 4 The least-squares estimates will be both unbiased and effi cient. These terms are defi ned in Appendix C. FIGURE  A.3 Deviation for a Single observation Yi − Y ^ i = deviation Y ^ i Yi 593 INTRoDuCTIoN To REGRESSIoN ANAlySIS 3. The sum of the absolute deviations is computationally far more unwieldy than the sum of the squared deviations. 4. The least-squares approach permits many useful tests of the reliability of the equation. It can be demonstrated by straightforward calculus proofs the values of a and b that minimize the sum of the squared deviations are: b nX YX Y nX X a Y ii ii i n i n i n ii i n i n i = ⋅− ⋅ −       = = == == ∑ ∑ ∑ ∑ ∑ 1 11 2 1 2 1 ii n i i n n b X n Yb X== ∑∑ −= −11 where n = number of observations Y = mean of Yi, and X = mean of Xi ■ A Practical Example As a practical example, we will find the best-fit line using the least-squares approach for the set of observations in Figure A.1. Table A.1 summarizes the necessary computations. The resulting best-fit line is illustrated in Figure A.4. T o obtain a specific forecast, we would merely plug the estimated pig crop value into the regression equation. For example, if the December–May pig crop estimate were 51 million, the forecast for hog slaughter in the subsequent June–November period would be 50.51 million (–3.6279 + (1.0615 * 51)). ■ Reliability of the Regression Forecast It is essential to understand that, by itself, a point price projection derived from a regression equation is of little use. one must first consider how well the model describes the data and the expected vari- ability of forecasts based upon the regression equation. W e can get an intuitive answer to this question by examining how closely the observations fall to the fitted regression line (Figure A.4). But we should be able to assess a model’s accuracy more precisely. Simply examining a scatter chart leaves many unanswered questions. How close do the observations have to be to the regression line for the model to be judged satisfactory? How do we check whether a model provides an undis- torted representation of the real world? How closely can we expect the model’s forecasts to anticipate actual results? 594 Appendix A TAble A.1 Computation of least-Squares best-Fit line Y ear pig Crop (dec–May, millions) Xi Hog Slaughter (Jun–nov, millions) Yi Xi2 XiYi 1995 50.077 48.294 2,507.71 2,418.40 1996 47.888 45.453 2,293.26 2,176.64 1997 48.394 46.201 2,341.98 2,235.85 1998 52.469 50.929 2,753.00 2,672.20 1999 51.519 51.111 2,654.21 2,633.20 2000 50.087 49.689 2,508.71 2,488.76 2001 49.472 49.169 2,447.48 2,432.50 2002 50.858 50.709 2,586.54 2,578.94 2003 50.029 50.758 2,502.90 2,539.38 2004 50.737 52.265 2,574.24 2,651.76 2005 51.33 52.333 2,634.77 2,686.23 2006 52.242 53.150 2,729.23 2,776.68 2007 54.266 55.569 2,944.80 3,015.52 2008 57.019 57.648 3,251.17 3,287.05 2009 57.564 57.391 3,313.61 3,303.68 2010 56.326 55.681 3,172.62 3,136.26 2011 57.118 56.264 3,262.47 3,213.69 2012 57.818 57.478 3,342.92 3,323.23 2013 57.02 55.914 3,251.28 3,188.23 2014 53.821 52.418 2,896.70 2,821.17 ∑Xi = 1,056.05 ∑Yi = 1,048.42 ∑Xi2 = 55,969.58 ∑XiYi = 55,579.37 b = (20 * 55,579.37) – (1,056.05 * 1,048.42) / (20 * 55,969.58) – (55,969.58)2 = 1.0615 a = (1,048.42/20) – 1.0615 * (1,056.05/20) = –3.6279 Yi = −3.6279 + 1.0615Xi Another problem with the graphic analysis depicted in Figure A.4 is that it just isn’t feasible for regression equations that include two or more explanatory variables—a situation that is the rule rather than the exception. These considerations lead us to one of the primary benefits of regression analysis: The approach permits a wide variety of scientific tests of a model’s adequacy. Such tests are essential to the success- ful application of regression analysis. An understanding of these tests, as opposed to a mere cookbook application, requires a synopsis of some key statistical concepts. Appendix B provides an abridged crash course in elementary statistics. W e will return to regression analysis in Appendix C. 595 INTRoDuCTIoN To REGRESSIoN ANAlySIS FIGURE  A.4 Best-Fit line for June–November Hog Slaughter vs. December–May Pig Crop 44 46 48 50 52 54 56 58 60 47 49 51 53 55 57 59 Jun-Nov hog slaughter Dec-May pig crop ’96 ’01 ’97 ’95 ’00 ’03 ’02 ’04 ’05 ’07 ’08 ’12 ’09 ’11 ’13’10 ’14’98 ’06 ’99 Y = −3.6279+ 1 .0615X 597 A Review of Elementary Statistics The theory of probabilities is at bottom nothing but common sense reduced to Calculus. —Pierre Simon de Laplace ■ Measures of Dispersion For any data series there are two basic types of descriptive statistics: (1) some measure of central tendency (e.g., arithmetic mean, median, mode, geometric mean, harmonic mean); and (2) a measure of dispersion. The intuitive meaning of dispersion is quite clear. For example, consider the following two sets of numbers: A. 30, 53, 3, 22, 16, 104, 71, 41 B. 42, 40, 42, 46, 39, 45, 42, 44 Although both series have the same arithmetic mean, it is clear that series A would have a high dispersion measure and series B a low dispersion measure. The concept of dispersion is extremely important in forecasting. For example, if we were told there was a ninth number in each of the series that was not listed, we would be far more certain about our guess being close to the mark in series B than in series A. Thus, it is extremely desirable to have a measure that describes the dispersion of a set of numbers, much as the mean describes the central tendency of a set of numbers. The basic question is: How do we measure dispersion? In a sense, we have already answered this question. Deriving a dispersion measure for a set of numbers is entirely analogous to the computation of a single deviation measure for a group of points from a line. In the case of a set of numbers, the deviations would be measured relative to some central point. For theoretical reasons, the arithmetic mean is the most desirable measure of central tendency. T o derive a single deviation measure for a set of numbers, we cannot simply add the individual deviations, because they will tend to cancel each other out. Once again, two possible solutions are the sum of the absolute deviations or the sum of the squared deviations. The latter measure is far more convenient to use and is preferable for theoretical reasons. Appendix B 598 Appendix B However, the sum of the squared deviations is not a representative measure of dispersion since it is dependent on how many numbers are in the series. For example, if series B contained 1,000 sets of the indicated string of numbers, the sum of the squared deviations for the series would be greater than the corresponding figure for series A. This measure is therefore quite misleading because series A would still reflect greater dispersion by any intuitive definition of that term. This problem is solved simply by dividing the sum of the squared deviations by the number of items in the series. The result- ing measure is called the variance, which can be expressed as: Variance == − = ∑ σ2 2 1 ()XX N i i N where X = mean Xi = individual data values N = number of observations Note the variance is not stated in the same units as the original data series. For example, if the units of the original set of numbers were tons, the variance would be expressed in tons squared. The dispersion measure can be expressed in the same units as the original data series by simply taking the square root of the variance. This computation also makes intuitive sense since it reverses the original squaring process applied to the individual terms. The resulting figure is called the standard deviation and can be expressed as: Standard deviation == − = ∑ σ ()XX N i i N 2 1 In a rough sense, the standard deviation is a type of average deviation (of the individual data points from the mean), in which the data points that are further from the mean have greater than propor- tionate impact on the calculation. (This greater weight is the result of the squaring process.)1 1 These definitions for the variance and standard deviation are applicable when the entire set of data elements is known, in which case the set of numbers is called the population. However, in actual practice, available sets of numbers will often represent samples from a population. In fact, this assumption appears to be implied for series A and B. For reasons that will be explained later, the variance and standard deviation calculations for a sample are slightly different. Specifically, for samples, the variance and standard deviation would be expressed as follows: Variance sample Standard deviatio ns amp () () ( == − − = ∑ s XX n i i n 2 2 1 1 lle ) () == − − = ∑ s XX n i i n 2 1 1 where n = number of observations in the sample. 599 A REvIEw OF ELEMENTARy STATISTIcS TABle B.1 Standard deviation Computations Series A: 30, 53, 3, 22, 16, 104, 71, 41 Series B: 42, 40, 42, 46, 39, 45, 42, 44 Xi XXi − ()XXi − 2 Xi XXi − ()XXi − 2 30 −12.5 156.25 42 −0.5 0.25 53 +10.5 110.25 40 −2.5 6.25 3 −39.5 1,560.25 42 −0.5 0.25 22 −20.5 420.25 46 +3.5 12.25 16 −26.5 702.25 39 −3.5 12.25 104 +61.5 3,782.25 45 +2.5 6.25 71 +28.5 812.25 42 −0.5 0.25 41 −1.5 2.25 44 +1.5 2.25 Xi i n = = ∑ 340 1 XXi i N −() = = ∑ 2 1 7 546 00,. Xi i N = = ∑ 340 1 XXi i N −() = = ∑ 2 1 40 00. X X N i ==∑ 42 5 . X X N i ==∑ 42 5 . Variance == −() === ∑ σ2 2 1 7 546 8 943 25 XX N i i N , . Variance == −() === ∑ σ2 2 1 40 8 5 XX N i i N Standard deviation == −() == ∑ σ XX N i i n 2 1 30 712. Standard deviation == −() == ∑ σ XX N i i n 2 1 2 236. Note: These computations apply to a population. For samples, the computation would be slightly different (see footnote 1). The greater the standard deviation, the greater the degree of variability in a set of numbers. T o get a better sense of this statistic, Table B.1 calculates the standard deviation for series A and B. It is essential to have a clear understanding of the standard deviation before proceeding, since this term will play a pivotal role in defining the normal distribution and in probability testing. ■ Probability Distributions A random variable is a variable with a value that depends on a statistical experiment in which each out- come (or range of outcomes) has a specific probability of occurrence. For example, if trading decisions were based on the toss of a coin, the number of winning trades, excluding commissions, in 10 trades would be a random variable. A probability distribution indicates the probability associated with different values of a random variable. Figure B.1 indicates the probabilities for different numbers of gains in 10 trades if trading decisions are based on chance. The highest probability of 0.246 is associated with five gains in 10 trades. The probability of alternative events decreases as the number of gains moves 600APPENDIX B away from fi ve. The probability of 10 out of 10 winning trades is only 0.001. (By defi nition, the sum of all the probabilities equals 1.0.) This example of a probability distribution was based on a discrete variable, which is a variable that can take on only certain fi xed values—for example, we can have six winning trades or seven winning trades, but not 6.3 winning trades. Frequently, we will be concerned with random variables that are continuous, which are variables that can assume any value. An example of a continuous variable would be the reaction time of drivers in stepping on the brake when a stop sign is fl ashed on a screen in a simulation test. For continuous variables, the probability of each event (e.g., probability of the reac- tion time being exactly 0.41237 second) is not meaningful or even defi nable. Instead, the relevant consideration is the probability of events in a certain range (e.g., the probability of a reaction time between 0.4 and 0.5 seconds). A continuous distribution describes the probability associated with a continuous random variable. The total area under a continuous distribution curve will equal 1.0 (100 percent) since there is 100 percent probability an event will take on some value, and the sum of all the probabilities of mutu- ally exclusive events cannot exceed 100 percent. 2 A continuous distribution is characterized by the 2 Mutually exclusive means that only one event can occur at a time. For example, in the reaction time test, only one time value can be associated with any given test. FIGURE  B.1 Probability Distribution for Number of winning Trades in 10 Trades If Decision Based on chance .25 .20 .15 .10 .05 Probability 012345 Number of wins in 10 trades (excluding commissions) 6789 10 601 A REvIEw OF ELEMENTARy STATISTIcS fact that the area between any two given values is equal to the probability the random variable will fall in the interval between these two values. For example, in Figure B .2 the total area under the curve would be equal to 1.0, and the shaded area would indicate the probability of the continuous variable having a value between X 1 and X 2 . If the shaded area represented 20 percent of the total area under the curve, the probability of the continuous variable falling in a range between X 1 and X 2 would be 20 percent. Figure B .2 represents the familiar bell-shaped normal distribution curve. Empirically, the normal distribution has been shown to serve as a good approximation of the probability distribution for an extremely wide range of random variables. For example, it can be demonstrated that as the number of trades in Figure B .1 increases, the distribution will begin to approach a normal distribution. For a large number of trades (e.g., 1,000), the probability distribution would be almost exactly repre- sented by a normal distribution. Probabilities for continuous random variables such as reaction time frequently will also be well described by the normal distribution. Figure B .3 shows how the probability of an event falling within a fi xed interval increases as the interval moves closer to the mean. The probability of an event occurring in the range X 1 − X 2 (i.e., the area under the curve between X 1 and X 2 ) is greater than the probability of an event in the range FIGURE  B.2 continuous Probability Distribution X1 X2 FIGURE  B.3 Fixed Interval Probability Increases with Proximity to Mean X1XX 2 X3 X4 X5 602 Appendix B X3−X4. Note the probability of an event occurring in a range distant from the mean is near zero, even if it is a very broad range. For example, in Figure B.3, the probability of the variable having a value between X5 and infinity is near zero. The formula for the normal distribution is: Ye XX= −− []1 2 12 2 σπ σ(/ )( )/ This seemingly intimidating formula is not as frightening as it might initially appear. Like any other equation describing a relationship between X and Y, it tells us the value of Y given a value for X. The key point to realize about this equation is the precise relationship between X and Y will be determined entirely by the mean of XX() and the variance of X (σ).3 All the other values in the formula are con- stants (π = 3.1416, e = 2.7183). Thus, once X and σ are determined, the normal distribution for a particular set of numbers is completely defined. Note the value of Y will reach a maximum when X equals X , at which point the formula reduces to Y = 1 2σπ At any other value of X, the value of the term 1 2 2 XX−   σ will be greater than 0, resulting in a lower value of Y. The further any given value X is from X, the larger this term and the lower the value of Y.4 Because the normal distribution will differ for any given set of values for X and σ, it is desirable to choose a given set of values upon which to base a standard table of probability values. For simplicity, this table is based on X = 0 and σ = 1. T o be able to use this standard table, we have to transform the numbers in a series into Z values, where Z XX i i x = − σ 3 X and σ are parameters. As explained in footnote 2 in Appendix A, a parameter can be thought of as a hybrid between a variable and a constant. In this instance, X and σ will assume different values for different distribu- tions of X (i.e., different sets of numbers); however, for any given distribution (set of numbers), X and σ will be fixed (i.e., constants). 4 e−k is equivalent to l/e k, therefore the larger 12 2/[ () ]XX− /σ gets, the smaller the value of e XX−−() [( )]12 2// σ , hence the smaller the value of Y. 603 A REvIEw OF ELEMENTARy STATISTIcS and Xi is a given value in a set of numbers. 5 The numerator of this term is the distance of the given number from the mean; the denominator is the standard deviation of the set of numbers. Thus, the Z value is simply the distance of a given value from the mean in terms of standard deviations. For example, if the mean of a set of numbers is 10, and the standard deviation is 2, the Z value for a 5 The fact that the distribution of Z values will always have a mean equal to zero ()Z = 0 and a standard deviation equal to 1 (σz = 1) given that any set of X values is easy to demonstrate: Z XX Z XX N XX N i X i Xi N X i i N i N = − = −      = −      = == ∑ ∑ ∑ σ σ σ1 11 1 Keeping in mind that XX Ni i N =       = ∑ 1 /. Z N NX NX X =− () =1 0σ The standard deviation of Z (σz) can be expressed as σz i i N ZZ N= −() = ∑ 2 1 But we have just proved that Z = 0, so σ σ σ σ σ Z i i N i Xi n x i i N Z N XX N XX N== −      =⋅ −() = = = = ∑ ∑ ∑ 2 1 2 1 2 2 11 1 Z X X i i N XX N −() = ∑ 2 1 Since XX N i i N −() = ∑ 2 1 is the definition for σx, σ σ σZ X X=⋅ =1 1 604 Appendix B number X = 6 would be −2 (i.e., X is 2 standard deviations removed from the mean). This standard- ized distance of a number from its mean will allow us to gauge the probabilities of a given value being higher or lower than a given number. ■ Reading the Normal Curve (Z) Table Remember, a Z value indicates how many standard deviations a given observation lies above or below its mean, with the sign indicating whether the number is above or below the mean. Table B.2 lists the prob- abilities corresponding to different Z values. These numbers represent the probabilities of an observa- tion of a normally distributed random variable falling in the range between zero and the given Z value. For example, there is a .4332 (43.32 percent) probability the Z value will be between zero and +1.5. T o determine the probability of a Z value being less than a given number, simply add .50 (the probability of a value below the mean) to the probability listed in Table B.2. Thus, the probability of a Z value less than 1.5 = .9332. The probability of a Z value greater than 1.5 would be .0668 (i.e., 1 − .9332). T o find the probability of a Z value being more than +1.5 or less than −1.5 (in other words, more than 1.5 standard deviations removed from the mean), we would merely double this figure and get .1336. From Table B.2, we can verify that for a normal distribution there is a .6826 probability that an observation will fall within one standard deviation of the mean, a .9554 probability that it will be within two standard deviations, and a .9974 probability that it will be within three standard deviations. An example may help clarify some of these ideas. AB c is a brokerage house that has a long-running program to train new brokers. In addition to interviews, the firm administers a test to decide which candidates will be accepted into the program. After testing thousands of candidates over the years they have found the scores are approximately normally distributed, with a mean of 70 and a standard deviation of 10. Given these facts, try the following questions: 1. w hat is the probability a new applicant taking the test will get a score above 92 (assuming we are not given any additional information about the person)? 2. w hat is the probability the applicant will get a score between 50 and 80? Give it a try before reading on. Answers 1. Z XX= − σ Z = − =92 70 10 22. checking Table B.2, we see that the probability value corresponding to Z = 2.2 is .4861. Thus, there is a .9861 probability that a candidate will score 92 or less, or equivalently, a .0139 (1.39 per- cent) probability that the score will be higher. 605 A REvIEw OF ELEMENTARy STATISTIcS TABle B.2 Areas under the normal Curve An entry in the table is the proportion under the entire curve that is between z = 0 and a positive value of z. Areas for negative values of z are obtained by symmetry. Second decimal place of Z z .00 .01 .02 .03 .04 .05 .06 .07 .08 .09 0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359 0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753 0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .0164 .1103 .1141 0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517 0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879 0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224 0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549 0.7 .2580 .2611 .2642 .2673 .2703 .2734 .2764 .2794 .2823 .2852 0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133 0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389 1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621 1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830 1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015 1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177 1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4306 .4319 1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441 1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545 1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633 1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706 1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767 2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817 2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857 2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890 2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916 2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936 2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952 2.6 .4953 .4955 .4956 .4957 .4959 .4960 .4961 .4962 .4963 .4964 2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974 2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 .4981 2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986 3.0 .4987 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990 Source: Donald J. Koosis, Business Statistics (New york, Ny: John wiley & Sons, 1997). copyright © 1997 by John wiley & Sons; reprinted by permission. 606 Appendix B 2. This question is not as easy. It would be incorrect to proceed as follows: Z = − =80 50 10 30. why? Because Z values must be measured relative to the mean. So the solution requires two steps: First, the probability of getting a score between 70 and 80 must be calculated. This can be done as follows: Z = − =80 70 10 10. checking Table B.2, we find that this probability equals .3413. Next, to calculate the probability of a score between 50 and 70, we proceed as follows: Z = − =−50 70 10 20. This corresponds to a probability of .4772. Thus, the probability of a score between 50 and 80 is the sum of these two values: .3413 + .4772 = .8185 (81.85 percent) ■ Populations and Samples If a data set contains all possible observations, it is called a population. If it consists of only a portion of these observations, it is called a sample. whether a data set represents a population or a sample depends on the intended use. For example, if we are interested in the average income of all the employed people in Manhattan, the population would consist of all workers in Manhattan, and a sample would be only a portion of those workers. However, if we wish to estimate the average income of all U.S. workers, all workers in Manhattan would be a sample. Intuitively, it should be clear that all workers in Manhattan would not be a very good sample of all U.S. workers. The problem in this case is that the sample is not representative of the population. In order for a sample to be representative of a population, it must be a random sample. A random sam- pling process is one in which each sample that can be drawn from the population has an equal chance of being selected. Samples that are not random will be biased, and a sampling approach that is not random will yield biased estimates. The mean of sample means that are biased will deviate from the population mean. Ironically, for a biased sample, the larger the sample size, the more certain its mean will deviate from the population mean. In standard terminology, when a measure refers to the population, it is called a parameter. 6 A measure that refers to a sample is called a statistic. Thus, the standard deviation for a population (σ) is a param- eter, and the standard deviation of a sample (s) is a statistic. 6 The meaning of the term parameter when used in this context should not be confused with the distinction among parameters, variables, and constants explained in footnote 2 of Appendix A. 607 A REvIEw OF ELEMENTARy STATISTIcS ■ Estimating the Population Mean and Standard Deviation from the Sample Statistics Although the intention of probability testing is to draw inferences about a population, it is usually impractical to collect data for the entire population. In fact, it is frequently impossible, since some populations are infinite. For example, the number of heads in 10 tosses of a coin is an infinite population, since there is no limit to how many times this event can be repeated. In practice, most applications of probability testing, including those in regression analysis, are based on samples rather than on populations. Thus far, we have avoided the troublesome fact that the population mean and standard devia- tion are usually not known. we must now turn to the question of how the population mean and standard deviation can be estimated from a sample. It can be demonstrated that the mean of a random sample is an unbiased estimate of the population mean, even if the population does not show a normal distribution. This is equivalent to saying that, on average, the mean of randomly selected samples will equal the population mean. The sample standard deviation, however, is not an unbiased estimate of the population standard deviation, since it tends to slightly underesti- mate the population parameter. It has been proved that an unbiased estimate of the population variance (once again, variance is the square of the standard deviation) is given by the following equation 7: s XX n 2 2 1= −() − ∑ Taking the square root to translate this variance into a standard deviation, we get s XX n= −() − ∑ 2 1 This formula is almost identical to the population standard deviation. The only difference is the use of the divisor n − l instead of N.8 For large samples, the difference between the formulas will be nearly negligible. Finally, although the sample mean is an unbiased estimate of the population mean, this does not suggest the sample mean is necessarily close to the population mean. Thus, in addition to the point estimate provided by the sample mean, it would be highly desirable to determine a probable range for the population mean. But before we consider how such a range might be determined, we must first grasp the concept of a sampling distribution. 7 when a standard deviation refers to a sample rather than a population, it is designated by an s instead of σ. 8 The quantity n − 1 is called the number of degrees of freedom. we will define this term later. 608 Appendix B ■ Sampling Distribution Fast Fred is a relatively active day trader. Being meticulous—but old-fashioned—at the end of every trading day he records the details of each of his trades in a notebook because he feels doing so helps him better absorb the lessons of his successes and failures in the markets. He eventually realizes that he should have kept his entries in an Excel spreadsheet so he could make calcula- tions on his performance, but being a creature of habit, he continues to enter his trades in his notebook. Fast Fred varies the number of contracts per trade based on the volatility of the market. He does all his trades using market orders. Recently, he has noticed that his average slippage per trade has increased significantly. (Slippage is the difference between the actual execution price and the market price at the time of trade entry.) Being concerned that his trading approach may no longer be viable, Fast Fred begins monitoring his slippage and notices that it is running around $75 per trade, which he believes is roughly $50 higher than it has averaged in the past. He reasons that if his average net profit (profit after gross commission and slippage) is not at least $60 per trade, it is probably not worthwhile continuing to trade. Unfortunately, he has never bothered to compile summary statistics from his many trades. The thought of going through all his trade records, which he estimates at more than 3,000 for the past year alone, seems worse than just taking his chances. Instead, he decides to draw a sample. Knowing a little about statistics, Fred creates a random sample of 30 trade entries and calculates the average net profit per trade of this sample is $85 and the standard deviation of the sample is $100. He believes a 95 percent probability of an expected gain of at least $60 per trade is necessary to justify his continued trading activity. (An implicit assumption is that the past mean gain can be used as an estimate of his future expected gain per trade.) Given this information, is Fred’s day trading method still viable? Unfortunately, we are not quite ready to answer this question without some additional theoretical background. we will eventually return to Fred’s dilemma, but first let us consider what might happen if Fred took another random sample of all his trades (including those selected for the first sample).9 The mean net profit per trade of this sample would be different. If he repeated this process many times, Fred would generate list of different means, each corresponding to a different sample. However, it should be apparent these sample means would be much less spread out (i.e., have a smaller standard deviation) than the individual observations in a single sample. As will be detailed shortly, the standard deviation of observations within a sample and the standard deviation of sample means are related in a specific way. In Figure B.4, hypothetical sample means for the net profit per trade are grouped by class (ranges of $10), with the y axis indicating the frequency of occurrences in each class. If the 9 The assumption that trades that were picked for a prior sample can be picked again is important. Remember, the definition of a random sample is that each sample must have an equal chance of being selected. If the trade entries are not replaced, all possible samples that included any of the original trades will no longer be able to be picked—violating the random sample assumption. If the population is very large, the absence of replacement will not be significant, since combinations involving the selected sample will account for only a minute fraction of all possible combinations. 609 A REvIEw OF ELEMENTARy STATISTIcS number of samples was repeated infinitely, and the class sizes were reduced correspondingly, Figure B .4 would approach a continuous curve known as a sampling distribution. The key point to realize is that the sampling distribution is a probability distribution curve related to sample statistics (e.g., sample means). Looking at Figure B .4 , we might guess the sampling distribu- tion would be similar to a normal distribution. In fact, if the sample size (i.e., standard size of each sample, not number of samples) is large enough, the sampling distribution will precisely approach a normal distribution. ■ Central Limit Theorem The preceding illustration leads us to the central limit theorem, one of the most important concepts in statistical testing. The central limit theorem can be paraphrased as follows: The distribution of sample means from a population will approach a normal distribution as the sample size increases even if the population is not normally distributed. FIGURE  B.4 Sampling Distribution of Mean 7 6 5 4 3 2 1 Frequency (number of samples with mean in indicated profit range) 35−45 45−55 55−65 65−75 75−85 X Average net profit per trade of sample _85−95 95−105105−115115−125125−135 610APPENDIX B .10 .20Probability 2 1 3456789 10 FIGURE  B.5 Probability Distribution for Spinning wheel 7 6 5 4 3 2 1 Frequency (number of samples with mean in specified range) 5.8−6.2 6.3−6.7 6.8−7 .2 7 .3−7.7 7.8−8.2 5.3−5.7 4.8−5.2 4.3−4.7 3.3−3.7 2.8−3.2 FIGURE  B.6 Sampling Distribution of Mean for Spinning wheel Trials T o illustrate the central limit theorem, consider the probability distribution for the number that turns up when spinning a wheel numbered 1 through 10. The probability distribution for this ran- dom variable is depicted in Figure B .5 . Assuming an honest wheel, each number has an equal 0.10 probability of turning up. This illustration is obviously well removed from a normal probability 611 A REvIEw OF ELEMENTARy STATISTIcS distribution. Table B.3 summarizes the means of 30 samples of 10 spins each. 10 These samples are grouped by class in Figure B.6. Note the sample means roughly approximate a normal distribution, even though the parent population bears no resemblance to a normal distribution. Our sample size of 10 was fairly small. If a larger sample size had been used, the approximation of a normal distribution would have been better. 10 These numbers were constructed using a random numbers table, an approach precisely equivalent to the example given. TABle B.3 30 Samples on Spinning Wheel (N = 10) Sample number numbers on Wheel (10 spins) Mean ()X 1 8 10 5 6 6 2 4 6 8 10 6.5 2 5 7 1 1 4 3 8 9 5 3 4.5 3 8 5 4 10 7 5 5 4 10 10 6.8 4 3 1 8 5 7 1 6 5 9 10 5.5 5 1 9 10 9 3 2 6 5 2 10 5.7 6 9 1 6 2 1 3 5 7 3 1 3.8 7 4 6 6 10 8 4 4 9 5 2 5.8 8 4 10 10 2 4 5 6 3 8 1 5.3 9 8 7 8 10 6 6 10 3 1 9 6.8 10 7 4 9 8 6 9 7 6 8 10 7.4 11 7 9 2 10 3 7 10 5 10 9 7.2 12 6 4 1 3 8 8 1 1 10 7 4.9 13 5 7 2 7 9 6 4 8 8 9 6.5 14 1 2 6 10 3 5 10 9 1 4 5.1 15 7 4 10 6 8 2 4 5 4 3 5.3 16 5 3 1 10 3 10 7 4 7 5 5.5 17 6 2 4 8 8 5 8 5 4 8 5.8 18 6 3 9 2 4 9 9 6 1 10 5.9 19 2 5 3 6 9 3 4 6 6 9 5.3 20 6 2 1 8 6 1 5 2 9 7 4.7 21 4 4 5 7 8 7 5 10 8 6 6.4 22 2 9 10 6 9 1 4 5 3 5 5.4 23 5 4 7 1 10 1 4 7 3 3 4.5 24 9 4 5 2 6 9 6 4 2 2 4.9 25 4 5 8 5 7 6 8 5 9 7 6.4 26 8 2 1 2 8 6 8 7 1 6 4.9 27 7 8 7 6 6 5 1 7 9 6 6.2 28 9 7 7 5 9 4 3 3 2 1 4.9 29 2 3 5 7 9 1 6 1 8 9 5.1 30 4 3 2 9 2 1 8 4 1 6 4.0 612 Appendix B Before moving on, bear in mind the examples involving repeated samplings were intended only as illustrations to elucidate the concepts of sampling distributions and the central limit theorem. In practice, however, we would always select only a single sample. Accuracy could be improved by simply increasing the size of this single sample. ■ Standard Error of the Mean The standard deviation of sample means is usually smaller than the standard deviation of any given sample. The standard deviation of sample means is called the standard error of the mean and is repre- sented by the symbol: σX. (Standard error is a frequently used statistical term and can be interpreted as the standard deviation of the sampling distribution of the given statistic. In this case, the given statistic is the mean. Other types of standard error related to regression analysis are considered in Appendix c.) Given a distribution with a standard deviation σ, it can be proved that a random sample of size n has the following standard error of the mean:11 σ σ x n = Of course, we usually will not know the value of σ and will have to use s as an unbiased estimate of σ. (Recall that the two are very similar for all but very small samples.) Thus, in practice we would use σx s n = For example, if the standard deviation of the sample (s) is 20 and the sample size is 25, then σx would equal 4. The larger the sample, the smaller σx . However, note that the accuracy of the sample increases much more slowly than the sample size. For instance, a 25-fold increase in the sample size would reduce σx only by a factor of 5. ■ Confidence Intervals Recall that assuming a data set is normally distributed, the probability of an observation falling within a given range can be determined from Table B.2. For example, the ±Z values that include 95 percent of observations are ±1.96, since 2.5 percent of the distribution lies above +1.96 and 2.5 percent below −1.96. (Table B.2 indicates that .4750 of the area lies between Z = 0 and Z = +1.96; so, given 11 This formula applies to infinite populations or samples in which the sample size is relatively small compared with the population. Although we will not be concerned with such cases, the precise formula when the sample size represents a significant percent of the population is (/ )( )/()σ nN nN−− 1 where n = sample size and N = population size. 613 A REvIEw OF ELEMENTARy STATISTIcS the symmetry of the normal distribution, 95 percent of observations could be expected to fall within the range of −1.96 to +1.96.) The formula for the Z value was formerly stated as Z XX= − σ In the case of a distribution of sample means (which the central limit theorem assures us will approximate a normal distribution), we have Z X x = −µ σ where X = sample mean m = population mean σx = standard error of the mean (i.e., the standard deviation of sample means) From the previous section, we know that σx can be approximated by sn . Thus, Z X sn = −µ or µ= −⋅XZ s n If we were interested in the area that enclosed 95 percent of sample means, Z = ±1.96, the previ- ous formula could be expressed as µ µ =± −⋅ << +⋅ X s n X s n X s n 19 6 19 61 96 . .. This calculation can be interpreted as follows. In repeated samplings the true population mean could be expected to lie between Xs n−⋅19 6 . and Xs n+⋅19 6 . 95 percent of the time. Such a range is called a confidence interval. The confidence interval can be used to test hypotheses about the population mean.12 The standard approach involves testing the null hypothesis, which states there is no difference between the sample mean and the hypothesized population mean. Typically, we want to reject the null hypothesis, or, equivalently, demonstrate the sample mean is different from the hypothesized population mean at 12 This discussion refers to population and sample means. However, it applies more generally to any sample statistic used to test an hypothesis about the population parameter. 614 Appendix B some specified level of significance. The most commonly used level of significance is 0.05 (5 percent), which means that the sample mean lies outside the 95 percent confidence interval of the hypothesized population mean. 13 A statistical rejection of the null hypothesis demonstrates, with a probability at the stated level, that the sample could not have been drawn from a parent population with the hypoth- esized mean. Sometimes, however, it is more critical to minimize the chance of rejecting the null hypothesis when in fact it is true (i.e., accepting that the sample mean is statistically different from the hypoth- esized population mean when it is not). 14 In such a case we might use a 0.01 level of significance. Of course, there is a tradeoff, because the lower the value for the level of significance (the more stringent the test), the wider (less specific) the confidence interval. ■ The t-Test The Z-test is appropriate when the sampling distribution is normal, a condition that can be assumed true when the sample size is large. 15 However, for small samples the sampling distribution is better approximated by the t-distribution, and hence the t-test is more accurate. The t distribution is very similar to the normal distribution for all but very small samples. As the sample size increases, the nor- mal and t distributions become increasingly similar. For example, at a 0.05 level of significance for a one-tailed test, the t value is 10 percent greater than the Z value for a sample of 10, 3 percent greater for a sample of 30, and 1 percent greater for a sample of 100. For an infinite sample, the normal and t distributions will be identical. Similar to the standardized normal distribution, the t distribution is symmetrical, with a mean equal to zero and a standard deviation equal to 1. The formula for the t value of a sample statistic (e.g., mean) is totally analogous to the Z value: t X sn = −µ 13 This statement assumes that there is no a priori reason for assuming a value above or below the hypothesized mean. Such a situation is referred to as a two-tailed test. If, however, there is reason to believe that the sample mean would be above the null hypothesis population mean, the relevant question would be whether the sample mean was significantly higher than the population mean, not whether it was significantly different from the population mean. Such a situation is called a one-tailed test. The 0.05 significance level for a one-tailed test would correspond to the probability that a value was outside the 90 percent confidence interval. The distinc- tion between one-tailed and two-tailed tests is discussed in greater detail in subsequent sections. 14 An incorrect decision of this type is called a type 1 error. The probability of making a type 1 error is indicated by the level of significance. Accepting the null hypothesis when it is false is called a type 2 error. It should be stressed that the acceptance of the null hypothesis does not prove it is true, but only indicates that the null hypothesis could not be rejected at the stated level of significance. Thus, the acceptance of the null hypothesis does not prove that the sample was drawn from a population with the hypothesized mean, but rather that the sample and hypothesized population means are not statistically different at the specified level of significance. 15 The meaning of large depends on the distribution of the underlying population. Roughly speaking, 30 is usually sufficiently large. 615 A REvIEw OF ELEMENTARy STATISTIcS The t-test uses the t distribution for probability testing and is entirely analogous to the Z-test.16 The specific t distribution will depend on the degrees of freedom (df )—the number of observations (sample size) minus the number of constraints. For example, in tests of the sampling distribution of the mean, df = n − 1. There is one constraint, since given the mean, only n − 1 terms can be freely assigned. T o see this, assume we have 10 observations with a mean of 50. If the sum of the first nine items equals 400, the value of the last term must be 100. Thus we say there are only n − 1 df. In a two- variable regression line, there are two parameters: a and b. Once these are fixed, only n − 2 terms can be assigned freely. Thus, t-tests of regression coefficients in the two-variable model are based on n − 2 degrees of freedom. The application of the t-test is almost totally analogous to the Z-test. The only difference between the two is that the specific value used in the t-test depends on the degrees of freedom. Table B.4 provides a list of t values. The appropriate row is determined by the number of degrees of freedom, and the column by the desired level of significance in testing. Given the great similarity between the Z-test and the t-test, it would probably be redundant to provide a detailed description of the use of Table B.4. However, to check that you understand how to use this table, try the following questions: 1. If you are testing the hypothesis that the population mean is not significantly greater than the null hypothesis, what value must t exceed to reject this hypothesis at a 0.05 level of significance (i.e., to conclude that the true population mean is significantly greater than the null hypothesis)? The sample size is 20. 2. If you are testing the hypothesis that the population mean is not significantly different from the null hypothesis, what value must t exceed in order to reject this hypothesis at the 0.05 level of significance (i.e., to conclude that the true population mean is significantly different from the null hypothesis)? Once again, the sample size is 20. 3. a. Given a four-unit sample with a mean equal to 40 and a standard deviation equal to 10, what is the 95 percent confidence interval for the population mean? b. Now try it for a sample size equal to 30. Answers 1. 1.729. For df = 19, Table B.4 indicates that there is only a 5 percent probability that this level will be exceeded. This type of test is called a one-tailed test. 2. 2.093. A 5 percent probability of being significantly different from the null hypothesis is equiva- lent to determining the t values that will define the boundaries for the upper and lower 2.5 per- cent of the distribution. This is an example of a two-tailed test. 16 The astute reader may well wonder why we bother describing the Z-test in the first place, since the t-test would be more accurate for samples. The reason is that the mathematics underlying the t distribution assume that the population of the data series is normally distributed. This is a much stronger assumption than was necessary for the application of the Z-test, which only required that the sampling distribution be normal—a condition that the central limit theorem guaranteed would be approximately fulfilled for a sufficiently large sample. Thus, the Z-test provides the justification for probability testing of non-normally distributed populations. This is a critical fact, since the assumption of a normally distributed population is often not warranted. 616 Appendix B TABle B.4 Student’s t distribution The first column lists the number of degrees of freedom (k). The headings of the other columns give probabilities (P) for t to exceed the entry value. Use symmetry for negative t values. p df .10 .05 .025 .01 .005 1 3.078 6.314 12.706 31.821 63.657 2 1.886 2.920 4.303 6.965 9.925 3 1.638 2.353 3.182 4.541 5.841 4 1.533 2.132 2.776 3.747 4.604 5 1.476 2.015 2.571 3.365 4.032 6 1.440 1.943 2.447 3.143 3.707 7 1.415 1.895 2.365 2.998 3.499 8 1.397 1.860 2.306 2.896 3.355 9 1.383 1.833 2.262 2.821 3.250 10 1.372 1.812 2.228 2.764 3.169 11 1.363 1.796 2.201 2.718 3.106 12 1.356 1.782 2.179 2.681 3.055 13 1.350 1.771 2.160 2.650 3.012 14 1.345 1.761 2.145 2.624 2.977 15 1.341 1.753 2.131 2.602 2.947 16 1.337 1.746 2.120 2.583 2.921 17 1.333 1.740 2.110 2.567 2.898 18 1.330 1.734 2.101 2.552 2.878 19 1.328 1.729 2.093 2.539 2.861 20 1.325 1.725 2.086 2.528 2.845 21 1.323 1.721 2.080 2.518 2.831 22 1.321 1.717 2.074 2.508 2.819 23 1.319 1.714 2.069 2.500 2.807 24 1.318 1.711 2.064 2.492 2.797 25 1.316 1.708 2.060 2.485 2.787 26 1.315 1.706 2.056 2.479 2.779 27 1.314 1.703 2.052 2.473 2.771 28 1.313 1.701 2.048 2.467 2.763 29 1.311 1.699 2.045 2.462 2.756 30 1.310 1.697 2.042 2.457 2.750 40 1.303 1.684 2.021 2.423 2.704 60 1.296 1.671 2.000 2.390 2.660 120 1.289 1.658 1.980 2.358 2.617 ∞ 1.282 1.645 1.960 2.326 2.576 Source: Donald J. Koosis, Business Statistics (New york, Ny: John wiley & Sons, 1997). copyright © 1997 by John wiley & Sons; reprinted by permission. 617 A REvIEw OF ELEMENTARy STATISTIcS 3. a. Xt s n Xt s n ⋅⋅ << +⋅µ 40 3 182 10 4 40 31 82 10 4 −⋅ << +⋅.. µ 24.09 < μ < 55.91 b. 40 2 045 10 30 40 20 45 10 30 −⋅ << +⋅.. µ 36.27 < μ < 43.73 Note how dramatically the larger sample size increases the precision of the estimated confidence interval at the same probability level. The choice of whether to employ a one-tailed or two-tailed test is not always clear-cut. Normally, a two-tailed test is used when we do not have any preconceived conclusion about the sample. In this case, the probability test for significance must allow for variation in either direction of the statistic being estimated (e.g., population mean). However, sometimes there are strong reasons to believe the sample statistic will be above or below the hypothesized population value—the only question being whether the difference will be significant. This type of situation will often apply in testing the signifi- cance of regression coefficients, as will be detailed in Appendix c. It is finally time to return to our beleaguered day trader. we now see the solution to Fred’s dilemma is fairly straightforward. you might wish to return to the section, “Sampling Distribution,” to try to determine the correct decision before reading on. Given the previously stated assumptions, the confidence interval for the expected net profit per trade would be $. $ $. $85 16 99 100 30 −⋅ << ⋅expected net pro fit per trad e8 5+16 99 1100 30 53 98$. $.< 1.0. It has been demonstrated that if explanatory variables are retained if their t-value > 1.0 and deleted otherwise, the “Corrected R2” (which is discussed later) will be maximized. 641 THE MULTIPLE REGRESSION MODEL level of 2.0. The key words are theoretically meaningful. A low t value does not contradict the assumed relationship between the dependent and explanatory variable. Remember, a t value below the level of statistical significance does not indicate that the independent variable is not meaningful in explaining the dependent variable. It only means that its significance has not been demonstrated at the desired probability level. As long as the variable has the anticipated sign, the results are still consistent with theoretical expectations, albeit the relationship is not as strong as would be desired. Furthermore, even a t value of 1.0 would still be significant at the 0.20 level (i.e., 80 percent probability) for any regression equation in which df > 2. Variables with t values below 1.0 should usually be dropped. There is one exception to the decision process just detailed. Occasionally, the analyst might try including all the independent variables she believes should significantly affect the dependent variable, only to find that the resulting regression equation is disappointing. At this point, in desperation she might try a variety of independent variables in the hopes that perhaps one or more of these are signifi- cantly related to the dependent variable. Such a method could be termed a “shotgun” or “kitchen sink” approach and is not recommended unless all theoretically plausible variables have been exhausted. In any event, in this case one should apply stricter requirements for retaining a variable. First, a two- tailed rather than one-tailed test should be used (see section “T esting the Significance of the Regres- sion Coefficients” in Appendix C). Second, variables with t values below the 0.05 level of significance should be rejected. In fact, one can argue that a more restrictive significance level should be adopted (e.g., 0.01), since the probability of accepting a meaningless variable increases with the number of variables tested. Thus far, we have assumed that a theoretically chosen variable has the correct sign. However, in equations with many variables, a coefficient with the wrong sign is not uncommon. Such an occur- rence usually indicates the presence of multicollinearity—a linear dependence between two or more explanatory variables. (A discussion of how to handle such variables is presented in the section on multicollinearity in Appendix E.) At this point, suffice it to say that the t values of such variables are usually irrelevant. ■ Standard Error of the Regression The standard error of the regression (SER) is a measure of the unexplained variation. The definition of the SER is almost totally analogous to the simple regression case. The only difference is that the sum of the squared residuals is divided by the appropriate degrees of freedom, instead of n−2. Thus, for the more general multiple regression case, the SER could be expressed as SER = −() − = ∑ YY nk ii i n ˆ 2 1 where k = number of parameters in equation (which is equal to the number of independent vari- ables plus 1, assuming there is a constant term in the equation). Note in the simple regression case that k = 2. 642 Appendix d As in the simple regression case, the % SER is equal to the SER divided by Y . Where appropriate (see Appendix C), the % SER may be more convenient to use, because it is stated in a form that is intuitively meaningful. ■ Confidence Intervals for an Individual Forecast In the multiple regression case, the calculation of a confidence interval for an individual forecast is somewhat complicated. As a simplification, the confidence interval can be calculated for the situation in which all of the independent variables are equal to their means. In this specialized case, the formula for the confidence interval would be analogous to the simple regression case in which XX= : ˆˆYt s n YY t nff f−⋅ +< <+ ⋅+1 1 1 1 where s = SER t = t value at specified level of significance for the given degrees of freedom This represents a minimum confidence interval, and the further removed the independent vari- ables are from their respective means, the wider the actual confidence interval. ■ R2 and Corrected R2 The term R2 is the multiple regression counterpart of r2 and is defined in exactly the same way. Thus, the entire discussion related to r2 in Appendix C applies here as well and need not be duplicated. In the multiple regression case, it is important to realize that the addition of another independent variable can only increase R2. Remember that R2 is the ratio of explained variation to total variation. The introduction of a new variable will not affect total variation, and it can only increase explained variation. Even the introduction of a totally irrelevant variable will probably result in a small increase in explained variation. For example, it is a safe bet that adding a variable for the number of ducks in Belgium would increase the R 2 of a regression equation for forecasting U.S. interest rates. The point that the addition of a meaningless explanatory variable will raise R 2 is more than an esthetic consideration. Recall that each additional variable will decrease the degrees of freedom by 1, thereby reducing the significance of the equation on the basis of other measures such as the t-test and SER, all else being equal. For this reason, it is desirable to modify the R 2 measure so that it is penalized for the addition of irrelevant variables. This alternative measure is called the Corrected R 2 (CR2), or sometimes the Adjusted R2. The problem with R2 is that it is based on variation, which does not account for the number of degrees of freedom. The CR2 avoids this defect, because it is based on variance. The variance is simply the variation divided by the number of degrees of freedom. It will be recalled that R 2 can be defined as4 R2 1=− unexplai ned vari ation total variatio n 4 The formulas for R2 and r2 are identical. 643 THE MULTIPLE REGRESSION MODEL W e now define CR2 as CR2 1=− unexplai ned vari ance total variance where Variance variatio n= df Thus, CR YY nk YY n i i n i n 2 1 2 1 1 2 1 1 1 =− − − − − = = ∑ ∑ () ()  The numerator of the ratio term is based on n observations, but there are k constraints in find- ing the regression line used to calculate Y i. Thus df = n − k. The denominator is also based on n observations, but there is only one constraint, Y ; thus df = n − 1. The preceding equation can be rewritten as CR R n nk 22 11 1=− −⋅ − −() As is readily apparent in this form of the equation, when n is large relative to k, the CR2 will almost equal R2. Typical regression runs will provide the CR2 (corrected R square or adjusted R square) along with R2 (R square). As a general rule, the CR2 is a more useful measure for comparing different regression equations for the same dependent variable. ■ F-Test Whereas the t distribution is used to test the significance of the individual regression coefficients, the F distribution is used to test the significance of the regression equation as a whole. In other words, the F statistic tests the hypothesis that none of the regression coefficients is significant. The F statistic can be expressed as F = explained variance unexplai ned vari ance 644 Appendix d Note that the F value is based on variance, not variation. Once again, variance = variation + df. F YY k YY nk YY YY i i n ii i n i i n ii i = −() − −() − = −() −() = = = ∑ ∑ ∑ 2 1 2 1 2 1 2 1 ˆ ˆ ˆ = = ∑ ⋅ − − 1 1n nk k The degrees of freedom for the explained variance = k − 1, since k values are employed in defining the regression line used to calculate ˆYi, but one df is lost because of the constraint imposed by Y . As for the unexplained variance, there are n observations, but k constraints are imposed in finding the regression line upon which Y i is based. Recalling the alternative definitions for R 2, we can re-express F as5 F R R nk k= − ⋅ − − 2 211 The appropriate degrees of freedom will be specified in the notation for the F statistic. For example, F (2/8) = 23.5 indicates an F value for a regression equation in which k − 1 = 2 and n − k = 8. T o check for significance, the F statistic is compared to the listed values in the F table for the corresponding number of degrees of freedom. For example, checking Table D.1, it can be determined that at the 0.01 level of significance, F (2/8) = 8.65; thus, a value of 23.5 would be significant. In practice, the F-test is not particularly critical, since it will almost invariably prove significant. This should not be surprising, because the F-test checks whether all the regression coefficients com- bined have any predictive value—a very weak criterion. In any case, for comparisons of regression equations with the same dependent variable, higher F values would indicate a better model (assuming none of the regression assumptions are violated). However, similar information could be gathered by comparing CR 2 values. ■ Analyzing a Regression Run Table D.2 presents the results for a sample regression run. At this juncture, most of Table D.2 should be comprehensible. However, it may be helpful to interpret the key statistics of this table. 1. The regression equation is Y = 49.06899 − 1.07049 (X1) + 0.35775 (X2). T o get a point fore- cast for Y, one would merely plug in the estimated values of X1 and X2. For example, if X1 = 20 5 ˆYY RY Yii i n i n −() =⋅ −() == ∑∑ 2 2 2 11 and YY RY Yii i i n i n −() =− − == ∑∑ ˆ () () 2 22 11 1 645 THE MULTIPLE REGRESSION MODEL TAble d.1 F distribution Values of Fn1,n2,α on the F(n1,n2,α)-distribution pr{F(n1,n2)-variable ≥ Fn1,n2,α} = α = 0.01 0 /uni03B1 = .01 /uni03B1 = .01 Fn1, n2, /uni03B1 F(n1, n2)-distribution n1 (numerator df ) n2 (denominator df ) 1 2 4 6 8 10 12 24 ∞ [tn2,.005]2 Values of Fn1,n2,α 1 4,052 5,000 5,625 5,859 5,982 6,056 6,106 6,235 6,366 2 98.50 99.00 99.25 99.33 99.37 99.40 99.42 99.46 99.50 3 34.12 30.82 28.71 27.91 27.49 27.23 27.05 26.60 26.13 4 21.20 18.00 15.98 15.21 14.80 14.55 14.37 13.93 13.46 5 16.26 13.27 11.39 10.67 10.29 10.05 9.89 9.47 9.02 6 13.75 10.92 9.15 8.47 8.10 7.87 7.72 7.31 6.88 7 12.25 9.55 7.85 7.19 6.84 6.62 6.47 6.07 5.65 8 11.26 8.65 7.01 6.37 6.03 5.81 5.67 5.28 4.86 9 10.56 8.02 6.42 5.80 5.47 5.26 5.11 4.73 4.31 10 10.04 7.56 5.99 5.39 5.06 4.85 4.71 4.33 3.91 11 9.65 7.21 5.67 5.07 4.74 4.54 4.40 4.02 3.60 12 9.33 6.93 5.41 4.82 4.50 4.30 4.16 3.78 3.36 13 9.07 6.70 5.21 4.62 4.30 4.10 3.96 3.59 3.17 14 8.86 6.51 5.04 4.46 4.14 3.94 3.80 3.43 3.00 15 8.68 6.36 4.89 4.32 4.00 3.80 3.67 3.29 2.87 20 8.10 5.85 4.43 3.87 3.56 3.37 3.23 2.86 2.42 25 7.77 5.57 4.18 3.63 3.32 3.13 2.99 2.62 2.17 30 7.56 5.39 4.02 3.47 3.17 2.98 2.84 2.47 2.01 40 7.31 5.18 3.83 3.29 2.99 2.80 2.66 2.29 1.80 60 7.08 4.98 3.65 3.12 2.82 2.63 2.50 2.12 1.60 120 6.85 4.79 3.48 2.96 2.66 2.47 2.34 1.95 1.38 ∞ 6.63 4.61 3.32 2.80 2.51 2.32 2.18 1.79 1.00 Source: Abridged from Table 18 of Pearson and Hartley, Biometrika T ables for Statisticians, Third Edition, V olume 1, 1976, with kind permission of the Biometrika Trustees (http://biomet.oxfordjournals.org). The diagram, and this presentation of the table, are taken from Table 4b of S. R. Searle, Linear Models (New Y ork, NY: John Wiley & Sons, 1997). Copyright © 1997 by John Wiley & Sons; reprinted by permission. 646 Appendix d TAble d.2 Sample Regression Run Results Variable Coefficient Standard error T-Stat Mean CONSTANT 49.06899 9.67267 5.07 41.16071 (dependent variable) X1 −1.07049 0.23464 −4.56 21.00714 X2 0.35775 0.13400 2.67 40.75357 Observation Actual Fitted Residual % deviation 1 35.90000 35.25925 0.64075 1.82 2 52.70000 54.54910 −1.84910 −3.39 3 46.30000 50.74680 −4.44680 −8.76 4 34.20000 36.98609 −2.78609 −7.53 5 51.30000 46.15574 5.14426 11.15 6 44.20000 44.02220 0.17780 0.40 7 33.90000 29.70675 4.19325 14.12 8 31.30000 30.54304 0.75696 2.48 9 31.70000 32.74207 −1.04207 −3.18 10 29.90000 31.58795 −1.68795 −5.34 11 51.10000 49.76981 1.33019 2.67 12 56.10000 51.62468 4.47532 8.67 13 43.90000 45.56465 −1.66465 −3.65 14 33.7500 36.99187 −3.24187 −8.76 Y = CONSTANT + C1 · X1 + C2 · X2 RSQ = 0.8953 SER = 3.2338 F(2,11) = 47.0 RSQC = 0.8762 % SER = 7.86 DW = 1.69 and X2 = 40, the predicted Y value would be 41.969. In practice, it will be more convenient to use mnemonic symbols for the variables instead of Y, X1, and X2. 2. R2 = 0.8953, which means that X1 and X2 explain 89.53 percent of the total variation in Y. The CR2, which is adjusted downward for lost degrees of freedom, is 0.8762. 3. SER = 3.2338. This would be a key figure of merit in comparisons with alternative models. The SER could also be used to construct a crude confidence interval for an individual forecast based on the assumption that all the independent variable values are equal to their respective means. This confidence interval would be 6 ˆˆYt s n YY ts nff f−⋅ +< <+ ⋅+1 1 1 1 6 See the section, “Confidence Intervals for an Individual Forecast.” 647 THE MULTIPLE REGRESSION MODEL where s = SER = 3.23 n = 14 t = 2.201 (t value for two-sided test at 0.05 level of significance for 11 df ) ˆ .( .) (. ) ˆ .( .) .) ˆ . (YY Y Y ff f f −< < − 22 01 32 31 03512 2013 23 10 351 73 5 + 888 7 3588< dU No positive autocorrelation exists 3. dL < DW < dU T est is inconclusive 653 ANALYZING THE REGRESSION EQUATION TAble e.1 The distribution of durbin-Watson d 5 percent Significance points of dl and du k = 1 k = 2 k = 3 k = 4 k = 5 n d L dU dL dU dL dU dL dU dL dU 15 1.08 1.36 0.95 1.54 0.82 1.75 0.69 1.97 0.56 2.21 16 1.10 1.37 0.98 1.54 0.86 1.73 0.74 1.93 0.62 2.15 17 1.13 1.38 1.02 1.54 0.90 1.71 0.78 1.90 0.67 2.10 18 1.16 1.39 1.05 1.53 0.93 1.69 0.82 1.87 0.71 2.06 19 1.18 1.40 1.08 1.53 0.97 1.68 0.86 1.85 0.75 2.02 20 1.20 1.41 1.10 1.54 1.00 1.68 0.90 1.83 0.79 1.99 21 1.22 1.42 1.13 1.54 1.03 1.67 0.93 1.81 0.83 1.96 22 1.24 1.43 1.15 1.54 1.05 1.66 0.96 1.80 0.86 1.94 23 1.26 1.44 1.17 1.54 1.08 1.66 0.99 1.79 0.90 1.92 24 1.27 1.45 1.19 1.55 1.10 1.66 1.01 1.78 0.93 1.90 25 1.29 1.45 1.21 1.55 1.12 1.66 1.04 1.77 0.95 1.89 26 1.30 1.46 1.22 1.55 1.14 1.65 1.06 1.76 0.98 1.88 27 1.32 1.47 1.24 1.56 1.16 1.65 1.08 1.76 1.01 1.86 28 1.33 1.48 1.26 1.56 1.18 1.65 1.10 1.75 1.03 1.85 29 1.34 1.48 1.27 1.56 1.20 1.65 1.12 1.74 1.05 1.84 30 1.35 1.49 1.28 1.57 1.21 1.65 1.14 1.74 1.07 1.83 31 1.36 1.50 1.30 1.57 1.23 1.65 1.16 1.74 1.09 1.83 32 1.37 1.50 1.31 1.57 1.24 1.65 1.18 1.73 1.11 1.82 33 1.38 1.51 1.32 1.58 1.26 1.65 1.19 1.73 1.13 1.81 34 1.39 1.51 1.33 1.58 1.27 1.65 1.21 1.73 1.15 1.81 35 1.40 1.52 1.34 1.58 1.28 1.65 1.22 1.73 1.16 1.80 36 1.41 1.52 1.35 1.59 1.29 1.65 1.24 1.73 1.18 1.80 37 1.42 1.53 1.36 1.59 1.31 1.66 1.25 1.72 1.19 1.80 38 1.43 1.54 1.37 1.59 1.32 1.66 1.26 1.72 1.21 1.79 39 1.43 1.54 1.38 1.60 1.33 1.66 1.27 1.72 1.22 1.79 40 1.44 1.54 1.39 1.60 1.34 1.66 1.29 1.72 1.23 1.79 45 1.48 1.57 1.43 1.62 1.38 1.67 1.34 1.72 1.29 1.78 50 1.50 1.59 1.46 1.63 1.42 1.67 1.38 1.72 1.34 1.77 55 1.53 1.60 1.49 1.64 1.45 1.68 1.41 1.72 1.38 1.77 60 1.55 1.62 1.51 1.65 1.48 1.69 1.44 1.73 1.41 1.77 65 1.57 1.63 1.54 1.66 1.50 1.70 1.47 1.73 1.44 1.77 70 1.58 1.64 1.55 1.67 1.52 1.70 1.49 1.74 1.46 1.77 75 1.60 1.65 1.57 1.68 1.54 1.71 1.51 1.74 1.49 1.77 80 1.61 1.66 1.59 1.69 1.56 1.72 1.53 1.74 1.51 1.77 85 1.62 1.67 1.60 1.70 1.57 1.72 1.55 1.75 1.52 1.77 90 1.63 1.68 1.61 1.70 1.59 1.73 1.57 1.75 1.54 1.78 95 1.64 1.69 1.62 1.71 1.60 1.73 1.58 1.75 1.56 1.78 100 1.65 1.69 1.63 1.72 1.61 1.74 1.59 1.76 1.57 1.78 Note: DW values below dL indicate that positive autocorrelation exists; values above dU indicate that no positive autocorrelation exists. DW values between dL and dU are inconclusive. T o test for negative correlation use 4 − DW instead of DW. Source: S. Chatterjee and B. Price, Regression Analysis by Example, 3rd ed. (New Y ork, NY: John Wiley & Sons, 1999). Copyright © 1999 by John Wiley & Sons; reprinted with permission. 654 Appendix e For example, assume we are testing a regression equation with 18 observations and three vari- ables. Positive autocorrelation would be indicated if DW < 0.93, no autocorrelation if DW > 1.69, and the test would be inconclusive if 0.93 < DW < 1.69. The test for negative autocorrelation would be analogous, using 4 − DW instead of DW. A routine check of summary statistics for a regression equation should include the DW . A par- ticularly low or high DW would indicate a definite need for further analysis and model modification. However, it should be emphasized that even a perfect DW value (2.0) does not guarantee that auto- correlation does not exist. The DW only tests for first-order autocorrelation. If the interrelationship between the error terms is more complex, the DW might not pick it up. For this reason, it is also advis- able to check a residual plot for autocorrelation. Furthermore, as will be illustrated in subsequent sec- tions, the residual plot can also be used to provide important clues for improving the regression model. ■ The Implications of Autocorrelation The presence of a pattern in the residuals suggests a potential inadequacy in the regression equation. Specifically, autocorrelation may reflect one of the two following flaws: 1. The omission of significant explanatory variables in the regression equation. 2. The use of the linear regression method to describe a nonlinear relationship between the depen- dent and independent variables. If the autocorrelation is due to one of these factors, it is clear why autocorrelation is undesirable. These conditions indicate that a better model can be constructed, either by adding variables to the equation or by trying different functional relationships. However, even when this is not the case, an equation that exhibits autocorrelation is still undesirable, because the violation of the assumption that the error terms are randomly distributed will lead to distortions. 1 For this reason, as a last resort, transformations designed to remove the autocorrelation should be considered. T o summarize, the DW and residual plot should be checked for autocorrelation. If residuals are found to be correlated, the following steps should be taken: 1. Try to find any significant variables that may have been omitted from the equation. 2. If all feasible variables have been tried and autocorrelation still exists, experiment to see whether alternative functional forms (other than the linear form assumed in the regression procedure) are more appropriate. 3. If both of the preceding steps are unsuccessful, transformations to remove autocorrelation might be tried. 1 If autocorrelation exists, the standard regression approach, which is called ordinary least squares (OLS), will still yield unbiased estimates (i.e., estimates that on average will equal the population parameters). However, the estimates will no longer be efficient (i.e., they will not be the minimum variance estimates). Even worse, the standard error estimates of the regression coefficients and the equation as a whole may be severely understated. Consequently, the true confidence interval may be much wider than suggested, and the regression equation may be too imprecise to be used for forecasting. 655 ANALYZING THE REGRESSION EQUATION The fi rst of these steps will be illustrated by an example in the next section. Methods to address the second two steps are discussed in the addendum to this appendix. ■ Missing Variables and Time Trend A pattern in the residual plot (or the presence of autocorrelation) can be viewed as an indica- tion that signifi cant explanatory variables are missing from the equation. For example, Figure E.2 shows the residual plot for the simple regression model of the average December hog futures price during July–November as a function of per capita June–November hog slaughter. Note the obvious nonrandom distribution of the residuals: There seems to be a defi nite trending pattern in the residu- als with large negative values predominating in the earlier years and large positive values predomi- nating in the later years. Given this strong trending pattern in the residuals, we add a time trend as one of the explanatory variables. A time trend is simply a set of successive integers. Normally, the fi rst observation would be assigned a value of 1, the second a value of 2, and so on. However, since the regression model is linear, any set of consecutive integers would serve equally well. It is not surprising that the fi tted values of the original equation tend to be too high in the earlier years and too low in the later years since our model used nominal rather than defl ated prices. The reader may well wonder why we didn’t fi rst change the model by using defl ated prices instead of adding a time trend. In fact, this alternative approach is entirley reasonable as the fi rst change to try, FIGURE  E.2 Standardized Residuals for Average Price of December Hog Futures (July–November) vs. June–November Hog Slaughter Standardized Residuals for Average Price of December Hog Futures −2.0 −1.5 −1.0 −0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 656 Appendix e and we did run this model (not shown), but the results were substantially inferior to the model that added a time trend. Table E.2 compares the summary statistics of this two-independent-variable regression equation with those of the original one-independent-variable model. Note the dramatic improvement in all the summary statistics and the significance of the time trend as reflected by its t statistic. In fact, the time trend is statistically even more significant in explaining hog prices than hog slaughter! In addition, the strong trend evident in the residual plot for the original simple regression (Figure E.2) has been eliminated in the residual plot for the new equation (Figure E.3). Although the trend in the residuals has been eliminated, Figure E.3 still exhibits a non-random pattern. Specifically, the residuals now conform to a broad “U” pattern, with positive residuals predominating in the early and late years and negative residuals predominating in the middle years. The existence of this pattern suggests other significant variables are still missing from the equation. Next we add per capita broiler slaughter to the model, since poultry is an important competi- tive meat to pork. Table E.3 compares the key statistics for this new equation (Model 3) with the corresponding values for the first two models. As can be seen, the addition of poultry slaughter provides a large improvement in all the key statistics. For example, the corrected R2 jumps from 0.66 in Model 2 to 0.82 in Model 3. Moreover, not only is the t statistic for broiler slaughter highly significant but the addition of this variable also increases the t statistics for the other explanantory variables (hog slaughter and trend). The addition of broiler slaughter to the equation also eliminates the pattern in the residuals. As can be seen in Figure E.4, which shows the residual plot corresponding to Model 3, the scatter of residuals now seems random. Achieving a random residual plot doesn’t necessarily mean the model is complete. It may well be possible to further improve the model by adding other variables. Model 4 in Table E.3 illustrates TAble e.2 Regression Summary Statistics for Hog-price-Forecasting Models Statistic Model 1: Hog price vs. per Capita Hog Slaughter Model 2: Hog price vs. per Capita Hog Slaughter and Trend R2 0.21 0.66 CR2 0.20 0.64 SER 13.95 9.30 %SER 27.2 18.16 F 11.72 40.62 t-stat (constant) 5.19 4.57 t-stat (hog slaughter) –3.42 –3.12 t-stat (trend) NA 7.41 t-stat (broiler slaughter) NA NA t-stat (cattle slaughter) NA NA 657 ANALYZING THE REGRESSION EQUATION FIGURE  E.3 Standardized Residuals for Average Price of December Hog Futures (July– November) vs. June–November Hog Slaughter, and Trend −3.0 −2.5 −2.0 −1.5 −1.0 −0.5 0.0 0.5 1.0 1.5 2.0 2.5 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 TAble e.3 Regression Summary Statistics for Hog-price-Forecasting Models Statistic Model 1: Hog price vs. per Capita Hog Slaughter Model 2: Hog price vs. per Capita Hog Slaughter and Trend Model 3: Hog price vs. per Capita Hog Slaughter, broiler Slaughter, and Trend Model 4: Hog price vs. per Capita Hog Slaughter, broiler Slaughter, Cattle Slaughter, and Trend R 2 0.21 0.66 0.84 0.85 CR 2 0.20 0.64 0.82 0.84 SER 13.95 9.30 6.53 6.24 %SER 27.2 18.16 12.76 12.18 F 11.72 40.62 69.51 58.40 t -stat (constant) 5.19 4.57 8.45 6.02 t -stat (hog slaughter) –3.42 –3.12 –4.39 –5.11 t -stat (trend) NA 7.41 10.29 5.88 t -stat (broiler slaughter) NA NA –6.64 –7.23 t -stat (cattle slaughter) NA NA NA –2.22 658APPENDIX E FIGURE  E.4 Standardized Residuals for Average Price of December Hog Futures (July– November) vs. June–November Hog Slaughter, Broiler Slaughter, and Trend −3.0 −2.0 −1.0 0.0 1.0 2.0 3.0 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 one such attempt: adding per capita cattle slaughter to the model on the premise that beef is another competitive meat to pork. The t statistic for cattle slaughter is statistically signifi cant and adding this variable modestly increases the corrected R 2 and lowers the SER. ■ Dummy Variables In Appendix A we derived a regression equation for forecasting June–November hog slaughter from the prior December–May pig crop. Consider what happens when we attempt to make the equation more general by forecasting hog slaughter during a six-month period from the pig crop of the previ- ous six-month period. In this case, half the observations are those of the original equation, while the other half relate December–May slaughter to the June–November pig crop. Figure E.5 illustrates the residual plot for this equation. W e have used two diff erent symbols to distinguish between the residuals for June–November slaughter and the residuals for December–May slaughter. Note the striking pattern of the predominance of positive residuals for June–November slaughter and nega- tive residuals for December–May slaughter. As Figure E.5 dramatically indicates, our equation is missing some important information: the seasonal period of the slaughter forecast. Clearly, we want our equation to distinguish between the two periods. In other words, it is necessary to include a seasonal indicator. 659 ANALYZING THE REGRESSION EQUATION A simple method for handling such a situation would be to add a dummy variable to the equation, which has a value of 1 for one season and a value of 0 for the other season. The regression equation adding a dummy variable could be written as HS ab PC cS=+ + where HS = hog slaughter PC = pig crop S = dummy variable, which equals 0 during December–May and 1 during June–November The dummy variable can be thought of as a switch that is set to off (0) during the base period (December–May) and on (1) during June–November. The dummy variable will have the eff ect of shifting the intercept by an amount c for the June–November observations. Note that this adjustment will be exactly equivalent to fi nding two separate equations with the same slope, one for each period. That is, HS = a + bPC + cS for all periods is equivalent to: HS ab PC HS ab PC =+ =+ 1 2 forD ecember-Ma ys laughte r forJ une-November s slaughte r where a 2 = a 1 + c FIGURE  E.5 Standardized Residuals for Hog Slaughter vs. Previous Six-Month Pig Crop −2.0 −1.5 −1.0 −0.5 0.0 0.5 1.0 1.5 2.0 2.5 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 December-May HS June-November HS 660 Appendix e Typically, most users of regression analysis will only employ a dummy variable to shift the inter- cept, while the slope is assumed to remain constant from period to period. However, in most instances there is no reason to impose an a priori restriction that the slopes be equal in different periods. Rather, it seems preferable to begin by using dummy variables for both the intercept and the slopes. 2 Once this full version of dummy variables is run, we can check the t statistics to see which of the dummy variables are significant and then choose the appropriate model accordingly. Thus, in our example, we would begin with: HS ab PC cS dS PC=+ ++ ⋅⋅ where S = 0 during December–May S = 1 during June–November The form of the equation used will depend on which of the dummy variables proves significant. Some examples: 1. If neither c or d is significant, we would use: HS ab PC=+ 2. If only c is significant, we would use: HS ab PC cS=+ + 3. If both c and d are significant, we would use the full-version equation: HS ab PC cS dS PC=+ ++ ⋅⋅ 2 There are two important exceptions: (1) When one of the periods contains only a few observations, the slope estimate for this period might be unreliable, and it would be better to pool the data in terms of assuming a common slope coefficient for all observations. For example, consider an annual price-forecasting model with 15 observations, three of which coincided with a government program that distorted normal market behavior. In this case, we would definitely only use the dummy variable for the constant term (with the aforementioned three years having a dummy variable value equal to 1), thereby implicitly imposing the restriction of a common slope. The reason for this is that a slope estimate based on only three observations would not be very reliable. This example illustrates one of the advantages of using dummy variables, as opposed to separate equations for each set of observations. (2) When the number of all possible dummy variables is large compared with the number of observations, it may be desirable to conserve degrees of freedom by limiting the number of dummy variables. 661 ANALYZING THE REGRESSION EQUATION Note that in this last case, when both c and d are significant, the resulting equation is equivalent to the following two separate equations for each period:3 HS = a + bPC for December–May HS = (a + c) + (b + d)PC for June–November Why, then, do we not just run separate equations for each period? There are several reasons: 1. By pooling the data, we increase the number of degrees of freedom and add to the statistical reliability of the equation. 2. W e do not know beforehand which, if any, of the dummy variables will be significant. The single-equation approach will allow us to eliminate the dummy variables that appear insignifi- cant, thereby providing a better model. In contrast, the two-equation approach is equivalent to automatically assuming that all the dummy variables are significant. 3. In terms of the various tasks of checking alternative models, testing for significance, and fore- casting, it is more convenient to have a single equation that is applicable to all periods than a separate equation for each period. 4. As mentioned in footnote 2, there are times when it is definitely preferable to impose slope restrictions—an approach that requires the use of dummy variables. Since in our example of hog slaughter versus the prior six-month pig crop the dummy variable for the slope is statistically significant, we use the full form of the equation: HS ab PC cS dS PC=+ ++ ⋅⋅ Figure E.6 shows the residual plot for the regression equation that adds dummy variables for the slope and intercept. Note that the positive bias for June–November residuals and the negative bias for December–May residuals has been eliminated. The failure to include dummy variables when they are appropriate will bias the regression coef- ficient estimates. In Figure E.7 we provide a hypothetical example where the points associated with two different periods are best described by best-fit lines with different constant terms. Note how the slope of a single regression equation line without inclusion of dummy variables is biased by the failure to distinguish between the two periods. Although our example involved only two periods (one period other than the base period), the dummy variable approach can be extended to more period divisions. For example, if we were using a quarterly model, there would be one dummy variable for each quarter other than the base quarter. Ya bX cS cS cS dS Xe SX fS X=+ ++ ++ ⋅⋅ +⋅ ⋅+ ⋅⋅11 22 33 12 3 3 Although the intercept and slopes will be identical in the one- and two-equation versions, there is a minor technical difference between the two models. The single equation implicitly assumes a common variance for all periods, while the two-equation version allows for different variances in each period. This difference could theoretically affect the various tests of significance. 662APPENDIX E FIGURE  E.6 Standardized Residuals for Hog Slaughter vs. Previous Six-Month Pig Crop after Including Dummy Variables -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 December-May HS June-November HS FIGURE  E.7 Bias in Regression Line Due to Omission of Dummy Variables Fitted line without use of dummy variables Two equations implied by equation that includes a dummy variable for constant term 663 ANALYZING THE REGRESSION EQUATION where S1 = dummy variable for the first quarter S2 = dummy variable for the second quarter S3 = dummy variable for the third quarter Note that the number of dummy variables is always equal to one less than the number of periods, since the base period conditions, assumed to be the fourth quarter in our example, are captured by the original constant and regression coefficient.4 If there are two independent variables, the full-version equation would be Ya bX bX cS cS cS dS X dS Xe SX e =+ ++ ++ +⋅ ⋅ ⋅⋅ +⋅ ⋅++ 11 22 11 22 33 11 1 21 21 21 2 ⋅⋅ ⋅+ ⋅⋅ +⋅ ⋅SX fS Xf SX22 13 12 32 Note that: b values are regression coefficients for regular independent variables. c values are regression coefficients for dummy constants. d values are regression coefficients for dummy slope for the first period (S 1). e values are regression coefficients for dummy slope for the second period (S2). f values are regression coefficients for dummy slope for the third period (S3). As should be quite apparent, when the number of periods is increased, the number of dummy variables increases like rabbits. Since the researcher might wish to avoid beginning with an equa- tion that contains a large number of dummy variables, she might prefer to only include constant dummy variable terms in the starting equation and then experiment with the addition of selected slope dummy variable terms if she believes that her initial equation needs improvement. ■ Multicollinearity The reader may recall that the extension to the multiple regression model required the addi- tional assumption that the independent variables be linearly independent. Multicollinearity is a term used to describe the presence of significant correlation between two or more independent variables. T o see why multicollinearity is a problem, consider a hog-slaughter-forecasting model that includes both the pig crop during the prior six-month period and the number of market hogs at the start of the period as explanatory variables. In this case, the independent variables would be extremely highly correlated, that is, large market hog figures would coincide with large pig-crop numbers. As illustrated in Figure E.8, a three-dimensional representation is really unnecessary for this model, as 4 In fact, including a dummy variable for the base period would actually result in perfect multicollinearity—a totally undesirable situation (see next section). 664APPENDIX E demonstrated by the proximity of the points to a straight line. Actually, either the X 1, Y plane or the X 2, Y plane alone would have been adequate. The fi rst plane would be a two-dimensional representa- tion of the relationship between hog slaughter and the pig crop, and the second, a two-dimensional representation of the relationship between hog slaughter and market hogs. In eff ect, the inclusion of both the pig crop and market hogs forces the use of a three-dimensional model to represent a relation- ship that can be adequately described by two dimensions. The problem lies not in the fact that multicollinearity implies the inclusion of superfl uous information, but rather that this redundancy can severely aff ect the regression equation’s reli- ability. Multicollinearity is a perfect example of the phrase “more is less.” As can be seen in Figure E.8 , when multicollinearity is present, there may be very divergent planes that closely approxi- mate the fi t of points. For any given set of observations, the regression procedure will choose one plane that best fi ts the observations. However, the real problem in multicollinearity lies in the fact that if the observations were only slightly altered, a totally diff erent plane might be chosen as the best fi t. Thus, if multicollinearity exists, the regression coeffi cients are no longer reliable indicators of how the dependent variable will change when each of the independent variables is changed (while all the other independent variables are held constant). This fact will be refl ected by high standard errors, and hence low t statistics, for the regression coeffi cients of highly cor- related explanatory variables. FIGURE  E.8 Multicollinearity Source: Adapted from T . H. W onnacott and R. J. W onnacott, Econometrics , John Wiley & Sons, New Y ork, 1980. Y = hog slaughter X1 = pig crop X2 = market hogs 665 ANALYZING THE REGRESSION EQUATION What about the reliability of the equation in forecasting? If the values of the independent variables for the forecast period lie in the neighborhood of past observations, then the multicollinear model can still provide adequate forecasts. This situation describes the preceding example, since presumably the pig crop and market hogs will continue to remain highly correlated. In other circumstances, however, if the two correlated independent variables cease to be correlated in the future, then the forecast provided by the multicollinear equation could be distorted because the model is only valid for points in the neighborhood of past observations. At other locations, there is no historical evidence to provide any clues regarding the expected relationship between the variables. In geometric terms, all planes passing through a line provide accurate forecasts in the vicinity of the line, but drastically different projections at points removed from the line (Figure E.8). T o summarize, there are two major drawbacks to a multicollinear equation: 1. The regression coefficients lose their meaning (i.e., are no longer statistically reliable). 2. If the equation is used for forecasts in which the independent variables do not lie in the neigh- borhood of past observations, the projection could be severely distorted. Clearly, then, it is always desirable to avoid multicollinearity. The presence of multicollinearity can be detected in a number of ways: 1. Check the regression coefficients. The regression coefficients of an equation can provide a number of clues indicating that multicollinearity is present: a. Low t statistics for coefficients that were expected to be highly significant. b. In more extreme cases, a regression coefficient sign that may actually be counter to theoreti- cal expectations. c. Large changes in the coefficient values when variables are added or deleted from the equation. d. Large changes in coefficient values when data points are added or deleted from the equation. Any of these patterns would suggest that the independent variables should be examined for signs of correlation. 2. Compare the independent variables. Sometimes common sense will dictate when the independent variables are likely to be correlated. By being aware of the problem, one can often avoid multicollinearity by carefully selecting the independent variables. For example, if the researcher thought that gross national product (GNP) and disposable income might help explain the variation of the dependent variable, she would use either one, or try both successively, but she would not include them in the same equation simultaneously. Beyond intuition, one can check for correlation between the independent variables statistically. High absolute values of the correlation coefficients 5 between any two independent variables would indicate a potential 5 The correlation coefficient, denoted by the symbol r, reflects the degree of relationship between two variables and can range between −1 and +1. Values close to +1 indicate a strong positive relationship, while values close to −1 indicate a strong inverse relationship. If r is close to 0, it means that there is little, if any, correlation between the two variables. The square of the correlation coefficient is equal to the r 2 of the simple regression equation in which one of the variables is a dependent variable and the other an independent variable. 666 Appendix e multicollinearity problem. The correlation matrix—an output feature in some software pack- ages—offers a summary array of all the paired correlation values. What should be done if multicollinearity is discovered in an equation? One solution is simply to delete one of the correlated independent variables. ■ Addendum: Advanced Topics Transformations to Achieve linearity6 Perhaps the most basic assumption in a regression analysis is that the relationship between the dependent and independent variables is approximately linear. If, in fact, the relationship is deci- sively nonlinear, the error terms might appear to be correlated. For example, consider what hap - pens when we try to fit a regression line to the scatter points in Figure E.9a. Forcing these points into a linear fit would result in the residual pattern illustrated in Figure E.9b, in which the residuals would tend to be positive at high and low values of the independent variable X and negative in the middle range of values. (In Figure E.9b, the standardized residuals are plotted against the indepen- dent variable not time.) Fortunately, many nonlinear relationships can be transformed into linear equations. For example, the scatter of points in Figure E.9a suggests a hyperbolic function, or an equation of the general form Ya b Xc=+ + This can be transformed into a linear relationship by setting X Xc′= + 1 then Ya bX=+ ′ In this form, the equation can be solved in straightforward fashion using ordinary least squares (OLS), the standard regression procedure. T o get a specific forecast for Y, one would merely plug in the value 1/(X + c) for X′. For example, if a = 2, b = 16, c = 4, and X = 4, the forecast for Y is 4. 6 Although still involving nothing more mathematically complex than algebra, the remainder of this appendix covers material that is somewhat more advanced. 667 ANALYZING THE REGRESSION EQUATION FIGURE  E.9 Distortion in Applying Linear Regression to Nonlinear Function Y X 0 (a) (b) Standardized residuals X Many other types of functions can be transformed into linear equations. Let us consider a few more examples: 1. Y = a + b 1 X + b 2 X 2 + b 3 X 3 Let X 1 = X ; X 2 = X 2; X 3 = X 3; then Y = a + b 1 X 1 + b 2 X 2 + b 3 X 3 This is a linear equation and OLS can be applied. Note that although the independent vari- ables are related, the relationship is nonlinear, so that the regression assumption regarding linear independence among the explanatory variables is not violated. 2. Y = ae bX Taking the natural logarithm of both sides: ln lnYa bX=+ Let Y ′ = ln Y ; a ′ = ln a ; then Ya bX′= ′+ This is a linear equation and OLS can be applied. Note that in this case, plugging a value for X into the derived regression equation will yield a forecast for ln Y . T o get a forecast for Y , it would be necessary to fi nd the antilog value. Figure E.10 illustrates the shapes of the function Y = ae bX for diff erent values of b. 668APPENDIX E FIGURE  E.10 Y = ae bX Source: S. Chatterjee and B. Price, Regression Analysis by Example, 3rd ed. (New Y ork, NY: John Wiley & Sons 1999). Copyright © 1999 by John Wiley & Sons; reprinted with permission. (b > 0) 1/b (a) x y ae 0 (b < 0) 1/|b| (b) x y a/e 0 3. Ya Xb=⋅ Taking logs of both sides: logl og logYa bX=+ Let Y ′ = log Y ; a ′ = log a ; X ′ = log X ; then Ya bX′= ′+ ′ This is a linear equation and OLS can be applied. Here we would plug the value for log X , not X , into the regression equation to get a forecast of log Y . T o get a forecast for Y , it would then be necessary to fi nd the antilog value. Figure E.11 illustrates the shape of the function Y = aX b for diff erent values of a and b . If a residual plot still refl ects autocorrelation after all feasible variables have been tried, the pos- sibility of nonlinearity should be considered. In the simple regression case, a scatter diagram can be constructed in order to check whether a linear assumption is warranted or whether another functional form is more appropriate, just as Figure E.9 a suggested the equation form Y = a + b/ ( X + c ). In a multiple regression, if nonlinearity is expected for one of the independent variables, a regres- sion could be run using only the other independent variables. The residuals of this equation would then be plotted against the unused independent variable. The presence of any nonlinearity would be apparent in the resulting scatter diagram. 669 ANALYZING THE REGRESSION EQUATION FIGURE  E.11 Y = aX b Source: S. Chatterjee and B. Price, Regression Analysis by Example , 3rd ed. (New Y ork, NY: John Wiley & Sons, 1999). Copyright © 1999 by John Wiley & Sons; reprinted with permission. (a, b, x all > 0) x a 1 0 b > 1 (a) b = 1 0 < b < 1 y (a, x > 0, b < 0) x a 1 0 (b) −1 < b < 0 b = −1 b < −1 y Transformation to Remove Autocorrelation The simplest assumption one can make about autocorrelation is that a current period’s error term will be equal to the previous period’s error term plus a random disturbance. This can be expressed as ee tt t=+ −1 υ , where υ t = a random disturbance term. Since Y t = α + βX t + e t and Y t −1 = α + βX t −1 + e t −1 , then YY XXtt tt t−= −+−−11 βυ() Let YY Ytt t * =− −1 and XX Xtt t * =− −1 ; then YXtt t ** =+βυ For a k -variable multiple regression equation, these steps would yield YX XXtt tk kt t ** **=+ ++ +ββ βυ11 22  Since by defi nition υ t is randomly distributed, OLS can now be applied to this equation. 670 Appendix e The preceding method, which is perhaps the most commonly used transformation for removing autocorrelation, is known as first differences. In effect, the first difference regression equation states that the change in Y will be linearly dependent on the change in X. Equations of this type will tend to have much lower R2 values. This is only to be expected, since forecasting the change from one period to the next is much more difficult than forecasting the level. Once again, consider the following daytrading price-forecasting model: Pa bPtt =+ −1 where Pt = closing price on day t Pt − 1 = closing price on day t − 1 Such an equation would have an extremely high R2 since it would give us a close approximation of the price level for a given day. However, it would be useless in forecasting the change in price from day to day. The model Pa bXtt ** =+ where PP Ptt t * =− −1 XX Xtt t * =− −1 in which Xt is some explanatory variable the value of which is known before day t, would be far pref- erable, even if its R2 value were low (e.g., R2 = 0.30). The first difference approach is easy to use, but it does involve an extreme simplifying assumption regarding the nature of the autocorrelation. A more realistic assumption would be eett t=+ −ρυ 1 where | ρ | < 1. Note that the larger the value of ρ, the more the error term in a given period will be dependent upon the previous period’s error term. A generalized transformation is analogous to the first difference transformation: YX e YX e tt t tt t =+ + =+ +−− − αβ αβ 11 1 If we multiply the equation for Yt − 1 by ρ ρρ αρ βρYX ett t−− −=+ +11 1 Thus, Yt − ρYt − 1 = α(1 − ρ) + β(Xt − ρXt − 1) + υt. Let YY Ytt t * =− −ρ 1 and XX Xtt t * =− −ρ 1. Then YXtt t ** ()=− ++αρ βυ1 . 671 ANALYZING THE REGRESSION EQUATION For a k-variable equation, these steps would yield YX XXtt kk tt ** **()=− ++ ++ +αρ ββ βυ1 11 22  Since by definition υ t is randomly distributed, OLS can once again be used. The only problem with this procedure is that we do not know the value of ρ. W e very briefly describe two approaches for estimating ρ. 1. The Hildreth-lu procedure. This procedure specifies a set of spaced values for ρ. If positive autocorrelation is assumed, these values might be 0, 0.1, 0.2, 0.3, 0.4, 0.5, 0.6, 0.7, 0.8, 0.9, 1.0. A regression is then run for the transformed equation: YX XXtt tk kt ** **()=− ++ ++αρ ββ β1 11 22  using each of the specified values. The procedure will select the equation that results in the low- est SER. If desired, the process can be repeated using a closer spacing of ρ values in the vicinity of the ρ selected in the initial step. 2. The Cochrane-Orcutt procedure. This iterative procedure estimates a ρ value from the residuals of the original equation, and a regression is then run on the transformed equation using this estimate of ρ. If the resulting equation still indicates autocorrelation, the process is repeated using the residuals of the new equation. ■ Heteroscedasticity One of the assumptions that justifies the use of ordinary least squares (OLS) is that the error terms are homoscedastistic, that is, they have an approximate constant variance. When this condition is not met, the problem is called heteroscedasticity. Figure E.12 illustrates a case of heteroscedasticity. Note that the relationship between the dependent and independent variables becomes increasingly variable as X increases, resulting in higher absolute residual values at higher values of X. The wider variability between the dependent and independent variables in a given region will make the resulting regression equation less reliable. Weighted least squares (WLS) is a method used to circumvent this problem. For the relationship depicted in Figure E.12, the WLS approach would give greater weight to the observations for lower values of X, since these offer a more precise indication of the location of the true regression line. Rather than describe the WLS procedure, suffice it to say that there is a simpler approach using a transformation that achieves exactly equivalent results. This transformation assumes that the standard deviation of the error terms is proportional to the independent variable. Specifically, σii kX= 672APPENDIX E where σ i = standard deviation of the error terms ( e i ). Starting with the standard regression equation YX eii i=+ +αβ we divide by X i , Y X a X e X i ii i i =+ + β The standard deviation of e i / X i . is equal to the standard deviation of e i divided by X i . Since the standard deviation of e i is σ i , which equals kX i , the standard deviation of e i /X i = k , a constant. Thus, this transformation removes the heteroscedasticity of the original equation. Now if we let ′= ′ = ′ = ′ = ′ =Y Y X X X e e Xi i i i i i i 1 αβ βα and then ′= ′+ ′′ + ′YX eii iαβ This equation can be solved by using OLS, yielding ′=+ ′Ya bXii where a is an estimator of β in the original equation and b is an estimator of α in the original equation. FIGURE  E.12 Heteroscedasticity Y X 0 (a) (b) Standardized residuals X 673 Appendix F I remember the rage I used to feel when a prediction went awry. I could have shouted at the subjects of my experiments, “Behave, damn you, behave as you ought!” Eventually I realized that the subjects were always right. It was I who was wrong. I had made a bad prediction. —Burrhus Frederic Skinner ■ Determining the Dependent Variable The title of this section might sound trivial. After all, the dependent variable is what we wish to fore- cast. However, in a price-forecasting equation, the selection of a dependent variable is by no means obvious. The following choices must be made: 1. Should the price be stated in nominal or deflated terms? 2. Should the price be based on cash or futures? Practical Considerations in Applying Regression Analysis 674 Appendix F 3. If the price is based on futures, should it be based on a nearest futures price series or a single contract? 4. Should the price represent the entire season or only a specified segment of the season? The answer to question 1 would typically be deflated prices, unless a trend variable is included in the equation, in which case nominal prices may be a better choice. If, however, the equation does not include a trend variable, then the use of nominal prices implicitly assumes that equivalent fundamental conditions in two widely spaced years should result in approximately equal price levels. Obviously, this assumption is wrong. All else being equal, inflation will result in considerably higher prices in the more recent year. The subject of adjusting prices for inflation is covered in greater detail in Chapter 25. The answers to questions 2 and 3 depend primarily on the particular price you wish to forecast. Although this consideration is also a factor in answering question 4, the choice of the time period should depend more heavily on the fundamental characteristics of the market. Of course, if the initial choice is inappropriate, the misjudgment will become apparent in analyzing the regression results. However, by giving some thought to the intrinsic market fundamentals before selecting the forecast period, it is possible to minimize unnecessary trial and error in the regression-analysis process. For example, in most agricultural markets, the statistical balance for a given season will have a far greater impact on price levels during the first half of the season than on price levels during the second half. This typical market behavioral pattern reflects the fact that by the second half of the season, the prevail- ing fundamental situation is well-defined and frequently largely discounted. More often than not, major price shifts during the latter part of a season reflect developments affecting new crop expectations (e.g., drought and freeze). Consequently, for a fundamental model that does not include new crop expecta- tions as an explanatory variable, it would generally make more sense to select a price forecast period that approximates the first half of the season rather than the full season. This approach does not mean that we ignore the other six months. Rather, the implication is that it will be necessary to develop other models to forecast prices in those months. For example, the latter months of a season might be grouped with the early months of the following season in a model that employed new-crop statistics to forecast prices. In some markets, intrinsic fundamental considerations will not dictate a specific observation period. In such cases, the choice will involve only the time frame of the individual observations (e.g., annual, semiannual, quarterly, monthly). 1 Here a general rule might apply: start with the longest period (i.e., annual or semiannual), and if the regression model is satisfactory, work toward a shorter period. Although the shortest time frame projection is most useful for trading purposes, the difficulty of forecasting is inversely proportional to the length of the time period. Also, the shorter the time frame, the more likely the problem of autocorrelation. For example, in a monthly model there is a high probability that a high positive residual in one month will be followed by a positive residual in the next month. Thus, for monthly and even quarterly models, transformations to remove autocor- relation may be necessary (e.g., first differences). 1 The choice of the length of the period must also be made for markets in which the structure of the model depends on the forecast period. For example, a model based solely on old-crop statistics (i.e., a model that does not incorporate new-crop expectations) could use a six-month forecast period (coinciding with the first half of the season) or it could be applied to two separate three-month periods. 675 PRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS ■ Selecting the Independent Variables General Considerations There is more to selecting the independent variables than choosing the factors that intuitively appear to be good candidates for explanatory variables. Perhaps the pivotal question to be considered is whether the regression equation is intended for explaining or forecasting the dependent variable. Sometimes, a regression equation is only intended as an explanatory model. For example, a wheat producer might be interested in determining the relationship between yield and the quantity of fertil- izer applied. In this case, his goal is not to forecast yield, a projection that will also depend heavily on other factors, such as weather conditions, but to understand the implications of various management choices. Furthermore, he need not worry about estimating the independent variable (quantity of fertilizer), since it is entirely under his control. In contrast, most applications of regression analysis in the futures markets will be concerned with forecasting. If an equation is intended primarily for prediction, it is critical to choose explanatory variables that can be determined with relative reliability. For example, if we were to construct a cop- per price-forecasting model in which the concurrent gross domestic product (GDP) was an impor- tant input, the equation would be useless if GDP levels were no more predictable than copper prices, even if R 2 = 1.00. Thus, in selecting independent variables, the researcher should keep in mind the precision with which these variables can be estimated before the forecast period. If they prove statistically significant, lagged variables are the ideal choice for explanatory variables. A lagged variable is one whose value is determined during a period before the period for the corre- sponding dependent variable. For example, the average GDP during the prior six months would be a lagged variable. Thus, even if the lagged value of GDP were substantially less significant in explaining copper prices than the concurrent value, it might still be a preferable choice. Unfortunately, the analyst will rarely be lucky enough to construct a regression equation that uses only lagged variables. Concurrent variables that can be forecast with reasonable accuracy provide an acceptable alternative. In fact, some variables, such as population, can be forecast with such accuracy that they are similar to lagged variables. Other variables can be projected within a reasonable range. For example, in the hog model, hog slaughter is much easier to project than hog prices, since it depends on lagged variables (e.g., prior pig crop, market hogs at start of period). In short, the essential question to consider is whether the values for a potential explanatory variable are known before the forecast period or are at least substantially easier to project than the values for the dependent variable. Another criterion in selecting the independent variables is that they should not be correlated, in order to avoid the problem of multicollinearity. If several correlated variables seem to be good choices for explanatory variables, they should be tested individually. ■ Should the Preforecast Period Price Be Included? An important question to be decided in a price-forecasting equation is whether to include the pre- forecast period (PFP) price as an explanatory variable. One reason for including the PFP price is that 676 Appendix F it is usually an important factor. For example, consider the following two situations in which the PFP price was not taken into account by the model: Situation A Projected average price for forecast period = 60¢; price on day before forecast period = 40¢. Situation B Projected average price for forecast period = 60¢; price on day before forecast period = 80¢. W ould it be reasonable to expect the same price level in both cases? Definitely not! Some textbook theories notwithstanding, in the real world, prices do not adjust instantaneously to changing funda- mentals. In situation A, a major uptrend would be required for prices merely to reach the forecasted equilibrium level. Such an advance will not occur overnight. Furthermore, it is not sufficient for prices to reach 60¢ in order to achieve the projected 60¢ average. Prices would have to go far beyond .60¢ in order to make up for all the days of sub-60¢ prices during the early part of the period. Simi- larly, in situation B, prices would have to go far below 60¢ to achieve a 60¢ average. In practice, prices may well reach 60¢ in both situations A and B, but the average price is likely to be well below 60¢ in situation A and well above 60¢ in situation B. The preceding example illustrates that the PFP price may often be an important explanatory variable. Then why not always include it in the model? Ironically, the answer is that it may sometimes be too good in explaining price behavior. In other words, if the PFP price swamps the effect of the other independent variables, the price projection will primarily reflect current price levels. Thus, if the PFP price accounts for a large percentage of the R 2, the model may be good at explaining prices, but will be ineffective at predicting price changes, which after all is the primary goal in price projec- tion. However, in some cases, the other independent variables may explain a major portion of total variation, even when the PFP price is included. In these situations, including the PFP price may help eliminate a significant portion of the unexplained variation that would exist if it were omitted, while still yielding a model that is capable of predicting price changes. The decision of whether to include the PFP price as an independent variable must be made empir- ically on a case-by-case basis. A reasonable procedure would be to use a stepwise regression approach (see the section titled “Stepwise Regression” in this appendix) both with and without including the PFP price on the list of independent variables. Although the model that includes the PFP price will always exhibit better summary statistics, it should only be chosen if the effect of the PFP price is sig- nificant without being overwhelming. ■ Choosing the Length of the Survey Period Ideally, it is desirable to use the longest feasible survey period, since more data points will increase the accuracy of the regression statistics. However, in the real world, there is a tradeoff between the length of the survey period and the relevance of the earliest data points to current conditions. For example, it would be ludicrous to include data before 1973 in a fundamental forecasting model for currency rates, since exchange rates were fixed before that point. 677 PRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS As the preceding example illustrates, fundamental considerations will often limit the number of observations that can be included without distorting the model. Basically, the longest survey period consistent with current market conditions should be used. Scatter diagrams for the dependent vari- able plotted against each of the explanatory variables may be helpful in making this decision. It will often be necessary to run several regressions for periods of different lengths in order to decide on the optimum number of observations to be included. Occasionally, it may be possible to include earlier nonrepresentative years through the use of dummy variables. ■ Sources of Forecast Error In order to build the best model as well as understand its potential limitations, it is important to be aware of the potential sources of forecast error. These include: 1. Random errors for true population regression. Any regression equation is only a simpli- fication that cannot include all possible influences on the dependent variable. Thus, even if we knew the true population regression equation, which we never do, and the explanatory variables were precisely determined, this source of error would still exist. In other words, this type of error can never be avoided. 2. Random errors in the estimated regression coefficients. Since the data used to run a regression represents only a sample from the population, the estimated regression coefficients will deviate from the true population values. 3. Regression equation may be misspecified. The regression model may not represent the true underlying model because of the following reasons: a. Omission of significant variables; b. True model is nonlinear or wrong functional form is assumed in a linear transformation; c. Error terms are autocorrelated 2. 4. errors in independent variable values. Often, the independent variables must themselves be projected, thereby introducing another tier of potential forecasting error. Sometimes, unexpected events (e.g., droughts, freezes, export embargoes) can result in the actual values of the explanatory variables deviating sharply from the estimated levels. In these situations, the regression projections can prove wide of the mark, even when the model would have provided an accurate forecast if the input had been correct. 5. data errors. Lagged variable data and the data used to forecast the independent variables may be inaccurate because of sampling or compilation errors. 6. Structural changes. Structural change accounts for perhaps the most serious vulnerability of the regression forecast. Regression analysis is a static approach to a dynamic process; that is, the structure and behavior of a market are constantly changing. Thus, even if a model offers a good rep- resentation of the past, it may fail to describe a market adequately in the future. Any major structural change in a market can lead to large forecast errors. 2 Of course, conditions 3(a) and 3(b) could also result in autocorrelation; the implication here is autocorrelation that exists without the presence of 3(a) and 3(b). 678 Appendix F As an example, consider the plight of the unfortunate fundamental analyst using historical regres- sions to forecast prices for the 1981–1982 period, when the unprecedented combination of severe recession and high interest rates resulted in a dramatic downward shift in demand for many com- modities. As a result, prices in a broad spectrum of markets declined to well below the levels that might have been anticipated on the basis of fundamental models that worked well in prior years, but did not include these effects. As a more recent example, the late 2008 financial crisis had such a huge depressant impact on commodity prices across the board that virtually any viable fundamental model for any commodity market would have been likely to yield price forecasts for the late 2008, early 2009 period that were far too high. The preceding examples illustrated structural changes simultaneously affecting a broad range of markets. A structural change can also be confined to a single market. One example of such a change was the dramatic shift in corn usage for ethanol production. Corn use for fuel went from one-tenth the feed-use level before 2000 to greater than feed usage by 2010. It is important to realize the standard error measures in regression analysis only account for the first two sources of error just listed. Perhaps even more sobering is the fact that with the exception of a misspecified equation (3), all these sources or error are beyond the control of the analyst. However, the potential variability attributable to errors in estimating the independent variables (4) can at least be defined by allowing for a range of possibilities. For example, in addition to generating a price fore- cast based on a set of best estimates for the explanatory variables, projections can also be derived for sets of bearish and bullish assumptions. In this way, it is at least possible to gauge the potential impact of inaccurate estimates for the independent variables. Furthermore, some solace can be drawn from the fact that the various types of errors listed here are not necessarily cumulative; that is, they may partly offset each other. As a final word, it should be emphasized that this list of potential errors is not intended to discour- age the potential user of regression analysis, but rather to instill a sense of realism in interpreting regression results. ■ Simulation As the previous section demonstrated, comparisons between the fitted values of the regression equation and actual observations may severely understate potential forecasting errors. The process of determining how forecasts based on the given model would have compared with reality is called simulation, which is an extremely useful technique for testing a model under near real-life conditions. Simulation should only be undertaken once the choice of a model has been finalized, or at least reduced to a small number of pos- sibilities. Ideally, the simulation period should be long enough to include a variety of conditions (e.g., at least one bull, one bear, and one neutral market in a price-forecasting equation). For example, assume it is 2015 and we have decided the past 20 years of data are relevant to the current market structure. Given the constraint that each forecast must be based on at least 10 years of data, a 10-year simulation of a calendar-year forecast could be constructed as follows: 1. Using only data available on January 1, 2005, derive a regression equation for the same model for 1995 through 2004. 679 PRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS 2. Using only data available on January 1, 2005, estimate the independent variables. 3. Plug these values into the 1995–2004 regression equation to obtain a forecast for 2005. 4. Repeat an analogous procedure for each subsequent year (2006–2014). 5. Compare simulations to actual values and calculate the root mean square (defined later in this section). For a quarterly model, the simulation procedure would be analogous. However, with a quarterly model, very little would be lost by revising the regression equation only once every four times (each year) in order to reduce the amount of computation. It may be instructive to compare the differences between the simulation forecasts and actual values with the residuals of the current regression equation. Of course, the former will almost invariably be higher, since simulation results are based on forecasts, while the regression equation is a best fit of past values. A measure that may be useful in comparing the simulation results of different models is the root mean square (RMS): rms = −() = ∑ YY N t F t A t N 2 1 where Yt F = forecasted value of Y for period t Yt A = actual value of Y for period t N = number of simulated observations Note that the RMS calculation is analogous to the formula for the standard error of the regres- sion (SER) (except for the number of degrees of freedom) and reflects the same underlying meaning. ■ Stepwise Regression Ideally, having selected a list of explanatory variables, regression equations would be generated for each possible equation form. For example, given a dependent variable Y and three independent vari- ables X 1, X2, and X3 there would be eight possible equations: 1. Y vs. X1, X2, and X3 (all independent variables included) 2. Y vs. X1, X2 3. Y vs. X1, X3 4. Y vs. X2, X3 5. Y vs. X1 6. Y vs. X2 7. Y vs. X3 8. YY= (no independent variables included) 680 Appendix F Such a procedure, however, is not very efficient. The total number of possible equations doubles with the addition of each independent variable (e.g., 16 for four variables, 32 for five). Stepwise regression is a highly useful and efficient procedure for isolating and providing summary results for the most statistically interesting equations. There are two basic types of stepwise regression: 1. Forward selection. The program selects the single independent variable that provides the highest r2 value to form the first equation. Explanatory variables are then added one at a time to form subsequent equations, with the choice depending on which variable will result in the highest R 2 equation. The program terminates with an equation that includes all of the specified explanatory variables. 2. Backward elimination. The program begins by listing the equation that includes all the speci- fied independent variables. The program then deletes the variable with the lowest t value to form the second equation. Subsequent equations are formed by continuing to delete variables, one at a time, with the elimination decision dependent on which remaining variable has the lowest t value. The two methods will not necessarily yield the same subset of equations. Overall, the backward elimination process is preferable, particularly if the PFP price is one of the explanatory variables. In the forward selection process, the PFP price will usually be chosen first, since it is likely to explain more variation in the dependent variable than any other single variable. However, once more explana- tory variables are added, the significance of the PFP price may drop sharply, as other variables in combination explain a portion of the variation originally attributed to the PFP price. Thus, in the backward elimination process, at some stage the PFP price might have a lower t value than any of the remaining variables. Although the PFP price is effective as an explanatory variable, its inclusion may yield equations that are less useful for forecasting purposes. With the forward selection process, there is a higher probability that all of the chosen equations will include the PFP price, since the first variable chosen remains in all subsequent equations. Once the stepwise regression results have been analyzed, detail should be generated for the equa- tions that appear to be the most promising. 3 Minimum detail would include a listing of actual observa- tions, predicted values, and residuals. Residual plots should also be constructed for these equations and modification implemented as suggested by these plots. ■ Sample Step-by-Step Regression Procedure There is no single right order in which to perform the various elements of regression analysis. The following order merely represents one suggested sequence: 1. Determine the dependent variable. 2. List all possible choices for explanatory variables. 3 The summary statistics would not be the only criteria for making this choice. For example, an equation that did not include the PFP price as a dependent variable might be preferable to one that did if the summary statistics were only modestly less favorable. 681 PRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS 3. Choose a subset of these (usually no more than five), taking care to avoid selecting correlated independent variables. Scatter diagrams can be used as an aid in this selection process. 4. Choose the length of the survey period. Scatter diagrams can also be used as an aid in this step. 5. Apply a stepwise regression program to the selected variables. 6. Analyze the results by examining the various key statistics: t values, SER, CR2, F, and DW. If there is any evidence of multicollinearity, check out this possibility and rerun stepwise regression with a different set of variables if necessary. 7. Generate detail and construct residual plots for the most promising equations in the stepwise regression run. 8. Check residual plots for outliers. Decide whether outliers should be deleted. 9. Check residual plots for autocorrelation. 10. If outliers or autocorrelation exist, try to correct through the addition of variables or transfor- mations to achieve linearity. 11. If autocorrelation is still a problem, try a transformation to eliminate autocorrelation (e.g., first differences). 12. Check the correlation matrix or R 2 values for various combinations of equations based on the explanatory variables in order to verify that multicollinearity is not a problem. 13. Repeat steps 3–12 for other selections of explanatory variables. 14. Optional: After narrowing the number of possible models to three or less, generate simulations. ■ Summary Regression analysis is an extremely efficient and powerful tool; it is a virtual necessity for fundamen- tal analysis. The foregoing appendices were intended to provide the necessary background to inter- pret and analyze the results available on standard regression software packages. Regression analysis provides the means for precisely answering the question: What is the approximate equilibrium level, given the specified conditions and assumptions? The italicized qualification is essential. There is a danger of viewing regression results with great rigidity because of the scientific manner in which they are derived. This would be a mistake. As explained in the section “Sources of Forecast Error,” a variety of factors are capable of causing the regression projection to be inaccurate. Therefore, the trader must always be open to the possibility the regression forecast might be wrong. However, given such a sense of realistic awareness, fundamental regression models can provide valuable insight into a market’s current state and its potential future direction. 683 REFERENCES AND RECOMMENDED READINGS W onnacott, R. J., and T . H. W onnacott. Econometrics (New Y ork, NY: John Wiley & Sons, 1980). This is an extraordinarily lucid treatment of an abstruse subject and is an excellent choice for readers interested in a more in-depth understanding of regression analysis. One of the outstanding features of this book is that it is divided into two separate parts, which cover essentially the same material but on different levels of difficulty. As a result, Part I, which provides a comprehensive and insightful overview of the key concepts of regression analysis, is fully accessible to a reader with only limited mathematical background. Chatterjee, Samprit, and Ali S. Hadi. Regression Analysis by Example, 5th edition (New Delhi: Wiley India, 2012). This may be the best book available on the practical application of regression analysis. As promised in the title, the essential concepts are demonstrated by example. Perhaps the book’s best feature is its thorough exposition of the use and interpretation of residual plots, an extremely effective yet easy-to-apply method for analyzing regression results. Pindyck, R. S., and D. L. Rubinfeld. Econometric Models and Econometric Forecasts, 4th edition (New Y ork, NY: McGraw-Hill/Irwin, 1997). The first of the three sections in this book covers single-equation regression analysis. (The other two sections are Multi-Equation Simulation Models and Time Series Models.) This book offers a clear exposition of theoretical concepts, as well as many useful insights into the practical application of regression analysis. Readers with limited mathematical background will find the presentation more difficult than Part I of W onnacott and W onnacott. Makridakis, S., and S. C. Wheelwright. Forecasting Methods and Applications, 3rd edition (New Y ork, NY: John Wiley & Sons, 1997). This text provides a broad overview of forecasting techniques, with regression analysis accounting for one of six sections. The presentation is aimed at an audience interested in practical applications rather than theory. This book is clearly written, covers a wide range of topics, and provides a plethora of examples to illustrate the discussion. Freund, J. E., and F. J. Williams. Elementary Business Statistics: The Modern Approach, 6th sub edition (Upper Saddle River, NJ: Prentice Hall College Div ., 1992). This book provides a good general overview of elementary statistics for the nonmathematical reader. The text is clearly written and replete with examples. Kimble, G. A. How to Use (and Misuse) Statistics (Englewood Cliffs, NJ: Prentice-Hall, 1978). This introduction to elementary statistics is written with style and a sense of humor. Although it may be hard to believe, this is one statistics book that can actually be read for entertainment value alone. 685 Achievement, elements of, 586–587 Acreage figures, 355 Action, taking, 583 Actual contract series, 279–280 Adjusted R 2, 642 Adjusted rate mortgages (ARMs), 423, 424 Advice, seeking, 580 Agricultural markets. See also U.S. Department of Agriculture (USDA) acreage figures, 355 cattle (see Cattle) corn (see Corn) cotton (see Cotton) grain prices and, 351 hogs (see Hog production) production costs and, 351 seasonal considerations and, 356 wheat (see Wheat market) AMR. See Average maximum retracement (AMR) Analogous season method, 374 Analysis of regression equation: autocorrelation and (see Autocorrelation) dummy variables and, 659–663 Durbin-Watson statistic, as measure of autocorrelation, 652–654 heteroscedasticity and, 672–673 missing variables, time trend and, 655–658 multicollinearity and, 663–666 outliers and, 649–673 residual plot, 650–651 topics, advanced, 666–671 a priori restriction, 660 Arbitrage, pure, 530 ARMs. See Adjusted rate mortgages (ARMs) At-of-the-money call, buying, 555 At-of-the-money options definition of, 480 delta values and, 485 ATR. See Average true range (ATR) Autocorrelation: definition of, 651 Durbin-Watson statistic as measure of, 652–654 implications of, 654–655 transformations to remove, 670–671 Availability of substitutes, 361 Average maximum retracement (AMR), 331 Average parameter set performance, 311 Average percentage method, seasonal index, 391–394 Average return, 323, 326 Average true range (ATR), 262, 463 Backward elimination, stepwise regression, 682 Bad luck insurance, 257 Balanced spread, 455 Balance table, 373–374 Bar charts, 35–39 Bear call money spread, 535–538 case 1: short call with lower strike price/long call with higher strike price, 535–536 case 2: short call with lower strike price/long call with higher strike price, 537–538 Index 686 Index Bullishness: bullish put trade, 477 fundamentals and, 349 market response analysis and, 404, 405 Bullish T exas option hedge, 517–519 Bull market: flags, pennants and, 131–132 intramarket spreads and, 460 run days in, 118 spread trades and, 443 thrust days and, 116, 117 Bull put money spread: case 1: long put with lower strike price/short put with higher strike price, 538–539 case 2: long put with lower strike price/short put with higher strike price, 540 “Bull trap”: about, 205–211 confirmation conditions, 208, 209 Butterfly spread, 542 Buy and sell signals, trend-following systems and, 252 Buy hedge, cotton mill, 12–13 Call options, 477 Calmar ratio, 331 Calmness, 585 Cancel if close order. See CIC (cancel if close) order. Candlestick charts, 43–44 “real body,” 43, 44 “shadows,” 43 Carrying-charge markets, 282 Carrying charges, limited-risk spread and, 446, 447–448 Carryover stocks, 355, 432–433 Case-Shiller Home Price Index, 423, 424 Cash settlement process, 4 Cash versus futures price seasonality, 389–390 Cattle: cattle-on-feed numbers, 352–354 futures, 348, 385 inflation and, 385 production loss, 351 spread trades and, 444–445 Central limit theorem, 609–612 Change of market opinion, 204 Bearishness: bearish put trade, 477 fundamentals and, 349 market response analysis and, 404, 406 Bearish T exas option hedge, 519–520 Bear market: of 1980-1982, 366–367 flags, pennants and, 133–134 run days in, 118, 119 spread trades and, 443 thrust days and, 116 “Bear trap”: about, 205–211 confirmation conditions, 208, 210 Beat the Dealer, 587 Bell-shaped curve, 601 Benchmark, 327 Bernanke, Ben, 431–432 Best fit, regression analysis and, 591–593 deviations, 591–592 least-squares approach, 592–593, 594 “Best linear unbiased estimators” (BLUE), 621 Bet size, variation in, 581 “Black box” system, 576 Blind simulation approach, system optimization, 311 BLASH approach, 27–28 BLUE. See “Best linear unbiased estimators” (BLUE) Bottom formations. See T op and bottom formations Bowe, James, 482–483 Box size, 42 Breakout(s), 86–89 confirmation of, 86 continuation patterns and, 180–181 counter-to-anticipated, flag or pennant, 219–222 definition of, 33 downside, 87, 88 false signals for, 151, 153 false trend-line, 211–213 flags, pennants and, 128 opposite direction breakout of flag or pennant following normal, 222–225 upside, 87, 89 winning signals for, 152, 153 Breakout systems, 243–244 British pound (BP), intercurrency spreads and, 472–473 Bull call money spread, 534–535 687 Index Comfortable choices, trading principles and, 584 Comfort zone, trading within, 577 Commissions, 19 Commodities: bearing little or no relationship to general rule, 444–445 conforming to inverse of general rule, 444 demand curves and, 361 general spread trade rule and, 443–444 intercommodity spread and, 441–442 nonstorable, 351, 360, 444 perishable, 360, 364 Commodities, 357 Commodity T raders Consumers Report, 434 Commodity trading advisors (CTAs), 23, 578 Comparing indicators, 157–165 difference indicators, 158, 159 indicator correlations, 161–162, 163 popular comparisons, 164 Comparisons: nominal price levels, 355 one-year, 350 two managers, 320–322 Compounded return, 323 Computer testing of trading systems. See T esting/ optimizing trading systems Confidence, 579–580 Confidence interval(s), 612–614 for an individual forecast, 627–629 multiple regression model and, 642 Confirmation conditions, 247–250 bull or bear trap, 208 pattern, 249, 250 penetration as, 248 time delay and, 248–249 Confirmation myth, 170 Congestion phases. See Continuation patterns Consistency, 582 Constant-forward (“perpetual”) series, 281–282 Consumer price index (CPI), 383 Consumption: definition of, 363 demand and, 357, 363–366 price and, 364 as proxy for inelastic demand, 370 Contingent order, 18 Chart(s): BLASH approach, 27–28 equity, 566 linked-contract (see Linked-contract charts) Random Walkers and, 29–34 types of (see Chart types) Chart analysis, 149–154 confirmation conditions and, 150 false breakout signals, 151, 153 long-term chart, 152, 154 most important rules in, 205–231 spread trades and, 449 trading range and, 150 winning breakout signals, 152, 153 Chart-based objectives, 189 Chart patterns, 109–147 continuation patterns, 123–134 flags and pennants (see Flags and pennants) head and shoulders, 138–141 one-day patterns (see One-day patterns) reversal days, 113–116, 147 rounding tops and bottoms, 141–143 run days, 116, 118–119 spikes (see Spikes) thrust days, 116, 117 T op and bottom formations (see T op and bottom formations) Triangles (see Triangles) wedge, 146–147 wide-ranging days (see Wide-ranging days) Chart types, 35–44 bar charts, 35–39 candlestick charts, 43–44 close-only (“line”) charts, 40–42 linked contract series: nearest futures versus continuous futures, 39–40 point-and-figure charts, 42–43 CIC (cancel if close) order, 188 Close-only (“line”) charts, 40–42 CME/COMEX contract, 459 Cochrane-Orcutt procedure, 671 Code parameter, 293 Coefficient of determination (r 2), 630–633 Coffee: intercommodity spreads and, 453–454, 456 seasonal index and, 400 spread trade example, 445–446 688 Index Countertrend systems, 254–256 contrary opinion, 256 definition of, 236 fading minimum move, 255 fading minimum move with confirmation delay, 255 general considerations, 254–255 oscillators, 255 types of, 255–256 Countertrend trade entry signals, 182 Covered call write, 526–527 Covered put write, 527–528 CPI. See Consumer price index (CPI) CR 2 (corrected R2), 642–643 CRB Commodity Yearbook, 414 Credit spread, 535 Crop reports, 434 Crop years, intercrop spread and, 441 Crossover points, moving averages and, 182 Crude oil market. See also WTI crude oil money stop and, 185 poor timing and, 425 seasonal index and, 399 CTAs. See Commodity trading advisors (CTAs) Currency futures, 471–476 intercurrency spreads, 471–473 intracurrency spreads, 473–476 Curvature, breaking of, 229, 230 Daily price limit, 8–9 Data errors, 679 Data insufficiency, conclusions and, 357 Data vendors, futures price series selection and, 287 Day versus good-till-canceled (GTC) order, 16 Degrees of freedom (df), 615, 640, 644 Deliverable grade, 9 Delivery, 4 Delta (neutral hedge ratio), 484–485 Demand: consumption and, 357, 363–366 definition of, 359–362, 363 elasticity of, 361–362 highly inelastic, 370–371 incorporation of (see Incorporation of demand) increase in, 364 inflation and, 355 price and, 362–363 quantifying, 362–363 stable, 368 Continuation patterns, 123–134 flags and pennants (see Flags and pennants) trading range breakouts and, 180–181 triangles (see Triangles) Continuous (spread-adjusted) price series, 282–285 Continuous distribution, 600–601 Continuous futures. See also Nearest vs. continuous futures price gaps and, 282 rule of seven and, 194–196 Continuous futures charts: creation of, 47 measured moves and, 190–193 nearest futures vs., 39–40 Continuous parameter, 292–293 Contract months, 5, 8 Contract rollovers. See Rollover dates Contract size, 5 Contract specifications: about, 5–9 sample, 6–7 Contrary opinion, 203–204, 256 Conversion, 530 Copper: inflation and, 385 price-forecasting model, 366–367 price moves and, 428, 429 Corn: ethanol production and, 680 intercommodity spreads and, 457–459 major resistance area and, 427 price movements and, 430 production, 348 seasonal index and, 401 unexpected developments and, 419, 420, 421 Corrected R 2 (CR2), 642–643 Correlation coefficient (r), independent variables and, 665–666 Correlation matrix, 666 Costs. See also Carrying charges production, price declines and, 351–352 transaction, 295–296, 313 Cotton: carryover and, 432–433 unexpected developments and, 418 yields, 355 689 Index Dummy variables, 659–663 Durbin-Watson statistic, as measure of autocorrelation, 652–654 Eckardt, Bill, 578, 584 Edge, having an, 576 Efficient market hypothesis, 428, 431 Elasticity of demand, 361–362 Elementary statistics, 597–618 central limit theorem, 609–612 confidence intervals, 612–614 measures of dispersion, 597–599 normal curve (Z) table, reading, 604–606 population mean, 607 populations and samples, 606 probability distributions, 599–604 sampling distribution, 608–609 standard deviation, 599, 607 t-test, 614–618 E-Mini Dow: descending triangle, 127 futures, uptrend line, 60 intermarket stock index spreads, 461–470 E-Mini Nasdaq 100: double bottom, 135, 137 downtrend lines and, 67 flags and pennants, 130 intermarket stock index spreads, 461–470 uptrend lines and, 59, 61 wide-ranging down bar, 123 E-Mini S&P 500: intermarket stock index spreads, 461–470 market response analysis and, 408, 409 options on futures and, 482, 484 price envelope bands and, 107, 108 seasonal index and, 399 trend lines and, 74 upthrust/downthrust days and, 117 Employment report: stock index futures response to, 408–409 T -Note futures response to monthly, 404–407 ENPPT . See Expected net profit per trade (ENPPT) Equal-dollar-spread ratio, 472 Equal-dollar-value spread, 455–460 Equally weighted term, 453 Equilibrium, 363, 365 Equity change, intercurrency spreads and, 472–473 Equity chart, 566 Demand curve, 359, 361 Demand-influencing variables, 368–370 DeMark, Thomas, 66, 69, 199 DeMark sequential, 199–203 Dependent variable, determining, 675–676 Detrended seasonal index, 394 Deviation: definition of, 623 total, 630–631 Diagonal spread, 542 Diary, maintaining trader’s, 565 Difference indicators: Close – Close vs. Close – MA, 158 ratio versions, 159 Discipline, 578 Discrete parameter, 293 Discrete variable, 600 Discretionary traders, losing period adjustments, 562–563 Disloyalty/loyalty, 583–584 Dispersion, measures of, 597–599 Disturbance, definition of, 623 Diversification: planned trading approach and, 560, 561–562 trend-following systems and, 256–258 Dividends, 462 Dollar: equal-dollar-value spread, 455–460 intercurrency spreads and, 471 price, 383 Dollar value, option premiums and, 477–478 Double top, penetration of, 227–229 curvature, breaking of, 229 Double tops and bottoms: double bottom, 137–138 double top, 136 triple top, 129 Down run day, 118, 268 Downthrust day, 116 Downtrend channels, 62, 63 Downtrend lines: definition of, 57 examples of, 59, 61, 65 false breakout signals, 211, 213 Driehaus, Richard, 578, 585 Druckenmiller, Stanley, 581, 584 690 Index expectations, ignoring, 355–356 improper influences, 352–355 lack of perspective, 351 nominal price levels, comparing, 355 one-year comparisons, 350 price declines/cost of production, 351–352 prices, target levels and, 356–357 relative time considerations, ignoring, 351 seasonal considerations, ignoring, 356 short scenes and, 347–349 using fundamentals for timing, 350 viewing fundamentals in a vacuum, 349 viewing old information as new , 349–350 False trend-line breakouts, 211–213 Faulkner, Charles, 585, 586 Fill-or-kill (FOK) order, 18 Filter, trend-following systems and, 250–251 Financial crisis of 2008, 323, 423, 680 First notice day, 9 Fixed or nonoptimized parameter, 293 Flags and pennants: bearish signal, 133–134 breakout from, 128 bullish signal, 131–132 counter-to-anticipated breakout of, 219–222 E-mini Nasdaq 100, 130 Euro Schatz continuous futures, 130 main trend and, 131 natural gas continuous futures, 128 opposite direction breakout of, following normal breakout, 222–225 soybean continuous futures, 129 stop-loss points and, 184–185 wheat, 129 FCOJ. See Frozen concentrated orange juice (FCOJ) FOK. See Fill-or-kill (FOK) order Forecast error, regression analysis and, 679–680 Forecasting model, building, 413–415 Forward selection, stepwise regression, 682 Fourteen fallacies. See Fallacies Free markets, 357 Frozen concentrated orange juice (FCOJ): crop reports and, 434 seasonal index and, 401 unexpected developments and, 418, 419 F-test, 643–644 Full carry, 446–447, 448 Equity retracements, dampened, 257 Error, definition of, 623 Error of the mean, 628 Error of the slope, 628 Ethanol production, 680 Euphoria, 585 Eurocurrency rates, 473 Events, pivotal, 422 Excess return, definition of, 323 Exchange, 5 Exercise price, 477 Exit points, planning time routine and, 563 Expectations: ignoring, 355–356 new-crop, 381 role of (see Role of expectations) seasonal analysis and, 390 Expected gain, 550, 551 Expected net profit per trade (ENPPT), 560 Expiration date, 477 Explained variation, 630 Exponentially weighted moving average (EWMA), 239–240 Exponential moving average (EMA), 165–167 Exposure, leverage and, 322 Extrapolation, 630 Fabrication, 313 Fading minimum move, 255 with confirmation delay, 255 Failed signals: about, 205, 206 bull and bear traps, 205–211 curvature, breaking of, 229 false trend-line breakouts, 211–213 flag or pennant, counter to anticipated breakout, 219–222 flag or pennant, opposite direction breakout following normal breakout, 222–225 future reliability of, 229–231 spike extremes, return to, 213–216 top and bottom formations, penetration of, 225–229 wide-ranging day extremes, return to, 216–218 Fallacies, 347–357 data insufficiency, conclusions and, 357 demand/consumption, confusion of concepts, 357 691 Index Generic trading systems: breakouts (see Breakout systems) moving averages and, 237–243 Gold: fundamental analysis and, 347, 371 futures (see Gold futures) intramarket stock index spreads and, 461 market response analysis and, 410 prices, 284 seasonal index and, 400 spot, buying, 555 Gold futures: buying, 555 volume shift in, 10 Gold/silver spread, 454 Good-till-canceled (GTC) orders. See GTC orders Government regulations, potential impact of, 415 Government reports, unexpected developments and, 420 GPR (gain-to-pain ratio), 328–329 Grain prices, 351 Great Recession, 423 Gresham’s law of money, 312 Grinder, John, 586 Gross domestic product (GDP): deflator, 383 independent variables and, 677 GTC orders: about, 16 order placement and, 568 stop-loss points and, 183, 188 trade exit and, 569 Hard work, skill versus, 576–577 Head and shoulders: about, 138–141 failed top pattern, 227–229 Heating oil: alternative approach, 396–397 average percentage method, 391, 392–394, 398 link relative method, 394–396, 398 Hedge, definition of, 517 Hedge ratio, neutral (delta), 484–485 Hedging, 11–13 applications, 554–555 buy hedge, 12–13 Fundamental analysis: about, 16 analogous season method, 374 balance table, 373–374 danger in using, 417 discounting and, 428–430 expectations, role of, 379–381 fallacies. see Fallacies forecasting model, building, 413–415 gold market and, 371 index models, 376–377 inflation, incorporation of, 383–388 long-term implications versus short-term response, 432–435 market response analysis (see Market response analysis) money management and, 426–427 “old hand” approach, 373 pitfalls in, 418–426 reasons to use, 427–428 regression analysis, 374–375 seasonal analysis and, 389–401 spread trades and, 449 supply-demand analysis, 359–371 technical analysis and, 21–24, 417–418, 426–427 trading and, 417–435 types of, 373–377 FundSeeder.com, 343 Futures markets, nature of, 3–4 Futures price series selection, 279–288 actual contract series, 279–280 comparing the series, 285–287 constant-forward (“perpetual”) series, 281–282 continuous (spread-adjusted) price series, 282–285 nearest futures, 280 Gain(s): expected, 550, 551 maximization of, 583 Gain-to-pain ratio (GPR), 328–329 Gardner, John, 314 GDP . See Gross domestic product (GDP) General rule, spreads, 443–445 about, 443 applicability and nonapplicability, 443–444 commodities bearing little or no relationship to, 444–445 commodities conforming to inverse of, 444 692 Index Intercurrency spreads, 471–473 equity change and, 472–473 reasons for implementing, 471–472 Interest rate differentials, intracurrency spreads and, 473, 476 Interest rate parity theorem, 475 Interest rate ratios, intracurrency spreads and, 475 Interest rates: option premiums and, 482–483 recession and, 367 Intermarket spreads, 442, 453, 462–470 Internal trend lines, 73–78 alternate, 75 versus conventional, 74, 76–77 support and resistance and, 106 International Cocoa Agreement, 356 International Sugar Agreement, 356 In-the-money options: definition of, 480 delta values and, 485 Intracurrency spreads, 473–476 interest rate differentials and, 473, 476 interest rate ratios and, 475 Intramarket (or interdelivery) spread, 441 Intramarket stock index spreads, 461–462 Intrinsic value, of options, 489 Intuition, 586 Investment insights, 343 Japanese stock market, 22 Japanese yen (JY), intercurrency spreads and, 471 Jobs report. See Employment report Kitchen sink approach, 312 Kuwait, 1990 invasion of, 420 Last notice day, 9 Last trading day, 9 Leading Indicator myth, 171–172 Least-squares approach, 592–593, 594 Lefèvre, Edwin, 178, 570, 580–581 Lessons, trader’s diary and, 565 Leverage: negative, 320 risk and, 320 through borrowing. see Notional funding Limit days, automatic trading systems and, 296 financial markets and, 13–14 general observations on, 13–15 sell hedge, 11–12 Heteroscedasticity, 672–673 Hidden risk, 320 Hildreth-Lu procedure, 671 Hite, Larry, 585 Hog production: fundamentals and, 348, 350, 356 regression analysis and, 374, 589–591 regression equation and, 633 supply-demand analysis and, 360, 365 Hope, as four-letter word, 584 Housing market: Case-Shiller Home Price Index, 423 housing bubble, 2003-2006, 423, 425 Implied volatility, 483–484 Incorporation of demand: demand change, growth pattern in, 368 demand-influencing variables, identification of, 368–370 highly inelastic demand (and supply elastic relative to demand), 370–371 methods for, 367–371 need for, 366–367 stable demand, 368 Independence, 579 Independent variables: forecasting model, building, 415 multicollinearity and, 665 regression analysis and, 677, 679 Index models, 376–377 Individual contract series, 279–280 Inflation: adjustments, 355 price data for, 414 price-forecasting models and, 383–388 Inflationary boom, 422 Inflation indexes, 383 Information, viewing old as new , 349–350 Intelligence, 582–583 Intercommodity spreads, 441–442. See also Limited- risk spread about, 441–442 contract ratios and, 453–460 Intercrop spreads, 441, 460 Hedging (continued) 693 Index Market(s): agricultural, 351 bear (see Bear market) bull (see Bull market) correlated, leverage reduction and, 562 excitement and, 585 exiting position and, 584–585 free, 357 housing (see Housing market) nonrandom prices and, 587 planned trading approach and, 560 trading results and, 317 Market characteristic adjustments, trend-following systems and, 251–252 Market direction, 449 Market hysteria, 585 Market-if-touched (MIT) order, 18 Market observations. See Rules, trading Market opinion: appearances and, 582–583 change of, 204 Market order, 16 Market patterns, trading rules and, 572–573 Market Profile trading technique, 585 Market psychology, shift in, 429 Market response analysis, 403–411 isolated events and, 409–410 limitations of, 410–411 repetitive events and, 403–410 stock index futures response to employment reports, 408–409 T -Note futures response to monthly U.S. employment report, 404–407 Market Sense and Nonsense: How the Markets Really Work, 319 Market statistics, balance table and, 373–374 Market wizard lessons, 575–587 Market Wizards books, 575, 579, 580, 581, 585, 586 MAR ratio, 330, 335 MBSs. See Mortgage-backed securities (MBSs) McKay, Randy, 576, 581, 583 Measured moves (MM), 190–193 Measures of dispersion, 597–599 Mechanical systems. See T echnical trading systems Metals. See Copper; Gold market Method: determination of, 576 development of, 576 Limited-risk spread, 446–448 Limit order, 17 “Line” (close-only) charts, 40–42 Linearity, transformations to achieve, 666–669 Linearly weighted moving average (LWMA), 239–240 Linked-contract charts, 45–56 comparing the series, 48 continuous (spread-adjusted) price series, 47 creation of, methods for, 46–48 nearest futures, 46–47 nearest vs. continuous futures, 39–40, 48–51, 52–56 necessity of, 45–46 Linked contract series: nearest futures versus continuous futures, 39–40 Link relative method, seasonal index, 394–396 Liquidation information, 564 Live cattle. See Cattle Livestock markets, 287. See also Cattle; Hog production Long call (at-the-money) trading strategy, 491–492 Long call (out-of-the-money) trading strategy, 493–494 Long futures trading strategy, 489–490 Long put (at-the-money), 503–504 Long put (in-the-money), 506–508 Long put (out-of-the-money), 504–506 Long straddle, 515–516 Long-term implications versus short-term response, 432–435 Long-term moving average, reaction to, 181–182 Look-back period, 173 Losing period adjustments, planned trading approach and, 562–563 Losing trades, overlooking, 313 Losses: partial, taking, 583 temporary large, 245 Loyalty/disloyalty, 583–584 Lumber, inflation and, 384 “Magic number” myth, 170 Managers: comparison of two, 320–322 negative Sharpe ratios and, 325 MAR. See Minimum acceptable return (MAR) Margins, 19 694 Index trending market and, 79, 80 types of, 165–167 Multicollinearity, 663–666 independent variables and, 665 multiple regression and, 639 regression coefficients and, 665 Multimarket system testing, 313–314 Multiple regression equation, 637 Multiple regression model, 637–647 basics of, 637–639 confidence intervals for individual forecast, 642 definition of, 625 F-test, 643–644 regression run, analyzing, 644–647 R 2 and corrected R2, 642–643 standard error of the regression and, 641–642 t-test application in, 640–641 Multiple-unit option strategies, 543 Mutually exclusive, 600 Natural disasters, 418 N AV. See Net asset value (NAV) NAV charts, 335–336 Nearest futures chart, 39–40 Nearest vs. continuous futures: chart analysis and, 48–51 futures price series selection and, 280 linked contract series, 39–40 measured moves and, 190 support and resistance, 91 Negative leverage, 320 Net asset value (NAV), 321, 331 Net asset value (NAV) charts, 335–336 Neuro-linguistic programming (NLP), 585 New-crop expectations, 381 New Science of T echnical Analysis, The, 199 Nikkei index futures, unexpected developments and, 418, 420 NLP . See Neuro-linguistic programming (NLP) Nominal price levels, comparing, 355 Nonoptimized parameters, 293 Nonsensitive (slow) systems, 245, 246 Nonstorable commodities, 351, 360 Normal curve (Z) table, reading, 604–606 Normal distribution, 599 Normal distribution curve, 601 Notional funding, 320, 321 Midtrend entry, 177–182 continuation pattern and trading range breakouts, 180–181 goals and, 178–179 percent retracement, 178 reaction to long-term moving average, 181–182 Minimum acceptable return (MAR), 326 Minimum price fluctuation, 5 Minor reaction, reversal of, 179–180 Mint Management, 585 Missing variable, 421 Mission, 586 Mistakes, trading, 584 MIT (market if touched) order, 18 MM (measured moves), 190–193 Models, equations and, 593 Modern T rader, 357 Modifications, trend-following systems, 247–254 buy and sell signals, differentiation between, 252 confirmation conditions, 247–250 filter, 250–251 market characteristic adjustments, 251–252 pyramiding, 252–253, 254 trade exit, 253, 254 Momentum, 163 Momentum indicator, 167 Money management: fundamental analysis, technical analysis and, 426–427 risk control and, 560, 577–578 rules, other, 570 trade exit and, 569 Money stop, stop loss points and, 185, 187 Mortgage-backed securities (MBSs), 423, 425 Mortgage lending, subprime, 423 Moving average convergence-divergence (MACD), 199 Moving averages, 78–81, 157–165 calculation of, 238 crossovers of, 182 definition of, 78, 238 exponentially weighted moving average (EWMA), 239–240 linearly weighted moving average (LWMA), 239–240 long-term, reaction to, 181–182 sideways market and, 79, 81 technical trading systems for, 237–243 695 Index Option trading strategies, 487–555 comparing, 487–489 hedging applications and, 554–555 multiunit strategies, 543–544 optimal, choosing, 544–554 profit/loss profiles (see Profit/loss profile) spread strategies, other, 542–543 Orders, types of, 16–19 Ordinary least squares (OLS), 654 Organization of the Petroleum Exporting Countries (OPEC), 356, 425 Original trading systems, 261–278 run-day breakout system, 268–273 run-day consecutive count system, 273–278 wide-ranging-day system (see Wide-ranging-day system) Oscillators, 167–170, 255 Out-of-the-money call, buying, 555 Out-of-the-money options: definition of, 480 delta values and, 485 Outright positions, spread tables and, 440, 441 Overbought/oversold indicators, 198–199 Parabolic price moves, 585 Parameter(s): definition of, 291, 606 types of, 292–293 Parameter set: average performance, 311 definition of, 291 Parameter shift, trend-following systems and, 247 Parameter stability, optimizing systems and, 297 Past performance, evaluation, 319–341 investment insights, 343 return alone, 319–322 risk-adjusted return measures, 323–335 visual (see Visual performance evaluation) Patience, virtue of, 580–581 Pattern(s). See also Chart patterns; Continuation patterns; One-day patterns market, 572–573 seasonal, 415 Pattern recognition systems, definition of, 237 Penetration of top and bottom formations, 225–229 Observations, market. See Rules, trading OCO (one-cancels-other) order, 18 Oil. See Crude oil market; Heating oil; WTI crude oil “Old hand” approach, 373 OLS (Ordinary least squares), 654 One-cancels-other (OCO) order, 18 One-day patterns: about, 109–123 spikes, 109–113 One-tailed test, 614, 617 One-year comparisons, 350 OPEC. See Organization of the Petroleum Exporting Countries’ (OPEC) Open interest, volume and, 9–10 Open-mindedness, 585 Optimization: definition of, 297 past performance and, 313 Optimization myth, 298–310 Optimizing systems, 297–298 Option(s): fair value of, theoretical, 483 qualities of, 489 Option premium curve, theoretical, 481 Option premiums, 480–483 components of, 480 interest rates and, 482–483 intrinsic value and, 480 strike price and current futures price, 480–481 theoretical versus actual, 483–484 time remaining until expiration, 481–482 time value and, 480–483 volatility and, 482 Option-protected long futures: long futures + long at-the-money put, 520–521 long futures + long out-of-the-money put, 522–523 Option-protected short futures: short futures + long at-the-money call, 523–524 short futures + long out-of-the-money call, 524–525 Options on futures, 477–485 about, 477–479 delta and (neutral hedge ratio), 484–485 option premiums and (see Option premiums) 696 Index Preforecast period (PFP) price, 677–678 Premium(s): definition of, 477 dollar value of option, 477–478 Price(s): consumption and, 364 dollar price, 383 grain, 351 nonrandom, 587 preforecast period (PFP) price, 677–678 strike or exercise, 477 supply, demand and swings (see Price swings) target levels and, 356–357 Price changes, price series and, 285 Price envelope bands, 107–108 Price-forecasting models: adding expectations as variable in, 380 demand and, 366–367 inflation and, 383 Price-indicator divergences, 171–172 Price levels: nearest futures and, 91, 101 nearest futures price series and, 48 nominal, comparing, 355 price series and, 285 Price movements: dramatic, 428 fitting news to, 431–432 linked series and, 286 parabolic, 585 trend-following systems and, 245, 246 Price oscillator, 163 Price quoted in, 5 Price reversals, 229 Price seasonality, cash versus futures, 389–390 Price-supporting organizations, 356 Price swings: nearest futures and, 101 nearest futures price series and, 48 Price trigger range (PTR), 262 Probability: distributions, 599–604 heads and tails coin tosses, 390 real versus, 390–391 Probability-weighted profit/loss ratio (PWPLR), 550–551 Producer price index (PPI), 383 Pennants. See Flags and pennants People’s Republic of China (PRC), 418 Percent retracement, reversal of minor reaction, 179–180 Percent return, optimizing systems and, 297 Performance evaluation, visual. See Visual performance evaluation Perishable commodities, 360 “Perpetual” (constant-forward) series, 281–282 Personality, trading method and, 576 Personal trading, analysis of, 565–566 Perspective: keeping, 587 lack of, 351 Petroleum. See Crude oil market; Heating oil; Organization of the Petroleum Exporting Countries’ (OPEC); WTI crude oil Philosophy, trading, 559, 578 Pivotal events, 422 Planned trading approach, 559–566 markets to be traded, 560 personal trading, analysis of, 565–566 planning time routine and, 563 risk control plan (see Risk control plan) trader’s diary, maintaining, 565 trader’s spreadsheet, maintaining, 563–564 trading philosophy and, 559 Point-and-figure charts, 42–43 Population, definition of, 598 Population mean, estimation of, 607 Population regression line, 619–620 Populations and samples, 606 Position, trading around, 581–582 Position exit criteria, 189–204 change of market opinion, 204 chart-based objectives, 189 contrary opinion, 203–204 DeMark sequential, 199–203 measured moves, 190–193 overbought/oversold indicators, 198–199 rule of seven, 194–196 support and resistance levels, 196–197 trailing stops, 204 PPI. See Producer price index (PPI) PRC. See People’s Republic of China (PRC) Precious metals market. See also Gold market carrying charges and, 446 demand and, 362 697 Index Prudence, 583 PTR. See Price trigger range (PTR) Pure arbitrage, 530 PWPLR. See Probability-weighted profit/loss ratio (PWPLR) Pyramiding: midtrend entry and, 182 rejected signals and, 251 trend-following systems and, 252–253 Quantum Fund, 22 Random error, 628, 679 Random sample, definition of, 608 Random variable, 599 Random Walkers, 29–34 Rate of change, 163 Ratio call write, 532–534 Reaction count, 179–180 Recession, severe, 367. See also Great Recession Regression analysis, 589–595, 675–683 about, 374–375, 589–591 assumptions of, basic, 620 best fit, meaning of, 591–593 dependent variable, determining, 675–676 example, practical, 593 forecast error and, 679–680 independent variables, selecting, 677 least-squares approach, 592–593, 594 practical considerations in applying, 675–683 preforecast period (PFP) price and, 677–678 regression forecast, reliability of, 593–595 simulation, 680–681 step-by-step procedure, sample, 682–683 stepwise regression, 681–682 survey period length and, 678–679 Regression coefficients: computing t-value for, 626 multicollinearity and, 665 sampling distribution of, 621 testing significance of, 620–626 Regression equation, 619–635 analyzing (see Analysis of regression equation) coefficient of determination R 2, 630–633 confidence interval for an individual forecast, 627–629 extrapolation, 630 misspecification and, 679 Production costs, price declines and, 351–352 Profit(s): partial, pulling out, 584 slow systems and, 245, 246 winning trades and, 570–571 Profit/loss matrix, short puts with different strike prices, 514 Profit/loss profile: alternative bearish strategies, three, 548 alternative bullish strategies, three, 547 alternative neutral strategies, two, 549 bear call money spread, 536, 538 bearish “T exas option hedge,” 520 bear put money spread, 539, 542 bull call money spread, 535 bullish “T exas option hedge,” 518 bull put money spread, 541 covered call write, 527 covered put write, 528 definition of, 488 key option trading strategies and, 489–542 key trading strategies and, 489–542 long call (at-the-money), 492, 495 long call (out-of-the-money), 494 long futures, 490 long futures and long call comparisons, 497 long futures and short put comparisons, 514 long put (at-the-money), 504 long put (in-the-money), 507 long put (out-of-the-money), 505 long straddle, 516 option-protected long futures, 521, 522 option-protected short futures, 524, 525 ratio call write, 533 short call (at-the-money), 498 short call (in-the-money), 501 short call (out-of-the-money), 500 short futures, 491 short futures and long put comparisons, 509 short futures and short call comparisons, 503 short put (at-the-money), 510 short put (in-the-money), 513 short put (out-of-the-money), 511 short straddle, 517 synthetic long futures, 529 synthetic short futures, 532 trading strategies and, 488–489 two long calls vs. long futures, 544 698 Index Risk-adjusted return measures, 323–335 advantages/disadvantages of, 334–335 Calmar ratio, 331 comparison of, 332–334 gain-to-pain ratio (GPR), 328–329, 334–335 MAR ratio, 330, 335 properties of, 334 return retracement ratio (RRR), 331–332, 335 SDR Sharpe ratio, 334 Sharpe ratio, 323–325, 332, 334, 343 Sortino ratio, 325–327, 334 symmetric downside-risk (SDR) Sharpe ratio, 327–328 tail ratio, 329–330, 335 Risk control: money management rules, other, 570 trade exit and, 569–570 Risk control plan, 560–562 correlated markets, leverage reduction and, 562 equity size, position changes and, 562 losing period adjustments, 562–563 market volatility adjustments, 562 risk per trade, maximum, 560–561 stop-loss strategy, 561 “Risk-free” return, 323, 326 RMS. See Root mean square (RMS) Rogers, Jim, 22 Role of expectations, 379–381 actual statistics, influence on, 381 adding expectations as variable, 380 prior year estimates and, 379–380 Rolling window return charts, 337–340 12-month returns, 337, 338–339 24-month returns, 339, 340 Rollover, 15 Rollover dates: continuous series and, 48, 51 nearest futures charts and, 47 Root mean square (RMS), 681 Rounding tops and bottoms: breaking of curvature and, 229, 230 chart patterns and, 141–143 RSI, 199 R 2 (coefficient of determination), 630–633 R2 and corrected R2, 642–643 Rule of seven, 193–196 population regression line, 619–620 regression analysis and, 620 regression coefficients, testing significance of, 620–626 spurious (“nonsense”) correlations, 634–635 standard error of the regression (SER), 627 Relative highs and relative lows: definitions of, 66 stop-loss points and, 185, 186 Relative strength index (RSI), 198 Reminiscences of a Stock Operator, 178, 570, 580–581 Residual, definition of, 623 Residual plot, 650–651 Residuals, 592 Resistance. See Support and resistance Responsibility, 578–579 Results, negative, 314–315 Retracement criterion, percent retracement, 178 Return(s). See also Minimum acceptable return (MAR) average, 323 compounded, 323 return alone, meaninglessness of, 319–322 risk-adjusted return measures, 319–322 “risk-free,” 323 rolling, 337–340 small difference in, 338 stability of, 338 Return retracement ratio (RRR), 335 Return/risk statistics, performance charts and, 343 Return to spike extremes, 213–216 Return to wide-ranging day extremes, 216–218 Reversal days, 113–116 definition of, 114–115 spike reversal days, 115–116 spikes and, 147 Reversal of minor reaction, 179–180 Reversal size, 42 Reverse conversion, 530 Risk: hidden, 320 ignoring, 312–313 leverage and, 320 low-risk idea, 581 scared money, 584 Regression equation (continued) 699 Index detrended, 394 link relative method, 394–396, 398 Seasonal patterns, forecasting model, 415 Securitizations, 423 SEE. See Standard error of the estimate (SEE) Segmented trades, analysis of, 565–566 Sell hedge, cotton producer, 11–12 Sell signals, trend-following systems and, 252 SER. See Standard error of the regression (SER) Series selection. See Futures price series selection Settlement type, 9 Sharpe ratio, 323–325, 334, 343. See also Symmetric downside-risk (SDR) Sharpe ratio Short call (at-the-money) trading strategy, 498–499 Short call (in-the-money) trading strategy, 500–502 Short call (out-of-the-money) trading strategy, 499–500 Short futures trading strategy, 490–491 Short put (at-the-money), 509–510 Short put (in-the-money), 512–513 Short put (out-of-the-money), 510–512 Short straddle, 516–517 Short-term response versus long-term implications, 432–435 Sideways market, moving averages and, 79, 81 Signal price, limit days and, 296 Signals, failed, 205, 206 Simple moving average (SMA), 165–167 Simple regression, 625 Simulated results, 312–313 fabrication, 313 kitchen sink approach, 312 losing trades, overlooking, 313 optimization and, 317 risk, ignoring, 312–313 terminology and, 311 transaction costs, 313 well-chosen example, 312 Simulation, blind, 311 Single market system variation (SMSV), 256–257 Skill, hard work versus, 576–577 Sklarew , Arthur, 194 Slippage: automatic trading systems and, 295 sampling distribution and, 608 transaction costs and, 291 trend-following systems and, 247 Rules, trading, 567–574 analysis and review of, 573–574 market patterns and, 572–573 miscellaneous, 571–572 risk control (money management), 569–570 trade entry, 568–569 trade exit, 569–570 winning trades, holding/exiting, 570–571 Run-day breakout system, 268–273 basic concept, 268 daily checklist, 269 illustrated example, 270–273 parameters, 269 parameter set list, 270 trading signals, 269 Run-day consecutive count system, 273–278 basic concept, 273 daily checklist, 274 definitions, 273 illustrated example, 275–278 parameters, 274 parameter set list, 274 trading signals, 273–274 Run days, 116, 118–119, 268 Russell 2000 Mini, intermarket stock index spreads, 461–470 Samples, populations and, 598, 606 Sampling distribution, 608–609 Sands, Russell, 434 Saucers. See Rounding tops and bottoms Saudi Arabia, 425 Scale order, 18 Schwager, Jack, 319 Schwartz, Marty, 22, 585 SDR Sharpe ratio, 327–328, 334 SE. See Standard error (SE) Seasonal analysis, 389–401 cash versus futures price seasonality, 389–390 expectations, role of, 390 real or probability, 390–391 seasonal index (see Seasonal index) seasonal trading, 389 Seasonal considerations, ignoring, 356 Seasonal index, 391–401 alternative approach, 396–401 average percentage method, 391–394 700 Index stock index futures and (see Stock index futures) time, 542 types of, 441–442 Spread seasonality, 449 Spreadsheet, maintaining traders, ’ 563–564 Stability: of return, 338 time (see Time stability) Standard deviation: calculation of, 323, 599 estimation of, 607 Standard error (SE), 612, 627 Standard error of the estimate (SEE), 627 Standard error of the mean, 612 Standard error of the regression (SER): about, 627 multiple regression model and, 641–642 simulation and, 681 Standardized residuals, regression run analysis and, 647 Statistic, definition of, 606 Statistics: elementary (see Elementary statistics) forecasting model, building, 414 influence of expectations on actual, 381 using prior-year estimates rather than revised, 379–380 Steidlmayer, Peter, 585 Stepwise regression, 681–682 Stochastic indicator, 199 Stock index futures: dividends and, 462 intermarket stock index spreads, 462–470 intramarket stock index spreads, 461–462 most actively traded contracts, 463 response to employment reports, 408–409 spread pairs, 463 spread trading in, 461–470 Stock market collapse, 425 Stop, trailing. See Trailing stop Stop close only, 18 Stop-limit order, 17 Stop-loss points, 183–188 flags and pennants and, 184–185 money stop and, 185, 187 relative highs and relative lows, 185, 186 relative lows and, 185, 186 selecting, 183–188 SMSV . See Single market system variation (SMSV) Soros, George, 22 Source/product spread, 442 Soybeans, inflation and, 384 Spike(s), 109–113 definition of, 112–113 reversal days and, 147 “spike days,” 237 Spike days. See Spike(s) Spike extremes, return to, 213–216 Spike highs: penetration of, 214–215 qualifying conditions and, 110–111 significance of, 109 spike extremes and, 213–216 Spike lows: penetration of, 215 price declines, 109 significance of, 110 Spike penetration signals negated, 216 Spike reversal days, 115–116 Spot gold, 555 Spread-adjusted (continuous) price series, 282–285 Spread order, 15, 19 Spreads: about, 439–440 analysis and approach, 448–449 balanced, 455 butterfly, 542 chart analysis and, 449 credit, 535 currency futures and (see Currency futures) definition of, 440 diagonal, 542 equal-dollar-value spread, 455–460 fundamentals and, 449 general rule (see General rule, spreads) historical comparison and, 448 intercommodity (see Intercommodity spreads) intercrop, 441, 460 intermarket, 442, 453 intramarket (or interdelivery), 441 limited-risk, 446–448 pitfalls and points of caution, 449–451 rather than outright - example, 445–446 reason for trading, 440–441 seasonality and, 449 similar periods, isolation of, 449 701 Index relative low , 66 TD downtrend line, 66, 67, 68–69, 71–72 TD uptrend line, 67–68, 69–70 true high and true low , 72–73 T echnical analysis: about, 16 fundamental analysis and, 21–24, 417–418, 426–427 money management and, 426–427 T echnical indicators, 155–171 about, 155–156 calculations, basic, 157 comparing indicators (see Comparing indicators) moving average types, 165–167 myths about, 170–172 oscillators, 167–170 trading signals, 167–170 “types,” 173 T echnical trading systems, 233–259 benefits of, 236 countertrend systems (see Countertrend systems) pattern recognition systems (see Pattern recognition systems) trend-following systems (see Trend-following systems) types of, overview , 236–237 T echniques of a Professional Commodity Chart Analyst, 194 T esting/optimizing trading systems, 289–318, 291–293 assumptions, realistic, 295–296 concepts and definitions, 291 continuous futures and, 51 example, well-chosen, 289–291, 314–315 multimarket system testing, 313–314 negative results, 314–315 optimizing myth, 298–310 optimizing systems, 297–298 price series and, 287 price series selection, 293 simulated results, truth about, 312–313 steps in constructing/testing system, 315–316 testing versus fitting, 310–311 time period selection, 293–295 trading systems, observations, 316–318 T exas option hedge: bearish, 519–520 bullish, 517–519 trading ranges and, 184 trailing stop and, 187–188 trend lines and, 183–184 wide-ranging days and, 185, 186 Stop-loss strategy, planned trading approach and, 561 Stop order, 17 Strategies. See Option trading strategies Stress, 585–586 Strike price, 477 Subprime mortgage lending, 423–425 Substitutes, availability of, 361 Sugar prices, 348–349 Supply: consumption and, 365 definition of, 359–362 elastic relative to demand (highly inelastic demand and), 370–371 fixed, 360 price and, 362–363 Supply curve, 359, 360–361 Supply-demand interaction, 364 Supply-demand reports, 366 Support and resistance, 91–108 levels, 196–197 nearest or continuous futures, 91 price envelope bands and, 107–108 prior major highs and lows, 94–100 resistance zone, 104, 105 support zone, 101–104, 105–106 trading ranges, 92–94 trend lines/channels and, 106 Swiss franc, unexpected developments and, 420, 421 Symmetric downside-risk (SDR) Sharpe ratio, 327–328 Synthetic long futures, 528–531 Synthetic short futures, 531–532 System-testing platforms, price series and, 287 System variation, 291 Tail ratio, 329–330, 335 Tautological relationship, 631 Tax considerations, 19–20 T -bill rates, 323 TD lines, 66–73 definitions and, 66–67, 72 relative high, 66 702 Index Trading method, personality and, 576 Trading philosophy, 559 Trading plan, 578 Trading range(s), 83–89, 92–94 breakouts from, 86–89, 180–181 definition of, 33 intraday, 86 multi-year, 83–85 stop-loss points and, 184 trading considerations, 83–86 trend-following systems and, 245 Trading rules, 567–574 Trading signals, 167–170 Trading system(s): definition of, 291 price series and, 287 updating, 563 Trailing stop, 187–188 profitable trades and, 571 stop-loss points and, 187–188 trade exit point and, 204 Transaction costs, 295–296, 313 Trend(s), 57–81 downtrend lines, 65 internal trend lines (see Internal trend lines) middle portion of, 583 moving averages (see Moving averages) news coverage and, 579 participation in major, 257 TD lines (see TD lines) uptrend lines, 63–65 “whipsawing” signals, 80 Trend channels: definition of, 62 rules applied to, 63 support and resistance and, 106 Trend-following systems, 237–244 breakout systems, 243–244 common problems with, 244–247, 259 countertrend systems, 254–256 definition of, 236 diversification, 256–258 modifications for (see Modifications, trend- following systems) moving average systems, 237–243 Thorp, Edward, 587 Thrust count, 180 Thrust days, 89, 116, 117 Ticker symbol, 5 “Tick” size and value, 5 Time considerations, ignoring relative, 351 Time-outs, 580 Time spread, 542 Time stability: automatic trading systems and, 295 optimizing systems and, 297 Time value, of options, 489 Time value decay, 481 Timing: poor, 422 using fundamentals for, 350, 425 T -Note: futures response to monthly U.S. employment report, 404–407 market response analysis and, 406, 407 T op and bottom formations: double tops and bottoms, 134, 136–138 penetration of, 225–229 V tops and bottoms, 134 T otal variation, 630 Trade(s): entering, 568–569 exiting, risk control and, 569–570 new , planning, 563 reason for, 565 scaling in and out of, 581 segmented, analysis of, 565–566 winning (see Winning trades) Trade entry: poor timing and, 422–425 timing of, 415 Trade exit comments, 565 Trade opportunity, forecasting model and, 415 Trader’s diary, maintaining, 565 Trader’s spreadsheet, maintaining, 563–564 Trading: about, 15–16 around a position, 581–582 fundamental analysis and, 417–435 seasonal, 389 Trading hours, 8 703 Index Variable(s): dependent, determining, 675–676 discrete, 600 dummy, 659–663 independent, 415, 665, 677 lagged, 677 missing, 421, 655–658 random, 599 Variance, 607 Variation: degrees of freedom and, 642 R 2 and, 642–643 total, 630 Visual performance evaluation, 335–342 2DUC charts, 341–342 net asset value (NAV) charts, 335–336 rolling window return charts, 337–340 underwater curve, 341–342 V olatility: implied, 483–484 market adjustments, 562 option premiums and, 482, 483 planned trading approach and, 560 Sharpe ratio and, 324 spread trades and, 440 V olatility ratio (VR): trend-following systems and, 247 wide-ranging days and, 119 V olume, open interest and, 9–10 V tops and bottoms, 134, 135 Wallet Street Week, 29–32 W edge, 146–147 W eighted least squares (WLS), 672 W eighted moving average (WMA), 165–167 W einstein, Mark, 580 Wheat market: balance table, 373–374 crop expectations, 355–356 intercommodity spreads and, 457–459 Whipsaws: trend-following systems and, 244 trend signals, 80 Wide-ranging days: definition, 262 stop-loss points and, 185, 186 Trending phase, price sample and, 294 Trend lines, 106, 183–184. See also Internal trend lines breakouts, false, 211–213 rules applied to, 63 stop-loss points and, 183–184 Triangles, 123–127, 143–146 ascending, 125–126 descending, 126–127 nonsymmetrical, 123 symmetrical, 123, 124–125 triangle bottom, 145 triangle top, 144 Triple top, 129 True range: definitions, 262 wide-ranging day and, 261 t-test: about, 614–618 multiple regression model and, 640–641 2DUC charts, 341–342 Two-tailed test, 614, 617 Type 1 error, 614 Type 2 error, 614 Underwater curve, 341–342 Unexpected developments, 418 Unexplained variation, 630 Up run day, 118, 268 Upthrust day, 116 Uptrend: definition of, 57 examples of, 58 Uptrend channel, 62 Uptrend lines, 63–65 examples of, 59, 60, 62 false breakout signals, 211, 212 U.S. Department of Agriculture (USDA): balance table, 373–374 consumption, demand and, 366 forecasting model, building, 414 unexpected developments and, 420 U.S. dollar (USD). See Dollar U.S. employment report, T -Note futures response to monthly, 404–407 U.S. Treasury, fundamentals and, 347 704 Index gains and, 583 holding/exiting, 570–571 losing and, concepts of, 578, 580 needing to win, 584 Wizard lessons, market, 575–587 WLS. See W eighted least squares (WLS) W orld trade agreements, 356–357 WRDs. See Wide-ranging days (WRDs) WTI crude oil. See also Crude oil market poor timing and, 426 unexpected developments and, 420, 421 Zero return, 326 Ziemba, William T ., 327 Z-test, 614, 615 Wide-ranging days (WRDs), 119–121 down bar, 123 down days, 120 extremes, return to, 216–218 stop-loss points and, 185, 186 up and down days, 121–122 up days, 120 up weeks, 122 Wide-ranging-day system, 261–268 basic concept, 261–262 daily checklist, 262–263 illustrated example, 264–268 parameter set list, 263 system parameters, 263 trading signals, 262 Winning trades: WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA. ================================================================================ SOURCE: eBooks\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf ================================================================================ The InTellI genT OpTIOn Inves TOr This page intentionally left blank The InTellI genT OpTIOn Inves TOr Applying Value Investing to the World of Options erik Kobayashi-solomon new Y ork Chicago s an Francisco Athens l ondon Madrid Mexico City Milan n ew Delhi s ingapore s ydney Toronto Copyright © 2015 by Erik Kobayashi-Solomon. 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To Fred Solomon (1930–2013) To my family and my “tribe” This page intentionally left blank vii Contents Acknowledgments xi Introduction xiii Part I: options for the Intelligent Investor 1 Chapter 1: Option Fundamentals 3 Characteristics and history 4 Directionality 9 Flexibility 20 Chapter 2: The Black-scholes-Merton Model 29 The BsM’s Main Job is to predict stock prices 30 The BsM is lousy at Its Main Job 39 Chapter 3: The Intelligent Investor’s guide to Option pricing 49 how Option prices are Determined 50 Time value versus Intrinsic value 56 how Changing Market Conditions Affect Option prices 59 Part II: A sound Intellectual Framework for Assessing Value 75 Chapter 4: The golden rule of valuation 77 The value of an Asset 78 Cash Flows generated on Behalf of Owners 80 The Company’s economic life 82 Time value of Money: summing Up Cash Flows Over Time 87 Chapter 5: The Four Drivers of value 91 Bird’s eye view of the valuation process 91 A Detailed look at the Drivers of value 97 viii  •   Contents Chapter 6: Understanding and Overcoming Investing pitfalls 113 Behavioral Biases 114 structural Impediments 131 Part III: Intelligent option Investing 141 Chapter 7: Finding Mispriced Options 143 Making sense of Option Quotes 144 Delta: The Most Useful of the greeks 151 Comparing an Intelligent valuation range with a BsM range 155 Chapter 8: Understanding and Managing leverage 163 Investment leverage 164 simple Ways of Measuring Option Investment leverage 169 Understanding leverage’s effects on a portfolio 174 Managing leverage 183 Chapter 9: gaining exposure 187 long Call 189 long put 201 strangle 205 straddle 208 Chapter 10: Accepting exposure 211 short put 212 short Call (Call spread) 220 short straddle/short strangle 230 Chapter 11: Mixing exposure 233 long Diagonal 235 short Diagonal 238 Covered Call 240 protective puts 248 Collar 258 Chapter 12: risk and the Intelligent Option Investor 263 Market risk 263 valuation risk 265 Intelligent Option Investing 267 Appendix A: Choose Y our Battles Wisely 269 Where the BsM Works Best 269 Where the BsM Works Worst 273 Appendix B: The Many Faces of leverage 282 Operational leverage 282 Financial leverage 285 Appendix C: p ut-Call parity 287 Dividend Arbitrage and put-Call parity 288 Notes 295 Index 305 Contents    • ix This page intentionally left blank xi ACknowledgments Many thanks to all the people who have been part of the process during the writing of this book. I am indebted to three people in particular, Mr. Brent Farler, Mr. Ben louviere, and Mr. neil Kozarsky, who have gra- ciously offered their time, help, and business expertise in bringing this pro- ject to fruition. Certainly this book would be much different and of not nearly the quality without Brent’s guidance, thorough reading, and insight- ful, helpful suggestions, starting with the very first draft in late 2012. In the literary world, I cannot say enough good things about Mr. sam Fleishman, of l iterary Arts r epresentatives, and Mr. Knox h uston and Ms. Daina penikas, my editors at Mcgraw-hill, all of whom have allowed this work to move from conception to completion and whose advice and support have made all the hard work worthwhile. In the investment-management world, I am indebted to Mr. steve silverman, owner and portfolio manager of Ironbound Capital Manage- ment, who taught me important lessons about the business of investing and about how to critically assess the value of a company, and to Mr. Deepinder Bhatia, Founding partner of Bayard Asset Management llC, a true expert in the art and science of equity research and analysis. In addition, I thank Mr. rafael garcia, of the International Financial Corporation; Mr. Joe Miramonti, of Fedora Investment p artners; Mr. Franco Dal pont, of Batalha Capital Management; and Mr. paul neff, of the Federal reserve Bank of Chicago, for the excellent discussions about valuation, option theory, and bringing the touchstone of valuation into the realm of option investments. When I began work on this book, I did not realize just what an enormous process it would be. Truly, without the help and support of all the people mentioned here and all my friends and family around the world, I would have had a much more difficult time completing this work. xii  •   Acknowledgments xiii IntroduCtIon You have a tremendous advantage over algorithmic trading models, investment bank trading desks, hedge funds, and anyone who appears on or pays attention to cable business news shows. This book is written to show where that advantage lies and how to exploit it to make confident and suc- cessful investment choices. In doing so, it explains how options work and what they can tell you about the market’s estimation of the value of stocks. even if, after reading it, you decide to stick with straight stock in- vesting and never make an option transaction, understanding how options work will give you a tremendous advantage as an investor. The reason for this is simple: by understanding options, you can understand what the rest of the market is expecting the future price of a stock to be. Understanding what future stock prices are implied by the market is like playing cards with an opponent who always leaves his or her hand face up on the table. Y ou can look at the cards you are dealt, compare them with your opponent’s, and play the round only when you are sure that you have the winning hand. By incorporating options into your portfolio, you will enjoy an even greater advantage because of a peculiarity about how option prices are determined. Option prices are set by market participants making trans- actions, but those market participants all base their sale and purchase decisions on the same statistical models. These models are like sausage grinders. They contain no intelligence or insight but rather take in a few simple inputs, grind them up in a mechanical way, and spit out an option price of a specific form. An option model does not, for instance, care about the operational details of a company. This oversight can lead to situations that seem to be too good to be true. For instance, I have seen a case in which an investor could commit to buy a strong, profitable company for less than the amount of cash it held—in effect, allowing the investor to pay $0.90 to receive a dollar plus a share of the company’s future profits! Although it is true that these kinds of opportunities do not come along every day, they do indeed come along for patient, insightful investors. This example lies at the heart of intelligent option investing, the es- sence of which can be expressed as a three-step process: 1. Understanding the value of a stock 2. Comparing that intelligently estimated value with the mechani- cally derived one implied by the option market 3. Tilting the risk-reward balance in one’s favor by investing in the best opportunities using a combination of stocks and options The goal of this book is to provide you with the knowledge you need to be an intelligent option investor from the standpoint of these three steps. There is a lot of information contained within this book but also a lot of information left out. This is not meant to be an encyclopedia of option equations, a handbook of colorfully named option strategies, or a treatise on financial statement analysis. Unlike academic books covering options, such as hull’s excellent book, 1 not a single integration symbol or mathematical proof is found between this book’s covers. Understanding how options are priced is an important step in being an intelligent option investor; doing dif- ferential partial equations or working out mathematical proofs is not. Unlike option books written for professional practitioners, such as natenberg’s book,2 you will not find explanations about complex strategies or graphs about how “the greeks”3 vary under different conditions. Floor traders need to know these things, but intelligent option investors—those making considered long-term investments in the financial outcomes of companies—have very different motivations, resources, and time horizons from floor traders. Intelligent option investors, it turns out, do better not even worrying about the great majority of things that floor traders must consider every day. Unlike how-to books about day trading options, this book does not have one word to say about chart patterns, market timing, get-rich-quick schemes, or any of the many other delusions popular among people who xiv  •   Introduction Introduction    • xv will soon be paupers. Making good decisions is a vital part of being an intelligent option investor; frenetic, haphazard, and unconsidered trading is most certainly not. Unlike books about securities analysis, you will not find detailed dis- cussions about every line item on a financial statement. Understanding how a company creates value for its owners and how to measure that value is an important step in being an intelligent option investor; being able to rattle off information about arcane accounting conventions is not. To paraphrase Warren Buffett, 4 this book aims to provide you with a sound intellectual framework for assessing the value of a company and making rational, fact-based decisions about how to invest in them with the help of the options market. The book is split into three parts: • part I provides an explanation of what options are, how they are priced, and what they can tell you about what the market thinks the future price of a stock will be. This part corresponds to the second step of intelligent option investing listed earlier. • part II sets forth a model for determining the value of a company based on only a handful of drivers. It also discusses some of the behavioral and structural pitfalls that can and do affect investors’ emotions and how to avoid them to become a better, more rational investor. This part corresponds to the first step of intelligent option investing listed earlier. • part III turns theory into practice—showing how to read the nec- essary information on an option pricing screen; teaching how to measure and manage leverage in a portfolio containing cash, stocks, and options; and going into detail about the handful of op- tion strategies that an intelligent option investor needs to know to generate income, boost growth, and protect gains in an equity port- folio. This part corresponds to the final step of intelligent option investing listed earlier. no part of this book assumes any prior knowledge about options or stock valuation. That said, it is not some sort of “Options for Beginners” or “My First Book of valuation” treatment either. Investing beginners will learn all the skills—soup to nuts—they need to successfully and confidently invest in the stock and options market. peo- ple who have some experience in options and who may have used covered calls, protective puts, and the like will find out how to greatly improve their results from these investments and how to use options in other ways as well. professional money managers and analysts will develop a thorough understanding of how to effectively incorporate option investments into their portfolio strategies and may in fact be encouraged to consider ques- tions about valuation and behavioral biases in a new light as well. The approach used here to teach about valuation and options is unique, simple without being simpleminded, and extremely effective in communicating these complex topics in a memorable, vivid way. r ead- ers used to seeing option books littered with hockey-stick diagrams and partial differential equations may have some unlearning to do, but no mat- ter your starting point—whether you are a novice investor or a seasoned hedge fund manager—by the end of this book, I believe that you will look at equity investing in a new light. xvi  •   Introduction 1 Part I OptiOns FOr the intelligent invest Or Don’t believe anything you have heard or read about options. If you listen to media stories, you will learn that options are modern financial innovations so complex that only someone with an advanced degree in mathematics can properly understand them. Every contention in the preceding sentence is wrong. If you listen to the pundits and traders blabbing on the cable business channels, you will think that you will never be successful using options unless you understand what “put backspreads, ” “iron condors, ” and count- less other colorfully named option strategies are. Y ou will also learn that options are short-term trading tools and that you’ll have to be a razor-sharp “technical analyst” who can “read charts” and jump in and out of positions a few times a week (if not a few times a day) to do well. Every contention in the preceding paragraph is so wrong that believing them is liable to send you to the poor house. The truth is that options are simple, directional instruments that we understand perfectly well from countless encounters with them in our daily lives. They are the second-oldest financial instrument known to humanity—in a quite literal sense, modern economic life would not be possible without them. Options are instruments that not only can be used but should be used in long-term strategies; they most definitely should be traded in and out of as infrequently as possible. 2  •   The Intelligent Option Investor The first part of this book will give you a good understanding of what options are, how their prices are determined, and how those prices fluctuate based on changes in market conditions. There is a good reason to develop a solid understanding of this theoretical background: the framework the option market uses to determine the price of options is based on provably faulty premises that, while “approximately right” in certain circumstances, are laughably wrong in other circumstances. The faults can be exploited by intelligent, patient inves- tors who understand which circumstances to avoid and which to seek out. Without understanding the framework the market uses to value options and where that framework breaks down, there is no way to exploit the faults. Part I of this book, in a nutshell, is designed to give you an understanding of the framework the market uses to value options. This book makes extensive use of diagrams to explain option theory, pricing, and investment strategies. Those readers of the printed copy of this book are encouraged to visit the Intelligent Option Investor website (www .IntelligentOptionInvestor.com) to see the full-color versions of the type of illustrations listed here. Doing so will allow you to visualize options even more effectively in the distinctive intelligent option investing way. 3 Chapter 1 OptiOn Fundamentals This chapter introduces what an option is and how to visualize options in an intelligent way while hinting at the great flexibility and power a sensible use of options gives an investor. It is split into three sections: 1. Option Overview: Characteristics, everyday options, and a brief option history. 2. Option Directionality: An investigation of similarities and differ - ences between stocks and options. This section also contains an introduction to the unique way that this book visualizes options and to the inescapable jargon used in the options world and a bit of intelligent option investor–specific jargon as well. 3. Option Flexibility: An explanation of why options are much more investor-friendly than stocks, as well as examples of the handful of strategies an intelligent option investor uses most often. Even those of you who know something about options should at the very least read the last section. Y ou will find that the intelligent option investor makes very close to zero use of the typical hockey-stick diagrams shown in other books. Instead, this book uses the concept of a range of exposure. The rest of the book—discussing option pricing, corporate valuation, and option strategies—builds on this range-of-exposure concept, so skipping it is likely to lead to confusion later. This chapter is an important first step in being an intelligent option investor. Someone who knows how options work does not qualify as be- ing an intelligent option investor, but certainly, one cannot become an 4  •   The Intelligent Option Investor intelligent option investor without understanding these basic facts. The concepts discussed here will be covered in greater detail and depth later in this book. For now, it is enough to get a sense for what options are, how to think about them, and why they might be useful investment tools. Characteristics and History By the end of this section, you should know the four key characteristics of options, be able to name a few options that are common in our daily lives, and understand a bit about the long history of options as a financial product and how modern option markets operate. Jargon introduced in this section is as follows: Black-Scholes-Merton model (BSM) Listed look-alike Central counterparty Characteristics of Options Rather than giving a definition for options, I’ll list the four most important characteristics that all options share and provide a few common examples. Once you understand the basic characteristics of options, have seen a few examples, and have spent some time thinking about them, you will start to see elements of optionality in nearly every situation in life. An option 1. Is a contractual right 2. Is in force for a specified time 3. Allows an investor to profit from the change in value of another asset 4. Has value as long as it is still in force This definition is broad enough that it applies to all sorts of options— those traded on a public exchange such as the Chicago Board Options Exchange and those familiar to us in our daily lives. Option Fundamentals   • 5 Options in Daily Life The type of option with which people living in developed economies are most familiar is an insurance contract. Let’s say that you want to fully insure your $30,000 car. Y ou sign a contract (option characteristic number 1) with your insurance company that covers you for a specified amount of time (option characteristic number 2)—let’s say one year. If during the coverage period your car is totaled, your insurance company buys your wreck of a car (worth $0 or close to it) for $30,000—allowing you to buy an identical car. When this happens, you as the car owner (or investor in a real asset) realize a profit of $30,000 over the market value of your destroyed car (option characteristic number 3). Obviously, the insurance company is bound to uphold its promise to indemnify you from loss for the entire term of the contract; the fact that you have a right to sell a worthless car to your insurance company for the price you paid for it implies that the insurance has value during its entire term (option characteristic number 4). Another type of option, while perhaps not as widely used by everyday folks, is easily recognizable. Imagine that you are a struggling author who has just penned your first novel. The novel was not a great seller, but one day you get a call from a movie producer offering you $50,000 for the right to draft a screenplay based on your work. This payment will grant the producer exclusive right (option characteristic number 1) to turn the novel into a movie, as well as the right to all proceeds from a potential future movie for a specific period of time (option characteristic number 2)—let’s say 10 years. After that period is up, you as the author are free to renegotiate an- other contract. As a struggling artist working in an unfulfilling day job, you happily agree to the deal. Three weeks later, a popular daytime talk show host features your novel on her show, and suddenly, you have a New York Times bestseller on your hands. The value of your literary work has gone from slight to great in a single week. Now the movie producer hires the Cohen brothers to adapt your film to the screen and hires George Clooney, Matt Damon, and Julia Roberts to star in the movie. When it is released, the film breaks records at the box office. How much does the producer pay to you? Nothing. The producer had a contractual right to profit from the screenplay based on your work. When the producer bought this right, your literary work was not worth much; suddenly, it is worth a great deal, and 6  •   The Intelligent Option Investor the producer owns the upside potential from the increase in value of your story (option characteristic number 3). Again, it is obvious that the right to the literary work has value for the entire term of the contract (option characteristic number 4). Keep these characteristics in mind, and we will go on to look at how these defining elements are expressed in financial markets later in this chapter. Now that you have an idea of what an option looks like, let’s turn briefly to a short history of these financial instruments. A Brief History of Options Many people believe that options are a new financial invention, but in fact, they have been in use for more than two millennia—one of the first historically attested uses of options was by a pre-Socratic philosopher named Miletus, who lived in ancient Greece. Miletus the philosopher was accused of being useless by his fellow citizens because he spent his time considering philosophical matters (which at the time included a study of natural phenomena as well) rather than putting his nose to the grindstone and weaving fishing nets or some such thing. Miletus told them that his knowledge was in fact not useless and that he could apply it to something people cared about, but he simply chose not to. As proof of his contention, when his studies related to weather revealed to him that the area would enjoy a bumper crop of olives in the upcoming season, he went around to the owners of all the olive presses and paid them a fee to reserve the presses (i.e., he entered into a contractual agreement— option characteristic number 1) through harvest time (i.e., the contract had a prespecified life—option characteristic number 2). Indeed, Miletus’s prediction was correct, and the following season yielded a bumper crop of olives. The price of olives must have fallen because of the huge surge of supply, and demand for olive presses skyrocketed (because turning the olive fruit into oil allowed the produce to be stored longer). Because Miletus had cornered the olive press market, he was able to generate huge profits, turning the low-value olives into high-value oil (i.e., he profited from the change in value of an underlying asset—option characteristic number 3). His rights to the olive presses ended after the har- vest but not before he had become very wealthy thanks to his philosophical Option Fundamentals   • 7 studies (i.e., his contractual rights had value through expiration—option characteristic number 4). This is only one example of an ancient option transaction (a few thou- sand years before the first primitive common stock came into existence), but as long as there has been insurance, option contracts have been a well- understood and widely used financial instrument. Can you imagine how little cross-border trade would occur if sellers and buyers could not shift the risk of transporting goods to a third party such as an insurance company? How many ships would have set out for the Spice Islands during the Age of Exploration, for instance? Indeed, it is hard to imagine what trade would look like today if buyers and sellers did not have some way to mitigate the risks associated with uncertain investments. For hundreds of years, options existed as private contracts specifying rights to an economic exposure of a certain quantity of a certain good over a given time period. Frequently, these contracts were sealed between the producers and sellers of a commodity product and wholesale buyers of that commodity. Both sides had an existing exposure to the commodity (the producer wanted to sell the commodity, and the wholesaler wanted to buy it), and both sides wanted to insure themselves against interim price movements in the underlying commodity. But there was a problem with this system. Let’s say that you were a Renaissance merchant who wanted to insure your shipment of spice from India to Europe, and so you entered into an agreement with an insurer. The insurer asked you to pay a certain amount of premium up front in return for guaranteeing the value of your cargo. Y our shipment leaves Goa but is lost off Madagascar, and all your investment capital goes down with the ship to the bottom of the Indian Ocean. However, when you try to find your option counterparty—your insurer—it seems that he has absconded with your premium money and is living a life of pleasure and song in another country. In the parlance of modern financial markets, your option investment failed because of counterparty risk. Private contracts still exist today in commodity markets as well as the stock market (the listed look-alike option market—private contracts specifying the right to upside and downside exposure to single stocks, exchange-traded funds, and baskets is one example that institutional investors use heavily). However, private contracts still bring with them a 8  •   The Intelligent Option Investor risk of default by one’s counterparty, so they are usually only entered into after both parties have fully assessed the creditworthiness of the other. Obviously, individual investors—who might simply want to speculate on the value of an underlying stock or exchange-traded fund (ETF)—cannot spend the time doing a credit check on every counterparty with whom they might do business. 1 Without a way to make sure that both parties are financially able to keep up their half of the option bargain, public option markets simply could not exist. The modern solution to this quandary is that of the central counter - party. This is an organization that standardizes the terms of the option con- tracts transacted and ensures the financial fulfillment of the participating counterparties. Central counterparties are associated with securities exchanges and regulate the parties with which they deal. They set rules regarding collateral that must be placed in escrow before a transaction can be made and request additional funds if market price changes cause a counterparty’s account to become undercollateralized. In the United States, the central counterparty for options transactions is the Options Clearing Corporation (OCC). The OCC is an offshoot of the oldest option exchange, the Chicago Board Option Exchange (CBOE). In the early 1970s, the CBOE itself began as an offshoot of a large futures exchange—the Chicago Mercantile Exchange—and subsequently started the process of standardizing option contracts (i.e., specifying the exact per-contract quantity and quality of the underlying good and the expiration date of the contract) and building the other infrastructure and regulatory framework necessary to create and manage a public market. Although market infrastructure and mechanics are very important for the brokers and other professional participants in the options market, most aspects are not terribly important from an investor’s point of view (the things that are—such as margin—will be discussed in detail later in this book). The one thing an investor must know is simply that the option market is transparent, well regulated, and secure. Those of you who have a bit of extra time and want to learn more about market mechanics should take a look through the information on the CBOE’s and OCC’s websites. Listing of option contracts on the CBOE meant that investors needed to have a sense for what a fair price for an option was. Three academics, Fischer Black, Myron Scholes, and Robert Merton, were responsible for Option Fundamentals   • 9 developing and refining an option pricing model known as the Black- Scholes or Black-Scholes-Merton model, which I will hereafter abbreviate as the BSM. The BSM is a testament to human ingenuity and theoretical elegance, and even though new methods and refinements have been developed since its introduction, the underlying assumptions for new option pricing methods are the same as the BSM. In fact, throughout this book, when you see “BSM, ” think “any statistically based algorithm for determining option p r i c e s .” The point of all this background information is that options are not only not new-fangled financial instruments but in fact have a long and proud history that is deeply intertwined with the development of modern economies themselves. Those of you interested in a much more thorough coverage of the history of options would do well to read the book, Against the Gods: The Remarkable History of Risk, by Peter Bernstein (New Y ork: Wiley, 1998). Now that you have a good sense of what options are and how they are used in everyday life, let’s now turn to the single most important thing for a fundamental investor to appreciate about these financial instruments: their inherent ability to exploit directionality. Directionality The key takeaway from this section is evident from the title. In addition to demonstrating the directional power inherent in options, this section also introduces the graphic tools that I will use throughout the rest of this book to show the risk and reward inherent in any investment—whether it is an investment in a stock or an option. For those of you who are not well versed in options yet, this is the section in which I explain most of the jargon that you simply cannot escape when transacting in options. However, even readers who are familiar with options should at least skim through this explanation. Doing so will likely increase your appreciation for the characteristics of options that make them such powerful investment tools and also will introduce you to this novel way of visualizing them. 10  •   The Intelligent Option Investor Jargon introduced in this section is as follows: Call option Moneyness Put option In the money (ITM) Range of exposure At the money (ATM) Strike price Out of the money (OTM) Gain exposure Premium Accept exposure American style Canceling exposure European style Exercise (an option) Visual Representation of a Stock Visually, a good stock investment looks like this: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 Future Stock Price Last Stock Price Y ou can make a lot of mistakes when investing, but as long as you are right about the ultimate direction a stock will take and act accordingly, all those mistakes will be dwarfed by the success of your position. Good investing, then, is essentially a process of recognizing and exploiting the directionality of mispriced stocks. Usually, investors get exposure to a stock’s directionality by buying, or going long, that stock. This is what the investor’s risk and reward profile looks like when he or she buys the stock: Option Fundamentals   • 11 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 GREEN RED As soon as the “Buy” button is pushed, the investor gains expo- sure to the upside potential of the stock—this is the shaded region la- beled “green” in the figure. However, at the same time, the investor also must accept exposure to downside risk—this is the shaded region labeled “red. ” Anyone who has invested in stocks has a visceral understanding of stock directionality. We all know the joy of being right as our investment soars into the green and we’ve all felt the sting as an investment we own falls into the red. We also know that to the extent that we want to gain exposure to the upside potential of a stock, we must necessarily simultane- ously accept its downside risk. Options, like stocks, are directional instruments that come in two types. These two types can be defined in directional terms: Call option A security that allows an investor exposure to a stock’s upside potential (remember, “Call up”) Put option A security that allows an investor exposure to a stock’s downside potential (remember, “Put down”) The fact that options split the directionality of stocks in half—up and down—is a great advantage to an investor that we will investigate more in a moment. Right now, let’s take a look at each of these directional instruments— call options and put options—one by one. 12  •   The Intelligent Option Investor Visual Representation of Call Options In a similar way that we created a diagram of the risk-reward profile of owner- ship in a common stock, a nice way of understanding how options work is to look at a visual representation. The following diagram represents a call option. There are a few things to note about this representation: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 GREEN 1. The shaded area (green) represents the price and time range over which the investor has economic exposure—I term this the range of exposure. Because we are talking about call options, and because call options deal with the upside potential of a stock, you see that the range of exposure lies higher than the present stock price (remember, “Call up”). 2. True to one of the defining characteristics of an option mentioned earlier, our range of exposure is limited by time; the option pictured in the preceding figure expires 500 days in the future, after which we have no economic exposure to the stock’s upside potential. 3. The present stock price is $50 per share, but our upside exposure only begins at $60 per share. The price at which economic exposure begins is called the strike price of an option. In this case, the strike price is $60 per share, but we could have picked a strike price at the market price of the stock, further above the market price of the stock (e.g., a strike price of $75), or even below the market price of the stock. We will inves- tigate optimal strike prices for certain option strategies later in this book. Option Fundamentals   • 13 4. The arrow at the top of the shaded region in the figure indicates that our exposure extends infinitely upward. If, for some reason, this stock suddenly jumped not from $50 to $60 per share but from $50 to $1,234 per share, we would have profitable exposure to all that upside. 5. Clearly, the diagram showing a purchased call option looks a great deal like the top of the diagram for a purchased stock. Look back at the top of the stock purchase figure and compare it with the preceding figure: the inherent directionality of options should be completely obvious. Any time you see a green region on diagrams like this, you should take it to mean that an investor has the potential to realize a gain on the investment and that the investor has gained exposure. Any time an option investor gains exposure, he or she must pay up front for that potential gain. The money one pays up front for an option is called premium (just like the fee you pay for insurance coverage). In the preceding diagram, then, we have gained exposure to a range of the stock’s upside potential by buying a call option (also known as a long call). If the stock moves into this range before or at option expiration, we have the right to buy the stock at our $60 strike price (this is termed exer - cising an option) or simply sell the option in the option market. It is almost always the wrong thing to exercise an option for reasons we discuss shortly. 2 If, instead, the stock is trading below our strike price at expiration, the option is obviously worthless—we owned the right to an upside scenario that did not materialize, so our ownership right is worth nothing. It turns out that there is special jargon that is used to describe the relationship between the stock price and the range of option exposure: Jargon Situation In the money (ITM) Stock price is within the option’s range of exposure Out of the money (OTM) Stock price is outside the option’s range of exposure At the money (ATM) Stock price is just at the border of the option’s range of exposure Each of these situations is said to describe the moneyness of the option. Graphically, moneyness can be represented by the following diagram: 14  •   The Intelligent Option Investor 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 ITM ATM OTM Date/Day Count Stock Price 749 999 GREEN As we will discuss in greater detail later, not only can an investor use options to gain exposure to a stock, but the investor also can choose to accept exposure to it. Accepting exposure means running the risk of a financial loss if the stock moves into an option’s range of exposure. If we were to accept expo- sure to the stock’s upside potential, we would graphically represent it like this: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 RED Any time you see a shaded region labeled “red” on diagrams like this, you should take it to mean that the investor has accepted the risk of realizing a loss on the investment and should say that the investor has accepted exposure. Any time an option investor accepts exposure, he or she gets to receive premium up front in return for accepting the risk. In the preceding example, the investor has accepted upside exposure by selling a call option (a.k.a. a short call). Option Fundamentals   • 15 In this sold call example, we again see the shaded area representing the exposure range. We also see that the exposure is limited to 500 days and that it starts at the $60 strike price. The big difference we see between this diagram and the one before it is that when we gained upside exposure by buying a call, we had potentially profitable exposure infinitely upward; in the case of a short call, we are accepting the possibility of an infinite loss. Needless to say, the decision to accept such risk should not be taken lightly. We will discuss in what circumstances an investor might want to accept this type of risk and what techniques might be used to manage that risk later in this book. For right now, think of this diagram as part of an explanation of how options work, not why someone might want to use this particular strategy. Let’s go back to the example of a long call because it’s easier for most people to think of call options this way. Recall that you must pay a premium if you want to gain exposure to a stock’s directional potential. In the diagrams, you will mark the amount of premium you have to pay as a straight line, as can be seen here: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 Breakeven Line: $62.50 499 Date/Day Count Stock Price 749 999 GREEN I have labeled the straight line the “Breakeven line” for now and have as- sumed that the option’s premium totals $2.50. Y ou can think of the breakeven line as a hurdle the stock must cross by expiration time. If, at expiration, the stock is trading for $61, you have the right to purchase the shares for $60. Y ou make a $1 profit on this trans- action, which partially offsets the original $2.50 cost of the option. 16  •   The Intelligent Option Investor It is important to note that a stock does not have to cross this line for your option investment to be profitable. We will discuss this dynamic in Chapter 2 when we learn more about the time value of options. Visual Representation of Put Options Now that you understand the conventions we use for our diagrams, let’s think about how we might represent the other type of option, dealing with downside exposure—the put. First, let’s assume that we want to gain expo- sure to the downside potential of a stock. Graphically, we would represent this in the following way: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 GREEN First, notice that, in contrast to the diagram of the call option, the directional exposure of a put option is bounded on the downside by $0, so we do not draw an arrow indicating infinite exposure. This is the same downside exposure of a stock because a stock cannot fall below zero dollars per share. In this diagram, the time range for the put option is the same 500 days as for our call option, but the price range at which we have exposure starts at a strike price of $50—the current market price of the stock—making this an at-the-money (ATM) put. If you think about moneyness in terms of a range of exposure, the difference between out of the money (OTM) and in the money (ITM) becomes easy and sensible. Here are examples of differ- ent moneyness cases for put options: Option Fundamentals   • 17 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 OTM ATM ITMGREEN We are assuming that this put option costs $5, leading to a breakeven line of $45. This breakeven line is like an upside-down hurdle in that we would like the stock to finish below $45; if it expires below $50 but above $45, again, we will be able to profit from the exercise, but this profit will not be great enough to cover the cost of the option. 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 Breakeven Line: $45.00 GREEN Obviously, if we can gain downside exposure to a stock, we must be able to accept it as well. We can accept downside exposure by selling a put; this book represents a sold put graphically like this: 18  •   The Intelligent Option Investor 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 Breakeven Line: $45.00 RED In this diagram, we are receiving a $5 premium payment in return for accepting exposure to the stock’s downside. As such, as long as the stock expires above $45, we will realize a profit on this investment. Visual Representation of Options Canceling Exposure Let’s take a look again at our visual representation of the risk and reward of a stock: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 GREEN RED We bought this stock at $50 per share and will experience an unreal- ized gain if the stock goes up and an unrealized loss if it goes down. What might happen if we were to simultaneously buy a put, expiring in 365 days and struck at $50, on the same stock? Because we are purchasing a put, we know that we are gaining expo- sure to the downside. Any time we gain exposure, we shade the exposure Option Fundamentals   • 19 in green. Let’s overlay this gain of downside exposure on the preceding risk-return diagram and see what we get. 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 GREEN RED The region representing the downside exposure we gained by buy- ing the put perfectly overlaps part of the region representing the downside exposure we accepted when we bought the stock. When there is a region such as this, where we are simultaneously gaining and accepting exposure, the two exposures cancel out, creating no economic exposure whatsoever. From here on out, to show a canceling of economic exposure, we will shade the region in gray, like the following: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 GREEN REDGRAY 20  •   The Intelligent Option Investor Any time a gain of exposure overlaps another gain of exposure, the potential gain from an investment if the stock price moves into that region rises. We will not represent this in the diagrams of this book, but you can think of overlapping gains as deeper and deeper shades of green (when gaining exposure) and deeper and deeper shades of red (when accepting it). Now that you understand how to graphically represent gaining and accepting exposure to both upside and downside directionality and how to represent situations when opposing exposures overlap, we can move onto the next section, which introduces the great flexibility options grant to an investor and discusses how that flexibility can be used as a force of either good or evil. Flexibility Again, the main takeaway of this section should be obvious from the title. Here we will see the only two choices stock investors have with regard to risk and return, and we will contrast that with the great flexibility an option investor has. We will also discuss the concept of an effective buy price and an effective sell price—two bits of intelligent option investor jargon. Last, we will look at a typical option strategy that might be recommended by an option “guru” and note that these types of strategies actually are at cross-purposes with the directional nature of options that makes them so powerful in the first place. Jargon introduced in this chapter is as follows: Effective buy price (EBP) Covered call Effective sell price (ESP) Long strangle Leg Stocks Give Investors Few Choices A stock investor only has two choices when it comes to investing: going long or going short. Using our visualization technique, those two choices look like this: Option Fundamentals   • 21 - 20 40 60 80 100 120 140 160 180 200 - 20 40 60 80 100 120 140 160 180 200 GREEN GREEN RED RED Going long a stock (i.e., buying a stock). Going short a stock (i.e., short selling a stock). If you want to gain exposure to a stock’s upside potential by going long (left-hand diagram), you also must simultaneously accept exposure to the stock’s downside risk. Similarly, if you want to gain exposure to a stock’s downside potential by going short (right-hand diagram), you also must ac- cept exposure to the stock’s upside risk. In contrast, option investors are completely unrestrained in their ability to choose what directionality to accept or gain. An option investor could, for example, very easily decide to establish exposure to the direc- tionality of a stock in the following way: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 GREEN GREEN GRAY GRAY GREEN RED RED RED Why an investor would want to do something like this is completely beyond me, but the point is that options are flexible enough to allow this type of a crazy structure to be built. 22  •   The Intelligent Option Investor The beautiful thing about this flexibility is that an intelligent option in- vestor can pick and choose what exposure he or she wants to gain or accept in order to tailor his or her risk-return profile to an underlying stock. By tailoring your risk-return profile, you can increase growth, boost income, and insure your portfolio from downside shocks. Let’s take a look at a few examples. Options Give Investors Many Choices Buying a Call for Growth - 50 100 150 200 BE = $55 GREEN Above an investor is bullish on the prospects of the stock and is using a call op- tion to gain exposure to a stock’s upside potential above $50 per share. Rather than accepting exposure to the stock’s entire downside potential (maximum of a $50 loss) as he or she would have by buying the stock outright, the call- option investor would pay an upfront premium of, in this case, $5. Selling a Put for Income 50 100 150 200 - BE = $45 RED Option Fundamentals   • 23 Here an investor is bullish on the prospects of the stock, so he or she doesn’t mind accepting exposure to the stock’s downside risk below $50. In return for accepting this risk, the option investor receives a premium—let’s say $5. This $5 is income to the investor—kind of like a do-it-yourself dividend payment. By the way, as you will discover later in this book, this is also the risk- return profile of a covered call. Buying a Put for Protection 50 100 150 200 - GREEN REDGRAY Above an investor wants to enjoy exposure to the stock’s upside potential while limiting his or her losses in case of a market fall. By buying a put option struck a few dollars under the market price of the stock, the investor cancels out the downside exposure he or she accepted when buying the stock. With this protective put overlay in place, any loss on the stock will be compensated for through a gain on the put contract. The investor can use these gains to buy more of the stock at a lower price or to buy another put contract as protection when the first contract expires. Tailoring Exposure with Puts and Calls - 20 40 60 80 100 120 140 160 180 200 BE = $60.50 GREEN RED 24  •   The Intelligent Option Investor Here an investor is bullish on the prospects of the stock and is tailor - ing where to gain and accept exposure by selling a short-term put and simultaneously buying a longer-term call. By doing this, the investor basically subsidizes the purchase of the call option with the sale of the put option, thereby reducing the level the stock needs to exceed on the upside before one breaks even. In this case, we’re assuming that the call option costs $1.50 and the put option trades for $1.00. The cash inflow from the put option partially offsets the cash outflow from the call op- tion, so the total breakeven amount is just the call’s $60 strike price plus the net of $0.50. Effective Buy Price/Effective Sell Price One thing that I hope you realized while looking at each of the preceding diagrams is how similar each of them looks to a particular part of our long and short stock diagrams: Buying a stock. - 20 40 60 80 100 120 140 160 180 200 - 20 40 60 80 100 120 140 160 180 200 RED GREEN GREEN RED Short selling a stock. For example, doesn’t the diagram labeled “Buying a call for growth” in the preceding section look just like the top part of the buying stock diagram? Option Fundamentals   • 25 In fact, many of the option strategies I will introduce in this book simply represent a carving up of the risk-reward profile of a long or short stock position and isolating one piece of it. To make it more clear and easy to remember the rules for breaking even on different strategies, I will actu- ally use a different nomenclature from breakeven. If a diagram has one or both of the elements of the risk-return profile of buying a stock, I will call the breakeven line the effective buy price and abbreviate it EBP. For example, if we sell a put option, we accept downside risk in the same way that we do when we buy a stock: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 EBP = $45 RED Basically, what we are saying when we accept downside risk is that we are willing to buy the stock if it goes below the strike price. In return for accepting this risk, we are paid $5 in premium, and this cash inflow effectively lowers the buying price at which we own the stock. If, when the option expires, the stock is trading at $47, we can think of the situation not as “being $3 less than the strike price” but rather as “being $2 over the b u y p r i c e .” Conversely, if a diagram has one or both of the elements of the risk- return profile of short selling a stock, I will call the breakeven line the effective sell price and abbreviate it ESP. For example, if we buy a put option anticipating a fall in the stock, we would represent it graphically like this: 26  •   The Intelligent Option Investor 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 ESP = $45 GREEN When a short seller sells a stock, he or she gets immediate profit exposure to the stock’s downside potential. The seller is selling at $50 and hopes to make a profit by buying the shares back later at a lower price—let’s say $35. When we get profit exposure to a stock’s downside potential using options, we are getting the same exposure as if we sold the stock at $50, except that we do not have to worry about losing our shirts if the stock moves up instead of down. In order to get this peace of mind, though, we must spend $5 in premium. This means that if we hold the position to expiration, we will only realize a net profit if the stock is trading at the $50 mark less the money we have already paid to buy that ex- posure—$5 in this case. As such, we are effectively selling the stock short at $45. There are some option strategies that end up not looking like one of the two stock positions—the flexibility of options allows an investor to do things a stock investor cannot. For example, here is the graphic representa- tion of a strategy commonly called a long strangle: 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 BE 1 = $80.75 BE 2 = $19.25 GREEN GREEN Option Fundamentals   • 27 Here we have a stock trading at $50 per share, and we have bought one put option and one call option. The put option is struck at $20 and is trading for $0.35. The call option is struck at $80 and is trading for $0.40. Note that the top part of the diagram looks like the top part of the long-stock diagram and that the bottom part looks like the bottom part of the short-stock diagram. Because a stock investor cannot be simulta- neously long and short the same stock, we cannot use such terminology as effective buy or effective sell price. In this case, we use breakeven and abbreviate it BE. This option strategy illustrates one way in which options are much more flexible than stocks because it allows us to profit if the stock moves up (into the call’s range of exposure) or down (into the put’s range of exposure). If the stock moves up quickly, the call option will be in the money, but the put option will be far, far, far out of the money . Thus, if we are ITM on the call, the premium paid on the puts probably will end up a total loss, and vice versa. For this reason, we calculate both break- even prices as the sum of both legs of our option structure (where a leg is defined as a single option in a multioption strategy). As long as the leg that winds up ITM is ITM enough to cover the cost of the other leg, we will make a profit on this investment. The only way we can fail to make a profit is if the stock does not move one way or another enough before the options expire. Flexibility without Directionality Is a Sucker’s Game Despite this great flexibility in determining what directional invest- ments one wishes to make, as I mentioned earlier, option market mak- ers and floor traders generally attempt to mostly (in the case of floor traders) or wholly (in the case of market makers) insulate themselves against large moves in the underlying stock or figure out how to lim- it the cost of the exposure they are gaining and do so to such an ex- tent that they severely curtail their ability to profit from large moves. I do not want to belabor the point, but I do want to leave you with one graphic illustration of a “typical” complex option strategy sometimes called a condor : 28  •   The Intelligent Option Investor 5/18/2012 - 20 40 60 80 100 120 140 160 180 200 5/20/2013 249 499 Date/Day Count Stock Price 749 999 BE 1 BE 2 RED RED There are a few important things to notice. First, notice how much shorter the time frame is—we have moved from a 500-day time exposure to a two-week exposure. In general, a floor trader has no idea of what the long-term value of a stock should be, so he or she tries to protect himself or herself from large moves by limiting his or her time exposure as much as possible. Second, look at how little price exposure the trader is accepting! He or she is attempting to control his or her price risk by making several simultaneous option trades (which, by the way, puts the trader in a worse position in terms of breakeven points) that end up canceling out most of his or her risk exposure to underlying moves of the stock. With this position, the trader is speculating that over the next short time period, this stock’s market price will remain close to $50 per share; what basis the trader has for this belief is beyond me. In my mind, winning this sort of bet is no better than going to Atlantic City and betting that the marble on the roulette wheel will land on red—completely random and with only about a 50 percent chance of success. 3 It is amazing to me that, after reading books, subscribing to newslet- ters, and listening to TV pundits advocating positions such as this, inves- tors continue to have any interest in option investing whatsoever! With the preceding explanation, you have a good foundation in the concept of options, their inherent directionality, and their peerless flex- ibility. We will revisit these themes again in Part III of this book when we investigate the specifics of how to set up specific option investments. However, before we do that, any option investor must have a good sense of how options are priced in the open market. We cover the topic of option pricing in Chapter 2. 29 Chapter 2 The black-scholes- merTon model As you can tell from Chapter 1, options are in fact simple financial instru- ments that allow investors to split the financial exposure to a stock into upside and downside ranges and then allow investors to gain or accept that expo- sure with great flexibility. Although the concept of an option is simple, trying to figure out what a fair price is for an option’s range of exposure is trickier. The first part of this chapter details how options are priced according to the Black- Scholes-Merton model (BSM)—the mathematical option pricing model mentioned in Chapter 1—and how these prices predict future stock prices. Many facets of the BSM have been identified by the market at large as incorrect, and you will see in Part III of this book that when the rubber of theory meets the road of practice, it is the rubber of theory that gets deformed. The second half of this chapter gives a step-by-step refutation to the principles underlying the BSM. Intelligent investors should be very, very happy that the BSM is such a poor tool for pricing options and pre- dicting future stock prices. It is the BSM’s shortcomings and the general market’s unwillingness or inability to spot its structural deficiencies that allow us the opportunity to increase our wealth. Most books that discuss option pricing models require the reader to have a high level of mathematical sophistication. I have interviewed candidates with master’s degrees in financial engineering who indeed had a very high level of mathematical competence and sophistication yet could not translate that sophistication into the simple images that you will see over the next few pages. 30  •   The Intelligent Option Investor This chapter is vital to someone aspiring to be an intelligent options investor. Contrary to what you might imagine, option pricing is in itself something that intelligent option investors seldom worry about. Much more important to an intelligent option investor is what option prices im- ply about the future price of a stock and in what circumstances option prices are likely to imply the wrong stock prices. In terms of our intelligent option investing process, we need two pieces of information: 1. A range of future prices determined mechanically by the option market according to the BSM 2. A rationally determined valuation range generated through an insightful valuation analysis This chapter gives the theoretical background necessary to derive the former. The BSM’s Main Job is to Predict Stock Prices By the end of this section, you should have a big-picture sense of how the BSM prices options that is put in terms of an everyday example. Y ou will also understand the assumptions underlying the BSM and how, when combined, these assumptions provide a prediction of the likely future value of a stock. Jargon introduced in this section includes the following: Stock price efficiency Forward price (stock) Lognormal distribution Efficient market hypothesis (EMH) Normal distribution BSM cone Drift The Big Picture Before we delve into the theory of option pricing, let me give you a general idea of the theory of option prices. Imagine that you and your spouse or significant other have reservations at a nice restaurant. The reservation time is coming up quickly, and you are still at home. The restaurant is extremely hard to get reservations for, and if you are not there at your reservation time, The Black-Scholes-Merton Model   • 31 your seats are given to someone else. Now let’s assume that in the midst of the relationship stress you are likely feeling at the moment, you decide to lighten the mood by betting with your spouse or significant other as to whether you will be able to make it to the restaurant in time for your seating. If you were a statistician attempting to lighten the mood of the evening, before you placed your bet, you would have attempted to factor in answers to the following questions to figure out how likely or unlikely you would be to make it on time: 1. How long do you have until your reservation time? 2. How far away is the restaurant? 3. How many stop signs/stoplights are there, and how heavy is traffic? 4. What is the speed limit on the streets? 5. Does your car have enough gasoline to get to the restaurant? Let’s say that your reservation time is 6 p.m. and it is now 5:35 p.m . Y ou realize that you will not be able to calculate an exact arrival time be - cause there are some unknown factors—especially how heavy traffic is and how often you’ll have to stop at stoplights. Instead of trying to pick a point estimate of your arrival time, you decide to calculate the upper and lower bounds of a range of time over which you may arrive. After assessing the input factors, let’s say that your estimated arrival time range looks something like this: Moderate traffic No traffic Heavy traffic 12 6 5 4 39 10 11 8 7 2 1 In other words, you think that your best chance of arrival is the 15-minute range between 5:50 and 6:05 p.m. If traffic is light, you’ll make it toward the beginning of that interval; if traffic is heavy, you’ll make it toward the end of that interval or may not make it at all. How willing would you be to bet on making it on time? How much would be a fair amount to bet? 32  •   The Intelligent Option Investor This example illustrates precisely the process on which the BSM and all other statistically based option pricing formulas work. The BSM has a fixed number of inputs regarding the underlying asset and the contract itself. Inputting these variables into the BSM generates a range of likely future values for the price of the underlying security and for the statistical probability of the security reaching each price. The statistical probability of the security reach- ing a certain price (that certain price being a strike price at which we are inter- ested in buying or selling an option) is directly tied to the value of the option. Now that you have a feel for the BSM on a conceptual dining- reservation level, let’s dig into a specific stock-related example. Step-by-Step Method for Predicting Future Stock Price Ranges—BSM-Style In order to understand the process by which the BSM generates stock price predictions, we should first look at the assumptions underlying the model. We will investigate the assumptions, their tested veracity, and their impli- cations in Chapter 3, but first let us just accept at face value what Messrs. Black, Scholes, and Merton take as axiomatic. According to the BSM, • Securities markets are “efficient” in that market prices perfectly reflect all publicly available information about the securities. This implies that the current market price of a stock represents its fair value. New information regarding the securities is equally likely to be positive as negative; as such, asset prices are as likely to move up as they are to move down. • Stock prices drift upward over time. This drift cannot exceed the risk-free rate of return or arbitrage opportunities will be available. • Asset price movements are random and their percentage returns follow a normal (Gaussian) distribution. • There are no restrictions on short selling, and all hedgers can bor - row at the risk-free rate. There are no transaction costs or taxes. Trading never closes (24/7), and stock prices are mathematically continuous (i.e., they never gap up or down), arbitrage opportuni- ties cannot persist, and you can trade infinitely small increments of shares at infinitely small increments of prices. The Black-Scholes-Merton Model  • 33 Okay, even if the last assumption is a little hard to swallow, the first three sound plausible, especially if you have read something about the efficient market hypothesis (EMH). Suffice it to say that these assumptions express the “orthodox” opinion held by financial economists. Most finan- cial economists would say that these assumptions describe correctly, in broad-brush terms, how markets work. They acknowledge that there may be some exceptions and market frictions that skew things a bit in the real world but that on the whole the assumptions are true. Let us now use these assumptions to build a picture of the future stock price range predicted by the BSM. Start with an Underlying Asset First, imagine that we have a stock that is trading at exactly $50 right now after having fluctuated a bit in the past. Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price I am just showing one year of historical trading data and three years of calendar days into the future. Let’s assume that we want to use the BSM to predict the likely price of this asset, Advanced Building Corp. (ABC), three years in the future. The BSM’s first assumption—that markets are efficient and stock prices are perfect reflections of the worth of the corporation—means that if 34  •   The Intelligent Option Investor there is no additional information about this company, the best prediction of its future price is simply its present price. In graphic terms, we would represent this first step in the following way: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price Here the dotted straight line represents a prediction of the future price of the stock at any point in time. However, to the extent that the world simply cannot stop spinning, news never stops flowing. Some of this news likely will have an impact on the economic value of the firm, but as stated earlier, according to the EMH, the incoming information is random and is just as likely to be positive for valuation as it is to be negative. The first step of the BSM prediction is pretty raw. Stated simply, at this point in the process, the BSM predicts that the future price of the stock most likely will be the present price of the stock, with a possible range of values around that expected price randomly fluctuating from $0 to infinity. To refine this decidedly unhelpful range, the BSM must incorporate its second axiom into its prediction methodology. Calculate the Forward Price of the Stock Looking at a long-range chart of stock markets, one fact sticks out: mar - kets tend to rise over the long term. Although this is obvious to even a The Black-Scholes-Merton Model  • 35 casual observer, the fact that markets tend to rise is contradictory to our first principal—that stocks are as likely to go up as they are to go down. Indeed, if stocks in general did not go up, people would not think to invest in them as long as there were other investment choices such as risk- free bonds available. Thus the theorists modified their first assumption slightly, saying that stock prices are just as likely to go up as they are to go down over a very short period of time; over longer time periods, they would have to drift upward. The amount of this drift is set to the risk-free rate via a wonderfully elegant argument involving the no-arbitrage condi- tion in the fourth assumption listed earlier. Increasing the present price of the stock into the future at the risk- free rate generates what is known as the forward price of the stock. Here is what the forward price of our asset looks. Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price Here we see the stock being subject to risk-free drift—moving up steadily to $52 at the end of three years—this is the forward price. In terms of the BSM’s prediction of the future stock price, this forward price line represents its most likely value. The only slight modification to this calculation of forward price involves dividend-paying stocks. For dividend-paying stocks, the expected 36  •   The Intelligent Option Investor dividend serves as a downward drift that cancels out some of the upward drift of the risk-free rate. Simplistically, if the risk-free rate is 3 percent per year and the company has a dividend yield of 1 percent per year, the upward-drift term will be 2 percent (= 3 percent − 1 percent). Add a Range around the Forward Price Now even an academic would look at the preceding diagram and have his or her doubts that the model regarding whether the future price of this asset will ever be proven correct. This is when the academic will start to backpedal and remind us of the first axiom by saying, “Markets are effi- cient, but stock prices fluctuate based on new data coming into the market. Because good news is as likely to come into the market as bad news, stock prices should fluctuate up and down in equal probability. ” Because they are fluctuating randomly, our prediction should be a statistical one based on a range. To make the predictive range more usable than our earlier condition (i.e., a predicted stock price between $0 and infinity), we must take a look at the next axiom—the percentage return of stocks follows a normal (also called Gaussian) distribution. A normal distribution is simply a bell curve, with which most people are very familiar in the context of IQ scores and other natural phenomena. A bell curve is perfectly symmetrical—the most commonly found value (e.g., an IQ of 100) is the value at the tallest point of the curve, and there are approximately as many instances of profound genius as there are of profound mental disability. Note that the BSM assumes that percentage returns are normally dis- tributed. In our graphs, we are showing price rather than percentage return on the vertical axis, so we will have to translate a percentage return into a price. Translating a percentage return into a price gives us a distribution that is skewed to the right called a lognormal distribution. Thinking about stock prices for a moment, it becomes obvious that it is likely that stock prices will follow a skewed distribution simply because the price cannot fall any further than $0 per share but has no upward bound. For further evidence that this skewed distribution is correct, take a look at what happens to the prices of two stocks, both of which start initially at $50, but one of which decreases by 10 percent for three The Black-Scholes-Merton Model  • 37 consecutive days and the other which increases by 10 percent for three consecutive days. Losing Stock Winning Stock Original price $50.00 Original price $50.00 Price after falling 10% $45.00 Price after rising 10% $55.00 Price after falling another 10% $40.50 Price after rising another 10% $60.50 Price after falling another 10% $36.45 Price after rising another 10% $66.55 Final difference from $50 $13.55 Final difference from $50 $16.55 Notice that even though both have changed by the same percentage each day, the stock that has increased has done so more than the losing stock has decreased. This experiment shows that if we assume a normal distribu- tion of returns, we should wind up with a distribution that is skewed toward higher prices. Mathematically, this distribution is called the lognormal curve. If we use the forward price as a base and then draw a cone representing the lognormal distribution around it, we end up with the following diagram: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price 38  •   The Intelligent Option Investor This diagram shows that the most likely future price projected by the BSM still lies along the straight dotted line, and the most likely range lies between the solid lines of the curve. In this diagram, note that even though the skew is subtle, the lower bound is closer to the forward price of the stock than is the upper bound. This confirms that the BSM’s predictive model is consistent with its third assumption. It also gives us a much more sensible prediction of the future price of this stock than when we started out. We will term this graph the BSM cone. According to the BSM, if you want to know the price at which a stock will trade at any point in the future, you can look within the bounds of the BSM cone. The prices within this cone are more likely to be near the forward price line and less likely to be near the lines of the cone itself. In a phrase, the BSM tells an investor, “If you want to know what the future price of a stock will be, look within the cone. ” With the refinements we have made, we can say that our best guess for the value of this stock in three years will be $52, and the range of values between which the stock will most plausibly fall will be anywhere from around $37 to just over $70. One thing to note is that the cone as I have drawn it here does not, in fact, show the outline of the entire log- normal price distribution for the stock but rather just the most plausible range. Also, as mentioned earlier, the likelihood of the stock price reaching each of the prices along the vertical axis is not equal. The most likely future value according to the BSM is the forward price. Most likely means, in the statistical sense, that there is a 50-50 chance that the stock will be above or below that line. As one moves up the vertical (price) axis from the forward price line, the likelihood that the stock price will be above that point is pro- gressively lower. By the time you reach the upper line of the cone, the chance that the stock price will be higher than that is only around 16 percent. Conversely, as you move down the vertical axis from the for - ward price line, the likelihood that the stock price will be below that point is progressively lower. By the time you reach the lower line of the cone, the chance that the stock price will fall lower than that is again around 16 percent. The Black-Scholes-Merton Model  • 39 Stock has ~16% chance of rising above this line 50% chance of stock being above or below this price Stock has ~16% chance of falling below this line 5/18/2012 5/20/2013 249 499 749 999 90 100 80 70 60 50 40 30 20 Advanced Building Corp. (ABC) Date/Day Count Stock Price Because the BSM assumes that stock returns are lognormally distrib- uted, and because the properties of the lognormal curve are very well un- derstood by mathematicians, every single point on the vertical price axis is associated with a distinct probability. In other words, with just the few simple inputs we have discussed, the BSM mechanically churns out pre- dictions of future stock prices by associating a future stock price with a theoretically derived probability. Now that we know what the theory says and have created a predic- tion of the future price of a stock based on the theory, let’s look at key areas where the BSM breaks down. The BSM is Lousy at Its Main Job By the end of this section, you will have a good understanding why the BSM—although a testament to human ingenuity and logical reasoning—is deeply flawed as a model to predict asset prices in general and stock prices specifically. 40  •   The Intelligent Option Investor Jargon that will be introduced in this section is as follows: Leptokurtic Fat-tailed Critiques of the Base Assumptions of the BSM Before we head into the critique section, let us remind ourselves of the base assumptions of the BSM. When I introduced these assumptions ear - lier, I suggested that you should just accept them at face value, but this time around, let’s look at the assumptions with a more critical eye. • Securities markets are efficient in that market prices perfectly reflect all publicly available information about the securities. This implies that the current market price of a stock represents its fair value. New information regarding the securities is equally likely to be positive as negative; as such, asset prices are as likely to move up as they are to move down. • Stock prices drift upward over time. This drift cannot exceed the risk-free rate of return, or arbitrage opportunities will be available. • Asset price percentage returns follow a normal (Gaussian) distribution. • There are no restrictions on short selling, and all hedgers can bor - row at the risk-free rate. There are no transaction costs or taxes. Trading never closes (24/7), and stock prices are mathematically continuous (i.e., they never gap up or down), arbitrage opportuni- ties cannot persist, and you can trade infinitely small increments of shares at infinitely small increments of prices. Although the language is formal and filled with jargon, you need not be in- timidated by the special terminology but should simply look at the assumptions from a commonsense perspective. Doing so, you will see how ridiculous each of these assumptions appears. Indeed, each one of them has either been proven wrong through experimental evidence (i.e., the first three assumptions) or is plainly false (the fourth assumption). Let’s look at each assumption one by one. Markets Are Efficient The first two assumptions spring from a theory in financial economics called the efficient market hypothesis (EMH), which is strongly associated The Black-Scholes-Merton Model  • 41 with the University of Chicago and which, more or less, still holds truck with many theorists to this day. Stock prices, under this theory, move in ac- cordance with the random-walk principal—having a 50-50 chance of going up or down in a short time period because they are bought and sold on the basis of new information coming into the market, and this new informa- tion can be either good or bad. The EMH proposes that there are different levels of efficiency in fi- nancial markets. The weakest form of efficiency holds that one cannot gen- erate returns that are disproportionate to risk in a market simply by having access to information related to historical prices of the market (i.e., refut- ing so-called technical analysis). The strongest form of efficiency holds that even an investor with inside information about a company cannot generate returns that are disproportionate to the risk they assume by investing (this form is usually rejected even by supporters of the EMH). In short, the EMH says that investors, in aggregate, dispassionately assess all available facts regarding the economic environment and rationally and methodically incorporate their well-informed expectations about likely future outcomes into their decisions to buy or sell a given stock. They always act in such a way as to maximize their utility in a ra- tional, considered way. Now, before running to your favorite search engine to look for aca- demic papers refuting or defending the EMH, just step back and ask one sim- ple question: Does this model of human behavior seem right to you? How many people on the road with you during rush hour or attending a sporting event or going holiday shopping seem to make calculated, rational, and well- considered decisions? When it comes to something dealing with money and investing, how many people do you know who act in the way just described? No matter what mathematical proof may or may not support the EMH, as a model of human behavior, the EMH simply does not ring true—to us at least. Aside from the fundamental criticism that the EMH does not pre- sent a model of human behavior that seems, well, human, there have been empirical refutations of the EMH from almost its conception. Studies showing that stocks with low price-to-book ratios, price-to-sales ratios, and price-to-earnings ratios outperform those with high ratios have been well documented, and the effects mentioned seem to persist. One of my professors in business school, Graeme Rankine, helped to discover the 42  •   The Intelligent Option Investor so-called stock-split effect—the fact that stocks that split (i.e., the owners were simply told that for every share they previously owned, they now owned multiple shares, a change that should not have any effect whatsoever on the value of the firm) performed better after the split than those that did not split. More recently, Andrew Lo and Craig MacKinlay have demonstrated that financial markets are not efficient on even a weak basis but that they have some sort of a long-term price “memory” and seem to act more like an organic system than a mechanical one. Later in this book we will discuss behavioral factors that affect invest- ing, and in fact, several prominent behavioral economics theorists (Daniel Kahneman and Robert Shiller) have won Nobel prizes in economics as a result of their groundbreaking work in this field. In essence, what behav- ioral economics points out is that when given questions that test decision- making ability and process, most people—even highly trained people—do not make decisions in a way described by the tenants of the EMH. In fact, economists have found that experimentally, human decision makers are swayed by all sorts of issues that someone subscribing to the EMH would find irrational. Human decision makers do not, it turns out, act as perfectly rational economic animals as the EMH posits but rather are swayed by emotion, illusion, and ingrained prejudice that cause their decisions to be made in consistently flawed ways. Obviously, the experimental evi- dence that behavioral economics researchers have highlighted regarding how economic actors make decisions casts doubt on the basic premises of the EMH. Indeed, proponents of EMH would argue (do argue in the case of Eugene Fama, a Nobel prize–winning economist at the University of Chicago and one of the intellectual godfathers of the EMH) that asset price bubbles cannot occur. If markets are efficient, they incorporate all avail- able information regarding the likely future outcome of stocks and other financial assets in their present prices—meaning that even when prices are very high, as they were during the Internet boom and the mortgage finance boom, market participants’ expectations are “rational. ” Fama has famously said, “I don’t even know what a ‘bubble’ is. ” This type of pedagogical rigidity in the face of clear evidence of the existence of bubbles and crashes, and in fact the enormous human costs that the bursting of bubbles bring about (e.g., in the wake of the The Black-Scholes-Merton Model  • 43 bursting of the mortgage finance bubble), has soured many laypeople on the philosophical underpinnings of the EMH, even if they have never heard the term specifically mentioned. Academic responses to the ten- ants of the EMH from economists such as Nobel prize–winner Rob- ert Shiller and Australian Steven Keen have been gaining strength and acceptance in recent years, whereas only a few years ago they would have been considered apostate and would have been ridiculed by “respectable” orthodox economists. Whatever the arguments both for and against the EMH, if you are reading this book, you implicitly must hold the belief that stock markets are inefficient because by reading this book, you must be trying to “beat” the markets—an act that the EMH maintains is impossible. Although it is a pretty blunt tool for someone trying to accurately describe the complexity of markets, the one thing the EMH does have to recommend it is that if you hold to its assumptions, the mathematics describing asset prices is made much easier, and this ease leads to the ability to develop a pricing model such as the BSM. In fact, although one of my favorite indoor sports is making fun of EMH assumptions, I do not disagree that, especially over short time frames and especially for certain types of assets, the EMH assumptions hold up pretty well and that the BSM is useful in describing likely price ranges. I discuss when the BSM is more useful and correct in Appendix A because in those instances an intelligent investor has a small chance of success. It goes without saying that intelligent investors choose not to invest in situations in which there is a small chance of success! A good theory must be simple, but it also must be provably correct under all conditions. While the EMH is certainly simple, I maintain that it cannot be considered a good theory because it does not explain phenom- ena in financial markets correctly in all (most?) circumstances. This means that the first pillar on which the BSM is built is, for the purposes of intel- ligent investors, wrong. Stock Returns Are Normally Distributed A picture is worth a thousand words. Here is a picture of a normal distribution probability curve: 44  •   The Intelligent Option Investor -3σ 0 x .1359 .0214 Gaussian or “normal” distribution fg(x) .00135 .3413 .3413 .1359 .0214 .00135 -2σ 2σ 3σ-σ σ The numbers near the horizontal axis show the percent of cases in each region (e.g., between the 0 and σ, you see the number 0.3413—this means that for a normally distributed quantity such as IQ, you would ex- pect 34.13 percent of cases to lie in that region), and the regions are marked off into numbers of standard deviations [denoted by the lowercase Greek letter sigma (σ)]. Now that you’ve seen a normal curve, let’s take a look at daily returns for the Standard & Poor’s 500 Index (S&P 500) over the past 50 years: -21% -19% -17% -15% -13% -11% -9%- 7% -5%- 3% -1%3 %1% 5% 7% 9% 11% 0 100 200 300 400 500 900 800 700 600 S&P Returns Frequency S&P 500 Daily Returns The Black-Scholes-Merton Model  • 45 There is a very easily recognizable difference between this curve and the preceding one—namely that this one looks much pointier than the other. However, a more profound difference can be seen by looking at the cases out near the –21 percent mark and the +11 percent mark. If the S&P 500’s actual returns were normally distributed, these points simply would not exist—not for another billion years or so. The huge fall (a 20-standard- deviation event) might be expected to happen in financial markets every few billion years if in fact daily returns were normally distributed. Instead, they seem to happen about once every 70 years or so. These observations should provide good anecdotal evidence that the assumption of normally distributed returns is unfounded. Indeed, empir- ical evidence has shown that stock market returns are what are termed strongly leptokurtic (a.k.a. fat-tailed) to the extent that it is not helpful to think of them as normal at all. The two characteristics of leptokurtic distri- butions are that (1) they are pointy and (2) they contain a relatively large proportion of extreme tail values. Some theorists think that the best way to understand stock returns is actually to conceive of them as multiple over - lapping (and non-Gaussian) distributions. Whatever statistical distribu- tion stock returns follow, it is certainly not Gaussian. Option traders, in fact, took markets to be normally distributed until the great crash of 1987. After that time, the practitioner response to the obvious leptokurtic nature of stock price returns—charging a much higher than theoretically justified price for far out-of-the money (OTM) puts and far in-the-money (ITM) calls—came into being, and the volatility smile, a feature we will discuss in detail in Part III of the book, came into existence. This means that the second pillar on which the BSM is built is wrong. Stock Prices Drift Upward at the Risk-Free Rate On average, the compound annual growth of the stock market since 1926 has been on the order of 10 percent. The average annual compound growth of U.S. government Treasury bonds (our risk-free benchmark) has been on the order of 5 percent. Therefore, just comparing these averages, it would seem that stocks drift upward at roughly twice the risk-free rate. 46  •   The Intelligent Option Investor Averages can be misleading, however, so in the following graph I have plotted the five-year rolling compound annual growth rate for both the S&P 500 and T-bonds: 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15%1932 1937 1942 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 Stocks 5-year CAGR T-Bonds 5-year CAGR Y ou can see that there are some significant outliers in the Great Depression area of the graph, but in general, stock returns are much higher than those of risk-free instruments on this rolling basis as well. In fact, if you asked me to guess what any randomly selected rolling five-year compound annual growth rate (CAGR) for stocks was going to be, I would probably pick a number like 13 percent and figure that I would at least be in the ballpark 80 percent of the time. Certainly, by looking at the preceding graph, you can tell that there is no reasonable basis to believe that stocks should increase anywhere around the rate of risk-free securities! As such, we can discard the third pillar of the BSM. No Taxes, No Trading Restrictions, and All Market Participants Can Borrow at the Risk-Free Rate, Etc. No comment, other than to say, “Ha!” With no pillars left, the edifice of the BSM crumbles in on itself after even just a cursory look. The Black-Scholes-Merton Model  • 47 The fact that the theoretical basis of option pricing is provably wrong is very good news for intelligent investors. The essence of intelligent option investing involves comparing the mechanically determined and unreason- able range of stock price predictions made by the BSM with an intelligent and rational valuation range made by a human investor. Because the BSM is using such ridiculous assumptions, it implies that intelligent, rational investors will have a big investing advantage. Indeed, I believe that they do. Now that we have seen how the BSM forecasts future price ranges for stocks and why the predictions made by the BSM are usually wrong, let us now turn to an explanation of how the stock price predictions made by the BSM tie into the option prices we see on an option exchange such as the Chicago Board Option Exchange (CBOE). This page intentionally left blank 49 Chapter 3 The InTellIgenT InvesTor’s guIde To opTIon prIcIng By the end of this chapter, you should understand how changes in the follow- ing Black-Scholes-Merton model (BSM) drivers affect the price of an option: 1. Moneyness 2. Forward volatility 3. Time to expiration 4. Interest rates and dividend yields Y ou will also learn about the three measures of volatility—forward, im- plied, and statistical. Y ou will also understand what drivers affect option prices the most and how simultaneous changes to more than one variable may work for or against an option investment position. In this chapter and throughout this book in general, we will not try to figure out a precise value for any options but just learn to realize when an op- tion is clearly too expensive or too cheap vis-à-vis our rational expectations for a fair value of the underlying stock. As such, we will discuss pricing in general terms; for example, “This option will be much more expensive than that one. ” This generality frees us from the computational difficulties that come about when one tries to calculate too precise a price for a given op- tion. The BSM is designed to give a precise answer, but for investing, simply knowing that the price of some security is significantly different from what it should be is enough to give one an investing edge. 50  •   The Intelligent Option Investor In terms of how this chapter fits in with the goal of being an intelligent option investor, it is in this chapter that we start overlaying the range of exposure introduced in Chapter 1 with the implied stock price range given by the BSM cone that was introduced in Chapter 2. This perspective will allow us to get a sense of how expensive it will be to gain exposure to a given range or, conversely, to see how much we are likely to be able to generate in revenue by accepting exposure to that range. Understanding the value of a given range of exposure as perceived by the marketplace will allow us to determine what option strategy will be best to use after we determine our own intelligent valuation range for a stock. Jargon introduced in this chapter is as follows: Strike–stock price ratio Volatility (Vol) Time value Forward volatility Intrinsic value Implied volatility Tenor Statistical volatility Time decay Historical volatility How Option Prices are Determined In Chapter 1, we saw what options looked like from the perspective of ranges of exposure. One of the takeaways of that chapter was how flexible options are in comparison with stocks. Thinking about it a moment, it is clear that the flexibility of options must be a valuable thing. What would it be worth to you to only gain upside to a stock without having to worry about losing capital as a result of a stock price decline? The BSM, the principles of which we discussed in detail in Chapter 2, was intended to answer this question precisely—“What is the fair value of an option?” Let us think about option prices in the same sort of probabilis- tic sense that we now know the BSM is using. First, let’s assume that we want to gain exposure to the upside poten- tial of a $50 stock by buying a call option with a strike price of $70 and a time to expiration of 365 days. Here is the risk-return profile of this option position merged with the image of the BSM cone: The Intelligent Investor’s Guide to Option Pricing  •  51 5/18/2012 20 30 40 50 60 70 80 90 100 5/20/2013 249 499 999749 Advanced Building Corp. (ABC) Date/Day Count Stock Price GREEN Notice that because this call option is struck at $70, the upside po- tential we have gained lies completely outside the cone of values the BSM sees as reasonably likely. This option, according to the BSM, is something like the bet that a seven-year-old might make with another seven-year- old: “If you can [insert practically impossible action here], I’ll pay you a zillion dollars. ” The action is so risky or impossible that in order to entice his or her classmate to take the bet, the darer must offer a phenomenal return. Off the playground and into the world of high finance, the way to offer someone a phenomenal return is to set the price of a risky asset very low. Following this logic, we can guess that the price for this option should be very low. In fact, we can quantify this “very low” a bit more by thinking about the probabilities surrounding this call option investment. Remembering back to the contention in Chapter 2 that the lines of the BSM cone represent around a 16 percent probability of occurrence, we can see that the range of exposure lies outside this, so the chance of the stock making it into this range is lower than 16 percent. Let’s say that the range of exposure sits at just the 5 percent probability level. What this means is that if you can find 20 identical investments like this and invest in all of them, only one will pay off (1/20 = 5 percent). 52  •   The Intelligent Option Investor Thus, if you thought that you would win $1 for each successful invest- ment you made, you might only be willing to pay $0.04 to play the game. In this case, you would be wagering $0.04 twenty times in the hope of making $1 once—paying $0.80 total to net $0.20 for a (probabilistic) 25 percent return. Now how much would you be willing to bet if the perceived chance of success was not 1 in 20 but rather 1 in 5? With options, we can increase the chance of success simply by altering the range of exposure. Let’s try this now by moving the strike price down to $60: 5/18/2012 5/20/2013 249 499 749 20 30 40 50 60 70 80 90 100 999 Advanced Building Corp. (ABC) Date/Day Count Stock Price GREEN After moving the strike price down, one corner of the range of exposure we have gained falls within the BSM probability cone. This option will be significantly more expensive than the $70 strike option because the perceived probability of the stock moving into this range is material. If we say that the chance of this call option paying its owner $1 is 1 in 5 rather than 1 in 20 (the range of exposure is within the 16 percent line, so we’re estimating it as a 20 percent chance—1 in 5, in other words), we should be willing to pay more to make this investment. If we expected to win $1 for every five tries, we should be willing to spend $0.16 per bet. Here we would again expect to pay $0.80 in total to net $0.20, and again our expected percentage return would be 25 percent. The Intelligent Investor’s Guide to Option Pricing  •  53 Notice that by moving the strike down from an expected 5 percent chance of success to an expected 20 percent chance of success, we have agreed that we would pay four times the amount to play. What would happen if we lowered the strike to $50 so that the exposure range started at the present price of the stock? Obviously, this at-the-money (ATM) option would be more expensive still: 5/18/2012 30 20 40 50 60 70 80 90 100 5/20/2013 249 499 749 999 Advanced Building Corp. (ABC) Date/Day Count Stock Price GREEN The range of upside exposure we have gained with this option is not only well within the BSM probability cone, but in fact it lies across the dotted line in- dicating the “most likely” future stock value as predicted by the BSM. In other words, this option has a bit better than a 50 percent chance of paying off, so it should be proportionally more expensive than either of our previous options. The payouts and probabilities I provided earlier are completely made up in order to show the principles underlying the probabilistic pricing of option contracts. However, by looking at an option pricing screen, it is very easy to extrapolate annualized prices associated with each of the probabil- ity levels I mentioned—5, 20, and 50 percent. The following table lists the relative market prices of call options cor- responding to each of the preceding diagrams. 1 The table also shows the calculation of the call price as a percentage of the present price of the stock ($50) as well as the strike–stock price ratio , which shows how far above or below the present stock price a given strike price is. 54  •   The Intelligent Option Investor Strike Price Strike–Stock Price Ratio Call Price Call Price as a Percent of Stock Price 70 140% $0.25 0.5 60 120% $1.15 2.3 50 100% $4.15 8.3 Notice that each time we lowered the strike price in successive examples, we lowered the ratio of the strike price to the stock price. This relationship (sometimes abbreviated as K/S, where K stands for strike price and S stands for stock price) and the change in option prices associated with it are easy for stock investors to understand because of the obvious tie to directionality. This is precisely the reason why we have used changes in the strike–stock price ratio as a vehicle to explain option pricing. There are other variables that can cause option prices to change, and we will discuss these in a later section. I will not make such a long-winded explanation, but, of course, put options are priced in just the same way. In other words, this put option, 5/18/2012 - 10 20 30 40 50 60 70 80 90 100 5/20/2013 249 499 749 999 Advanced Building Corp. (ABC) Date/Day Count Stock Price GREEN The Intelligent Investor’s Guide to Option Pricing  •  55 would be more expensive than the following put option, which looks like this: 5/18/2012 5/20/2013 249 499 749 999 - 10 20 30 40 50 60 70 80 90 100 Advanced Building Corp. (ABC) Date/Day Count Stock Price GREEN The former would be more expensive than the latter simply because the range of exposure for the first lies further within the BSM cone of prob- ability than the latter. We can extrapolate these lessons regarding calls and puts to come up with a generalized rule about comparing the prices of two or more op- tions. Options will be more expensive in proportion to the total range of exposure that lies within the BSM cone. Graphically, we can represent this rule as follows: This call option will be much less expensive… GREEN GREEN than this call option. 56  •   The Intelligent Option Investor This is so because the area of the range of exposure for the option on the left that is bounded by the BSM probability cone is much smaller than the range of exposure for the option on the right that is bounded by the same BSM probability cone. Time Value versus Intrinsic Value One thing that I hope you will have noticed is that so far we have talked about options that are either out of the money (OTM) or at the money (ATM). In-the-money (ITM) options—options whose range of exposure already contains the present stock price—may be bought and sold in just the same way as ATM and OTM options, and the pricing principle is ex- actly the same. That is, an ITM option is priced in proportion to how much of its range of exposure is contained within the BSM probability cone. However, if we think about the case of an OTM call option, we realize that the price we are paying to gain access to the stock’s upside potential is based completely on potentiality. Contrast this case with the case of an ITM call option, where an investor is paying not only for potential upside exposure but also for actual upside as well. It makes sense that when we think about pricing for an ITM call option, we divide the total option price into one portion that represents the poten- tial for future upside and another portion that represents the actual upside. These two portions are known by the terms time value and intrinsic value, respectively. It is easier to understand this concept if we look at a specific example, so let’s consider the case of purchasing a call option struck at $40 and having it expire in one year for a stock presently trading at $50 per share. We know that a call option deals with the upside potential of a stock and that buying a call option allows an investor to gain exposure to that up- side potential. As such, if we buy a call option struck at $40, we have access to all the upside potential over that $40 mark. Because the stock is trading at $50 right now, we are buying two bits of upside: the actual bit and the potential bit. The actual upside we are buying is $10 worth (= $50 − $40) and is termed the intrinsic value of the option. A simple way to think of intrinsic value that is valid for both call options and put options is the amount by which an option is ITM. However, the option’s cost will be greater than only the intrinsic value as long as there is still time The Intelligent Investor’s Guide to Option Pricing  •  57 before the option expires. The reason for this is that although the intrinsic value represents the actual upside of the stock’s price over the option strike price, there is still the possibility that the stock price will move further upward in the future. This possibility for the stock to move further upward is the potential bit mentioned earlier. Formally, this is called the time value of an option. Let us say that our one-year call option struck at $40 on a $50 stock costs $11.20. Here is the breakdown of this example’s option price into in- trinsic and time value: $10.00 Intrinsic value: the amount by which the option is ITM + $1.20 Time value: represents the future upside potential of the stock = $11.20 Overall option price Recall that earlier in this book I mentioned that it is almost always a mis- take to exercise a call option when it is ITM. The reason that it is almost always a mistake is the existence of time value. If we exercised the preceding option, we would generate a gain of exactly the amount of intrinsic value—$10. How- ever, if instead we sold the preceding option, we would generate a gain totaling both the intrinsic value and the time value—$11.20 in this example—and then we could use that gain to purchase the stock in the open market if we wanted. Our way of representing the purchase of an ITM call option from a risk-reward perspective is as follows: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 EBP = $51.25 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price GREEN ORANGE 58  •   The Intelligent Option Investor Usually, our convention is to shade a gain of exposure in green, but in the case of an ITM option, we will represent the range of exposure with intrinsic value in orange. This will remind us that if the stock falls from its present price of $50, we stand to lose the intrinsic value for which we have already paid. Notice also that our (two-tone) range of exposure completely over - laps with the BSM probability cone. Recalling that each upper and lower line of the cone represents about a 16 percent chance of going higher or lower, respectively, we can tell that according to the option market, this stock has a little better than an 84 percent chance of trading for $40 or above in one year’s time. 2 Again, the pricing used in this example is made up, but if we take a look at option prices in the market today and redo our earlier table to in- clude this ITM option, we will get the following: Strike Price ($) Strike–Stock Price Ratio (%) Call Price ($) Call Price as a Percent of Stock Price 70 140 $0.25 0.5 60 120 $1.15 2.3 50 100 $4.15 8.3 40 80 10.85 21.7 Again, it might seem confounding that anyone would want to use the ITM strategy as part of their investment plan. After all, you end up paying much more and being exposed to losses if the stock price drops. I ask you to suspend your disbelief until we go into more detail regarding option investment strategies in Part III of this book. For now, the important points are (1) to understand the difference between time and intrinsic value, (2) to see how ITM options are priced, and (3) to understand our convention for diagramming ITM options. From these diagrams and examples it is clear that moving the range of exposure further and further into the BSM probability cone will increase the price of the option. However, this is not the only case in which options will change price. Every moment that time passes, changes can occur to The Intelligent Investor’s Guide to Option Pricing  •  59 the size of the BSM’s probability cone itself. When the cone changes size, the range-of-exposure area within the cone also changes. Let’s explore this concept more. How Changing Market Conditions Affect Option Prices At the beginning of Chapter 2, I started with an intuitive example related to a friendly bet on whether a couple would make it to a restaurant in time for a dinner reservation. Let’s go back to that example now and see how the inputs translate into the case of stock options. Dinner Reservation Example Stock Option Equivalent How long before seating time Tenor 3 of the option Distance between home and restaurant Difference between strike price and present market price (i.e., strike–stock price ratio) Amount of traffic/likelihood of getting caught at a stoplight How much the stock returns are thought likely to vary up and down Average traveling speed Stock market drift Gas expenditure Dividend payout Looking at these inputs, it is clear that the only input that is not known with certainty when we start for the restaurant is the amount of traffic/ number of stoplights measure. Similarly, when the BSM is figuring a range of future stock prices, the one input factor that is unknowable and that must be estimated is how much the stock will vary over the time of the option contract. It is no surprise, then, that expectations regarding this variable become the single most important factor for determining the price of an option and the factor that people talk most about when they talk about options— volatility (vol). This factor is properly known as forward volatility and is formally defined as the expected one-standard-deviation fluctuation up and down around the forward stock price. If this definition sounds familiar, 60  •   The Intelligent Option Investor it is because it is also the definition of the BSM cone. To the extent that expectations are not directly observable, forward volatility can only be guessed at. The option market’s best guess for the forward volatility, as expressed through the option prices themselves, is known as implied volatility. We will discuss implied volatility in more detail in the next section and will see how to build a BSM cone using option market prices and the forward volatility they imply in Part III. The one other measure of volatility that is sometimes mentioned is sta- tistical volatility (a.k.a. historical volatility). This is a purely descriptive statis- tic that measures the amount the stock price actually fluctuated in the past. Because it is simply a backward-looking statistic, it does not directly affect option pricing. Although the effect of statistical volatility on option prices is not direct, it can have an indirect effect, thanks to a behavioral bias called anchoring. Volatility is a hard concept to understand, let alone a quantity to attempt to predict. Rather than attempt to predict what forward volatility should be, most market participants simply look at the recent past statistical volatility and tack on some cushion to come to what they think is a reason- able value for implied volatility. In other words, they mentally anchor on the statistical volatility and use that anchor as an aid to decide what forward vola- tility should be. The amount of cushion people use to pad statistical volatility differs for different types of stocks, but usually we can figure that the market’s implied volatility will be about 10 percentage points higher than statistical volatility. It is important to realize that this is a completely boneheaded way of figuring what forward volatility will be (so don’t emulate it yourself), but people do boneheaded things in the financial markets all the time. However people come to an idea of what forward volatility is rea- sonable for a given option, it is certain that changing perceptions about volatility are one of the main drivers of option prices in the market. To understand how this works, let’s take a look at what happens to the BSM cone as our view of forward volatility changes. Changing Volatility Assumptions Let’s say that we are analyzing an option that expires in two years, with a strike price of $70. Further assume that the market is expecting a forward The Intelligent Investor’s Guide to Option Pricing  •  61 volatility of 20 percent per year for this stock. Visually, our assumptions yield the following: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price GREEN A forward volatility of 20 percent per year suggests that after three years, the most likely range for the stock’s price according to the BSM will be around $41 on the low side to around $82 on the high side. Furthermore, we can tell from our investigations in Chapter 2 that this option will be worth something, but probably not much—about the same as or maybe a little more than the one-year, $60 strike call option we saw in Chapter 2. 4 Now let’s increase our assumption for volatility over the life of the contract to 40 percent per year. Increasing the volatility means that the BSM probability cone becomes wider at each point. In simple terms, what we are saying is that it is likely for there to be many more large swings in price over the term of the option, so the range of the possible outcomes is wider. Here is what the graph looks like if we double our assumptions regarding implied volatility from 20 to 40 percent: 62  •   The Intelligent Option Investor Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 110 120 130 90 80 70 60 50 40 20 30 10 - Date/Day Count Stock Price GREEN Compared with the preceding diagram, look how far into the exposure range the new BSM probability cone extends! Under an assumption of 40 percent per year forward volatility, the most likely price range for the stock as calculated by the BSM is around $30 to nearly $120. Looking at the range of exposure contained within the new BSM probability cone, we can tell that the likelihood of the stock being at $70 or greater in two years is much higher than it was when we assumed a forward volatility of 20 percent. Because the area of the range of exposure contained within the new BSM cone is much greater, we can be sure that the option will be much more expensive now. Let’s now take a look at the opposite case—volatility is assumed to be half that of our original 20 percent per year assumption: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 80 70 60 50 40 30 20 10 - Date/Day Count Stock Price GREEN The Intelligent Investor’s Guide to Option Pricing  •  63 With this change in assumptions, we can see that the most likely range for the stock’s price three years in the future is between about $50 and about $70. As such, the chance of the stock price hitting $70 in two years moves from somewhat likely (20 percent volatility in the first example) to very likely (40 percent volatility in the second example) to very unlikely (10 percent volatility in the third example) in the eyes of the BSM. This characterization of “very unlikely” is seen clearly by the fact that the BSM probability cone contains not one whit of the call option’s exposure range. In each of these cases, we have drawn the graphs by first picking an assumed volatility rate and then checking the worth of an option at a cer - tain strike price. In actuality, option market participants operate in reverse order to this. In other words, they observe the price of an option being transacted in the marketplace and then use that price and the BSM model to mathematically back out the percentage volatility implied by the option price. This is what is meant by the term implied volatility and is the process by which option prices themselves display the best guesses of the option market’s participants regarding forward volatility. Indeed, many short-term option speculators are not interested in the range of stock prices implied by the BSM at all but rather the dramatic change in price of the option that comes about with a change in the width of the volatility cone. For example, a trader who saw the diagram representing 10 percent annu- alized forward volatility earlier might assume that the company should be trad- ing at 20 percent volatility and would buy options hoping that the price of the options will increase as the implied volatility on the contracts return to normal. This type of market participant talks about buying and selling volatility as if implied volatility were a commodity in its own right. In this style of option trad- ing, investors assume that option contracts for a specific stock or index should always trade at roughly the same levels of implied volatility. 5 When implied vola- tilities change from the normal range—either by increasing or decreasing—an option investor in this vein sells or buys options, respectively. Notice that this style of option transaction completely ignores not only the ultimate value of the underlying company but also the very price of the underlying stock. It is precisely this type of strategy that gives rise to the complex short- term option trading strategies we mentioned in Chapter 1—the ones that are set up in such a way as to shield the investor transacting options from any of the directionality inherent in options. Our take on this kind of trading is that 64  •   The Intelligent Option Investor although it is indeed possible to make money using these types of strategies, because multiple options must be transacted at one time (in order to control directional risk), and because in the course of one year many similar trades will need to be made, after you pay the transaction costs and assuming that you will not be able to consistently win these bets, the returns you stand to make using these strategies are low when one accounts for the risk undertaken. Of course, because this style of option trading benefits brokers by allowing them to profit from the bid-ask spread and from a fee on each transaction, they tend to encourage clients to trade in this way. What is good for the goose is most definitely not good for the gander in the case of brokers and investors, so, in general, strategies that will benefit the investor relatively more than they benefit the investor’s broker—like the intelligent option investing we will discuss in Part III—are greatly preferable. The two drivers that have the most profound day-to-day impact on option prices are the ones we have already discussed: a change in the strike–stock price ratio and a change in forward volatility expectations. However, over the life of a contract, the most consistent driver of option value change is time to expiration. We discuss this factor next. Changing Time-to-Expiration Assumptions To see why time to expiration is important to option pricing, let us leave our volatility assumptions fixed at 20 percent per year and assume that we are buying a call option struck at $60 and expiring in two years. First, let’s look at our base diagram—two years to expiration: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price GREEN The Intelligent Investor’s Guide to Option Pricing  •  65 It is clear from the large area of the exposure range bordered by the BSM probability cone that this option will be fairly expensive. Let’s now look at an option struck at the same price on the same un- derlying equity but with only one year until expiration: Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 100 90 80 70 60 50 40 30 20 Date/Day Count Stock Price GREEN Consistent with our expectations, shortening the time to expiration to 365 days from 730 days does indeed change the likelihood as calculated by the BSM of a call option going above $60 from quite likely to just barely likely. Again, this can be confirmed visually by noting the much smaller area of the exposure range bounded by the BSM probability cone in the case of the one-year option versus the two-year one. Indeed, even without drawing two diagrams, we can see that the chance of this stock rising above $60 decreases the fewer days until expira- tion simply because the outline of the BSM probability cone cuts diagonal- ly through the exposure range. As the cone’s outline gets closer to the edge of the exposure range and finally falls below it, the perceived chance falls to 16 percent and then lower. We would expect, just by virtue of the cone’s shape, that options would lose value with the passage of time. This effect has a special name in the options world—time decay. Time decay means that even if neither a stock’s price nor its volatility change very much over the duration of an option contract, the value of that option will 66  •   The Intelligent Option Investor still fall slowly. Time decay is governed by the shape of the BSM cone and the degree to which an option’s range of exposure is contained within the BSM cone. The two basic rules to remember are: 1. Time decay is slowest when more than three months are left before expiration and becomes faster the closer one moves toward expiration. 2. Time decay is slowest for ITM options and becomes faster the closer to OTM the option is. Visually, we can understand the first rule—that time decay increases as the option nears expiration—by observing the following: Slope is shallow here... But steep here... The steepness of the slope of the curve at the two different points shows the relative speed of time decay. Because the slope is steeper the less time there is on the contract, time decay is faster at this point as well. Visually, we can understand the second rule—that OTM options lose value faster than ITM ones—by observing the following: Time BT ime A Time BT ime A GREEN GREEN ORANGE OTM option ITM option The Intelligent Investor’s Guide to Option Pricing  •  67 At time A for the OTM option, we see that there is a bit of the range of exposure contained within the cone; however, after some time has passed and we are at time B, none of the range of exposure is contained within the BSM cone. In contrast, at times A and B for the ITM option, the entire range of exposure is contained within the BSM cone. Granted, the area of the range of exposure is not as great at time B as it was at time A, but still, what there is of the area is completely contained within the cone. Theoretically, time decay is a constant thing, but sometimes actual market pricing does not conform well to theory, especially for thinly traded options. For example, you might not see any change in the price of an option for a few days and then see the quoted price suddenly fall by a nickel even though the stock price has not changed much. This is a function of the way prices are quoted—often moving in 5-cent increments rather than in 1-cent increments—and lack of “interest” in the option as measured by liquidity. Changing Other Assumptions The other input assumptions for the BSM (stock market drift and dividend yield) have very small effects on the range of predicted future outcomes in what I would call “normal” economic circumstances. The reason for this is that these assumptions do not change the width of the BSM cone but rather change the tilt of the forward stock price line. Remember that the effect of raising interest rates by a few points is simply to tilt the forward stock price line up by a few degrees; increasing your dividend assumptions has the opposite effect. As long as interest rates and dividend yields stay within typical limits, you hardly see a difference in predicted ranges (or option prices) on the basis of a change in these variables. Simultaneous Changes in Variables In all the preceding examples, we have held all variables but one constant and seen how the option price changes with a change in the one “free” variable. The thing that takes some time to get used to when one is first dealing with options is that, in fact, the variables don’t all hold still when another variable changes. The two biggest determinants of option price are, as we’ve seen, the strike–stock price ratio and the forward volatility 68  •   The Intelligent Option Investor assumption. Because these are the two biggest determinants, let’s take a look at some common examples in which a change in one offsets or exac- erbates a change in the other. Following are a few examples of how interactions between the variables sometimes appear. For each of these examples, I am assuming a shorter investment time horizon than I usually do because most people who get hurt by some adverse combination of variables exacerbate their pain by trading short-term contracts, where the effect of time value is particularly severe. Falling Volatility Offsets Accurate Directional Prediction Let’s say that we are expecting Advanced Building Corp. to announce that it will release a new product and that we believe that this product announcement will generate a significant short-term boost in the stock price. We think that the $50 stock price could pop up to $55, so we buy some short-dated calls struck at $55, figuring that if the price does pop, we can sell the calls struck at $55 for a handsome profit. Here’s a diagram of what we are doing: 20 25 30 35 40Stock Price 45 50 55 60 Advanced Building Corp. (ABC) 65 GREEN As you should be able to tell by this diagram, this call option should be pretty cheap—there is a little corner of the call option’s range of expo- sure within the BSM cone, but not much. The Intelligent Investor’s Guide to Option Pricing  •  69 Now let’s say that our analysis is absolutely right. Just after we buy the call options, the company makes its announcement, and the shares pop up by 5 percent. This changes the strike–stock price ratio from 1.05 to 1.00. All things being held equal, this should increase the price of the option because there would be a larger portion of the range of exposure contained within the BSM cone. However, as the stock price moves up, let’s assume that not everything remains constant but that, instead, implied volatility falls. This does hap- pen all the time in actuality; the option market is full of bright, insightful people, and as they recognize that the uncertainty surrounding a product announcement or whatever is growing, they bid up the price of the options to try to profit in case of a swift stock price move. In the preceding diagram, we’ve assumed an implied volatility of 35 percent per year. Let’s say that the volatility falls dramatically to 15 percent per year and see what happens to our diagram: 20 25 30 35 40Stock Price 45 50 55 60 Advanced Building Corp. (ABC) 65 Stock price jumps Implied volatility drops GREEN The stock price moves up rapidly, but as you can see, the BSM cone shrinks as the market reassesses the uncertainty of the stock’s price range in the short term. The tightening of the BSM cone is so drastic that it more than offsets the rapid price change of the underlying stock, so now the option is actually worth less! 70  •   The Intelligent Option Investor We, of course, know that it is worth less because after the announce- ment, there is only the smallest sliver of the call’s range of exposure con- tained within the BSM cone. Volatility Rise Fails to Offset Inaccurate Directional Prediction Let’s say that we are bullish on the Antelope Bicycle Co. (ABC) and, noting that the volatility looks “cheap, ” buy call options on the shares. In this case, an investor would be expecting to make money on both the stock price and the implied volatility increasing—a situation that would indeed create an amplification of investor profits. We buy a 10 percent OTM call on ABC that expires in 60 days when the stock is trading for $50. 20 25 30 35 40Stock Price 45 50 55 Antelope Bicycle Corp. (ABC) 60 GREEN The next morning, while checking our e-mail and stock alerts, we find that ABC has been using a metal alloy in its crankshafts that spontaneously combusts after a certain number of cranks. This process has led to severe burn injuries to some of ABC’s riders, and the possibility of a class-action lawsuit is high. The market opens, and ABC’s shares crash by 10 percent. At the same time, the volatility on the options skyrocket from 15 to 35 percent The Intelligent Investor’s Guide to Option Pricing  •  71 because of the added uncertainty surrounding product liability claims. Here is what the situation looks like now: 20 25 30 35 40Stock Price 45 50 55 Antelope Bicycle Corp. (ABC) 60 GREEN This time we were right that ABC’s implied volatility looked too cheap, but because we were directionally wrong, our correct volatility prediction does us no good financially. The stock has fallen heavily, and even with a large increase in the implied volatility, our option is likely worth less than it was when we bought it. Also, because the option is now further OTM than it originally was, time decay is more pronounced. Thus, to the extent that the stock price stays at the new $45 level, our option’s value will slip away quickly with each passing day. Rise in Volatility Amplifies Accurate Directional Prediction These examples have shown cases in which changes in option pricing variables work to the investor’s disadvantage, but it turns out that changes can indeed work to an investor’s advantage as well. For instance, let’s say that we find a company—Agricultural Boron Co. (ABC)—that we think, because of its patented method of producing agricultural boron com- pounds, is relatively undervalued. We decide to buy 10 percent OTM calls on it. Implied volatility is sitting at around 25 percent, but our option is far enough OTM that it is not very expensive. 72  •   The Intelligent Option Investor 20 30 40Stock Price 50 60 70 Agricultural Boron Co. 80 GREEN The morning after we buy these call options, chemical giant DuPont (DD) announces that it is initiating a hostile takeover and of- fering shareholders of ABC a 20 percent premium to the present mar - ket price—$60 per share. DuPont’s statement mentions that it wants to gain exclusive access to ABC’s boron processing technology. The market immediately thinks of German chemical giant BASF and believes BASF will make a higher counteroffer so as to keep ABC’s revolutionary boron processing technology out of DuPont’s hands. Because there is uncer - tainty surrounding the possibility of a counterbid and perhaps even the uncertainty that DuPont’s offer will not be accepted, forward volatility on the contracts increases. The net result is this 6: 20 30 40Stock Price 50 60 70 Agricultural Boron Co. (ABC) 80 GREEN The Intelligent Investor’s Guide to Option Pricing  •  73 With this happy news story, our call options went from nearly worthless to worth quite a bit—the increase in volatility amplified the rising stock price and allowed us to profit from changes to two drivers of option pricing. There is an important follow-up to this happy story that is well worth keeping in the back of your mind when you are thinking about investing in possible takeover targets using options. That is, our BSM cone widened a great deal when the announcement was made because the market be- lieved that there might be a higher counteroffer or that the deal would fall through. If instead the announcement from DuPont was that it had made a friendly approach to the ABC board of directors and that its offer had already been accepted, uncertainty surrounding the future of ABC would fall to zero (i.e., the market would know that barring any antitrust con- cerns, DuPont would close on this deal when it said it would). In this case, implied volatility would simply fall away, and the call option’s value would become the intrinsic value (in other words, there is no potential or time value left in the option). The situation would look like this: 20 30 40 Stock Price 50 60 70 Agricultural Boron Co. (ABC) 80 GREEN We would still make $5 worth of intrinsic value on an invested base that must have been very small (let’s say $0.50 or so), but were the situation to remain uncertain, we would make much more. 74  •   The Intelligent Option Investor Y ou now have a good understanding of how options work and how they are priced from a theoretical perspective. Although it is clear from Chapter 2 that the BSM has its faults, it is undeniable that in certain times and under certain conditions, it works well. Please see Appendix A for a brief discussion of the situations in which the BSM is fairly good at pricing options—intelligent option investors will want to avoid these—and when it is poor—cases that present the most attractive chances for intelligent in- vestors. Now that you have a good idea of how options work and are priced, let’s turn to how we can do a better job of predicting valuation ranges than the BSM does. This is the subject of Part II. 75 Part II A sound intellectuAl frAmework for Assessing vAlue After reading Part I, you should have a very good theoretical grasp on how options work and how option prices predict the future prices of stocks. This takes us partway to the goal of becoming intelligent option investors. The next step is to understand how to make intelligent, rational es- timates of the value of a company. It makes no sense at all for a person to invest his or her own capital buying or selling an option if he or she does not have a good understanding of the value of the underlying stock. The problem for most investors—both professional and individual— is that they are confused about how to estimate the value of a stock. As such, even those who understand how the Black-Scholes-Merton model (BSM) predicts future stock prices are not confident that they can do any better. There is a good reason for the confusion among both professional and private investors: they are not taught to pay attention to the right things. Individual investors, by and large, do not receive training in the basic tools of valuation analysis—discounted cash flows and how economic transac- tions are represented in a set of financial statements. Professional investors are exquisitely trained in these tools but too often spend time spinning their wheels considering immaterial details simply because that is what they have been trained to do and because their compensation usually relies on short- rather than long-term performance. They have all the tools in the world but are taught to apply them to answering the wrong questions. 76  •   The Intelligent Option Investor Part II of this book sets forth a commonsense approach to determining the value of a company. It aims to provide individual investors with the tools they need and to offer both individual and professional investors a framework that allows them to focus their attention on the most important things and ignore the rest. Chapter 4 discusses what I call the golden rule of valuation. Chapter 5 looks at the only four things that can affect the long-term value of a stock and offers a way to estimate the value a company will create over its entire economic life. Chapter 6 investigates the behavioral biases and structural impediments working against us in our investment decisions and offers tools to avoid them. In general, I have written these chapters to present the valuation framework from a conceptual perspective and have thus left out many de- tails regarding financial statement line items and the like. These details are important, however, and it is unrealistic to think that you could translate theory into practice without knowing them. For this reason, I have provid- ed a detailed valuation example on the Intelligent Option Investor website, complete with descriptions of all the financial statements I analyzed and explanations of the thought processes I used when doing the analysis. 77 Chapter 4 the golden rule of v AluAtion Commit the following definition to memory: The value of an asset is the sum of the cash flows it creates on behalf of its owners over its economic life. Contrary to popular opinion, valuation is easy. One does not need a master’s degree in accounting or to be an expert in financial statement analysis to com- petently value a company and estimate a fair value range for a stock. The only thing a person needs is to internalize the preceding sentence and understand the handful of factors that affect the cash flows of a firm over time. This chapter focuses on developing a theoretical framework using the golden rule of valuation—which you have already memorized—and looks at each part of that simple definition phrase by phrase, with each phrase a different section of the chapter. The sections are as follows: 1. The Value of an Asset: Here we offer a specific definition for an as- set and discuss the distinction between value and price. 2. Cash Flows Generated on Behalf of the Owners: Specifies which cash flows we will measure when valuing an asset. 3. The Company’s Economic Life: Breaks the life of the firm into three stages to help make the valuation process easier and more transparent. For those new to the subject of valuation, I present an additional section that provides overviews of specific topics such as time value of 78  •   The Intelligent Option Investor money and discount rates, but even being unacquainted with these terms right now will not be a handicap. Business is essentially a collection of very simple transactions—pro- ducing, selling, and investing excess profits. In my experience, one of the biggest investing mistakes occurs when people forget to think about busi- ness in terms of these simple transactions. Having a firm grasp of valuation is an essential part of being an in- telligent option investor. The biggest drawback of the BSM is its initial as- sumption that all stock prices represent the true values of the stocks in question. It follows that the best opportunity for investors comes when a stock’s present price is far from its true intrinsic value. In order to assess how attractive an investment opportunity is, we must have a good under- standing of the source of value for a firm and the factors that contribute to it. These are the topics of this chapter and the next. In terms of our intelligent option investing process, we need two pieces of information: 1. A range of future prices determined mechanically by the option market according to the BSM 2. A rationally determined valuation range generated through an in- sightful valuation analysis This chapter and the next give the theoretical background necessary to de- rive the latter. Jargon to be introduced in this chapter is as follows: Asset Structural constraints Demand-side constraints Supply-side constraints Owners’ cash profit (OCP) Expansionary cash flow Free cash flow to owner(s) (FCFO) Working capital The Value of an Asset The meaning of asset , in financial terms, is different from the vernacular meaning of “something I’ d be upset about if it broke or was stolen. ” In financial terms, an asset is anything that can be owned that (1) was created The Golden Rule of Valuation    • 79 through an expenditure and (2) has the capacity to generate revenues and/or to increase profits. Thinking about assets from the perspective of revenue creation and profit growth, it is clear that things such as family cars are usually not assets but are rather convenience items. A collection of assets is also an asset—if you own a taxi cab, you own an asset; if you own a taxi-cab company, you also own an asset. Modern corporations are extremely complex, frequently with multiple business lines and operations in multiple states and countries and with assets com- prised of machinery, land, and intellectual property. However, even though corporations are complex, they are still assets in the sense that they are a collection of discrete assets themselves. An asset is created through an expenditure, so it follows that all assets have a price; this price may be greater or less than the asset’s value. The distinc- tion between the price of an asset and its value lies at the heart of what is known as value investing, so it is an important one to grasp. As an example, let’s say that you would like to start a suburban taxi service, and frame the difference be- tween price and value of the main asset you need to start this business: a car. In order for your business to be successful, the car you buy should be roomy, reli- able, and attractive to customers. Y ou do some research and decide to buy one of the two following cars—both of which fit your above-stated requirements: 1. 2013 Bentley Mulsanne: Manufacturer’s suggested retail price (MSRP) of $300,000 2. 2013 Toyota Camry: MSRP of $28,000 The choice between the two cars for a typical taxi business is simple. The price of the Mulsanne is clearly too high. It is hard to imagine that the cash flows that would accrue to the owner of a Mulsanne taxi service would ever be enough to cover the cost of the car itself. In this case, the asset’s value as a cab is much less than its price. In the parlance of modern financial theorists, a company paying the price of a Mulsanne for a car to start a suburban taxi service is “destroying shareholder value. ” Obviously, it is not necessary to do complex calculations to see that value would be destroyed in this case with the purchase of the Bentley. We cannot be sure of what the value of a suburban taxi service is without some more information, but we can pretty easily guess that the cash generated from such a service would not be enough to pay off the price of the Mulsanne. 80  •   The Intelligent Option Investor Whether the purchase of the Camry is a good idea or not is a bit more complicated. However, our conception of value for the service should not change, so our decision to invest will be driven completely by the relation- ship of the price of the Camry to our best idea for the value it can create. If the likely value of the car is higher than its price, it’s an investment worth considering; if the likely value of the car is less than its price (as was the case in the Mulsanne), it is folly to do anything but walk away. If the likely value is much, much higher than the price, to the extent that it would pro- vide you much more wealth than you might generate with another simi- larly sized, similarly risky investment, it would be irrational not to make the investment. All of this—determination of the value and considerations surrounding investment—should seem very sensible to you. Indeed, it is only common sense. The problem is that when it comes to the investment process, many investors—professional and amateur alike—throw this common sense to the wind and start getting confused by what other people are saying about chart patterns and multiples and potential demand for a company’s nascent product line. I will talk about where this confusion might come from in Chapter 6. Now that we have an understanding of what an asset is—something that can be owned, that is created through expenditures, and has the capac- ity to generate revenue or increase profits—let’s investigate the next phrase in our golden rule: “cash flows generated on behalf of owners. ” Cash Flows Generated on Behalf of Owners Our taxi-cab entrepreneur buys the Camry—an act that, in the parlance of financiers, is called a capital expense—and opens the taxi service. In order to receive revenues, she will have to do a few things: • Advertise • Pay herself a salary • Spend money to maintain the taxi in good working condition (gas, oil changes, etc.) • Spend money on such things as insurance, licensing, mobile phone service, and banking and professional fees The Golden Rule of Valuation    • 81 Let’s assume that the owner runs the business for an entire year, and she leaves what is left over after paying the preceding expenses in her bank account. At the end of the year, the owner is sitting on excess profits of $5,000. Y ou might be tempted to say that this amount is the cash flow gen- erated on behalf of the owner, but let’s think about it more carefully for a moment. The owner is a good businessperson, so she realizes that the Camry is not going to last forever. At some point, the owner will need to buy another one, so she wants to set some money aside for a down payment—let’s say she sets aside $1,000. Now the owner has $4,000 that is not spoken for—perhaps this is the amount of the total cash flow generated on behalf of the owner. It could be. The owner might simply be interested in running the business at the pre- sent level and may be content with the $4,000 in cash or so that she figures she can generate in excess of expenses every year. If so, the owner might pay herself a special “bonus” and use the $4,000 to go on a cruise. However, let’s say that the owner has an idea that she can schedule more efficiently if she uses an online ordering system that is tied into her accounting system. She thinks this online ordering system will allow her to schedule a few more fares a week just from improved order efficiency and will also save her a few hours a month 10-keying data into her accounting system. In other words, she believes that if she invests in the system, she will be able to increase the rate of growth of both revenues (through more fares per week) and profits (from the reduced time expended on bookkeeping). The online ordering system and related equipment cost $2,000. If the owner does not spend the $2,000, she can be pretty confident that her business will keep buzzing along and will generate about $4,000 in cash flow for her the next year. If she spends the $2,000, she figures that she will be able to generate $4,500 next year—the extra $500 representing a nice return on her investment of 25 percent (= $500/$2,000). This extra return is at risk—it could be that the investment in the computerized system will not pay off, in which case the $2,000 she spent will simply be a waste—but if successful, the expenditure will pay for itself in just a few years. If the taxi owner decides to spend the money on the new system, she ends up with $2,000 free and clear in her bank account. This money—the 82  •   The Intelligent Option Investor money that is left over after paying all her daily expenses, setting aside money for the maintenance of her business, and purchasing an asset de- signed to help her business expand—is the amount that we will term cash flows generated on behalf of the owner. We have developed some terms to use in this book to describe each step of the process of generating cash flows on behalf of an owner. These are: 1. Owners’ Cash Profit (OCP): Cash available to owners after all nec- essary direct costs of the business have been paid and after money is spent or set aside to maintain the business as a going concern (e.g., gas, insurance, maintenance, and setting aside funds for the next taxi). 2. Expansionary Cash Flows: Any money invested to try to generate more revenues or increase profit in the future. Expansionary cash flows are an investment, so are not guaranteed of being successful (e.g., online ordering system). 3. Free Cash Flow to Owners (FCFO): Any OCP left over after expansionary cash flows are made. Free cash flow to owners is the quantity that we will measure and project to get an estimate of the value of a company. From these descriptions, you can certainly identify the OCP , ex- pansionary cash flows, and FCFO for our taxi entrepreneur. To analyze a public company, we need to associate these concepts with particular line items on a financial statement. On my website, I have a detailed valuation example (of enterprise software giant, Oracle) that shows what specific line items to estimate each of the quantities mentioned here. Now that we have a good understanding of what cash flows we are looking at in order to value a company, let’s investigate the phrase over the company’s economic life. The Company’s Economic Life The economic life of a company involves the firm struggling to generate cash flow subject to various constraints that change as the company grows older. When a company is young, like our taxi company, the main The Golden Rule of Valuation    • 83 constraint it is likely to face is a supply-side one. Our taxi company has only one car and one driver. Assuming that the average ride for a customer lasts 15 minutes, the taxi company would be hard pressed to service more than about 40 customers a day or 240 customers a week (assuming a 10-hour work day and a 6-day work week). Because the taxi’s capital resource base is small—one car—no matter how many potential customers may exist, the volume of service that may be provided is also small. This is a classic example of supply-side constraints. Money and credit are like oxygen to a fire for supply-constrained companies. Given extra money—whether generated through operations, borrowed from a bank, or raised by selling shares to other part owners— our taxi company will be able to buy more cars and hire more drivers. If we think about these expenditures as investments, this is clearly an investor’s dream because virtually any investment made is guaranteed to have good results. “There is enough customer demand for 10 taxis in this town. We have three taxis and some money to invest. Let’s buy another taxi. ” This is not a difficult or intellectually draining analytical process! As long as the company has access to capital 1 and is producing some- thing consumers want, the percentage growth rates of its revenues year over year during this stage of the business’s economic life can be phenom- enal; after all, if you own one cab and simply buy two others to serve a cab- starved region, your revenues are likely to show a year-over-year growth rate of somewhere around 200 percent. FCFO during this time may, in fact, be negative—a company can fund itself through debt and actually pay more on expansionary projects than it receives in profits—but this does not mean that the business is bad, merely that it is facing supply-side constraints and trying to expand its capital base to meet the size of the market’s demand. We see this type of rapid growth in public companies all the time. Railroads in the 1800s, automobile companies in the 1900s, and Internet firms in the late 1990s all showed incredible revenue growth as customer demand swelled for products and services based on the latest technological advances. If the taxi owner can navigate the process of raising money, eventu- ally, she will have built up her capital base to match the size of the market 84  •   The Intelligent Option Investor opportunity. It is at this point that a company begins operating subject to demand-side constraints—constraints arising from the vagaries of competi- tion and consumer choice. When faced with demand-side constraints, the taxi cab owner is no longer concerned with finding new investment money to expand her capi- tal base but rather with finding ways to keep her cash flows growing even though her capital base is sufficient to meet current customer demand. Dur- ing this part of the company’s economic life, investment decisions become more difficult. One possible investment choice is to spend money on systems or processes to make the operation more efficient. This will not affect top-line (i.e., revenue) growth but likely will increase the flow of cash to the owner by allowing for a higher proportion of revenues to be converted into profits. Other investment possibilities for our demand-constrained taxi entrepreneur include opening an operation in another geographic area— maybe in the form of a joint venture (JV) with another entrepreneur in the new region who understands the local economy well—buying a rival taxi company, or indeed branching out to start some other business under the taxi company’s umbrella. In terms of our original example to illustrate FCFO, in this period, for a single car in her fleet, our taxi owner may be receiving the same $5,000 in profits, setting aside the same $1,000 for a replacement vehicle, paying the driver a $500 profit-sharing bonus, spending $700 for an improved lighting and security system for the lot in which she parks her fleet of cars, and squirreling away the rest in case the opportunity to buy the taxi company across town presents itself. The company may look as though it is generat- ing $2,800 in FCFO (= $5,000 − $1,000 − $500 − $700), but in fact, in the owner’s mind, that $2,800 may just be temporarily available. If a good, large investment opportunity presents itself, what had looked like free cash flow from years past might get used all at once in a major investment program. To find examples of companies in this stage of development, one only needs to open the business section of the local newspaper. General Motors’ JVs with Chinese carmakers to get a toehold in the burgeoning China market, Procter & Gamble buying Gillette Razors to boost its personal- care product lines, and Google stepping out of its turf of Internet search- based advertising to buy Motorola Mobility Systems and manufacturing mobile phones are all cases in point. The Golden Rule of Valuation    • 85 The growth of the taxi company’s cash flows will depend on how good the potential investment opportunities are and how skillful the company’s management is at exploiting those opportunities. If the opportunities are good and management is skillful, growth rates will continue to be high. They will certainly not be as high as during the “shooting fish in a barrel” investment environment when the company was supply constrained, but they will be higher than the growth rates of most of the companies in the larger economy. At some point, however, good investment opportunities will become fewer and farther between. The taxi-cab company has bought up most of its regional competitors and is now constrained by the local regulator’s rules against monopoly power and anticompetitive practices. The JV in a neighboring region did well, so our taxi owner bought out her partner and has expanded that business as far as it will go as well. She dallied with set- ting up a craft beer brewery (figuring that tipsy customers would be more likely to hire taxis) but abandoned that when it seemed like it was more trouble than it was worth. In fact, the taxi owner noticed that in general, as her business grew larger, her investment opportunities seemed to generate less and less mar- ginal improvement in cash flow to her. As with the case of the brewery, sometimes the extra money flowing in was simply not worth the time and hassle of running the new business. So it goes in listed companies as well. Eventually, all the low-hanging investment fruit is picked and in placed in the company’s basket, and get- ting that next apple requires more energy than it is worth. Looking at long data series of companies’ profit growth, you can clearly see the downward trend over time as the investment opportunities become less and less com- pelling. Part of the problem for listed firms is not only the availability of good investment opportunities but also the fact that they have grown so large that it takes not only a compelling investment but also a compelling investment that is enormous in size to really move the needle. This is col- loquially known as the law of large numbers . 2 Stated simply, this rule says that if you are really big, it is hard to grow really fast. Now what? The taxi cab company has been operating under an environment of demand constraints for some time, and the company—through 86  •   The Intelligent Option Investor acquisitions, expansion, and the like—has expanded as far as it can into its local economy. From here on, as long as no one invents a teleportation device (which would fairly quickly make taxis obsolete), its growth will depend on structural constraints —factors such as population growth, general economic conditions, and inflation. If our taxi cab owner is smart, when faced with structural constraints, she will stop looking to invest the excess profits her company is generating every year and instead start paying herself a bonus (which she should in- vest wisely by buying a copy of this book, of course). In the world of listed companies, this bonus is termed a dividend. There is, in fact, a structural speed limit for public companies as well—the rate of growth of the economy at large. And when a company is consistently growing at or near this structural rate, it is time for sharehold- ers to demand to be paid dividends. In the old days, before globalization, the rate of growth of the econ- omy at large meant the growth rate of one’s domestic economy. However, more and more, reduced trade barriers and cheap transportation cost have meant that the limiting growth rate is closer to that of the global economy. There are investing cases in which a company can potentially grow very quickly overseas, but for large, well-established firms (i.e, “Blue Chip” companies), usually their overseas exposure is much smaller or much less profitable than their domestic exposure, so the maximum growth rate ends up being pretty close to the domestic rate. Thinking about this progression from start to finish, you can see that growth rates vary broadly in three stages—a startup stage (during which the firm faces supply constraints), an investment phase (during which the firm faces demand constraints), and a terminal phase (during which the firm faces structural constraints). It is important to realize that companies can sometimes jump between these growth stages, even though it is fairly rare. 3 Throughout the life of a company, the firm is a machine generating profits and cash flows on behalf of its owners. I have said that the value of a company is the sum of the cash flows created by that company on behalf of its owners over its economic life. We only have one more tiny bit to inves- tigate to have a complete understanding of this definition: how to sum up cash flows that are generated over time. The Golden Rule of Valuation    • 87 Time Value of Money: Summing Up Cash Flows Over Time It turns out that summing up cash flows is not as easy as simply adding one year’s cash flows to the next because the value of cash flows depends on when they are received. Have a hard time believing this? Look at this example: assume that you get stranded in the middle of the Mojave Desert and have to walk through the intense summer sun to find help at the next town. Y ou stumble into a convenience store, suffering from acute dehy- dration—shaking, nauseous, and with an intense headache—but soon you realize that you have lost your wallet on the trek into town. The shopkeeper offers to loan you $5 now to buy drinks, but you will have to pay him $20 when you return with your wallet. Of course, under the circumstances, your need is so great for the $5 worth of liquid now that you are glad to part with $20 a few hours later. In a sense, the difference between the two amounts is sort of an exchange rate between two different time periods. If you go to England, it takes one U.S. dollar to equal 0.66 of a British pound (let’s assume). In the case of the Mojave convenience store, it takes 20 future dollars to equal 5 dollars right now. This is the basic idea behind the time value of money. I will not go into detail behind this concept here (because it is discussed in detail in various online and print sources), but the main point is the one I made earlier: cash flows from different periods cannot be directly summed. The main assumption behind modern finance is that cash flows that occur later are always worth proportionally less than cash flows that occur sooner. The formula to translate a future cash flow (CF) into its present value (PV) is PV = CF × e −rt where r is what is called the discount rate, e is the exponential function, and t is the time before the future cash flow is set to occur. When one raises an exponent to a negative power, the result is a num- ber smaller than one. This is just the mathematical translation of the phrase “a dollar today is worth more than a dollar tomorrow. ” 4 Assuming we can forecast a future cash flow, the next most impor - tant question we should ask is what we should use for the discount rate. 88  •   The Intelligent Option Investor According to the orthodox view of finance [embodied in something called the capital asset pricing model (CAPM), which is an idea closely related to the efficient market hypothesis (EMH)], there is a statistical formula that should generate the proper discount rate for any publicly traded asset by plugging in a few numbers. I will not go into detail as to why, but suffice it to say that I believe that the CAPM model’s discount rate should be ignored by anyone who believes that stocks can be mispriced in the marketplace. Abandoning orthodoxy, I advocate use of a 10 percent discount rate for most U.S. large- or medium-cap investments and about 12 percent for U.S. small- and microcap investments. The reason for this is that the market as a whole has generated compounded returns for the last century or so of around 10 percent per year. If you restrict yourself to the small-cap stock universe, that number increases to around 12 percent. By using 10 and 12 percent as fixed discount rates, the question I am answering is this: “If I expect this company to perform about as well as its peers, what is my best guess for what its peers will return?” 5 Using these set numbers allows you to measure different stocks according to a common yardstick, thereby taking out one source of error that one can make a mistake on in a valuation. For now, let’s just see what happens to a nominal payment of $100 per year when discounted at 10 and 12 percent. In the following graph, I have assumed that a payment of $100 is made at the end of the next 100 years. I discounted each of these payments at the discount rate listed and then kept the running sum of those discounted payments. Here is the graph: 1,200 1,000 800 600 400 200 0 048 12 16 20 24 28 32 36 40 44 48 52 56 60 Years 64 68 72 76 80 84 88 92 96 100 10% Discount Rate 12% Discount Rate The Golden Rule of Valuation    • 89 The interesting thing to note is how much the value is in the first 30 years or less of cash flows. At the 12 percent discount rate, the sum of the present value of all future cash flows trends toward around $506; at the 10 percent discount rate, the value levels off at $1,051. The points at which each of the curves level off represent the total value of the respective stream of cash flows. Using a 12 percent discount rate, the sum of the first 13 years of cash flows already exceeds 95 percent of the total $506 value—in other words, by year 14, it is almost the same as if you stop counting. At a 10 percent discount rate, it takes until year 29 to reach this point. Thinking about this graph from a practical standpoint, it makes per- fect sense. What if you loaned $100 to someone and he or she promised to repay you in 75 years. What value would you put on that promise of repay- ment? Nothing or next to nothing, I wager. At a 10 percent discount rate, a promise to pay $100 in 75 years, using the preceding formula, is worth about $0.06; at a 12 percent discount rate, that promise is worth about $0.00001. These figures can surely be consid- ered “next to nothing” and “nothing, ” respectively. Look at the golden rule of valuation again: The value of an asset is the sum of the cash flows it creates on behalf of its owners over its economic life. After the preceding discussion, its meaning now should be perfectly clear. And now that you have a good grasp of the golden rule, let’s take a look at the only four factors that can affect the value of a firm—I call them the drivers of value—and how we can analyze them to get a picture of what the company is worth. This page intentionally left blank 91 Chapter 5 the four Drivers of value In my experience, most people who analyze investments spend far too much time getting distracted by trivialities. These trivialities end up pull- ing them off course, confusing them, and creating valuation rationales that are so complex as to become gothic. Getting carried away with unimpor - tant minutiae also contributes to the difficulties people have in making investing decisions—whether to invest in the first place and whether to decrease, increase, or close an investment. This chapter introduces a process to estimate the value of a compa- ny—based on the golden rule of valuation —by singling out and analyzing only a handful of drivers. It seems counterintuitive, but you will see later in this book that less information actually counts for more in many circum- stances, especially when valuing a company’s stock. This chapter works hand in hand with Chapter 4 in teaching the skills of an intelligent option investor. Chapter 4 outlined how value accrues to the owner of a company. This chapter looks at the specific factors that allow that value to accrue. Jargon introduced in this chapter is as follows: Explicit forecast stage Structural growth stage Investment stage Bird’s Eye View of the Valuation Process Before looking at each of the drivers in turn, let’s first get an idea of the goal we are trying to reach from a high level. Our golden rule of valuation ties the value of a company to the cash flows it creates over time. Cash flows are 92  •   The Intelligent Option Investor created through the process we saw in the example of the taxi company in Chapter 4: revenues come in, present costs are paid, likely future costs are saved up for, and some investments may be undertaken to expand the busi- ness. Any cash that is left over after this process can be paid to the owners. This is a pretty simple model, so it should not be hard to create a fairly accurate picture of how an individual company operates and how it is likely to operate in the future. All we need to understand is: 1. How revenues are likely to change 2. How efficiently a company is translating those revenues into profits 3. What proportion of the profits the company is investing in the growth of the business and how effective those investments are Indeed, this picture also describes all the typical drivers of value for a company. There is one more driver, that I call “Balance Sheet Effects” and will describe in detail later in this chapter, but it is only applicable in a very few companies, so most of the time all you have to consider are the preced- ing three. In tabular format, the drivers are as follows: Driver Description Revenue growth How fast sales will likely increase Profitability How efficient the firm is in converting revenues to profits Investment level and efficacy Proportion of profits that must be invested to allow profits to grow in the future Balance-sheet effects The effect of hidden assets or liabilities on future cash flows This seems like an easy enough task—just figure out three or maybe four things, and you are set—until you remember that you must make this analysis for the entire economic life of the firm. “How can I know what the revenues of this company are going to be 50 years in the future? What will its profitability be then? How should I know what kinds of investments it will be making?” Indeed, having to forecast revenue growth and profitability 50, 75, or 100 years into the future for a company is an impossible task, and an inves- tor would be foolish to even try (although in my consulting work I have seen financial models extending 50 years into the future). The Four Drivers of Value  •  93 Happily, the task of an intelligent investor can be made easier by doing three things: 1. Breaking up the economic life of a company into discrete stages and using shortcuts to make assumptions about what will happen in each stage 2. Recalling that based on the time value of money, future cash flows have increasingly shrinking present values 3. Focusing not on forecasting a single, exact number for each of the drivers but rather on developing a sensible best- and worst-case scenario for each one Let’s first look at shortcut number one: breaking up the economic life of a company into stages. It is not rocket science—the stages are short, medium, and long term. In the short term (0–3 or 5 years, let’s say), we have a pretty easy time of thinking about how revenues, profitability, and investment levels are likely to change, so we can model the cash flows in this stage explicitly. For this reason, I call this the explicit forecast stage. In the medium term (from the end of the short-term period to a point in time 5 or 10 years in the future for most companies), we would have a much more difficult time of forecasting explicit cash flows, so we dodge the difficulty by using a shortcut. We can see what investments are avail- able to the company at present—whether the firm is supply- or demand- constrained—and what the company’s track record has been regarding the outcomes of its past investments. Based on this analysis, we can say, “Con- sidering the investment environment and management’s skill in investing in the past, this firm’s cash flows should be able to grow at an average rate of x percent during this period. ” Because this medium-term stage relies on the success of present investments, I call this the investment stage . Note, though, that mature companies—those that are already constrained by structural factors—will not, by definition, be able to grow any faster than the economy, no matter what investments they make. As such, for a mature firm in a mature industry, the investment stage usually does not have to be considered. The one case where it does is when a mature firm continues to invest in value-destructive projects. In this case, rather than factoring in above-normal growth, we should factor in below-normal growth because the owner’s cash profit is eaten up by poor investments. 1 94  •   The Intelligent Option Investor In the long term (anything after the investment valuation stage), we know that a company will become constrained by structural factors and will, on average, only be able to grow as fast as the economy at large. Because of the structural constraints on growth, I call this the structural growth stage. Pulling all these stages together in graphic format is instructive, and on careful inspection, we can also see something important about the second shortcut regarding the time value of money: 1,600 1,400 1,200 1,000 800 600 400 200 05 10 15 20 25 30 Years in the Future Cash Flows 35 40 45 50 - Nominal Cash Flow Cumulative DCF This diagram shows the nominal amount of cash flow generated by the company over a period of 50 years—represented by the solid line—overlain by its discounted value—represented by the dashed line. The explicit fore- cast stage is from zero to five years, the investment stage picks up after that and lasts five years, and the structural growth stage begins after that. Y ou will notice that the dashed line starts to level off at a figure of around $1,200. The point at which that line levels off represents the total discounted value of those cash flows and, by extension, the value of this firm. The explicit forecast stage assumes that cash-flow growth will vary up and down because of various competitive pressures that we have forecast based on our understanding of the business environment. In this diagram, The Four Drivers of Value  •  95 the value of the discounted cash flows generated during the explicit fore- cast stage makes up 39 percent of the total value of the firm. During the investment stage, we have assumed that the company’s investments will be very successful and allow the firm to generate a growth in cash flows of 15 percent per year (suggesting that this is a company with a large number of high-quality investment possibilities). An assumption of a constant-percentage rate of growth implies that the resulting line will be an exponential curve, and indeed, we can see that exponential curve between the 5- and 10-year marks. In this example—assuming this quick 15 percent per year rate of growth—the sum of discounted cash flows generated during the investment stage makes up 23 percent of the total value of the firm. The structural growth stage—covering years 11 onto forever—assumes that investment opportunities will dry up for the firm as it hits structurally based demand constraints and that cash flows from that point forward will grow at 5 percent per year. We are again assuming a constant-percentage growth per year that again will generate an exponential curve—this is the solid line starting after year 5 and continuing upward through year 50. Note, though, that the slope of the solid line during the structural growth stage is subtly shallower than the slope of the solid line during the investment stage. This subtle change of slope represents a pretty big slowdown from an average growth rate of 15 percent per year to only 5 percent per year. All in all, the discounted cash flows generated during the structural growth stage make up the remaining 38 percent of total value of this example firm. Note how small a percentage of overall value cash flows generated during the explicit forecast stage represents—only 39 percent of the total. This obviously implies that more than three-fifths of the value of this stock is based on the cash flows generated in the investment and structural growth stages. The sadly amusing fact about almost all the target prices published by sell-side research companies (such as the big brokerage houses), the fair-value estimates published by third-party research companies, and the investment valuations used by buy-side companies (such as hedge and mutual funds) is that they are generated by analysts who spend the vast majority of their analytical energy on estimating only the explicit stage of the forecast—which proportionally makes up the least amount of value of a going concern—and only a tiny sliver of their time and energy on the most important, weightiest component of the forecast—future growth rates. 96  •   The Intelligent Option Investor The best thing that we as intelligent investors can do is to understand the effect of medium- and long-term growth rates on the value of compa- nies (this makes us less susceptible to being swayed by short-term, nonma- terial developments such as the delayed launch of a product line or the like) and to attempt to rationally analyze the amount of cash flows likely to be generated along all three of the stages. The final shortcut we use to improve the quality of our valuations is to not make the mistake of false precision and try to forecast one “right” number for each of the valuation drivers but rather to develop an idea of what the best- and worst-case scenarios are for each of the drivers. There are some very compelling benefits to taking this tact that I will discuss in greater detail in Chapter 6 on behavioral biases and later when we talk about finding option investments in Chapter 7. In the end, what we should be looking to develop is a series of ranges for our drivers in the first two stages 2 that looks something like this: Explicit Forecast Stage Best Case Worst Case Revenues 8% 5% Profits 18% 12 % Investment Level 30% of OCP 45% of OCP Investment Stage Best Case Worst Case Duration Growth of cash flows 15% 8% 10 years One last thing to note is that although the number of drivers we need to consider and forecast is few, we really need to understand what makes each of these drivers vary. In Chapter 6, I will address the idea of anchoring more, but in short, it is the assumption that the next number in a series will be close to the last number in that series. This assumption is not necessarily true and can, in fact, be dangerously false. For instance, just because a firm has expanded revenues at an average annual percentage rate of 37 percent over the past few years does not mean that the next yearly increase needs to be 35, 30, or 25 percent or even positive. 3 The Four Drivers of Value  •  97 So making projections for each of the drivers should never be just a pro- cess of simply extrapolating past results. Making projections for each driver means really understanding what factors are influencing that driver and how those factors are likely to change in the future. Although this process of under- standing the underlying factors and projecting driver values into the future is not as difficult or complex as neurosurgery or designing a manned spacecraft to Mars, it does require some creativity, insight, thought, and patience. For an actual, specific example of a valuation done using this methodology, please see the detailed valuation example of Oracle posted on the Intelligent Option Investor (IOI) website www.IntelligentOptionInvestor .com. A general explanation of the valuation drivers, along with a few high- level examples, follows. A Detailed Look at the Drivers of Value Now that we have an idea of where we are going in our valuation process, let us take a look at each of the valuation drivers one by one. Revenue Growth Revenue growth is the first determinant of value for a company—if rev- enues are not coming in, it is obvious that cash will not flow to the com- pany’s owners. Organic revenue growth (i.e., that which does not come from acquiring another company) can come from 1. Increased volume of sales (selling more stuff) 2. Increased value of sales (selling stuff for more) At the heart of understanding a company’s revenues and forecasting the future growth rate of its revenues is understanding what the company is selling and to whom it is selling its product(s). The business model for a company such as Bentley that is selling $300,000 Mulsannes that we re- jected for our taxi-cab company in Chapter 4 is going to be very different from that of the $30,000 Camry-selling Toyota. Toyota has very little ability to raise prices—that is, to sell its stuff for more money—so it must sell more stuff. Bentley, on the other hand, has enormous pricing power—its customers are more sensitive to the image 98  •   The Intelligent Option Investor that the possession of a Bentley conveys to them than they are to the mon- etary cost of possession—and one of the ways Bentley maintains that pric- ing power is by restricting its production—selling less stuff, in other words. Understanding the interplay between selling more stuff and selling stuff for more is essential to understanding the first driver of value to a firm. Some people—experienced analysts included—tend to look at rev- enues as year-over-year percent changes and simply extrapolate the recent percentage growth into the future. This is a big mistake and can be a very expensive one. Companies that are at the transition between the supply- constrained early growth period and the demand-constrained investment- based growth period can sometimes see some very rapid slowdowns in revenue growth from one year to the next. If you are trying to value a com- pany as though its revenue stream will continue forever (or for a long time) or as though it were a supply-constrained startup—which is basically what people do when they extrapolate recent growth rate numbers too far into the future—you will estimate the value of the company as being too great. Likewise, when a company whose business tends to move with the business cycle—like a steel producer—is in a cyclic trough, and you assume that its business is going to keep growing at low rates or even shrinking far into the future, you will generate too low an estimate for the value of the firm. Rather than extrapolating, really understanding the dynamics of the business is crucial. Most Wall Street analysts spend proportionally less of their time trying to figure out revenues than they do profit. In contrast, I usually suggest that people try to spend more time getting a very firm grasp of how a firm generates revenues. Who is buying the company’s products or services and why are they buying those products or services rather than another’s? Are customers using credit to buy the company’s products or services? And if so, how tenuous is that line of credit? How many of the company’s products might people need or want and how often would they be willing to buy them? These are all essential questions to answer, and once you have a good idea about them, you will have gone a long way to understanding the value of the company in which you are considering taking an ownership stake. Profit generation, while undeniably an important factor, is for most companies, an almost mechanical process that is largely dependent upon the amount of revenues flowing into the firm. I will discuss why most of the market focuses so much on profitability in the next section, but readers The Four Drivers of Value  •  99 who are interested in seeing what parts of a financial statement I believe are the most important to dig into when analyzing revenues, please consult the valuation example on the IOI website. Profitability Think back to our taxi-cab example in Chapter 4. After the first year of op- eration, our transportation entrepreneur had $5,000 in her bank account. She was planning to set $1,000 aside for a down payment on a new taxi in a few years’ time, after her present car had used up its economic life; this would give her a total of $4,000 that she could decide how to spend—either on a Caribbean cruise or on a new computerized ordering system. In this example, profitability means this $4,000 amount that we are calling owner’s cash profit. As I mentioned earlier, most sell-side analysts and market specula- tors spend their time trying to forecast profitability. Usually, the profitabil- ity they are trying to predict is an accounting line item such as earnings per share (EPS), earnings before interest and taxes (EBIT), or earnings before interest, taxes, depreciation, and amortization (EBITDA). The reason for this is simple: most sell-side analysts’ target prices (and more than a few buy-side investment strategies) are generated by multiplying one of these quantities by some market multiple. For example, an analyst might say that the target price of ABC = 7.8 × EBITDA = $27.50 per share. There are three main reasons why using multiples analysis to value a company should be used with circumspection. First and foremost, there is no law of nature saying that a stock price has to be a certain multiple of some financial statement line item. Just because other companies in a given industry are trading between 7.5 and 8.5 times EBITDA doesn’t mean that they can’t trade for higher or lower, nor does it mean that another company has to trade within that range either. Second, the financial statement quantities mentioned (EPS, EBIT, and EBITDA) can all vary fairly substantially because of various account- ing technicalities and other measures that do not have a material impact on the firm’s long-term value. Last but not least, multiples imply future profitability growth rates, but simultaneously make these implied growth rates much less meaningful. 100  •   The Intelligent Option Investor To illustrate this point, consider the following question: Which of the fol- lowing predictions seems more transparent and testable? 1. I forecast this company’s medium-term cash flows will grow at an average of 10 percent per year for five years followed by GDP-like growth afterward. 2. I forecast this company is worth 23.5 times next year’s EPS estimates. Clearly, the former is preferable, since by specifying the growth rates, you are forced to think of how that growth might be achieved. The latter gives no hint of growth rates, so in effect detaches the value of the company from the operational details of the firm. There are a few reasons why Wall Street analysts love to publish multiples-based target prices that I will discuss in Chapter 6 when I introduce structural impediments. For the time being, just realize that what is good for an investment banker or equity sales trader is rarely good for an investor. Discounting the efficacy and transparency of market multiples-based valuation is not the same as saying that profitability is not important—of course it is. However, profitability is, to a surprisingly large extent, gov- erned by structural factors and profit margins tend to be quite similar be- tween companies in the same industry. For many companies, this makes estimating best- and worst-case profit margins fairly easy. For example, the grocery business is one in which a supermarket buys an item at a low price and sells it at a higher price. Because the items it sells are basically identical to the items sold at competitors’ stores, and because there are numerous competitors serving essentially the same customer base in the same area, it is impossible for the supermarket to raise its prices very much or for very long before customers start switching to another store. Because of these industry dynamics, the range over which grocery chain profitability varies is quite narrow. We can see an illustration of this in the following table of three large-capitalization pure-play grocery stores: Company (Ticker) Market Cap Avg. 3-year OCP Margin Kroger (KR) $23.9 B 1.5% Whole Foods Mkt (WFM) $14.1 B 4.9% Safeway (SWY) $7.9 B 1.4% Data courtesy of YCharts.com The Four Drivers of Value  •  101 Here we see that even the fancy Whole Foods Market, which, in terms of grocery stores operates on a sell-stuff-for-more model, is still generat- ing OCP margins (i.e., OCP divided by revenues) of less than 5 percent. Kroger and Safeway—two supermarkets operating on a sell-more-stuff model—have virtually identical profit margins. Of course, not all businesses are as stable and predictable as grocery stores. There are four effects that can alter the profitability of a company: operational leverage, demand changes, environmental factors, and efficiency increases. The single most important factor affecting the ability to predict profitability at a firm is something called operating leverage. I describe this factor in Appendix B and go into detail about how to estimate the effects of operating leverage in the example valuation posted on the Intelligent Option Investor website. The takeaway from this material is that for companies with a high degree of operating leverage, the amount of revenues coming in will huge- ly influence profitability. This dependence of profits on revenues provides a prospective investor in a company with high operational leverage more reason to understand the demand environment and how a firm generates revenues. Of course, if there are changes in the demand environment that cause consumers’ preferences to change away from the product a company is providing and toward another that it is not (e.g., consumers preferring electronic tablets made by Apple over PCs made by Dell), or changes in the supply environment that causes a company’s capital base to be too large (e.g., American car companies’ factories having too much capacity after the U.S. car market saturated in the early 1980s), profit margins are not likely to settle into an historical range but may materially increase (e.g., Apple, after the release of iPads, iPhones, and so on) or decrease (e.g., Dell, after Apple’s release of iPads, iPhones, and so on). Being able to correctly forecast this type of secular shift is difficult, but can be extremely profitable. In addition to these factors, there can be rapid drops and rises in profitability caused by changes in the economic environment. These might be company-specific events, such as a natural disaster destroying a supply of inventory, or economy-wide conditions, such as loose monetary policy encouraging consumers to use debt to make more purchases. While these kind of factors can have a large short-term effect on profitability, averaged over a longer time frame of a few years, most businesses’ profit margins end up returning to a fairly dependable range. 102  •   The Intelligent Option Investor Another case in which the normal profit range of a company may change is through improvements in productivity. And although improve- ments to productivity can take a long time to play out, they can be ex- tremely important. The reason for this is that even if a company is in a stage in which revenues do not grow very quickly, if profit margins are in- creasing, profit that can flow to the owner(s) will grow at a faster rate than revenues. Y ou can see this very clearly in the following table: Year 0 1 2 3 4 5 6 7 8 9 10 Revenues ($) 1,234 1,271 1,309 1,348 1,389 1,431 1,473 1,518 1,563 1,610 1,658 Revenue growth (%) — 3 3 3 3 3 3 3 3 3 3 OCP ($) 4 432 445 497 485 514 544 560 637 625 708 746 OCP margin (%) 35 35 38 36 37 38 38 42 40 44 45 OCP growth rate (%) — 3 12 –2 6 6 3 14 –2 13 5 Even though revenues grew by a constant 3 percent per year over this time, OCP margin (owner’s cash profit/revenues) increased from 35 to 45 percent, and the compound annual growth in OCP was nearly twice that of revenue growth—at 6 percent. Thinking back to the earlier discussion of the life cycle of a company, recall that the rate at which a company’s cash flows grew was a very important determinant of the value of the firm. The dynamic of a company with a rela- tively slow-growing revenue line and an increasing profit margin is common. A typical scenario is that a company whose revenues have been increasing quickly may be more focused on meeting demand by any means possible rath- er than in the most efficient way. As revenue growth slows, attention starts to turn to increasing the efficiency of the production processes. As that efficiency increases, so does the profit margin. As the profit margin increases, as long as the revenue line has some positive growth, profit growth will be even faster. This dynamic is worth keeping in mind when analyzing companies and in the next section, where I discuss the next driver of company value— investment level and efficacy. The Four Drivers of Value  •  103 Investing Level and Efficacy After our taxi company owner generated profits, she had to figure out if she was going to invest those profits or spend them, and if she invested them, she had to figure out what investment project was best. Listed companies also face the same process and choices. Managers are responsible for in- vesting owners’ cash profits with the aim of generating greater profits in the future or for returning owners’ cash profits to the owners via dividends. Because modern companies are so large and have so many shareholders, most owners not only do not take an active role in shaping the investments of their company, but they also don’t even realize that the investment process is taking place. 5 In this environment, there are unfortunately many instances in which the owners’ cash profits are invested badly or otherwise squandered on wasteful projects. Ford paying top dollar to buy a decrepit Jaguar springs to mind, as does Time Warner’s miserable purchase of AOL at the very peak of the tech bubble. But these egregious examples are certainly just the tip of the ice- berg. Companies routinely make implicit capital spending decisions by refus- ing to close down an underperforming or obsolete business, thereby robbing owners of cash flows that should have been theirs and instead filling the wallets of consultants and employees. 6 Or the managers, realizing that their mature core business throws off an enormous amount of cash, decide to spend some of that cash on acquisitions of dubious economic benefit to the owners. 7 Luck- ily, managers can always find an investment banker or two who are ready to talk about the numerous “synergies” that will no doubt someday come to pass, and too often boards and shareholders blithely accept the decisions and, once made, do not demand an accounting of owner benefits as a result of the union. Using an intelligent option investing framework, however, these here- tofore hidden investment programs and their success or failure can be seen much more clearly. First, we must see how much of the owners’ cash profits for the company were spent on investing projects and forecast the amount that will likely be invested in the future. The online valuation example provides an actual look at precisely what financial line items go into this calculation. Right now, it is enough to frame the term investments as any cash outflows on capital projects that the company is making over and above the cash outflows neces- sary to maintain the business as a going concern. Recall that in Chapter 4, I called this spending expansionary cash flows because they are designed to generate faster profit growth in the future. 104  •   The Intelligent Option Investor The phrase faster profit growth should prompt the question, “Faster than what?” It is at this point that we think back to the discussion of the life cycle of a company. After a company has cleared its supply-side con- straints, and after it has done all it can to increase profits in an environment of demand-side constraints, it bumps up against structural constraints . Structural constraints represent the long-run “speed limit” for the growth of a firm. Because there is a speed limit for a firm in the long run, it is logical that during the investment stage of a company’s life we compare the investment-boosted growth with that structural speed limit. The ultimate structural speed limit, as discussed earlier, is the nomi- nal growth in U.S. gross domestic product (GDP). In this case, nominal means the GDP growth that includes the effect of inflation as well as the increase in economic activity. A graph of this nominal increase in GDP from the postwar period follows: 3/1/1947 100 1,000 10,000 Nominal U.S. GDP (Billions of USD) March 1997–September 2013 U.S. GDP (Logarithmic Scale) 3/1/1957 3/1/1967 3/1/1977 3/1/1987 3/1/1997 3/1/2007 Note that I have displayed this on a logarithmic axis to show how consistent growth has been. The line representing U.S. nominal GDP swings above or below the straight trend line but seems to swing back toward the line eventually. The Four Drivers of Value  •  105 Over this very long period, the nominal GDP growth in the United States averaged just over 6 percent per year. If the investment projects of a company are generally successful, the company will be able to dependably grow its profits at a rate faster than this 6 percent (or so) benchmark. The length of time it will be able to grow faster than this benchmark will depend on various factors related to the competitive- ness of the industry, the demand environment, and the investing skill of its managers. Seeing whether or not investments have been successful over time is a simple matter of comparing OCP growth with nominal GDP . Let’s look at a few actual examples. Here is a graph of my calculation of Walmart’s OCP and OCP margin over the last 13 years: 2000 2005 2010 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00%20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 - Estimated Owners’ Cash Profit and OCP Margin for Walmart Total Estimated OCP (LH) OCP Margin (RH) As one might expect with such a large, mature firm, OCP margin (shown on the right-hand axis) is very steady—barely breaking from the 3.5 to 4.5 percent range over the last 10 years. At the same time, its to- tal OCP (shown on the left-hand axis) grew nicely as a result of increases in revenues. Over the last seven years, Walmart has spent an average of around 2 percent of its revenues on expansionary projects, implying that 106  •   The Intelligent Option Investor cash flow left for shareholders amounted to about $0.02 (≈ $0.045 – $0.02) on every dollar, on average. How efficacious were these investments? In the graph below, any point above the “0 ppt” horizontal axis indicates that Walmart’s year-over-year OCP growth has exceeded the U.S. GDP by that amount, and vice versa. The year-over-year OCP growth statistics are fairly noisy, bouncing back and forth above and below growth in GDP; however, looking at a five-year compound annual growth rate (CAGR) tells the same story as the linear trend line on the chart: Walmart’s growth has slowed significantly and now looks to be close to that of the economy at large on average. The rise in Walmart’s fiscal 2010 result (which corresponds with calendar year 2009) is more a function of the company’s revenues remaining resilient despite a U.S. recession than its growth out- pacing a growing U.S. economy. 40 ppt 30 ppt 20 ppt 10 ppt 0 ppt -10 ppt -20 ppt -30 ppt 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Growth in Walmart’s OCP Over (Below) Nominal GDP Real Growth in OCP Linear (Real Growth in OCP) To the credit of Walmart’s management, the company has spent in- creasingly smaller proportions of revenues on expansionary projects over the last few years, perhaps in recognition that its expansionary projects were bringing in less bang for the buck over time. In contrast, let’s take a look at a firm whose investments seem to be adding considerable value—Oracle. First, let’s take a look at its OCP margin: The Four Drivers of Value  •  107 35% 40% 30% 25% 20% 15% 10% 5% 0% Estimated OCP Margin for Oracle 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Other than the disastrous year of the tech bust in 2001, the company’s OCP margin has held fairly steadily in the 30 percent range, but recently it has started to move toward the 35 percent level. Over the last five years, the company’s expansionary spending has averaged around 15 percent of revenues per year, mainly through acquisitions. Because the expansionary spending is governed by its acquisitions, its investments are not uniform, and looking at the 2005–2008 period, the company was spending roughly half its revenues on expansion. Over this time period, how has Oracle’s OCP growth been vis-à-vis GDP? Let’s take a look: 50 ppt 60 ppt 40 ppt 30 ppt 20 ppt 10 ppt 0 ppt -10 ppt -20 ppt Growth in Oracle’s OCP Above (Below) Nominal GDP 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Real Growth in OCP Linear (Real Growth in OCP) 108  •   The Intelligent Option Investor In contrast with Walmart, through this lens, we see that Oracle’s investments have generally allowed its OCP to grow at a much faster rate than the economy at large (2010 was the year Oracle acquired Sun Microsystems, and the OCP that year is an artifact of that acquisition— I believe that its OCP that year was actually higher than stated here). The beauty of this way of looking at companies is that the hidden or implicit investments a company is making will show up in this as well. I believe that, like many large companies, Walmart is finding that it must spend money on expansion because it is investing ineffectually through its internal business processes. One percent of revenues worth of expansionary cash flows per year—roughly 25 percent of owners’ cash profits—is be- ing spent so that the company can basically keep up with growth of the economy at large. This discussion deals with investment efficacy. Investments— especially in the corporate environment, where one company completely takes control of another and must integrate the acquiree into its own business systems and culture—take time for results to be visible. As such, it is easy to see why the table at the start of this section showed investment efficacy affecting the medium-term results of the company—its growth rates in particular. Understanding the interaction among these three drivers—revenue growth, profitability, and investing efficacy—allows an investor to take the biggest step toward valuing a stock. Occasionally, though, one must take what I call balance-sheet effects into consideration. Balance-Sheet Effects Let’s think back to our taxi-cab service. Let’s say that our owner decided that after the first year, the investment prospects for her firm were so good that she would buy two new cars. She thought that she could save money by buying two low-mileage, off-lease cars rather than new ones. Before putting the cars into service, she cleans each of the cars thoroughly. While cleaning out the trunk of the first car, she finds a tightly wrapped brown paper package. Curious, she opens the package to find a pound of illegal drugs. She calls the police, who come to The Four Drivers of Value  •  109 investigate. After looking over the situation, the police impound the car, telling our taxi entrepreneur that they had no estimate for when it would be returned. The value of our taxi-cab company suddenly drops. Without the use of the car, there is no way for it to generate revenues. However, while revenues are not coming in, the company is still incurring costs (financing and insurance costs, in particular), so the new car is actually lowering the cash flow available to the owner. In the parlance of accounting experts, the company has experienced a nonoperational contingency that has resulted in a devaluation of one of its assets. This is a value-destroying balance- sheet effect. The taxi company owner, upset with the turn of events and her bad luck in picking automobiles, grumbles as she gets back to work cleaning out the second car. Cleaning between the back seats, she finds a valid lottery ticket that was forgotten by the previous owner. Expecting a couple bucks worth of winnings, she checks the number and is more than overjoyed to find that she is holding the winning ticket for a $500,000 prize! The disappointment from the police impounding her other car melts away as she realizes this little slip of paper represents 125 years’ worth (+$500,000/$4,000) of her company’s first-year OCP . This is one heck of a positive balance-sheet effect. The base assumption we make when we analyze a company is that all the assets on the balance sheet are operating assets—that they are being fully exploited to generate cash flows on behalf of owner(s). However, this is sometimes not a valid assumption to make. Sometimes the true value of assets can be hidden and remain hidden for some time. On the hidden-asset side, one of the biggest jobs of the class of institutional investors known as activist investors is to dig into the operating details of a company to find assets that the company is not fully using or is using so badly that the company is not able to create maximum cash flows. Usually, the activist investor is looking to throw out the current management team and replace it with people he or she thinks can better use the assets. This is termed a hostile takeover , but it is important to remember that the term hostile is only valid from the perspective of the target’s management team. An insightful activist investor with patience, 110  •   The Intelligent Option Investor foresight, and enough board seats to push through a change can be an enormous boon to investors in the company. In the same way that there are hidden assets, there also can be hidden liabilities. Enron’s complex transactions with its “special- purpose vehicles” are a vivid example of how dangerous hidden liabilities can be. Enron managers found ways to effectively channel financial transactions and obligations that they did not want on Enron’s own books (namely, losses and liabilities) onto the books of off-shore entities. Even though the off-shore entities were established and controlled by Enron’s management, they were not consolidated into Enron’s own financial statements, so the transactions and obligations effectively disappeared from most investors’ view. Several investor groups started putting two and two together and realized that the answer was less than four. Eventually, when the special-purpose vehicles became known by the investment community, it was obvious that there was much less equity for investors to own than they had thought previously, and the stock price plummeted. Whereas hidden assets can be thought of as a winning lottery ticket stuck in between the seats of a used car, an old colleague of mine in the hedge fund world used to call hidden liabilities “snakes sleeping in a basket. ” Usually, it takes some time and familiarity with a company or industry to understand where these lottery tickets or snakes may reside, but most companies have them to a greater or lesser extent. Mostly, these hidden items are not material to valuation and thus can be ignored, but when they are not material, they can be truly powerful influences on valuation. It is impossible to explain precisely where to look for these hidden items, but there are a few places one can typically start looking: Lottery Tickets 1. Real estate carried at historical cost 2. Intellectual property (e.g., patents, copyrighted material, etc.) 3. Government connections (not as important in developed markets but could be vitally important in certain emerging markets) 4. Overfunded pensions The Four Drivers of Value  •  111 Snakes 1. Latent product/accident liability claims (e.g., asbestos, pollution remediation, etc.) 2. Manager malfeasance (e.g., price fixing, Foreign Corrupt Practices Act noncompliance, etc.) 3. Underfunded pensions 4. Off-balance-sheet corruption 5. Fraud It’s usually hard to find these, but if you do, you should try to make an assumption about the best- and worst-case financial impacts of these items and simply tack that onto whatever cash-flow projections you have made. Tying It All Together Throughout our analysis of a company’s valuation drivers, our focus as investors should always be to estimate the free cash flow to owners that a firm will likely generate. In the short-term, FCFO is driven by how fast revenues are growing, how efficiently the company is converting those revenues to profits, and how much of the profits the firm is spending on expansionary projects. In the medium-term, FCFO is driven by how effective the investments the firm made in the preceding period are likely to be. In the long-term FCFO is driven by structural constraints because a firm cannot grow faster than the economy at large. Each driver has both best- and worst-case projections, so pooling all the best-case projections into a best-case FCFO scenario and all the worst- case projections into a worst-case FCFO scenario gives us an idea of the most and least cash flow that the firm will generate for us in the future (you can see an example of this on the Intelligent Option Investor website). Discounting those FCFO scenarios generates a present value range for the company. If we can find any balance-sheet effects, we add or deduct those effects from the value found from discounting the FCFO scenarios. This is the final valuation range of the company that we can compare to the market price of the stock. When the valuation range of a company and the price of a stock differ by a great amount, we have an opportunity to invest profitably. 112  •   The Intelligent Option Investor Advanced Building Corp. (ABC) 5/18/2012 5/20/2013 249 499 749 999 Worst Case, 45 Best Case, 70 80 60 40 20 - Date/Day Count Stock Price These are the general principles of intelligent investing, but again, the reader is invited to work through the detailed valuation example on the IOI website to help bring these general principles to life. The preceding chapter on understanding the golden rule of valuation and this chapter on recognizing the valuation drivers are a great step to- ward building what Warren Buffett called a “sound framework for making [investment] decisions. ” The one thing that I hope you have realized while reading this and the preceding chapter is what a simple and commonsense process valuation is. It is worth asking why—if rational valuation is such a simple process—do people generally have such a very difficult time investing and run into so many pitfalls. To understand this, I now turn to an explanation of the behavioral biases and structural impediments that trip investors up and make sugges- tions on how to avoid them. 113 Chapter 6 understanding and overcoming investing pitfalls You have seen that valuation is not a difficult thing. It requires understanding of a few key relationships, but it is basically a straightforward process most of the time. Why then, do so many investors have such a hard time doing it well? The main reason, I am sorry to say, is our nature as human beings and the weaknesses of our nature. This chapter discusses two facets of that—be- havioral biases and structural impediments. The first facet—behavioral bi- ases—involves how we as human beings try to figure out complex things and get caught in the process of doing so. The second facet—structural impedi- ments—speaks about how we investors tend to buy—lock, stock, and bar- rel—into a game designed only for us to lose, whereas the winners’ kids go to $50,000-a-year prep schools followed by a four-year tour of the Ivy Leagues. There is hope. Don’t despair. The first step to not falling for these pitfalls is simply to understand that they exist. Obviously, being an intelligent option investor means investing intelligently, minimizing—as much as possible—the effects of irrational and emotional decision making. This chapter is designed to help you do just that. Jargon introduced in this chapter is as follows: X-system Risk neutral Risk seeking Risk averse C-seeking Prospect theory 114  •   The Intelligent Option Investor Behavioral Biases Human intelligence evolved in an environment that is very different from the one in which we live today. Gone is the necessity to hunt and gather, protect ourselves from predators, and fashion our own shelter. In con- trast, in our modern lives, we are safe from most environmental factors but are instead confronted with massive amounts of data. Groundbreak- ing photographer Rick Smolan, in his book, The Human Face of Big Data (Sausalito, CA: Against All Odds Productions, 2012), contends that a mod- ern person processes more information in a single day than the typical sixteenth-century person processed in an entire lifetime. I am not sure if there is a scientific way of proving such a contention, but it does seem at least plausible. In terms of investing, the mismatch between how our mental processes have evolved and the tasks that we expect them to carry out becomes an issue because, by and large, we are still using mental strategies that served our Stone Age ancestors well but that serve us investing denizens of the “Information Age” much less well. The study of human bias in economic decision making is a big topic— called behavioral economics or behavioral finance—and it is not possible to cover it fully here. I will give a few examples here and suggest how you might work to counteract theses biases in your intelligent investing, but you are encouraged to study up on these issues themselves. It is a fascinating topic, and the more you learn, the more you will realize how much behavioral biases affect everyone’s decision-making processes. Here I will discuss three issues: 1. Love of symmetry 2. Confidence and overconfidence 3. Humans’ kinky perception of risk Love of Symmetry Here is the chart of an asset that has had a smart 8.3 percent return in just 50 trading days. Is this thing likely to keep going up from here or fall back down after its relatively rapid rise? Understanding and Overcoming Investing Pitfalls •  115 38.50 38.00 37.50 37.00 36.50 36.00 35.50 35.00 34.50 34.00 33.50 16 11 16 21 26 31 36 41 46 51 Trading Days Price per Share Y ou would be correct if you answered, “Neither of the above. ” This is a chart I created using the random-number-generator function in Excel. Be- cause Excel recalculates the values on the sheet any time a change is made, I could not get the next value in this series—the series changed as soon as I asked Excel to calculate the next day’s return. I have presented similar series to various groups, including groups of traders. It is fascinating to hear the predictions regarding this series and the reasoning behind the predictions. Usually, the crowd settles on an an- swer that is acceptable to most people (e.g., “It will probably go higher, but I’ d set a stop loss at $37.25 and aggressively buy if it goes down to $35.50”). 1 Why do so many people see patterns where no patterns exist? Why do so many people put their faith in so-called technical analysis (which is neither technical nor analysis) even though they are just as likely to be successful consulting a Magic 8 Ball for investment advice? To understand this, we need to realize that there are two separate human mental processes for analyzing and solving problems: X-system and C-system. The X-system is in control of refleXive thought processes, and these processes take place in some very primitive areas of the brain. This system 116  •   The Intelligent Option Investor is extremely good at perceiving patterns and symmetry and can operate very quickly to solve common problems. It is also capable of multitask- ing. The C-system is in control of refleCtive thought processes, and these processes take place in parts of the brain associated with higher reasoning. This system works slowly to solve complex problems about which we have limited experience. Its ability to multitask is limited. For an illustration of these two systems, consider this problem: you are walking in a house and are confronted with the following object: Y our X-system recognizes this object as a door, quickly retrieves information about how to use objects of this type from your memory, and directs you Understanding and Overcoming Investing Pitfalls •  117 to rotate the metal handle downward to open the door and move into the next room. Y ou can solve this problem extremely quickly, with no conscious thought, even while you are doing something else, like speaking with a friend. Now let’s say that when you grab the handle and rotate it, rather than the door opening, the handle comes off in your hand. What do you do? Y our mind automatically switches from X-system mode to C-system mode, and you begin to solve the problem of the closed door in a logical, systematic way. Y ou would stop talking to your friend, push the door to see if it will open with- out the latch, bend down to take a look at the handle mechanism, and so on. Throughout the process of attempting to solve this problem, you may switch back and forth between X-system and C-system processing, using your C-system as the controller and the X-system to check on prior solutions to similar problems you may have faced. With this example, you likely have a good intuitive feel for the char- acteristics of the X- and C-systems, but for completeness’s sake, here is a grid describing them: X-System C-System Reflexive Reflective Good for recognizing symmetry and patterns and for solving commonly experienced problems Good for analyzing complex, multistep problems outside previous experience Operates quickly Operates slowly Separate processes do not interfere with one another, allowing for multitasking Separate processes do interfere with one another, making multitasking difficult or impossible Uses amygdala, basal ganglia, and temporal cortex—the areas of the brain associated with “fight or flight,” reward training, identification of objects, and behavior Uses anterior cingulate cortex, prefrontal cortex, medial temporal lobe, including the hippocampus—the areas of the brain associated with higher-order functions such as planning and control Didactic style: analogy Didactic style: mathematical proof Psychologically comfortable and easy Psychologically uncomfortable and difficult The X-system is more psychologically comfortable to us (or to most of us) because it is the part of the brain we as a species have been using during most of our evolutionary history. The pattern-recognition portion of our brain is highly 118  •   The Intelligent Option Investor developed—so much so that even though computers such as Deep Blue can go toe to toe with chess grand masters, no computer has yet been designed that would be able to recognize a fork that is rotated 30 percent off center or a series of random items placed in front of it. Even the greatest computer “mind” can- not carry out a pattern-recognition task that is simple even for human infants. In investing, humans tend to lean on this X-system pattern recognition and try to use shortcuts to analysis based on it. We have mental models for cer- tain kinds of companies, certain kinds of information, and certain situations, and we attempt to escape uncomfortable, analytical C-system processing by allowing our X-system to match current conditions with those mental models. When presented with a stimulus (e.g., bad quarterly earnings numbers), our tendency is to reflexively react rather than to analyze the information. This tendency is made more visceral because the X-system that is processing this stimulus is tied into the “fight or flight” response. We would rather act first, even if acting proves to be a detriment rather than a benefit. This is a phenomenally difficult—I think impossible—bias to complete- ly overcome. Although this bias can be extremely detrimental to us and our investing process, our highly developed X-system is also incredibly useful to us in our daily lives—allowing us to navigate the difficult problems present- ed by doors, car operation, and so on. I discuss how to recognize and work around X-system biases, how to use the X-system when it is useful to do so, and how to frame investment decisions using C-system processes in the valu- ation example of Oracle that can be found on the Intelligent Option Investor website. For now, let’s look at another behavioral bias—overconfidence. Confidence and Overconfidence Scientific research has shown that humans do not feel comfortable with C-system-style analysis and tend to doubt the results of these processes. As men- tioned earlier, C-system processes do not seem intuitive and certainly do not jibe with the satisfying off-the-hip decision making that seems to be prized culturally. In what may seem like a counterintuitive reaction to this feeling of discomfort with C-system processes, you often find analysts and investors attempting to collect every scrap and shred of detail regarding a company’s operations before making an investment decision. This phenomenon may have something to do not only with a certain discomfort with C-system Understanding and Overcoming Investing Pitfalls •  119 processes but also with a natural human discomfort with the unknown. All investments are made in an environment of uncertainty, and uncertainty is an unsettling psychological state for humans to find themselves in. To ameliorate the discomfort from uncertainty, people have a tendency to attempt to gain control of the uncontrollable by not leaving any stone unturned in their analyses. This may seem sensible, but in fact, studies have shown that more information does not help you to make better decisions—just the opposite, in fact. The first study showing this bias was done by a psychologist at the University of Oregon named Paul Slovic, who studied the accuracy and con- fidence of professional horserace handicappers. 2 Similar studies have been performed on other groups—medical doctors and stock brokers among them—and the results from subsequent studies have been very similar. Professor Slovic gave professional handicappers varying amounts of in- formation about horses running in a series of races and then asked them to make a prediction about the first-place finisher in each race. The handicappers were then asked to assess the confidence they had in their predictions. Slovic had the actual race results and compared the professionals’ confidence with their actual accuracy. The results can be represented graphically as follows: 30% 20% 10% 0% 51 02 04 0 Number of Items of Information Accuracy vs. Confidence of Professional Handicappers Confidence and Accuracy (Accuracy measured by correct first-place selections) AccuracyC onfidence 120  •   The Intelligent Option Investor This is an incredible graph. The horizontal line represents the accuracy of the expert predictions. The dotted line represents the confidence of the experts depending on the amount of information they had. The fact that the predictive efficacy line remains horizontal and the confidence line increases so sharply indicates an interesting and, think- ing about it, frightening facet of human behavior. Namely, even though the predictions made by the experts who had the most data were no more accurate in reality than those of their colleagues who had limit- ed data, the ones with access to more and more data became more and more confident, to the extent that they were massively overconfident. Accuracy remains just under 20 percent, but confidence goes up to 30 percent—a 10 percentage point difference in perception (confidence) versus reality (accuracy)! This behavioral bias has two large negative effects on investors. First is a tendency to spend too much time looking at too many nonmaterial minutiae until finally one cannot come to a decision regarding whether or not to invest—or, as it is colloquially known, analysis paralysis. I think of the attempt to gather a huge amount of increasingly detailed information about an investment prospect as a sort of cosmic bargaining. The analyst or investor who spends hundreds of hours looking at very de- tailed information not material to the valuation is doing something akin to making a burnt offering of old. The analyst or investor is, in some sense, making a prayer to the market gods: “I will sacrifice a lot of time and mental effort learning about this company. Please reward me with positive returns this year. ” In the attempt to bargain with the great unseen hand of the mar - ket, an analyst spends more and more time collecting increasingly less and less important information about the potential investment until the cost of collecting the extra information greatly outweighs the benefit of having gathered it. The big problem with very detailed analyses is that the closer one looks at a given problem, the more involved that problem becomes. Every fact has some supporting details, and each supporting detail has a few scenarios that may be associated with it. To do a really thorough job, you must look at each scenario in turn. Ah! But these scenarios turn out to be interrelated, so you must think about not only first-order changes in the scenarios but also secondary and tertiary ones as well. Soon the analyst or Understanding and Overcoming Investing Pitfalls •  121 investor’s spreadsheet model winds up being 45 tabs deep, and it still seems like there is more work that needs to be done before a decision can be made (“Where were those numbers regarding the depreciation of fixed as- sets at the Malaysian subbranch?! How can I invest if I don’t know that?!”). At this point, the analysis has become thoroughly paralyzed, and frequently the investor will decide (after putting in all that hard work) just to drop the whole thing because he or she “can’t get his or her head around” the valuation. Another cost to gathering a great amount of detailed information is more subtle but no less dangerous. Let’s say that the analyst has worked through all those secondary and tertiary scenarios and decides that the firm in question is undervalued. The company is trading for $X and is worth “$Y at a minimum. ” What is the analyst’s confidence level in that $Y valuation? If the scientific studies I mentioned earlier hold true, the analyst is 50 percent more confident than the position warrants. This is an unhealthy dose of overconfidence. The investor hits the “Buy” button and hopes for the best. However, after a few quarters, some of the operational metrics at the firm begin to falter. The Capex project that was forecast to take 5 percent of sales in year one ends up taking closer to 9 percent. Sales are a bit lower than expected, and costs are a bit higher. But the investor has thought about all these pos- sibilities and is still very confident in the valuation; these discrepancies are thus looked at like anomalies that will soon be corrected with another quarter or two of results. The situation can drag on for an extended time until suddenly the investor is confronted with the possibility that the firm is running out of cash, its new product line has failed, or whatever. The in- vestor, once so confident, now has to face the unpleasant task of realizing a loss (why he or she may not want to realize a loss is discussed in the section “Humans’ Kinky Perception of Risk” later). “Love is blind. ” Unfortunately, overconfidence in an investment opin- ion can make one just as blind as love. I believe that two facets of intelligent option investing can help to ameliorate these biases. First, recall that there are at most four—and most often only three—drivers determining company valuation. While you are reading about a company and analyzing its value, it is wise to constantly ask yourself two questions: 122  •   The Intelligent Option Investor 1. Is what I’m analyzing related to one of the drivers of company value? 2. Is what I’m analyzing material to the valuation? Sure, there is some sort of satisfaction in knowing everything there is to know about coal-processing technology or oil reservoir structure and engineering, but recognize that this satisfaction is purely personal and is not going to make a bit of difference to the valuation. Understanding these kinds of technical details might help a tiny bit in understanding competi- tive dynamics in an industry, but the cost of learning them almost always exceeds the benefit from the knowledge. For any technical points you are trying to learn about as a layperson, there are likely two armies of engi- neers, specifically trained in that field, arguing with one another about whatever point you are learning about. No matter how large your band- width is, it is not likely that you will be able to make a more informed deci- sion than those people. And if the final result is, “Company A will likely be able to produce coal at a slightly cheaper cost than Company B because of the geology where Company A has its mines, ” this is a fact that can be reasonably ensured by a few minutes on Wikipedia rather than by checking out books from the local university’s engineering library. Second, the online valuation example shows how you can create rational valuation ranges for a company, and I believe that those ranges can be very helpful. Estimating valuation ranges rather than tying them- selves to point estimates of a specific stock value can help investors to re- main more objective about information coming in and more observant of changing conditions. For example, if an investor sees one group of valua- tion ranges clustered near $30 and one group clustered near $50, the inves- tor can objectively assess operational data coming in over time and decide which set of projected economic results the actual results will match. The investor may have thought the economic results underlying the $50 cluster were more likely, but as time goes on, he or she may see that the results leading to the $30 cluster are closer to the truth. In this case, the investor can be confident and happy about making accurate projections (because the investor projected both the $30 level and the $50 level), even if he or she is not particularly pleased with the investment outcome. This may be the psychological slack required to combat the last behavioral bias we will discuss—humans’ kinky perception of risk. Understanding and Overcoming Investing Pitfalls •  123 Humans’ Kinky Perception of Risk Take a look at the following questions: First question: you have a choice between playing two games with the following monetary payoffs. Which game would you play? • Game 1: 75 percent chance of winning $6,000 and a 25 percent chance of winning $0 • Game 2: 100 percent certainty of winning $4,000 Make a note of your choice. Second question: you have a choice between playing two games with the following monetary payoffs. Which game would you play? • Game 3: 75 percent chance of losing $6,000 and a 25 percent chance of losing $0. • Game 4: 100 percent certainty of losing $4,000 What was your answer to this question? Mathematically, you should choose to play games 1 and 4—these are the rational choices. Most people irrationally would choose to play games 2 and 3. The expected payout of game 1 = 75 percent × $6,000 + 0 = $4,500. As such, game 1’s outcome generates a higher expected payoff than game 2. If you chose game 2 in this instance, it would indicate that you are risk averse. Reversing the conditions of the games to generate losses instead of profits, you can see that game 3 yields an expected loss ($4,500) that is greater than the expected loss of game 4 ($4,000). If you chose to play game 3 over game 4, this would indicate that you are risk seeking rather than risk averse. Psychologists Amos Tversky and Daniel Kahnemann—two research- ers who began the systematic study of behavioral biases—found that peo- ple tend to be risk averse with respect to gains and risk seeking with respect to losses and have coined the term prospect theory to describe this ten- dency. 3 To understand risk aversion and risk seeking, let’s look at a simple betting example. Y ou offer a test subject a choice of either receiving a certain payment of a certain amount or receiving an amount based on the result of a fair 124  •   The Intelligent Option Investor bet such as a coin toss. If the coin comes up heads, the subject wins $100; if it comes up tails, the subject walks away with no payment. The expected payoff from the fair bet from a mathematical perspective is $100 × 50% + $0 × 50% = $50 Economists describe risk preferences for individuals on the basis of the fixed payment the individual would accept in order not to subject the payout to a risky outcome. The three risk preferences are • Risk neutral • Risk averse • Risk seeking The risk-neutral investor is completely rational. The mathematical expected payoff is $50, so the risk-neutral approach is not to accept any guaranteed payment other than $50 in lieu of making the bet. If you were to diagram the value the rational risk-neutral investor would assign to the expected value of a risky outcome (using what economists call a utility curve ), you would get the following: 0 0 Expected Value of a Risky Outcome Risk-Neutral Utility Function Value Placed on a Safe Outcome Because $50 is not a great deal of money to some people, they can and do remain risk neutral at this monetary level. Increase the potential payout Understanding and Overcoming Investing Pitfalls •  125 to $1 million, and I guarantee that people will most happily demonstrate risk aversion. Risk aversion is demonstrated by someone who would be willing to accept a guaranteed amount of less than the mathematically calculated ex- pected payout in order to avoid putting the total payout at risk. For exam- ple, if you would prefer to accept a sure $45 instead of a 50 percent chance of winning $100, you are risk averse. The utility curve for a risk-averse investor would be represented like this: 0 0 Expected Value of a Risky Outcome Risk-Averse Utility Function Value Placed on a Safe Outcome Most mentally healthy people with relatively low blood-alcohol levels are risk averse to a greater or lesser extent. As the amount in question becomes material (however the person in question defines materiality), the tendency toward risk aversion becomes much stronger. Risk-seeking behavior is seen in gambling addicts and people with high enough blood-alcohol levels that they should not be operating heavy machinery. It is, of course, the converse of risk aversion: a risk seeker requires a higher guaranteed payment than the mathematically expected payout in order to forgo the bet. For instance, a risk seeker would not want to stop betting unless he or she was offered $60 or more for an expected-value bet of $50. The utility curve for a risk-seeking investor looks like this: 126  •   The Intelligent Option Investor 0 0 Expected Value of a Risky Outcome Risk-Seeking Utility Function Value Placed on a Safe Outcome Risk seeking may seem implausible for anyone whose problems are not the feature of a daytime psychology talk show, but as you will see, each and every person reading this now likely displays risk seeking many times in an investing career. If you read an Economics 101 textbook, you will learn that peo- ple are either risk neutral (professional economists always try hard to show that they are risk neutral because they generally pride themselves on being rational), risk averse, or risk seeking. In fact, we all display each of these profiles at different times depending on the situation. The unfortunate fact, discovered by Tversky and Kahnemann, is that humans tend to display the least helpful of each profile in different situations. When we are winning, we tend to be risk averse. We have made 20 percent on an investment in a short time, and our tendency is to “take our money off the table” and realize our gains. The thing we fail to realize when we feel the pride and satisfaction of hitting the “Sell” button is that at the moment we close the position, our money is again sitting idle, and we are faced with the prospect of having to find another risky investment to replace the one we just closed. Conversely, when we are losing, we tend to be risk seeking. For example, let’s say that we have lost 60 percent on an investment. Is our natural tendency to sell that position? No. Because the value of our stake Understanding and Overcoming Investing Pitfalls •  127 has fallen so much, we sense that any small movement up will be a big improvement to the present situation. We “let it ride” and hope for a lucky break. This is the action of someone who realizes that he or she has little to lose (because so much is lost already) and everything to gain—which, of course, is the very definition of desperation (and the day-to-day modus operandi of many hedge fund employees). This variable risk profile is depicted by the following graph. The top- right quadrant shows a risk-averse profile—one would rather cap one’s gains than let them ride. The bottom-left quadrant shows a risk-seeking profile—one would rather bet than realize one’s losses. Prospect theory utility curve x U(x) Note how the curve in the upper right-hand quadrant looks like the risk-averse utility curve and that everything in the lower left-hand quadrant looks like the risk-seeking utility curve. This is an astounding graph, but perhaps an actual, visceral example would carry an even larger impact. Think of the fellow who got in on the Google initial public offering, buying at $85 per share. A few months later, after more than doubling his money, he happily sells at just above $200 and again puts his capital at risk in another investment—starting over from square one in terms of making an investment decision. 128  •   The Intelligent Option Investor 250 Google (GOOG) Closing Price A 200 150 100 50 0 8/19/2004 9/19/2004 11/19/2004 12/19/2004 1/19/200510/19/2004 This investor’s thought at point A: “I am an investing genius! I just made a 100 percent return in a couple months—time to take my money off the table. ” However, after selling the shares and feeling the sense of relief that he had reduced his risk exposure to Google, he eventually grows dis- mayed about being hasty in realizing his gain: 800 Google (GOOG) Closing Price B C D E F A 700 600 500 400 300 200 100 0 8/19/2004 2/19/2005 2/19/20068 /19/20068 /19/20078/19/2005 2/19/2007 Understanding and Overcoming Investing Pitfalls •  129 The investor’s reasoning may have gone like this: A Original sale realizing profits B “I did the right thing.” C “I left a little on the table, but it’ll come back soon, and I’ll buy some more then.” D “Should I short Google?!” E “Aaaaaaaaaaaargh!” F Second purchase Finally, after his mail carrier comments that she is retiring early after selling her Google position for $675 per share and a person at the country club buys a new Lexus using his Google sale proceeds, our kinked utility curve investor does the thing that social creatures tend to do when faced with uncertainty and remorse—follow the herd. He is happy that his limit order to buy at $695 is filled at midday and happier still that he made a gain of 3 percent after buying the shares. Our hapless investor’s bad sense of timing is good for us because his purchase of Google shares at the local 2007 market peak and ownership through the fall allow us to simultaneously follow the psychological pain he suffered on the stock chart and the utility function curve: 800 Google (GOOG) Closing Price B C A 700 600 500 400 300 200 100 0 11/1/2007 2/1/2008 5/1/2008 8/1/2008 11/1/2008 130  •   The Intelligent Option Investor Thus an investor in Google at $695 feels pain extremely quickly when the value of the position drops slightly to the $620 per share level, let’s say; this is indicated at position A in the diagram. However, as the price continues to decline (let’s say to the $450 per share level indicated by position B ), human decision makers have a tendency to say something like, “If only I could get $475 for my shares, I’ d sell right now. ” If and when the shares do in- deed reach $475, the curvature of the line in this quadrant implies that now the investor will require yet a higher guaranteed price (e.g., $525 per share) before he closes the bet. At some point, which may be one representing a significant loss of principal, the investor is largely inured to the prospect of further losses, and if the stock price goes far enough down, the investor is no longer tempted to bet on a small rise in price. This is the point that people usually sell—just as the $50 stock they bought is trading for $1.50 on the Pink Sheets! This psychological effect is dreadfully difficult to overcome— perhaps impossible. However, again, I believe that the most important first step is having a rational, educated estimate of the fair value range of a company and understanding the drivers that go into the values making up that range. Let’s say that you bought a stock for $30 after having determined a low-end valuation of $39 and the high-end valuation around $50. Now a quarterly earnings announcement reports good numbers—data suggesting that the valuation cluster around $50 is closer to correct—and the stock advances by 10 percent—to $33. Under these conditions, you are less likely to excitedly take your profits after the 10 percent up day because you know that the stock still has about 50 percent to go before it gets to your best-case valuation range. Again, understanding the drivers of valuation and having an appreciation for (and humility in the face of) the uncertainty involved in any projection of future conditions (as reflected by a valuation range) constitute the best way I have found to combat the deep-seated bias related to the kinks in our perception of risk. Now we’ll look briefly at structural impediments to rational investing before pulling together all the lessons learned so far to see how to invest intelligently using options. Understanding and Overcoming Investing Pitfalls •  131 Structural Impediments We know that we have an enemy living inside of us in the form of the behav- ioral biases discussed earlier. If this weren’t bad enough, we are attempting to invest intelligently in an environment not conducive to intelligence. In other words, not only must we battle an enemy within, but enemies without as well. The enemies without are comprised of the forces arrayed against us— the owners of capital attempting to invest intelligently. These forces are part of the very structure that has developed to trade, manage, custody, ana- lyze, and report on securities that is such an integral part of the investing process. They consist of the many explicit messages we as investors receive every week telling us that we should “trade like a pro” and the implicit mes- sages that we don’t know what we are doing so we should put our faith in this expert or the next if we hope to be successful. At the heart of these structural issues is the distinction between prin- cipals and agents. Principals versus Agents Y ou cannot talk about structural impediments without making the distinc- tion between principals and agents. Principals are the owners of capital who invest in risky projects or assets with the expectation of generating a positive return. Principals can be like you and me—individuals with finite lives—or can be legal entities such as endowments or companies—which are theoretically perpetual actors. Agents, on the other hand, are the inter- mediaries who act on behalf of principals in return for salaries and who are paid for out of the capital of principals. Any time a person is compensated for doing something, his or her own interests are on the line. When our own interests are on the line, we look for opportunities to protect and advance them. Unless a great deal of thought is put into how investment performance is measured and assessed and how compensation is awarded to agents as a result of that performance, in the process of advancing their own agendas, agents actually may end up working at cross-purposes to their principals. This tension between agents—who must work within the constraints of their industry to keep 132  •   The Intelligent Option Investor their jobs and advance their careers—and principals—who by and large are simply looking to save enough money to live comfortably in retirement and pass something on to their descendants—lies at the root of what I term structural impediments. To investigate these structural impediments, we first need to figure out who is playing this investment game and what the rules are. To do this, I’ll introduce the teams: the buy side and the sell side—both of which are agents—and the principals. With this knowledge, we can better avoid the structural pitfalls established by the agents largely for their own benefit. The Buy Side The buy side consists of agents hired by principals to invest and manage the principals’ capital on their behalf. The most well-known buy-side play- ers are mutual funds and hedge funds, but insurance companies, pension funds, and endowments also fit into this category. I tend to think of hedge funds and mutual funds as being different in approach from the others, so we’ll look at these two groups separately. Perhaps the attitude of mutual and large hedge fund players can best be summed up by the words of a professional money manager, who once told me, “Erik, no one ever got fired for not making money; they got fired for losing money. ” Most people unfamiliar with the money-management industry think that performance is paramount for the managers. In fact, investment performance is only a slightly inconvenient means to an end for money managers. For the owner of a hedge or mutual fund, the real name of the game is assets under management (AUM). AUM is the total amount of money a fund manages on behalf of its clients, and it is the main source of wealth for the owners of a fund. Mutual funds charge a load that represents a percentage of money clients leave with them to manage but are not usually directly rewarded for the performance of the fund. In the case of mutual funds, AUM is all important, and investment performance is merely a marketing tool. If fund A can generate good enough performance to stand prominently in the pack of other funds (i.e., “x percent of our funds beat their Lipper averages”), and rating companies such as Morningstar give the fund a positive rating, present customers of fund A are less likely to take their money to another fund, and customers of lower-performing funds Understanding and Overcoming Investing Pitfalls •  133 will move their money to be managed by fund A. Of course, at the annual bonus time, fund employees are compensated in rough proportion to the performance of their investment recommendations, so there is an incentive for analysts and portfolio managers to perform well. However, if an analyst is interested in keeping his or her revenue stream coming in in the form of salary, the analyst quickly learns that the best route is usually the safest one. This leads to a phenomenon known as closet indexing , where an in- vestment fund’s portfolio is so diversified that it effectively takes on a risk- return profile equivalent to the index (or whatever benchmark the fund is using to measure relative performance). A 2011 study by Martijn Cremers and colleagues concluded the following (italics added by author): In this paper we examine the prevalence of explicit and implicit (closet) indexing in equity mutual fund management across 30 countries. We find that although little explicit indexing exists as a proportion of assets under management [N.B.: There are few low-load index funds in proportion to “actively managed” funds] in almost all countries, a large amount of closet indexing exists. That is, equity fund managers in many countries choose portfolios that track their stated benchmark closely. Or, to put it simply, whether an investor puts money into an active fund or an index fund, the investor mainly just gets the performance of the index. In addition, bonuses and salary increases are apportioned out on an annual basis, meaning that the natural investing time horizon for an analyst or money manager is only one year. Almost everyone in the industry feels a sense of excitement and relief at the beginning of a new year because they know they are starting out with a fresh slate. Clearly, the agents—the employees and owners of the funds—are not acting in the best interests of the principals (because they are charging fees but not provid- ing much or any benefit), and the agents’ investing time horizons are not, by and large, aligned with the investing time horizons of the principals (agents start again with a fresh slate every year whereas principals worry only about the value of their investment assets at some point in time, like college admission or retirement). The same sort of dynamic occurs in the hedge fund industry, al- though with a bit of a twist. Large hedge funds usually are set up in a 134  •   The Intelligent Option Investor “2-and-20” arrangement, where 2 percent of a client’s money every year goes immediately to the manager (this is the load in a mutual fund), and 20 percent of profits (or profits over some benchmark) are apportioned out on a periodic basis. The owners of these prominent funds usually set up their businesses in such a way as to receive all the moneys based on AUM and leave the lion’s share of the risky, performance-based payout to the portfolio managers and analysts hired to manage the money. The owners of large hedge funds, in other words, have compensation structures that are very similar to those of the owners of large mutual funds and so are con- cerned mainly with clients not moving their money to other hedge funds. For the owners of these funds, performance is, in a sense, just a necessary evil to their goal of generating wealth by safekeeping the wealth of others. The owners of small hedge funds and the managers/analysts of all hedge funds lead a much more tenuous existence. This business is extremely competitive, and the continuation of these agents’ salary- and bonus-gen- erated revenue streams is extremely sensitive to recent performance. Small hedge fund owners are beholden to hedge funds of funds (HFoF)—another intermediary that funnels principals’ capital to different hedge funds in re- turn for a fee—and their money is extremely “fast. ” If a small fund manager does not outperform the appropriate benchmark in a given quarter or can- not convince the HFoF that performance lagged in the last quarter for some reason that will reverse itself in spades in the next quarter, it is very likely that the HFoF will pull its money from the fund. Similarly, a portfolio man- ager working for a large fund must, at least on an annual basis, prove to the hedge fund owner that his or her performance has been good enough or will soon be good enough to deserve a continued allotment of the clients’ capital. Strangely enough, as more and more hedge funds flood the market, soaking up opportunities to generate alpha (excess returns), hedge funds have come to display returns that are highly correlated with the underly- ing index. A recent research report published by Morgan Stanley told this tale in figures—the correlation between the Standard and Poor’s 500 Index (S&P 500) and an index of hedge funds reached around 90 percent in mid- 2013. 4 This does not mean that an individual hedge fund will engage in closet indexing as a mutual fund might, but it does mean that if you invest your money in multiple hedge funds to try to generate better performance, your returns will start looking a lot like the returns of the index at large. Understanding and Overcoming Investing Pitfalls •  135 Turning now to the next buy-side group—insurance companies, pension funds, and endowments—we see a different business model and different motivations for employees. In general, these buy-side businesses have much less pressure to generate superlative returns and exist as a sort of appendage of another primary business. Life insurance companies invest their clients’ money but generally promise very limited returns— structuring agreements with clients in such a way as to ensure that if their investment decisions are at least minimally competent, they will be able to fulfill their promises to clients. As such, investments tend to be a default se- lection of blue chip equities and high-quality bonds. In this environment, the portfolio manager is not measured so much on his or her investment prowess but rather on his or her ability to allocate to bonds and stocks in a sensible enough proportion to be able to satisfy the insurance company’s obligations to its clients when they come due. The real risk to the insurance company is not collecting enough fees or promising its clients too much. The investment horizon for these funds is something like 10 to 20 years. Pension funds are much the same in terms of investment philosophy— if a portfolio manager allocates assets sensibly between high-grade corporate bonds and blue chip stocks, his or her career is basically safe. It is rare to find private sector entities now that even offer pensions to their employees and tougher still to think of examples of pensions that are adequately or overfunded (meaning that they have enough funds to meet their future obligations). Again, the investment horizon for these entities is a long 10 to 20 years. Until rather recently, university endowments were very similar to in- surance or pension funds, but they naturally have much longer investment time horizons because the money is usually not promised to any specific purpose in some limited time frame. Endowments usually allocate to a wider range of asset classes—including hedge funds, private equity funds, real estate, and so on—and several gifted portfolio managers at Harvard and Y ale have done this to enormous effect on behalf of their schools in recent years. However, in general, asset selection or allocation risks are low for managers in this environment. Rather, the risks are much more related to the ability of managers to satisfy their schools’ boards of governors that they are managing the school assets with propriety and foresight. One undeniable fact to all buy-side firms is that as the entity grows larger, it becomes harder and harder to invest in anything but very large 136  •   The Intelligent Option Investor and liquid stocks. Even if you have a small cap position that increases by 100 percent in a single year, if your investment base is so large that the win- ning position’s size is only 0.005 percent of the total AUM at the beginning of the year, it only represents 0.01 percent of the portfolio at the end of the year—hardly moving the needle in terms of excess performance. To summarize the players in tabular format: Player Clients Are . . . Time Horizon Risk Investment Paradigm Hedge funds Demanding, fast money 3 months to 1 year Owner: Losing clients Managers: Not making risky enough bets Anything that pro- vides alpha Mutual funds Docile and uninformed 1 year Breaking from the herd and see- ing AUM drop Closet indexing Insurance companies and pension funds Largely unaware of their investments 10 to 20 years Not charging clients enough (insurance); not retiring before the pension is discontinued/ defaulted on (pensions) AAA bonds and blue chip stocks—risk aversion Endowments Not born yet 10 years to 100 years Losing confidence of board of governors Wide asset-class level allocation with long-term perspective Look back at this table. As a principal owner of capital, is there any- thing listed in the risk column that speaks to the risk of investing that you yourself have experienced or feel is most pressing to you? The Sell Side The sell side consists of companies whose job it is to connect principals (through their agents) who have capital with the financial markets. Understanding and Overcoming Investing Pitfalls •  137 Broker-dealers are the sell-side counterparties for institutional investors, whereas stock brokers and online brokers are the counterparties for indi- vidual ones. The operative principle for this business is best summed up in the old adage, “Bears make money, and Bulls make money. Pigs get slaughtered. ” In other words, sell-siders do not care if the market goes up or down be- cause their revenues depend only on investors accessing the market. The only way to lose this game is to get too greedy and take a risk position in a security that subsequently loses value. 5 Sell-side players basically make money in proportion to how often their clients come to the market. As such, the sell side has a vested interest in getting its clients to trade as often as possible. Sell-side research groups hire very smart graduates from top universities and industry insiders who basically act as marketing arms for the firms’ sales and trading desks. The more short-term “catalysts” the research group can find that might prompt a client to make a stock purchase or sale, the better for them. Research groups’ bonuses are determined in large part by feedback from the sales and trading desk. Because the sales and trading team only makes money if a client trades, research that advocates long holding periods and infrequent trading is certainly not welcome, no matter how efficacious it might be. The main duty of the people on the sales desks is to prompt clients to make a trading decision and to trade with them (rather than another bank), so salespeople spend a good bit of time making cold calls to hedge fund traders to give them some market “color” and point out opportunities to make short-term trades. The End Result The buy and sell sides interact with one another in such a way as to create an investing environment that values short-termism and dependence on large-capitalization stocks. The problem is that individual investors get wrapped up in these machinations and end up trying to act like agents when they are in fact principals. Agents, as we have seen, get paid a salary and bonus on the basis of various short-term factors that are, at best, neutral and, at worst, damaging to the interests of principals. Buy-side agents, as 138  •   The Intelligent Option Investor we have seen, are either relatively disinterested in investment performance (e.g., insurance companies and pension funds) or are interested only in relative outperformance over a very short time frame (e.g., hedge funds and mutual funds). Sell-side agents make money in proportion to trading volume and frequency, so they are happy to facilitate the enormous trade in a blue chip securities on behalf of a pension fund or the hundreds or thousands of individual trades in a day on behalf of an aggressive active hedge fund. None of these agents are considering the economic value that may be created by the company in which they are investing, and in the attempt to maximize their own compensation, they are happy to ignore the long-term view in favor of a trade that will work within 90 days. Individual investors read sell-side research, and because the research analysts are so intelligent and well informed about various minutiae of a given company or industry, they think that the analysts’ recommendations will help them in the long term. Business news channels offer a constant stream of pundits from both buy and sell sides pontificating about things that matter to them—short- term opportunities to generate a small advantage for the quarter—and that individual investors wrongly assume should be important to them as well. An experienced technical analyst can find an investment opportu- nity in any chart pattern. A sell-side investment banker can always talk about why one company looks cheap in comparison with another in the same industry based on some ratio analysis that has a shelf life of about two weeks. Discount brokerages are happy to supply individual investors with sophisticated software and data packages that are “free” as long as the investors make a certain number of trades per month, and they encourage their clients to “trade like a pro. ” The end result of these structural factors is that individual investors get caught in a mental trap that if they are doing anything different from what they see their highly paid agents doing, they must be doing some- thing wrong. This is reinforced by one behavioral bias I mentioned in pass- ing earlier—herding—the human tendency to try to find safety in following the lead of others rather than risk independent action. In general, any information or strategy that does not hone in on the long-term economic value of a company should be considered by intel- ligent investors to be a red herring and ignored. No individual investor is Understanding and Overcoming Investing Pitfalls •  139 being compensated with respect to short-term or relative performance, so information that is purported to give them advantages in this realm should be taken with a grain of salt. Now that you have a good idea of the theory behind options from Part I and the theory of how to assess rational valuation ranges for a stock without falling into behavioral or structural traps from Part II, let’s apply this knowledge to the practical task of investing. Part III discusses how to apply the principles of intelligent stock valuation to option investing and shows how to tilt the balance of risk and reward in our favor. This page intentionally left blank 141 Part III IntellIgent OptIOn InvestIng Now that you understand how options work and how to value companies, it is time to move from the theoretical to the practical to see how to apply this knowledge to investing in the market. With Part III of this book, we make the transition from theoretical to practical, and by the time you finish this part, you will be an intelligent option investor. To invest in options, you must know how to transact them; this is the subject of Chapter 7. In it, you will see how to interpret an option pricing screen and to break down the information there so that you can under - stand what the option market is predicting for the future price of a stock. I also talk about the only one of the Greeks that an intelligent option investor needs to understand well—delta. Chapter 8 deals with a subject that is essential for option investors— leverage. Not all option strategies are levered ones, but many are. As such, without understanding what leverage is, how it can be measured and used, and how it can be safely and sanely incorporated into a portfolio, you can- not be said to truly understand options. Chapters 9–11 deal with specific strategies to gain, accept, and mix exposure. In these chapters I offer specific advice about what strike prices are most effective to select and what tenors, what to do when the expected outcomes of an investment materially change, and how to incorporate each strategy into your portfolio. Chapter 11 also gives guidance on so- called option overlay strategies, where a position in a stock is overlain by an option to modify the stock’s risk-reward profile (e.g., protective puts for hedging and covered calls for generating income). 142  •   The Intelligent Option Investor Unlike some books, this book includes only a handful of strategies, and most of those are very simple ones. I shun complex positions for two reasons. First, as you will see, transacting in options can be very expensive. The more complex an option strategy is, the less attractive the potential returns become. Second, the more complex a strategy is, the less the inher- ent directionality of options can be used to an investor’s advantage. Simple strategies are best. If you understand these simple strategies well, you can start modifying them yourself to meet specific investing sce- narios when and if the need arises. Perhaps by using these simple strategies you will not be able to chat with the local investment club option guru about the “gamma on an iron condor, ” but that will be his or her loss and not yours. Chapter 12 looks at what it means to invest intelligently while under- standing the two forms of risk you assume by selecting stocks in which to invest: market risk and valuation risk. 143 Chapter 7 FIndIng MIsprIced OptIOns All our option-related discussions so far have been theoretical. Now it is time to delve into the practical to see how options work in the market. After finishing this chapter, you should understand 1. How to read an option chain pricing screen 2. Option-specific pricing features such as a wide bid-ask spread, volatility smile, bid and ask volatility, and limited liquidity/ availability 3. What delta is and why it is important to intelligent option investors 4. How to compare what the option market implies about future stock prices to an intelligently determined range In terms of where this chapter fits into our goal of becoming intelligent option investors, obviously, even if you have a perfect understanding of option and valuation theory, if you do not understand the practical steps you must take to find actual investment opportunities in the real world, all the theory will do you no good. New jargon introduced in this chapter includes the following: Closing price Bid implied volatility Settlement price Ask implied volatility Contract size Volatility smile Round-tripping Greeks Bid-ask spread Delta 144  •   The Intelligent Option Investor Making Sense of Option Quotes Let’s start our practical discussion by taking a look at an actual option pricing screen. These screens can seem intimidating at first, but by the end of this chapter, they will be quite sensible. Last 0.86 -0.23 -0.14 -0.04 -0.17 -0.14 -0.06 -0.13 -0.12 -0.07 -0.09 -0.14 -0.06 -0.20 -0.26 -0.10 +0.01 0.91 0.94 21.672% 24.733% 0.8387 0.4313 0.0631 0.0000 0.0000 0.0000 0.9580 0.9598 0.9620 0.7053 0.4743 0.2461 0.0357 0.0392 0.0482 21.722% 22.988% 62.849% 72.188% 81.286% 201.771% 192.670% 175.779% 20.098% 18.997% 18.491% 25.587% 29.201% 35.855% 55.427% 123.903% 64.054% 23.311% 22.407% 21.813% 21.147% 22.144% 23.409% 54.689% 66.920% 35.642% 23.656% 23.072% 22.553% 21.460% 21.374% 21.581% 32.597% 24.854% 23.426% 20.380% 19.627% N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A 0.26 0.04 0.02 0.02 0.02 13.30 12.40 11.35 1.19 0.58 0.22 0.01 0.01 0.02 11.90 12.35 10.10 1.68 1.10 0.67 0.05 0.03 0.02 0.24 0.02 10.35 9.30 8.40 1.17 19.408% 18.405% 17.721% 0.56 0.20 11.75 10.70 9.50 1.65 1.08 0.65 0.04 0.01 0.01 11.55 12.30 12.00 10.00 2.48 1.93 1.48 0.41 0.29 0.21 12.20 3.60 1.75 10.05 9.85 2.44 1.91 1.45 0.39 0.27 0.18 12.10 3.50 1.70 0.00 0.23 0.02 C0.00 C0.00 C0.00 0.09 0.45 1.15 C4.99 C5.99 C6.99 C4.99 C5.99 C6.99 C12.01 C11.01 C10.01 1.16 0.54 0.22 C0.00 C0.00 C0.00 C0.00 C0.00 C0.00 0.33 0.76 1.40 C5.03 C6.00 C6.99 C0.00 C0.01 C0.03 0.84 1.23 1.88 C12.02 C11.03 C10.04 1.65 1.06 0.66 C0.06 0.03 0.02 C12.05 C11.07 C10.10 C2.58 1.93 12.10 3.40 1.69 0.68 4.25 C7.27 1.42 0.38 C0.30 C0.22 C0.11 C0.15 C0.19 1.80 2.27 2.73 C5.57 C6.43 C7.35 Chng Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta JUL 26 ´13 31 32 33 37 38 39 20 21 22 31 32 33 37 38 39 Description Call Last Chng Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta Put 0.9897 0.9869 0.9834 0.6325 0.4997 0.3606 0.0463 0.0266 0.0155 0.9712 0.9628 0.9535 0.5890 0.5118 0.4324 0.1664 0.1258 0.0923 0.9064 0.5354 0.3336 +0.01 +0.10 +0.11 0.07 0.09 22.812%2 4.853% -0.1613 -0.5689 -0.9373 -1.0000 -1.0000 -1.0000 22.469% 24.612% 85.803% 203.970% 267.488% 20.456% 19.851% N/A N/A N/A 0.42 1.20 5.25 7.25 8.90 0.39 1.17 4.90 4.85 5.40 +0.02 +0.09 +0.14 -0.0420 -0.0402 -0.0380 -0.2948 -0.5261 -0.7545 -0.9652 -0.9616 -0.9524 77.739% 70.681% 63.514% 20.303% 19.170% 19.011% 41.423% 61.602% 52.378% N/A N/A N/A N/A N/A N/A 0.02 0.02 0.02 0.34 0.73 1.38 5.30 6.55 7.30 0.33 0.71 1.35 4.95 19.958% 18.577% 17.954% 4.65 6.70 22.720% 22.019% 21.378% 20.455% 19.050% 21.354% 0.000% 23.193% 22.845% 22.218% 21.148% 20.913% 20.899% +0.07 +0.05 +0.16 +0.09 +0.12 +0.04 50.831% 48.233% 46.993% 23.384% 22.672% 22.106% 36.111% 30.947% 44.342% N/A N/A N/A N/A 0.02 0.03 0.05 0.82 1.25 1.82 5.55 6.30 7.55 0.01 0.80 1.23 1.79 4.95 6.15 6.85 -0.0103 -0.0131 -0.0166 -0.3679 -0.5008 -0.6402 -0.9558 -0.9757 -0.9871 22.989% 22.284% 21.453% 17.134% 37.572% 38.919% 37.587% 35.246% 23.914% 23.485% 22.925% 22.967% 26.265% 28.715% 0.11 0.13 0.17 0.19 1.78 2.25 2.80 5.80 6.85 7.85 0.13 0.17 1.75 2.22 2.76 5.70 6.50 7.40 -0.0318 -0.0406 -0.0503 -0.4120 -0.4879 -0.5665 -0.8294 -0.8690 -0.9025 34.172% 23.567% 23.145% 22.479% 21.404% 19.420% 18.411% 37.790% 35.385% 30.523% 24.198% 23.081% 0.00 +0.09 33.497% 26.033% 24.745% 0.68 4.25 7.40 0.66 4.15 7.30 -0.0906 -0.4520 -0.6521 33.203% 25.378% 24.054% AUG 16 ´13 20 21 22 31 32 33 37 38 39 SEP 20 ´13 20 21 22 31 32 33 37 38 39 20 32 37 JAN 17 ´14 JAN 16 ´15 I pulled this screen—showing the prices for options on Oracle (ORCL)— on the weekend of July 20–21, 2013, when the market was closed. The last trade of Oracle’s stock on Friday, July 19, was at $31.86, down $0.15 from the Thursday’s close. Y our brokerage screen may look different from this one, but you should be able to pull back all the data columns shown here. I have limited the data I’m pulling back on this screen in order to increase its readability. More strikes were available, as well as more expiration dates. The expirations shown here are 1 week and 26, 60, 180, and 544 days in the future—the 544-day expiry being the longest tenor available on the listed market. Let’s first take a look at how the screen itself is set up without paying attention to the numbers listed. Finding Mispriced Options    • 145 Calls are on the left, puts on the right. Strike prices and expirations are listed here. You can tell the stock was down on this day because most of the call options are showing losses and all the put options are showing gains. All the strikes for each selected expiry are listed grouped together. This query was set up to pull back three strikes at the three moneyness regions (20–22, 29–31, 37–39). The 1-week options and the LEAPS did not have strikes at each of the prices I requested. Now that you can see what the general setup is, let’s drill down and look at only the calls for one expiration to see what each column means. Last C12.02 11.75 10.70 9.50 1.65 1.08 0.65 0.04 0.01 0.01 0.02 0.03 0.05 0.67 1.10 1.68 10.10 12.35 11.90 N/A N/A N/A 22.720% 55.427% 20 SEP 20 ´13 21 22 31 32 33 37 38 39 0.9869 0.9834 0.6325 0.4997 0.3606 0.0463 0.0266 0.0155 123.903% 64.054% 23.311% 22.407% 21.813% 21.147% 22.144% 23.409% 22.019% 21.378% 20.455% 19.050% 21.354% C11.03 C10.04 1.65 1.06 -0.13 -0.12 -0.07 0.00 +0.01 0.66 C0.06 0.03 0.02 Chnq Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta Description Call 0.9897 Red (loss) Green (gain) 146  •   The Intelligent Option Investor Last This is the last price at which the associated contract traded. Notice that the last price associated with the far in-the-money (ITM) strikes ($20, $21, $22) and one of the far out-of-the-money (OTM) strikes ($37) have the letter “C” in front of them. This is just my broker’s way of showing that the contract did not trade during that day’s trading session and that the last price listed was the closing price of the previous day. Closing prices are not necessarily market prices. At the end of the day, if a contract has not traded, the exchange will give an indicative closing price (or settlement price ) for that day. The Oracle options expiring on August 16, 2013, and struck at $20 may not have traded for six months or more, with the exchange simply “marking” a closing price every day. One important fact to understand about option prices is that they are quoted in per-share terms but must be transacted in contracts that rep- resent control of multiple shares. The number of shares controlled by one contract is called the contract size . In the U.S. market, one standard con- tract represents control over 100 shares. Sometimes the number of shares controlled by a single contract differs (in the case of a company that was acquired through the exchange of shares), but these are not usually avail- able to be traded. In general, one is safe remembering that the contract size is 100 shares. Y ou cannot break a contract into smaller pieces or buy just part of a contract—transacting in options means you must do so with indivisible contracts, with each contract controlling 100 shares. Period. As such, every price you see on the preceding screenshot, if you were to transact in one of those options, would cost you 100 times the amount shown. For example, the last price for the $31-strike option was $1.65. The investor who bought that contract paid $165 for it (plus fees, taxes, and commissions, which are not included in the posted price). In the rest of this book, when I make calculations regarding money spent on a certain transaction, you will al- ways see me multiply by 100. Change This is the change from the previous day’s closing price. My broker shows change only for contracts that were actively traded that day. It looks like Finding Mispriced Options    • 147 the near at-the-money (ATM) strikes were the most active because of the two far OTM options that traded; one’s price didn’t change at all, and the other went up by 1 cent. On a day in which the underlying stock fell, these calls theoretically should have fallen in price as well (because the K/S ratio, the ratio of strike price to stock price, was getting slightly larger). This just shows that sometimes there is a disconnect between theory and practice when it comes to options. To understand what is probably happening, we should understand something about market makers. Market makers are employees at bro- ker-dealers who are responsible for ensuring a liquid, orderly securi- ties market. In return for agreeing to provide a minimum liquidity of 10 contracts per strike price, market makers get the opportunity to earn the bid-ask spread every time a trade is made (I will talk about bid-ask spreads later). However, once a market maker posts a given price, he or she is guaranteeing a trade at that price. If, in this case (because we’re dealing with OTM call options), some unexpected positive news comes out that will create a huge rise in the stock price once it filters into the market and an observant, quick investor sees it before the market maker realizes it, the investor can get a really good price on those far OTM call options (i.e., the investor could buy a far OTM call option for 1 cent and sell it for 50 cents when the market maker realizes what has happened. To provide a little slack that prevents the market maker from losing too much money if this happens, market makers usually post prices for far OTM options or options on relatively illiquid stocks that are a bit unrea- sonable—at a level where a smart investor would not trade with him or her at that price. If someone trades at that price, fine—the market maker has committed to provide liquidity, but the agreement does not stipulate that the liquidity must be provided at a reasonable price. For this reason, frequently you will see prices on far OTM options that do not follow the theoretical “rules” of options. Bid-Ask For a stock investor, the difference between a bid price and an ask price is inconsequential. For option investors, though, it is a factor that must be taken into consideration for reasons that I will detail in subsequent 148  •   The Intelligent Option Investor paragraphs. The easiest way to think of the bid-ask spread is to think in terms of buying a new car. If you buy a new car, you pay, let’s say, $20,000. This is the ask price. Y ou grab the keys, drive around the block, and return to the showroom offering to sell the car back to the dealership. The dealership buys it for $18,000. This is the bid price. The bid-ask spread is $2,000 in this example. Bid-ask spreads are proportionally much larger for options than they are for stocks. For example, the options I’ve highlighted here are on a very large, important, and very liquid stock. The bid-ask spread on the $32-strike call option (which you will learn in the next section is exactly ATM) is $0.02 on a midprice of $1.09. This works out to a percentage bid- ask spread of 1.8 percent. Compare this with the bid-ask spread on Ora- cle’s stock itself, which was $0.01 on a midprice of $31.855—a percentage spread of 0.03 percent. For smaller, less-liquid stocks, the percentage bid-ask spread is even larger. For instance, here is the option chain for Mueller Water (MW A): 2.5 5 7.5 10 Last C5.30 C2.80 0.55 C0.00 Change Bid AskI mpl. Bid Vol. Impl. Ask Vol. Impl. Bid Vol. Impl. Ask Vol.Delta 2.5 5 7.5 10 2.5 5 7.5 10 12.5 DescriptionCall Last Change BidA sk Delta Put C0.00 C0.00 C0.25 C2.25 C0.00 C0.00 C0.55 C2.35 C0.00 C0.10 C0.85 C2.55 C4.80 5.20 5.50 N/A 340.099% 0.9978 0.9978 0.7330 0.1316 0.9347 0.8524 0.6103 0.1516 0.9933 0.9190 0.6070 0.2566 0.1024 142.171% 46.039% 76.652% N/A N/A 2.95 0.55 0.10 0.20 0.10 N/A N/A N/A 0.10 0.30 2.35 40.733% N/A N/A N/A N/A 36.550% 38.181% 35.520% 35.509% 35.664% 2.10 0.50 0.05 0.10 0.60 2.402.30 0.05 0.15 0.15 0.85 2.60 4.90 0.70 2.45 4.60 2.70 0.500.00 5.20 5.50 3.00 0.90 0.20 2.80 0.80 0.10 5.505.10 3.102.85 1.151.05 0.400.30 0.200.05 39.708% N/A N/A 36.722% N/A 38.754% 38.318% 39.127% 36.347% 36.336% 292.169% 0.0000 -0.0000 -0.2778 -0.8663 -0.0616 -0.1447 -0.3886 -0.8447 -0.0018 -0.0787 -0.3890 -0.7375 -0.8913 128.711% 53.108% 88.008% 117.369% 60.675% 42.433% 44.802% 110.810% 50.757% 42.074% 43.947% 49.401% 163.282% 75.219% 42.610% 45.215% 122.894% 64.543% 42.697% 44.728% 50.218% C5.30 C2.80 C0.85 C0.10 C5.30 C1.10 C0.35 C0.10 3.00 +0.15 AUG 16 ´13 NOV 15 ´13 FEB 21 ´14 Looking at the closest to ATM call options for the November expiration— the ones struck at $7.50 and circled in the screenshot—you can see that the bid-ask spread is $0.10 on a midprice of $0.85. This works out to 11.8 percent. Because the bid-ask spread is so very large on option contracts, round-tripping 1 an option contract creates a large hurdle that the returns of the security must get over before the investor makes any money. In the case of Mueller Water, the options one buys would have to change in price by 11.8 percent before the investor starts making any money at all. It is for this reason that I consider day trading in options and/or using complex Finding Mispriced Options    • 149 strategies involving the simultaneous purchase and sale of multiple con- tracts to be a poor investment strategy. Implied Bid Volatility/Implied Ask Volatility Because the price is so different between the bid and the ask, the range of fu- ture stock prices implied by the option prices can be thought of as different depending on whether you are buying or selling contracts. Employing the graphic conventions we used earlier in this book, this effect is represented as follows: Implied price range implied by ask price volatility of 23.4% Implied price range implied by bid price volatility of 21.4% 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20131/12/2012 Oracle (ORCL) Price per Share 60 50 40 30 20 10 - Because Oracle is such a big, liquid company, the difference between the stock prices implied by the different bid-ask implied volatilities is not large, but it can be substantial for smaller, less liquid companies. Looking at the ask implied volatility column, you will notice the huge difference between the far ITM options’ implied volatilities and those for ATM and OTM options. The data in the preceding diagram are incomplete, but if you were to graph all the implied volatility data, you would get the following: 150  •   The Intelligent Option Investor 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 Strike Price Oracle (ORCL) Implied Volatility Implied Volatility (Percent) 160 180 140 100 120 80 40 60 20 0 Thinking about what volatility means with regard to future stock prices—namely, that it is a prediction of a range of likely values—it does not make sense that options struck at different prices would predict such radi- cally different stock price ranges. What the market is saying, in effect, is that it expects different things about the likely future range of stock prices depending on what option is selected. Clearly, this does not make much sense. This “nonsensical” effect is actually proof that practitioners understand that the Black-Scholes-Merton model’s (BSM’s) assumptions are not correct and specifically that sudden downward jumps in a stock price can and do occur more often than would be predicted if returns fol- lowed a normal distribution. This effect does occur and even has a name— the volatility smile . Although this effect is extremely noticeable when graphed in this way, it is not particularly important for the intelligent op- tion investing strategies about which I will speak. Probably the most im- portant thing to realize is that the pricing on far OTM and far ITM options is a little more informal and approximate than for ATM options, so if you are thinking about transacting in OTM or ITM options, it is worth looking for the best deal available. For example, notice that in the preceding dia- gram, the $21-strike implied volatility is actually notably higher than the Finding Mispriced Options    • 151 $20-strike volatility. If you were interested in buying an ITM call option, you would pay less time value for the $20-strike than for the $21-strike op- tions—essentially the same investment. I will talk more about the volatility smile in the next section when discussing delta. In a similar way, sometimes the implied volatility for puts is different from the implied volatility for calls struck at the same price. Again, this is one of the market frictions that arises in option markets. This effect also has investing implications that I will discuss in the chapters detailing dif- ferent option investing strategies. The last column in this price display is delta , a measure that is so important that it deserves its own section—to which we turn now. Delta: The Most Useful of the Greeks Someone attempting to find out something about options will almost certainly hear about how the Greeks are so important. In fact, I think that they are so unimportant that I will barely discuss them in this book. If you understand how options are priced—and after reading Part I, you do—the Greeks are mostly common sense. Delta, though, is important enough for intelligent option investors to understand with a bit more detail. Delta is the one number that gives the probability of a stock being above (for calls) or below (for puts) a given strike price at a specific point in time. Deltas for calls always carry a positive sign, whereas deltas for puts are always negative, so, for instance, a call option on a given stock whose delta is exactly 0.50 will have a put delta of −0.50. The call delta of 0.50 means that there is a 50 percent chance that the stock will expire above that strike, and the put delta of −0.50 means that there is a 50 percent chance that the stock will expire below that strike. In fact, this strike demonstrates the technical definition of ATM—it is the most likely future price of the stock according to the BSM. The reason that delta is so important is that it allows you one way of creating the BSM probability cones that you will need to find option investment opportunities. Recall that the straight dotted line in our BSM cone diagrams meant the statistically most likely future price for the stock. The statistically most likely future price for a stock—assuming that stocks 152  •   The Intelligent Option Investor move randomly, which the BSM does—is the price level at which there is an equal chance of the actual future stock price to be above or below. In other words, the 50-delta mark represents the forward price of a stock in our BSM cones. Recall now also that each line demarcating the cone represents roughly a 16 percent probability of the stock reaching that price at a particular time in the future. This means that if we find the call strike prices that have deltas closest to 0.16 and 0.84 (= 1.00 − 0.16) or the put strike prices that have deltas closest to −0.84 and −0.16 for each expiration, we can sketch out the BSM cone at points in the future (the data I used to derive this graph are listed in tabular format at the end of this section). 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Date Oracle (ORCL) Price per Share 45 40 35 30 25 20 5 10 15 - Obviously, the bottom range looks completely distended compared with the nice, smooth BSM cone shown in earlier chapters. This dis- tension is simply another way of viewing the volatility smile. Like the volatility smile, the distended BSM cone represents an attempt by partici- pants in the options market to make the BSM more usable in real situa- tions, where stocks really can and do fall heavily even though the efficient market hypothesis (EMH) says that they should not. The shape is saying, Finding Mispriced Options    • 153 “We think that these prices far below the current price are much more likely than they would be assuming normal percentage returns. ” (Or, in a phrase, “We’re scared!”) If we compare the delta-derived “cone” with a theoretically derived BSM cone, here is what we would see: Oracle (ORCL) Date Price per Share 60 50 40 30 20 10 - 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Of course, we did not need the BSM cone to tell us that the points associated with the downside strikes look too low. But it is interesting to see that the upside and most likely values are fairly close to what the BSM projects. Note also that the downside point on the farthest expiration is nearly fairly priced according to the BSM, contrary to the shorter-tenor options. This effect could be because no one is trading the far ITM call long-term equity anticipation securities (LEAPS), so the market maker has simply posted his or her bid and ask prices using the BSM as a base. In the market, this is what usually happens—participants start out with a mechanically generated price (i.e., using the BSM or some other computational option pricing model) and make adjustments based on what feels right, what arbitrage opportunities are available, and so on. 154  •   The Intelligent Option Investor One important thing to note is that although we are using the delta figure to get an idea of the probability that the market is assigning to a certain stock price outcome, we are also using deltas for options that nearly no one ever trades. Most option volume is centered around the 50-delta mark and a 10 to 20 percentage point band around it (i.e., from 30- to 40-delta to 60- to 70-delta). It is doubtful to me that these thinly traded options contain much real information about market projections of future stock prices. Another problem with using the deltas to get an idea about market projections is that we are limited in the length of time we can project out to only the number of strikes available. For this example, I chose an impor- tant tech company with a very liquid stock, so it has plenty of expirations and many strikes available so that we can get a granular look at deltas. However, what if we were looking at Mueller Water’s option chain and try- ing to figure out what the market is saying? 2.5 5 7.5 10 Last C5.30 C2.80 0.55 C0.00 Change Bid Ask Impl. Bid Vol. Impl. Ask Vol. Delta AUG 16 ´13 2.5 5 7.5 10 NOV 15 ´13 2.5 5 7.5 10 12.5 FEB 21 ´14 DescriptionCall 5.20 5.50 N/A 340.099% 0.9978 0.9978 0.7330 0.1316 0.9347 0.8524 0.6103 0.1516 0.9933 0.9190 0.6070 0.2566 0.1024 142.171% 46.039% 76.652% N/A N/A 2.95 0.55 0.10 2.70 0.500.00 5.20 5.50 3.00 0.90 0.20 2.80 0.80 0.10 5.505.10 3.102.85 1.151.05 0.400.30 0.200.05 39.708% N/A N/A 36.722% N/A 38.754% 38.318% 39.127% 36.347% 36.336% 163.282% 75.219% 42.610% 45.215% 122.894% 64.543% 42.697% 44.728% 50.218% C5.30 C2.80 C0.85 C0.10 C5.30 C1.10 C0.35 C0.10 3.00 +0.15 Here you can see that we only have three expirations: 26, 117, and 215 days from when these data were taken. In addition, there are hardly any strikes that are reasonably close to our crucial 84-delta, 50-delta, and 16-delta strikes, which means that we have to do a lot of extrapolation to try to figure out where the market’s idea of the BSM cone lies. To get a better picture of what the market is saying, I recommend looking at options that are the most heavily traded and assuming that the implied volatility on these strikes gives true information about the mar - ket’s assumptions about the future price range of a stock. Using the im- plied volatility on heavily traded contracts as the true forward volatility expected by the market allows us to create a theoretical BSM cone that we Finding Mispriced Options    • 155 can extend indefinitely into the future and that is probably a lot closer to representing actual market expectations for the forward volatility (and, by extension, the range of future prices for a stock). Once we have this BSM cone—with its high-low ranges spelled out for us—we can compare it with the best- and worst-case valuations we derived as part of the company analysis process. Let’s look at this process in the next section, where I spell out, step by step, how to compare an intelligent valuation range with that implied by the option market. Note: Data used for Oracle graphing example: Expiration Date Lower Middle Upper 7/25/2013 29.10 31.86 32.75 8/16/2013 22.00 32.00 33.50 9/20/2013 19.00 32.00 35.00 12/20/2013 20.00 32.50 37.00 1/17/2014 19.00 32.50 37.20 1/16/2015 23.00 32.30 42.00 Here I have eyeballed (and sometimes done a quick extrapolation) to try to get the price that is closest to the 84-delta, 50-delta, and 16-delta marks, respectively. Of course, you could calculate these more carefully and get exact numbers, but the point of this is to get a general idea of how likely the market thinks a particular future stock price is going to be. Comparing an Intelligent Valuation Range with a BSM Range The point of this book is to teach you how to be an intelligent option investor and not how to do stochastic calculus or how to program a computer to calculate the BSM. As such, I’m not going to explain how to mathematically derive the BSM cone. Instead, on my website I have an application that will allow you to plug in a few numbers and create a graphic representation of a BSM cone and carry out the comparison process described in this section. The only thing you need to know is what numbers to plug into this web application! 156  •   The Intelligent Option Investor I’ll break the process into three steps: 1. Create a BSM cone. 2. Overlay your rational valuation range on the BSM cone. 3. Look for discrepancies. Create a BSM Cone The heart of a BSM cone is the forward volatility number. As we have seen, as forward volatility increases, the range of future stock prices projected by the BSM (and expected by the market) also increases. However, after hav- ing looked at the market pricing of options, we also know that a multitude of volatility numbers is available. Which one should we look at? Each strike price has its own implied volatility number. What strike price’s volatility should we use? There are also multiple tenors. What tenor options should we look at? Should we look at implied volatility at the bid price? At the ask price? Perhaps we should take the “kitchen sink” approach and just average all the implied volatilities listed! The answer is, in fact, easy if you use some simplifying assumptions to pick a single volatility number. I am not an academic, so I don’t neces- sarily care if these simplifying assumptions are congruent with theory. Also, I am not an arbitrageur, so I don’t much care about very precise numbers, and this attitude also lends itself well to the use of simplifying assumptions. All we have to make sure of is that the simplifying as- sumptions don’t distort our perception to the degree that we make bad economic choices. Here are the assumptions that we will make: 1. The implied volatility on a contract one or two months from expi- ration that is ATM or at least within the 40- to 60-delta band and that is the most heavily traded will contain the market’s best idea of the true forward volatility of the stock. 2. If a big announcement is scheduled for the near future, implied volatility numbers may be skewed, so their information might not be reliable. In this case, try to find a heavily traded near ATM strike at an expiry after the announcement will be made. If the announcement will be made in about four months or more, just try Finding Mispriced Options    • 157 to eyeball the ATM volatility for the one- and two-month contracts. 3. If there is a large bid-ask spread, the relevant forward volatility to use is equal to the implied volatility we want to transact. In other words, use the ask implied volatility if you are thinking about gaining exposure and the bid implied volatility if you are thinking about accepting exposure (the online application shows cones for both the bid implied volatility and the ask implied volatility). Basically, these rules are just saying, “If you want to know what the option market is expecting the future price range of a stock to be, find a nice, liquid near ATM strike’s implied volatility and use that. ” Most op- tion trading is done in a tight band around the present ATM mark and for expirations from zero to three months out. By looking at the most heavily traded implied volatility numbers, we are using the market’s price-discov- ery function to the fullest. Big announcements sometimes can throw off the true volatility picture, which is why we try to avoid gathering infor - mation from options in these cases (e.g., legal decisions, Food and Drug Administration trial decisions, particularly impactful quarterly earnings announcements, and so on). If I was looking at Oracle, I would probably choose the $32-strike options expiring in September. These are the 50-delta options with 61 days to expiration, and there is not much of a difference between calls and puts or between the bid and ask. The August expiration op- tions look a bit suspicious to me considering that their implied volatility is a couple of percentage points below that of the others. It probably doesn’t make a big difference which you use, though. We are trying to find opportunities that are severely mispriced, not trying to split hairs of a couple of percentage points. All things considered, I would prob- ably use a number somewhere around 22 percent for Oracle’s forward volatility. C12.02 11.75 N/A 55.427% 0.9897 C0.00 0.02 N/A 50.831%- 0.01032011.90 C11.03 10.70 N/A 123.903% 0.9869 C0.01 0.03 N/A 48.233%- 0.01312112.35 C10.04 9.50 N/A 64.054% 0.9834 C0.03 0.05 37.572% 46.993%- 0.01660.012210.10 C0.06 0.04 20.455% 21.147% 0.0463 C5.03 5.55 N/A 36.111%- 0.95584.95370.05 1.65 1.65 22.720% 23.311% 0.6325 0.84 +0.07 0.82 22.989% 23.384%- 0.36790.80311.68-0.13 1.06 1.08 22.019% 22.407% 0.4997 1.23 +0.05 1.25 22.284% 22.672%- 0.50081.23321.10-0.12 0.66 0.65 21.378% 21.813% 0.3606 1.88 +0.16 1.82 21.453% 22.106%- 0.64021.79330.67-0.07 0.02 0.01 21.354% 23.409% 0.0155 C6.99 7.55 N/A 44.342%- 0.98716.85390.02+0.01 0.03 0.01 19.050% 22.144% 0.0266 C6.00 6.30 17.134% 30.947%- 0.97576.15380.030.00 SEP 20 ´13 158  •   The Intelligent Option Investor For Mueller Water, it’s a little trickier: 2.5 5 7.5 10 Last C5.30 C2.80 0.55 C0.00 Change BidA sk Delta AUG 16 ´13 2.5 5 7.5 10 NOV 15 ´13 2.5 5 7.5 10 12.5 FEB 21 ´14 DescriptionCall Last Change BidA sk Impl. Bid Vol. Impl. Ask Vol.Impl. Bid Vol. Impl. Ask Vol. Delta Put C0.00 C0.00 C0.25 C2.25 C0.00 C0.00 C0.55 C2.35 C0.00 C0.10 C0.85 C2.55 C4.80 5.20 5.50N /A 340.099% 0.9978 0.9978 0.7330 0.1316 0.9347 0.8524 0.6103 0.1516 0.9933 0.9190 0.6070 0.2566 0.1024 142.171% 46.039% 76.652% N/A N/A 2.95 0.55 0.10 0.20 0.10 N/A N/A N/A 0.10 0.30 2.35 40.733% N/A N/A N/A N/A 36.550% 38.181% 35.520% 35.509% 35.664% 2.10 0.50 0.05 0.10 0.60 2.402.30 0.05 0.15 0.15 0.85 2.60 4.90 2.70 0.500.00 5.20 5.50 3.00 0.90 0.20 2.80 0.80 0.10 5.505.10 3.102.85 1.151.05 0.400.30 0.200.05 39.708% N/A N/A 36.722% N/A 38.754% 38.318% 39.127% 36.347% 36.336% 292.169% 0.0000 -0.0000 -0.2778 -0.8663 -0.0616 -0.1447 -0.3886 -0.8447 -0.0018 -0.0787 -0.3890 -0.7375 -0.8913 128.711% 53.108% 88.008% 117.369% 60.675% 42.433% 44.802% 110.810% 50.757% 42.074% 43.947% 49.401% 163.282% 75.219% 42.610% 45.215% 122.894% 64.543% 42.697% 44.728% 50.218% C5.30 C2.80 C0.85 C0.10 C5.30 C1.10 C0.35 C0.10 3.00 +0.15 0.70 2.45 4.60 In the end, I would probably end up picking the implied volatility associated with the options struck at $7.50 and expiring in August 2013 (26 days until expiration). I was torn between these and the same strike expiring in November, but the August options are at least being actively traded, and the percentage bid-ask spread on the call side is lower for them than for the November options. Note, though, that the August 2013 put options are so far OTM that the bid-ask spread is very wide. In this case, I would probably look closer at the call options’ implied volatilities. In the end, I would have a bid volatility of around 39 percent and an ask volatility of around 46 percent. Because the bid-ask spread is large, I would probably want to see a cone for both the bid and ask. Plugging in the 22.0/22.5 for Oracle, 2 I would come up with this cone: Date Oracle (ORCL) Price per Share 60 40 50 30 10 20 - 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Finding Mispriced Options    • 159 Plugging in the 39/46 for Mueller Water, I would get the following: 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Date Mueller Water (MWA) Price per Share 25 20 15 5 10 - Y ou can see with Mueller Water just how big a 7 percentage point dif- ference can be for the bid and ask implied volatilities in terms of projected outcomes. The 39 percent bid implied volatility generates an upper range at just around $15; the 46 percent ask implied volatility generates an upper range that is 20 percent or so higher than that! Overlay an Intelligent Valuation Range on the BSM Cone This is simple and exactly the same for a big company or a small one, so I’ll just keep going with the Oracle example. After having done a full valuation as shown in the exam valuation of Oracle on the IOI website, you’ve got a best-case valuation, a worst-case valuation, and probably an idea about what a likely valuation is. Y ou simply draw those numbers onto a chart like this: 160  •   The Intelligent Option Investor 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Date Oracle (ORCL) Price per Share 60 Best Case Likely Case Worst Case 40 50 30 10 20 - $52 $43 $30 Once this step is done, we are ready to go onto the next and final step. Look for Discrepancies The last step is also easy. Because options split a stock’s returns into upside and downside exposure, we need to take a look at both the upside and downside to see where our projections differ from those of the market. 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Date Oracle (ORCL) Price per Share 60 Best Case Likely Case Worst Case 40 50 30 10 20 Downside Upside - $52 $43 $30 A B Finding Mispriced Options    • 161 On the upside, we can see that our likely case valuation is $43 per share, whereas the BSM’s most likely value is a bit less than $35—a difference of more than 20 percent. This is the area on the graph labeled “ A. ” The BSM prices options based on the likelihood of the stock hitting a certain price level. The BSM considers the $43 price level to be relatively unlikely, whereas I consider it relatively likely. As such, I believe that options that allow me to gain exposure to the upside potential of Oracle—call options—are underval- ued. In keeping with the age-old rule of investing to buy low, I will want to gain exposure to Oracle’s upside by buying low-priced call options. On the downside, I notice that there is a fairly large discrepancy between my worst-case valuation ($30) and the lower leg of the BSM cone (approximately $24)—this is the region of the graph labeled “B, ” and the separation between the two values is again (just by chance) about 20 percent. The BSM is pricing options granting exposure to the downside—put options—struck at $24 as if they were fairly likely to occur; something that is fairly likely to occur will be priced expensively by the BSM. My analysis, on the other hand, makes me think that the BSM’s valuation outcome is very unlikely. The discrepancy implies that I believe the put options to be overvalued—the BSM sees a $24 valuation as likely, with expensive options, whereas I see it as unlikely, with nearly valueless options. In this case, we should consider the other half of the age-old investing maxim and sell high. In a graphic representation, this strategy might look like this: 6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012 Date Oracle (ORCL) Price per Share 60 Best Case Likely Case Worst Case 40 50 30 10 20 Downside Upside - $52 $43 $30 GREEN RED 162  •   The Intelligent Option Investor Why would I select such a short-term put option to sell? Why would I pick an OTM call option to buy? These are the kinds of questions I will cover in Chapters 9–11, which look at the specifics of different option strategies. Before we look at strategies, though, an option investor cannot be said to be intelligent without understanding what leverage is and how to use it safely and effectively in a portfolio. We turn to this in Chapter 8. 163 Chapter 8 Understanding and managing Leverage In the media, the word leverage seems like it usually occurs alongside such words as dangerous, speculative, or even irresponsible, so most people have internalized the message that leverage is morally wrong; options—levered instruments that they are—are, by extension, viewed as morally wrong as well. In fact, nearly everyone uses leverage every day of their lives without incident and presumably without incurring a moral stain. In my opinion, it is not leverage that is the problem but rather an ignorance of how lever- age works, coupled with overleverage and the inherent human belief that disasters only happen to someone else, that is the problem. Leverage is a powerful tool, but like all powerful tools, if used recklessly and without understanding, it can bring its user to unpleasant outcomes. Certainly a discussion of gaining and accepting exposure using option con- tracts would be incomplete without a good explanation of leverage. I like to think of leverage coming in three flavors: operational, financial, and investment—the first two of which I mentioned in an earlier chapter and go into more detail in Appendix B. This chapter delves specifically into in- vestment leverage, but to the extent that investment leverage is similar to the other forms of leverage, referring to Appendix B to learn about those forms will help deepen your understanding of investment leverage. In this chapter, I first define investment leverage, discuss how it can be gained by using either debt or options, look at common ways to measure it, and introduce a unique method of measuring and managing leverage in an investment portfolio. Leverage is not something to be taken lightly. Many very highly trained, well-educated, and well-capitalized investors have gone bankrupt 164  •   The Intelligent Option Investor because of their lack of appreciation for the fact that the sword of lever - age cuts both ways. Certainly an option investor cannot be considered an intelligent investor without having an understanding and a deep sense of respect for the simultaneous power and danger that leverage conveys. New jargon introduced in this chapter includes the following: Lambda Notional exposure Investment Leverage Commit the following definition to memory: Investment leverage is the boosting of investment returns calcu- lated as a percentage by altering the amount of one’s own capital at risk in a single investment. Investment leverage is inextricably linked to borrowing money—this is what I mean by the phrase “altering the amount of one’s own capital at risk. ” In this way, it is very similar to financial leverage. In fact, in my mind, the difference between financial and investment leverage is that a company uses financial leverage to fund projects that will produce goods or provide services, whereas in the case of investing leverage, it is used not to produce goods or services but to amplify the effects of a speculative position. Frequently people think of investing leverage as simply borrowing money to invest. However, as I mentioned earlier, you can invest in options for a lifetime and never explicitly borrow money in the process. I believe that the preceding definition is broad enough to handle both the case of investment leverage generated through explicit borrowing and the case of leverage generated by options. Let’s take a look at a few example investments—unlevered, levered using debt, and levered using options. Unlevered Investment Let’s say that you buy a stock for exactly $50 per share, expecting that its intrinsic value is closer to $85 per share. Over the next year, the stock increases by $5, or 10 percent in value. Y our unrealized percentage gain on this investment is Understanding and Managing Leverage    • 165 obviously 10 percent. If instead the stock declines to $45 per share over that year, you would be sitting on an unrealized percentage loss of 10 percent. Of course, this is very straightforward. Let’s now look at the purchase of a share of common stock using borrowed capital. Levered Investment Using Debt Let’s say that to buy a $50 share, you borrow $45 from a bank at an inter - est rate of 5 percent per year, put in $5 of your own cash, and buy that same share of stock. Again, let’s assume that the stock increases in value by $5 over one year, closing at $55 per share. At the end of the year, you sell the stock and pay back the bank loan with interest (a total of $47.25). Doing so, you realize gross proceeds of $7.75 on an original investment of $5 of your own capital, which equates to $2.75 in gross profits and implies a percent- age investment return of 55 percent. There are three important things to note by comparing the levered and unlevered examples: 1. The percentage return is much higher for the levered investment (55 versus 10 percent) because you have reduced the amount of your own capital at risk much more than you have reduced the dollar return in the numerator. 2. The actual dollar amount gained is lower in the levered example ($2.75 versus $10). If your investment mandate would have been “Generate at least $10 worth of investment returns, ” a single unit of the levered investment would have failed to meet this mandate. 3. Obviously, the underlying asset and its returns are the same in both levered and unlevered scenarios—we are changing our profit expo- sure to the underlying, not altering its volatility or other behavior. To fully understand leverage’s effects, however, we should also con- sider the loss scenario. Again, let’s assume that we borrow $45 and spend $5 of our own money to buy the $50 per share stock. We wake the next morning to news that the company has discovered accounting irregulari- ties in an important foreign subsidiary that has caused it to misstate reve- nues and profits for the last three years. The shares suddenly fall 10 percent on the news. The unrealized loss is $5—the 10 percent fall in stock value has wiped out 100 percent of our investment capital. 166  •   The Intelligent Option Investor And herein lies the painful lesson learned by many a soul in the financial markets: leverage cuts both ways. The profits happily roll in dur- ing the good times, but the losses inexorably crash down during bad times. Levered Investment Using Options Discussing option-based investing leverage is much easier if we focus on the perspective of gaining exposure. Because most people are more com- fortable thinking about the long side of investing, let’s look at an example of gaining upside exposure on a company. Let’s assume we see a $50 per share stock that we believe is worth $85 (in this example, I am assuming that we only have a point estimate of the intrinsic value of the company so as to simplify the following diagram—normally, it is much more helpful to think about fair value ranges, as explained in Part II of this book and demonstrate in the online example). We are willing to buy the share all the way up to a price of $68 (implying a 25 percent return if bought at $68 and sold at $85) and can get call options struck at $65 per share for only $1.50. Graphically, this prospective investment looks like this: Fair Value Estimate 5/18/2012 5/20/2013 249 499 749 999 - 10 20 30 40 50 60 70 80 90 EBP = $66.50 Date/Day Count Advanced Building Corp. (ABC) Stock Price GREEN Understanding and Managing Leverage    • 167 In two years, you are obligated to pay your counterparty $65 if you want to hold the stock, but the decision as to whether to take possession of the stock in return for payment is solely at your discretion. In essence, then, you can look at buying a call option as a conditional borrowing of funds sometime in the future. Buying the call option, you are saying, “I may want to borrow $65 two years from now. I will pay you some interest up front now, and if I decide to borrow the $65 in two years, I’ll pay you that principal then. ” In graphic terms, we can think about this transaction like this: 5/18/2012 5/20/2013 249 499 749 999 - 10 20 30 40 50 60 70 80 90 $1.50 “prepaid interest” Contingent loan, the future repayment of principal is made solely at the investor’s own discretion. Fair Value Estimate Advanced Building Corp. (ABC) Date/Day Count Stock Price GREEN If the stock does indeed hit the $85 mark just at the time our option expires, we will have realized a gross profit of $20 (= $85 − $65) on an investment of $1.50, for a percentage return of 1,233 percent! Obviously, the call option works very much like a loan in terms of altering the investor’s capital at risk and boosting subsequent investment returns. However, although the leverage looks very similar, there are two impor - tant differences: 168  •   The Intelligent Option Investor 1. As shown and mentioned earlier, when using an option, payment on the principal amount of $65 in this case is conditional and com- pletely discretionary. For an option, the interest payment is made up front and is a sunk cost. 2. Because repayment is discretionary in the case of an option, you do not have any financial risk over and above the prepayment of interest in the form of an option premium. Repayment of a con- ventional loan is mandatory, so you have a large financial risk if you cannot repay the principal at maturity in this case. Regarding the first difference, not only is the loan conditional and discretionary, the loan also has value and can be transferred to another for a profit. What I mean is this: if the stock rises quickly, the value of that option in the open market will increase, and rather than holding the “loan” to maturity, you can simply sell it with your profits offsetting the original cost of the prepaid interest plus giving you a nice profit. Regarding the second difference, consider this: if you are using bor - rowed money to invest and your stock drops heavily, the broker will make a margin call (i.e., ask you to deposit more capital into the account), and if you cannot make the margin call, the broker will liquidate the position (most brokers shoot first and ask questions later, simply closing out the position and selling other assets to cover the loss at the first sign margin requirements will not be met). If this happens, you can be 100 percent correct on your valuation long term but still fail to benefit economically because the position has been forcibly closed. In the case of options, the underlying stock can lose 20 percent in a single day, and the owner of a call option will never receive a margin call. The flip side of this benefit is that although you are not at risk of losing a position to a margin call, option ownership does not guarantee that you will receive an economic reward either. For example, if the option mentioned in the preceding example ex- pires in two years when the stock is trading at $64.99 and the stock has paid $2.10 in dividends over the previous two years, the option holder ends up with neither the stock nor the dividend check. Understanding and Managing Leverage    • 169 Simple Ways of Measuring Option Investment Leverage There are several single-point, easily calculable numbers to measure option-based investment leverage. There are uses for these simple measures of leverage, but unfortunately, for reasons I will discuss, the simple num- bers are not enough to help an investor intelligently manage a portfolio containing option positions. The two simple measures are lambda and notional exposure. Both are explained in the following sections. Lambda The standard measure investors use to determine the leverage in an option position is one called lambda . Lambda—sometimes known as percent delta—is a derivative of the delta 1 factor we discussed in Chapter 7 and is found using the following equation: = ×Lambda deltas tock price optionprice Let’s look at an actual example. The other day, I bought a deep in- the-money (ITM) long-tenor call option struck at $20 when the stock was trading at $30.50. The delta of the option at that time was 0.8707, and the price was $11. The leverage in my option position was calculated as follows: = × = × =Lambda deltas tock price optionprice 0.87 30.50 11 2.40 What this figure of 2.4 is telling us is that when I bought that option, if the price of the underlying moved by 1 percent, the value of my position would move by about 2.4 percent. This is not a hard and fast number—a change in price of either the stock or the option (as a result of a change in volatility or time value or whatever) will change the delta, and the lambda will change based on those things. 170  •   The Intelligent Option Investor Because investment leverage comes about by changing the amount of your own capital that is at risk vis-à-vis the total size of the investment, you can imagine that moneyness has a large influence on lambda. Let’s take a look at how investment leverage changes for in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) options. The stock underlying the following options was trading at $31.25 when these data were taken, so I’m showing the $29 and $32 strikes as ATM: Strike Price K /S Ratio Call Price Delta Lambda 15.00 0.48 17.30 0.91 1.64 20.00 0.64 11.50 0.92 2.50 ITM 21.00 0.67 11.30 0.86 2.38 22.00 0.70 9.60 0.89 2.90 … … … … … 29.00 0.93 3.40 0.68 6.25 30.00 0.96 2.74 0.61 6.96 ATM 31.00 0.99 2.16 0.54 7.81 … … … … … 39.00 1.25 0.18 0.09 15.63 40.00 1.28 0.13 0.06 14.42 OTM 41.00 1.31 0.09 0.05 17.36 When an option is deep ITM, as in the case of the $20-strike call, we are making a significant expenditure of our own capital compared with the size of the investment. Buying a call option struck at $20, we are— as explained in the preceding section—effectively borrowing an amount equal to the $20 strike price. In addition to this, we are spending $11.50 in premium. Of this amount, $11.25 is intrinsic value, and $0.25 is time value. We can look at the time value portion as the prepaid interest we discussed in the preceding section, and we can even calculate the interest rate im- plied by this price (this option had 189 days left before expiration, implying an annual interest charge of 2.4 percent, for example). This prepaid interest can be offset partially or fully by profit realized on the position, but it can never be recaptured so must be considered a sunk cost. Time value always decays independent of the price changes of the underlying, so although an Understanding and Managing Leverage    • 171 upward movement in the stock will offset the money spent on time value, the amount spent on time value is never recoverable. The remaining $11.25 of the premium paid for a $20-strike call op- tion is intrinsic value . Buying intrinsic value means that we are exposing our own capital to the risk of an unrealized loss if the stock falls below $31.25. Lambda is directly related to the amount of capital we are exposing to an unrealized loss versus the size of the “loan” from the option, so be- cause we are risking $11.25 of our own capital and borrowing $20 with the option (a high capital-to-loan proportion), our investment leverage meas- ured by lambda is a relatively low 2.50. Now direct your attention to a far OTM call option—the one struck at $39. If we invest in the $39-strike option, we are again effectively taking out a $39 contingent loan to buy the shares. Again, we take the time-value portion of the option’s price—in this case the entire premi- um of $1.28—to be the prepaid interest (an implied annualized rate of 6.3 percent) and note that we are exposing none of our own capital to the risk of an unrealized loss. Because we are subjecting none of our own capital in this investment and taking out a large loan, our invest- ment leverage soars to a very high value of 15.63. This implies that a 1 percentage point move in the underlying stock will boost our invest- ment return by over 15 percent! Obviously, these calculations tell us that our investment returns are going to be much more volatile for small changes in the underlying’s price when buying far OTM options than when buying far ITM options. This is fine information for someone interested in more speculative strategies—if a speculator has the sense that a stock will rise quickly, he or she could, rather than buying the stock, buy OTM options, and if the stock went up fast enough and soon enough offset any drop of implied volatility and time decay, he or she would pocket a nice, highly levered profit. However, there are several factors that limit the usefulness of lambda. First, because delta is not a constant, the leverage factor does not stay put as the stock moves around. For someone who intends to hold a position for a longer time, then, lambda provides little information regarding how the position will perform over their investment horizon. In addition, reading the preceding descriptions of lambda, it is ob- vious that this measure deals exclusively with the percentage change in 172  •   The Intelligent Option Investor the option’s value. Although everyone (especially fly-by-night investment newsletter editors) likes to tout their percentage returns, we know from our earlier investigations of leverage that percentage returns are only part of the story of successful investing. Let’s see why using the three invest- ments I mentioned earlier—an ITM call struck at $20, an OTM call struck at $39, and a long stock position at $31. I believe that there is a good chance that this stock is worth north of $40—in the $43 range, to be precise (my worst-case valuation was $30, and my best-case valuation was in the mid-$50 range). If I am right, and if this stock hits the $43 mark just as my options expire, 2 what do I stand to gain from each of these investments? Let’s take a look. Spent Gross Profit Net Profit Percent Profit $39-strike call 0.18 4.00 3.82 2,122 $20-strike call 11.50 23.00 11.50 100 Shares 31.25 43.00 11.75 38 This table means that in the case of the $20-strike call, we spent $11.50 to win gross proceeds of $23.00 (= $43 − $20) and a profit net of investment of $11.50. Netting $11.50 on an $11.50 investment generates a percentage profit of 100 percent. Looking at this chart, the first thing you are liable to notice is the “Percent Profit” column. That 2,122 percent return looks like something you might see advertised on an option tout service, doesn’t it? Y es, that percentage return is wonderful, until you realize that the absolute value of your dollar winnings will not allow you to buy a latte at Starbuck’s. Likewise, the 100 percent return on the $20-strike options looks heads and shoulders better than the measly 38 percent on the shares, until you again realize that the latter is still giving you more money by a quarter. Recall the definition of leverage as a way of “boosting investment re- turns calculated as a percentage, ” and recall that in my previous discussion of financial leverage, I mentioned that the absolute dollar value is always highest in the unlevered case. The fact is that many people get excited about stratospheric percentage returns, but stratospheric percentage returns only Understanding and Managing Leverage    • 173 matter if a significant chunk of your portfolio is exposed to those returns! Lambda is a good measure to show how sensitive percentage returns are to a move in the stock price, but it is useless when trying to understand what the portfolio effects of those returns will be on an absolute basis. Notional Exposure Look back at the preceding table. Let’s say that we wanted to make lambda more useful in understanding portfolio effects by seeing how many contracts we would need to buy to match the absolute return of the underlying stock. Because our expected dollar return of one of the $39-strike calls only makes up about a third of the absolute return of the straight stock investment ($3.82 / $11.75 = 32.5% ≈ 1/3), it follows that if we wanted to make the same dollar return by investing in these call options that we expect to make by buying the shares, we would have to buy three of the call options for every share we wanted to buy. Recalling that op- tions are transacted in contract sizes of 100 shares, we know that if we were willing to buy 100 shares of Oracle’s stock, we would have to buy options implying control over 300 shares to generate the same absolute profit for our portfolio. I call this implied control figure notional exposure. Continuing with the $39-strike example, we can see that the measure of our leverage on the basis of notional exposure is 3:1. The value of the notional exposure is cal- culated by multiplying it by the strike; in this case, the notional exposure of 300 shares multiplied by the strike price of $39 gives a notional value for the contracts of $11,700. This value is called the notional amount of the option position. Some people calculate a leverage figure by dividing the notional amount by the total cost of the options. In our example, we would pay $18 per con- tract for three contracts, so leverage measured in this way would work out to be 217 (= $11,700 ÷ $54). I actually do not believe this last measure of lever- age to be very helpful, but notional control will become important when we talk about the leverage of short-call spreads later in this chapter. These simple methods of measuring leverage have their place in ana- lyzing option investment strategies, but in order to really master leverage, you must understand leverage in the context of portfolio management. 174  •   The Intelligent Option Investor Understanding Leverage’s Effects on a Portfolio Looking at leverage from a lambda or notional control perspective gives some limited information about leverage, but I believe that the best way to think about option-based investment leverage is to think about the ef- fect of leverage on an actual portfolio allocation basis. This gives a richer, more nuanced view of how leverage stands to help or hurt our portfolio and allows us more insight into how we can intelligently structure a mixed option-stock portfolio. Let’s start our discussion of leverage in a portfolio context by thinking about how to select investments into a portfolio. We will assume that we have $100 in cash and want to use some or all of that cash to invest in risky securities. Cash is riskless (other than inflation risk, but let’s ignore that for a moment), so the risk we take on in the portfolio will be dampened by keeping cash, and the returns we will win from the portfolio will be similarly dampened. We have a limited amount of capital and want to allocate that capital to risky investments in proportion to two factors: 1. The amount we think we can gain from the investment 2. Our conviction in the investment, which is a measure of our per - ception of the riskiness of the investment We might see a potential investment that would allow us to reap a profit of $9 for every $1 invested (i.e., we would gain a great deal), but if our conviction in that investment is low (i.e., we think the chance of winning $9 for every $1 invested is very low), we would likely not allocate much of our portfolio to it. In constructing a portfolio, most people set a limit on the proportion of their portfolio they want to allocate to any one investment. I personally favor more concentrated positions, but let’s say that you paid better atten- tion to your finance professor in school than I did and figure that you want to limit your risk exposure to any one security to a maximum of $5 of your $100 portfolio. An unlevered portfolio means that each $5 allocation would be made by spending $5 of your own capital. Y ou would know that if the value of the underlying security decreases by $2.50, the value of the allocation will Understanding and Managing Leverage    • 175 also fall to $2.50. If, instead, the value of the underlying security increases by $2.50, the value of that allocation will rise to $7.50. In a levered portfolio, each $5 allocation uses some proportion of capital that is not yours—borrowed in the case of a margin loan and con- tingently borrowed in the case of an option. This means that for every $1 increase or decrease in the value of the underlying security, the lev- ered allocation increases or decreases by more than $1. Leverage, in this context, represents the rate at which the value of the allocation increases or decreases for every one-unit change in the value of the underlying security. When thinking about the risk of leverage, we must treat different types of losses differently. A realized loss represents a permanent loss of capital—a sunk cost for which future returns can offset but never undo. An unrealized loss may affect your psychology but not your wealth (unless you need to realize the loss to generate cash flow for something else—I talk about this in Chapter 11 when I address hedging). For this reason, when we measure how much leverage we have when the underlying security declines, we will measure it on the basis of how close we are to suffering a realized loss rather than on the basis of the unrealized value of the loss. Leverage on the profit side will be handled the same way: we will treat our fair value estimate as the price at which we will realize a gain. Because the current market price of a security may not sit exactly between our fair value estimate and the point at which we suffer a realized loss, our upside and downside leverage may be different. Let’s see how this comes together with an actual example. For this ex- ample, I looked at the price of Intel’s (INTC) shares and options when the former were trading at $22.99. Let’s say that we want to commit 5 percent of our portfolio value to an investment in Intel, which we believe is worth $30 per share. For every $100,000 in our portfolio, this would mean buying 217 shares. This purchase would cost us $4,988.83 (neglecting taxes and fees, of course) and would leave us with $11.17 of cash in reserve. After we made the buy, the stock price would fluctuate, and depending on what its price was at the end of 540 days [I’m using as an investment horizon the days to expiration of the longest-tenor long-term equity anticipation secu- rities (LEAPS)], the allocation’s profit and loss profile would be represented graphically like this: 176  •   The Intelligent Option Investor 02468 10 12 14 16 18 20 22 24 Stock Price Unlevered Investment (Full Allocation) Gain (Loss) on Allocation 26 28 30 32 34 36 38 40 42 44 46 48 50(6,000) (4,000) (2,000) - 2,000 4,000 6,000 8,000 Unrealized Gain Unrealized Loss Cash Value Net Gain (Loss) - Unlevered Realized Loss Here the future stock price is listed from 0 to 50 on the horizontal axis, and the net profit or loss to this position is listed on the vertical axis. Obvious- ly, any gain or loss would be unrealized unless Intel’s stock price went to zero, at which point the total position would only be worth whatever spare cash we had. The black profit and loss line is straight—the position will lose or gain on a one-for-one basis with the price of the stock, so our leverage is 1.0. Now that we have a sense of what the graph for a straight stock position looks like, let’s take a look at a few different option positions. When I drew the data for this example, the following 540-day expiration call options were available: Strike Price Ask Price Delta 15 8.00 0.79 22 2.63 0.52 25 1.43 0.35 Let’s start with the ITM option and construct a simple-minded posi- tion that attempts to buy as many of these option contracts as possible with the $5,000 we have reserved for this investment. We will pay $8 per share Understanding and Managing Leverage    • 177 or $800 per contract, which would allow us to buy six contracts in all for $4,800. There is only $0.01 worth of time value (= $15.00 + $8.00 − $22.99) on these options because they are so far ITM. This means that we are pay- ing $1 per contract worth of time value that is never recoverable, so we shall treat it as a realized loss. If we were to graph our potential profit and loss profile using this option, assuming that we are analyzing the position just as the 540-day options expire, we would get the following 3: Net Gain (Loss) - Levered 0246810 12 14 16 18 20 22 24 Stock Price Levered Strategy Overview Gain (Loss) on Allocation 26 28 30 32 34 36 38 40 42 44 46 48 50(10,000) (5,000) - 5,000 10,000 Unrealized Gain Unrealized Loss Cash Value Realized Loss 15,000 20,000 The most obvious differences from the diagram of the unlevered po- sition are (1) that the net gain/loss line is kinked at the strike price and (2) that we will realize a total loss of invested capital—$4,800 in all—if Intel’s stock price closes at $15 or below. The kinked line demonstrates the meaning of the first point made earlier regarding option-based investment leverage—an asymmetrical return profile for profits and losses. Note that this kinked line is just the hockey-stick representation of option profit and loss at expiration that one sees in every book about options except this one. Although I don’t believe that hockey-stick diagrams are terribly useful for understanding individual option transactions, at a portfolio level, they do represent the effect of leverage very well. This black line represents a 178  •   The Intelligent Option Investor levered position, and its slope is much steeper than that of an equivalent line showing net profit and loss on an unlevered position. A comparison of the two net profit lines on the same graph shows this clearly: 02468 10 12 14 16 18 20 22 24 Stock Price Profit and Loss Profile for Levered and Unlevered Investments Gain (Loss) on Allocation 26 28 30 32 34 36 38 40 42 44 46 48 50 (10,000) (5,000) - 5,000 10,000 15,000 20,000 Net Gain (Loss) - Unlevered Net Gain (Loss) - Levered Looking at this diagram, you will notice the following things about the risk and return characteristics of the two positions: Investment Maximum Loss Price Net Profit at Fair Value Estimate Stock $0 $1,472 Option $15 (2.8 × stock loss) $4,200 (3.0 × stock profit) The leverage on the stock loss and the leverage on the stock profit are nearly equal in this instance because the point at which we realize a loss ($15) is just about the same distance below the market price as our pre- sumed fair value ($30) is above. The leverage to loss is calculated as =Loss leverage realized loss as ap ercent of allocation percents tock declinet or ealizedl oss Understanding and Managing Leverage    • 179 In this example, we suffer a realized loss of 96 percent (= $4,800 ÷ $5,000) if the stock falls 35 percent, so the equation becomes = − =− ×Lossleverage 96% 35% 2.8 (By convention, I’ll always write the loss leverage as a negative.) This equation just means that it takes a drop of 35 percent to realize a loss on 96 percent of the allocation. The profit leverage is simply a ratio of the levered portfolio’s net profit to the unlevered portfolio’s net profit at the fair value estimate. For this example, we have == ×Profitleverage $4,200 $1,472 3.0 Let’s do the same exercise for the ATM and OTM options and see what fully levered portfolios with each of these options would look like from a risk-return perspective. If we bought as many $22-strike options as a $5,000 position size would allow (19 contracts in all), our profit and loss graph and table would look like this: 02468 10 12 14 16 18 20 22 24 Stock Price Levered Strategy Overview Gain (Loss) on Allocation 26 28 30 32 34 36 38 40 42 44 46 48 50(20,000) - 40,000 60,000 80,000 100,000 20,000 Unrealized Gain Unrealized Loss Cash Value Net Gain (Loss) - Levered Realized Loss 180  •   The Intelligent Option Investor Instrument Maximum-Loss Price Net Profit at Fair Value Estimate Stock $0 $1,472 Option $22 (23.2 × stock loss) $10,203 (6.9 × stock profit) This is quite a handsome potential profit—6.9 times higher than we could earn using a straight stock position—but at an enormous risk. Each $1 drop in the stock price equates to a $23.20 drop in the value of the posi- tion. Note that the realized loss shows a step up from $22 to $23. This just shows that above the strike price, our only realized loss is the money we spent on time value. The last example is that of the fully levered OTM call options. Here is the table illustrating this case: Instrument Maximum-Loss Price Net Profit at Fair Value Estimate Stock $0 $1,472 Option $25 (IRL 5 percent) $12,495 (8.5 × stock profit) There is no intrinsic value to this option, so the entire cost of the option is treated as an immediate realized loss (IRL) from inception. The “IRL 5 percent” notation means that there is an immediate realized loss of 5 percent of the total portfolio. The maximum net loss is again at the strike price of $25. The leverage factor at our fair value estimate price is 8.5, but again this leverage comes at the price of having to realize a 5 percent loss on your portfolio—500 basis points of performance—and there is no certainty that you will have enough or any profits to offset this realized loss. Of course, investing choices are not as black and white as what I have presented here. If you want to commit 5 percent of your portfolio to a straight stock idea, you have to spend 5 percent of your portfolio value on stock, but this is not true for options. For example, I might choose to spend 2.5 percent of my portfolio’s worth on ATM calls (nine contracts in this ex- ample), considering the position in terms of a 5 percent stock investment, and then leave the rest as cash reserve. Here is what this investment would look like from a leverage perspective: Understanding and Managing Leverage    • 181 02468 10 12 14 16 18 20 22 24 Stock Price Levered Strategy Overview Gain (Loss) on Allocation 26 28 30 32 34 36 38 40 42 44 46 48 50(5,000) - 15,000 10,000 20,000 25,000 30,000 5,000 Unrealized Gain Unrealized Loss Cash Value Net Gain (Loss) - Levered Realized Loss Instrument Maximum-Loss Price Net Profit at Fair Value Estimate Stock $0 $1,472 Option $22 (11 × stock loss) $4,833 (5.1 × stock profit) The 11 times loss figure was calculated in the following way: there is a total of 47.3 percent of my allocation to this investment that is lost if the price of the stock goes down by 4.3 percent, so −47.3 percent/4.3 percent = −11.0. Obviously, this policy of keeping some cash in reserve represents a sensible ap- proach to portfolio management when leverage is used. An investor in straight stock who makes 20 investments that do not hit his or her expected fair value within the investment horizon might have a few bad years of performance, but an investor who uses maximum option leverage and allocates 5 percent to 20 ideas will end up bankrupt if these don’t work out by expiration time! Similar to setting a cash reserve, you also might decide to make an investment that combines cash, stock, and options. For example, I might buy 100 shares of Intel, three ITM option contracts, and leave the rest of my 5 percent allocation in cash. Here is what that profit and loss profile would look like: 182  •   The Intelligent Option Investor 0 24681 01 21 41 61 82 02 22 4 Stock Price Levered Strategy Overview Gain (Loss) on Allocation 26 28 30 32 34 36 38 40 42 44 46 48 50(6,000) (4,000) (2,000) - 4,000 2,000 6,000 10,000 12,000 8,000 Unrealized Gain Unrealized Loss Cash Value Net Gain (Loss) - Levered Realized Loss Instrument Maximum-Loss Price Net Profit at Fair Value Estimate Stock $0 $1,472 Option $15 (1.8 × stock loss) $3,803 (2.6 × stock profit) Three $800 option contracts represent $2,400 of capital or 48 percent of this allocation’s capital. Thus 48 percent of the capital was lost with a 34.8 per- cent move downward in the stock, generating a −1.4 times value for the options plus we add another −0.4 times value to represent the loss on the small stock allocation; together these generate the −1.8 times figure you see on the loss side. Of course, if the option loss is realized, we still own 100 shares, so the maximum loss will not be felt until the shares hit $0, as shown in the preceding diagram. For the remainder of this book I will describe leverage positions us- ing the two following terms: loss leverage and profit leverage . I will write these in the following way: − X.x Y.y where the first number will be the loss leverage ratio, and the second number will be the profit leverage ratio based on the preceding rules that Understanding and Managing Leverage    • 183 I’ve used for calculation. All OTM options will be marked with an IRL fol- lowed by the percentage of the total portfolio used in the option purchase (not the percentage of the individual allocation but the total percentage amount of your investment capital). On my website, you’ll find an online leverage tool that allows you to calculate these numbers yourself. Managing Leverage A realized loss is, to me, serious business. There are times when an inves- tor must take a realized loss—specifically when his or her view of the fair value or fair value range of a company changes materially enough that an investment position becomes unattractive. However, if you find yourself taking realized losses because of material changes in valuation too often, you should either figure out where you are going wrong in the valuation process or just put your money into a low-load mutual fund and spend your time doing something more productive. The point is that taking a realized loss is not something you have to do too often if you are a good investor, and hopefully, when those losses are taken, they are small. As such, I believe that there are two ways to successfully manage leverage. First is to use leverage sparingly by investing in combinations of ITM options and stocks. ITM option prices mainly represent intrinsic value, and be- cause the time-value component is that which represents a realized loss right out of the gate, buying ITM options means that you are minimizing realized losses. The second method for managing leverage when you cannot resist taking a higher leverage position is spending as little as possible of your investment capital on it. This means that when you see that there is a com- pany that has a material chance of being worth a lot more or a lot less than it is traded for at present but that material chance is still much less likely than other valuation scenarios, you should invest your capital in the idea sparingly. By making smaller investments with higher leverage, you will not realize a loss on too much of your capital at one time, and if you are right at least some of the time on these low-probability, high-potential- reward bets, you will come out ahead in the end. Of course, you also can use a combination of these two methods. For example, I have found it helpful to take the main part of a position using a 184  •   The Intelligent Option Investor combination of stock and ITM call options but also perhaps buying a few OTM call options as well. As the investment ages and more data about the company’s operations come in, if this information leads me to be more bullish about the prospects of the stock, I may again increase my leverage using OTM call options—especially when I see implied volatility trading at a particularly low level or if the stock price itself is depressed because of a generally weak market. I used to be of the opinion that if you are confident in your valuation and your valuation implies a big enough unlevered return, it is irrational not to get exposure to that investment with as much leverage as possible. A few large and painful losses of capital have convinced me that where- as levering up on high-conviction investments is theoretically a rational investment regime, practically, it is a sucker’s game that is more likely to deplete your investment capital than it is to allow you to hit home runs. Y ounger investors, who still have a long investing career ahead of them and plenty of time to make up for mistakes early on, probably can feel more comfortable using more leverage, but as you grow closer to the time when you need to use your investments (e.g., paying for retirement, kids’ college expenses, or whatever), using lower leverage is better. Looking back at the preceding tables, one row in one table in particular should stand out to you. This is the last row of the last table, where the leverage is −1.8/2.6. To me, this is a very attractive leverage ratio because of the asymmetry in the risk-reward balance. This position is levered, but the leverage is lopsided in the investor’s favor, so the investor stands to win more than he or she loses. This asymmetry is the key to successful investing—not only from a leverage standpoint but also from an economic standpoint as well. I believe an intelligent, valuation-centric method for investing in companies such as the ones outlined in this book that allow investors an edge up by allowing them to identify cases in which the valuation simply does not line up with the market price. This in itself presents an asymmetrical profit opportunity, and the real job of an intelligent investor is to find as large an asymmetry as possible and courageously invest in that company. If you can also tailor your leverage such that your payout is asymmetrical in your favor as well, this only adds potential for outsized returns, in my opinion. The other reason that the −1.8/2.6 leverage ratio investment interests me is because of the similarity it has to the portfolio of Warren Buffett’s Understanding and Managing Leverage    • 185 Berkshire Hathaway (BRK.A). In a recent academic paper written by re- searchers at AQR Capital titled, “Buffett’s Alpha, ”4 the researchers found that a significant proportion of Buffett’s legendary returns can be attributed to finding firms that have low valuation risk and investing in them using a leverage ratio of roughly 1.8. The leverage comes from the float from his in- surance companies (the monies paid in premium by clients over and above that required to pay out claims). As individual investors, we do not have a captive insurance company from which we can receive continual float, but by buying options and using leverage prudently, it is possible to invest in a manner similar to a master investor. In this section, we have only discussed leverage considerations when we gain exposure by buying options. There is a good reason to ignore the case where we are accepting exposure by selling options that we will dis- cuss when we talk about margining in Chapter 10. We now continue with chapters on gaining, accepting, and mixing exposure. In these chapters, we will use all of what we have learned about option pricing, valuation, and leverage to discuss practical option investment strategies. This page intentionally left blank 187 Chapter 9 GaininG ExposurE This chapter is designed as an encyclopedic listing of the main strategies for gaining exposure (i.e., buying options) that an intelligent option inves- tor should understand. Gaining exposure seems easy in the beginning be- cause it is straightforward—simply pay your premium up front, then if the stock moves into your option’s range of exposure by expiration time, you win. However, the more you use these strategies in investing exposure, the more nuances arise. What tenor should I choose? What strike price should I choose? Should I exercise early if my option is in the money (ITM)? How much capital should I commit to a given trade? If the stock price goes in the opposite direction from my option’s range of exposure, should I close my option position? All these questions are examples of why gaining exposure by buying options is not as straightforward a process as it may seem at first and are all the types of questions I will cover in the following pages. Gaining exposure means buying options, and the one thing that an option buyer must never lose sight of is that time is always working against him or her. Options expire. If your options expire out of the money (OTM), the capital you spent on premiums on those options is a realized loss. No matter how confident you are about your valuation call, you should al- ways keep this immutable truth of option buying in mind. Indeed, there are ways to reduce the risk of this happening or to manage a portfolio in 188  •   The Intelligent Option Investor such a way that such a loss of capital becomes just a cost of doing business that will be made up for in another investment down the line. For each of the strategies mentioned in this chapter, I present a stylized graphic representing the Black-Scholes-Merton model (BSM) cone and the option’s range of exposure plus best- and worst- case valuation scenarios. These are two of the required inputs for an intelligent option investing strategy—an intelligently determined valu- ation range and the mechanically determined BSM forecast range. I will also provide a summary of the relative pricing of upside and downside exposure vis-à-vis an intelligent valuation range (e.g., “Upside expo- sure is undervalued”), the steps taken to execute the strategy, and its potential risks and return. After this summary section, I provide textual discussions of tenor se- lection, strike price selection, portfolio management (i.e., rolling, exercise, etc.), and any miscellaneous items of interest to note. Understanding the strategies well and knowing how to use the tools at your disposal to tilt the balance of risk and reward in your favor are the hallmark and pinnacle of intelligent option investing. Intelligent option investors gain exposure when the market underestimates the likelihood of a valuation that the in- vestor believes is a rational outcome. In graphic terms, this means that ei- ther one or both of the investor’s best- and worst-case valuation scenarios lie outside the BSM cone. Simple (one-option) strategies to gain exposure include • Long calls • Long puts Complex (multioption) strategies to gain exposure include • Long strangles • Long straddles Jargon introduced in this chapter includes the following: Roll Ratio(ing) Gaining Exposure • 189 Long Call GREEN Downside: Fairly priced Upside: Undervalued Execute: Buy a call option Risk: Amount equal to premium paid Reward: Unlimited less amount of premium paid The Gist An investor uses this strategy when he or she believes that there is a material chance that the value of a company is much higher than the present market price. The investor must pay a premium to initiate the position, and the proportion of the premium that represents time value should be recognized as a realized loss because it cannot be recovered. If the stock fails to move into the area of exposure before option expiration, there will be no profit to offset this realized loss. In economic terms, this transaction allows an investor to go long an undervalued company without accepting an uncertain risk of loss if the stock falls. Instead of the uncertain risk of loss, one must pay the fixed pre- mium. This strategy obeys the same rules of leverage as discussed earlier in this book, with in-the-money (ITM) call options offering less leverage but being much more forgiving regarding timing than are at-the-money (ATM) or especially out-of-the-money (OTM) options. 190  •   The Intelligent Option Investor T enor Selection In general, the rule for gaining exposure is to buy as long a tenor as is available. If a stock moves up faster than you expected, the option will still have time value left on it, and you can sell it to recoup the extra money you spent to buy the longer-tenor option. In addition, long-tenor options are usually proportionally less expensive than shorter-tenor ones. Y ou can see this through the following table. These ask prices are for call options on Google (GOOG) struck at whatever price was closest to the 50-delta mark for every tenor available. Days to Expiration Ask Price Marginal Price/Day Delta 3 6.00 2.00 52 10 10.30 0.61 52 17 12.90 0.37 52 24 15.50 0.37 52 31 17.70 0.31 52 59 22.40 0.17 49 87 34.40 0.43 50 150 42.60 0.13 50 178 47.30 0.17 50 241 56.00 0.14 50 542 86.40 0.10 50 The “Marginal Price/Day” column is simply the extra that you pay to get the extra days on the contract. For example, the contract with three days left is $6.00. For seven more days of exposure, you pay a total of $4.30 extra, which works out to a per-day rate of $0.61. We see blips in the marginal price per day field as we go from 59 to 87 to 150 days, but these are just artifacts of data availability; the closest strikes did not have the same delta for each expiration. The preceding chart, it turns out, is just the inverse of the rule we already learned in Chapter 3: “time value slips away fastest as we get closer to expiration. ” If time value slips away more quickly nearer expiration, it must mean that the time value nearer expiration is proportionally worth more than the time value further away from expiration. The preceding table simply illustrates this fact. Gaining Exposure • 191 Value investors generally like bargains and to buy in bulk, so we should also buy our option time value “in bulk” by buying the longest tenor available and getting the lowest per-day price for it. It follows that if long-term equity anticipation securities (LEAPS) are available on a stock, it is usually best to buy one of those. LEAPS are wonderful tools because, aside from the pricing of time value illustrated in the preceding table, if you find a stock that has undervalued upside potential, you can win from two separate effects: 1. The option market prices options as if underlying stocks were ef- ficiently priced when they may not be (e.g., the market thinks that the stock is worth $50 when it’s worth $70). This discrepancy gives rise to the classic value-investor opportunity. 2. As long as interest rates are low, the drift term understates the ac- tual, probable drift of the stock market of around 10 percent per year. This effect tends to work for the benefit of a long-tenor call option whether or not the pricing discrepancy is as profound as originally thought. There are a couple of special cases in which this “buy the longest tenor possible” rule of thumb should not be used. First, if you believe that a company may be acquired, it is best to spend as little on time value as possible. I will discuss this case again when I discuss selecting strike prices, but when a company agrees to be acquired by another (and the market does not think there will be another offer and regulatory approv- als will go through), the time value of an option drops suddenly because the expected life of the stock as an independent entity has been short- ened by the acquiring company. This situation can get complicated for stock-based acquisitions (i.e., those that use stocks as the currency of acquisition either partly or completely) because owners of the acquiree’s options receive a stake in the acquirer’s options with strike price adjusted in proportion to the acquisition terms. In this case, the time value on your acquiree options would not disappear after the acquisition but be transferred to the acquirer’s company’s options. The real point is that it is impossible, as far as I know, to guess whether an acquisition will be made in cash or in shares, so the rule of thumb to buy as little time value as possible still holds. 192  •   The Intelligent Option Investor In general, attempting to profit from potential mergers is dif- ficult using options because you have to get both the timing of the suspected transaction and the acquisition price correct. I will discuss a possible solution to this situation in the next section about picking strike prices. The second case in which it is not necessary to buy as long a tenor as possible is when you are trading in expectation of a particular company announcement. In general, this game of anticipating stock price move- ments is a hard one to win and one that value investors usually steer clear of, but if you are sure that some announcement scheduled for a particular day or week is likely to occur but do not want to make a long-term invest- ment on the company, you can buy a shorter-tenor option that obviously must include the anticipated announcement date. It is probably not a bad idea to build in a little cushion between your expiration and the anticipated date of the announcement because sometimes announcements are pushed back and rescheduled. Strike Price Selection From the discussion regarding leverage in the preceding section, it is clear that selecting strike prices has a lot to do with selecting what level of leverage you have on any given bet. Ultimately, then, strike selec- tion—the management of leverage, in other words—is intimately tied to your own risk profile and the degree to which you are risk averse or risk seeking. My approach, which I will talk more about in the following section on portfolio management, may be too conservative for others, but I put it forward as one alternative among many that I have found over time to be sensible. Any investment has risk to the extent that there is never perfect certainty regarding a company’s valuation. Some companies have a fairly tight valuation range—meaning that the confluence of their revenue stream, profit stream, and investment efficacy does not vary a great deal from best to worst case. Other companies’ valuation ranges are wide, with a few clumps of valuation scenarios far apart or with just one or two outlying valuation scenarios that, although not the most likely, are still materially probable. Gaining Exposure • 193 On the rare occasion in which we find a company that has a valuation range that is far different from the present market price (either tight or wide), I would rather commit more capital to the idea, and for me, committing more capital to a single idea means using less leverage. In other words, I would prefer to buy an ITM call and lever at a reasonable rate (e.g., the −1.8 × /2.6 × level we saw in the Intel example earlier). Graphically, my approach would look like this: Advanced Building Corp. (ABC) 110 100 90 80 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Date/Day Count Stock Price GREEN ORANGE Here I have bought a deep ITM call option LEAPS that gives me lev- erage of about −1.5/2.0. I have maximized my tenor and minimized my leverage ratio with the ITM call. This structure will allow me to profit as long as the stock goes up by the time my option expires, even if the stock price does not hit a certain OTM strike price. In the more common situation, in which we find a company that is probably about fairly valued in most scenarios but that has an outlying valuation scenario or two that doesn’t seem to be priced in properly by the market, I will commit less capital to the idea but use more leverage. Graphically, my approach would look more like this: 194  •   The Intelligent Option Investor Advanced Building Corp. (ABC) 100 90 80 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Date/Day Count Stock Price GREEN Here I have again maximized my tenor by buying LEAPS, but this time I increase my leverage to something like an “IRL/10.0” level in case the stars align and the stock price sales to my outlier valuation. Some people would say that the IIM approach is absolutely the op- posite of a rational one. If you are—the counterargument goes—confident in your valuation range, you should try to get as much leverage on that idea as possible; buying an ITM option is stupid because you are not using the leverage of options to their fullest potential. This counterargument has its point, but I find that there is just too much uncertainty in the markets to be too bold with the use of leverage. Options are time-dependent instruments, and if your option expires worthless, you have realized a loss on whatever time value you original- ly spent on it. Economies, now deeply intertwined all over the globe, are phenomenally complex things, so it is the height of hubris to claim that I can perfectly know what the future value of a firm is and how long it will take for the market price to reflect that value. In addition, I as a human decision maker am analyzing the world and investments through a con- genital filter based on behavioral biases. Retaining my humility in light of the enormous complexity of the marketplace and my ingrained human failings and expressing this humility Gaining Exposure • 195 by using relatively less leverage when I want to commit a significant amount of capital to an idea constitute, I have found, given my risk tolerance and experience, the best path for me for a general investment. In contrast, we all have special investment loves or wild hares or whatever, and sometimes we must express ourselves with a commitment of capital. For example, “If XYZ really can pull it off and come up with a cure for AIDS, its stock will soar. ” In instances such as these, I would rather commit less capital and express my doubt in the outcome with a smaller but more highly levered bet. If, on average, my investment wild hares come true every once in a while and, when they do, the options I’ve bought on them pay off big enough to more than cover my realized losses on all those that did not, I am net further ahead in the end. These rules of thumb are my own for general investments. In the spe- cial situation of investing in a possible takeover target, there are a few extra considerations. A company is likely to be acquired in one of two situations: (1) it is a sound business with customers, product lines, or geographic exposure that another company wants, or (2) it is a bad business, either because of management incompetence, a secular decline in the business, or something else, but it has some valuable asset(s) such as intellectual prop- erty that a company might want to have. If you think that a company of the first sort may be acquired, I be- lieve that it is best to buy ITM call options to attempt to minimize the time value spent on the investment (you could also sell puts, and I will discuss this approach in Chapter 10). In this case, you want to minimize the time value spent because you know that the time value you buy will drain away when a takeover is announced and accepted. By buying an ITM contract, you are mainly buying intrinsic value, so you lose little time value if and when the takeover goes through. If you think that a company of the second sort (a bad company in decline) may be acquired, I believe that it is best to minimize the time value spent on the investment by not buying a lot of call contracts and by buying them OTM. In this case, you want to minimize the time value spent using OTM options by limiting the number of contracts bought because you do not want to get stuck losing too much capital if and when the bad company’s stock loses value while you are holding the options. Typical buyout premiums are in the 30 percent range, so buy- ing call options 20 percent OTM or so should generate a decent profit if 196  •   The Intelligent Option Investor the company is taken out. Just keep in mind that the buyout premium is 30 percent over the last price, not 30 percent over the price at which you decided to make your investment. If you buy 20 percent OTM call options and the stock decreases by 10 percent before a 30 percent premium buyout is announced, you will end up with nothing, as shown in the following timeline: $12-Strike Options Bought When the Stock Is Trading for $10 • Stock falls to $9. • Buyout is announced at 30 percent above last price—$11.70. • 12-strike call owner’s profit = $0. However, there is absolutely no assurance that an acguirer will pay some- thing for a prospective acguiree. Depending on how keen the acquirer is to get its hands on the assets of the target, it may actually allow the target company to go bankrupt and then buy its assets at $0.30 on the dollar or whatever. It is precisely this uncertainty that makes it unwise to commit too much capital to an idea involving a bad company—even if you think it may be taken out. Portfolio Management I like to think of intelligent option investing as a meal. In our investment meal, the underlying instrument—the stock—should, in most cases, form the main course. People have different ideas about diversification in a securities portfolio and about the maximum percentage of a portfolio that should be allocated to a specific idea. Clearly, most people are more comfortable allocating a greater percentage of their portfolio to higher-confidence ideas, but this is normal- ly framed in terms of relative levels (i.e., for some people, a high-conviction idea will make up 5 percent of their portfolio and a lower-conviction one 2.5 percent; for others, a high-conviction idea will make up 20 percent of their portfolio and a lower-conviction one 5 percent). Rather than addressing what size of investment meal is best to eat, let’s think about the meal’s composition. Considering the underlying stock as the main course, I consider the leverage as sauces and side dishes. ITM options positions are the main Gaining Exposure • 197 sauce to make the main course more interesting and flavorful. Y ou can layer ITM options onto the stock to increase leverage to a level with which you feel comfortable. This does not have to be Buffett’s 1.8:1 leverage of course. Levering more lightly will provide less of a kick when a company performs according to your best-case scenario, but also carries less risk of a severe loss if the company’s performance is mediocre or worse. OTM option positions (and “long diagonals” to be discussed in Chapter 11) can be thought of as a spicy side dish to the main meal. They can be added opportunistically (when and if the firm in which you are investing has a bad quarter and its stock price drops for temporary reasons involving sen- timent rather than substance) for extra flavor. OTM options can also be used as a snack to be nibbled on between proper meals. Snack, in this case, means a smaller sized position in firms that have a small but real upside potential but a greater chance that it is fairly valued as is, or in a company in which you don’t have the conviction in its ability to create much value for you, the owner. Another consideration regarding the appropriate level of investment leverage one should apply to a given position is how much operational and financial leverage (both are discussed in detail in Appendix B) a firm has. A firm that is highly levered will have a much wider valuation range and will be much more likely to be affected by macroeconomic considera- tions that are out of the control of the management team and inscrutable to the investor. In these cases, I think the best response is to adjust one’s investment leverage according to the principles of “margin of safety” and contrarianism. By creating a valuation range, rather than thinking only of a single point- estimate for the value of the firm, we have unwittingly allowed ourselves to become very skillful at picking appropriate margins of safety. For example, I recently looked at the value of a company whose stock was trading for around $16 per share. The company had very high operational and financial lever- age, so my valuation range was also very large—from around $6 per share worst case to around $37 per share best case with a most likely value of around $25 per share. The margin of safety is 36 percent (= ($25 − $16)/ $25). While some might think this is a reasonable margin of safety to take a bold, concentrated position, I elected instead to take a small, unlevered one because to me, the $9 margin of safety for this stock is still not wide enough. The best 198  •   The Intelligent Option Investor time to take a larger position and to use more leverage is when the market is pricing a stock as if it were almost certain that a company will face a worst-case future when you consider this worst-case scenario to be relatively unlikely. In this illustration, if the stock price were to fall by 50 percent—to the $8 per share level—while my assessment of the value of the company remained unchanged (worst, likely, and best case of $6, $25, and $37, respectively), I would think I had the margin of safety necessary to commit a larger proportion of my portfo- lio to the investment and add more investment leverage. With the stock sitting at $8 per share, my risk ($8 − $6 = $2) is low and unlikely to be realized while my potential return is large and much closer to being assured. With the stock’s present price of $16 per share, my risk ($16 − $6 = $10) is large and when bad- case scenarios are factored in along with the worst-case scenario, more likely to occur. Thinking of margins of safety from this perspective, it is obvious that one should not frame them in terms of arbitrary levels (e.g., “I have a rule to only buy stocks that are 30% or lower than my fair value estimate. ”), but rather in terms informed by an intelligent valuation range. In this example, a 36 percent margin of safety is sufficient for me to commit a small proportion of my portfolio to an unlevered investment, but not to go “all in. ” For a concentrated, levered position in this investment, I would need a margin of safety approaching 76 percent (= ($25 − $6)/$25) and at least over 60 percent (= ($25 - $10)/$25). When might such a large margin of safety present itself? Just when the market has lost all hope and is pricing in disaster for the company. This is where the contrarianism comes into play. The best time to make a levered investment in a company with high levels of operational lever - age is when the rest of the market is mainly concerned about the possible negative effects of that operational leverage. For example, during a reces- sion, consumer demand drops and idle time at factories increases. This has a quick and often very negative effect on profitability for companies that own the idle factories, and if conditions are bad enough or look to have no near-term (i.e., within about six months) resolution, the price of those companies’ stocks can plummet. Market prices often fall so low as to imply, from a valuation perspective, that the factories are likely to remain idled forever. In these cases, I believe that not using investment leverage in this case may carry with it more real risk than using investment leverage Gaining Exposure • 199 (see my discussion of risk in Chapter 12 after reading the paragraphs below about financial leverage). In boom times, just the opposite is true. Factories are nearing full capacity and demand is strong. Most of the market is thinking only of the extra percentage points of profit that can be squeezed out of the opera- tions when continuing strong demand pushes factory capacity even higher. As every contrarian knows, this is precisely the wrong time to fall in love with the stock of an operationally levered company; it is also precisely the wrong time to use investment leverage to gain exposure to the stock of an operationally levered company. Financial leverage is more dangerous and requires a much more care- ful consideration of valuation scenarios, especially if the economy is in or is going into recession. In recessions, consumer demand for products slows, but banks’ and bondholders’ demand for interest and principal payments continues unabated. If demand is so low that a company is not generating enough cash flow to pay interest on its debt, or if it can pay interest on its debt but does not have enough cash on hand to pay an entire principal pay- ment (and banks refuse to finance that payment), the equity of the com- pany will be worth nothing. As Buffett has so eloquently wrote in the 2010 annual letter to Berkshire Hathaway shareholders, “[A]ny series of positive numbers, however impressive the numbers may be, evaporates when mul- tiplied by a single zero. ” It doesn’t matter how great a given business may be during boom times; if its equity value falls to zero during bad times, the owner of the company’s stock will lose his or her entire investment. One sad fact of life is that in many cases, companies with great op- erational leverage (e.g., those that own factories) have funded this leverage through the issuance of debt—hereby layering financial leverage onto oper- ational leverage. Because financial leverage represents such a severe risk to equity investors during bust times, and because it is devilishly hard to know when the next bust time might come, I personally think that using less in- vestment leverage on companies fitting this profile is generally prudent. Let us assume that you have decided on the composition of an investment meal and dug in using your chosen allocation size and leverage level. How do you know when to stop “eating” and close all or part of your position? Or con- versely, what should you do when you realize that the meal is more delicious than you had originally imagined? These are natural questions to ask. 200  •   The Intelligent Option Investor After you enter a position and some time passes, it becomes clearer what valuation scenario the company is tending toward. In some cases, a bit of information will come out that is critical to your valuation of the company on which other market participants may not be focused. Obvi- ously, if a bit of information comes out that has a big, positive or negative impact on your assessment of the company’s value, you should adjust your position size accordingly. If you believe the impact is positive, it makes sense to build to a position by increasing your shares owned and/or by adding “spice” to that meal by adjusting your target leverage level. If the impact is negative, it makes sense to start by reducing leverage (or you can think of it as increasing the proportion of cash supporting a particular position), even if this reduction means realizing a loss. If the impact of the news is so negative that the investment is no longer attractive from a risk- reward perspective, I believe that it should be closed and the lumps taken sooner rather than later. Considering what we know about prospect theory, this is psychologically a difficult thing to do, but in my experience, waiting to close a position in which you no longer have confidence seldom does you any good. Obviously, the risk/reward equation of an investment is also influ- enced by a stock’s market price. If the market price starts scraping against the upper edge of your valuation range, again, it is time to reduce leverage and/or close the position. If your options are in danger of expiring before a stock has reached your fair value estimate, you may roll your position by selling your option position and using the proceeds to buy another option position at a more distant tenor. At this time, you must again think about your target leverage and adjust the strikes of your options accordingly. If the price of the stock has decreased over the life of the option contract, this will mean that you realize a loss, which is not an easy thing to do psychologically, but consid- ering the limitations imposed by time for all option investments, this is an unavoidable situation in this case. One of the reasons I dislike investing in non-LEAPS call options is that rolling means that not only do we have to pay another set of bro- ker and exchange fees, but we also must pay both sides of the bid-ask spread. Keeping in mind how wide the bid-ask spread can be with options and what an enormous drag this can be on returns, you should carefully Gaining Exposure • 201 consider whether the prospective returns justify entering a long call posi- tion that will likely have to be rolled multiple times before the stock hits your fair value estimate. By the way, it goes without saying that to the extent that an option you want to roll has a significant amount of time value on it, it is better to roll before time decay starts to become extreme. This usually occurs at around three months before expiration. It turns out that option liquidity increases in the last three months before expiration, and rolling is made easier with the greater liquidity. Having discussed gaining bullish exposure with this section about long calls, let’s now turn to gaining bearish exposure in the following sec- tion on long puts. Long Put GREEN Downside: Undervalued Upside: Fairly priced Execute: Buy a put option Risk: Amount of premium paid Reward: Amount equal to strike price—premium The Gist An investor uses this strategy when he or she believes that it is very likely that the value of a company is much lower than the present market price. The investor must pay a premium to initiate the position, and the propor- tion of the premium that represents time value should be recognized as a 202  •   The Intelligent Option Investor realized loss because it cannot be recovered. If the stock fails to move into the area of exposure before option expiration, there will be no profit to offset this realized loss. In economic terms, this transaction allows an investor to sell short an overvalued company without accepting an uncertain risk of loss if the stock rises. Instead of the uncertain risk of loss, the investor must pay the fixed premium. This strategy obeys the same rules of leverage as discussed earlier in this book, with ITM put options offering less leverage but a great- er cushion before realizing a loss than do ATM or OTM put options. T enor Selection Shorting stocks, which is what you are doing when you buy put op- tions, is hard work, not for the faint of heart. There are a couple of reasons for this: 1. Markets generally go up, and for better or worse, a rising tide usu- ally does lift all boats. 2. Even when a company is overvalued, it is hard to know what cata- lyst will make that fact obvious to the rest of the market and when. In the words of Jim Chanos, head of the largest short-selling hedge fund in the world, the market is a “giant positive reinforcement machine. ” 1 It is psychologically difficult to hold a bearish position when it seems like the whole world disagrees with you. All these difficulties in taking bearish positions are amplified by options because options are levered instruments, and losses feel all the more acute when they occur on a levered position. My rule for gaining bullish exposure is to pick the longest-tenor op- tion possible. I made the point that by buying LEAPS, you can enjoy a likely upward drift that exceeds the drift assumed by option pricing. When buying puts, you are on the opposite side of this drift factor (i.e., the “ris- ing tide lifts all boats” factor), and every day that the stock does not fall is another day of time value that has decayed without you enjoying a profit. On the other hand, if you decide not to spend as much on time value and buy a shorter-tenor put option, unless the market realizes that the stock is Gaining Exposure • 203 overvalued and it drops before the shorter option expires, you must pay the entire bid-ask spread and the broker and exchange fees again when you roll your put option. The moral of the story is that when selecting tenors for puts, you need to balance the existence of upward market drift (which lends weight to the argument for choosing shorter tenors) with bid-ask spreads and other fees (which lends weight to the argument for longer tenors). If you can iden- tify a catalyst, you can plan the tenor of the option investment based on the expected catalyst. However, it’s unfortunate but mysteriously true that bearish catalysts have a tendency to be ignored by the market’s “happy ma- chine” until the instant when suddenly they are not and the shares collapse. The key for a short seller is to be in the game when the market realizes the stock’s overvaluation. Strike Price Selection When it comes to strike prices, short sellers find themselves fighting drift in much the same way as they did when selecting tenors. A short seller with a position in stocks can be successful if the shares he or she is short go up less than other stocks in the market. The short exposure acts as a hedge to the portfolio as a whole, and if it loses less money than the rest of the port- folio gains, it can be thought of as a successful investment. However, the definition for success is different for buyers of a put option, who must not only see their bearish bets not go up by much but rather must see their bearish bets fall if they are to enjoy a profit. If the investor wanting bearish exposure decides to gain it by buying OTM puts, he or she must—as we learned in the section about leverage—accept a realized loss as soon as the put is purchased. If, on the other hand, the investor wants to minimize the realized loss accepted up front, he or she must accept that he or she is in a levered bearish position so that every 1 percent move to the upside for the stock generates a loss larger than 1 percent for the position. There is another bearish strategy that you can use by accepting exposure that I will discuss in the next section, but for investors who are gaining bearish exposure, there is no way to work around the dilemma of the option-based short seller just mentioned. 204  •   The Intelligent Option Investor Portfolio Management There is certainly no way around the tradeoff between OTM and ITM risk—the rules of leverage are immutable whether in a bullish or a bear - ish investment—but there are some ways of framing the investment that will allow intelligent investors to feel more comfortable with making these types of bearish bets. First, I believe that losses associated with a bearish position are treated differently within our own minds than those associated with bullish positions. The reason for this might be the fact that if you decide to proactively invest in the market, you must buy se- curities, but you need not sell shares short. The fact that you are losing when you are engaged in an act that you perceive as unnecessary just adds to a sense of regret and self-doubt that is necessarily part of the investing process. In addition, investors seem to be able to accept underperform- ing bullish investments in a portfolio context (e.g., “XYZ is losing, but it’s only 5 percent of my holdings, and the rest of my portfolio is up, so it’s okay”) but look at underperforming bearish investments as if they were the only investments they held (e.g., “I’m losing 5 percent on that damned short. Why did I ever short that stock in the first place?”). In gen- eral, people have a hard time looking at investments in a portfolio con- text (I will discuss this more when I talk about hedging in Chapter 11), but this problem seems to be orders of magnitude worse in the case of a bearish position. My solution to this dilemma—perhaps not the best or most rational from a performance standpoint but most manageable to me from a psy- chological one—is to buy OTM puts with much smaller position sizes than I might for bullish bets with the same conviction level. This means that I have smaller, more highly levered positions. The reason this works for me is that once I spend the premium on the put option, I consider the money gone—a sunk cost—and do not even bother to look at the mark-to-market value of the option after that unless there is a large drop in the stock price. Somehow this acknowledgment of a realized loss up front is easier to han- dle psychologically than watching my ITM put position suffer unrealized losses of 1.5 times the rise of the stock every day. This strategy may well be proof that I simply am not a natural-born short seller, and you are encouraged, now that you understand the issues Gaining Exposure • 205 involved, to devise a method for gaining bearish exposure that fits your own risk profile. Strangle GREEN GREEN Downside: Undervalued Upside: Undervalued Execute: Buy an OTM call option simultaneously with buying an OTM put option Risk: Amount of premium paid Reward: Unlimited on upside, limited to strike less total (two-leg) premium on the downside The Gist The strangle is used when the market is undervaluing the likelihood that a stock’s value is significantly above or below the present market price. It is a more speculative position and, because both legs are OTM, a highly lever- aged one. It can sometimes be useful for companies such as smaller drug companies whose value hinges on the success or failure of a particular drug or for companies that have a material chance of bankruptcy but if they can 206  •   The Intelligent Option Investor avoid this extreme downside are worth much more than they are presently trading at. The entire premium paid must be treated as a realized loss because it can never be recovered. If the stock fails to move into one of the areas of exposure before option expiration, there will be no profit to offset this realized loss. There is no reason why you have to buy puts and calls in equal num- bers. If you believe that both upside and downside scenarios are materially possible but believe that the downside scenario is more plausible, you can buy more puts than calls. This is called ratioing a position. T enor Selection Because the strangle is a combination of two strategies we have already discussed, the considerations regarding tenor are the same as for each of the components—that is, using the drift advantage in long-term equity an- ticipating securities (LEAPS) and buying them or the longest-tenor calls available and balancing the fight against drift and the cost of rolling and buying perhaps shorter-tenor puts. Strike Price Selection A strangle is slightly different in nature from its two components—long calls and long puts. A strangle is an option investor’s way of expressing the belief that the market in general has underestimated the intrinsic uncertainty in the valuation of a firm. Options are directional instru- ments, but a strangle is a strategy that acknowledges that the investor has no clear idea of which direction a stock will move but only that its future value under different scenarios is different from its present market price. Because both purchased options are OTM ones, this implies, in my mind, a more speculative investment and one that lends itself to taking profit on it before expiration. Nonetheless, my conservatism forces me to select strike prices that would allow a profit on the entire position if the stock price is at one of the two strikes at expiration. Because I am buying exposure to both the upside and the downside, I always like to make sure Gaining Exposure • 207 that if the option expires when the stock price is at either edge of my valu- ation range, it is far enough in-the-money to pay me back for both legs of the investment (plus an attractive return). Portfolio Management As mentioned earlier, this is naturally a more speculative style of option investment, and it may well be more beneficial to close the successful leg of the strategy before expiration than to hold the position to expiration. Com- pared with the next strategy presented here (the straddle), the strangle ac- tually generates worse returns if held to expiration, so if you are happy with your returns midway through the investment, you should close the posi- tion rather than waiting for expiration. The exception to this rule is that if news comes out that convinces you that the value of the firm is materially higher or lower than what you had originally forecast and uncertainty in the other direction has been removed, you should assess the possibility of making a more substantial investment in the company. One common problem with investors—even experienced and sophis- ticated ones—is that they check the past price history of a stock and decide whether the stock has “more room” to move in a particular direction. The most important two things to know when considering an investment are its value and the uncertainty surrounding that value. Whether the stock was cheaper three years ago or much more expensive does not matter—these are backward-looking measures, and you cannot invest with a rear-view mirror. One final note regarding this strategy is what to do with the unused leg. If the stock moves up strongly and you take profits on the call, what should you do with the put, in other words. Unfortunately, the unused leg is almost always worthless, and often it will cost more than it’s worth to close it. I usually keep this leg open because you never know what may happen, and perhaps before it expires, you will be able to close it at a better price. This is a speculative strategy—a bit of spice or an after-dinner mint in the meal of investing. Don’t expect to get rich using it (if you do get rich using it, it means that you were lucky because you would have had to have used a lot of leverage in the process), but you may be pleasantly surprised with the boost you get from these every once in a while. Let’s now turn briefly to a related strategy—the straddle. 208  •   The Intelligent Option Investor Straddle GREEN Downside: Undervalued Upside: Undervalued Execute: Simultaneously buy an ATM put and an ATM call Risk: Amount of premium paid Reward: Unlimited? The Gist I include the straddle here for completeness sake. I have not included a lot of the fancier multioption strategies in this book because I have found them to be more expensive than they are worth, especially for someone with a definite directional view on a security. However, the straddle is re- ferred to commonly and is deceptively attractive, so I include it here to warn investors against its use, if for no other reason. The straddle shares many similarities with the strangle, of course, but straddles are enormously expensive because you are paying for every pos- sible price the stock will move to over the term of the options. For example, I just looked up option prices for BlackBerry (BBRY), whose stock was trading at $9.00. For the 86 days to expiry, $9-strike calls (delta = 0.56) and $9-strike puts (delta = –0.44) were priced at $1.03 and $1.13, respectively. Gaining Exposure • 209 The total premium of $2.16 represents 24 percent of the stock’s price, which means that if the implied volatility (around 60 percent) remains constant, the stock would have to move 24 percent before an investor even breaks even. It is true that during sudden downward stock price moves, implied volatility usually rises, so it might take a little less of a stock price move- ment to the downside to break even. However, during sudden upside moves, implied volatility often drops, which would make it more difficult to break even to the upside. Despite this expense, a straddle will still give an investor a lower breakeven point than a strangle on the same stock if held to expiration. The key is that a strangle will almost always generate a higher profit than a straddle if it is closed before expiration simply because the initial cost of the strangle is lower and the relative leverage of each of its legs is higher. This is yet another reason to consider closing a strangle early if and when you are pleased with the profits made. If you do not know whether a stock will move up or down, the best you can hope for is to make a speculative bet on the company. When you make speculative bets, it is best to reduce the amount spent on it or you will whittle down all your capital on what amounts to a roulette wheel. Reduc- ing the amount spent on a single bet is the reason an intelligent investor should stay away from straddles. With all the main strategies for gaining exposure covered, let’s now turn to accepting exposure by selling options. This page intentionally left blank 211 Chapter 10 Accepting exposure Brokerages and exchanges treat the acceptance of exposure by counter - parties in a very different way from counterparties who want to gain expo- sure. There is a good reason for this: although an investor gaining exposure has an option to transact in the future, his or her counterparty—an investor accepting exposure—has a commitment to transact in the future at the sole discretion of the option buyer. If the investor accepting exposure does not have the financial wherewithal to carry out the committed transaction, the broker or exchange is on the hook for the liability. 1 For example, an investor selling a put option struck at $50 per share is committing to buy the stock in question for $50 a share at some point in the future—this is the essence of accepting exposure. If, however, the investor does not have enough money to buy the stock at $50 at some point in the future, the investor’s commitment to buy the shares is economically worthless. To guard against this eventuality, brokers require exposure-accepting investors to post a security deposit called margin that will fully cover the fi- nancial obligation to which the investor is committing. In the preceding ex- ample, for instance, the investor would have to keep $5,000 (= $50 per share × 100 shares/contract) in reserve and would not be able to spend those reserved funds for stock or option purchases until the contract has expired worthless. Because of this margin requirement, it turns out that one of our strat- egies for accepting leverage—short puts—always carries with it a loss lev- erage of –1.0—exactly the same as the loss leverage of a stock. Think about it this way: what difference is there between using $50 to buy a stock and 212  •   The Intelligent Option Investor setting $50 aside in an escrow account you can’t touch and promising that you will buy the stock with the escrow funds in the future if requested to do so? From a risk perspective, “very little” is the answer. Short calls are more complicated, but I will discuss the leverage car - ried by them using elements of the structure I set forth in Chapter 8. In the following overviews, I add one new line item to the tables that details the margin requirements of the positions. Intelligent option investors accept exposure when the market over - estimates the likelihood of a valuation that the investor believes is not a rational outcome. In graphic terms, this means that either one or both of the investor’s best- and worst-case valuation scenarios lie well within the Black-Scholes-Merton model (BSM) cone. Simple (one-option) strategies to accept exposure include 1. Short put 2. Short call (call spread) Complex (multioption) strategies to accept exposure include the following: 1. Short straddle 2. Short strangle Jargon introduced in this chapter includes the following: Margin Put-call parity Early exercise Cover (a position) Writing (an option) Short Put RED Accepting Exposure   • 213 Downside: Overvalued Upside: Fairly valued Execute: Sell a put contract Risk: Strike price minus premium received [same as stock inves- tor at the effective buy price (EBP)] Reward: Limited to premium received Margin: Notional amount of position The Gist The market is pricing in a relatively high probability that the stock price will fall. An investor, from a longer investment time frame perspective, believes that the value of the stock is likely worth at least the present mar- ket value and perhaps more. The investor agrees to accept the downside risk perceived by the market and, in return, receives a premium for doing so. The premium cannot be fully realized unless the option expires out- of-the money (OTM). If the option expires in-the-money (ITM), the investor pays an amount equal to the strike price for the stock but can partially offset the cost of the stock by the premium received. The inves- tor thus promises to buy the stock in question at a price of the strike price of the option less the premium received—what I call the effective buy price. I think of the short-put strategy as being very similar to buying cor - porate bonds and believe that the two investment strategies share many similarities. A bond investor is essentially looking to receive a specific monetary return (in the form of interest) in exchange for accepting the risk of the business failing. The only time a bond investor owns a company’s assets is after the value of the firm’s equity drops to zero, and the assets revert to the control of the creditors. Similarly, a short-put in- vestor is looking to receive a specific monetary return (in the form of an option premium) in exchange for accepting the risk that the company’s stock will decrease in value. The only time a short-put investor owns a company’s shares is after the market value of the shares expires below the preagreed strike price. Because the strategies are conceptually similar, I usually think of short- put exposure in similar terms and compare the “yield” I am generating 214  •   The Intelligent Option Investor from a portfolio of short puts with the yield I might generate from a cor - porate bond portfolio. With this consideration, and keeping in mind that these investments are unlevered, 2 the name of the game is to generate as high a percentage return as possible over the investing time horizon while minimizing the amount of real downside risk you are accepting. T enor Selection To maximize percentage return, in general, it is better to sell options with relatively short-term expirations (usually tenors of from three to nine months before expiration). This is just the other side of the coin of the rule to buy long-tenor options: the longer the time to expiration, the less time value there is on a per-day basis. The rule to sell shorter-tenor options implies that you will make a higher absolute return by chaining together two back-to-back 6-month short puts than you would by selling a single 12-month option at the beginning of the period. During normal market conditions, selling shorter-tenor options is the best tactical choice, but during large market downdrafts, when there is terror in the marketplace and implied volatilities increase enormously for options on all companies, you might be able to make more by sell- ing a longer-tenor option than by chaining together a series of shorter- tenor ones (because, presumably, the implied volatilities of options will drop as the market stabilizes, and this drop means that you will make less money on subsequent put sales). At these times of extreme market stress, there are situations where you can find short-put opportunities on long-tenor options that defy economic logic and should be invested in opportunistically. For example, during the terrible market drops in 2009, I found a company whose slightly ITM put long-term equity anticipation securities (LEAPS) were trading at such a high price that the effective buy price of the stock was less than the amount of cash the firm had on its balance sheet. Obviously, for a firm producing positive cash flows, the stock should not trade at less than the value of cash presently on the balance sheet! I ef- fectively got the chance to buy a firm with $6 of cash on the balance sheet and the near certainty of generating about $2 more over the economic life of the options for $5.50. The opportunity to buy $6–$8 worth of cash for Accepting Exposure   • 215 $5.50 does not come along very often, so you should take advantage of it when you see it. Of course, the absolute value of premium you will receive by writing (jargon that means selling an option) a short-term put is less than the ab- solute value of the premium you will receive by writing a long-term one. 3 As such, an investor must balance the effective buy price of the stock (the strike price of the option less the amount of premium to be received) in which he or she is investing in the short-put strategy with the percentage return he or she will receive if the put expires OTM. I will talk more about effective buy price in the next section, but keep in mind that we would like to generate the highest percentage return pos- sible and that this usually means choosing shorter-tenor options. Strike Price Selection In general, the best policy is to sell options at as close to the 50-delta [at- the-money (ATM)] mark as one can because that is where time value for any option is at its absolute maximum. Our expectation is that the option’s time value will be worthless at expiration, and if that is indeed the case, we will be selling time value at its maximum and “closing” our time value position at zero—its minimum. In this way, we are obeying (in reverse order) the old investing maxim “Buy low, sell high. ” Selling ATM puts means that our effective buy price will be the strike price at which we sold less the amount of the premium we received. It goes without saying that an intelligent investor would not agree to accept the downside exposure to a stock if he or she were not prepared to buy the stock at the effective buy price. Some people want to sell OTM puts, thereby making the effective buy price much lower than the present market price. This is an understandable impulse, but simply attempting to minimize the effective buy price means that you must ignore the other element of a successful short put strategy: maximizing the return generated. There are times when you might like to sell puts on a company but only at a lower strike price. Rather than accept- ing a lower return for accepting that risk, I find that the best strategy is simply to wait awhile until the markets make a hiccup and knock down the price of the stock to your desired strike price. 216  •   The Intelligent Option Investor Portfolio Management As we have discussed, the best percentage returns on short-put investments come from the sale of short-tenor ATM options. I find that each quarter there are excellent opportunities to find a fairly constant stream of this type of short- term bet that, when strung together in a portfolio, can generate annualized returns in the high-single-digit to low-teens percentage range. This level of returns—twice or more the yield recently found on a high-quality corporate bond portfolio and closer to the bond yield on highly speculative small com- panies with low credit ratings—is possible by investing in strong, high-quality blue chip stocks. In my mind, it is difficult to allocate much money to corpo- rate bonds when this type of alternative is available. Some investors prefer to sell puts on stocks that are not very vola- tile or that have had a significant run-up in price, 4 but if you think about how options are priced, it is clear that finding stocks that the market perceives as more volatile will allow you to generate higher returns. Y ou can confirm this by looking at the diagrams of a short-put investment given two different volatility scenarios. First, a diagram in which implied volatility is low: Advanced Building Corp. (ABC) 80 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Date/Day Count Stock Price RED Accepting Exposure   • 217 Now a diagram when implied volatility is higher: RED Advanced Building Corp. (ABC) 80 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Date/Day Count Stock Price Obviously, there is much more of the put option’s range of exposure bounded by the BSM cone in the second, high-volatility scenario, and this means that the price received for accepting the same downside risk will be substantially higher when implied volatility is elevated. The key to setting up a successful allocation of short puts is to find companies that have relatively low downside valuation risk but that also have a significant amount of perceived price risk (as seen by the market)— even if this risk is only temporary in nature. Quarterly earnings seasons are nearly custom made for this purpose. Sell-side analysts (and the market in general) mainly use multiples of reported earnings to generate a target price for a stock. As such, a small shortfall in reported earnings as a result of a transitory and/or nonmaterial accounting technicality can cause sell- side analysts and other market participants to bring down their short-term target price estimates sharply and can cause stock prices to drop sharply as well. 5 These times, when a high-quality company drops sharply as a re- sult of perceived risk by other investors, are a wonderful time to replen- ish a portfolio of short puts. If you time the tenors well, your short-put 218  •   The Intelligent Option Investor investment will be expiring just about the time another short-put invest- ment is becoming attractive, so you can use the margin that has until re- cently been used to support the first position to support the new one. Obviously, this strategy only works when markets are generally trend- ing upward or at least sideways over the investment horizon of your short puts. If the market is falling, short-put positions expire ITM, so you are left with a position in the underlying stocks. For an option trader (i.e., a short- term speculator), being put a stock is a nightmare because he or she has no concept of the underlying value of the firm. However, for an intelligent option investor, being put a stock simply means the opportunity to receive a dividend and enjoy capital appreciation in a strong stock with very little downside valuation risk. The biggest problem arises when an investor sells a put and then re- vises down his or her lowest-case valuation scenario at a later time. For in- stance, the preceding diagram shows a worst-case scenario of $55 per share. What if new material information became known to you that changed your lower valuation range to $45 per share just as the market price for the stock dropped, as in the following diagram? Advanced Building Corp. (ABC) 80 70 60 50 EBP = $47.50 Overvaluation of downside exposure 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Date/Day Count Stock Price RED Accepting Exposure   • 219 Looking at this diagram closely, you should be able to see several things: 1. The investor who is short this put certainly has a notable unrealized loss on his or her position. Y ou can tell this because the put the investor sold is now much more valuable than at the time of the original sale (more of the range of exposure is carved out by the BSM cone now). When you sell something at one price and the value of that thing goes up in the future, you suffer an opportunity loss on your original sale. 2. With the drop in price and the cut in fair value, the downside ex- posure on this stock still looks overvalued. 3. If the company were to perform so that its share price eventually hit the new, reduced best-case valuation mark, the original short- put position would generate a profit—albeit a smaller profit than the one originally envisioned. At this point, there are a couple of choices open to the investor: 1. Convert the unrealized loss on the short-put position to a realized one by buying $50-strike puts to close the position (a.k.a. cover the position). 2. Leave the position open and manage it in the same way that the investor would manage a struggling stock position. It is rarely a sound idea to close a short put immediately after the re- lease of information that drives down the stock price (the first choice above, in other words). At these times, investors are generally panicked, and this panic will cause the price of the option you buy to cover to be more expen- sive than justified. Waiting a few days or weeks for the fear to drain out of the option prices (i.e., for the BSM cone to narrow) and for the stock price to stabilize some will usually allow you to close the option position at a more favorable price. There is one exception to this rule: if your new valuation suggests a fair value at or below the present market price, it is better to close the position immediately and realize those losses. If you do not close the position, you are simply gambling (as opposed to investing) because you no longer have a better than even chance of making money on the investment. 220  •   The Intelligent Option Investor The decision to leave the position open must depend on what other potential investments you are able to make and how the stock position that will likely be put to you at expiration of the option contract stacks up on a relative basis. For instance, let’s assume that you had received a premium of $2.50 for writing the puts struck at $50. This gives you an effective buy price of $47.50. The stock is now trading at $43 per share, so you can think of your position as an unlevered, unrealized loss of $4.50, or a little under 10 percent of your EBP . Y our new worst-case valuation is $55 per share, which implies a gain of about 15 percent on your EBP; your new best-case valuation is $65 per share, which implies a gain of 37 percent. How do these numbers compare with other investments in your port- folio? How much spare capacity does your portfolio have for additional investments? (That is, do you have enough spare cash to increase the size of this investment by selling more puts at the new market price or buying shares of stock? And if so, would your portfolio be weighted too heavily on a single industry or sector?) By answering these questions and understanding how this presently losing investment compares with other existing or poten- tial investments should govern your portfolio management of the position. An investor cannot change the price at which he or she transacted in a security. The best he or she can do is to develop a rational view of the value of a security and judge that security by its relative merit versus other possible investments. Whether you ever make an option transaction, this is a good rule to keep in mind. Let us now take a look at short calls and short-call spreads—the strategy used for accepting upside exposure. Short Call (Call Spread) RED Accepting Exposure   • 221 Downside: Fairly valued Upside: Overvalued Execute: Sell a call contract (short call); sell a call contract while simultaneously buying a call contract at a higher strike price (short-call spread) Risk: Unlimited for short call; difference between strike prices and premium received (short-call spread) Reward: Limited to the amount of premium received Margin: Variable for a short call; dollar amount equal to the differ- ence between strike prices for a short-call spread The Gist The market overestimates the likelihood that the value of a firm is above its pre- sent market price. An investor accepts the overvalued upside exposure in return for a fixed payment of premium. The full amount of the premium will only flow through to the investor if the price of the stock falls and the option expires OTM. There are two variations of this investment—the short call and the short-call spread. This book touches on the former but mainly addresses the latter. A short call opens up the investor to potentially unlimited capital losses (because stocks theoretically do not have an upper bound for their price), and a broker will not allow you to invest using this strategy except for the following conditions: 1. Y ou are a hedge fund manager and have the ability to borrow stocks through your broker and sell them short. 2. Y ou are short calls not on a stock but on a diversified index (such as the Dow Jones Industrial Index or the Standard and Poor’s 500 Index) through an exchange-traded fund (ETF) or a futures con- tract and hold a diversified stock portfolio. For investors fitting the first condition, short calls are margined in the same way as the rest of your short portfolio. That is, you must deposit initial margin on the initiation of the investment, and if the stock price goes up, you must pay in variance margin to support the position. Obviously, as the stock price falls, this margin account is settled in your favor. For investors fitting the second condition, when you originally sell the call option, your broker should 222  •   The Intelligent Option Investor indicate on your statements that a certain proportion of your account effec- tively will be treated as margin. This means that you stand to receive the eco- nomic benefit from your diversified portfolio of securities but will not be able to liquidate all of it. If the market climbs higher, a larger proportion of your portfolio will be considered as margin; if it falls lower, a smaller proportion of your portfolio will be considered as margin. Basically, a proportion of any gains from your diversified stock portfolio will be reapportioned to serve as collateral for your short call when the market is rising, and a proportion of any losses from your diversified stock portfolio will be offset by a freeing of margin related to your profits on the short call when the market is falling. Most brokers restrict the ability of individual investors to write un- covered calls on individual stocks, so the rest of this discussion will cover the short-call spread strategy for individual stocks. T enor Selection Tenors for short-call spreads should be fairly short under the same reason- ing as that for short puts—one receives more time value per day for short- er-tenor options. Look for calls in the three- to nine-month tenor range. The tenor of the purchased call (at the higher strike price) should be the same as the tenor of the sold calls (at the lower strike price). Theoretically, the bought calls could be longer, but it is hard to think of a valuation justifi- cation for such a structure. By buying a longer-tenor call for the upside leg of the investment, you are expressing an investment opinion that the stock will likely rise over the long term—this exactly contradicts the purpose of this strategy: expressing a bearish investment opinion. Strike Price Selection Theoretically, you can choose any two strike prices, sell the call at the lower price, and buy the call at the higher price and execute this investment. If you sold an ITM call, you would receive premium that consists of both time and intrinsic value. If the stock fell by expiration, you would realize all the wasted time value plus the difference between the intrinsic value at initiation and the intrinsic value at expiration. Despite the theory, however, in practice, the lower strike option is usually sold ATM or OTM because of the threat of assignment. Assignment is the pro- cess the exchange goes through when investors choose to exercise the option Accepting Exposure   • 223 they own rather than trade them away for a profit. Recall from Chapter 2 that experienced option investors do not do this most of the time; they know that because of the existence of time value, it is usually more beneficial for them to sell their option in the market and use the proceeds to buy the stock if they want to hold the underlying. Inexperienced investors, however, often are not conscious of the time-value nuance and sometimes elect to exercise their option. In this case, the exchange randomly pairs the option holders who wish to exercise with an option seller who has promised to sell at that exercise price. There is one case in which a sophisticated investor might chose to exercise an ITM call option early, related to a principle in option pricing called put-call parity. This rule, which was used to price options before advent of the BSM, simply states that a certain relationship must exist be- tween the price of a put at one strike price, the price of a call at that same strike price, and the market price of the underlying stock. Put-call parity is discussed in Appendix C. In this appendix, you can learn what the exact put-call parity rule is (it is ridiculously simple) and then see how it can be used to determine when it is best to exercise early in case you are long a call and when your short-call (spread) position is in danger of early exercise because of a trading strategy known as dividend arbitrage. The assignment process is random, but obviously, the more contracts you sell, the better the chance is that you will be assigned on some part or all of your sold contracts. Even if you hold until expiration, there is still a chance that you may be assigned to fulfill a contract that was exercised on settlement. Clearly, from the standpoint of option sale efficiency, an ATM call is the most sensible to sell for the same reason that a short put also was most efficient ATM. As such, the discussion that follows assumes that you are selling the ATM strike and buying back a higher strike to cover. In a call-spread strategy, the capital you have at risk is the difference be- tween the two strike prices—this is the amount that must be deposited into margin. Depending on which strike price you use to cover, the net premium received differs because the cost of the covering call is cheaper the further OTM you cover. As the covering call becomes more and more OTM, the ratio of premium received to capital at risk changes. Put in these terms, it seems that the short-call spread is a levered strategy because leverage has to do with altering the capital at risk in order to change the percentage return. This con- trasts with the short-call spread’s mirror strategy on the put side—short puts— in that the short-put strategy is unlevered. 224  •   The Intelligent Option Investor For instance, here are data from ATM and OTM call options on IBM (IBM) expiring in 80 days. I took these data when IBM’s shares were trad- ing at $196.80 per share. Sell a Call at 195 Cover at ($) Net Premium Received ($) Percent Return Capital at Risk ($) 200 2.40 48 5 205 4.26 43 10 210 5.47 36 15 215 6.17 31 20 220 6.51 26 25 225 6.70 22 30 230 6.91 20 35 235 6.90 17 40 240 6.96 15 45 In this table, net premium received was calculated by selling at the $195 strike’s bid price and buying at each of the listed strike price’s ask prices. Percent return is the proportion of net premium received as a percentage of the capital at risk—the width of the spread. This table clearly shows that accepting expo- sure with a call spread is a levered strategy. The potential return on a percent- age basis can be raised simply by lowering the amount of capital at risk. However, although accepting exposure with a call spread is un- deniably levered from this perspective, there is one large difference: un- like the leverage discussed earlier in this book for a purchase of call op- tions—in which your returns were potentially unlimited—the short-call spread investor receives premium up front that represents the maximum return possible on the investment. As such, in the sense of the investor’s potential gains being limited, the short-call spread position appears to be an unlevered investment. Considering the dual nature of a short-call spread, it is most help- ful to think about managing these positions using a two-step process with both tactical and strategic aspects. We will investigate the tactical aspect of leverage in the remainder of this section and the strategic aspect in the portfolio management section. Accepting Exposure   • 225 Tactically, once an investor has decided to accept exposure to a stock’s upside potential using a call spread, he or she has a relatively limited choice of investments. Let’s assume that we sell the ATM strike; in the IBM ex- ample shown earlier, there is a choice of nine strike prices at which we can cover. The highest dollar amount of premium we can receive—what I will call the maximum return—is received by covering at the most distant strike. Every strike between the ATM and the most distant strike will at most generate some percentage of this maximum return. Now let’s look at the risk side. Let’s say that we sell the $195-strike call and cover using the $210-strike call. Now assume that some bit of good news about IBM comes out, and the stock suddenly moves to exactly $210. If the option expires when IBM is trading at $210, we will have lost the entire amount of margin we posted to support this investment—$15 in all. This $15 loss will be offset by the amount of premium we received from selling the call spread—$5.47 in the IBM example—generating a net loss of $9.53 (= $5.47 − $15). Compare this with the loss that we would suffer if we had covered using the most distant call strike. In this case, we would have received $6.96 in premium, so if the option expires when IBM is trading at the same $210 level as earlier, our net loss would be $8.04 (= $6.96 − $15). Because our maximum return is generated with the widest spread, it fol- lows that our minimum loss for the stock going to any intermediate strike price also will be generated with the widest spread. At the same time, if we always select the widest spread, we face an entirely different problem. That is, the widest spread exposes us to the great- est potential loss. If the stock goes only to $210, it is true that the widest spread will generate a smaller loss than the $195–$210 spread. However, in the extreme, if the stock moves up strongly to $240, we would lose the $45 gross amount supporting the margin account and a net amount of $38.04 (= $45 – $6.96). Contrast this with a net loss of $9.53 for the $195–$210 spread. Put simply, if the stock moves up only a bit, we will do better with the wider spread; if it moves up a lot, it is better to choose a narrower spread. In short, when thinking about call spreads, we must balance our amount of total exposure against the exposure we would have for an inter- mediate outcome against the total amount of premium we are receiving. If we are too protective and initiate the smallest spread possible, our chance 226  •   The Intelligent Option Investor of losing the entire margin amount is higher, but the margin amount lost is smaller. On the other hand, if we attempt to maximize our winnings and initiate the widest spread possible, our total exposure is greatest, even though the chance of losing all of it is lower. Plotting these three variables on a graph, here is what we get: 200 (11%) 0% 20% 40% 60% 80% 106% 102% 94%89% 100% 120% 140% 160% 180% 200% 205 (22%) 210 (33%) 215 (44%) 220 (56%) 225 (67%) 230 (78%) 235 (89%) 240 (100%) Strike (% of Total Exposure) Risk & Return of Call Spreads vs. Maximum Spread Risk Comparison Return Comparison Here, on the horizontal axis, we have the value of the covering strike and the size of the corresponding spread as a percentage of the widest spread. This shows how much proportional capital is at risk (e.g., at the $215-strike, we are risking a total of $20 of margin; $20 is 44 percent of total exposure of $45 if we covered at the $240-strike level). The top line shows how much greater the loss would be if we used that strike to cover rather than the maximum strike and the option expired at that strike price (e.g., if we cover at the $215-strike and the option expires when the stock is trading at $215, our loss would be 6 percent greater than the loss we would suffer if we covered at the $240-strike). The bottom line shows the premium we will realize as income if the stock price declines as a percentage of the total pre- mium possible if we covered at the maximum strike price. Here are the val- ues from the graph in tabular format so that you can see the numbers used: Strike Price Dollar Spread Percent of Maximum Spread (a) Bid Price Ask Price Covering at Strike Covering at Maximum Strike Difference Risk Comparison (%) (b) Return Comparison (%) (c) Potential Gain Worst-Case (Loss) Potential Gain Worst-Case Gain (Loss) 195 — — 7.05 7.10 — — — — — — — 200 5 11 4.55 4.65 2.40 (2.60) 6.96 1.96 (3.55) N.C. 34 205 10 22 2.75 2.79 4.26 (5.74) 6.96 (3.04) 2.29 189 61 210 15 33 1.54 1.58 5.47 (9.53) 6.96 (8.04) 0.87 119 79 215 20 44 0.84 0.88 6.17 (13.83) 6.96 (13.04) 0.53 106 89 220 25 56 0.38 0.54 6.51 (18.49) 6.96 (18.04) 0.39 102 94 225 30 67 0.12 0.35 6.70 (23.30) 6.96 (23.04) 0.30 101 96 230 35 78 0.11 0.14 6.91 (28.09) 6.96 (28.04) 0.25 100 99 235 40 89 0.03 0.15 6.90 (33.10) 6.96 (33.04) 0.21 100 99 240 45 100 0.02 0.09 6.96 (38.04) 6.96 (38.04) 0.18 100 100 227 228  •   The Intelligent Option Investor With a table like this, you can balance, on the one hand, the degree you are reducing your overall exposure in a worst-case scenario (by look- ing at column a) against how much risk you are taking on for a bad-case (intermediary upward move of the stock) scenario (by looking at column b) against how much less premium you stand to earn if the stock does go down as expected (by looking at column c). There are no hard and fast rules for which is the correct covering strike to select—that will depend on your confidence in the valuation and timing, your risk profile, and the position size—but looking at the table, I tend to be drawn to the $215 and $220 strikes. With both of those strikes, you are reducing your worst-case exposure by about half, increasing your bad-case exposure just marginally, and taking only a small haircut on the premium you are receiving. 6 Now that we have an idea of how to think about the potential risk and return on a per-contract basis, let’s turn to leverage in the strategic sense— figuring out how much capital to commit to a given bearish idea. Portfolio Management When we thought about leverage from a call buyer’s perspective, we thought about how large of an allocation we wanted to make to the idea itself and changed our leverage within that allocation to modify the profits we stood to make. Let’s do this again with IBM—again assuming that we are willing to allocate 5 percent of our portfolio to an investment in the view that this company’s stock price will not go higher. At a price of $196.80, a 5 percent allocation would mean controlling a little more than 25 shares for every $100,000 of portfolio value. 7 Because options have a contract size of 100 shares, an unlevered 5 percent allocation to this investment would require a portfolio size of $400,000. The equation to calculate the leverage ratio on the basis of notional exposure is × =Notional valueo fo ne contract Dollarv alue of allocation number of contractsl everager atio So, for instance, if we had a $100,000 portfolio of which we were willing to commit 5 percent to this short-call spread on IBM, our position would have a leverage ratio of Accepting Exposure   • 229 ×= ≈$19,500 $5,000 13 .9 4: 1leverage Selling the $195/$220 call spread will generate $651 worth of pre- mium income and put at risk $2,500 worth of capital. Nothing can change these two numbers—in this sense, the short-call spread has no leverage. The 4:1 leverage figure merely means that the percentage return will ap- pear nearly four times as large on a given allocation as a 1:1 allocation would appear. The following table—assuming the sale of one contract of the $195/$220 call spread—shows this in detail: Winning Case Losing Case Premium Received ($) Target Allocation ($) Leverage Stock Move ($) Percent Return on Allocation Stock Move ($) Dollar Return Percent Return on Allocation 651 20,000 1:1 –2 3.3 +25 –1,849 –9.2 651 10,000 2:1 –2 6.5 +25 –1,849 –18.5 651 5,000 4:1 –2 13.0 +25 –1,849 –37.0 Note: The dollar return in the losing case is calculated as the loss of the $2,500 of margin per contract less than the premium received of $651. Notice that the premium received never changes, nor does the worst- case return. Only the perception of the loss changes with the size of our target allocation. Now that we have a sense of how to calculate what strategic leverage we are using, let’s think about how to size the position and about how much risk we are willing to take. When we are selling a call or call spread, we are committing to sell a stock at the strike price. If we were actually selling the stock at that price rather than committing to do so, where would we put our stop loss—in other words, when would we close the position, assuming that our valuation or our timing was not correct? Let’s say that for this stock, if the price rose to $250, you would be willing to admit that you were wrong and would realize a loss of $55 per share, or $5,500 per hundred shares. This figure—the $5,500 per hundred shares you would be willing to lose in an unlevered short stock position—can be used as a guide to select the size of your levered short-call spread. 230  •   The Intelligent Option Investor In this case, you might choose to sell a single $195–$240 call spread, in which case your maximum exposure would be $4,500 [= 1 × (240 – 195) × 100] at the widest spread. This investment would have a leverage ratio of approxi- mately 1:1. Alternatively, you could choose to sell two $195–$220 spreads, in which case your maximum exposure would be $5,000 [= 2 × (220 − 195) × 100], with a leverage ratio of approximately 2:1. Which choice you select will depend on your assessment of the valuation of the stock, your risk tolerance, and the composition of your portfolio (i.e., how much of your portfolio is al- located to the tech sector, in this example of an investment in IBM). Because the monetary returns from a short-call or call-spread strategy are fixed and the potential for losses are rather high, I prefer to execute bearish investments using the long-put strategy discussed in the “Gaining Exposure” section. With this explanation of the short-call spread complete, we have all the building blocks necessary to understand all the other strategies mentioned in this book. Let’s now turn to two nonrecommended complex strategies for accepting exposure—the short straddle and the short strangle—both of which are included not because they are good strategies but rather for the sake of completeness. Short Straddle/Short Strangle Short Straddle RED Downside: Overvalued Upside: Overvalued Execute: Sell an ATM put; simultaneously sell an ATM call spread Accepting Exposure   • 231 Risk: Amount equal to upper strike price minus premium received Reward: Limited to premium received Margin: Dollar amount equal to upper strike price Short Strangle RED RED Downside: Overvalued Upside: Overvalued Execute: Sell an OTM put; simultaneously sell an OTM call spread Risk: Call-spread leg: Amount equal to difference between strikes and premium received. Put leg: Amount equal to strike price minus premium received. Total exposure is the sum of both legs. Reward: Limited to premium received Margin: Call-spread leg: Amount equal to difference between strikes. Put leg: Amount equal to strike price. Total mar - gin is the sum of both legs. The Gist In my opinion, these are short-term trades rather than investments. Even though a short put uses a short-tenor option, the perspective of the inves- tor is that he or she is buying shares. These strategies are a way to express the belief that the underlying stock price will not move over a short time. In my experience, there is simply no way to develop a rational view of how a single stock will move over a short time frame. In the short term, markets 232  •   The Intelligent Option Investor fluctuate based on animal spirits, fads, and various other insanities. Why subject yourself to the torture of trying to figure out these insanities and profit from them when there are easier, more intelligent ways of doing so? Of the two strategies, the short straddle is preferable because it yields the greatest amount of premium. Use this strategy at your own peril, however. Let’s turn now to a discussion of how to mix exposure—simultane- ously gaining and accepting exposure and overlaying options on stock po- sitions. 233 Chapter 11 Mixing ExposurE Mixing exposure uses combinations of gaining and accepting exposure, employing strategies that we already discussed to create what amounts to sort of a short-term synthetic position in a stock (either long or short). These strategies, nicknamed “diagonals” can be extremely attractive and extremely financially rewarding in cases where stocks are significantly mis- priced (in which case, exposure to one direction is overvalued, whereas the other is extremely undervalued). Frequently, using one of these strategies, an investor can enter a po- sition in a levered out-of-the-money (OTM) option for what, over time, becomes zero cost (or can even net a cash inflow) and zero downside expo- sure. This is possible because the investor uses the sale of one shorter-tenor at-the-money (ATM) option to subsidize the purchase of another longer- tenor OTM one. Once the sold option expires, another can be sold again, and whatever profit is realized from that sale goes to further subsidize the position. This strategy works well because of a couple of rules of option pricing that we have already discussed: 1. ATM options are more expensive than OTM options of the same tenor. 2. Short-tenor options are worth less than long-tenor options, but the value per day is higher for the short-tenor options. 234  •   The Intelligent Option Investor I provide actual market examples of these strategies in this chapter and will point out the effect of both these points in those examples. Because these strategies are a mix of exposures, it makes sense that they are just complex (i.e., multioption) positions. I will discuss the following: 1. Long diagonal 2. Short diagonal Note that the nomenclature I use here is a bit different from what others in the market may use. What I term a diagonal in this book is what others might call a “spit-strike synthetic stock. ” Since Bernie Madoff ’s infamous “split-strike conversion” fraud, this term doesn’t have a very good ring to it. For other market participants, a diagonal means simultaneously buying and selling options of the same type (i.e calls or puts). In this book, it means selling an option of one kind and buying the other kind. I will also talk about what is known in the options world as overlays. One of the most useful things about options is the way that they can be grafted or overlain onto an existing common stock position in a way that alters the port- folio’s overall risk-reward profile. The strategies I will review here are as follows: 1. Covered calls 2. Protective puts 3. Collars These strategies are popular but often misunderstood ways to alter your portfolio’s risk-reward profile. Coming this far in this book, you already have a good understand- ing about how options work, so the concepts presented here will not be difficult, but I will discuss some nuances that will help you to evaluate investment choices and make sound decisions regarding the use of these strategies. I will refer to strike selection and tenor selection in the following pages, but for these, along with “The Gist” section, I’ll include an “Execu- tion” section and a “Common Pitfalls” section. Covered calls are an easy strategy to understand once you understand short puts, so I will discuss those first. Protective puts share a lot of simi- larities with in-the-money (ITM) call options, and I will discuss those next. Mixing Exposure  •  235 Collars are just a combination of the other two overlay strategies and so are easiest left to the end. Long Diagonal GREEN RED Downside: Overvalued Upside: Undervalued Execute: Sell an ATM put option (short put) and simultaneously buy an OTM call option (long call) Risk: Sum of put’s strike price and net premium paid for call Reward: Unlimited Margin: Amount equal to put’s strike price The Gist Other than the blank space in the middle of the diagram and the disparity between the lengths of the tenors, the preceding diagram looks very much like the risk-return profile diagram for a long stock—accepting downside exposure in return for gaining upside exposure. As you can see from the diagram, the range of exposure for the short put lies well within the Black-Scholes-Merton model (BSM) cone, but the range of exposure for the long call is well outside the cone. It is often possible to find short-put–long-call combinations that al- low for an immediate net credit when setting up this investment. 236  •   The Intelligent Option Investor Because we must fully margin a short-put investment, that leg of the long diagonal carries with it a loss leverage ratio of –1.0. However, the OTM call leg represents an immediate realized loss coupled with a very high lambda value for gains. As such, if the put option expires ITM, the long diagonal is simply a levered strategy; if the put option expires OTM, the investment is a very highly levered one because the unlevered put ceases to influence the leverage equation. Another short put may be written after the previous short put expires; this further subsidizes the cost of the calls and so greatly increases the leverage on the strategy. If the stock moves quickly toward the upper valuation range, this structure becomes extremely profitable on an unrealized basis. If the put option expires ITM, the investor is left with a levered long investment in the stock in addition to the long position in the OTM. As in any other complex structure, the investment may be ratioed—for instance, by buying one call for every two puts sold or vice versa. Strike Price Selection The put should be sold ATM or close to ATM in order to maximize the time value sold, as explained earlier in the short-put summary. The call strike may be bought at any level depending on the investor’s appetite for leverage but is usu- ally purchased OTM. The following table shows the net debit or credit associated with the long diagonal between the ATM put ($55 strike price, delta of –0.42, priced at the bid price) with an expiration of 79 days and each call strike (at the ask price) listed, all of which are long-term equity anticipated securities (LEAPS) having expirations in 534 days. The lambda figure for the OTM calls is also given to provide an idea of the comparative leverage of each call option. For this exam- ple, I am using JP Morgan Chase (JPM) when its stock was trading for $56.25. Strike Delta (Debit) Credit Call Lambda (%) 57.50 0.43 (2.52) 5.6 60.00 0.37 (1.57) 6.1 62.50 0.31 (0.76) 6.7 65.00 0.26 (0.25) 7.0 70.00 0.16 0.78 8.4 75.00 0.10 1.28 9.5 80.00 0.06 1.56 10.5 Mixing Exposure  •  237 Here we can see that for a long diagonal using 79-day ATM puts and 594-day LEAPS that are OTM by just over 15 percent, we are paying a net of only $25 per contract for notional control of 100 shares. On a per-contract basis, at the following settlement prices, we would generate the following profits (or losses, in the case of the first row): Settlement Price ($) Dollar Profit per Contract Percentage Return on Original Investment (%) 65 0 –100 66 100 300 67 200 700 68 300 1,100 69 400 1,500 70 500 1,900 71 600 2,300 72 700 2,700 73 800 3,100 74 900 3,500 75 1,000 3,900 If the stock price moves up very quickly, it might be more beneficial to close the position or some portion of the position before expiration. Let’s say that my upper-range estimate for this stock was $75. From the preced- ing table, I can see that my profit per contract if the stock settles at my fair value range is $1,000. If there is enough time value on a contract when the stock is trading in the upper $60 range to generate a realized profit of $1,000, I am likely to take at least some profits at that time rather than wait- ing for the calls to expire. In Chapter 9, I discussed portfolio composition and likened the use of leverage as a side dish to a main course. This is an excellent side dish that can be entered into when we see a chance to supplement the main meal of a long stock–ITM call option position with a bit more spice. Let’s now turn to its bearish mirror—the short diagonal. 238  •   The Intelligent Option Investor Short Diagonal RED GREEN Downside: Undervalued Upside: Overvalued Execute: Sell an ATM call option while buying one to cover at a higher price (short-call spread) and simultaneously buy an OTM put option (long put) Risk: Sum of put’s strike price and net premium paid for call Reward: Amount equal to the put’s strike price minus any net premium paid for it Margin: Amount equal to spread between call options The Gist The diagram for a short diagonal is just the inverse of the long diagonal and, of course, looks very similar to the risk-return profile diagram for a short stock— accepting upside exposure in return for gaining downside exposure. The gist of this strategy is simply the short-exposure equivalent to the long diagonal, so the comments about the long diagonal are applicable to this strategy as well. The one difference is that because you must spend money to cover the short call on the upside, the subsidy that the option sale leg provides to the option purchase leg is less than in the case of the long diagonal. Also, of course, a stock price cannot turn negative, so your profit upside is capped at an amount equal to the effective sell price. This investment also may be ratioed (e.g., by using one short-call spread to subsidize two long puts). Mixing Exposure  •  239 Strike Price Selection Strike price selection for a short diagonal is more difficult because there are three strikes to price this time. Looking at the current pricing for a call spread with the short call struck at $55, I get the following selection of credits: Upper Call Strike ($) Call Spread Net Credit ($) Percent Total Risk Percent Total Return 57.50 1.27 17 49 60.00 2.14 33 83 62.50 2.44 50 94 65.00 2.51 67 97 70.00 2.59 100 100 Looking at this, let’s say we decide to go with the $55.00/$62.50 call spread. Doing so, we would receive a net credit of $2.44. Now selecting the put to purchase is a matter of figuring out the leverage of the position with which you are comfortable. Strike ($) Delta (Debit) Credit ($) Put Lambda (%) 20.00 –0.02 2.20 –4.5 23.00 –0.02 2.11 –4.6 25.00 –0.03 2.05 –4.6 28.00 –0.04 1.91 –4.8 30.00 –0.05 1.78 –4.8 33.00 –0.07 1.57 –4.8 35.00 –0.09 1.38 –4.8 38.00 –0.12 0.99 –4.8 40.00 –0.15 0.67 –4.7 42.00 –0.17 0.30 –4.7 45.00 –0.23 (0.43) –4.5 47.00 –0.26 (1.01) –4.4 50.00 –0.33 (1.91) –4.4 52.50 –0.39 (3.11) –4.0 240  •   The Intelligent Option Investor Notice that there is much less leverage on the long-put side than on the long-call side. This is a function of the volatility smile and the abnor - mally high pricing on the far OTM put side. It turns out that the $20-strike puts have an implied volatility of 43.3 percent compared to an ATM im- plied volatility of 22.0 percent. Obviously, the lower level of leverage will make closing before expira- tion less attractive, so it is important to select a put strike price between the present market price and your worst-case fair value estimate. In this way, if the option does expire when the stock is at that level, you will at least be able to realize the profit of the intrinsic value. With these explanations of the primary mixed-exposure strategies, now let’s turn to overlays—where an option position is added to a stock position to alter the risk-return characteristics of the investor’s portfolio. Covered Call Contingent Upside Exposure Contingent Downside Exposure LIGHT GREEN RED LIGHT RED Downside: Overvalued Upside: Fairly valued or undervalued Mixing Exposure  •  241 Execute: Buy common stock and simultaneously sell a call option Risk: Strike price minus premium received Reward: Limited to premium and, as long as the shares are not called, the dividends received during the tenor of the option Margin: None as long as stock and option positions are evenly matched—long stock position serves as collateral for the sold call The Gist If you look just as far as the option tenor lasts on the preceding diagram, you will see that the risk-return profile is identical to that of a short put. As evidence, please compare the following two diagrams: We have sold away the upside exposure so are left with only the acceptance of downside exposure here. RED Covered call 242  •   The Intelligent Option Investor We accepted downside exposure when we sold this put, so have no exposure to the upside here. RED The top of the “Covered call” diagram is grayed out because we have sold away the upside exposure to the stock by selling the call option, and we are left only with the acceptance of the stock’s downside exposure. The pictures are slightly different, but the economic impact is the same. The other difference you will notice is that after the option expires, in the case of the covered call, we have represented the graphic as though there is some residual exposure. This is represented in this way because if the option expires ITM, you will have to deliver your stock to the counterparty who bought your call options. As such, your future exposure to the stock is contingent on another investor’s actions and the price movement of the stock. This is an important point to keep in mind, and I will discuss it more in the “Common Pitfalls” section. Execution Because this strategy is identical from a risk-reward perspective to short puts, the execution details should be the same as well. Indeed, covered calls should—like short puts—be executed ATM to get the most time value possible and preferably should be done on a stock that has had a recent fall and whose implied volatility has spiked. However, these theoretical points Short put Mixing Exposure  •  243 ignore the fact that most people simply want to generate a bit of extra in- come out of the holdings they already have and so are psychologically re- sistant to both selling ATM (because this makes it more likely for their shares to be called away) and selling at a time when the stock price sud- denly drop (because they want to reap the benefit of the shares recovering). Although I understand these sentiments, it is important to realize that options are financial instruments and not magical ones. It would be nice if we could simply find an investment tool that we could bolt onto our present stock holdings that would increase the dividend a nice amount but that wouldn’t put us at risk of having to deliver our beloved stocks to a complete stranger; unfortunately, this is not the case for options. For example, let’s say that you own stock in a company that is paying out a very nice dividend yield of 5 percent at present prices. This is a mature firm that has tons of cash flow but few opportunities for growth, so management has made the welcome choice to return cash to shareholders. The stock is trad- ing at $50 per share, but because the dividend is attractive to you, you are loathe to part with the stock. As such, you would prefer to write the covered call at a $55 or even a $60 strike price. A quick look at the BSM cone tells us why you should not be expecting a big boost in yield from selling the covered calls: 80 Sold call range of exposure 70 60 50 40 30 20 5/18/2012 5/20/2013 249 499 749 999 Cash Flows R Us, Inc. (CASH) Date/Day Count Stock Price GREEN LIGHT GREENGRAY LIGHT REDRED 244  •   The Intelligent Option Investor Clearly, the range of exposure for the $55-strike call is well above the BSM cone. The BSM cone is pointing downward because the dividend rate is 5 percent—higher than the risk-free rate. This means that BSM drift will be lower. In addition, because this is an old, mature, steady-eddy kind of company, the expected forward volatility is low. Basically, this is a perfect storm for a low option price. My suggestion is to either write calls on stocks you don’t mind de- livering to someone else—stocks for which you are very confident in the valuation range and are now at or above the upper bound—or simply to look for a portfolio of short-put/covered-call investments and treat it like a high-yield bond portfolio, as I described in Chapter 10 when explaining short puts. It goes without saying that if you think that a stock has a lot of unappreciated upside potential, it’s not a good idea to sell that exposure away! One other note about execution: as I have said, short puts and cov- ered calls are the same thing, but a good many investors do not realize this fact or their brokerages prevent them from placing any trade other than a covered call. This leads to a situation in which there is a tremendous sup- ply of calls. Any time there is a lot of supply, the price goes down, and you will indeed find covered calls on some companies paying a lot less than the equivalent short put. Because you will be accepting the same downside exposure, it is better to get paid more for it, so my advice is to write the put rather than the covered call in such situations. To calculate returns for covered calls, I carry out the following steps: 1. Assume that you buy the underlying stock at the market price. 2. Deduct the money you will receive from the call sale as well as any projected dividends—these are the two elements of your cash inflow—from the market price of the stock. The resulting figure is your effective buy price (EBP). 3. Divide your total cash inflow by the EBP . I always include the projected dividend payment as long as I am writ- ing a short-tenor covered call and there are no issues with the company that would prevent it from paying the dividend. Owners of record have a right to receive dividends, even after they have written a covered call on the Mixing Exposure  •  245 stock, so it makes sense to count the dividend inflow as one element that reduces your EBP . In formula form, this turns out to be −−Coveredc allr eturn= premiumr eceivedf romc all+ projectedd ividends stockp rice premiumf romc allp rojected dividends For a short put, you have no right to receive the dividend, so I find the return using the following formula: −Shortp ut return= premiumr eceivedf roms hort put strikepricep remium from shortp ut Common Pitfalls Taking Profit One mistake I hear people make all the time is saying that they are going to “take profit” using a covered call. Writing a covered call is taking profit in the sense that you no longer enjoy capital gains from the stock’s appre- ciation, but it is certainly not taking profit in the sense of being immune to falls in the market price of the stock. The call premium you receive will cushion a stock price drop, but it will certainly not shield you from it. If you want to take profits on a successful stock trade, hit the “Sell” button. Locking in a Loss A person sent me an e-mail telling me that she had bought a stock at $17, sold covered calls on it when it got to $20 (in order to “take profits”), and now that the stock was trading for $11, she wanted to know how she could “repair” her position using options. Unfortunately, options are not magical tools and cannot make up for a prior decision to buy a stock at $17 and ride it down to $11. If you are in such a position, don’t panic. It will be tempting to write a new call at the lower ATM price ($11 in this example) because the cash inflow from that covered call will be the most. Don’t do it. By writing a covered call at the lower price, you are—if the shares are called away— locking in a realized loss on the position. Y ou can see this clearly if you list each transaction in the example separately. 246  •   The Intelligent Option Investor No. Buy/Sell Instrument Price of Instrument Effective Buy (Sell) Price of Stock Note 1 Buy Stock $17/share $17/share Original purchase 2 Sell Call option $1/share $16/share Selling a covered call to take profits when stock reaches $20/ share leaves the investor with down- side exposure and $1 in premium income. 3 Sell Call option $0.75 ($11.75/ share) Stock falls to $11, and investor sells another covered call to generate income to ameliorate the loss. In transaction 1, the investor buys the shares for $17. In transaction 2, when the stock hits $20 per share, the investor sells a covered call and receives $1 in premium. This reduces the effective buy price to $16 per share and means that the investor will have to deliver the shares if the stock is trad- ing at $20 or above at expiration. When the stock instead falls to $11, the investor—wanting to cushion the pain of the loss—sells another ATM cov- ered call for $0.75. This covered call commits the investor to sell the shares for $11.75. No matter how you look at it, buying at $16 per share and sell- ing at $11.75 per share is not a recipe for investing success. The first step in such a situation as this—when the price of a stock on which you have accepted downside exposure falls—is to look back to your valuation. If the value of the firm has indeed dropped because of some material negative news and the position no longer makes sense from an economic perspective, just sell the shares and take the lumps. If, however, the stock price has dropped but the valuation still makes for a compelling investment, stay in the position; if the investment is Mixing Exposure  •  247 compelling enough, this is the time to figure out a clever way to get more exposure to it. Y ou can write calls as long as they are at least at the same strike price as your previous purchase price or EBP; this just means that you are buying at $16 and agreeing to sell at at least $16, in other words. Also keep in mind that any dividend payment you receive you can also think of as a reduction of your EBP—that cash inflow is offsetting the cost of the shares. Factoring in dividends and the (very small) cash inflow as- sociated with writing far OTM calls will, as long as you are right about the valuation, eventually reduce your EBP enough so that you can make a profit on the investment. Over-/Underexposure Options are transacted in contract sizes of 100 shares. If you hold a number of shares that is not evenly divisible by 100, you must decide whether you are going to sell the next number down of contracts or the next number up. For example, let’s say that you own 250 shares of ABC. Y ou can either choose to sell two call contracts (in which case you will not be receiving yield on 50 of your shares) or sell three call contracts (in which case you will be effectively shorting 50 shares). My preference is to sell fewer con- tracts controlling fewer shares than I hold, and in fact, your broker may or may not insist that you do so as well. If not, it is an unpleasant feeling to get a call from a broker saying that you have a margin call on a position that you didn’t know you had. Getting Assigned If you write covered calls, you live with the risk that you will have to deliver your beloved shares to a stranger. Y ou can deliver your shares and use the proceeds from that sale (the broker will deposit an amount equal to the strike price times the contract multiplier into your account, and you get to keep the premium you originally received) to buy the shares again, but there is no way around delivering the shares if assigned. 248  •   The Intelligent Option Investor Now that you understand covered calls, let’s turn to protective puts. Protective Puts LIGHT GREEN RED GRAY Downside: Irrelevant Upside: Undervalued Execute: Buy common stock and simultaneously buy a put op- tion (the diagram shows the purchase of an OTM put option) Risk: Purchase price of stock minus strike price of put option minus premium paid Reward: Unlimited, less premium paid for put option, which can- not be recovered Margin: None because this is a purchase of an option The Gist If you look just as far as the option tenor lasts in the preceding diagram, you will see that the risk-return profile is identical to that of a short put. As evidence, please compare the following two diagrams: Mixing Exposure  •  249 GREEN RED GRAY GREEN ORANGE Protective put ITM call 250  •   The Intelligent Option Investor The graphic conventions are a little different, but both diagrams show the acceptance of a narrow band of downside exposure offset by a bound- less gain of upside exposure. The area below the protective put’s strike price shows that economic exposure has been neutralized, and the area below the ITM call shows no economic exposure. The pictures are slightly differ- ent, but the economic impact is the same. The objective of a protective put is obvious—allow yourself the economic benefits from gaining upside exposure while shielding yourself from the economic harm of accepting downside exposure. The problem is that this protection comes at a price. I will provide more infromation about this in the next section. Execution Everyone understands the concept of protective puts—it’s just like the home insurance you buy every year to insure your property against dam- age. If you buy an OTM protective put (let’s say one struck at 90 percent of the current market price of the stock), the exposed amount from the stock price down to the put strike can be thought of as your “deductible” on your home insurance policy. The premium you pay for your put option can be thought of as the “premium” you pay on your home insurance policy. Okay—let’s go shopping for stock insurance. Apple (AAPL) is trad- ing for $452.53 today, so I’ll price both ATM and OTM put insurance for these shares with an expiration of 261 days in the future. I’ll also annualize that rate. Strike ($) “Deductible” ($) “Premium” ($) Premium as Percent of Stock Price Annualized Premium (%) 450 2.53 40.95 9.1 12.9 405 47.53 20.70 4.6 6.5 360 92.53 8.80 1.9 2.7 Now, given these rates and assuming that you are insuring a $500,000 house, the following table shows what equivalent deductibles, annual premiums, and total liability to a home owner would be for deductibles equivalent to the strike prices I’ve picked for Apple: Mixing Exposure  •  251 Equivalent AAPL Strike ($) Deductible ($) Annual Premium ($) Total Liability to Home Owner ($) 450 2,795 64,500 67,295 405 52,516 32,500 85,016 360 102,236 13,500 115,736 I know that I would not be insuring my house at these rates and under those conditions! In light of these prices, the first thing you must consider is whether protecting a particular asset from unrealized price declines is worth the huge realized losses you must take to buy put premium. Buying ATM put protection on AAPL is setting up a 12.9 percent hurdle rate that the stock must surpass in one year just for you to start making a profit on the position, and 13 percent per year is quite a hurdle rate! If there is some reason why you believe that you need to pay for insurance, a better option—cheaper from a realized loss perspective—would be to sell the shares and use part of the proceeds to buy call options as an option-based replacement for the stock position. This approach has a few benefits: 1. The risk-reward profile is exactly the same between the two structures. 2. Any ATM or ITM call will be more lightly levered than any OTM put, meaning a lower realized loss on initiation. 3. For dividend-paying stocks, call owners do not have the right to receive dividends, but the amount of the projected dividend is de- ducted from the premium (as part of the drift calculation shown in the section on covered calls). As such, although not being paid dividends over time, you are getting what amounts to a one-time upfront dividend payment. 4. If you do not like the thought of leverage in your portfolio, you can self-margin the position (i.e., keep enough cash in reserve such that you are not “borrowing” any money through the call purchase). I do not hedge individual positions, but I do like the ITM call op- tion as an alternative for people who feel the need to do so. For hedg- ing of a general portfolio, rather than hedging of a particular holding in a portfolio, options on sector or index exchange-traded funds (ETFs) are more reasonably priced. Here are the ask prices for put options on the SPX 252  •   The Intelligent Option Investor ETF [tracking the Standard and Poor’s 500 Index (S&P 500), which closed at 1,685.73 when these data were retrieved] expiring in about 10 months: Strike/Stock ($) Ask Price ($) Premium as Percent of Stock Price 0.99 106.60 6.3 0.89 50.90 3.0 0.80 25.80 1.5 This is still a hefty chunk of change to pay for protection on an index but much less than the price of protection on individual stocks. 1 Common Pitfalls Hedge Timing Assume that you had talked to me a year ago and decided to take my ad- vice and avoid buying protective puts on single-name options. Instead, you took a protective put position on the S&P 500. Good for you. Setting aside for a moment how much of your portfolio to hedge, let’s take a look at what happened since you bought the downside protection: S&P 500 1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013 GREEN Mixing Exposure  •  253 When you bought the protection, the index was trading at 1,375, so you bought one-year puts about 5 percent OTM at $1,300. If the market had fallen heavily or even moderately during the first five months of the contract, your puts would have served you very well. However, now the puts are not 5 percent OTM anymore but 23 percent OTM, and it would take another Lehman shock for the market to make it down to your put strike. Keeping in mind that buying longer-tenor options gives you a better annualized cost than shorter-tenor options, you should be leery of entering into a hedging strategy such as the one pictured here: S&P 500 1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013 GREEN Buying short-tenor puts helps in terms of providing nearer to ATM protection, but the cost is higher, and it gets irritating to keep buying expensive options and never benefiting from them (funny— no one ever says this about home insurance). Although there are no perfect solutions to this quandary, I believe the following approach has merit: 254  •   The Intelligent Option Investor S&P 500 1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013 GREEN GREENLIGHT GREEN LIGHT GREEN LIGHT GREEN Here I bought fewer long-term put contracts at the outset and then add- ed put contracts at higher strikes opportunistically as time passed. I have left myself somewhat more exposed at certain times, and my protection doesn’t all pick up at a single strike price, so the insurance coverage is spotty, but I have likely reduced my hedging cost a great deal while still having a potential source of investible cash on hand in the form of options with time value on them. The Unhappy Case of a Successful Hedge Markets are down across the board. Y our brokerage screen is awash in red. The only bright spot is the two or three lines of your screen showing your S&P 500 puts, which are strongly positive. Y ou bought your protection when the market was going up, so it was very cheap to purchase. Now, with the market in a terror, the implied volatilities have shot up, and you are sit- ting on a huge positive unrealized value. Now what? The psychological urge to keep that hedge on will be strong. Such a po- sition is safe after all, and with the rest of the world falling apart, it feels nice to have somewhere safe to go. What should you do with this unrealized profit? Mixing Exposure  •  255 Step one is always assessing the value of securities in your portfolio and securities that might be on your watch list. Does the news driving the markets down have a material effect on the value of any of your holdings? Certainly, if the market believes that the economy is going into a recession, the next few years’ worth of revenue growth and profits may be those that you projected for your explicit-period worst-case scenarios, but that will likely be offset by faster medium-term growth as the economy bounces back. Think about the valuations you have for your holdings objectively and with as little passion as possible. It’s better not to have your brokerage screen or a price chart of the financial markets or whatever up while you do this. Are there securities whose present prices are significantly different from your worst-case valuation range? Do the prices imply an unlevered return of 30, 40, or 50 percent or more? Is there a stock that has been on your watch list for a long time but until now has never been at a price at which you wanted to buy it? This is where you must resist the urge to take the safe path and close the hedge and then turn around the cash and increase your position size on your best investments or on investments that you have always wanted to make but haven’t had the chance. This will be a hard thing to do psychologically. The world is telling you to run and hide. This is the time to remember the maxim, “Be bold when others are scared and scared when others are bold. ” Times of stress are those that set great investors apart from the rest of the crowd. Not Having a Plan Finally, we get to the question of how to size our hedge. If we look at the in- dicative prices for S&P 500 puts shown earlier, we can see that if we choose to hedge the entire amount of our portfolio, we set up at least a 6 percent- age point drag on our portfolio every 10 months or so, and that is a lot of potentially dead weight to be carrying around. In daily life, I believe that people are prone to overinsure (e.g., extended warrantees for consumer electronic items and so on), and this is a good habit to keep away from in investing. Risk is not a temporary unrealized loss caused by market panic. Usually risk is not the inability to invest more capital when you want to invest more capital (unless by not investing it you will have a shortfall in capital in the future). Risk is usually not any of the things TV pundits talk about as being risk. 256  •   The Intelligent Option Investor I will discuss risk in greater detail in Chapter 12, but a sensible defini- tion of risk is not having the capital resources to pay for something when you need to pay for it. In this sense, risk can be talked about in terms of liquidity—a short-term lack of spending power—and solvency—a funda- mental lack of capital assets. For example, let’s say that you have commit- ted to pay a restaurant and entertainers the remainder of their $50,000 fee for your son’s bar mitzvah or your daughter’s wedding, and you only have $20,000 in net worth. Y ou are in a position of risk because of problems of solvency but not necessarily liquidity (i.e., you could borrow the money to pay for these things). However, if you have a net worth of $3 million—all of it unrealized gains on real estate holdings—and you have the same $50,000 bill to pay, you may be in a position of risk because of problems in liquidity but not solvency. Risk that stems from issues of liquidity usually can be controlled through intelligent asset allocation. For example, the millionaire father in the preceding bar mitzvah/wedding example can realize $50,000 worth of his unrealized investment gains to meet his immediate cash need. A 79-year-old with 85 percent of her net worth of $2.5 million invested in tech sector initial public offerings (IPOs) or companies in the Chinese in- frastructure supply chain can ameliorate her risk of not being able to pay for necessary healthcare and living expenses by shifting more of her assets into bonds and CDs. Usually, in cases such as this—which, I believe, make up the majority of cases people are trying to “hedge”—there are much better ways of controlling risk than buying puts on the S&P 500 or the Russell 2000! However, there is a more subtle instance of risk—not maximizing re- turns on one’s invested capital and, because of this, not having the capital adequacy to meet unforeseen cash-flow needs in the future. This instance of risk deals with solvency, rather than liquidity. This type of risk cannot be ameliorated through a defensive strategy but must be controlled through an offensive one. Setting aside savings, in- vesting those savings wisely and consistently in good times, and having the courage to invest when it is hardest to do so (i.e., when the market is crash- ing) are all elements of this risk-control strategy. Put options can only help with the third case here—investing when it is hardest to do so—but they cannot help without the put owner’s input of personal courage. Mixing Exposure  •  257 This topic brings us back to the last section—investing the proceeds in a successful hedge in undervalued assets. I believe that portfolio hedges should be set up with a particular cost and investing goal in mind. For example, “I am willing to allocate as much as 1 percentage point of my investment performance this year to have an extra 5 percent of cash on hand to invest in case the market drops by 10 to 20 percent. ” This is the rough outline of a hedging plan. It specifies the maximum you are will- ing to spend and a target for how much cash you want in case of a certain market downdraft. This plan does not mean that you always have to spend 1 percent of your net worth on hedges. There are times when it is more sensible to spend more on hedges—because of building macroeconomic uncertainty or whatever—and other times when it is more sensible to spend less—when the economy is just coming out of a recession for instance. Also note that the plan specifies a cash level. If you are not fully in- vested in your securities portfolio, you are already hedged to the degree that your cash assets are not subject to direct security price risk (cash is subject to inflation risk, but this is another topic). The cash you have on reserve will allow you to purchase if and when the market falls. As such, I don’t believe that people holding a significant allocation of cash should think about hedging per se. Y ou may believe that the market is ready to fall, in which case, you can make a bearish bet on the level of the index using a long put, a short-call spread, or a short diagonal, but this is a proactive in- vestment that expresses your opinion about the level of the market vis-à-vis the state of the economy. What it does not specify is what you will spend the cash on. This is where an understanding of the value of the companies in your portfolio or on your watch list comes into play. If you had an extra 5 percent (or $50,000 or however you want to think about it) in cash, in what securities would you invest? Of course, the answer will change depending on the price of the securities vis-à-vis what you know to be a sensible valuation range because the expected returns on the investments will change with the market price. So this is the last step in a sensible hedging plan—having an idea of what companies you would want to invest in were you to have the extra capital and if you could be reasonably assured of a good return. Having a 258  •   The Intelligent Option Investor plan like this in place will allow you to size and time your hedges appropri- ately and will help you to make the most out of whatever temporary crisis might come your way. 2 Now that you have a good understanding of protective puts and hedging, let’s turn to the last overlay strategy—the collar. Collar Contingent Exposure Contingent Exposure Contingent Exposure GREEN LIGHT GREEN LIGHT ORANGE LIGHT RED ORANGE RED Downside: Irrelevant Upside: Undervalued Execute: Sell a call option on a stock or index that you own and on which you have a gain, and use the proceeds from the call sale to buy an OTM put Risk: Flexible, depending on selection of strikes Reward: Limited to level of sold call strike Margin: None because the long position in the hedged security serves as collateral for the sold call option, and the OTM put option is purchased, so it does not require margining Mixing Exposure  •  259 The Gist This structure is really much simpler and has a much more straightfor - ward investment purpose than it may seem when you look at the preceding diagram. When people talk about “taking profits” using a covered call, the collar is actually the strategy they should be using. Imagine that you bought a stock some time ago and have a nice unrealized gain on it. The stock is about where you think its likely fair value is, but you do not want to sell it for whatever reason (e.g., it is paying a nice dividend or you bought it less than a year ago and do not want to be taxed on short-term capital gains or whatever). Although you do not want to sell it, you would like to protect yourself from downside exposure. Y ou can do this cheaply using a collar. The collar is a covered call, which we have already discussed, whose income subsidizes the purchase of a protective put at some level that will allow you to keep some of the unre- alized gains on your securities position. The band labeled “Orange” on the diagram shows an unrealized gain (or, conversely, a potential unrealized loss). If you buy a put that is within this orange band or above, you will be guaranteed of making at least some realized profit on your original stock or index investment. Depending on how much you receive for the covered call and what strike you select for the protective put, this collar may rep- resent completely “free” downside protection or you might even be able to realize a net credit. Execution The execution of this strategy depends a great deal on personal prefer - ence and on the individual investor’s situation. For example, an investor can sell a short-tenor covered call and use those proceeds to buy a longer- tenor protective put. He or she can sell the covered call ATM and buy a protective put that is close to ATM; this means the maximum and mini- mum potential return on the previous security purchase is in a fairly tight band. Conversely, the investor might sell an OTM covered call and buy a protective put that is also OTM. This would lock in a wider range of guaranteed profits over the life of the option. 260  •   The Intelligent Option Investor I show a couple of examples below that give you the flavor of the possibilities of the collar strategy. With these examples, you can experi- ment yourself with a structure that fits your particular needs. Look on my website for a collar scenario calculator that will allow you to visualize the collar and understand the payoff structure given different conditions. For these examples, I am assuming that I bought Qualcomm stock at $55 per share. Qualcomm is now trading for $64.71—an unrealized gain of 17.7 percent. Collar 1: 169 Days to Expiration Strike Price ($) Bid (Ask) Price ($) Sold call 65.00 3.40 Purchased put 60.00 (2.14) Net credit $1.26 This collar yields the following best- and worst-case effective sell prices (ESPs) and corresponding returns (assuming a $55 buy price): ESP ($) Return (%) Best case 66.26 20.5 Worst case 61.26 11.4 Here we sold the $65-strike calls for $3.40 and used those proceeds to buy the $60-strike put options at $2.14. This gave us a net credit of $1.26, which we simply add to both strike prices to calculate our ESP . We add the net credit to the call strike because if the stock moves above the call strike, we will end up delivering the stock at the strike price while still keeping the net credit. We add the net credit to the put strike because if the stock closes below the put strike, we have the right to sell the shares at the strike price and still keep the net credit. The return numbers are calculated on the basis of a $55 purchase price and the ESPs listed. Thus, by setting up this collar in Mixing Exposure  •  261 this way, we have locked in a worst possible gain of 11.4 percent and a best possible gain of 20.5 percent for the next five and a half months. Let’s look at another collar with a different profit and loss profile: Collar 2: 78 Days to Expiration Strike Price ($) Bid (Ask) Price ($) Sold call 70 0.52 Purchased put 62.50 (1.55) Net debit (1.03) This collar yields the following best- and worst-case ESPs and corresponding returns (assuming a $55 buy price): ESP ($) Return (%) Best case 68.97 25.4 Worst case 61.47 11.8 This shows a shorter-tenor collar—about two and a half months be- fore expiration—that allows for more room for capital gains. This might be the strategy of a hedge fund manager who is long the stock and uncertain about the next quarterly earnings report. For his or her own business rea- sons, the manager does not want to show an unrealized loss in case Qual- comm’s report is not good, but he or she also doesn’t want to restrict the potential capital gains much either. Calculating the ESPs and the returns in the same way as described here, we get a guaranteed profit range from around 12 to over 25 percent. One thing to note as well is that the protection is provided by a put, and a put option can be sold any time before expiry to generate a cash inflow from time value. Let’s say then that when Qualcomm reports its quarterly earnings, the stock price drops to $61—a mild drop that the hedge fund manager considers a positive sign. Now that the manager is less worried about the downside exposure, he or she can sell the put for a profit. 262  •   The Intelligent Option Investor The cash inflow from selling the put for a profit may even change the net debit on the collar to a net credit, or the manager can use some of the cash flow to buy back the sold call option if he or she is worried about the upside being limited. These are just two examples, but they show the kind of flexibility that makes collars very useful investing instruments. With this chapter com- plete, you have all the tools required to be an intelligent option investor. Let’s finish with an important discussion—an investigation of risk and in- telligent option investing. This is the topic of Chapter 12. 263 Chapter 12 Risk and the intelligent OptiOn investOR The preceding 11 chapters have given you a great deal of information about the mechanics of option investing and stock valuation. In this last chapter, let’s look at a subject that I have mentioned throughout this book—risk— and see how an intelligent option investor conceives of it. There are many forms of risk—some of which we discussed earlier (e.g., the career risk of an investment business agent, solvency risk of a retiree looking to maintain a good quality of life, and liquidity risk of a parent needing to make a big payment for a child’s wedding). The two risks I discuss here are those that are most applicable to an owner of capital making potentially levered investments in complex, uncertain assets such as stocks. These two risks are market risk and valuation risk. Market Risk Market risk is unavoidable for anyone investing capital. Markets fluctuate, and in the short term, these fluctuations often have little to do with the long-term value of a given stock. Short term, it must be noted, is also relative. In words attributed to John Maynard Keynes, but which is more likely an anonymous aphorism, “The market can remain irrational longer than you can remain sol- vent. ” Indeed, it is this observation and my own painful experience of the truth of it that has brought me to my appreciation for in-the-money (ITM) options as a way to preserve my capital and cushion the blow of timing uncertainty. 264  •   The Intelligent Option Investor Market risk is a factor that investors in levered instruments must always keep in mind. Even an ITM call long-term equity anticipated security (LEAPS) in the summer of 2007 might have become a short-tenor out-of-the-money (OTM) call by the fall of 2008 after the Lehman shock because of the sharp decline in stock prices in the interim. Unexpected things can and do happen. A portfolio constructed oblivious to this fact is a dangerous thing. As long as market fluctuations only cause unrealized losses, market risk is manageable. But if a levered loss must be realized, either because of an option expiration or in order to fund another position, it has the poten- tial to materially reduce your available investment capital. Y ou cannot ma- terially reduce your investment capital too many times before running out. A Lehman shock is a worst-case scenario, and some investors live their entire lives without experiencing such severe and material market risk. In most cases, rather than representing a material threat, market risk represents a wonderful opportunity to an intelligent investor. Most human decision makers in the market are looking at either technical indicators—which are short term by nature—or some sort of multiple value (e.g., price-to-something ratio). These kinds of measures are wonderful for brokers because they encourage brokerage clients to make frequent trades and thus pay the brokerages frequent fees. The reaction of short-term traders is also wonderful for intelligent investors. This is so because a market reaction that might look sensible or rational to someone with an investment time horizon measured in days or months will often look completely ridiculous to an investor with a longer- term perspective. For example, let’s say that a company announces that its earnings will be lower next quarter because of a delay in the release of a new product. Investors who are estimating a short-term value for the stock based on an earnings multiple will sell the stock when they see that earn- ings will likely fall. Technical traders see that the stock has broken through some line of “resistance” or that one moving average has crossed another moving average, so they sell it as well. Perhaps an algorithmic trading engine recognizes the sharp drop and places a series of sell orders that are covered almost as soon as they are filled. In the meantime, someone who has held the stock for a while and has a gain on it gets protective of this gain and decides to buy a put option to protect his or her gains. Risk and the Intelligent Option Investor   • 265 For an intelligent option investor who has a long-term worst-case valuation that is now 20 percent higher than the market price, there is a wonderful opportunity to sell a put and receive a fat premium (with the possibility of owning the stock at an attractive discount to the likely fair value), sell a put and use the proceeds to buy an OTM call LEAPS, or sim- ply buy the stock to open a position. Indeed, this strategy is perfectly in keeping with the dictum, “Be fear- ful when others are greedy and greedy when others are fearful. ” This strat- egy is also perfectly reasonable but obviously rests on the ability of the investor to accurately estimate the actual intrinsic value of a stock. This brings us to the next form of risk—valuation risk. Valuation Risk Although valuation is not a difficult process, it is one that necessarily in- cludes unknowable elements. In our own best- and worst-case valuation methodology, we have allowed for these unknowns by focusing on plausi- ble ranges rather than precise point estimates. Of course, our best- or worst- case estimates might be wrong. This could be due to our misunderstanding of the economic dynamics of the business in which we have invested or may even come about because of the way we originally framed the problem. Thinking back to how we defined our ranges, recall that we were focusing on one-standard-deviation probabilities—in other words, scenarios that might plausibly be expected to materialize two times out of three. Obvi- ously, even if we understand the dynamics of the business very well, one time out of three, our valuation process will generate a fair value range that is, in fact, materially different from the actual intrinsic value of the stock. In contrast to market risk, which most often is a nonmaterial and tem- porary issue, misestimating the fair value of a stock represents a material risk to capital, whether our valuation range is too low or too high. If we esti- mate a valuation range that is too low, we are likely to end up not allocating enough capital to the investment or using inappropriately light leverage. This means that we will have missed the opportunity to generate as much return on this investment as we may have. If we estimate a valuation range that is too high, we are likely to end up allocating too much capital to the 266  •   The Intelligent Option Investor investment or using inappropriately high leverage. In the best case, we allo- cate too much capital to an idea that generates low returns when we might have allocated it to a higher-return investment. In the worst case, we suffer a loss of capital when the market price falls and we realize that our original estimates were overly optimistic. One of the best ways to protect against valuation risk is to invest in only the most compelling, most clearly mispriced securities. A friend who worked for years advising companies on mergers and acquisitions has a wonderful way of visualizing valuation risk that I have found particularly helpful. 1 In his conception, a company’s stock price can be represented by layers. At the bottom layer is the value of the company’s net assets if they were all sold today. The next layer assumes that, for instance, the company will cease to exist as a going concern after 10 years and will sell its net assets then. The next layer assumes that, for instance, the company exists perpetually as a going concern, but its free cash flow to owner(s) (FCFO) doesn’t grow again. On and on, each layer represents a more aggressive assumption about the growth of its cash flows until we are assuming, for instance, that the company’s FCFO will grow at an average of 50 percent per year for the next 15 years and then 6 percent for every year after that in perpetuity. We can visualize this in the following graphic: Value of cash flows growing at 50 percent per year for 15 years and then at 6 percent per year after that—$52 per share. Value of cash flows growing at 20 percent per year for 15 years and then at 6 percent per year after that—$27/share. Value of cash flows not growing but continuing on into perpetuity—$9 per share. Value of cash flows not growing and lasting 20 years—$7 per share. Market value of hard assets—$2 to $4 per share. Risk and the Intelligent Option Investor   • 267 Let’s assume that the present market value of the shares is $16 per share. This share price assumes a growth in FCFO of 8 percent per year for the next 5 years and 5 percent per year in perpetuity after that—roughly equal to what we consider our most likely operational performance scenario. We see the possibility of faster growth but realize that this faster growth is unlikely—the valuation layer associated with this faster growth is the $18 to $20 level. We also see the possibility of a slowdown, and the valuation layer associated with this worst-case growth rate is the $11 to $13 level. Now let’s assume that because of some market shock, the price of the shares falls to the $10 range. At the same time, let’s assume that the likely economic scenario, even after the stock price fall, is still the same as before— most likely around $16 per share; the best case is $20 per share, and the worst case is $11 per share. Let’s also say that you can sell a put option, struck at $10, for $1 per share—giving you an effective buy price of $9 per share. In this instance, the valuation risk is indeed small as long as we are correct about the relative levels of our valuation layers. Certainly, in this type of scenario, it is easier to commit capital to your investment idea than it would be, say, to sell puts struck at $16 for $0.75 per share! Thinking of stock prices in this way, it is clear that when the market price of a stock is within a valuation layer that implies unrealistic economic assumptions, you will more than likely be able to use a combination of stocks and options to tilt the balance of risk and reward in your own favor—the very definition of intelligent option investing. Intelligent Option Investing In my experience, most stocks are mostly fairly priced most of the time. There may be scenarios at one tail or the other that might be inappropriately priced by the option market (and, by extension, by the stock market), but by and large, it is difficult to find profoundly mispriced assets—an asset whose market price is significantly different from its most likely valuation layer. Opportunities tend to be most compelling when the short-term pic- ture is the most uncertain. Short-term uncertainties make investing boldly 268  •   The Intelligent Option Investor a psychologically difficult process, but indeed, it is those times that make the difference between a successful investor and an investor who nurtures many regrets. In the end, an intelligent option investor is not one who has a much better knowledge of some sector, industry, or even company. It is not the investor who takes the biggest risks in the hope of realizing the biggest return. It is not the investor who attempts always to be the investing “hero” and make the most complex, theoretically beautiful, laboriously researched argument to justify an investment. Rather, the intelligent op- tion investor is the one who has a sound, repeatable process for estimat- ing the value of stocks, an understanding of the pitfalls that can limit an investor’s potential, and a firm understanding of the tools that can be used to invest. It is the investor who understands the limits to his or her own expertise but who also understands that market risk does not equal valuation risk and has the courage to act boldly when the two deviate the most. In short, the intelligent option investor is you. 269 Appendix A Choose Your Battles WiselY I discuss specific option investment strategies in great detail in Part III of this book. However, after reading Chapters 2 and 3, you should have a good understanding of how options are priced, so it is a good time to see in what circumstances the Black-Scholes-Merton model (BSM) works best and where it works worst. An intelligent investor looks to avoid the condi- tions where the BSM works best like the plague and seek out the conditions where it works worst because those cases offer the best opportunities to tilt the risk-reward balance in the investor’s favor. Jargon introduced in this appendix includes Front month Fungible Idiosyncratic assets Where the BSM Works Best The following are the situations in which the BSM works best and are the conditions you should most avoid: 1. Short investment time horizons 2. Fungible investment assets 270  •   The Intelligent Option Investor Short Investment Time Horizons When the scholars developing the BSM were researching financial markets for the purpose of developing their model, the longest-tenor options had expirations only a few months distant. Most market partic- ipants tended to trade in the front-month contracts (i.e., the contracts that will expire first), as is still mainly the case. Indeed, thinking back to our preceding discussion about price randomness, over short time horizons, it is very difficult to prove that asset price movements are not random. As such, the BSM is almost custom designed to handle short time horizons well. Perhaps not unsurprisingly, agents 1 are happy to encourage clients to trade options with short tenors because 1. It gives them more opportunities per year to receive fees and com- missions from their clients. 2. They are mainly interested in reliably generating income on the basis of the bid-ask spread, and bid-ask spreads differ on the basis of liquidity, not time to expiration. 3. Shorter time frames offer fewer chances for unexpected price movements in the underlying that the market makers have a hard time hedging. In essence, a good option market maker is akin to a used car sales- man. He knows that he can buy at a low price and sell at a high one, so his main interest is in getting as many customers to transact as possible. With this perspective, the market maker is happy to use the BSM, which seems to give reasonable enough option valuations over the time period about which he most cares. In the case of short-term option valuations, the theory describes reality accurately enough, and structural forces (such as wide bid-ask spreads) make it hard to exploit mispricings if and when they occur. To see an example of this, let’s take a look at what the BSM assumes is a reasonable range of prices for a company with assumed 20 percent volatility over a period of 30 days. Appendix A: Choose Your Battles Wisely   • 271 10 - 20 30 40 50 60 70 The range of prices implied over the next 30 days goes from around $47 per share to around $53 per share. If we translate what the BSM con- siders the reasonable range into percentage terms, it works out to a loss or gain of around 6 percent. Just thinking about this in terms of one’s personal experience for a moment, this is actually not a bad guess for a range for a large-capitalization firm (the forward volatility assumption of 20 percent is consistent with a large-cap firm’s “typical” implied volatility). I certainly would have no confidence in trying to guess the upper and lower stock price boundaries any better than the BSM on such a short time frame. It is funny, then, that most investors insist on speculating in options on a short-term basis—usually at tenors of a month or shorter. Again, these seem like the kinds of bets you might get betting on red at a roulette wheel in Vegas. Sure, it makes one feel like James Bond the 50 percent of the time that the marble falls on red, but anyone who is the least bit thoughtful would, after a time, step back and wonder how far ahead he or she is getting by playing such a game. 2 272  •   The Intelligent Option Investor It is important to realize that the fact that options are usually efficiently priced in the short term does not prevent us from transacting in short-tenor options. In fact, some strategies discussed in Part III are actually more attractive when an investor uses shorter-tenor options or combines short- and long-tenor options into a single strategy. Hopefully, the distinction between avoiding short-tenor option strategies and making long-term investments in short-tenor options is clear after reading through Part III. Fungible Underlying Assets Again, returning for a moment to the foundation of the BSM, the scholars built their mathematical models by studying short-term agricultural commodity markets. A commodity is, by definition, a fungible or interchangeable asset; one bushel of corn of a certain quality rating is completely indistinguishable from any other bushel of corn of the same quality rating. Stocks, on the other hand, are idiosyncratic assets. They are intangible markers of value for incredibly complex systems called companies, no two of which is exactly alike (e.g., GM and Ford—the pair that illustrates the idea of “paired” investments in many people’s minds—are both American car companies, but as operating entities, they have some significant differ- ences. For example, GM has a much larger presence in China and has a different capital and governance structure since going bankrupt than Ford, which avoided bankruptcy during the mortgage crisis). The academics who built the BSM were not hesitant to apply a model that would value idiosyncratic assets such as stocks because they had as- sumed from the start that financial markets are efficient—meaning that every idiosyncratic feature for a given stock was already fully “priced in” by the market. This allowed them to overlook the complexity of individual companies and treat them as interchangeable, homogeneous entities. The BSM, then, did not value idiosyncratic, multidimensional companies; rather, it valued single-dimensional entities that the scholars assumed had already been “standardized” or commoditized in some sense by the communal wisdom of the markets. Y ou will see in the next sec- tion that the broad, implicit assumption by option market participants that markets are efficient actually brings about the greatest opportunity Appendix A: Choose Your Battles Wisely   • 273 to derive low-risk profits for intelligent investors. The point I make here is simply how difficult it is to invest in options on commodities or in fact any asset that you cannot analyze using fundamental valuation techniques. For investors who simply cannot resist making commodity investments, I offer the following case study: I personally believe that climate change will make it harder for the world to feed its burgeoning population. Among exchange-traded funds (ETFs), futures, and options, it is very easy these days to express an investment opinion on such a belief, and I have done just that— put my money where my mouth is. While I have made such investments, I must admit that I have absolutely no basis for my valuation of the agricul- tural commodities in question and have no way to know if I have received my bullish exposure to these commodities at a reasonable or unreasonable price. Such speculative investments satisfy some psychological need, but they are not investments in the strict “intelligent investor” sense because it is very hard to rationally calculate a fair value for the asset. Should these types of investments not be made, then? A strict adherent to rational investment principles might say, “No, they should not be. ” However, considering the irrational ways people find to spend money, it would seem that we have been somehow hardwired to do things in a way that an economist would not consider totally rational. Rather than fight that primitive urge, I prefer to give into it—but only with very small parts of my portfolio. This strategy is akin to taking only $50 to the casino floor and promising that once that money is gone, you won’t spend any more. Y ou may have a gut feeling about the price of oil, the level of interest rates, the price of cotton, or whatever. Do yourself a favor, and if you chose to make a financial bet on the basis of your hunch, do as I do and make it a small one. While a small investment means different things to differ - ent people, a good way to judge is to imagine the capital being completely gone. If you have heart palpitations at that thought, keep cutting the pro- spective investment in half until you feel better. Where the BSM Works Worst Now that we know where not to look for intelligent option investments, let’s look at conditions in which the BSM works worst—these are the best places for us to tilt the balance of risk and return in our favor. 274  •   The Intelligent Option Investor 1. Grossly mispriced assets 2. Bimodal outcomes 3. Long investment time horizons Grossly Mispriced Assets The main assumption of the BSM is that there are no grossly mispriced as- sets. I believe that this contention is wrong on the basis of behavioral and structural factors that are covered briefly in Part II of this book but would require another book to fully cover. Just imagine, though, that, for some reason, a stock is dramatically undervalued. For right now, I will not discuss why this situation could come about, but let’s say that rather than being worth $50 per share, a company is worth, best case, closer to $110 per share and, worst case, $70 per share. Let’s further say that we had some sort of a hazy crystal ball that would give us a very high degree of certainty that these best- and worst-case values represent the real future range of values. Here is what a diagram of that situation would look like: 5/18/2012 10 20 30 40 50 60 70 80 90 100 110 120 5/20/2013 249 499 749 999 Date/Day Count Advanced Building Corp. (ABC) Stock Price Best Case, 110 Worst Case, 70 - Now look at the following diagrams of a put and a call option and, based on what you know about the way the BSM prices options, think about the answers to the following questions. Appendix A: Choose Your Battles Wisely   • 275 5/18/2012 10 20 30 40 50 60 70 80 90 100 110 120 5/20/2013 249 499 749 999 Date/Day Count Advanced Building Corp. (ABC) Stock Price - GREEN Put option If someone were worried about this stock’s downside potential below $50, what would likely be the price that investor would pay to buy this put option? a. Almost nothing b. A little c. A good bit 5/18/2012 10 20 30 40 50 60 70 80 90 100 110 120 5/20/2013 249 499 749 999 Date/Day Count Advanced Building Corp. (ABC) Stock Price - RED Call option 276  •   The Intelligent Option Investor If someone wanted to make extra income by selling calls to accept expo- sure to the stock’s upside, what price would they likely charge for someone wanting to buy this call option? a. Almost nothing b. A little c. A good bit Obviously, the correct answer to the put option question is c. This option would be pretty expensive because its range of exposure overlaps with so much of the BSM cone. Conversely, the answer to the call option question is a. This option would be really cheap because its range of exposure is well above the BSM cone. Remember, though, that we have our crystal ball, and we know that this stock will likely be somewhere between $70 and $110 per share in a few years. With this confidence, wouldn’t it make sense to take the opposite side of both the preceding trades? Doing so would look like this: 5/18/2012 10 20 30 40 50 60 70 80 90 100 110 120 5/20/2013 249 499 749 999 Date/Day Count Advanced Building Corp. (ABC) Stock Price Best Case, 110 Worst Case, 70 - GREEN RED In this investment, which I explain in detail in Chapter 11, we are receiving a good bit of money by selling an expensive put and paying Appendix A: Choose Your Battles Wisely   • 277 very little money to buy a cheap call. It may happen that the money we receive for selling the put actually may be greater than the money we pay for the call, so we actually get paid a net fee when we make this transaction! We can sell the put confidently because we know that our worst-case valuation is $70 per share; as long as we are confident in our valuation—a topic covered in Part II of this book—we need not worry about the price declining. We do not mind spending money on the call because we think that the chance is very good that at expiration or before the call will be worth much, much more than we paid for it. Truly, the realization that the BSM is pricing options on inefficiently priced stocks as if they were efficiently priced is the most profound and compelling source of profits for intelligent investors. Furthermore, finding grossly mispriced stocks and exploiting the mispricing using options rep- resents the most compelling method for tilting the risk-reward equation in our direction. The wonderful thing about investing is that it does not require you to swing at all the pitches. Individual investors have a great advantage in that they may swing at only the pitches they know they can hit. The process of intelligent investing is simply one of finding the right pitches, and intel- ligent option investing simply uses an extremely powerful bat to hit that sweet pitch. Bimodal Outcomes Some companies are speculative by nature—for instance, a drug company doing cancer research. The company has nothing but some intangible as- sets (the ideas of the scientists working there) and a great deal of costs (the salaries going to those scientists, the payments going to patent attor - neys, and the considerable costs of paying for clinical trials). If the research proves fruitful, the company’s value is great—let’s say $500 per share. If the clinical trials show low efficacy or dangerous side effects, however, the company’s worth goes to virtually nil. What’s more, it may take years before it is clear which of these alternatives is true. 278  •   The Intelligent Option Investor Given what you know about the BSM, does this seem like the kind of situation conducive to accurate option pricing? This example certainly does not sound like the pricing scenario of a short-term agricultural commodity, after all. If this hypothetical drug company’s stock price was sitting at $50 per share, what is the value of the upper range the option market might be pricing in? Let’s assume that this stock is trading with a forward volatility of 100 percent per year (on the day I am writing this, there are only four stocks with options trading at a price that implies a forward volatility of greater than 100 percent). What price range does this 100 percent per year volatility imply, and can we design an option structure that would allow us to profit from a big move in either direction? Here is a diagram of this situation: 5/18/2012 - 500 50 100 150 200 250 300 350 400 450 5/20/2013 249 499 Date/Day Count Advanced Biotechnology Co. (ABC) Stock Price 749 999 GREEN GREEN Indeed, even boosting volatility assumptions to a very high level, it seems that we can still afford to gain exposure to both the upside and downside of this stock at a very reasonable price. Y ou can see from the pre- ceding diagram that both regions of exposure on the put side and the call side are outside the BSM cone, meaning that they will be relatively cheap. The options market is trying to boost the price of the options enough so that the calls and puts are fairly priced, but for various reasons (including behavioral biases), most of the time it fails miserably. Appendix A: Choose Your Battles Wisely   • 279 Long Investment Time Horizons This is simply a corollary to the rule that the BSM is generally good at pricing short-time-horizon investments. The BSM is built on the prem- ise that stocks will only rise by as much as the risk-free rate. If you ask a finance professor or a market maker, he or she will be able to give you an elegant and logically consistent reason why this must be so. However, as you saw in Chapter 3, this situation has never been so— the return on stocks is sometimes negative but often much more positive than risk-free bonds. If we average the returns out, stocks still generate returns that are heads and shoulders above bonds. Over short time horizons, the difference simply isn’t material. For in- stance, let’s say that we assume that a given stock should generate around 10 percent compound annual returns over the next three to five years com- pared with a 5 percent assumption for the risk-free rate. If we are looking at very short time horizons—such as 60 days—and assume that our stock will grow at exactly that 10 percent rate over that short time, then we should compare our expectations with those of the option market. Here is the dia- gram we would get: Advanced Building Corp. (ABC) 30 20 40 50 60 70 60 days 80Stock Price 280  •   The Intelligent Option Investor Clearly, there is not much of a difference between the BSM expected value (shown by the dotted line) and the dot representing a 10 percent upward drift in the stock. However, if we extend this analysis out for three years, look what happens: 5/18/2012 5/20/2013 249 499 Date/Day Count Advanced Building Corp. (ABC) 749 999 20 30 40 50 60 70Stock Price 80 With the longer time horizon, our assumed stock price is significantly higher than what the BSM calculates as its expected price. If we take “assumed future stock price” to mean the price at which we think there is an equal chance that the true stock price will be above or below that mark, we can see that the difference, marked by the double-headed arrow in the preceding diagram, is the advantage we have over the option market. 3 This advantage again means that downside exposure will be overvalued and upside exposure will be undervalued. How, you may ask, can this discrepancy persist? Shouldn’t someone figure out that these options are priced wrong and take advantage of an arbitrage opportunity? The two reasons why these types of opportunities tend to persist are 1. Most people active in the option market are trading on a very short-term basis. Long-term equity anticipated securities (LEAPS)—options with tenors of a year or more—do exist, but Appendix A: Choose Your Battles Wisely   • 281 generally the volumes are light because the people in the option markets generally are not willing to wait longer than 60 days for their “investment” to work out. Because the time to expiration for most option contracts is so short, the difference between the BSM’s expected price based on a 5 percent risk-free rate and an expected price based on a 10 percent equity return is small, so no one real- izes that it’s there (as seen on the first diagram). 2. The market makers are generally able to hedge out what little ex- posure they have to the price appreciation of LEAPS. They don’t care about the price of the underlying security, only about the size of the bid-ask spread, and they always price the bid-ask spread on LEAPS in as advantageous a way as they can. Also, the career of an equity option trader on the desk of a broker-dealer can change a great deal in a single year. As discussed in Part II, market makers are not incentivized in such a way that they would ever care what happened over the life of a LEAPS. Congratulations. After reading Part I of this book and this appendix, you have a better understanding of the implications of option investing for fundamental investors than most people working on Wall Street. There are many more nuances to options that I discuss in Part III of this book—especially regarding leverage and the sensitivity of options to input changes—but for now, simply understanding how the BSM works puts you at a great advantage over other market participants. 282 Appendix B THe MAny FAceS OF LeverAGe An intelligent option investor must understand investing leverage in order to make sense of option investing strategies. Investing leverage is, however, not the only form of leverage, and to have a well-rounded and well-educated view of investing leverage, you should understand the other forms as well. In addition, when assessing the value of companies, it is im- portant to understand leverage because leverage often is the root cause of rapid changes in profitability during times of changing consumer demand such as inflection points in the business cycle. Operational Leverage Operational leverage is the acceptance of fixed operating costs in order to make a higher per-unit profit, such as when a company decides to build a factory rather than contracting for its products to be made by a third party. When a company spends cash to build a factory, that expenditure is not treated as an immediate cost on the income statement. Rather, the cost of the new factory is spread over future periods as the noncash expense known as depreciation. 1 Let us take a look at two companies, both of which produce the same items, but one of which outsources production to a third party (Unlevered Co.) and the other of which has built a factory to manufacture its products Appendix B: The Many Faces of Leverage  • 283 (Levered Co.). In reality, there are methods used by companies to front- load depreciation expenses in order to minimize taxable income for new projects, but let’s assume that Levered Co. is using what is called straight- line depreciation so that the charge is identical each quarter. Unlevered Co. Levered Co. Revenues 100.0 100.0 Fixed depreciation expense 0.0 −65.0 Variable operating expenses −85.0 −15.0 Operating profit 15.0 20.0 Pretax profit 15.0 20.0 Tax −4.5 −6.0 Net profit 10.5 14.0 As you can see here, Levered Co. ’s profits are a bit better than those of Unlevered Co. because the former is not paying a supplier and can produce the items at a lower cost. Note also that both companies have variable costs. For Unlevered Co., these variable costs include the costs of the items it has produced by the third party plus whatever salaries it has to pay to salespeople and administrative staff; for Levered Co., vari- able costs include the costs of raw materials plus the cost of any salaries paid to production, sales, and administrative staff. This is our base case— representing midcycle economic conditions (i.e., not boom or not bust). Now let’s look at the two companies during a trough in the business cycle—or bust conditions. Unlevered Co. Levered Co. Revenues 70.0 70.0 Fixed depreciation expense 0.0 −65.0 Variable operating expenses −59.5 −10.5 Operating profit 10.5 −5.5 Pretax profit 10.5 −5.5 Tax −3.2 +1.6 Net profit 7.3 −3.9 284  •   The Intelligent Option Investor Costs at Unlevered Co. decrease proportionally to the decrease in revenues, so the operating profit margin is the same in its case. However, for Levered Co., even though the variable costs decrease proportionally to the decrease in revenues, the cost of depreciation stays fixed, causing a loss that is only slightly ameliorated through a small tax benefit. Thus, obviously, in business-cycle trough conditions, profitability is hurt through the assumption of operational leverage. Let’s take a look at what happens to both companies in peak conditions. 2 Unlevered Co. Levered Co. Revenues 130.0 130.0 Fixed depreciation expense 0.0 −65.0 Variable operating expenses −110.5 −19.5 Operating profit 19.5 45.5 Pretax profit 19.5 45.5 Tax −5.9 −13.6 Net profit 13.6 31.9 Obviously, having the operational leverage during peak times is a wonderful thing. After the fixed-cost hurdle of depreciation is cleared, each extra widget produced allows the company to generate profits that are gov- erned solely by variable costs. Unlevered Co. is in a better position when there is a downturn, but its profitability falls behind Levered Co. ’s more and more the better economic conditions are. When thinking about the valuation of companies, we must remember what a large effect operational leverage can have on operations. Financial markets usually underestimate the effects of operational leverage both when the business cycle is at its peak and when it is at its trough. At the peak, analysts are wont to extrapolate high margins out forever and ignore the possibility that the sword of leverage swings both ways. At the trough, analysts are overly pessimistic and forget that a small improvement in de- mand can have a very large impact on financial results. Operational leverage is neither good nor bad—it is merely a strategic busi- ness choice that has different implications during different parts of the business cycle and under different revenue conditions. An intelligent investor under- stands this fact and is happy to invest when the rest of the market has forgotten it. Financial Leverage Financial leverage involves the acceptance of fixed financial costs such as a loan or a lease contract to fund a business. Considering the expense of building factories, usually operational and financial leverage occur simultaneously, but to understand financial leverage itself, let’s look at two companies that, other than the amount of debt on their balance sheets, are exactly the same in terms of revenues and profit margin. Our base case shows that the unlevered company will generate a higher absolute profit because it does not have the fixed financing costs. Unlevered Co. Levered Co. Revenues 100.0 100.0 Operating expenses −80.0 −80.0 Operating profit 20.0 20.0 Interest expense 0.0 −15.0 Pretax profit 20.0 5.0 Tax −6.0 −1.5 Net profit 14.0 3.5 Now let’s increase revenues for both companies by 50 percent and see what happens. Unlevered Co. Levered Co. Revenues 150.0 150.0 Operating expenses −120.0 −120.0 Operating profit 30.0 30.0 Interest expense 0.0 −15.0 Pretax profit 30.0 15.0 Tax −9.0 −4.5 Net profit 21.0 11.5 The absolute profit is still higher for the unlevered company, but the percentage change from the first case to the second shows a big difference. The unlevered company’s profits increased by 50 percent (from 14.0 to 21.0) with a 50 percent rise in revenues. However, the levered company’s profits increased by a whopping 229 percent (from 3.5 to 11.5) with the same 50 percent rise in revenues. Appendix B: The Many Faces of Leverage  • 285 286  •   The Intelligent Option Investor Here we see an example of a defining characteristic of financial and investment leverage; that is, these sorts of leverage affect percentage calcu- lations, but in absolute terms, unlevered transactions always generate more for a fixed level of exposure. We explore this concept in great detail when we discuss investment leverage in Chapter 8. To see the dangerous side of leverage’s double-edged sword, let’s look at a case where revenues drop 50 percent from the original baseline. Unlevered Co. Levered Co. Revenues 50.0 50.0 Operating expenses −40.0 −40.0 Operating profit 10.0 10.0 Interest expense 0.0 −15.0 Pretax profit 10.0 −5.0 Tax −3.0 +1.5 Net profit 7.0 −3.5 Here we see that even with the tax benefit for the levered company, it is still running at a loss because of the fixed financial costs, whereas the unlevered company is still realizing a gain. In a worst-case scenario, fixed financial costs can exceed the cash coming into the business, leading to debt default and, depending on the situation, bankruptcy. Thinking about the best and worst cases from an investment perspec- tive for a moment, you can see why some equity investors actually prefer a highly levered firm: the higher the leverage, the greater is the incremental profit for equity holders when times are good. For a levered company that is in transition from bad to good—whether due to an upturn in economic conditions during a business cycle or a company-specific issue such as the introduction of a new product line boosting a flagging legacy business— a small improvement in business conditions creates a big improvement in profits available to shareholders. The flip side is that when business conditions turn downward—a transition from good to bad—a levered company’s fall from profitability to loss is sudden, and its stock price fall can be even worse. The fact is that just in the case of operational lever - age, financial leverage is not good or bad—it is simply a strategic business choice that has different implications in different situations. 287 Appendix c PUT-cALL PArITy Before the Black-Scholes-Merton model (BSM), there was no way to directly calculate the value of an option, but there was a way to triangulate put and call prices as long as one had three pieces of data: 1. The stock’s price 2. The risk-free rate 3. The price of a call option to figure the fair price of the put, and vice versa In other words, if you know the price of either the put or a call, as long as you know the stock price and the risk-free rate, you can work out the price of the other option. These four prices are all related by a specific rule termed put-call parity. Put-call parity is only applicable to European options, so it is not ter- ribly important to stock option investors most of the time. The one time it becomes useful is when thinking about whether to exercise early in order to receive a stock dividend—and that discussion is a bit more technical. I’ll delve into those technical details in a moment, but first, let’s look at the big picture. Using the intelligent option investor’s graphic format employed in this book, the big picture is laughably trivial. Direct your attention to the following diagrams. What is the differ - ence between the two? 288  •   The Intelligent Option Investor - 20 5/18/2012 5/20/2013 40 60 80 100 120Stock Price 140 160 180 200 - 20 5/18/2012 5/20/2013 40 60 80 100 120Stock Price 140 160 180 200 GREENGREEN REDRED If you say, “Nothing, ” you are practically right but technically wrong. The image on the left is actually the risk-reward profile of a pur - chased call option struck at $50 paired with a sold put option struck at $50. The image on the right is the risk-reward profile of a stock trading at $50 per share. This simple comparison is the essence of put-call parity. The parity part of put-call parity just means that accepting downside exposure by sell- ing a put while gaining upside exposure by buying a call is basically the same thing as accepting downside exposure and gaining upside exposure by buying a stock. What did I say? It is laughably trivial. Now let’s delve into the details of how the put-call parity relationship can be used to help decide whether to exercise a call option or not (or whether the call option you sold is likely to be exercised or not). Dividend Arbitrage and Put-call Parity Any time you see the word arbitrage , the first thing that should jump to mind is “small differences. ” Arbitrage is the science of observing small dif- ferences between two prices that should be the same (e.g., the price of IBM Appendix C: Put-Call Parity   • 289 traded on the New Y ork Stock Exchange and the price of IBM traded in Philadelphia) but are not. An arbitrageur, once he or she spots the small difference, sells the more expensive thing and buys the less expensive one and makes a profit without accepting any risk. Because we are going to investigate dividend arbitrage, even a big- picture guy like me has to get down in the weeds because the differences we are going to try to spot are small ones. The weeds into which we are wading are mathematical ones, I’m afraid, but never fear—we’ll use nothing more than a little algebra. We’ll use these variables in our discussion: K = strike price C K = call option struck at K PK = put option struck at K Int = interest on a risk-free instrument Div = dividend payment S = stock price Because we are talking about arbitrage, it makes sense that we are going to look at two things, the value of which should be the same. We are going to take a detailed look at the preceding image, which means that we are going to compare a position composed of options with a position composed of stock. Let’s say that the stock at which we were looking to build a position is trading at $50 per share and that options on this stock expire in exactly one year. Further, let’s say that this stock is expected to yield $0.25 in dividends and that the company will pay these dividends the same day that the op- tions expire. Let’s compare the two positions in the same way as we did in the preceding big-picture image. As we saw in that image, a long call and a short put are the same as a stock. Mathematically, we would express this as follows: C K − PK = SK Although this is simple and we agreed that it’s about right, it is not technically so. The preceding equation is not technically right because we know that a stock is an unlevered instrument and that options are levered ones. In the 290  •   The Intelligent Option Investor preceding equation, we can see that the left side of the equation is levered (because it contains only options, and options are levered instruments), and the right side is unlevered. Obviously, then, the two cannot be exactly the same. We can fix this problem by delevering the left side of the preceding equation. Any time we sell a put option, we have to place cash in a mar - gin account with our broker. Recall that a short put that is fully margined is an unlevered instrument, so margining the short put should delever the entire option position. Let’s add a margin account to the left side and put $K in it: C K − PK + K = S This equation simply says that if you sell a put struck at K and put $K worth of margin behind it while buying a call option, you’ll have the same risk, return, and leverage profile as if you bought a stock—just as in our big-picture diagram. But this is not quite right if one is dealing with small differences. First, let’s say that you talk your broker into funding the margin ac- count using a risk-free bond fund that will pay some fixed amount of interest over the next year. To fund the margin account, you tell your broker you will buy enough of the bond account that one year from now, when the put expires, the margin account’s value will be exactly the same as the strike price. In this way, even by placing an amount less than the strike price in your margin account originally, you will be able to fulfill the commitment to buy the stock at the strike price if the put expires in the money (ITM). The amount that will be placed in margin originally will be the strike price less the amount of interest you will receive from the risk-free bond. In mathematical terms, the preceding equation becomes C K − PK + (K – Int) = S Now all is right with the world. For a non-dividend-paying stock, this fully expresses the technical definition of put-call parity. However, because we are talking about dividend arbitrage, we have to think about how to adjust our equation to include dividends. We know that a call option on a dividend-paying stock is worth less because the dividend Appendix C: Put-Call Parity   • 291 acts as a “negative drift” term in the BSM. When a dividend is paid, theory says that the stock price should drop by the amount of the dividend. Be- cause a drop in price is bad for the holder of a call option, the price of a call option is cheaper by the amount of the expected dividend. Thus, for a dividend-paying stock, to establish an option-based position that has exactly the same characteristics as a stock portfolio, we have to keep the expected amount of the dividend in our margin account. 1 This money placed into the option position will make up for the dividend that will be paid to the stock holder. Here is how this would look in our equation: C K − PK + (K − Int) + Div = S With the dividend payment included, our equation is complete. Now it is time for some algebra. Let’s rearrange the preceding equa- tion to see what the call option should be worth: CK = PK + Int − Div + (S − K) Taking a look at this, do you notice last term (S – K )? A stock’s price minus the strike price of a call is the intrinsic value. And we know that the value of a call option consists of intrinsic value and time value. This means that /dncurlybracketleft/dncurlybracketmid/horizcurlybracketext/horizcurlybracketext/dncurlybracketright/horizcurlybracketext/horizcurlybracketext/dncurlybracketleft/dncurlybracketmid/dncurlybracketright=+ −−CP SKKK IntD iv + () Time valueI ntrinsic value So now let’s say that time passes and at the end of the year, the stock is trading at $70—deep ITM for our $50-strike call option. On the day before expiration, the time value will be very close to zero as long as the op- tion is deep ITM. Building on the preceding equation, we can put the rule about the time value of a deep ITM option in the following mathematical equation: P K + Int − Div ≈ 0 If the time value ever falls below 0, the value of the call would trade for less than the intrinsic value. Of course, no one would want to hold an option that has negative time value. In mathematical terms, that scenario would look like this: P K + Int − Div < 0 292  •   The Intelligent Option Investor From this equation, it follows that if PK + Int < Div your call option has a negative implied time value, and you should sell the option in order to collect the dividend. This is what is meant by dividend arbitrage . But it is hard to get the flavor for this without seeing a real-life example of it. The following table shows the closing prices for Oracle’s stock and options on January 9, 2014, when they closed at $37.72. The options had an expiration of 373 days in the future—as close as I could find to one year—the one-year risk-free rate was 0.14 percent, and the company was expected to pay $0.24 worth of dividends before the options expired. Calls Puts Bid Ask Delta Strike Bid Ask Delta 19.55 19.85 0.94 18 0.08 0.13 −0.02 17.60 17.80 0.94 20 0.13 0.15 −0.03 14.65 14.85 0.92 23 0.25 0.28 −0.05 12.75 12.95 0.91 25 0.36 0.39 −0.07 10.00 10.25 0.86 28 0.66 0.69 −0.12 8.30 8.60 0.81 30 0.97 1.00 −0.17 6.70 6.95 0.76 32 1.40 1.43 −0.23 4.70 4.80 0.65 35 2.33 2.37 −0.34 3.55 3.65 0.56 37 3.15 3.25 −0.43 2.22 2.26 0.42 40 4.80 4.90 −0.57 1.55 1.59 0.33 42 6.15 6.25 −0.65 0.87 0.90 0.22 45 8.25 8.65 −0.75 0.31 0.34 0.10 50 12.65 13.05 −0.87 In the theoretical option portfolio, we are short a put, so its value to us is the amount we would have to pay if we tried to flatten the position by buying it back—the ask price. Conversely, we are long a call, so its value to us is the price we could sell it for—the bid price. Let’s use these data to figure out which calls we might want to exercise early if a dividend payment was coming up. Appendix C: Put-Call Parity   • 293 Strike Call Put (a) Interest2 (b) Put + Interest (a + b) Dividend P + I − D Notes 18 19.55 0.13 0.03 0.16 0.24 (0.08) P + I < D, arbitrage 20 17.60 0.15 0.03 0.18 0.24 (0.06) P + I < D, arbitrage 23 14.65 0.28 0.03 0.31 0.24 0.07 No arbitrage 25 12.75 0.39 0.04 0.43 0.24 0.19 No arbitrage 28 10.00 0.69 0.04 0.73 0.24 0.49 No arbitrage 30 8.30 1.00 0.04 1.04 0.24 0.80 No arbitrage 32 6.70 1.43 0.05 1.48 0.24 1.24 No arbitrage 35 4.70 2.37 0.05 2.42 0.24 2.18 No arbitrage 37 3.55 3.25 0.05 3.30 0.24 3.06 No arbitrage 40 2.22 4.90 0.06 4.96 0.24 4.72 No arbitrage 42 1.55 6.25 0.06 6.31 0.24 6.07 No arbitrage 45 0.87 8.65 0.06 8.71 0.24 8.47 No arbitrage 50 0.31 13.05 0.07 13.12 0.24 12.88 No arbitrage There are only two strikes that might be arbitraged for the dividends—the two furthest ITM call options. In order to realize the arbitrage opportunity, you would wait until the day before the ex-dividend date, exercise the stock option, receive the dividend, and, if you didn’t want to keep holding the stock, sell it and realize the profit. This page intentionally left blank 295 Notes Introduction 1. Options, Futures, and Other Derivatives by John C. Hull (New Y ork: Prentice Hall, Eighth Edition, February 12, 2011), is considered the Bible of the academic study of options. 2. Option Volatility and Pricing by Sheldon Natenberg (New Y ork: McGraw-Hill, Updated and Expanded Edition, August 1, 1994), is considered the Bible of professional option traders. 3. The Greeks are measures of option sensitivity used by traders to man- age risk in portfolios of options. They are named after the Greek symbols used in the Black-Scholes-Merton option pricing model. 4. “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the abil- ity to keep emotions from corroding that framework. ” Preface to The Intelligent Investor by Benjamin Graham (New Y ork: Collins Business, Revised Edition, February 21, 2006). Chapter 1 1. In other words, if all option contracts were specific and customized, every time you wanted to trade an option contract as an individual in- vestor, you would have to first find a counterparty to take the other side of the trade and then do due diligence on the counterparty to make sure that he or she would be able to fulfill his or her side of the bargain. It is hard to imagine small individual investors being very interested in the logistical headaches that this process would entail! 296 •   N o t e s 2. One more bit of essential but confusing jargon when investing in options is related to exercise. There are actually two styles of exercise; one can be exercised at any time before expiration—these are termed American style—and the other can only be exercised at expiration— termed European style. Confusingly, these styles have nothing to do about the home country of a given stock or even on what exchange they are traded. American-style exercise is normal for all single-stock options, whereas European-style exercise is normal for index futures. Because this book deals almost solely with single-stock options (i.e., options on IBM or GOOG, etc.), I will not make a big deal out of this distinction. There is one case related to dividend-paying stocks where American-style exercise is beneficial. This is discussed in Appendix C. Most times, exercise style is not a terribly important thing. 3. Just like going to Atlantic City, even though the nominal odds for rou- lette are 50:50, you end up losing money in the long run because you have to pay—the house at Atlantic City or the broker on Wall Street— just to play the game. Chapter 3 1. We adjusted and annualized the prices of actual option contracts so that they would correspond to the probability levels we mentioned earlier. It would be almost impossible to find a stock trading at exactly $50 and with the option market predicting exactly the range of future price that we have shown in the diagrams. This table is provided simply to give you an idea of what one might pay for call options of different moneyness in the open market. 2. Eighty-four percent because the bottom line marks the price at which there is only a 16 percent chance that the stock will go any lower. If there is a 16 percent chance that the stock will be lower than $40 in one year’s time, this must mean that there is an 84 percent chance that the stock will be higher than $40 in one year’s time. We write “a little better than 84 percent chance” because you’ll notice that the stock price corresponding to the bottom line of the cone is around $42—a little higher than the strike price. The $40 mark might corre- spond to a chance of, let’s say, 13 percent that the stock will be lower; Notes  • 297 this would, in turn, imply an 87 percent chance of being higher than $40 in a year. 3. Tenor is just a specialty word used for options and bonds to mean the remaining time before expiration/maturity. We will see later that op- tion tenors usually range from one month to one year and that special long-term options have tenors of several years. 4. We’re not doing any advanced math to figure this out. We’re just eye- balling the area of the exposure range within the cone in this diagram and recalling that the area within the cone of the $60 strike, one-year option was about the same. 5. In other words, in this style of trading, people are anchoring on recent implied volatilities—rather than on recent statistical volatilities—to predict future implied volatilities. 6. Note that even though this option is now ITM, we did not pay for any intrinsic value when we bought the option. As such, we are shading the entire range of exposure in green. Chapter 4 1. The “capital” we have discussed so far is strategic capital. There is an- other form of tactical capital that is vital to companies, termed working capital. Working capital consists of the short-term assets essential for running a business (e.g., inventory and accounts receivables) less the short-term liabilities accrued during the course of running the busi- ness (e.g., accounts payable). Working capital is tactical in the sense that it is needed for day-to-day operation of the business. A company may have the most wonderful productive assets in the world, but if it does not have the money to buy the inventory of raw materials that will allow it to produce its widgets, it will not be able to generate revenues because it will not be able to produce anything. 2. The law of large numbers is actually a law of statistics, but when most people in the investing world use this phrase, it is the colloquial version to which they are referring. 3. Apple Computer, for instance, was a specialized maker of computers mainly used by designers and artists in the late 1990s. Through some 298 •   N o t e s inspired leadership and a large capital infusion from Microsoft to keep it afloat in its darkest days, Apple Computer changed its name to just Apple and began producing handheld music devices, smartphones, and other media appliances (including computers). By the late 1990s, Apple was facing severe structural constraints. The market in which it com- peted—the market for personal computers—had been commoditized, and prices did nothing but go down. It was clinging to a niche market of a few educational institutions and creative professionals—not a very robust or quickly growing market. However, the company was able to reinvent itself as a media technology company and media content pro- vider using its investments and know-how in personal computing as a base. Doing so, Apple jumped from a mature company into a virtual startup and once again became a supply-constrained company in a very short period of time. This is a rare twist, but not unheard of. 4. Don’t waste your time remembering this formula unless you already know it. Y ou can always look up the exact equation when you need to use it. Just remember, “ A dollar today is worth more than a dollar tomorrow. ” 5. If you are curious about the CAPM or any of the other related aca- demic methods for determining discount rates, you have no further to go than your local library or various sources online. The CAPM is one of the pillars of modern finance, and there are plenty of resources to learn about it. In the end, though, the “proper” discount rate you will calculate will not be far off from these values. There are plenty of more important things on which to concentrate in a valuation, so my suggestion is to spend time on those and save learning about the CAPM. Chapter 5 1. Note that, even though it may feel like it from a shareholder perspective, the period during which a company is making poor investments and generating substructural profit growth will only last for a limited time. Sooner or later, an activist investor or another company will acquire all or part of the capital stock of the underperforming company and run the enterprise in a more rational way. Notes  • 299 2. For the structural stage, I usually only use one scenario. When I start- ed in the business of valuation, I used 6 percent growth of cash flows in perpetuity. Recently, convinced by PIMCO’s argument that we are entering an extended “new normal” period, I tend to use 5 percent instead. 3. For instance, a company may have only six very large and important customers, each of which it picked up in subsequent years. If it loses one of those customers, rather than +35 percent revenue growth over the next year, the revenue may decline by 20 percent. Or even if the company does not lose a customer, if it does not gain another, its revenue growth may be trivial—3 percent, let’s say. 4. Please see the online materials for the specific formulas used for OCP and FCFO. 5. A person with a 100-share stake in Exxon—an investment worth just under $10,000—has a proportional stake of 0.000006 percent in the company. No wonder investors usually do not have a strong sense of being an owner of the companies in which they are invested. 6. In a counterexample, IBM’s management should be commended for selling off the dying, undifferentiated PC business to Lenovo and rea- ligning the tech giant as primarily a provider of software and services. 7. Networking behemoth Cisco Systems’ (CSCO) purchase of Pure Digital (a company that made Flip video cameras) springs immedi- ately to mind. Chapter 6 1. The fact that a consensus of opinion is reached is an interesting social be- havioral bias called herding. This bias, one that I will not go into great de- tail about here, is the tendency for people to be influenced by the actions or opinions of others when making a decision as a member of a group. 2. Paul Slovic, “Behavioral Problems of Adhering to a Decision Policy, ” paper presented at the Institute for Quantitative Research in Finance, Napa, CA, May 1, 1973. 3. This research report was quoted and summarized on the following site: http://www.valuewalk.com/2013/07/hedge-fund-alpha-negative/. 300 •   N o t e s 4. The original academic paper discussing prospect theory was published in Econometrica, Volume 47, Number 2, in March 1979 under the title: “Prospect Theory: An Analysis of Decision Under Risk. ” 5. Over the years, the paradigm for broker-dealers has changed, so some of what is written here is a bit dated. Broker-dealers have one part of its business dedicated to increasing customer “flow” as is described here. Over the last 20 years or so, however, they have additionally begun to capitalize what amounts to in-house hedge funds, called “proprietary trading desks” or “prop traders. ” While the prop traders are working on behalf of corporations that were historically known as broker-dealers (e.g., Goldman Sachs, Morgan Stanley), they are in fact buy-side institutions. In the interest of clarity in this chapter, I treat broker-dealers as purely sell-side entities even though they in fact have elements of both buy- and sell-sides. Chapter 7 1. Round-tripping means buying a security and selling it later. 2. This bit of shorthand just means a bid volatility of 22.0 and an ask volatility of 22.5. Chapter 8 1. This is one of the reasons why I called delta the most useful of the Greeks. 2. When I pulled these data, I pulled the 189-day options, so my chance of this stock hitting that high a price in this short time period is slim, but the point I am making here about percentage versus absolute re- turns still holds true. 3. A tool to calculate all the downside and upside leverage figures shown in this chapter is available on the intelligent option investor website. 4. “Buffett’s Alpha, ” Andrea Frazzini, David Kabiller, and Lasse H. Ped- ersen, 2012, National Bureau of Economic Research, NBER Working Paper No. 19681. Notes  • 301 Chapter 9 1. Yale Alumni Magazine, “The Fraud Detective, ” September/October 2013 Issue, http://www.yalealumnimagazine.com/articles/3737. Chapter 10 1. This is, in fact, the crux of why U.S. taxpayers all got the opportunity to own a piece of AIG. One of the subsidiaries of AIG made commitments to carry out transactions that, with the collapse of the mortgage bubble, it had no ability to do. In this case, it was not a bro- ker or exchange that had to bear the exposure to AIG’s failure—the contracts AIG were trading were over-the-counter and thus not regu- lated by an exchange—it was the financial system at large and U.S. taxpayers in particular. 2. The fact that this strategy is unlevered means that percentage returns provide an accurate representation of the absolute wealth generated with the strategy. As we saw earlier, levered investments can show very high percentage returns, whereas absolute returns are not as great. This is not the case for short puts. 3. Writing an option means selling an option. 4. This is especially true for people investing in covered calls—a strategy I will discuss in Chapter 11 and that has the same risk-return profile as the short-put strategy. 5. Of course, there are other reasons for increased volatility during earnings seasons, and some of the volatility reflects issues that are ma- terial to valuation. In my opinion, though, the vast majority of infor - mation given at these times is helpful for understanding only a few months’ worth of prospective business results and, as such, should not cause a material change in an intelligent investor’s perception of long- run company value. 6. I am speaking here about the most attractive calls from a math- ematical perspective, not a valuation one. I have not valued IBM and am most definitely not making an investment recommenda- tion here. I used IBM because it is a liquid option with a good 302 •   N o t e s many OTM strikes, not because I believe it’s a bearish investment opportunity. 7. $100,000 × 5% = $5,000; $5,000/$196.80 per share = 25.4 shares. Chapter 11 1. This is due to a statistical property known as dispersion . Dispersion— the fact that prices on many things do not usually move in lockstep with one another—is the root of all diversification strategies. 2. This assumes that crises are only temporary. Of course, structural or secular downturns are a different matter, and the whole process of investing must be done in a different way. In particular, conceptions of sensible terminal growth rates become vital during these times. Chapter 12 1. I am indebted to Brent Farler for this image, which I think is really brilliant. Appendix A 1. Refer to the discussion of investing agents and principals in Chapter 6. 2. It is only the nominal odds that are 50:50 anyway. The player always has to pay the house (and if you’re James Bond, you must tip the dealer a cool million dollars), just as an investor must pay the broker. As such, the net odds are always against the owner of capital. 3. Remember that the dotted line in the BSM cone shows that 50:50 “expected” value. Because our expected value dot is much higher, this means that we are assigning a higher probability of that price occurring than is the option market as a whole. Notes  • 303 Appendix B 1. The idea behind this process is to match the timing of the costs of equipment with revenues from the items produced with that equip- ment. This is a key principle of accountancy called matching. 2. The problem is that troughs, by definition, follow peaks. Usually, just like the timing of large acquisitions, companies decide to spend huge amounts to build new production capacity at just about the same time that economic conditions peak, and the factories come online just as the economy is starting to sputter and fail. Appendix C 1. A penny saved is a penny earned. We can think of the option being cheaper by the amount of the dividend, so we will place the amount that we save on the call option in savings. 2. This is calculated using the following equation: Interest = strike × r × percent of 1 year In the case of the $18 strike, interest = 18 × 0.14% × (373 days/365 days per year) = $0.03. This page intentionally left blank 305 A Absolute dollar value of returns, 172–173 Accuracy, confidence vs., 119–121 Acquisitions (see Mergers and acquisitions) Activist investors, 110 Against the Gods (Peter Bernstein), 9 Agents: buy-side, 132–136 defined, 131 investment strategies of, 137–138 principals vs., 131–132 sell-side, 136–137 AIG, 301n1 Allocation: and leverage in portfolios, 174–183 and liquidity risk, 256 and portfolio management with short-call spreads, 228–229 Alpha, 134 American-style options, 296n2 (Chapter 1) Analysis paralysis, 120 Anchoring, 60, 97 Announcements: and creating BSM cones, 156, 157 market conditions following, 68–69, 72–73 tenor and trading in expectation of, 192 AOL, 103 Apple Computer, 101, 250–251, 297–298n3 Arbitrage: defined, 288–289 dividend, 223, 288–293 Ask price, 147 Asset allocation, liquidity risk and, 256 Assets: defined, 78–79 fungible, 272–273 in golden rule of valuation, 77 hidden, 110, 111 idiosyncratic, 272 interchangeable, 272–273 mispriced, 274–277 operating, 110 price vs. value of, 79–80 underlying, 33–34, 272–273 Assets under management (AUM), 132 Assignment: with covered calls, 247–248 defined, 222–223 Assumptions: BSM model, 32–33, 40–47, 78, 150 dividend yield, 67 with forward volatility number, 156–157 time-to-expiration, 64–67 volatility, 60–64 At-the-money (ATM) options: BSM cone for, 53 collars, 259 covered calls, 242–243, 245, 246 defined, 13, 16, 17 long calls, 189 long diagonals, 235–237 Index 306  •   Index At-the-money (ATM) options: (continued) long straddles, 208–209 OTM options vs., 233–234 protective puts, 250–251, 253 short diagonals, 238, 240 short puts, 215, 216 short straddles, 230 short-call spreads, 222–225 AUM (assets under management), 132 B Balance-sheet effects, 92, 108–111 Behavior, efficient market hypothesis as model for, 41–42 Behavioral biases, 114–130 overconfidence, 118–122 pattern recognition, 114–118 perception of risk, 123–130 Behavioral economics, 42, 114 Bentley, 97–98 Berkshire Hathaway, 185 Bernstein, Peter, 9 Biases, behavioral (see Behavioral biases) Bid price, 147 Bid-ask spreads, 147–149 Bimodal outcomes, companies with, 277–278 Black, Fischer, 8–9 BlackBerry, 208–209 Black-Scholes-Merton (BSM) model, 9 assumptions of, 32–33, 40–47, 78, 150 conditions favoring, 269–273 conditions not favoring, 273–281 incorrect facets of, 29 predicting future stock prices from, 32–39 ranges of exposure and price predictions from, 50–56 theory of, 32 (See also BSM cone) Bonds, investing in short puts vs., 213–214 Booms, leverage during, 199 Breakeven line, 25 for call options, 15, 16 for long strangle, 26–27 for put options, 17, 18 (See also Effective buy price [EBP]) Broker-dealers, 137, 299–300n5 Brokers, benefits of short-term trading for, 64 BSM cone: for call options, 50–55 for collars, 258 for covered calls, 240–244 creating, 156–160 defined, 38–39 delta-derived, 151–155 discrepancies between valuation and, 160–162 for ITM options, 57–58 for long calls, 189 for long diagonals, 235 for long puts, 201 for long strangles, 205 overlaying valuation range on, 160 for protective puts, 248, 249 for put options, 54–55 for short diagonals, 238 for short puts, 212, 216, 217 for short straddles, 230 for short strangles, 231 for short-call spreads, 220 with simultaneous changes in variables, 68–74 and time-to-expiration assumptions, 64–67 and volatility assumptions, 60–64 BSM model (see Black-Scholes-Merton (BSM) model) Bubbles, 42–43 Buffett, Warren, xv, 184–185 Buying options (see Exposure-gaining strategies) Buy-side structural impediments, 132–136 Index   • 307 C CAGR (compound annual growth rate), 46 Call options (calls): BSM cone for, 50–55 buying, for growth, 22 covered, 240–248 defined, 11 delta for, 151 dividend arbitrage with, 292–293 leverage with, 167–168 on quotes, 145 short, 14, 221 tailoring exposure with, 24 visual representation of, 12–16 and volatility, 68–74 (See also Covered calls; Long calls; Short-call spreads) Capital: investment, 183–184 strategic vs. working, 297n1 (Chapter 4) Capital asset pricing model (CAPM), 88, 298n4 Capital expense, 80 Career risk, 263 Cash, hedge size and, 257 Cash flows: on behalf of owners, 80–82 expansionary, 82, 104–108 in golden rule of valuation, 77 present value of future, 87–89 summing, from different time periods, 87–89 (See also Free cash flow to owners [FCFO]) “Catalysts, ” 137 CBOE (see Chicago Board Options Exchange) Central counterparties, 8 Change (option quotes), 146–147 Chanos, Jim, 202 Chicago Board Options Exchange (CBOE), 4, 8, 47 Chicago Mercantile Exchange, 8 China, joint ventures in, 84 Cisco Systems, 299n6 (Chapter 5) Closet indexing, 133 Closing prices: change in, 146–147 defined, 146 Collars, 258–262 Commitment, counterparties’ , 211 Commodities, options on, 6–7 Companies: with bimodal outcomes, 277–278 drivers of value for (see Value drivers) economic life of, 82–86, 93–94 economic value of, 137–139 operational details of, xiii–xiv, 110–111 Complex investment strategies, 142 Compound annual growth rate (CAGR), 46 Condors, 27–28 Confidence, accuracy vs., 119–121 Contingent loans, call options as, 167–168 Contract size, 146 Counterparties: central, 8 commitments of, 211 for options contracts, 295n1 (Chapter 1) Counterparty risk, 7–8 Covered calls, 23, 240–248, 301n4 about, 241–242 BSM cone, 240–244 execution of, 242–245 pitfalls with, 245–248 with protective puts, 259–262 Covering positions, 219, 228 Cremers, Martijn, 133 C-system, 115–118 Customer “flow, ” 299n5 (Chapter 6) 308  •   Index d Debt, investment leverage from, 165–166 Dell, 101 Delta, 151–155, 300n1 (Chapter 8) Demand-side constraints, 84–86 Depreciation, 282–284 Diagonals, 233 long, 235–237 short, 238–240 Directionality of options, 9–20 calls, 12–16 and exposure, 18–20 importance of, 27–28 puts, 16–18 and stock, 10–11 volatility and predications about, 68–74 Discount rate, 87–89, 298n5 Dispersion, 302n1 (Chapter 11) Distribution of returns: fat-tailed, 45 leptokurtic, 45 lognormal, 36–37 normal, 32, 36, 40, 43–45 Dividend arbitrage, 223, 288–293 Dividend yield, 67 Dividend-paying stocks, prices of, 35–36 Dividends, 86 Downturns, short puts during, 214–215 Drift: assumptions about, 32, 35–36 effects of, 67 and long calls, 202–203 and long puts, 191 and long strangles, 206 Drivers of value (see Value drivers) e Early exercise, 223 Earnings before interest, taxes, depreciation, and amortization (EBITDA), 99 Earnings before interest and taxes (EBIT), 99 Earnings per share (EPS), 99 Earnings seasons: and tenor of short puts, 217–218 volatility in, 301n5 EBIT (earnings before interest and taxes), 99 EBITDA (earnings before interest, taxes, depreciation, and amortization), 99 EBP (see Effective buy price) Economic environment, profitability and, 101 Economic life of companies: and golden rule of valuation, 82–86 improving valuations by understanding, 93–94 Economic value of companies, 137–139 Effective buy price (EBP), 24–25, 213, 244 Effective sell price (ESP), 25–26 Efficacy (see Investing level and efficacy) Efficient market hypothesis (EMH), 33, 34, 40–43 Endowments, 135, 136 Enron, 110 EPS (earnings per share), 99 ESP (effective sell price), 25–26 European-style options, 296n2 (Chapter 1) Exchange-traded funds (ETFs), options on, 251–252 Execution of option overlay strategies: collars, 259–262 covered calls, 242–245 protective puts, 250–252 Exercising options, 13, 296n2 (Chapter 1) Expansionary cash flows, 82, 104–108 Index   • 309 Expiration of options, 187 Explicit forecast stage, 93–96 Exposure: accepting, 14, 18–20 canceling out, 18–20 gaining, 13, 18–20 notional, 173 tailoring level of, 24 (See also Ranges of exposure) Exposure-accepting strategies, 211–232 margin requirements for, 211–212 short call, 220–230 short put, 212–220 short straddle, 230–232 short strangle, 231–232 Exposure-gaining strategies, 187–209 and expiration of options, 187 long call, 189–201 long put, 201–205 straddle, 208–209 strangle, 205–207 Exposure-mixing strategies, 233–262 collar, 258–262 covered call, 240–248 long diagonal, 235–237 and OTM vs. ATM options, 233–234 protective put, 248–258 short diagonal, 238–240 Exxon, 299n4 (Chapter 5) F False precision, 93, 96–97 Fama, Eugene, 42 Fat-tailed distribution, 45 FCFO (see Free cash flow to owners) “Fight or flight” response, 118 Financial crises, 302n2 (Chapter 11) Financial leverage: defined, 285–286 investment vs., 164 and level of investment leverage, 197–199 Financial statements, xv Flexibility (with option investing), 20–28 Float, 185 Ford, 103, 272 Forward prices: adding ranges to, 36–39 calculating, 34–36 defined, 35–36 ranges of exposure and, 50–56 Forward volatility: choosing forward volatility number, 156–160 defined, 59–61 and strike–stock price ratio, 67–74 Free cash flow to owners (FCFO): defined, 82 and drivers of value, 111–112 in joint ventures, 84 and supply-side constraints, 83 Front-month contracts, 270 Fungible assets, 272–273 G Gains, levered vs. unlevered, 165 Gaussian distribution (see Normal distribution) GDP (gross domestic product), 104–108 Gillette Razors, 84 GM, 272 Goals, for hedges, 257 “Going long, ” 10, 21 “Going short, ” 21 Golden rule of valuation, 77–89 cash flows generated on behalf of owners in, 80–82 and definition of assets, 78–80 and drivers of value, 91–92 and economic life of company, 82–86 and summing cash flows from different time periods, 87–89 Google, 84, 127–130, 190 “Greeks, ” xiv, 295n3 310  •   Index Gross domestic product (GDP), 104–108 Growth: buying call options for, 22 nominal GDP , 104–108 revenue, 92, 97–99 structural growth stage, 94, 95 H Hedge funds, 132–134, 136 Hedge funds of funds (HFoF), 134 Hedges: reinvesting profit from, 254–255 size of, 255–258 timing of, 252–254 Hedging: planning for, 255–258 for portfolios, 251–252 Herding, 138, 299n1 HFoF (hedge funds of funds), 134 Historical volatility, 60 Hostile takeovers, 110 The Human Face of Big Data (Rick Smolan), 114 I IBM, 224–230, 299n5 (Chapter 5), 301n6 Idiosyncratic assets, 272 Immediate realized loss (IRL), 180, 183 Implied volatility: bid/ask, 149–151 changing assumptions about, 60–64 and short puts, 216–217 Income, selling put options for, 23 Indexing, closet, 133 Insurance, 5, 250 Insurance companies, 135, 136 Intel, 175 Interchangeable assets, 272–273 Interest: calculating, 303n2 options and payment on, 168 prepaid, 170 Interest rates, 67 In-the-money (ITM) options: calls vs. puts, 27 covered calls, 242 defined, 13, 16, 17 investment leverage for, 170–172 levered strategy with, 176–180 long calls, 189, 193–197 long diagonals, 236 long puts, 204 managing leverage with, 183–184 and market risk, 263–264 pricing of, 56–59, 150 protective puts, 249–251 short puts, 213–215 short-call spread, 222, 223 time decay for, 66–67 Intrinsic value, 56–59, 171 Investing level and efficacy, 92, 103–108 Investment capital, leverage and, 183–184 Investment leverage, 163–185 from debt, 165–166 defined, 164 managing, 183–185 margin of safety for, 197–199 measuring, 169–173 from options, 166–168 and portfolio management, 196–197 in portfolios, 174–183 unlevered investments, 164–165 Investment phase (investment stage), 86, 93–96 Investors: activist, 110 risk-averse, 123, 125–127 risk-neutral, 124–126 risk-seeking, 123, 125–127 IRL (immediate realized loss), 180, 183 ITM (see In-the-money options) Index   • 311 J Jaguar, 103 Joint ventures (JVs), 84–85 JP Morgan Chase, 236–237 K Kahneman, Daniel, 42, 123, 126 Keen, Steven, 43 Keynes, John Maynard, 263 Kroger, 100 K/S (see Strike–stock price ratio) L Lambda, 169–173 Large numbers, law of, 85, 297n2 (Chapter 4) Last (option quotes), 146 LEAPS (see Long-term equity anticipated securities) Legs (option structure), 27 Lehman Brothers, 264 Lenovo, 299n5 (Chapter 5) Leptokurtic distribution, 45 Leverage, 163, 282–286 financial, 164, 197–199, 285–286 operating (operational), 101, 197–199, 282–284 (See also Investment leverage) Leverage ratio, 228–229 Levered investments, portfolios with, 176–183 Liabilities, hidden, 110–111 Life insurance companies, 135 Liquidity risk, 256, 263 Listed look-alike option market, 6 Literary work, options on, 5–6 Lo, Andrew, 42 Load, 132, 134 Loans, call options as, 167–168 Lognormal curve, 37 Lognormal distribution, 36–37 Long calls, 13, 189–201 about, 189 BSM cone, 189 in long diagonals, 235–237 portfolio management with, 196–201 strike price for, 192–196 tenor for, 190–192 Long diagonals, 235–237 Long puts, 201–205 about, 201–202 BSM cone, 201 portfolio management with, 204–205 in short diagonals, 238–240 strike price for, 203 tenor for, 202–203 Long straddles, 208–209 Long strangles, 26–27, 205–207, 209 Long-term equity anticipated securities (LEAPS), 153, 191, 280–281 Loss leverage: conventions for, 182–183 formula, 178–179 with short puts, 211–212 Losses: with levered vs. unlevered instruments, 165–166 locking in, 245–247 on range of exposure, 15 unrealized, 175–176 (See also Realized losses) M MacKinlay, Craig, 42 Margin calls, 168 Margin of safety, 197–199 Margin requirements, 211–212 Market conditions, 59–74 assumptions about drift and dividend yield, 67 simultaneous changes in, 67–74 312  •   Index Market conditions (continued) time-to-expiration assumptions, 64–67 and types of volatility, 59–60 volatility assumptions, 60–64 Market efficiency, 32–34, 40–43 Market makers, 147, 281 Market risk, 263–265 Matching, 302n1 (Appendix B) Maximum return, 225 Mergers and acquisitions: strike prices selection and, 195–196 tenor and, 191–192 Merton, Robert, 8–9 Miletus, 6–7 Mispriced assets, 274–277 Mispriced options, 143–162 deltas of, 151–155 reading option quotes, 144–151 and valuation risk, 266 and valuation vs. BSM range, 155–162 Moneyness of options: calls, 13–14 puts, 16–17 Morningstar, 132 Most likely (term), 38 Motorola Mobility Systems, 84 Mueller Water, 148–149, 154, 158–160 Multiples-based valuation, 99–100 Mutual funds, 132–133, 136 n Nominal GDP growth: owners’ cash profit vs., 104–108 as structural constraint, 104 Normal distribution, 32, 36, 40, 43–45 Notional amount of position, 173 Notional exposure, 173 O OCC (Options Clearing Corporation), 8 OCP (see Owners’ cash profit) Operating assets, 110 Operating leverage (operational leverage): defined, 282–284 and level of investment leverage, 197–199 and profitability, 101 Operational details of companies, xiii–xiv, 110–111 Option investing: choices in, 22–24 conditions favoring BSM, 269–273 conditions not favoring BSM, 273–281 flexibility in, 20–28 long-term strategies, 1 misconceptions about, 1 risk in, 268 shortcuts for valuation in, 93–97 stock vs., 21–22 strategies for, 142 (See also specific types of strategies) structural impediments in, 131–139 three-step process, xiv valuation in, 75 Option pricing, 29–47, 49–74 and base assumptions of BSM, 40–47 market conditions in, 59–74 predicting future stock prices from, 32–39 and ranges of exposure, 50–56 theory of, 30–32 time vs. intrinsic value in, 56–59 Option pricing models: base assumptions of, 40–47 history of, 8–9 operational details of companies in, xiii–xiv predicting future stock prices with, 32–39 ranges of exposure and price predictions from, 50–56 (See also Black-Scholes-Merton [BSM] model) Option quotes, 144–151 Index   • 313 Optionality, 4 Options, 3–28 buying (see Exposure-gaining strategies) characteristics of, 4 defined, 4 directionality of, 9–20 examples of, 5–6 expiration of, 187 history of, 6–9 investment leverage from, 166–168 misconceptions about, 1 mispriced, 143–162 (See also specific types) Options Clearing Corporation (OCC), 8 Options contracts: counterparties for, 295n1 (Chapter 1) examples of, 5–6 front-month, 270 private, 6–8 Oracle, 107–108, 144, 146, 148–153, 155, 157, 159–162 Organic revenue growth, 97 Out-of-the-money (OTM) options: ATM options vs., 233–234 call vs. put, 27 collars, 258–262 defined, 13, 16, 17 investment leverage for, 171–172 levered strategy with, 180, 181 long calls, 193, 195–197 long diagonals, 235–237 long puts, 203, 204 long strangles, 205–207 and market makers, 147 pricing of, 150 protective puts, 248, 250–253 realized losses and, 187 rising volatility and, 70–74 short diagonals, 238–240 short puts, 213, 215 short strangles, 231 short-call spreads, 221–224 time decay for, 66–67 unrealized losses, 187 Overconfidence, 118–122 Overexposure, 247 Overlays, 23, 234 Owners: cash flows generated on behalf of, 80–82 free cash flow to (see Free cash flow to owners (FCFO)) Owners’ cash profit (OCP): defined, 82 nominal GDP growth vs., 104–108 profitability as, 99–102 P Parity, 288 Pattern recognition, 114–118 Peaks (business-cycle): operational leverage in, 284 and troughs, 302–303n2 Pension funds, 135, 136 Percent delta, 169–173 Percent profit, 172–173 Percentage return, 229 Portfolio management: for long calls, 196–201 for long puts, 204–205 for long strangles, 207 for short puts, 216–220 for short-call spreads, 228–230 Portfolios: hedging, 251–252 investment leverage in, 174–183 Precision, false, 93, 96–97 Premium, 13 Prepaid interest, 170 Present value of future cash flows, 87–89 Pricing power, 98 Principal (financial), 168 Principals, agents vs., 131–132 Problem solving, X- vs. C-system, 115–118 314  •   Index Procter & Gamble, 84 Productivity, 102 Profit: from covered calls, 245 from hedging, 254–255 owners’ cash, 82 percent, 172–173 Profit leverage, 179–180, 182–183 Profitability: and financial leverage, 285–286 and operational leverage, 283–284 as value driver, 92, 99–102 Proprietary trading desks (prop traders), 300n5 Prospect theory, 123–127 Protective puts, 248–258 about, 248–250 BSM cone, 248, 249 with covered calls, 259–262 execution of, 250–252 pitfalls with, 252–258 Pure Digital, 299n6 (Chapter 5) Put options (puts): BSM cone for, 54–55 buying, for protection, 23 defined, 11 delta for, 151 on quotes, 145 selling, for income, 23 tailoring exposure with, 24 visual representation of, 16–18 (See also Long puts; Protective puts; Short puts) Put-call parity, 223, 287–293 defined, 287–288 and dividend arbitrage, 288–293 for non-dividend-paying stock, 289–290 Q Qualcomm, 260–262 Quotes, option, 144–151 R Random-walk principal, 41 Ranges of exposure, 3 for call options, 12–13, 15 for ITM options, 58–59 and option pricing, 50–56 Rankine, Graeme, 41–42 Ratioing, 206, 238 Realized losses: and buying puts, 203 immediate, 180, 183 managing leverage to minimize, 183–185 and option buying, 187–188 unrealized vs., 175–176 Recessions, leverage during, 198, 199 Reflective thought processes, 116–118 Reflexive thought processes, 116–118 Return(s): absolute dollar value of, 172–173 for covered calls, 244–245 maximum, 225 percentage, 229 for short puts, 245 (See also Distribution of returns) Revenue growth, 92, 97–99 Risk, 263–268 career, 263 counterparty, 7–8 liquidity, 256, 263 market, 263–265 in option investing, 267–268 perception of, 123–130 and size of hedges, 255–256 solvency, 256, 263 valuation, 265–267 Risk-averse investors, 123, 125–127 Risk-free rate: borrowing at, 32, 40, 46 BSM model assumption about, 32, 35–36, 40, 45–46 Risk-neutral investors, 124–126 Risk-seeking investors, 123, 125–127 Index   • 315 Rolling, 200–201 Round-tripping, 148–149, 300n1 (Chapter 7) S Safeway, 100 Schiller, Robert, 43 Scholes, Myron, 8–9 Secular downturns, 302n2 (Chapter 11) Secular shifts, profitability and, 101–102 Sell-side structural impediments, 136–137 Settlement prices, 146 Shiller, Robert, 42 Short calls, 14, 221 Short diagonal, 238–240 Short puts, 211–220 about, 213–214 BSM cone, 212 covered calls and, 241–244 in long diagonals, 235–237 loss leverage with, 211–212 portfolio management with, 216–220 protective puts vs., 248–250 returns for, 245 strike price for, 215 tenor for, 214–215 Short straddles, 230–232 Short strangles, 231–232 Short-call spreads, 220–230 about, 221–222 BSM cone, 220 portfolio management with, 228–230 in short diagonals, 238–240 strike price for, 222–228 tenor for, 222 Short-term trading strategies: implied volatility in, 63–64 intelligent investing vs., 267–268 and market risk, 264–265 Slovic, Paul, 119 Smolan, Rick, 114 Solvency risk, 256, 263 S&P 500 (see Standard & Poor’s 500 Index) Special-purpose vehicles, 110 Spreads: bid-ask, 147–149 short-call (see Short-call spreads) SPX ETF , 251–252 Standard & Poor’s 500 Index (S&P 500): correlation of hedge funds and, 134 distribution of returns, 44–46 protective puts on, 252–254 Startup stage, 86 Statistical volatility, 60 Stock investing, xiii choices in, 20–22 visual representation of, 10–11 Stock prices: BSM model assumption about, 32, 34–35, 40–47 directional predictions of, 68–74 of dividend-paying stocks, 35–36 predicting, with BSM model, 32–39 (See also Forward prices; strike– stock price ratio [K/S]) Stock-split effect, 42 Stop loss, 229 Straddles: long, 208–209 short, 230–232 Straight-line depreciation, 283 Strangles: long, 26–27, 205–207, 209 short, 231–232 Strategic capital, 297n1 (Chapter 4) Strike prices: and BSM cone, 52–54 defined, 12 long call, 192–196 long diagonal, 236–237 long put, 203 316  •   Index Strike prices: (continued ) long strangle, 206–207 short diagonal, 239–240 short put, 215 short-call spread, 222–228 Strike–stock price ratio (K/S): and change in closing price, 146–147 defined, 53–54 and forward volatility, 67–74 Structural constraints, 86, 104 Structural downturns, 302n2 (Chapter 11) Structural growth stage, 94, 95 Structural impediments, 131–139 buy-side, 132–136 and investment strategies, 137–139 principals vs. agents, 131–132 sell-side, 136–137 Sun Microsystems, 108 Supply-side constraints, 83 Symmetry, bias associated with, 114–118 T “Taking profit” with covered calls, 245 Taxes, BSM model assumption about, 32, 40, 46 Technical analysis, 115 Tenor, 297n3 (Chapter 3) defined, 59 for long calls, 190–192 for long puts, 202–203 for long strangles, 206 for protective puts, 252–254 for short puts, 214–215 for short-call spreads, 222 Terminal phase, 86 Time decay, 65–67 Time horizons: long, 279–281 short, 270–272 Time value: intrinsic vs., 56–59 of money, 87, 93–95 Time Warner, 103 Time-to-expiration assumptions, 64–67 Toyota, 97 Trading restrictions, 32, 40, 46 Troughs (business-cycle): operational leverage in, 283–284 and peaks, 302–303n2 Tversky, Amos, 123, 126 “2-and-20” arrangements, 134 U Uncertainty, 118–119 Underexposure, 247 Underlying assets: fungible, 272–273 and future stock price, 33–34 University of Chicago, 41 Unlevered investments: levered vs., 164–165 in portfolios, 175–176, 178 Unrealized losses, 175–176 Unrealized profit, 254–255 Unused leg, long strangle, 207 U.S. Treasury bonds, 45–46 Utility curves, 124–126 V Valuation: golden rule of, 77–89 multiples-based, 99–100 shortcuts for, 93–97 value drivers in, 91–97 Valuation range: BSM cone vs., 160–162 creating, 122 and margins of safety, 197–199 overlaying BSM cone with, 160 and strike price selection, 192–194 Valuation risk, 265–267 Index   • 317 Value: of companies, 137–139 intrinsic, 56–59, 171 time, 56–59, 87, 93–95 Value drivers, 91–112 balance-sheet effects, 108–111 investing level and efficacy, 103–108 profitability, 99–103 revenue growth, 97–99 in valuation process, 91–97 Value investing, 79 Volatility (vol.): amplifying directional predictions with, 71–74 changing assumptions about, 60–64 in earnings season, 301n5 failing to offset directional predictions with, 70–71 historical, 60 offsetting directional predictions with, 68–70 statistical, 60 types of, 59–60 (See also Forward volatility; Implied volatility) Volatility smile, 45, 150, 152 W Walmart, 105–108 Whole Foods Market, 100, 101 Working capital, 297n1 (Chapter 4) Writing options, 215, 301n3 x X-system, 115–118 This page intentionally left blank ABOUT THE AUTHOR erik Kobayashi-Solomon, a veteran from the investment banking and hedge fund world, is the founder and principal of IOI, LLC a financial consultancy for individual and institutional investors. In addition to publishing an institutional investor-focused subscription product, Erik runs option and investment “boot camps” and consults on risk control, option strategies, and stock valuations for individual and institutional investors. Before starting IOI, Erik worked for Morningstar in its stock research department for over six years. At Morningstar, he first managed a team of semiconductor industry analysts before becoming the coeditor and driv- ing force of Morningstar’s OptionInvestor newsletter and serving as the company’s Market Strategist. In addition to coauthoring a guide to fundamental investing and option strategies used in the Morningstar Investor Training Options Course and popular weekly articles about using options as a tool for in- vestment portfolios, Erik was the host of several popular webinars such as “Covered Calls A to Z” and “Hedging 101. ” His video lecture about avoid- ing behavioral and structural pitfalls called “Making Better Investment Decisions” was so popular that he was invited to be the featured speaker at several investment conferences throughout the United States. In addition, he represented Morningstar on television and radio, was interviewed by magazines and newspapers from Dallas to Tokyo to New Delhi, and was a frequent guest contributor to other Morningstar/Ibbotson publications. Erik started his career in the world of finance at Morgan Stanley Japan, where he ultimately headed Morgan’s listed derivatives operations in Tokyo. After returning to the United States, Erik founded a small hedge fund based on his original research in the field of Behavioral Finance and later became the Risk Manager for a larger investment fund. There, he de- signed option hedges for the fund’s $800 million global equity portfolio and advised the portfolio manager on quantitative investment strategies and Japanese stock market investments. Erik, the son of a NASA scientist father and a concert violin- ist mother, graduated Magna Cum Laude and Phi Beta Kappa from the University of Texas at Austin, where he majored in Asian Studies and Japanese. After working in Japan for several years as a teacher, translator, and television actor, he won a full-ride scholarship to study business at the number one ranked school for international business in the United States—Thunderbird—in Glendale, Arizona. There, he worked as a research assistant to Dr. Anant Sundaram (Finance, presently at Dartmouth) from whom he gained a love for finance and economics, Dr. Graeme Rankine (Accounting) who introduced him to Behavioral Finance, and Dr. Charles Neilson (Marketing) who taught him the importance of strategic thinking. Erik graduated Summa Cum Laude and was selected as the outstanding student of his graduating class. Erik lives in Chicago, Illinois with his family and enjoys long distance running and reading. In his spare time, he volunteers at the local Japanese school to teach children Kendo—the Japanese art of swordsmanship. ================================================================================ SOURCE: eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf ================================================================================ NUIF NEW YORK INSTITUTE OF FINANCE NEW YORK • TORONTO • SYDNEY • TOKYO • SINGAPORE NEW YORK INSTITUTE OF FINANCE NYIF and New York Institute of Finance ar; trademarks of Executive Tax Reports, Inc., used under license by Penguin Putnam Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. -From a Declaratlon of Principles jointly adapted by a Committee of the American Bar Association and a Committee of Publishers and Associations. Copyright © 2002 by Penguin Putnam Inc, Prentice Hall® is a registered trademark of Pearson Education, Inc. All rights reserved. No part of this book may be reproduced in any form or by any means, without per­ mission in writing from the publisher. Library of Congress Cataloging-in-Publication Data McMillan, L. G. (Lawrence G.) Options as a strategic investment/ Lawrence G. McMillan. - 4th ed. p.cm. Includes index. ISBN 0-7352-0197-8 (cloth) 1. Options (Finance) I. Title. HG6042.M35 2001 332.63'228-dc21 Associate Publisher: Ellen Schneid Coleman Production Editor: Mariann Hutlak Interior Design/Formatting: Inkwell Publishing Services Printed in the United States of America 10 9 8 7 6 5 4 3 ISBN 0-7352-0197-8 00-053319 Most NYIF and New York Institute of Finance books are available at special quantity discounts for bulk purchases for sales promotions, premiums, fund-raising, or educational use. Special books, or book excerpts, can also be created to fit specific needs. For details, write: Special Markets, Penguin Putnam Inc., 375 Hudson Street, New York, New York 10014. Contents Preface .......................................................... xv Part I BASIC PROPERTIES OF STOCK OPTIONS Chapter 1 Definitions ................................................. 3 Elementary Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Factors Influencing the Price of an Option .... ........................... 9 Exercise and Assignment: The Mechanics ............................... 15 The Option Markets . ............................................... 22 Option Symbology . ................................................ 23 Details of Option Trading ........................................... 27 Order Entry . ..................................................... 32 Profits and Profit Graphs ........................................... 34 Part II CALL OPTION STRATEGIES Chapter2 Covered Call Writing . ....................................... 39 The Importance of Covered Call Writing ............................... 39 Covered Writing Philosophy ......................................... 42 The Total Return Concept of Covered Writing ........................... 45 Computing Return-on Investment ..................................... 47 iii iv Contents Execution of the Covered Write Order ................................. 56 Selecting a Covered Writing Position . .................................. 58 Writing against Stock Already Owned . ................................. 62 Diversifying Return and Protection in a Covered Write .................... 66 Follow-Up Action ........ .......................................... 70 Special Writing Situations ........................................... 87 Covered Call Writing Summary ...................................... 93 Chapter3 Call Buying . ............................................... 95 Why Buy? ....................................................... 95 Risk and Reward for the Call Buyer ................................... 97 Which Option to Buy? .............. ............................... 101 Advanced Selection Criteria ........................................ 103 Follow-Up Action ............... .................................. 107 A Further Comment on Spreads ..................................... 117 Chapter4 Other Call Buying Strategies ................................ 118 The Protected Short Sale (or Synthetic Put) ............................ 118 Follow-Up Action . ................................................ 122 The Reverse Hedge (Simulated Straddle) ...... ......................... 123 Follow-Up Action ...... ........................................... 126 Altering the Ratio of Long Calls to Short Stock . ......................... 128 Summary . ...................................................... 131 Chapter 5 Naked Call Writing ........................................ 132 The Uncovered (Naked) Call Option .... .............................. 133 Investment Required ............ .................................. 135 The Philosophy of Selling Naked Options .............................. 137 Risk and Reward ................................................. 138 Summary ....................................................... 144 Chapter 6 Ratio Call Writing ......................................... 146 The Ratio Write .................................................. 146 Investment Required .... ..................... _ ..................... 150 Contents V Selection Criteria . ................................................ 151 The Variable Ratio Write . .......................................... 155 Follow-Up Action . ................................................ 158 An Introduction to Call Spread Strategies .. ............................ 168 Chapter7 Bull Spreads .............................................. 172 Degrees of Aggressiveness .......................................... 175 Ranking Bull Spreads ............................................. 176 Follow-Up Action . ................................................ 179 Other Uses of Bull Spreads ......................................... 180 Summary .... ................................................... 185 Chapter 8 Bear Spreads Using Call Options ............................ 186 The Bear Spread ................................................. 186 Selecting a Bear Spread ... ......................................... 189 Follow-Up Action . ................................................ 190 Summary ......... .............................................. 190 Chapter9 Calendar Spreads .......................................... 191 The Neutral Calendar Spread ..... .................................. 192 Follow-Up Action . ................................................ 194 The Bullish Calendar Spread ... ..................................... 196 Follow-Up Action ........ ......................................... 197 Using All Three Expiration Series .................................... 198 Summary . ...................................................... 199 Chapter 10 The Butterfly Spread ....................................... 200 Selecting the Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Follow-Up Action ... .............................................. 206 Summary ....................................................... 209 Chapter 11 Ratio Call Spreads ......................................... 210 Differing Philosophies ............................................. 213 vi Contents Follow-Up Action ..... ............................................ 217 Sumniary ....................................................... 221 Chapter 12 Combining Calendar and Ratio Spreads ...................... 222 Ratio Calendar Spread ............................................ 222 Choosing the Spread .............................................. 225 Follow-Up Action ... .............................................. 226 Delta-Neutral Calendar Spreads ....... .............................. 227 Follow-Up Action ... .............................................. 229 Chapter 13 Reverse Spreads ........................................... 230 Reverse Calendar Spread . .......................................... 230 Reverse Ratio Spread (Backspread) . .................................. 232 Chapter 14 Diagonalizing a Spread . .................................... 236 The Diagonal Bull Spread .......................................... 236 Owning a Call for "Free" ............ ............................... 239 Diagonal Backspreads ............................................. 240 Call Option Sumniary ............................................. 241 Part III PUT OPTION STRATEGIES Chapter 15 Put Option Basics . ....................................... ~ " 245 Put Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 Pricing Put Options ............................................... 247 The Effect of Dividends on Put Option Premiums ........................ 248 Exercise and Assignment ........................................... 250 Conversion . ..................................................... 253 Chapter 16 Put Option Buying . ........................................ 256 Put Buying versus Short Sale .. ...................................... 256 Selecting Which Put to Buy . ........................................ 258 Contents vii Ranking Prospective Put Purchases ................................... 261 Follow-Up Action . ................................................ 262 Loss-Limiting Actions ............................................. 267 Equivalent Positions .. ............................................. 270 Chapter 17 Put Buying in Conjunction with Common Stock Ownership ..... 271 Which Put to Buy ................................................ 273 Tax Considerations ............................................... 275 Put Buying As Protection for _the Covered Call Writer .................... 275 No-Cost Collars . ................................................. 278 Chapter18 Buying Puts in Conjunction with Call Purchases ............... 281 Straddle Buying . ................................................. 282 Selecting a Straddle Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285 Follow-Up Action . ................................................ 285 Buying a Strangle ................................................ 288 Chapter 19 The Sale of a Put ..................................... : .... 292 The Uncovered Put Sale . ........................................... 292 Follow-Up Action .......... ....................................... 295 Evaluating a Naked Put Write . ...................................... 296 Buying Stock below Its Market Price . ................................. 299 The Covered Put Sale ............................................. 300 Ratio Put Writing . ................................................ 300 Chapter 20 The Sale of a Straddle ...................................... 302 The Covered Straddle Write ........................................ 302 The Uncovered Straddle Write ...................................... 305 Selecting a Straddle Write .......................................... 307 Follow-Up Action ....... .......................................... 308 Equivalent Stock Position Follow-Up . ................................. 312 Starting Out with the Protection in Place .............................. 313 Strangle (Combination) Writing ..................................... 315 Further Comments on Uncovered Straddle and Strangle Writing . ........... 318 viii Contents Chapter21 Synthetic Stock Positions Created by Puts and Calls ............ 321 Synthetic Long Stock . ............................................. 321 Synthetic Short Sale . .............................................. 323 Splitting the Strikes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 Summary ....................................................... 328 Chapter22 Basic Put Spreads . ......................................... 329 Bear Spread . .................................................... 329 Bull Spread ..................................................... 332 Calendar Spread ................................................. 333 Chapter 23 Spreads Combining Calls and Puts . .......................... 336 The Butterfly Spread . ............................................. 336 Combining an Option Purchase and a Spread . .......................... 339 A Simple Follow-Up Action for Bull or Bear Spreads ..................... 342 Three Useful but Complex Strategies . ................................. 345 Selecting the Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 Summary ........................................................ 356 Chapter 24 Ratio Spreads Using Puts ................................... 358 The Ratio Put Spread . ............................................. 358 Using Deltas . .................................................... 361 The Ratio Put Calendar Spread . ..................................... 361 A Logical Extension (The Ratio Calendar Combination) .... ............... 364 Put Option Summary . ............................................. 366 Chapter 25 LEAPS ................................................... 367 The Basics ...................................................... 368 Pricing LEAPS . .................................................. 369 Comparing LEAPS and Short-Term Options ............................ 374 LEAPS Strategies . ................................................ 375 Speculative Option Buying with LEAPS ............................... 382 Selling LEAPS ................................................... 390 Contents ix Spreads Using LEAPS ............................................. 403 Sum111ary ....................................................... 409 PartIV ADDITIONAL CONSIDERATIONS Chapter 26 Buying Options and Treasury Bills ........................... 413 How the Treasury Bill/Option Strategy Operates ......................... 413 Sum111ary ....................................................... 421 Chapter 27 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422 Basic Put and Call Arbitrage ("Discounting") . .......................... 423 Dividend Arbitrage ............................................... 425 Conversions and Reversals . ......................................... 428 More on Carrying Costs ............................................ 430 Back to Conversions and Reversals ................................... 431 Risks in Conversions and Reversals ................................... 433 Sum111ary of Conversion Arbitrage ................................... 437 The "Interest Play" .... ............................................ 438 The Box Spread .................................................. 439 Variations on Equivalence Arbitrage .................................. 443 The Effects of Arbitrage . ........................................... 444 Risk Arbitrage Using Options ....................................... 445 Pairs Trading .................................................... 454 Facilitation (Block Positioning) ...................................... 455 Chapter 28 Mathematical Applications . ................................. 456 The Black-Scholes Model . .......................................... 456 Expected Return ................................................. 466 Applying the Calculations to Strategy Decisions ......................... 472 Facilitation or Institutional Block Positioning ........................... 482 Aiding in Follow-Up Action . ........................................ 485 Implementation .................................................. 488 Sum111ary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 X Contents PartV INDEX OPTIONS AND FUTURES Chapter 29 Introduction to Index Option Products and Futures . ............ 493 Indices ............................................ : ............ 493 Cash-Based Options .............................................. 500 Futures ........................................................ 506 Options on Index Futures .......................................... 512 Standard Options Strategies Using Index Options ........... ............. 516 Put-Call Ratio ................................................... 520 Summary ....................................................... 523 Chapter30 Stock Index Hedging Strategies . ............................. 531 Market Baskets .................................................. 531 Program Trading ................................................. 537 Index Arbitrage .................................................. 547 Follow-Up Strategies . ............................................. 557 Market Basket Risk ............................................... 560 Impact on the Stock Market . ........................................ 561 Simulating an Index . .............................................. 566 Trading the Tracking Error .... ..................................... 574 Summary ....................................................... 577 Chapter31 Index Spreading ........................................... 579 Inter-Index Spreading .. ........................................... 579 Summary ....................................................... 588 Chapter32 Structured Products ........................................ 589 Part I: "Riskless" Ownership of a Stock or Index ........................ 590 The "Structure" of a Structured Product . .............................. 590 Cash Value . ..................................................... 593 The Cost of the Imbedded Call Option ................................ 594 Price Behavior Prior to Maturity . .................................... 595 SIS ............................................................ 596 Contents xi Computing the Value of the Imhedded Call When the Underlying Is Trading at a Discount ......................................... 602 The Adjustment Factor ............................................ 602 Other Constructs ................................................. 607 Option Strategies Involving Structured Products ........................ 613 Lists of Structured Products ........................................ 618 Part II: Products Designed to Provide "Income" ......................... 618 PERCS ......................................................... 618 Call Feature . .................................................... 620 A PERCS Is a Covered Call Write .................................... 622 Price Behavior . .................................................. 623 PERCS Strategies ................................................ 625 PERCS Summary ................................................ 636 Other Structured Products ......................................... 637 Structured Product Summary ....................................... 640 Chapter33 Mathematical Considerations for Index Products ............... 641 Arbitrage ....................................................... 641 Mathematical Applications ......................................... 644 Chapter34 Futures and Futures Options ................................ 652 Futures Contracts ................................................ 653 Options on Futures ............................................... 660 Futures Option Trading Strategies .. .................................. 674 Commonplace Mispricing Strategies .................................. 683 Summary . ...................................................... 695 Chapter 35 Futures Option Strategies for Futures Spreads ................. 696 Futures Spreads . ................................................. 696 Using Futures Options in Futures Spreads ............................. 704 Summary ....................................................... 720 xii Contents Part VI MEASURING AND TRADING VOLATILITY Chapter36 The Basics of Volatility Trading . ............................. 727 Definitions of Volatility ............................................ 728 Another Approach: GARCH ........................................ 731 Moving Averages ................................................. 732 Implied Volatility . ................................................ 732 The Volatility of Volatility .......................................... 734 Volatility Trading . ................................................ 743 Why Does Volatility Reach Extremes? . ................................ 744 Summary ....................................................... 7 48 Chapter37 How Volatility Affects Popular Strategies ..................... 749 Vega ........................................................... 749 Implied Volatility and Delta ........................................ 753 Effects on Neutrality .... .......................................... 755 Position Vega .................................................... 757 Outright Option Purchases and Sales ................................. 757 Time Value Premium is a Misnomer .................................. 762 Volatility and the Put Option . ....................................... 765 Straddle or Strangle Buying and Selling ............................... 766 Call Bull Spreads . ................................................ 767 Vertical Put Spreads .............................................. 775 Put Bear Spreads . ................................................ 777 Calendar Spreads ................................................ 778 Ratio Spreads and Backspreads . ..................................... 780 Summary ....................................................... 782 Chapter38 The Distribution of Stock Prices ............................. 783 Misconceptions about Volatility ...................................... 783 Volatility Buyer's Rule! ............................................ 787 The Distribution of Stock Prices ..................................... 789 What This Means for Option Traders ................................. 795 Stock Price Distribution Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 796 Contents xiii The Pricing of Options . ............................................ 798 The Probability of Stock Price Movement .............................. 798 EX'f)ected Return ................................................. 809 Summary . ...................................................... 810 Chapter39 Volatility Trading Techniques ............................... 812 Two Ways Volatility Predictions Can Be Wrong ......................... 813 Trading the Volatility Prediction ..................................... 814 Trading the Volatility Skew ......................................... 837 Volatility Trading Summary ............ ............................. 844 Chapter40 Advanced Concepts ........................................ 846 Neutrality ...................................................... 846 The "Greeks" .................................................... 848 Strategy Considerations: Using the "Greeks" . ........................... 866 Advanced Mathematical Concepts . ................................... 901 Summary ....................................................... 907 Chapter41 Taxes . .................................................... 908 History .. ....................................................... 908 Basic Tax Treatment . .............................................. 910 Exercise and Assignment ........................................... 913 Special Tax Problems .............................................. 922 Summary ....................................................... 925 Tax Planning Strategies for Equity Options . ............................ 925 Summary ....................................................... ·930 Chapter42 The Best Strategy? ......................................... 932 General Concepts: Market Attitude and Equivalent Positions ............... 932 What Is Best for Me Might Not Be Best for You ......................... 934 Mathematical Ranking . ............................................ 936 Summary ....................................................... 937 Postscript . ................................................ 938 xiv Appendix A Part VII APPENDICES Contents Strategy Summary ......................................... 943 AppendixB Equivalent Positions ....................................... 945 AppendixC Formulae ................................................. 947 AppendixD Graphs ................................................... 957 Appendix E Qualified Covered Calls .................................... 961 Glossary . ....................................................... 963 Index .......................................................... 983 Preface When the listed option market originated in April 1973, a new world of investment strategies was opened to the investing public. The standardization of option terms and the formation of a liquid secondary market created new investment vehicles that, adapted properly, can enhance almost every investment philosophy, from the con­ servative to the speculative. This book is about those option strategies -which ones work in which situations and why they work. Some of these strategies are traditionally considered to be complex, but with the proper knowledge of their underlying principles, most investors can understand them. While this book contains all the basic definitions concerning options, little time or space is spent on the most elementary definitions. For example, the reader should be familiar with what a call option is, what the CBOE is, and how to find and read option quotes in a newspaper. In essence, everything is contained here for the novice to build on, but the bulk of the discussion is above the beginner level. The reader should also be somewhat familiar with technical analysis, understanding at least the terms support and resistance. Certain strategies can be, and have been, the topic of whole books - call buy­ ing, for example. While some of the strategies discussed in this book receive a more thorough treatment than others, this is by no means a book about only one or two strategies. Current literature on stock options generally does not treat covered call writing in a great deal of detail. But because it is one of the most widely used option strategies by the investing public, call writing is the subject of one of the most in­ depth discussions presented here. The material presented herein on call and put buying is not particularly lengthy, although much of it is of an advanced nature - especially the parts regarding buying volatility and should be useful even to sophis­ ticated traders. In discussing each strategy, particular emphasis is placed on showing why one would want to implement the strategy in the first place and on demonstrat- xv xviii Preface are made for using the computer as a tool in follow-up action, including an example printout of an advanced follow-up analysis. THIRD EDITION There were originally six new chapters in the third edition. There were new chapters on LEAPS, CAPS, and PERCS, since they were new option or option-related prod­ ucts at that time. LEAPS are merely long-term options. However, as such, they require a little different viewpoint than regular short-term options. For example, short-term inter­ est rates have a much more profound influence on a longer-term option than on a short-term one. Strategies are presented for using LEAPS as a substitute for stock ownership, as well as for using LEAPS in standard strategies. PERCS are actually a type of preferred stock, with a redemption feature built in. They also pay significantly larger dividends than the ordinary common stock. The redemption feature makes a PERCS exactly like a covered call option write. As such, several strategies apply to PERCS that would also apply to covered writers. Moreover, suggestions are given for hedging PERCS. Subsequently, the PERCS chapter was enveloped into a larger chapter in the fourth edition. The chapters on futures and other non-equity options that were written for the second edition were deleted and replaced by two entirely new chapters on futures options. Strategists should familiarize themselves with futures options, for many prof­ it opportunities exist in this area. Thus, even though futures trading may be unfamil­ iar to many customers and brokers who are equity traders, it behooves the serious strategist to acquire a knowledge of futures options. A chapter on futures concentrates on definitions, pricing, and strategies that are unique to futures options; another chap­ ter centers on the use of futures options in spreading strategies. These spreading strategies are different from the ones described in the first part of the book, although the calendar spread looks similar, but is really not. Futures traders and strategists spend a great deal of time looking at futures spreads, and the option strategies pre­ sented in this chapter are designed to help make that type of trading more profitable. A new chapter dealing with advanced mathematical concepts was added near the end of the book. As option trading matured and the computer became more of an integral way of life in monitoring and evaluating positions, more advanced tech­ niques were used to monitor risk. This chapter describes the six major measures of risk of an option position or portfolio. The application of these measures to initialize positions that are doubly or triply neutral is discussed. Moreover, the use of the com­ puter to predict the results and "shape" of a position at points in the future is described. Preface xix There were substantial revisions to the chapters on index options as well. Part of the revisions are due to the fact that these were relatively new products at the time of the writing of the second edition; as a result, many changes were made to the prod­ ucts - delisting of some index options and introduction of others. Also, after the crash of 1987, the use of index products changed somewhat (with introduction of circuit breakers, for example). FOURTH EDITION Once again, in the ever-changing world of options and derivatives, some new important products have been introduced and some new concepts in trading have come to the forefront. Meanwhile, others have been delisted or fallen out of favor. There are five new chapters in the fourth edition, four of which deal with the most important approach to option trading today - volatility trading. The chapter on CAPS was deleted, since CAPS were delisted by the option exchanges. Moreover, the chapter on PERCS was incorporated into a much larger and more comprehensive chapter on another relatively new trading vehicle - struc­ tured products. Structured products encompass a fairly wide range of securities - many of which are listed on the major stock exchanges. These versatile products allow for many attractive, derivative-based applications - including index funds that have limited downside risk, for example. Many astute investors buy structured prod­ ucts for their retirements accounts. Volatility trading has become one of the most sophisticated approaches to option trading. The four new chapters actually comprise a new Part 6 - Measuring And Trading Volatility. This new part of the book goes in-depth into why one should trade volatility (it's easier to predict volatility than it is to predict stock prices), how volatility affects common option strategies - sometimes in ways that are not initially obvious to the average option trader, how stock prices are distributed ( which is one of the reasons why volatility trading "works"), and how to construct and monitor a volatility trade. A number of relatively new techniques regarding measuring and pre­ dicting volatility are presented in these chapters. Personally, I think that volatility buying of stock options is the most useful strategy, in general, for traders of all levels - from beginners through experts. If constructed properly, the strategy not only has a high probability of success, but it also requires only a modest amount of work to monitor the position after it has been established. This means that a volatility buyer can have a "life" outside of watching a screen with dancing numbers on it all day. Moreover, most of the previous chapters were expanded to include the latest techniques and developments. For example, in Chapter 1 (Definitions), the entire area of option symbology has been expanded, because of the wild movements of xx Preface stocks in the past few years. Also, the margin rules were changed in 2000, and those changes are noted throughout the book. Those chapters dealing with the sale of options - particularly naked options - have been expanded to include more discussion of the way that stocks behave and how that presents problems and opportunities for the option writer. For example, in the chapter on Reverse Spreads, the reverse calendar spread is described in detail because - in a high-volatility environment - the strategy becomes much more viable. Another strategy that receives expanded treatment is the "collar" - the purchase of a put and simultaneous sale of a call against an underlying instrument. In fact, a similar strategy can be used - with a slight adjustment - by the outright buyer of an option (see the chapter on Spreads Combining Puts and Calls). I am certain that many readers of this book expect to learn what the "best" option strategy is. While there is a chapter discussing this subject, there is no defin­ itively "best" strategy. The optimum strategy for one investor may not be best for another. Option professionals who have the time to monitor positions closely may be able to utilize an array of strategies that could not possibly be operated diligently by a public customer employed in another full-time occupation. Moreover, one's partic­ ular investment philosophy must play an important part in determining which strat­ egy is best for him. Those willing to accept little or no risk other than that of owning stock may prefer covered call writing. More speculative strategists may feel that low­ cost, high-profit-potential situations suit them best. Every investor must read the Options Clearing Corporation Prospectus before trading in listed options. Options may not be suitable for every investor. There are risks involved in any investment, and certain option strategies may involve large risks. The reader must determine whether his or her financial situation and investment objectives are compatible with the strategies described. The only way an investor can reasonably make a decision on his or her own to trade options is to attemptto acquire a knowledge of the subject. Several years ago, I wrote that "the option market shows every sign of becom­ ing a stronger force in the investment world. Those who understand it will be able to benefit the most." Nothing has happened in the interim to change the truth of that statement, and in fact, it could probably be even more forcefully stated today. For example, the Federal Reserve Board now often makes decisions with an eye to how derivatives will affect the markets. That shows just how important derivatives have become. The purpose of this book is to provide the reader with that understanding of options. I would like to express my appreciation to several people who helped make this book possible: to Ron Dilks and Howard Whitman, who brought me into the bro- Preface xxi kerage business; to Art Kaufman, whose broad experience in options helped to crys­ tallize many of these strategies; to Peter Kopple for his help in reviewing the chap­ ter on arbitrage; to Shelley Kaufman for his help on the third and fourth editions in designing the graphs and in the massive task of proofreading and editing; to Ben Russell and Fred Dahl for their suggestions on format and layout of the initial book; and to Jim Dalton (then president of the CBOE) for recommending a little-known option strategist when the New York Institute of Finance asked him, in 1977, if he had any suggestions for an author for a new book on options. Special thanks go to Bruce Nemirow for his invaluable assistance, especially for reading and critiquing the original manuscript. Most of all, I am grateful to my wife, Janet, who typed the orig­ inal manuscript, and to Karen and Glenn, our children, all of whom graciously with­ stood the countless hours of interrupted family life that were necessary in order to complete this work. LAWRENCE G. MCMILLAN I PART I --·····-·····u·-a•-s·•···i~ Prop· ertie····s··· · ............... ~. . ..... ····••· . : ;· ...... .. . . /"•. ··•··· .. ·····•o·· ·· i:. ····s·····t·· ··o·c··k··•· •• .. O····· ·:·p·· · ··t···1·.·o···· ··:n.··. ·. ·::.·.s· ···· ,-" ~,~, ,:1,-,,, o ,,,,- V ,. •• '' ,,' '' "' ,,,., ,,,, ,,,,, " ''' • ,•,- ~t•" ,,,, . . . ~··"·" '•''"~ .,. ,_,,,, INTRODUCTION Each chapter in this book presents information in a logically sequential fashion. Many chapters build on the information presented in preceding chapters. One should therefore be able to proceed from beginning to end without constantly refer­ ring to the glossary or index. However, the reader who is using the text as a refer­ ence - perhaps scanning one of the later chapters - many find that terms are being encountered that have been defined in an earlier chapter. In this case, the extensive glossary at the back of the book should prove useful. The index may provide aid as well, since some subjects are described, in varying levels of complexity, in more than one place in the book. For example, call buying is discussed initially in Chapter 3; and mathematical applications, as they apply to call purchases, are described in Chapter 28. The latter chapters address more complex topics than do the early chapters. 2 CHAPTER 1 Definitions The successful implementation of various investment strategies necessitates a sound working knowledge of the fundamentals of options and option trading. The option strategist must be familiar with a wide range of the basic aspects of stock options how the price of an option behaves under certain conditions or how the markets function. A thorough understanding of the rudiments and of the strategies helps the investor who is not familiar with options to decide not only whether a strategy seems desirable, but also - and more important - whether it is suitable. Determining suit­ ability is nothing new to stock market investors, for stocks themselves are not suitable for every investor. For example, if the investor's primary objectives are income and safety of principal, then bonds, rather than stocks, would be more suitable. The need to assess the suitability of options is especially important: Option buyers can lose their entire investment in a short time, and uncovered option writers may be subjected to large financial risks. Despite follow-up methods designed to limit risk, the individual investor must decide whether option trading is suitable for his or her financial situa­ tion and investment objective. ELEMENTARY DEFINITIONS A stock option is the right to buy or sell a particular stock at a certain price for a lim­ ited period of time. The stock in question is called the underlying security. A call option gives the owner ( or holder) the right to buy the underlying security, while a put option gives the holder the right to sell the underlying security. The price at which the stock may be bought or sold is the exercise price, also called the striking price. (In the listed options market, "exercise price" and "striking price" are synony­ mous.) A stock option affords this right to buy or sell for only a limited period of time; 3 4 Part I: Basic Properties of Stodc Options thus, each option has an expiration date. Throughout the book, the term "options" is always understood to mean listed options, that is, options traded on national option exchanges where a secondary market exists. Unless specifically mentioned, over-the­ counter options are not included in any discussion. DESCRIBING OPTIONS Four specifications uniquely describe any option contract: 1. the type (put or call), 2. the underlying stock name, 3. the expiration date, and 4. the striking price. As an example, an option referred to as an "XYZ July 50 call" is an option to buy (a call) 100 shares (normally) of the underlying XYZ stock for $50 per share. The option expires in July. The price of a listed option is quo!_ed on a per-share basis, regardless of how many shares of stock can be bought with the option. Thus, if the price of the XYZ July 50 call is quoted at $5, buying the option would ordinarily cost $500 ($5 x 100 shares), plus commissions. THE VALUE OF OPTIONS An option is a "wasting" asset; that is, it has only an initial value that declines (or "wastes" away) as time passes. It may even expire worthless, or the holder may have to exercise it in order to recover some value before expiration. Of course, the holder may sell the option in the listed option market before expiration. An option is also a security by itself, but it is a derivative security. The option is irrevocably linked to the underlying stock; its price fluctuates as the price of the underlying stock rises or falls. Splits and stock dividends in the underlying stock affect the terms of listed options, although cash dividends do not. The holder of a call does not receive any cash dividends paid by the underlying stock. STANDARDIZATION The listed option exchanges have standardized the terms of option contracts. The terms of an option constitute the collective name that includes all of the four descrip­ tive specifications. While the type (put or call) and the underlying stock are self-evi­ dent and essentially standardized, the striking price and expiration date require more explanation. Chapter 1: Definitions s Striking Price. Striking prices are generally spaced 5 points apart for stocks, although for more expensive stocks, the striking prices may be 10 points apart. A $35 stock might, for example, have options with striking prices, or "strikes," of 30, 35, and 40, while a $255 stock might have one at 250 and one at 260. Moreover, some stocks have striking prices that are 2½ points apart - generally those selling for less than $35 per share. That is, a $17 stock might have strikes at 15, 17½, and 20. These striking price guidelines are not ironclad, however. Exchange officials may alter the intervals to improve depth and liquidity, perhaps spacing the strikes 5 points apart on a nonvolatile stock even if it is selling for more than $100. For exam­ ple, if a $155 stock were very active, and possibly not volatile, then there might well be a strike at 155, in addition to those at 150 and 160. Expiration Dates. Options have expiration dates in one of three fixed cycles: L the January/April/July/October cycle, 2. the February/May/August/November cycle, or 3. the March/June/September/December cycle. In addition, the two nearest months have listed options as well. However, at any given time, the longest-term expiration dates are normally no farther away than 9 months. Longer-term options, called LEAPS, are available on some stocks (see Chapter 25). Hence, in any cycle, options may expire in 3 of the 4 major months (series) plus the near-term months. For example, on February 1 of any year, XYZ options may expire in February, March, April, July, and October - not in January. The February option ( the closest series) is the short- or near-term option; and the October, the far- or long­ term option. If there were LEAPS options on this stock, they would expire in January of the following year and in January of the year after that. The exact date of expiration is fixed within each month. The last trading day for an option is the third Friday in the expiration month. Although the option actually does not expire until the following day (the Saturday following), a public customer must invoke the right to buy or sell stock by notifying his broker by 5:30 P.M., New York time, on the last day of trading. THE OPTION ITSELF: OTHER DEFINITIONS Classes and Series. A class of options refers to all put and call contracts on the same underlying security. For instance, all IBM options - all the puts and calls at various strikes and expiration months - form one class. A series, a subset of a class, 6 Part I: Basic Properties of Stock Options consists of all contracts of the same class (IBM, for example) having the same expi­ ration date and striking price. Opening and Closing Transactions. An opening transaction is the ini­ tial transaction, either a buy or a sell. For example, an opening buy transaction creates or increases a long position in the customer's account. A closing trans­ action reduces the customer's position. Opening buys are often followed by clos­ ing sales; correspondingly, opening sells often precede closing buy trades. Open Interest. The option exchanges keep track of the number of opening and closing transactions in each option series. This is called the open interest. Each opening transaction adds to the open interest and each closing transaction decreases the open interest. The open interest is expressed in number of option contracts, so that one order to buy 5 calls opening would increase the open interest by 5. Note that the open interest does not differentiate between buyers and sellers - there is no way to tell if there is a preponderance of either one. While the magnitude of the open interest is not an extremely important piece of data for the investor, it is useful in determining the liquidity of the option in question. If there is a large open interest, then there should be little problem in making fairly large trades. However, if the open interest is small - only a few hundred contracts outstanding - then there might not be a reasonable second­ ary market in that option series. The Holder and Writer. Anyone who buys an option as the initial transac­ tion - that is, buys opening - is called the holder. On the other hand, the investor who sells an option as the initial transaction - an opening sale - is called the writer of the option. Commonly, the writer ( or seller) of an option is referred to as being short the option contract. The term "writer" dates back to the over­ the-counter days, when a direct link existed between buyers and sellers of options; at that time, the seller was the writer of a new contract to buy stock. In the listed option market, however, the issuer of all options is the Options Clearing Corporation, and contracts are standardized. This important difference makes it possible to break the direct link between the buyer and seller, paving the way for the formation of the secondary markets that now exist. Exercise and Assignment. An option owner ( or holder) who invokes the right to buy or sell is said to exercise the option. Call option holders exercise to buy stock; put holders exercise to sell. The holder of most stock options may exercise the option at any time after taking possession of it, up until 8:00 P.M. on O,apter 1: Definitions 7 the last trading day; the holder does not have to wait until the expiration date itself before exercising. (Note: Some options, called "European" exercise options, can be exercised only on their expiration date and not before - but they are generally not stock options.) These exercise notices are irrevocable; once generated, they cannot be recalled. In practical terms, they are processed only once a day, after the market closes. Whenever a holder exercises an option, somewhere a writer is assigned the obligation to fulfill the terms of the option contract: Thus, if a call holder exercises the right to buy, a call writer is assigned the obligation to sell; conversely, if a put holder exercises the right to sell, a put writer is assigned the obligation to buy. A more detailed description of the exer­ cise and assignment of call options follows later in this chapter; put option exer­ cise and assignment are discussed later in the book. RELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE In- and Out-of-the-Money. Certain terms describe the relationship between the stock price and the option's striking price. A call option is said to be out-of-the­ money if the stock is selling below the striking price of the option. A call option is in­ the-money if the stock price is above the striking price of the option. (Put options work in a converse manner, which is described later.) Example: XYZ stock is trading at $47 per share. The XYZ July 50 call option is out­ of-the-money, just like the XYZ October 50 call and the XYZ July 60 call. However, the XYZ July 45 call, XYZ October 40, and XYZ January 35 are in-the-money. The intrinsic value of an in-the-money call is the amount by which the stock price exceeds the striking price. If the call is out-of-the-money, its intrinsic value is zero. The price that an option sells for is commonly referred to as the premium. The premium is distinctly different from the time value premium ( called time premium, for short), which is the amount by which the option premium itself exceeds its intrin­ sic value. The time value premium is quickly computed by the following formula for an in-the-money call option: Call time value premium = Call option price + Striking price - Stock price Example: XYZ is trading at 48, and XYZ July 45 call is at 4. The premium - the total price - of the option is 4. With XYZ at 48 and the striking price of the option at 45, the in-the-money amount (or intrinsic value) is 3 points (48-45), and the time value isl(4-3). 8 Part I: Basic Properties ol Stoclc Options If the call is out-of-the-money, then the premium and the time value premium are the same. Example: With XYZ at 48 and an XYZ July 50 call selling at 2, both the premium and the time value premium of the call are 2 points. The call has no intrinsic value by itself with the stock price below the striking price. An option normally has the largest amount of time value premium when the stock price is equal to the striking price. As an option becomes deeply in- or out-of­ the-money, the time value premium shrinks substantially. Table 1-1 illustrates this effect. Note that the time value premium increases as the stock nears the striking price (50) and then decreases as it draws away from 50. Parity. An option is said to be trading at parity with the underlying security if it is trading for its intrinsic value. Thus, if XYZ is 48 and the xyz July 45 call is selling for 3, the call is at parity. A common practice of particular interest to option writers ( as shall be seen later) is to refer to the price of an option by relat­ ing how close it is to parity with the common stock. Thus, the XY2 July 45 call is said to be a half-point over parity in any of the cases shown in Table 1-2. TABLE 1-1. Changes in time value premium. XYZ Stock XYZ Jul 50 Intrinsic Time Value Price Call Price Value Premium 40 1/2 0 ¼ 43 1 0 1 35 2 0 2 47 4 0 3 ➔50 5 0 5 53 7 3 4 55 8 5 3 57 9 7 2 60 101/2 10 ¼ 70 191/2 20 -1/20 asimplistically, a deeply in-the-money call may actually trade at a discount from intrinsic value, because call buyers are more interested in less expensive calls that might return better percentage profits on an upward move in the stock. This phenomenon is discussed in more detail when arbitrage techniques are examined. Cl,apter 1: Definitions 9 TABLE 1-2. Comparison of XYZ stock and call prices. XYZ July 45 XYZ Stock Over Striking Price + Coll Price Price Parity (45 + 45 1/2) 1/2 (45 + 21/2 47 ) 1/2 (45 + 51/2 50 ) ½ (45 + 151/2 60 ) 1/2 FACTORS INFLUENCING THE PRICE OF AN OPTION An option's price is the result of properties of both the underlying stock and the terms of the option. The major quantifiable factors influencing the price of an option are the: 1.. price of the underlying stock, 2. striking price of the option itself, 3. time remaining until expiration of the option, 4. volatility of the underlying stock, 5. current risk-free interest rate (such as for 90-day Treasury bills), and 6. dividend rate of the underlying stock. The first four items are the major determinants of an option's price, while the latter two are generally less important, although the dividend rate can be influential in the case of high-yield stock. THE FOUR MAJOR DETERMINANTS Probably the most important influence on the option's price is the stock price, because if the stock price is far above or far below the striking price, the other fac­ tors have little influence. Its dominance is obvious on the day that an option expires. On that day, only the stock price and the striking price of the option determine the option's value; the other four factors have no bearing at all. At this time, an option is worth only its intrinsic value. Example: On the expiration day in July, with no time remaining, an XYZ July 50 call has the value shown in Table 1-3; each value depends on the stock price at the time. 10 Part I: Basic Properties of Stock Options TABLE 1-3. XYZ option's values on the expiration day. XYZ July 50 Coll (Intrinsic) Value XYZ Stock Price ot Expiration 40 45 48 50 52 55 60 0 0 0 0 2 5 10 The Call Option Price Curve. The call option price curve is a curve that plots the prices of an option against various stock prices. Figure 1-1 shows the axes needed to graph such a curve. The vertical axis is called Option Price. The horizontal axis is for Stock Price. This figure is a graph of the intrinsic value. When the option is either out-of-the-money or equal to the stock price, the intrinsic value is zero. Once the stock price passes the striking price, it reflects the increase of intrinsic value as the stock price goes up. Since a call is usually worth at least its intrinsic value at any time, the graph thus represents the min­ imum price that a call may be worth. FIGURE 1-1. The value of an option at expiration, its intrinsic value. ~ it C: .Q 15.. 0 The intrinsic value line bends at the st~iking ~ pnce. ~ Stock Price Chapter 1: Definitions 11 When a call has time remaining to its expiration date, its total price consists of its intrinsic value plus its time value premium. The resultant call option price curve takes the form of an inverted arch that stretches along the stock price axis. If one plots the data from Table 1-4 on the grid supplied in Figure 1-2, the curve assumes two characteristics: 1. The time value premium ( the shaded area) is greatest when the stock price and the striking price are the same. 2. When the stock price is far above or far below the striking price (near the ends of the curve), the option sells for nearly its intrinsic value. As a result, the curve nearly touches the intrinsic value line at either end. [Figure 1-2 thus shows both the intrinsic value and the option price curve.] This curve, however, shows only how one might expect the XYZ July 50 call prices to behave with 6 months remaining until expiration. As the time to expiration grows shorter, the arched line drops lower and lower, until, on the final day in the life of the option, it merges completely with the intrinsic value line. In other words, the call is worth only its intrinsic value at expiration. Examine Figure 1-3, which depicts three separate XYZ calls. At any given stock price (a fixed point on the stock price scale), the longest-term call sells for the highest price and the nearest-term call sells for the lowest price. At the striking price, the actual differences in the three option prices are the greatest. Near either end of the scale, the three curves are much clos­ er together, indicating that the actual price differences from one option to another are small. For a given stock price, therefore, option prices decrease as the expiration date approaches. TABLE 1-4. The prices of a hypothetical July 50 call with 6 months of time remaining, plotted in Figure 1-2. XYZ Stock Price (Horizontal Axis) 40 45 48 ➔SO 52 55 60 XYZ July 50 Call Price (Vertical Axis) 2 3 4 5 61/2 11 Intrinsic Value 0 0 0 0 2 5 10 Time Value Premium (Shading) 2 3 4 3 11/2 1 12 Part I: Basic Properties of Stock Options Example: On January 1st, XYZ is selling at 48. An XYZ July 50 call will sell for more than an April 50 call, which in turn will sell for more than a January 50 call. FIGURE 1-2. Six-month July call option (see Table 1 ·4). .g a. C 0 a 11 10 9 8 7 6 5 Greatest Value for Time Value Premium 0 4 ---------------------- 3 2 0 FIGURE 1-3. 40 45 represents the option's time value premium. --------L---------50\ 55 60 Stock Price Intrinsic value remains at zero until striking price is passed. Price Curves for the 3-, 6·, and 9-month call options. / Intrinsic Value 9-Month Curve Striking Price Stock Price As expiration date draws closer, the lower curve merges with the intrinsic value line. The option price then equals its intrinsic value. Chapter 1: Definitions 13 This statement is true no matter what the stock price is. The only reservation is that with the stock deeply in- or out-of-the-money, the actual difference between the January, April, and July calls will be smaller than with XYZ stock selling at the strik­ ing price of 50. Time Value Premium Decay. In Figure 1-3, notice that the price of the 9- month call is not three times that of the 3-month call. Note next that the curve in Figure 1-4 for the decay of time value premium is not straight; that is, the rate of decay of an option is not linear. An option's time value premium decays much more rapidly in the last few weeks of its life ( that is, in the weeks immediately preceding expiration) than it does in the first few weeks of its existence. The rate of decay is actually related to the square root of the time remaining. Thus, a 3- month option decays (loses time value premium) at twice the rate of a 9-month option, since the square root of 9 is 3. Similarly, a 2-month option decays at twice the rate of a 4-month option (-..f4 = 2). This graphic simplification should not lead one to believe that a 9-month option necessarily sells for twice the price of a 3-month option, because the other factors also influence the actual price relationship between the two calls. Of those other fac­ tors, the volatility of the underlying stock is particularly influential. More volatile underlying stocks have higher option prices. This relationship is logical, because if a FIGURE 1-4. Time value premium decay, assuming the stock price remains con­ stant. 9 4 Time Remaining Until Expiration (Months) 0 14 Part I: Basic Properties ol Stodc Options stock has the ability to move a relatively large distance upward, buyers of the calls are willing to pay higher prices for the calls - and sellers demand them as well. For exam­ ple, if AT&T and Xerox sell for the same price (as they have been known to do), the Xerox calls would be more highly priced than the AT&T calls because Xerox is a more volatile stock than AT&T. The interplay of the four major variables - stock price, striking price, time, and volatility can be quite complex. While a rising stock price (for example) is directing the price of a call upward, decreasing time may be simultaneously driving the price in the opposite direction. Thus, the purchaser of an out-of-the-money call may wind up with a loss even after a rise in price by the underlying stock, because time has eroded the call value. THE TWO MINOR DETERMINANTS The Risk-Free Interest Rate. This rate is generally construed as the current rate of 90-day Treasury bills. Higher interest rates imply slightly higher option pre­ miums, while lower rates imply lower premiums. Although members of the financial community disagree as to the extent that interest rates actually affect option price, they remain a factor in most mathematical models used for pricing options. (These models are covered much later in this book.) The Cash Dividend Rate of the Underlying Stock. Though not clas­ sified as a major determinant in option prices, this rate can be especially impor­ tant to the writer (seller) of an option. If the underlying stock pays no dividends at all, then a call option's worth is strictly a function of the other five items. Dividends, however, tend to lower call option premiums: The larger the dividend of the underlying common stock, the lower the price of its call options. One of the most influential factors in keeping option premiums low on high-yielding stock is the yield itself. Example: XYZ is a relatively low-priced stock with low volatility selling for $25 per share. It pays a large annual dividend of $2 per share in four quarterly payments of $.50 each. What is a fair price of an XYZ call with striking price 25? A prospective buyer of XYZ options is determined to figure out a fair price. In six months XYZ will pay $1 per share in dividends, and the stock price will thus be reduced by $1 per share when it goes ex-dividend over that time period. In that case, if XYZ's price remains unchanged except for the ex-dividend reductions, it will then be $24. Moreover, since XYZ is a nonvolatile stock, it may not readily climb back to 25 after the ex-dividend reductions. Therefore, the call buyer makes a low bid - even Chapter I: Definitions 15 for a 6-month call - because the underlying stock's price will be reduced by the ex­ dividend reduction, and the call holder does not receive the cash dividends. This particular call buyer calculated the value of the XYZ July 25 call in terms of what it was worth with the stock discounted to 24 - not at 25. He knew for certain that the stock was going to lose 1 point of value over the next 6 months, provided the dividend rate of XYZ stock did not change. In actual practice, option buyers tend to discount the upcoming dividends of the stock when they bid for the calls. However, not all dividends are discounted fully; usually the nearest dividend is discounted more heavily than are dividends to be paid at a later date. The less-volatile stocks with the higher dividend payout rates have lower call prices than volatile stocks with low payouts. In fact, in certain cases, an impending large dividend payment can substan­ tially increase the probability of an exercise of the call in advance of expiration. (This phenomenon is discussed more fully in the following section.) In any case, to one degree or another, dividends exert an important influence on the price of some calls. OTHER INFLUENCES These six factors, major and minor, are only the quantifiable influences on the price of an option. In practice, nonquantitative market dynamics - investor sentiment - can play various roles as well. In a bullish market, call premiums often expand because of increased demand. In bearish markets, call premiums may shrink due to increased supply or diminished demand. These influences, however, are normally short-lived and generally come into play only in dynamic market periods when emo­ tions are running high. EXERCISE AND ASSIGNMENT: THE MECHANICS The holder of an option can exercise his right at any time during the life of an option: Call option holders exercise to buy stock, while put option holders exercise to sell stock. In the event that an option is exercised, the writer of an option with the same terms is assigned an obligation to fulfill the terms of the option contract. EXERCISING THE OPTION The actual mechanics of exercise and assignment are fairly simple, due to the role of the Options Clearing Corporation (OCC). As the issuer of all listed option contracts, it controls all listed option exercises and assignments. Its activities are best explained by an example. 16 Part I: Bask Properties ol Stock Options Example: The holder of an XYZ January 45 call option wishes to exercise his right to buy XYZ stock at $45 per share. He instructs his broker to do so. The broker then notifies the administrative section of the brokerage firm that handles such matters. The firm then notifies the OCC that they wish to exercise one contract of the XYZ January 45 call series. Now the OCC takes over the handling. OCC records indicate which member (brokerage) firms are short or which have written and not yet covered XYZ Jan 45 calls. The OCC selects, at random, a member firm that is short at least one XYZ Jan 45 call, and it notifies the short firm that it has been assigned. That firm must then deliver 100 shares of XYZ at $45 per share to the firm that exercised the option. The assigned firm, in tum, selects one of its customers who is short the XYZ January 45 call. This selection for the assignment may be either: 1. at random, 2. on a first-in/first-out basis, or 3. on any other basis that is fair, equitable, and approved by the appropriate exchange. The selection of the customer who is short the XYZ January 45 completes the exercise/assignment process. (If one is an option writer, he should obviously deter­ mine exactly how his brokerage firm assigns its option contracts.) HONORING THE ASSIGNMENT The assigned customer must deliver the stock - he has no other choice. It is too late to try buying the option back in the option market. He must, without fail, deliver 100 shares of XYZ stock at $45 per share. The assigned writer does, however, have a choice as to how to fulfill the assignment. If he happens to be already long 100 shares of XYZ in his account, he merely delivers that 100 shares as fulfillment of the assign­ ment notice. Alternatively, he can go into the stock market and buy XYZ at the cur­ rent market price - presumably something higher than $45 - and then deliver the newly purchased stock as fulfillment. A third alternative is merely to notify his bro­ kerage firm that he wishes to go short XYZ stock and to ask them to deliver the 100 shares of XYZ at 45 out of his short account. At times, borrowing stock to go short may not be possible, so this third alternative is not always available on every stock. Margin Requirements. If the assigned writer purchases stock to fulfill a contract, reduced margin requirements generally apply to the transaction, so that he would not have to fully margin the purchased stock merely for the pur­ pose of delivery. Generally, the customer only has to pay a day-trade margin of Oapter 1: Definitions 17 the difference between the current price of XYZ and the delivery price of $45 per share. If he goes short to honor the assignment, then he has to fully margin the short sale at the current rate for stock sold short on a margin basis. AFTER EXERCISING THE OPTION The OCC and the customer exercising the option are not concerned with the actual method in which the delivery is handled by the assigned customer. They want only to ensure that the 100 shares of XYZ at 45 are, in fact, delivered. The holder who exer­ cised the call can keep the stock in his account if he wants to, but he has to margin it fully or pay cash in a cash account. On the other hand, he may want to sell the stock immediately in the open market, presumably at a higher price than 45. If he has an established margin account, he may sell right away without putting out any money. If he exercises in a cash account, however, the stock must be paid for in full - even if it is subsequently sold on the same day. Alternatively, he may use the delivered stock to cover a short sale in his own account if he happens to be short XYZ stock. COMMISSIONS Both the buyer of the stock via the exercise and the seller of the stock via the assign­ ment are charged a full stock commission on 100 shares, unless a special agreement exists between the customer and the brokerage firm. Generally, option holders incur higher commission costs through assignment than they do selling the option in the secondary market. So the public customer who holds an option is better off selling the option in the secondary market than exercising the call. Example: XYZ is $55 per share. A public customer owns the XYZ January 45 call option. He realizes that exercising the call, buying XYZ at 45, and then immediately selling it at 55 in the stock market would net a profit of 10 points - or $1,000. However, the combined stock commissions on both the purchase at 45 and the sale at 55 might easily exceed $100. The net gain would actually be only $900. On the other hand, the XYZ January 45 call is worth (and it would normally sell for) at least 10 points in the listed options market. The commission for selling one call at a price of 10 is roughly $30. The customer therefore decides to sell his XYZ January 45 call in the option market. He receives $1,000 (10 points) for the call and pays only $30 in commissions - for a net of $970. The benefit of his decision is obvi­ ous. Of course, sometimes a customer wants to own XYZ stock at $45 per share, despite the stock commissions. Perhaps the stock is an attractive addition that will 18 Part I: Basic Properties of Stock Options bring greater potential to a portfolio. Or if the customer is already short the XYZ stock, he is going to have to buy 100 shares and pay the commissions sooner or later in any case; so exercising the call at the lower stock price of 45 may be more desir­ able than buying at the current price of 55. ANTICIPATING ASSIGNMENT The writer of a call often prefers to buy the option back in the secondary market, rather than fulfill the obligation via a stock transaction. It should be strJssed again that once the writer receives an assignment notice, it is too late to attempt to buy back (cover) the call. The writer must buy before assignment, or live up to the terms upon assignment. The writer who is aware of the circumstances that generally cause the holders to exercise can anticipate assignment with a fair amount of certainty. In antic­ ipation of the assignment, the writer can then close the contract in the secondary mar­ ket. As long as the writer covers the position at any time during a trading day, he can­ not be assigned on that option. Assignment notices are determined on open positions as of the close of trading each day. The crucial question then becomes, "How can the writer anticipate assignment?" Several circumstances signal assignments: 1. a call that is in-the-money at expiration, 2. an option trading at a discount prior to expiration, or 3. the underlying stock paying a large dividend and about to go ex-dividend. Automatic Exercise. Assignment is all but certain if the option is in-the­ money at expiration. Should the stock close even a half-point above the striking price on the last day of trading, the holder will exercise to take advantage of the half-point rather than let the option expire. Assignment is nearly inevitable even if a call is only a few cents in-the-money at expiration. In fact, even if the call trades in-the-money at any time during the last trading day, assignment may be forthcoming. Even if a holder forgets that he owns an option and fails to exer­ cise, the OCC automatically exercises any call that is ¾-point in-the-money at expiration, unless the individual brokerage firm whose customer is long the call gives specific instructions not to exercise. This automatic exercise mechanism ensures that no investor throws away money through carelessness. Example: XYZ closes at 51 on the third Friday of January (the last day of trading for the January option series). Since options don't expire until Saturday, the next day, the OCC and all brokerage firms have the opportunity to review their records to issue assignments and exercises and to see if any options could have been profitably exer- Gapter 1: Definitions 19 cised but were not. If XYZ closed at 51 and a customer who owned a January 45 call option failed to either sell or exercise it, it is automatically exercised. Since it is worth $600, this customer stands to receive a substantial amount of money back, even after stock commissions. In the case of an XYZ January 50 call option, the automatic exercise procedure is not as clear-cut with the stock at 51. Though the OCC wants to exercise the call automatically, it cannot identify a specific owner. It knows only that one or more XYZ January calls are still open on the long side. When the OCC checks with the broker­ age firm, it may find that the firm does not wish to have the XYZ January 50 call exer­ cised automatically, because the customer would lose money on the exercise after incurring stock commissions. Yet the OCC must attempt to automatically exercise any in-the-money calls, because the holder may have overlooked a long position. When the public customer sells a call in the secondary market on the last day of trading, the buyer on the other side of the trade is very likely a market-maker. Thus, when trading stops, much of the open interest in in-the-money calls held long belongs to market-makers. Since they can profitably exercise even for an eighth of a point, they do so. Hence, the writer may receive an assignment notice even if the stock has been only slightly above the strike price on the last trading day before expi­ ration. Any writer who wishes to avoid an assignment notice should always buy back ( or cover) the option if it appears the stock will be above the strike at expiration. The probabilities of assignment are extremely high if the option expires in-the-money. Early Exercise Due to Discount. When options are exercised prior to expiration, this is called early, or premature, exercise. The writer can usually expect an early exercise when the call is trading at or below parity. A parity or discount situation in advance of expiration may mean that an early exercise is forthcoming, even if the discount is slight. A writer who does not want to deliv­ er stock should buy back the option prior to expiration if the option is apparently going to trade at a discount to parity. The reason is that arbitrageurs (floor traders or member firm traders who pay only minimal commissions) can take advantage of discount situations. (Arbitrage is discussed in more detail later in the text; it is mentioned here to show why early exercise often occurs in a dis­ count situation.) Example: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered at a discount price of 9.80. The call is actually "worth" 10 points. The arbitrageur can take advantage of this situation through the following actions, all on the same day: 20 Part I: Basic Properties ol Stoclc Options 1. Buy the January 40 call at 9.80. 2. Sell short XYZ common stock at 50. 3. Exercise the call to buy XYZ at 40. The arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from which he deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents - the amount of the discount. Since he pays only a minimal commission, this trans- action results in a net profit. ' Also, if the writer can expect assignment when the option has no time value pre­ mium left in it, then conversely the option will usually not be called if time premium is left in it. Example: Prior to the expiration date, XYZ is trading at 50½, and the January 50 call is trading at 1. The call is not necessarily in imminent danger of being called, since it still has half a point of time premium left. Time value Call Striking Stock = + premium price price price = 1 + 50 50½ = ½ Early Exercise Due to Dividends on the Underlying Stock. Some­ times the market conditions create a discount situation, and sometimes a large dividend gives rise to a discount. Since the stock price is almost invariably reduced by the amount of the dividend, the option price is also most likely reduced after the ex-dividend. Since the holder of a listed option does not receive the dividend, he may decide to sell the option in the secondary market before the ex-date in anticipation of the drop in price. If enough calls are sold because of the impending ex-dividend reduction, the option may come to parity or even to a discount. Once again, the arbitrageurs may move in to take advantage of the sit­ uation by buying these calls and exercising them. If assigned prior to the ex-date, the writer does not receive the dividend for he no longer owns the stock on the ex-date. Furthermore, if he receives an assignment notice on the ex-date, he must deliver the stock with the dividend. It is therefore very important for the writer to watch for discount situations on the day prior to the ex­ date. 0.,,,,, I: Definitions 21 A word of caution: Do not conclude from this discussion that a call will be exer­ cised for the dividend if the dividend is larger than the remaining time premium. It won't. An example will show why. Emmple: XYZ stock, at 50, is going to pay a $1 dividend with the ex-date set for the next day. An XYZ January 40 call is selling at 10¼; it has a quarter-point of time pre­ mium. (TVP = 10¼ + 40 - 50 = ¼). The same type of arbitrage will not work Suppose that the arbitrageur buys the call at 10¼ and exercises it: He now owns the stock for the ex-date, and he plans to sell the stock immediately at the opening on the ex-date, the next day. On the ex-date, XYZ opens at 49, because it goes ex-dividend by $1. The arbitrageur's transactions thus consist of: 1. Buy the XYZ January 40 call at 10¼. 2. Exercise the call the same day to buy XYZ at 40. 3. On the ex-date, sell XYZ at 49 and collect the $1 dividend. He makes 9 points on the stock (steps 2 and 3), and he receives a 1-point dividend, for a total cash inflow of 10 points. However, he loses 10¼ points paying for the call. The overall transaction is a loser and the arbitrageur would thus not attempt it. A dividend payment that exceeds the time premium in the call, therefore, does not imply that the writer will be assigned. More of a possibility, but a much less certain one, is that the arbitrageur may attempt a "risk arbitrage" in such a situation. Risk arbitrage is arbitrage in which the arbitrageur runs the risk of a loss in order to try for a profit. The arbitrageur may sus­ pect that the stock will not be discounted the full ex-dividend amount or that the call's time premium will increase after the ex-date. In either case (or both), he might make a profit: If the stock opens down only 60 cents or if the option premium expands by 40 cents, the arbitrageur could profit on the opening. In general, howev­ er, arbitrageurs do not like to take risks and therefore avoid this type of situation. So the probability of assignment as the result of a dividend payment on the underlying stock is small, unless the call trades at parity or at a discount. Of course, the anticipation of an early exercise assumes rational behavior on the part of the call holder. If time premium is left in the call, the holder is always better off financially to sell that call in the secondary market rather than to exercise it. However, the terms of the call contract give a call holder the right to go ahead and exercise it anyway - even if exercise is not the profitable thing to do. In such a case, a writer would receive an assignment notice quite unexpectedly. Financially unsound early exercises do happen, though not often, and an option writer must realize that, 22 Part I: Basic Properties of Stock Options in a very small percentage of cases, he could be assigned under very illogical cir­ cumstances. THE OPTION MARKETS The trader of stocks does not have to become very familiar with the details of the way the stock market works in order to make money. Stocks don't expire, nor Cal} an investor be pulled out of his investment unexpectedly. However, the option trader is required to do more homework regarding the operation of the option markets. In fact, the option strategist who does not know the details of the working of the option markets will likely find that he or she eventually loses some money due to ignorance. MARKET-MAKERS In at least one respect, stock and listed option markets are similar. Stock markets use specialists to do two things: First, they are required to make a market in a stock by buying and selling from their own inventory, when public orders to buy or sell the stock are absent. Second, they keep the public book of orders, consisting of limit orders to buy and sell, as well as stop orders placed by the public. When listed option trading began, the Chicago Board Options Exchange (CBOE) introduced a similar method of trading, the market-maker and the board broker system. The CBOE assigns several market-makers to each optionable stock to provide bids and offers to buy and sell options in the absence of public orders. Market-makers cannot handle public orders; they buy and sell for their own accounts only. A separate person, the board broker, keeps the book of limit orders. The board broker, who cannot do any trading, opens the book for traders to see how many orders to buy and sell are placed nearest to the current market (consisting of the highest bid and lowest offer). (The specialist on the stock exchange keeps a more closed book; he is not required to for­ mally disclose the sizes and prices of the public orders.) In theory, the CBOE system is more efficient than the stock exchange system. With several market-makers competing to create the market in a particular security, the market should be a more efficient one than a single specialist can provide. Also, the somewhat open book of public orders should provide a more orderly market. In practice, whether the CBOE has a more efficient market is usually a subject for heat­ ed discussion. The strategist need not be concerned with the question. The American Stock Exchange uses specialists for its option trading, but it also has floor traders who function similarly to market-makers. The regional option exchanges use combinations of the two systems; some use market-makers, while oth­ ers use specialists. Cl,apter 1: Definitions 23 OPTION SYMBOLOGY It is probably a good idea for an option trader to understand how option symbols are created and used, for it may prove to be useful information. If one has a sophisticat­ ed option quoting and pricing system, the quote vendor will usually provide the translation between option symbols and their meanings. The free option quote sec­ tion on the CBOE's Web site, www.cboe.com, can be useful for that purpose as well. Even with those aids, it is important that an option trader understand the concepts surrounding option symbology. THE OPTION BASE SYMBOL The basic option symbol consists of three parts: Option symbol = Base symbol + Expiration month code + Striking price code The base symbol is never more than three characters in length. In its simplest form, the base symbol is the same as the stock symbol. That works well for stocks with three or fewer letters in their symbol, such as General Electric (GE) or IBM (IBM), but what about NASDAQ stocks? For NASDAQ stocks, the OCC makes up a three-let­ ter symbol that is used to denote options on the stock. A few examples are: Stock Cisco Microsoft Qualcomm Stock Symbol csco MSFT QCOM Option Base Symbol CYQ MSQ QAQ In the three examples, there is a letter "Q" in each of the option base symbols. However, that is not always the case. The option base symbol assigned by the OCC for a NASDAQ stock may contain any three letters (or, rarely, only two letters). THE EXPIRATION MONTH CODE The next part of an option symbol is the expiration month code, which is a one-char­ acter symbol. The symbology that has been created actually uses the expiration month code for two purposes: (1) to identify the expiration month of the option, and (2) to designate whether the option is a call or a put. The concept is generally rather simple. For call options, the letter A stands for January, B for February, and so forth, up through L for December. For put options, the letter M stands for January, N for February, and so forth, up through X for December. The letters Y and Z are not used for expiration month codes. 24 Part I: Basic Properties ol Stock Options THE STRIKING PRICE CODE This is also a one-character symbol, designed to identify the striking price of the option. Things can get ve:iy complicated where striking price codes are concerned, but simplistically the designations are that the letter A stands for 5, B stands for 10, on up to S for 95 and T for 100. If the stock being quoted is more expensive - say, trading at $150 per share - then it is possible that A will stand for 105, B for 110, S for 195 and T for 200 (although, as will be shown later, a more complicated approach might have to be used in cases such as these). It should be noted that the exchanges - who designate the striking price codes and their numerical meaning - do not have • to adhere to any of the generalized conventions described here. They usually adhere to as many of them as they can, in order to keep things somewhat standardized, but they can use the letters in any way they want. Typically, they would only use any strik­ ing price code letter outside of its conventional designation after a stock has split or perhaps paid a special dividend of some sort. Before getting into the more complicated option symbol constructions, let's look at a few simple, straightforward examples: Stock Stock Symbol Description Option Symbol IBM IBM IBM July 125 call IBMGE Cisco csco Cisco April 75 put CYQPO Ford Motor F Ford March 40 call FCH General Motors GM GM December 65 put GMXM In each option symbol, the last two characters are the expiration month code and the striking price code. Preceding them is the option base symbol. For the IBM July 125, the option symbol is quite straightforward. IBM is the option base symbol (as well as the stock symbol), G stands for July, and E for 125, in this case. For the Cisco April 75 put, the option base symbol is CYQ (this was given in the previous table, but if one didn't know what the base symbol was, you would have to look it up on the Internet or call a broker). The expiration month code in this case is P, because P stands for an April put option. Finally, the striking price code is 0, which stands for 75. The Ford March 40 call and the GM December 65 put are similar to the oth­ ers, except that the stock symbols only require one and two characters, respectively, so the option symbol is thus a shorter symbol as well - first using the stock symbol, then the standard character for the expiration month, followed by the standard char­ acter for the striking price. Chapter 1: Definitions 25 MORE STRIKING PRICE CODES The letters A through T cannot handle all of the possible striking price codes. Recall that many stocks, especially lower-priced ones, have striking prices that are spaced 2½ points apart. In those cases, a special letter designation is usually used for the striking price codes: Striking Price Code u V w X y z Possible Meanings 7.5 or 37.5 or 67.5 or 97.5 or even 127.5! 12.5 or 42.5 or 72.5 or 102.5 or 132.5 17.5 or 47.5 or 77.5 or 107.5 or 137.5 22.5 or 52.5 or 82.5 or 112.5 or 142.5 27.5 or 57.5 or 87.5 or 117.5 or 147.5 32.5 or 62.5 or 92.5 or 122.5 or 152.5 Typically, only the first or second meaning is used for these letters. The higher-priced ones only occur after a very expensive stock splits 2-for-l (say, a stock that had a strike price of 155 and split 2-for-l, creating a strike. price of 155 divided by 2, or 77.50). WRAPS Note that any striking price code can have only one meaning. Thus, if the letter A is being used to designate a strike price of 5, and the underlying stock has a tremen­ dous rally to over $100 per share, then the letter A cannot also be used to designate the strike price of 105. Something else must be done. In the early years of option trading, there was no need for wrap symbols, but in recent - more volatile - times, stocks have risen 100 points during the life of an option. For example, if XYZ was originally trading at 10, there might be a 9-month, XYZ December 10 call. Its symbol would be XYZLB. If, in the course of the next few months, XYZ traded up to nearly 110 while the December 10 call was still in exis­ tence, the exchange would want to trade an XYZ December 110 call. But a new let­ ter would have to be designated for any new strikes (A already stands for 5, so it can­ not stand for 105; B already stands for 10, so it cannot stand for 110, etc.). There aren't enough letters in the alphabet to handle this, so the exchange creates an addi­ tional option base symbol, called a wrap symbol. In this case, the exchange might say that the option base symbol XYA is now going to be used to designate strike prices of 105 and higher ( up to 200) for the com­ mon stock whose symbol is XYZ. Having done that, the letter A can be used for 105, B for 110, etc. 26 Option XYZ December 10 call XYZ December 110 call Part I: Basic Properties ol Stock Options Symbol XYZLB XYALB (wrap symbol is XYA) Note that the wrap symbol now allows the usage of Bin its standard interpretati<,n once again. This process can be extended. Suppose that, by some miracle, this stock rose to 205 prior to the December expiration. Things like this happened to Yahoo (YHOO), Amazon (AMZN), Qualcomm (QCOM), and others during the 1990s. If that hap­ pened, the exchange would now create another wrap symbol and use it to designate strike prices from 205 to 300. Suppose XYZ traded up to 210, and the exchange then said that YYA would now be the wrap symbol for the higher strikes. In that case, these symbols would exist: Option XYZ December 10 call XYZ December 110 call XYZ December 210 call Symbol XYZLB XYALB (wrap symbol is XYA) YYALB (wrap symbol is YYA) Note that there doesn't have to be any particular relationship between the wrap sym­ bols and the stock itself; any three-character designation could be used. LEAPS SYMBOLS A LEAPS option is one that is very long-term, expiring one or more years hence. Consequently, the expiration month codes encounter a problem with LEAPS similar to the one seen for striking price codes where wraps are concerned. The letter A stands for January as an expiration month code. However, if there is a LEAPS option on this same stock, and that LEAPS option expires in January of the next year, the letter A cannot be used to designate the expiration month of the LEAPS option, since it is already being used for the "standard" option. Consequently, LEAPS options have a different base option symbol than the "standard" base option symbol. Example: The current year is 2001. The OCC might have designated that, for IBM, LEAPS options expiring in the year 2002 will have the option base symbol VBM, and those expiring in the year 2003 will have the option base symbol WBM. Thus, the fol­ lowing symbols would be used to describe the designated options: Chapter 1: Definitions Option Description IBM January 125 call (expiring in 2001) IBM January 125 call (expiring in 2002) IBM January 125 call (expiring in 2003) IBM January 125 put (expiring in 2003) 27 Option Symbol IBMAE VBMAE WBMAE WBMME Note that the last line shows a LEAPS put option symbol. The letter M stands for a January put option - the standard usage for the expiration month code. STOCK SPLITS Stock splits often wreak havoc on option symbols, as the exchanges are forced to use the standard characters in nonstandard ways in order to accommodate all the addi­ tional strikes that are created when a stock splits. The actual discussion of stock splits and the resultant option symbology is deferred to the next section. SYMBOLOGY SUMMARY The exchanges do a good job of making symbol information available. Each exchange has a Web site where memos detailing the changes required by LEAPS, wraps, and splits are available for viewing. The OCC and the exchanges have been forced to create multiple option base symbols for a single stock in order to accommodate the various strike price and expi­ ration month situations - to avoid duplication of the standardized character used for the strike or expiration month. This is unwieldy and confusing for option traders and for data vendors as well. In some rare cases, mistakes are made, and there can briefly be two designations for the same option symbol. The only way to eliminate this con­ fusion would be to use a longer, more descriptive option symbol that included the expiration year and the striking price as numerical values, much as is done with futures options. It is the member firms themselves and some of the quote vendors who object to the transformation to this less confusing system, because they would have to recode their software and alter their databases. DETAILS OF OPTION TRADING The facts that the strategist should be concerned with are included in this section. They are not presented in any particular order of importance, and this list is not nec­ essarily complete. Many more details are given in the discussion of specific strategies throughout this text. 28 Part I: Basic Properties of Stock Options 1. Options expire on the Saturday following the third Friday of the expiration rrwnth, although the third Friday is the last day of trading. In general, however, waiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring options is not advisable. In the "crush" of orders during the final minutes of trad- • ing, even a market order may not have enough time to be executed. 2. Option trades have a one-day settlement cycle. The trade settles on the next busi­ ness day after the trade. Purchases must be paid for in full, and the credits from sales "hit" the account on the settlement day. Some brokerage firms require set­ tlement on the same day as the trade, when the trade occurs on the last trading day of an expiration series. 3. Options are opened for trading in rotation. When the underlying stock opens for trading on any exchange, regional or national, the options on that stock then go into opening rotation on the corresponding option exchange. The rotation system also applies if the underlying stock halts trading and then reopens during a trad­ ing day; options on that stock .reopen via a rotation. In the rotation itself, interested parties make bids and offers for each particular option series one at a time - the XYZ January 45 call, the XYZ January 50 call, and so on - until all the puts and calls at various expiration dates and striking prices have been opened. Trades do not necessarily have to take place in each series, just bids and offers. Orders such as spreads, which involve more than one option, are not executed during a rotation. While the rotation is taking place, it is possible that the underlying stock could make a substantial move. This can result in option prices that seem unrealistic when viewed from the perspective of each option's opening. Consequently, the opening price of an option can be a somewhat suspicious statistic, since none of them open at exactly the same time. Also, it should be noted that most option traders do not trade during rotation, so a market order may receive a very poor price. Hence, if one is considering trad­ ing during rotation, a limit order should be used. ( Order entry is discussed in more detail in a later section of this chapter.) 4. When the underlying stock splits or pays a stock dividend, the terms of its options are adjusted. Such an adjustment may result in fractional striking prices and in options for other than 100 shares per contract. No adjustments in terms are made for cash dividends. The actual details of splits, stock dividends, and rights offer­ ings, along with their effects on the option terms, are always published by the option exchange that trades those options. Notices are sent to all member firms, who then make that information available to their brokers for distribution to clients. In actual practice, the option strategist should ascertain from the broker 28 Part I: Bask Properties of Stock Options l. Options expire on the Saturday following the third Friday of the expiration rrwnth, although the third Friday is the last day of trading. In general, however, waiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring options is not advisable. In the "crush" of orders during the final minutes of trad- , ing, even a market order may not have enough time to be executed. 2. Option trades have a one-day settlement cycle. The trade settles on the next busi­ ness day after the trade. Purchases must be paid for in full, and the credits from sales "hit" the account on the settlement day. Some brokerage firms require set­ tlement on the same day as the trade, when the trade occurs on the last trading day of an expiration series. 3. Options are opened for trading in rotation. When the underlying stock opens for trading on any exchange, regional or national, the options on that stock then go into opening rotation on the corresponding option exchange. The rotation system also applies if the underlying stock halts trading and then reopens during a trad­ ing day; options on that stock reopen via a rotation. In the rotation itself, interested parties make bids and offers for each particular option series one at a time - the XYZ January 45 call, the XYZ January 50 call, and so on - until all the puts and calls at various expiration dates and striking prices have been opened. Trades do not necessarily have to take place in each series, just bids and offers. Orders such as spreads, which involve more than one option, are not executed during a rotation. While the rotation is taking place, it is possible that the underlying stock could make a substantial move. This can result in option prices that seem unrealistic when viewed from the perspective of each option's opening. Consequently, the opening price of an option can be a somewhat suspicious statistic, since none of them open at exactly the same time. Also, it should be noted that most option traders do not trade during rotation, so a market order may receive a very poor price. Hence, if one is considering trad­ ing during rotation, a limit order should be used. ( Order entry is discussed in more detail in a later section of this chapter.) 4. When the underlying stock splits or pays a stock dividend, the terms of its options are adjusted. Such an adjustment may result in fractional striking prices and in options for other than 100 shares per contract. No adjustments in terms are made for cash dividends. The actual details of splits, stock dividends, and rights offer­ ings, along with their effects on the option terms, are always published by the option exchange that trades those options. Notices are sent to all member firms, who then make that information available to their brokers for distribution to clients. In actual practice, the option strategist should ascertain from the broker 28 Part I: Basic Properties ol Stock Options 1. Options expire on the Saturday following the third Friday of the expiration month, although the third Friday is the last day of trading. In general, however, waiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring options is not advisable. In the "crush" of orders during the final minutes of trad- , ing, even a market order may not have enough time to be executed. 2. Option trades have a one-day settlement cycle. The trade settles on the next busi­ ness day after the trade. Purchases must be paid for in full, and the credits from sales "hit" the account on the settlement day. Some brokerage firms require set­ tlement on the same day as the trade, when the trade occurs on the last trading day of an expiration series. 3. Options are opened for trading in rotation. When the underlying stock opens for trading on any exchange, regional or national, the options on that stock then go into opening rotation on the corresponding option exchange. The rotation system also applies if the underlying stock halts trading and then reopens during a trad­ ing day; options on that stock reopen via a rotation. In the rotation itself, interested parties make bids and offers for each particular option series one at a time - the XYZ January 45 call, the XYZ January 50 call, and so on - until all the puts and calls at various expiration dates and striking prices have been opened. Trades do not necessarily have to take place in each series, just bids and offers. Orders such as spreads, which involve more than one option, are not executed during a rotation. While the rotation is taking place, it is possible that the underlying stock could make a substantial move. This can result in option prices that seem unrealistic when viewed from the perspective of each option's opening. Consequently, the opening price of an option can be a somewhat suspicious statistic, since none of them open at exactly the same time. Also, it should be noted that most option traders do not trade during rotation, so a market order may receive a very poor price. Hence, if one is considering trad­ ing during rotation, a limit order should be used. ( Order entry is discussed in more detail in a later section of this chapter.) 4. When the underlying stock splits or pays a stock dividend, the terms of its options are adjusted. Such an adjustment may result in fractional striking prices and in options for other than 100 shares per contract. No adjustments in terms are made for cash dividends. The actual details of splits, stock dividends, and rights offer­ ings, along with their effects on the option terms, are always published by the option exchange that trades those options. Notices are sent to all member firms, who then make that information available to their brokers for distribution to clients. In actual practice, the option strategist should ascertain from the broker a.,,., 1: Definitions 29 the specific terms of the new option series, in case the broker has overlooked the information sent. E«ample 1: XYZ is a $50 stock with option striking prices of 45, 50, and 60 for the January, April, and July series. It declares a 2-for-l stock split. Usually, in a 2-for-l split situation, the number of outstanding option contracts is doubled and the strik­ ing prices are halved. The owner of 5 XYZ January 60 calls becomes the owner of 10 XYZ January 30 calls. Each call is still for 100 shares of the underlying stock. If fractional striking prices arise, the exchange also publishes the quote symbol that is to be used to find the price of the new option. The XYZ July 45 call has a sym­ bol ofXYZGI: G stands for July and I is for 45. After the 2-for-l split, one July 45 call becomes 2 July 22½ calls. The strike of 22½ is assigned a letter. The exchanges usu­ ally attempt to stay with the standard symbols as much as possible, meaning that X would be designated for 22½. Hence, the symbol for the XYZ July 22½ call would be XYZGX. After the split, XYZ has options with strikes of 22½, 25, and 30. In some cases, the option exchange officials may introduce another strike if they feel such a strike is necessary; in this example, they might introduce a striking price of 20. E«ample 2: UVW Corp. is now trading at 40 with strikes of 35, 40, and 45 for the January, April, and July series. UVW declares a 2½ percent stock dividend. The con­ tractually standardized 100 shares is adjusted up to 102, and the striking prices are reduced by 2 percent (rounded to the nearest eighth). Thus, the "old" 35 strike becomes a "new" strike of 343/s: 1.02 divided into 35 equals 34.314, which is 343/s when rounded to the nearest eighth. The "old" 40 strike becomes a "new" strike of 39¼, and the "old" 45 strike becomes 441/s. Since these new strikes are all fraction­ al, they are given special symbols - probably U, V, and W. Thus, the "old" symbol UVWDH (UVW April 40) becomes the "new" symbol UVWDV (UVW April 39¼). After the split, the exchange usually opens for trading new strikes of 35, 40, and 45 - each for 100 shares of the underlying stock. For a while, there are six striking prices for UVW options. As time passes, the fractional strikes are eliminated as they expire. Since they are not reintroduced, they eventually disappear as long as UVW does not issue further stock dividends. Example 3: WWW Corp. (symbol WWW) is trading at $120 per share, with strike prices of ll0, ll5, 120, 125, and 130. WWW declares a 3-for-l split. In this case, the strike prices would be divided by 3 (and rounded to the nearest eighth); the number of contracts in every account would be tripled; and each option would still be an option on 100 shares of WWW stock. The general rule of thumb is that when a split results in round lots (2-for-l, 3-for-l, 4-for-l, etc.), the number of option contracts is 30 Part I: Basic Properties ol Stock Options increased and the strike price is decreased, and each option still represents 100 shares of the underlying stock. In this case, the strikes listed above (110 through 130) would be adjusted to• become new strikes: 36.625, 38.375, 40, 41.625, and 43.375. The 40 strike would be assigned the standard strike price symbol of the letter H. However, the others would need to be designated by the exchange, so U might stand for 38.375, V for 41.625, and so forth. Example 4: When a split does not result in a round lot, a different adjustment must be used for the options. Suppose that AAA Corp. (symbol: AAA) is trading at $60 per share and declares a 3-for-2 split. In this case, each option's strike will be multiplied by two-thirds (to reflect the 3-for-2 split), but the number of contracts held in an account will remain the same and each option will be an option on 150 shares of AAA stock. Suppose that there were strikes of 55, 60, and 65 preceding this split. After the split, AAA common itself would be trading at $40 per share, reflecting the post-split 3-for-2 adjustment from its previous price of 60. There would be new options with strikes of 36.625, 40, and 43.375 (these had been the pre-split strikes of 55, 60, and 65). Since each of these options would be for 150 shares of the underlying stock, the exchange creates a new option base symbol for these options, because they no longer represent 100 shares of AAA common. Suppose the exchange says that the post-split, 150-share option contracts will henceforth use the option symbol AAX. After the split, the exchange will then list "normal" 100-share options on AAA, perhaps with strike prices of 35, 40, and 45. This creates a situation that can some­ times be confusing for traders and can lead to problems. There will actually be two options with striking prices of 40 - one for 100 shares and the other for 150 shares. Suppose the July contract is being considered. The option with symbol AAAGH is a July 40 option on 100 shares of AAA Corp., while the option with symbol AAXGH is a July 40 option on 150 shares of AAA Corp. Since option prices are quoted on a per­ share basis, they will have nearly identical price quotes on any quote system (see item 5). If one is not careful, you might trade the wrong one, thereby incurring a risk that you did not intend to take. For example, suppose that you sell, as an opening transaction, the AAXGH July 40 call at a price of 3. Furthermore, suppose that you did not realize that you were selling the 150-share option; this was a mistake, but you don't yet realize it. A couple of days later, you see that this option is now selling at 13 - a loss of 10 points. You might think that you had just lost $1,000, but upon examining your brokerage state­ ment (or confirms, or day trading sheet), you suddenly see that the loss is $1,500 on 0.,,,, 1: Definitions 31 that contract! Quite a difference, especially if multiple contracts are involved. This could come as a shock if you thought you were hedged (perhaps you bought 100 shares of AAA common when you sold this call), only to find out later that you didn't have a correctly hedged position in place after all. Even more severe problems can arise if this stock splits again during the life of this option. Sometimes the options will be adjusted so that they represent a non­ standard number of shares, such as the 150-share options involved here; and after multiple splits, the exchange may even apply a multiplier to the option, rather than adjusting its strike price repeatedly. This type of thing wouldn't happen on the first stock split, but it might occur on subsequent stock splits, spaced closely together over the life of an option. In such a case, the dollar value of the option moves much faster than one would expect from looking at a quote of the contract. So you must be sure that you are trading the exact contract you intend to, and not relying on the fact that the striking price is correct and the option price quote seems to be in line. One must verify that the option being bought or sold is exactly the one intended. In general, it is a good idea, after a split or similar adjustment, to establish opening positions solely with the standard contracts and to leave the split­ adjusted contracts alone. 5. All options are quoted on a per-share basis, regardless of how many shares of stock the option involves. Normally the quote assumes 100 shares of the under­ lying stock. However, in a case like the UVW options just described, a quote of 3 for the UVW April 39¼ means a dollar price of $306 ($3 x 102). 6. Changes in the price of the underlying stock can also bring about new striking prices. XYZ is a $47 stock with striking prices of 45 and 50. If the price of XYZ stock falls to $40, the striking prices of 45 and 50 do not give option traders enough opportunities in XYZ. So the exchange might introduce a new striking price of 40. In practice, a new series is generally opened when the stock trades at the lowest (or highest) existing strike in any series. For example, if XYZ is falling, as soon as it traded at or below 45, the striking price of 40 may be intro­ duced. The officials of the option exchange that trades XYZ options make the decision as to the exact day when the strike begins trading. POSITION LIMIT AND EXERCISE LIMIT 1. An investor or a group of investors cannot be long or short more than a set limit of contracts in one stock on the same side of the market. The actual limit varies according to the trading activity in the underlying stock. The most heavily trad­ ed stocks with a large number of shares outstanding have position limits of 75,000 32 Part I: Basic Properties ol Stock Options contracts. Smaller stocks have position limits of 60,000, 31,000, 22,500, or 13,500 contracts. These limits can be expected to increase over time, if stocks' capital­ izations continue to increase. The exchange on which the option is listed makes available a list of the position limits on each of its optionable stocks. So, if one were long the limit of XYZ call options, he cannot at the same time be short any XYZ put options. Long calls and short puts are on the same side of the market; that is, both are bullish positions. Similarly, long puts and short calls are both on the bearish side of the market. While these position limits generally exceed by far any position that an individual investor normally attains, the limits apply to "relat­ ed" accounts. For instance, a money manager or investment advisor who is man­ aging many accounts cannot exceed the limit when all the accounts' positions are combined. 8. The numher of contracts that can be exercised in a particular period of time ( usu­ ally 5 business days) is also limited to the same arrwunt as the position limit. This exercise limit prevents an investor or group from "cornering" a stock by repeat­ edly buying calls one day and exercising them the next, day after day. Option exchanges set exact limits, which are subject to change. ORDER ENTRY Order Information Of the various types of orders, each specifies: 1. whether the transaction is a buy or sell, 2. the option to be bought or sold, 3. whether the trade is opening or closing a position, 4. whether the transaction is a spread (discussed later), and 5. the desired price. TYPES OF ORDERS Many types of orders are acceptable for trading options, but not all are acceptable on all exchanges that trade options. Since regulations change, information regarding which order is valid for a given exchange is best supplied by the broker to the cus­ tomer. The following orders are acceptable on all option exchanges: Market Order. This is a simple order to buy or sell the option at the best pos­ sible price as soon as the order gets to the exchange floor. Cl,apter 1: Definitions 33 Market Not Held Order. The customer who uses this type of order is giv­ ing the floor broker discretion in executing the order. The floor broker is not held responsible for the final outcome. For example, if a floor broker has a "mar­ ket not held" order to buy, and he feels that the stock will "downtick" (decline in price) or that there is a surplus of sellers in the crowd, he may often hold off on the execution of the buy order, figuring that the price will decline shortly and that the order can then be executed at a more favorable price. In essence, the customer is giving the floor broker the right to use some judgment regarding the execution of the order. If the floor broker has an opinion and that opinion is cor­ rect, the customer will probably receive a better price than if he had used a reg­ ular market order. If the broker's opinion is wrong, however, the price of the execution may be worse than a regular market order. Limit Order. The limit order is an order to buy or to sell at a specified price - the limit. It may be executed at a better price than the limit - a lower one for buyers and a higher one for sellers. However, if the limit is never reached, the order may never be executed. Sometimes a limit order may specify a discretionary margin for the floor broker. In other words, the order may read "Buy at 5 with dime discretion." This instruction enables the floor broker to execute the order at 5.10 if he feels that the market will never reach 5. Under no circumstances, however, can the order be executed at a price higher than 5.10. Other orders may or may not be accepted·on some option exchanges. Stop Order. This order is not always valid on all option exchanges. A stop order becomes a market order when the security trades at or through the price specified on the order. Buy stop orders are placed above the current market price, and sell stop orders are entered below the current market price. Such orders are used to either limit loss or protect a profit. For example, if a holder's option is selling for 3, a sell stop order for 2 is activated if the market drops down below the 2 level, whereupon the floor broker would execute the order as soon as possible. The customer, however, is not guaranteed that the trade will be exactly at 2. Stop-Limit Order. This order becomes a limit order when the specified price is reached. Whereas the stop order has to be executed as soon as the stop price is reached, the stop-limit may or may not be filled, depending on market behav­ ior. For instance, if the option is trading at 3 while a stop-limit order is placed at a price of 2, the floor broker may not be able to get a trade exactly at 2. If the 34 Part I: Basic Properties of Stock Options option continues to decline through 2 - 1.90, 1.80, 1.70, and so on - without ~ ever regaining the 2 level, then the broker's hands are tied. He may not execute what is now a limit order unless the call trades at 2. Good-Until-Canceled Order. A limit, stop, or stop-limit order may be des­ ignated "good until canceled." If the conditions for the order execution do not occur, the order remains valid for 6 months without renewal by the customer. Customers using an on-line broker will not be able to enter "market not held" orders, and may not be able to use stop orders or good-until-canceled orders either, depending on the brokerage firm. PROFITS AND PROFIT GRAPHS A visual presentation of the profit potential of any position is important to the over­ all understanding and evaluation of it. In option trading, the many multi-security positions especially warrant strict analysis: stock versus options (as in covered or ratio writing) or options versus options (as in spreads). Some strategists prefer a table list­ ing the outcomes of a particular strategy for the stock at various prices; others think the strategy is more clearly demonstrated by a graph. In the rest of the text, both a table and a graph will be presented for each new strategy discussed. Example: A customer wishes to evaluate the purchase of a call option. The potential profits or losses of a purchase of an XYZ July 50 call at 4 can be arrayed in either a table or a graph of outcomes at expiration. Both Table 1-5 and Figure 1-5 depict the same information; the graph is merely the line representing the column marked "Profit or Loss" in the table. The vertical axis represents dollars of profit or loss, and the horizontal axis shows the stock price at expiration. In this case, the dollars of prof­ it and the stock price are at the expiration date. Often, the strategist wants to deter­ mine what the potential profits and losses will be before expiration, rather than at the expiration date itself. Tables and graphs lend themselves well to the necessary analy­ sis, as will be seen in detail in various places later on. In practice, such an example is too simple to require a table or a graph - cer­ tainly not both - to evaluate the potential profits and losses of a simple call purchase held to expiration. However, as more complex strategies are discussed, these tools become ever more useful for quickly determining such things as when a position makes money and when it loses, or how fast one's risk increases at certain stock prices. Cl,opter 1: Definitions TABLE 1-5. Potential profits and losses for an XYZ call purchase. XYZ Price at Call Price at Profit or Expiration Expiration Loss 40 $ 0 -$ 400 45 0 - 400 50 0 - 400 55 5 + 100 60 10 + 600 70 20 + 1,600 FIGURE 1-5. Graph of potential profits for an XYZ call purchase. C .Q ~ ·a X w 1il (J) (J) $0 0 ..J 5 -e a. -$400 Stock Price at Expiration 35 fli\R'E II Call Option · .. Strategies INTRODUCTION The average person dealing in option trading utilizes primarily one of two option strategies - call buying or covered call writing. These strategies are, at face value, simple, and they are therefore the ones most often tried. There are many more strategies involving the use of call options, many of which will be described later in this Part. However, Chapters 2 and 3 deal with the fundamental call option strate­ gies. Both covered call writing and call buying are relatively simple strategies, but, like any investment, they can be employed with differing levels of skill and complex­ ity. The discussions to follow begin by describing the basics of each strategy and then discuss each in depth. 38 CHAPl'ER 2 Covered Call Writing Covered call writing is the name given to the strategy by which one sells a call option while simultaneously owning the obligated number of shares of underlying stock. The writer should be mildly bullish, or at least neutral, toward the underlying stock. By writing a call option against stock, one always decreases the risk of owning the stock. It may even be possible to profit from a covered write if the stock declines somewhat. However, the covered call writer does limit his profit potential and there­ fore may not fully participate in a strong upward move in the price of the underlying stock. Use of this strategy is becoming so common that the strategist must under­ stand it thoroughly. It is therefore discussed at length. THE IMPORTANCE OF COVERED CALL WRITING COVERED CALL WRITING FOR DOWNSIDE PROTECTION Example: An investor owns 100 shares of XYZ common stock, which is currently sell­ ing at $48 per share. If this investor sells an XYZ July 50 call option while still hold­ ing his stock, he establishes a covered write. Suppose the investor receives $300 from the sale of the July 50 call. If XYZ is below 50 at July expiration, the call option that was sold expires worthless and the investor earns the $300 that he originally received for writing the call. Thus, he receives $300, or 3 points, of downside protection. That is, he can afford to have the XYZ stock drop by 3 points and still break even on the total transaction. At that time he can write another call option if he so desires. Note that if the underlying stock should fall by more than 3 points, there will be a loss on the overall position. Thus, the risk in the covered writing strategy material­ izes if the stock falls by a distance greater than the call option premium that was orig­ inally taken in. 39 40 Part II: Call Option Strategies THE BENEFITS OF AN INCREASE IN STOCK PRICE If XYZ increases in price moderately, the trader may be able to have the best of both worlds. Example: If XYZ is at or just below 50 at July expiration, the call still expires worth­ less, and the investor makes the $300 from the option in addition to having a small profit from his stock purchase. Again, he still owns the stock. Should XYZ increase in price by expiration to levels above 50, the covered writer has a choice of alternatives. As one alternative, he could do nothing, in which case the option would be assigned and his stock would be called away at the striking price of 50. In that case, his profits would be equal to the $300 received from selling the call plus the profit on the increase of his stock from the purchase price of 48 to the sale price of 50. In this case, however, he would no longer own the stock. If as another alternative he desires to retain his stock ownership, he can elect to buy back ( or cover) the written call in the open market. This decision might involve taking a loss on the option part of the covered writing transaction, but he would have a cor­ respondingly larger profit, albeit unrealized, from his stock purchase. Using some specific numbers, one can see how this second alternative works out. Example: XYZ rises to a price of 60 by July expiration. The call option then sells near its intrinsic value of 10. If the investor covers the call at 10, he loses $700 on the option portion of his covered write. (Recall that he originally received $300 from the sale of the option, and now he is buying it back for $1,000.) However, he relieves the obligation to sell his stock at 50 ( the striking price) by buying back the call, so he has an unrealized gain of 12 points in the stock, which was purchased at 48. His total profit, including both realized and unrealized gains, is $500. This profit is exactly the same as he would have made if he had let his stock be called from him. If called, he would keep the $300 from the sale of the call, and he would make 2 points ( $200) from buying the stock at 48 and selling it, via exercise, at 50. This profit, again, is a total of $500. The major difference between the two cases is that the investor no longer owns his stock after letting it be called away, whereas he retains stock ownership if he buys back the written call. Which of the two alter­ natives is the better one in a given situation is not always clear. No matter how high the stock climbs in price, the profit from a covered write is limited because the writer has obligated himself to sell stock at the striking price. The covered writer still profits when the stock climbs, but possibly not by as much as he might have had he not written the call. On the other hand, he is receiving $300 of immediate cash inflow, because the writer may take the premium immediately and Gapter 2: Covered Call Writing 41 do with it as he pleases. That income can represent a substantial increase in the income currently provided by the dividends on the underlying stock, or it can act to offset part of the loss in case the stock declines. For readers who prefer formulae, the profit potential and break-even point of a covered write can be summarized as follows: Maximum profit potential = Strike price Stock price + Call price Downside break-even point = Stock price - Call price QUANTIFICATION OF THE COVERED WRITE Table 2-1 and Figure 2-1 depict the profit graph for the example involving the XYZ covered write of the July 50 call. The table makes the assumption that the call is bought back at parity. If the stock is called away, the same total profit of $500 results; but the price involved on the stock sale is always 50, and the option profit is always $300. Several conclusions can be drawn. The break-even point is 45 (zero total prof­ it) with risk below 45; the maximum profit attainable is $500 if the position is held until expiration; and the profit if the stock price is unchanged is $300, that is, the cov­ ered writer makes $300 even if his stock goes absolutely nowhere. The profit graph for a covered write always has the shape shown in Figure 2-1. Note that the maximum profit always occurs at all stock prices equal to or greater than the striking price, if the position is held until expiration. However, there is downside risk. If the stock declines in price by too great an amount, the option pre­ mium cannot possibly compensate for the entire loss. Downside protective strategies, which are discussed later, attempt to deal with the limitation of this downside risk. TABLE 2-1. The XYZ July 50 call. XYZ Price Stock July 50 Call Call Total at Expiration Profit at Expiration Profit Profit 40 -$ 800 0 +$300 -$500 45 - 300 0 + 300 0 48 0 0 + 300 + 300 50 + 200 0 + 300 + 500 55 + 700 5 - 200 + 500 60 + 1,200 10 - 700 + 500 42 FIGURE 2-1. XYZ covered write. C +$500 0 e ·a. i.ti cii en $0 en 0 ...J 0 ~ a. Part II: Call Option Strategies Maximum Profit Range 50 55 60 "-. Downside Risk Stock Price at Expiration COVERED WRITING PHILOSOPHY The primary objective of covered writing, for most investors, is increased income through stock ownership. An ever-increasing number of private and institutional investors are writing call options against the stocks that they own. The facts that the option premium acts as a partial compensation for a decline in price by the underly­ ing stock, and that the premium represents an increase in income to the stockhold­ er, are evident. The strategy of owning the stock and writing the call will outperform outright stock ownership if the stock falls, remains the same, or even rises slightly. In fact, the only time that the outright owner of the stock will outperform a covered writer is if the stock increases in price by a relatively substantial amount during the life of the call. Moreover, if one consistently writes call options against his stock, his portfolio will show less variability of results from quarter to quarter. The total posi­ tion - long stock and short option - has less volatility than the stock alone, so on a quarter-by-quarter basis, results will be closer to average than they would be with normal stock ownership. This is an attractive feature, especially for portfolio man­ agers. However, one should not assume that covered writing will outperform stock ownership. Stocks sometimes tend to make most of their gains in large spurts. A cov­ ered writer will not participate in moves such as that. The long-term gains that are quoted for holding stocks include periods of large gains and sometimes periods of large losses as well. The covered writer will not participate in the largest of those gains, since his profit potential is limited. Chapter 2: Covered Call Writing 43 PHYSICAL LOCATION Of THE STOCK Before getting more involved in the details of covered writing strategy, it may be use­ ful to review exactly what stock holdings may be written against. Recall that this dis­ cussion applies to listed options. If one has deposited stock with his broker in either a cash or a margin account, he may write an option for each 100 shares that he owns without any additional requirement. However, it is possible to write covered options without actually depositing stock with a brokerage firm. There are several ways in which to do this, all involving the deposit of stock with a bank. Once the stock is deposited with the bank, the investor may have the bank issue an escrow receipt or letter of guarantee to the brokerage firm at which the investor does his option business. The bank must be an "approved" bank in order for the bro­ kerage firm to accept a letter of guarantee, and not all firms accept letters of guaran­ tee. These items cost money, and as a new receipt or letter is required for each new option written, the costs may become prohibitive to the customer if only 100 or 200 shares of stock are involved. The cost of an escrow receipt can range from as low as $15 to upward of $40, depending on the bank involved. There is another alternative open to the customer who wishes to write options without depositing his stock at the brokerage firin. He may deposit his stock with a bank that is a member of the Depository Trust Corporation (DTC). The DTC guar­ antees the Options Clearing Corporation that it will, in fact, deliver stock should an assignment notice be given to the call writer. This is the most convenient method for the investor to use, and is the one used by most of the institutional covered writing investors. There is usually no additional charge for this service by the bank to insti­ tutional accounts. However, since only a limited number of banks are members of DTC, and these banks are generally the larger banks located in metropolitan centers, it may be somewhat difficult for many individual investors to take advantage of the DTC opportunity. TYPES Of COVERED WRITES While all covered writes involve selling a call against stock that is owned, different terms are used to describe various categories of covered writing. The two broadest terms, under which all covered writes can be classified, are the out-of the-rrwney cov­ ered write and the in-the-rrwney covered write. These refer, obviously, to whether the option itself was in-the-money or out-of-the-money when the write was first estab­ lished. Sometimes one may see covered writes classified by the nature of the stock involved (low-priced covered write, high-yield covered write, etc;), but these are only subcases of the two broad categories. 44 Part II: Call Option Strategies. In general, out-of-the-money covered writes offer higher potential rewards but have less risk protection than do in-the-money covered writes. One can establish an aggressive or defensive covered writing position, depending on how far the call option is in- or out-of-the-money when the write is established. In-the-money writes are more defensive covered writing positions. Some examples may help to illustrate how one covered write can be consider­ ably more conservative, from a strategy viewpoint, than another. Example: XYZ common stock is selling at 45 and two options are being considered for writing: an XYZ July 40 selling for 8, and an XYZ July 50 selling for 1. Table 2-2 depicts the profitability of utilizing the July 40 or the July 50 for the covered writing. The in-the-money covered write of the July 40 affords 8 points, or nearly 18% pro­ tection down to a price of 37 (the break-even point) at expiration. The out-of-the­ money covered write of the July 50 offers only 1 point of downside protection at expi­ ration. Hence, the in-the-rrwney covered write offers greater downside protection than does the out-of-the-rrwney covered write. This statement is true in general - not merely for this example. In the balance of the financial world, it is normally true that investment posi­ tions offering less risk also have lower reward potential. The covered writing exam­ ple just given is no exception. The in-the-money covered write of the July 40 has a maximum potential profit of $300 at any point above 40 at the time of expiration. However, the out-of-the-money covered write of the July 50 has a maximum poten­ tial profit of $600 at any point above 50 at expiration. The maximum potential profit of an out-of-the-rrwney covered write is generally greater than that of an in-the­ rrwney write. TABLE 2-2. Profit or loss of the July 40 and July 50 calls. In-the-Money Write Out-of-the-Money Write of July 40 of July SO Stock of Total Stock at Total Expiration Profit Expiration Profit 35 -$200 35 -$900 37 0 40 - 400 40 + 300 44 0 45 + 300 45 + 100 50 + 300 50 + 600 60 + 300 60 + 600 Cl,apter 2: Covered Call Writing 45 To make a true comparison between the two covered writes, one must look at what happens with the stock between 40 and 50 at expiration. The in-the-money write attains its maximum profit anywhere within that range. Even a 5-point decline by the underlying stock at expiration would still leave the in-the-money writer with his maximum profit. However, realizing the maximum profit potential with an out-of the-money covered write always requires a rise in price by the underlying stock. This further illustrates the more conservative nature of the in-the-money write. It should be noted that in-the-money writes, although having a smaller profit potential, can still be attractive on a percentage return basis, especially if the write is done in a margin account. One can construct a more aggressive position by writing an out-of-the-money call. One's outlook for the underlying stock should be bullish in that case. If one is neutral or moderately bearish on the stock, an in-the-money covered write is more appropriate. If one is truly bearish on a stock he owns, he should sell the stock instead of establishing a covered write. THE TOTAL RETURN CONCEPT OF COVERED WRITING When one writes an out-of-the-money option, the overall position tends to reflect more of the result of the stock price movement and less of the benefits of writing the call. Since the premium on an out-of-the-money call is relatively small, the total posi­ tion will be quite susceptible to loss if the stock declines. If the stock rises, the posi­ tion will make money regardless of the result in the option at expiration. On the other hand, an in-the-money write is more of a "total" position - taking advantage of the benefit of the relatively large option premium. If the stock declines, the position can still make a profit; in fact, it can even make the maximum profit. Of course, an in­ the-money write will also make money if the stock rises in price, but the profit is not generally as great in percentage terms as is that of an out-of-the-money write. Those who believe in the total return concept of covered writing consider both downside protection and maximum potential return as important factors and are willing to have the stock called away, if necessary, to meet their objectives. When premiums are moderate or small, only in-the-money writes satisfy the total return philosophy. Some covered writers prefer never to lose their stock through exercise, and as a result will often write options quite far out-of-the-money to minimize the chances of being called by expiration. These writers receive little downside protection and, to make money, must depend almost entirely on the results of the stock itself. Such a 46 Part II: Call Option Strategies philosophy is more like being a stockholder and trading options against one's stock position than actually operating a covered writing strategy. In fact, some covered writers will attempt to buy back written options for quick profits if such profits mate­ rialize during the life of the covered write. This, too, is a stock ownership philosophy, not a covered writing strategy. The total return concept represents the true strategy in covered writing, whereby one views the entire position as a single entity and is not predominantly concerned with the results of his stock ownership. THE CONSERVATIVE COVERED WRITE Covered writing is generally accepted to be a conservative strategy. This is because the covered writer always has less risk than a stockholder, provided that he holds the covered write until expiration of the written call. If the underlying stock declines, the covered writer will always offset part of his loss by the amount of the option premi­ um received, no matter how small. As was demonstrated in previous sections, however, some covered writes are clearly more conservative than others. Not all option writers agree on what is meant by a conservative covered write. Some believe that it involves writing an option (probably out-of-the-money) on a conservative stock, generally one with high yield and low volatility. It is true that the stock itself in such a position is conservative, but the position is more aptly termed a covered write on a conservative stock. This is dis­ tinctly different from a conservative covered write. A true conservative covered write is one in which the total position is conserva­ tive - offering reduced risk and a good probability of making a profit. An in-the-money wiite, even on a stock that itself is not conservative, can become a conservative total position when the option itself is properly chosen. Clearly, an investor cannot write calls that are too deeply in-the-money. If he did, he would get large amounts of down­ side protection, but his returns would be severely limited. If all that one desired was maximum protection of his money at a nominal rate of profit, he could leave the money in a bank. Instead, the conservative covered writer strives to make a potential­ ly acceptable return while still receiving an above-average amount of protection. Example: Again assume XYZ common stock is selling at 45 and an XYZ July 40 call is selling at 8. A covered write of the XYZ July 40 would require, in a cash account, an investment of $3,700 - $4,500 to purchase 100 shares of XYZ, less the $800 received in option premiums. The write has a maximum profit potential of $300. The potential return from this position is therefore $300/$3, 700, just over 8% for the peri­ od during which the write must be held. Since it is most likely that the option has 9 months of life or less, this return would be well in excess of 10% on a per annum Chapter 2: Covered Call Writing 47 basis. If the write were done in a margin account, the return would be considerably higher. Note that we have ignored dividends paid by the underlying stock and commis­ sion charges, factors that are discussed in detail in the next section. Also, one should be aware that if he is looking at an annualized return from a covered write, there is no guarantee that such a return could actually be obtained. All that is certain is that the writer could make 8% in 9 months. There is no guarantee that 9 months from now, when the call expires, there will be an equivalent position to establish that will extend the same return for the remainder of the annualization period. Annual returns should be used only for comparative purposes between covered writes. The writer has a position that has an annualized return (for comparative pur­ poses) of over 10% and 8 points of downside protection. Thus, the total position is an investment that will not lose money unless XYZ common stock falls by more than 8 points, or about 18%; and is an investment that could return the equivalent of 10% annually should XYZ common stock rise, remain the same, or fall by 5 points (to 40). This is a conservative position. Even if XYZ itself is not a conservative stock, the action of writing this option has made the total position a conservative one. The only factor that might detract from the conservative nature of the total position would be if XYZ were so volatile that it could easily fall more than 8 points in 9 months. In a strategic sense, the total position described above is better and more con­ servative than one in which a writer buys a conservative stock -yielding perhaps 6 or 7% - and writes an out-of-the-money call for a minimal premium. If this conserva­ tive stock were to fall in price, the writer would be in danger of being in a loss situa­ tion, because here the option is not providing anything more than the most minimal downside protection. As was described earlier, a high-yielding, low-volatility stock will not have much time premium in its in-the-money options, so that one cannot effectively establish an in-the-money write on such a "conservative" stock. COMPUTING RETURN ON INVESTMENT Now that the reader has some general feeling for covered call writing, it is time to discuss the specifics of computing return on investment. One should always know exactly what his potential returns are, including all costs, when he establishes a cov­ ered writing position. Once the procedure for computing returns is clear, one can more logically decide which covered writes are the most attractive. There are three basic elements of a covered write that should be computed before entering into the position. The first is the return if exercised. This is the return on investment that one would achieve if the stock were called away. For an out-of-the- 48 Part II: Call Option Strategies money covered write, it is necessary for the stock to rise in price in order for the return if exercised to be achieved. However, for an in-the-money covered write, the return if exercised would be attained even if the stock were unchanged in price at option expi­ ration. Thus, it is often advantageous to compute the return if unchanged - that is, the return that would be realized if the underlying stock were unchanged when the option expired. One can more fairly compare out-of-the-money and in-the-money covered writes by using the return if unchanged, since no assumption is made concerning stock price movement. The third important statistic that the covered writer should consid­ er is the exact downside break-even point after all costs are included. Once this down­ side break-even point is known, one can readily compute the percentage of downside protection that he would receive from selling the call. Example 1: An investor is considering the following covered write of a 6-month call: Buy 500 XYZ common at 43, sell 5 XYZ July 45 calls at 3. One must first compute the net investment required (Table 2-3). In a cash account, this investment consists of paying for the stock in full, less the net proceeds from the sale of the options. Note that this net investment figure includes all commissions necessary to establish the position. (The commissions used here are approximations, as they vary from firm to firm.) Of course, if the investor withdraws the option premium, as he is free to do, his net investment will consist of the stock cost plus commissions. Once the neces­ sary investment is known, the writer can compute the return if exercised. Table 2-4 illustrates the computation. One first computes the profit if exercised and then divides that quantity by the net investment to obtain the return if exercised. Note that dividends are included in this computation; it is assumed that XYZ stock will pay $500 in dividends on the 500 shares during the life of the call. Moreover, all com­ missions are included as well - the net investment includes the original stock pur­ chase and option sale commissions, and the stock sale commission is explicitly listed. For the return computed here to be realized, XYZ stock would have to rise in price from its current price of 43 to any price above 45 by expiration. As noted ear­ lier, it may be more useful to know what return could be made by the writer if the stock did not move anywhere at all. Table 2-5 illustrates the method of computing the TABLE 2-3. Net investment required-cash account. Stock cost (500 shares at 43) Plus stock purchase commissions Less option premiums received Plus option sale commissions Net cash investment + $21,500 320 1,500 + 60 $20,380 Oapter 2: Covered Call Writing TABLE 2-4. Return if exercised-cash account. Stock sale proceeds (500 shares at 45) Less stock sale commissions Plus dividends earned until expiration Less net investment Net profit if exercised Return if exercised $2,290 = 11 2o/c $20,380 . 0 TABLE 2-5. Return if unchanged-cash account. Unchanged stock value (500 shares at 43) Plus dividends Less net investment Profit if unchanged Return if unchanged $1,620 = 7.9'¼ $20,380 ° + $22,500 330 500 - 20,380 $ 2,290 $21,500 + 500 - 20,380 $ 1,620 49 return if unchanged - also called the static return and sometimes incorrectly referred to as the "expected return." Again, one first calculates the profit and then calculates the return by dividing the profit by the net investment. An important point should be made here: There is no stock sale commission included in Table 2-5. This is the most common way of calculating the return if unchanged; it is done this way because in a majority of cases, one would continue to hold the stock if it were unchanged and would write another call option against the same stock. Recall again, though, that if the written call is in-the-rrwney, the return if unchanged is the same as the return if exercised. Stock sale commissions must therefore be included in that case. Once the necessary returns have been computed and the writer has a feeling for how much money he could make in the covered write, he next computes the exact downside break-even point to determine what kind of downside protection the writ­ ten call provides (Table 2-6). The total return concept of covered writing necessitates viewing both potential income and downside protection as important criteria for selecting a writing position. If the stock were held to expiration and the $500 in div­ idends received, the writer would break even at a price of 39.8. Again, a stock sale commission is not generally included in the break-even point computation, because 50 Part II: Call Option Strategies the written call would expire totally worthless and the writer might then write anoth­ er call on the same stock. Later, we discuss the subject of continuing to write against stocks already owned. It will be seen that in many cases, it is advantageous to con­ tinue to hold a stock and write against it again, rather than to sell it and establish a covered write in a new stock. TABLE 2-6. Downside break-even point-cash account. Net investment Less dividends Total stock cost to expiration Divide by shares held Break-even price $20,380 500 $19,880 + 500 39.8 Next, we translate the break-even price into percent downside protection (Table 2-7), which is a convenient way of comparing the levels of downside protec­ tion among variously priced stocks. We will see later that it is actually better to com­ pare the downside protection with the volatility of the underlying stock. However, since percent downside protection is a common and widely accepted method that is more readily calculated, it is necessary to be familiar with it as well. Before moving on to discuss what kinds of returns one should attempt to strive for in which situati_ons, the same example will be worked through again for a covered write in a margin account. The use of margin will provide higher potential returns, since the net investment will be smaller. However, the margin interest charge incurred on the debit balance (the amount of money borrowed from the brokerage firm) will cause the break-even point to be higher, thus slightly reducing the amount of downside protection available from writing the call. Again, all commissions to establish the position are included in the net investment computation. TABLE 2-7. Percent downside protection-cash account. Initial stock price Less break-even price Points of protection Divide by original stock price Equals percent downside protection 43 -39.8 3.2 +43 7.4% Clrapter 2: Covered Call Writing 51 Example 2: Recall that the net investment for the cash write was $20,380. A margin covered write requires less than half of the investment of a cash write when the margin rate (set by the Federal Reserve) is 50%. In a margin account, if one desires to remove the premium from the account, he may do so immediately provid­ ed that he has enough reserve equity in the account to cover the purchase of the stock. If he does so, his net investment would be equal to the debit balance calcula­ tion shown on the right in Table 2-8. TABLE 2-8. Net investment required-margin account. Stock cost $21,500 Plus stock commissions + 320 Debit balance calculation: Net stock cost $21,820 Net stock cost $21,820 Times margin rate X 50% Less equity - 10,910 Equity required $10,910 Debit balance $10,910 Less premiums received 1,500 (at 50% margin) Plus option commissions + 60 Net margin investment $ 9,470 Tables 2-9 to 2-12 illustrate the computation of returns from writing on margin. If one has already computed the cash returns, he can use method 2 most easily. Method 1 involves no prior profit calculations. TABLE 2-9. Return if exercised-margin account. Method 1 Method 2 Stock sale proceeds Less stock commission Plus dividends $22,500 Net profit if exercised-cash $2,290 + Less margin interest charges 330 500 (10% on $10,910 for 6 months) - 545 Less debit balance Less net margin investment Net profit-margin - 10,910 - 9 470 $ 1,745 Less margin interest charges - Net profit if exercised­ margin $1,745 Return if exercised = $9 ,470 = 18.4% 545 $1,745 52 TABLE 2-10. Return if unchanged-margin account. Method 1 Unchanged stock value (500 shares at 43) Plus dividends Less margin interest charges (10% on $10,910 debit for 6 months) Less debit balance Less net investment (margin) Net profit if unchanged­ margin $21,500 + 500 545 10,910 - 9 470 $ 1,075 Part II: Call Option Strategies Method 2 Profit if unchanged-cash Less margin interest charges - Net profit if unchanged­ margin $1,620 545 $1,075 Return if unchanged = $ l ,075 = 11 .4% $9,470 TABLE 2-11. Break-even point-margin write. Net margin investment Plus debit balance Less dividends Plus margin interest charges Total stock cost to expiration Divide by shares held Break-even point-margin TABLE 2-12. Percent downside protection-margin write. Initial stock price Less break-even price-margin Points of protection Divide by original stock price Equals percent downside protection-margin $ 9,470 + 10,910 500 + 545 $20,425 + 500 40.9 43 -40.9 2.1 +43 4.9% The return if exercised is 18.4% for the covered write using margin. In Example 1 the return if exercised for a cash write was computed as 11.2%. Thus, the return if exercised from a margin write is considerably higher. In fact, unless a fairly deep in­ the-money write is being considered, the return on margin will always be higher than Cl,apter 2: Covered Call Writing 53 the return from cash. The farther out-of-the-money that the written call is, the big­ ger the discrepancy between cash and margin returns will be when the return if exer­ cised is computed. As with the computation for return if exercised for a write on margin, the return if unchanged calculation is similar for cash and margin also. The only difference is the subtraction of the margin interest charges from the profit. The return if unchanged is also higher for a margin write, provided that there is enough option premium to com­ pensate for the margin interest charges. The return if unchanged in the cash example was 7.9% versus 11.4% for the margin write. In general, the farther from the strike in either direction - out-of-the-money or in-the-money - the less the return if unchanged on margin will exceed the cash return if unchanged. In fact, for deeply out­ of-the-money or deeply in-the-money calls, the return if unchanged will be higher on cash than on margin. Table 2-11 shows that the break-even point on margin, 40.9, is higher than the break-even point from a cash write, 39.8, because of the margin inter­ est charges. Again, the percent downside protection can be computed as shown in Table 2-12. Obviously, since the break-even point on margin is higher than that on cash, there is less percent downside protection in a margin covered write. One other point should be made regarding a covered write on margin: The bro­ kerage firm will loan you only half of the strike price amount as a maximum. Thus, it is not possible, for example, to buy a stock at 20, sell a deeply in-the-money call struck at 10 points, and trade for free. In that case, the brokerage firm would loan you only 5 - half the amount of the strike. Even so, it is still possible to create a covered call write on margin that has little or even zero margin .requirement. For example, suppose a stock is selling at 38 and that a long-term LEAPS option struck at 40 is selling for 19. Then the margin requirement is zero! This does not mean you're getting something for free, however. True, your invest­ ment is zero, but your risk is still 19 points. Also, your broker would ask for some sort of minimum margin to begin with and would of course ask for maintenance margin if the underlying stock should fall in price. Moreover, you would be paying margin interest all during the life of this long-term LEAPS option position. Leverage can be a good thing or a bad thing, and this strategy has a great deal of leverage. So be careful if you utilize it. COMPOUND INTEREST The astute reader will have noticed that our computations of margin interest have been overly simplistic; the compounding effect of interest rates has been ignored. That is, since interest charges are normally applied to an account monthly, the investor will be paying interest in the later stages of a covered writing position not only on the original debit, but on all previous monthly interest charges. This effect is described in detail in a later chapter on arbitrage techniques. Briefly stated, rather 54 Part II: Call Option Strategies than computing the interest charge as the debit times the interest rate multiplied by the time to expiration, one should technically use: Margin interest charges = Debit [(l + r/ -1] where r is the interest rate per month and t the number of months to expiration. (It would be incorrect to use days to expiration, since brokerage firms compute interest monthly, not daily.) In Example 2 of the preceding section, the debit was $10,910, the time was 6 months, and the annual interest rate was 10%. Using this more complex formula, the margin interest charges would be $557, as opposed to the $545 charge computed with the simpler formula. Thus, the difference is usually small, in terms of percent­ age, and it is therefore comrrwn practice to use the simpler method. SIZE OF THE POSITION So far it has been assumed that the writer was purchasing 500 shares of XYZ and sell­ ing 5 calls. This requires a relatively considerable investment for one position for the individual investor. However, one should be aware that buying too few shares for cov­ ered writing purposes can lower returns considerably. Example: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call for 3, his return if exercised would drop from the 11.2% return (cash) that was com­ puted earlier to a return of9.9% in a cash account. Table 2-13 verifies this statement. Since commissions are less, on a per-share basis, when one buys more stock and sells more calls, the returns will naturally be higher with a 500- or 1,000-share posi­ tion than with a 100- or 200-share position. This difference can be rather dramatic, as Tables 2-14 and 2-15 point out. Several interesting and worthwhile conclusions can be drawn from these tables. The first and most obvious conclusion is that the rrwre shares TABLE 2-13. Cash investment vs. return. Net Investment-Cash ( l 00 shares) Stock cost $4,300 Plus commissions + 85 Less option premium 300 Plus option commissions + 25 Net investment $4,110 Return If Exercised-Cash ( l 00 shares) Stock sale price Stock commissions Plus dividend Less net investment Net profit if exercised $4,500 85 + 100 - 4 110 $ 405 Return if exercised = $4 05 = 9. 9% $4,110 Cl,apter 2: Covered Call Writing 55 one writes against, the higher his returns and the lower his break-even point will be. This is true for both cash and margin and is a direct result of the way commissions are figured: Larger trades involve smaller percentage commission charges. While the per­ centage returns increase as the number of shares increases for both cash and margin covered writing, the increase is much more dramatic in the case of margin. Note that in Table 2-14, which depicts cash transactions, the return from writing against 100 shares is 9.9% and increases to 12. 7% if 2,000 shares are written against. This is an increase, but not a particularly dramatic one. However, in Table 2-15, the return if exercised more than doubles (21.6 vs. 10.4) and the return if unchanged nearly triples (13.0 vs. 4.4) when the 100-share write is compared to the 2,000-share write. This effect is more dramatic for margin writes due to two factors - the lower investment required and the more burdensome effect of margin interest charges on the profits of smaller positions. This effect is so dramatic that a 100-share write in a cash account in our example actually offers a higher return if unchanged than does the margin write - 7.1 % vs. 4.4%. This implies that one should carefully compute his potential returns if he is writing against a small number of shares on margin. TABLE 2-14. Cash covered writes (costs included). Shares Written Against 100 200 300 400 500 1,000 2,000 Return if exercised (%) 9.9 10.0 10.4 10.8 11.2 12.1 12.7 Re~rn if unchanged(%) 7.1 7.2 7.5 7.7 7.9 8.4 8.7 Break-even point 40.1 40.0 39.9 39.9 39.8 39.6 39.5 TABLE 2-15. Margin covered writes (costs included). Shares Written Against 100 200 300 400 500 1,000 2,000 Return if exercised (%) 10.4 15.8 16.6 17.4 18.4 20.4 21.6 Return if unchanged (%) 4.4 9.8 10.3 10.8 11.4 12.3 13.0 Break-even point 41.2 41.1 41.0 41.0 40.9 40.7 40.6 WHAT A DIFFERENCE A DIME MAKES Another aspect of covered writing that can be important as far as potential returns are concerned is, of course, the prices of the stock and option involved in the write. 56 Part II: Call Option Strategies It may seem insignificant that one has to pay an extra few cents for the stock or pos­ sibly receives a dime or 20 cents less for the call, but even a relatively small fraction can alter the potential returns by a surprising amount. This is especially true for in­ the-money writes, although any write will be affected. Let us use the previous 500- share covered writing example, again including all costs. As before, the results are more dramatic for the margin write than for the cash write. In neither case does the break-even point change by much. However, the potential returns are altered significantly. Notice that if one pays an extra dime for the stock and receives a dime less for the call - the far right-hand column in Table 2-16 - he may greatly negate the effect of writing against a larger number of shares. From Table 2-16, one can see that writing against 300 shares at those prices (43 for the stock and 3 for the call) is approximately the same return as writing against 500 shares if the stock costs 431/s and the option brings in 27/s. Table 2-16 should clearly demonstrate that entering a covered writing order at the market may not be a prudent thing to do, especially if one's calculations for the potential returns are based on last sales or on closing prices in the newspaper. In the next section, we discuss in depth the proper procedure for entering a covered writ­ ing order. TABLE 2-16. Effect of stock and option prices on writing returns. Buy Stock at 43 Buy Stock at 43.10 Sell Call at 3 Sell Call at 3 Return if exercised 11.2% cash 10.9% cash 18.4% margin 17.7% margin Return if unchanged 7.9% cash 7.6% cash 11 .4% margin 10.7% margin Break-even point 39.8 cash 39.9 cash 40.9 margin 41.0 margin EXECUTION OF THE COVERED WRITE ORDER Buy Stock at 43. I 0 Sell Call at 2.90 10.6% cash 16. 9% margin 7.3% cash 9.9% margin 40.0 cash 41.1 margin When establishing a covered writing position, the question often arises: Which should be done first - buy the stock or sell the option? The correct answer is that nei­ ther should be done first! In fact, a simultaneous transaction of buying the stock and selling the option is the only way of assuring that both sides of the covered write are established at desired price levels. Cl,apter 2: Covered Call Writing 57 If one "legs" into the position - that is, buys the stock first and then attempts to sell the option, or vice versa - he is subjecting himself to a risk. Example: An investor wants to buy XYZ at 43 and sell the July 45 call at 3. Ifhe first sells the option at 3 and then tries to buy the stock, he may find that he has to pay more than 43 for the stock. On the other hand, if he tries to buy the stock first and then sell the option, he may find that the option price has moved down. In either case the writer will be accepting a lower return on his covered write. Table 2-16 demon­ strated how one's returns might be affected ifhe has to give up an eighth by "legging" into the position. ESTABLISHING A NET POSITION What the covered writer really wants to do is ensure that his net price is obtained. If he wants to buy stock at 43 and sell an option at 3, he is attempting to establish the position at 40 net. He normally would not mind paying 43.10 for the stock if he can sell the call at 3.10, thereby still obtaining 40 net. A "net" covered writing order must be placed with a brokerage firm because it is essential for the person actually executing the order to have full access to both the stock exchange and the option exchange. This is also referred to as a contingent order. Most major brokerage firms offer this service to their clients, although some place a minimum number of shares on the order. That is, one must write against at least 500 or 1,000 shares in order to avail himself of the service. There are, however, brokerage firms that will take net orders even for 100-share covered writes. Since the chances of giving away a dime are relatively great if one attempts to execute his own order by placing separate orders on two exchanges - stock and option - he should avail himself of the broker's service. Moreover, if his orders are for a small number of shares, he should deal with a broker who will take net orders for small positions. The reader must understand that there is no guarantee that a net order will be filled. The net order is always a "not held" order, meaning that the customer is not guaranteed an execution even if it appears that the order could be filled at prevailing market bids and offers. Of course, the broker will attempt to fill the order if it can reasonably be accomplished, since that is his livelihood. However, if the net order is slightly away from current market prices, the broker may have to "leg" into the posi­ tion to fill the order. The risk in this is the broker's responsibility, not the customer's. Therefore, the broker may elect not to take the risk and to report "nothing done" - the order is not filled. If one buys stock at 43 and sells the call at 3, is the return really the same as buy­ ing the stock at 43.10 and selling the call at 3.10? The answer is, yes, the returns are 58 Part II: Call Option Strategies very similar when the prices differ by small amounts. This can be seen without the use of a table. If one pays a dime more for the stock, his investment increases by $10 per 100 shares, or $50 total on a 500-share transaction. However, the fact that he has received an extra dime for the call means that the investment is reduced by $62.50. Thus, there is no effect on the net investment except for commissions. The commis­ sion on 500 shares at 43.10 may be slightly higher than the commission for 500 shares at 43. Similarly, the commission on 5 calls at 3.10 may be slightly higher than that on 5 calls at 3. Even so, the increase in commissions would be so small that it would not affect the return by more than one-tenth of 1 %. To carry this concept to extremes may prove somewhat misleading. If one were to buy stock at 40½ and sell the call at ½, he would still be receiving 40 net, but sev­ eral aspects would have changed considerably. The return if exercised remains amaz­ ingly constant, but the return if unchanged and the percentage downside protection are reduced dramatically. If one were to buy stock at 48 and sell the call at 8 - again for 40 net - he would improve the return if unchanged and the percentage downside protection. In reality, when one places a "net" order with a brokerage firm, he nor­ mally gets an execution with prices quite close to the ones at the time the order was first entered. It would be a rare case, indeed, when either upside or downside extremes such as those mentioned here would occur in the same trading day. SELECTING A COVERED WRITING POSITION The preceding sections, in describing types of covered writes and how to compute returns and break-even points, have laid the groundwork for the ultimate decision that every covered writer must make: choosing which stock to buy and which option to write. This is not necessarily an easy task, because there are large numbers of stocks, striking prices, and expiration dates to choose from. Since the primary objective of covered writing for most investors is increased income through stock ownership, the return on investment is an important consider­ ation in determining which write to choose. However, the decision must not be made on the basis of return alone. More volatile stocks will offer higher returns, but they may also involve more risk because of their ability to fall in price quickly. Thus, the amount of downside protection is the other important objective of covered writing. Finally, the quality and technical or fundamental outlook of the underlying stock itself are of importance as well. The following section will help to quantify how these factors should be viewed by the covered writer. Chapter 2: Covered Call Writing PROJECTED RETURNS 59 The return that one strives for is somewhat a matter of personal preference. In gen­ eral, the annualized return if unchanged should be used as the comparative measure between various covered writes. In using this return as the measuring criterion, one does not make any assumptions about the stock moving up in price in order to attain the potential return. A general rule used in deciding what is a minimally acceptable return is to consider a covered writing position only when the return if unchanged is at least 1 % per month. That is, a 3-month write would have to offer a return of at least 3% and a 6-month write would have to have a return if unchanged of at least 6%. During periods of expanded option premiums, there may be so many writes that satisfy this criterion that one would want to raise his sights somewhat, say to 1 ½% or 2% per month. Also, one must feel personally comfortable that his minimum return criterion - whether it be 1 % per month or 2% per month - is large enough to com­ pensate for the risks he is taking. That is, the downside risk of owning stock, should it fall far enough to outdistance the premium received, should be adequately com­ pensated for by the potential return. It should be pointed out that 1 % per month is not a return to be taken lightly, especially if there is a reasonable assurance that it can be attained. However, if less risky investments, such as bonds, were yielding 12% annually, the covered writer must set his sights higher. Normally, the returns from various covered writing situations are compared by annualizing the returns. One should not, however, be deluded into believing that he can always attain the projected annual return. A 6-month write that offers a 6% return annualizes to 12%. But if one establishes such a position, all that he can achieve is 6% in 6 months. One does not really know for sure that 6 months from now there will be another position available that will provide 6% over the next 6 months. The deeper that the written option is in-the-money, the higher the probability that the return if unchanged will actually be attained. In an in-the-money situation, recall that the return if unchanged is the same as the return if exercised. Both would be attained unless the stock fell below the striking price by expiration. Thus, for an in­ the-money write, the projected return is attained if the stock rises, remains unchanged, or even falls slightly by the time the option expires. Higher potential returns are avail­ able for out-of-the-money writes if the stock rises. However, should the stock remain the same or decline in price, the out-of-the-money write will generally underperform the in-the-money write. This is why the return if unchanged is a good comparison. DOWNSIDE PROTECTION Downside protection is more difficult to quantify than projected returns are. As men­ tioned earlier, the percentage of downside protection is often used as a measure. This 60 Part II: Call Option Strategies is somewhat misleading, however, since the more volatile stocks will always offer a large percentage of downside protection (their premiums are higher). The difficulty arises in trying to decide if 10% protection on a volatile stock is better than or worse than, say, 6% protection on a less volatile stock. There are mathematical ways to quantify this, but because of the relatively advanced nature of the computations involved, they are not discussed until later in the text, in Chapter 28 on mathemati­ cal applications. Rather than go into involved mathematical calculations, many covered writers use the percentage of downside protection and will only consider writes that offer a certain minimum level of protection, say 10%. Although this is not exact, it does strive to ensure that one has minimal downside protection in a covered write, as well as an acceptable return. A standard figure that is often used is the 10% level of pro­ tection. Alternatively, one may also require that the write be a certain percent in-the­ money, say 5%. This is just another way of arriving at the same concept. THE IMPORTANCE OF STRATEGY In a conservative option writing strategy, one should be looking for minimum returns if unchanged of 1 % per month, with downside protection of at least 10%, as general guidelines. Employing such criteria automatically forces one to write in-the-money options in line with the total return concept. The overall position constructed by using such guidelines as these will be a relatively conservative position - regardless of the volatility of the underlying stock - since the levels of protection will be large but a reasonable return can still be attained. There is a danger, however, in using fixed guidelines, because market conditions change. In the early days of listed options, premiums were so large that virtually every at- or in-the-money covered write satisfied the foregoing criteria. However, now one should work with a ranked list of covered writing positions, or perhaps two lists. A daily computer ranking of either or both of the following categories would help establish the most attractive types of conservative covered writes. One list would rank, by annualized return, the writes that afford, as a minimum, the desired downside protection level, say 10%. The other list would rank, by percentage downside protection, all the writes that meet at least the minimum acceptable return if unchanged, say 12%. If premium lev­ els shrink and the lists become quite small on a daily basis, one might consider expanding the criteria to view more potential situations. On the other hand, if pre­ miums expand dramatically, one might consider using more restrictive criteria, to reduce the number of potential writing candidates. A different group of covered writers may favor a more aggressive strategy of out­ of-the-money writes. There is some mathematical basis to believe, in the long rnn, that Chapter 2: Covered Call Writing 61 rrwderately out-of the-rrwney covered writes will peiform better than in-the-rrwney writes. In falling or static markets, any covered writer, even the more aggressive one, will outperform the stockowner who does not write calls. The out-of-the-money cov­ ered writer has more risk in such a market than the in-the-money writer does. But in a rising market, the out-of-the-money covered writer will not limit his returns as much as the in-the-money writer will. As stated earlier, the out-of-the-money writer's per­ formance will more closely follow the performance of the underlying stock; that is, it will be more volatile on a quarter-by-quarter basis. There is merit in either philosophy. The in-the-money writes appeal to those investors looking to earn a relatively consistent, moderate rate of return. This is the total return concept. These investors are generally concerned with preservation of capital, thus striving for the greater levels of downside protection available from in­ the-money writes. On the other hand, some investors prefer to strive for higher potential returns through writing out-of-the-money calls. These more aggressive investors are willing to accept more downside risk in their covered writing positions in exchange for the possibility of higher returns should the underlying stock rise in price. These investors often rely on a bullish research opinion on a stock in order to select out-of-the-money writes. Although the type of covered writing strategy pursued is a matter of personal philosophy, it would seem that the benefits of in-the-money strategy- more consis­ tent returns and lessened risk than stock ownership will normally provide - would lead the portfolio manager or less aggressive investor toward this strategy. If the investor is interested in achieving higher returns, some of the strategies to be pre­ sented later in the book may be able to provide higher returns with less risk than can out-of-the-money covered writing. The final important consideration in selecting a covered write is the underlying stock itself. One does not necessarily have to be bullish on the underlying stock to take a covered writing position. As long as one does not foresee a potential decline in the underlying stock, he can feel free to establish the covered writing position. It is generally best if one is neutral or slightly bullish on the underlying stock. If one is bearish, he should not take a covered writing position on that stock, regardless of the levels of protection that can be obtained. An even broader statement is that one should not establish a covered write on a stock that he does not want to own. Some individual investors may have qualms about buying stock they feel is too volatile for them. Impartially, if the return and protection are adequate, the characteristics of the total position are different from those of the underlying stock. However, it is still true that one should not invest in positions that he considers too risky for his portfolio, nor should one establish a covered write just because he likes a particular stock. If the 62 Part II: Call Option Strategies potential return is unchanged or levels of downside protection do not meet one's cri­ teria, the write should not be established. The covered writing strategist strives for a balance between acceptable returns and downside protection. He rejects situations that do not meet his criteria in either category and rejects stocks on which he is bearish. The resulting situations will prob­ ably fulfill the objectives of a conservative covered writing program: increased income, protection, and less variability of results on a less volatile investment portfolio. WRITING AGAINST STOCK ALREADY OWNED Establishing covered writing positions against stock that has previously been pur­ chased involves other factors. It is often the case that an investor owns stock that has listed options trading, but feels that the returns from writing are too low in comparison to other covered writes that simultaneously exist in the marketplace. This opinion may be valid, but often arises from the fact that the investor has seen a computer-generated list showing returns on his stock as being low in comparison to similarly priced stocks. One should note that such lists generally assume that stock is bought in order to establish the covered write; the returns are usually not computed and published for writing against stock already held. It may be the case that the commission costs for selling one stock and investing in another may alter the returns so substantially that one would be better off to write against the shares of stock initially held. Example: An investor owns XYZ stock and is comparing it against AAA stock for writing purposes. If AAA is more volatile than XYZ, the current prices might appear as follows: Stock XYZ: 50 AAA:50 Oct 50 Coll 4 6 Table 2-17 summarizes the computation of the return if exercised as one might see it listed on a daily or weekly summary of available covered writing returns. Assume that 500 shares are being written against, that XYZ will pay 50 cents per share in dividends while AAA pays none during the life of the call, and that the October 50 is a 6-month call. Without going into as much detail, the other significant aspects of these two writes are: Chapter 2: Covered Call Writing Return if exercised - margin Downside break-even point cash Downside break-even point - margin XYZ 7.9% 46.3 47.6 63 AAA 16.2% 44.9 46.1 Seeing these calculations, the XYZ stockholder may feel that it is not advisable to write against his stock, or he may even be tempted to sell XYZ and buy AAA in order to establish a covered write. Either of these actions could be a mistake. First, he should compute what his returns would be, at current prices, from writing against the XYZ he already owns. Since the stock is already held, no stock buy commissions would be involved. This would reduce the net investment shown below by the stock purchase commissions, or $345, giving a total net investment (cash) of $23,077. In theory, the stockholder does not really make an investment per se; after all, he already owns the stock. However, for the purposes of computing returns, an investment figure is necessary. This reduction in the net investment will increase his profit by the same amount - $345 - thus, bringing the profit up to $1,828. Consequently, the return if exercised (cash) wpuld be 7.9% on XYZ stock already held. On margin, the return would increase to 11.3% after eliminating purchase com­ missions. This return, assumed to be for a 6-month period, is well in excess of 1 % per TABLE 2-17. Summary of covered writing returns, XYZ and AAA. XYZ AAA Buy 500 shares at 50 $25,000 $25,000 Plus stock commissions + 345 + 345 Less option premiums received - 2,000 - 3,000 Plus option sale commissions + 77 + 91 Net investment-cash $23,422 $22,436 Sell 500 shares at 50 $25,000 $25,000 Less stock sale commissions 345 345 Dividend received + 250 0 Less net investment - 23,422 - 22,436 Net profit $ 1,483 $ 2,219 Return if exercised-cash 6.3% 9.9% ' 64 Part II: Call Option Strategies month, the level nominally used for acceptable covered writes. Thus, the investor who already owns stock may inadvertently be overlooking a potentially attractive cov­ ered write because he has not computed the returns excluding the stock purchase commission on his current stock holding. It could conceivably be an even more extreme oversight for the investor to switch from XYZ to AAA for writing purposes. The investor may consider making this switch because he thinks that he could substantially increase his return, from 6.3% to 9.9% for the 6-month period, as shown in Table 2-17 comparing the two writes. However, the returns are not truly comparable because the investor already owns XYZ. To make the switch, he would first have to spend $345 in stock commis­ sions to sell his XYZ, thereby reducing his profits on AAA by $345. Referring again to the preceding detailed breakdown of the return if exercised, the profit on AAA would then decline to $1,874 on the investment of $22,436, a return if exercised (cash) of 8.4%. On margin, the comparable return from switching stocks would drop to 14.8%. The real comparison in returns from writing against these two stocks should be made in the following manner. The return from writing against XYZ that is already held should be compared with the return from writing against AAA after switching fromXYZ: Return if exercised - cash Return if exercised - margin XYZ Already Held 7.9% 11.3% Switch from XYZ to AAA 8.4% 14.8% Each investor must decide for himself whether it is worth this much smaller increase in return to switch to a more volatile stock that pays a smaller dividend. He can, of course, only make this decision by making the true comparison shown imme­ diately above as opposed to the first comparison, which assumed that both stocks had to be purchased in order to establish the covered write. The same logic applies in situations in which an investor has been doing cov­ ered writing. If he owns stock on which an option has expired, he will have to decide whether to write against the same stock again or to sell the stock and buy a new stock for covered writing purposes. Generally, the investor should write against the stock already held. This justifies the method of computation of return if unchanged for out­ of-the-money writes and also the computation of downside break-even points in which a stock sale commission was not charged. That is, the writer would not nor­ mally sell his stock after an option has expired worthless, but would instead write another option against the same stock. It is thus acceptable to make these computa­ tions without including a stock sales commission. Chapter 2: Covered Call Writing A WORD OF CAUTION 65 The stockholder who owns stock from a previous purchase and later contemplates writing calls against that stock must be aware of his situation. He must realize and accept the fact that he might lose his stock via assignment. If he is determined to retain ownership of the stock, he may have to buy back the written option at a loss should the underlying stock increase in price. In essence, he is limiting the stock's upside potential. If a stockholder is going to be frustrated and disappointed when he is not fully participating during a rally in his stock, he should not write a call in the first place. Perhaps he could utilize the incremental return concept of covered writ­ ing, a topic covered later in this chapter. As stressed earlier, a covered writing strategy involves viewing the stock and option as a total position. It is not a strategy wherein the investor is a stockholder who also trades options against his stock position. If the stockholder is selling the calls because he thinks the stock is going to decline in price and the call trade itself will be profitable, he may be putting himself in a tenuous position. Thinking this way, he will probably be satisfied only if he makes a profit on the call trade, regardless of the unrealized result in the underlying stock. This sort of philosophy is contrary to a cov­ ered writing strategy philosophy. Such an investor - he is really becoming a trader should carefully review his motives for writing the call and anticipate his reaction if the stock rises substantially in price after the call has been written. In essence, writing calls against stock that you have no intention of selling is tantamount to writing naked calls! If one is going to be extremely frustrated, perhaps even experiencing sleepless nights, if his stock rises above the strike price of the call that he has written, then he is experiencing trials and tribulations much as the writer of a naked call would if the same stock move occurred. This is an unacceptable level of emotional worry for a true covered writing strategist. Think about it. If you have some very low-cost-basis stock that you don't really want to sell, and then you sell covered calls against that stock, what do you wish will happen? Most certainly you wish that the options will expire worthless (i.e., that the stock won't get called away) - exactly what a naked writer wishes for. The problems can be compounded if the stock rises, and one then decides to roll these calls. Rather than spend a small debit to close out a losing position, an investor may attempt to roll to more distant expiration months and higher strike prices in order to keep bringing in credits. Eventually, he runs out of room as the lower strikes disappear, and he has to either sell some stock or pay a big debit to buy back the written calls. So, if the underlying stock continues to run higher, the writer suffers emotional devastation as he attempts to "fight the market." There have been some classic cases of Murphy's law whereby people have covered the calls at a big 66 Part II: Call Option Strategies debit rather than let their "untouchable" stock be called away, just before the stock itself or the stock market collapsed. One should be very cautious about writing covered calls against stocks that he doesn't intend to sell. If one feels that he cannot sell his stock, for whatever reason - tax considerations, emotional ties, etc. - he really should not sell covered calls against it. Perhaps buying a protective put ( discussed in a later chapter) would be a better strategy for such a stockholder. DIVERSIFYING RETURN AND PROTECTION IN A COVERED WRITE FUNDAMENTAL DIVERSIFICATION TECHNIQUES Quite clearly, the covered writing strategist would like to have as much of a combina­ tion of high potential returns and adequate downside protection as he can obtain. Writing an out-of-the-money call will offer higher returns if exercised, but it usually affords only a modest amount of downside protection. On the other hand, writing an in-the-money call will provide more downside cushion but offers a lower return if exercised. For some strategists, this diversification is realized in practice by writing out-of-the-money calls on some stocks and in-the-moneys on other stocks. There is no guarantee that writing in this manner on a list of diversified stocks will produce supe­ rior results. One is still forced to pick the stocks that he expects will perform better (for out-of-the-money writing), and that is difficult to do. Moreover, the individual investor may not have enough funds available to diversify into many such situations. There is, however, another alternative to obtaining diversification of both returns and downside protection in a covered writing situation. The writer may often do best by writing half of his position against in-the-rrwn­ eys and half against out-of the-rrwneys on the same stock. This is especially attractive for a stock whose out-of-the-money calls do not appear to provide enough downside protection, and at the same time, whose in-the-money calls do not provide quite enough return. By writing both options, the writer may be able to acquire the return and protection diversification that he is seeking. Example: The following prices exist for 6-month calls: XYZ common stock, 42; XYZ April 40 call, 4; and XYZ April 45 call, 2. Chapter 2: Covered Call Writing 67 The writer wishing to establish a covered write against XYZ common stock may like the protection afforded by the April 40 call, but may not find the return particularly attractive. He may be able to improve his return by writing April 45's against part of his position. Assume the writer is considering buying 1,000 shares of XYZ. Table 2-18 compares the attributes of writing the out-of-the-money (April 45) only, or of writing only the in-the-money (April 40), or of writing 5 of each. The table is based on a cash covered write, but returns and protection would be similar for a margin write. Commissions are included in the figures. It is easily seen that the "combined" write - half of the position against the April 40's and the other half against the April 45's - offers the best balance of return and protection. The in-the-money call, by itself, provides over 10% downside protection, but the 5% return if exercised is less than 1 % per month. Thus, one might not want to write April 40's against his entire position, because the potential return is small. At the same time, the April 45's, if written against the entire stock position, would pro­ vide for an attractive return if exercised (over 2% per month) but offer only 5% down­ side protection. The combined write, which has the better features of both options, offers over 8% return if exercised (11h% per month) and affords over 8% downside protection. By writing both calls, the writer has potentially solved the problems inher­ ent in writing entirely out-of-the-moneys or entirely in-the-moneys. The "combined" write frees the covered writer from having to initially take a bearish (in-the-money write) or bullish (out-of-the-money write) posture on the stock ifhe does not want to. This is often necessary on a low-volatility stock trading between striking prices. TABLE 2-18. Attributes of various writes. Buy 1,000 XYZ and sell Return if exercised Re~rn if unchanged Percent protection In-the-Money Write 10 April 40's 5.1% 5.1% 10.5% Out-of-the-Money Write l O April 45's 12.2% 6.0% 5.7% Write Both Calls 5 April 40's and 5 April 45's 8.4% 5.4% 8.1% For those who prefer a graphic representation, the profit graph shown in Figure 2-2 compares the combined write of both calls with either the in-the-money write or the out-of-the-money write (dashed lines). It can be observed that all three choices are equal if XYZ is near 42 at expiration; all three lines intersect there. 68 Part II: Call Option Strategies FIGURE 2-2. Comparison: combined write vs. in-the-money write and out-of-the­ money write. Out-of-the-Money Write , .-------► ,,, Combined Write , / In-the-Money Write -----------➔ Stock Price at Expiration Since this technique can be useful in providing diversification between protec­ tion and return, not only for an individual position but for a large part of a portfolio, it may be useful to see exactly how to compute the potential returns and break-even points. Tables 2-19 and 2-20 calculate the return if exercised and the return if unchanged using the prices from the previous example. Assume XYZ will pay $1 per share in dividends before April expiration. Note that the profit calculations are similar to those described in earlier sec­ tions, except that now there are two prices for stock sales since there are two options involved. In the "return if exercised" section, half of the stock is sold at 45 and half is sold at 40. The "return if unchanged" calculation is somewhat more complicated now, TABLE 2-19. Net investment-cash account. Buy 1,000 XYZ at 42 Plus stock commissions Less options premiums: Sell 5 April 40's at 4 Sell 5 April 45's at 2 Plus total option commissions Net investment + $42,000 460 - 2,000 1,000 + 140 $39,600 Chapter 2: Covered Call Writing TABLE 2-20. Net return-cash account. Return If Exercised Sell 500 XYZ at 45 $22,500 Sell 500 XYZ at 40 20,000 Less total stock sale commissions 560 Plus dividends ($1 /share) + 1,000 Less net investment - 39,600 Net profit if exercised $ 3,340 Return if exercised = 3,340 = 8_4% (cash) 39,600 69 Return If Unchanged Unchanged stock value (500 shares at 42) $21,000 Sell 500 at 40 + 20,000 Commissions on sale at 40 280 Plus dividends ($1 /share) . + 1,000 Less net investment - 39,600 Net profit if unchanged $ 2, 120 Return if unchanged = 2, 120 = 5 _4% (cash) 39,600 because half of the stock will be called away if it remains unchanged (the in-the­ money portion) whereas the other half will not. This is consistent with the method of calculating the return if unchanged that was introduced previously. The break-even point is calculated as before. The "total stock cost to expiration" would be the net investment of $39,600 less the $1,000 received in dividends. This is a total of $38,600. On a per-share basis, then, the break-even point of 38.6 is 8.1 % below the current stock price of 42. Thus, the amount of percentage downside pro­ tection is 8.1 %. The foregoing calculations clearly demonstrate that the returns on the "com­ bined" write are not exactly the averages of the in-the-money and out-of-the-money returns, because of the different commission calculations at various stock prices. However, if one is working with a computer-generated list and does not want to both­ er to calculate exactly the return on the combined write, he can arrive at a relatively close approximation by averaging the returns for the in-the-money write and the out­ of-the-money write. OTHER DIVERSIFICATION TECHNIQUES Holders of large positions in a particular stock may want even more diversification than can be provided by writing against two different striking prices. Institutions, pension funds, and large individual stockholders may fall into this category. It is often advisable for such large stockholders to diversify their writing over time as well as over at least two striking prices. By diversifying over time - for example, writing one- 70 Part II: Call Option Strategies third of the position against near-term calls, one-third against middle-term calls, and the remaining third against long-term calls - one can gain several benefits. First, all of one's positions need not be adjusted at the same time. This includes either having the stock called away or buying back one written call and selling another. Moreover, one is not subject only to the level of option premiums that exist at the time one series of calls expires. For example, if one writes only 9-month calls and then rolls them over when they expire, he may unnecessarily be subjecting himself to the potential of lower returns. If option premium levels happen to be low when it is time for this 9-month call writer to sell more calls, he will be establishing a less-than-opti­ mum write for up to 9 months. By spreading his writing out over time, he would, at worst, be subjecting only one-third of his holding to the low-premium write. Hopefully, premiums would expand before the next eXpiration 3 months later, and he would then be getting a relatively better premium on the next third of his portfolio. There is an important aside here: The individual or relatively small investor who owns only enough stock to write one series of options should generally not write the longest-term calls for this very reason. He may not be obtaining a particularly attrac­ tive level of premiums, but may feel he is forced to retain the position until expira­ tion. Thus, he could be in a relatively poor write for as long as 9 months. Finally, this type of diversification may also lead to having calls at various striking prices as· the market fluctuates cyclically. All of one's stock is not necessarily committed at one price if this diversification technique is employed. This concludes the discussion of how to establish a covered writing position against stock. Covered writes against other types of securities are described later. FOLLOW-UP ACTION Establishing a covered write, or any option position for that matter, is only part of the strategist's job. Once the position has been taken, it must be monitored closely so that adjustments may be made should the stock drop too far in price. Moreover, even if the stock remains relatively unchanged, adjustments will need to be made as the writ­ ten call approaches expiration. Some writers take no follow-up action at all, preferring to let a stock be called away if it rises above the striking price at the expiration of the option, or preferring to let the original expire worthless if the stock is below the strike. These are not always optimum actions; there may be much more decision making involved. Follow-up action can be divided into three general categories: Chapter 2: Covered Call Writing 71 1. protective action to take if the stock drops, 2. aggressive action to take when the stock rises, or 3. action to avoid assignment if the time premium disappears from an in-the-money call. There may be times when one decides to close the entire position before expiration or to let the stock be called away. These cases are discussed as well. PROTECTIVE ACTION IF THE UNDERLYING STOCK DECLINES IN PRICE The covered writer who does not take protective action in the face of a relatively sub­ stantial drop in price by the underlying stock may be risking the possibility of large losses. Since covered writing is a strategy with limited profit potential, one should also take care to limit losses. Otherwise, one losing position can negate several win­ ning positions. The simplest form of follow-up action in a decline is to merely close out the position. This might be done if the stock declines by a certain percentage, or if the stock falls below a technical support level. Unfortunately, this method of defen­ sive action may prove to be an inferior one. The investor will often do better to con­ tinue to sell more time value in the form of additional option premiums. Follow-up action is generally taken by buying back the call that was originally written and then writing another call, with a different striking price and/or expiration date, in its place. Any adjustment of this sort is referred to as a rolling action. When the underlying stock drops in price, one generally buys back the original call - pre­ sumably at a profit since the underlying stock has declined - and then sells a call with a lower striking price. This is known as rolling down, since the new option has a lower striking price. Example: The covered writing position described as "buy XYZ at 51, sell the XYZ January 50 call at 6" would have a maximum profit potential at expiration of 5 points. Downside protection is 6 points down to a stock price of 45 at expiration. These fig­ ures do not include commissions, but for the purposes of an elementary example, the commissions will be ignored. If the stock begins to decline in price, taking perhaps two months to fall to 45, the following option prices might exist: XYZ common, 45; XYZ January 50 call, l; and XYZ January 45 call, 4. 72 Part II: Call Option Strategies • The covered writer of the January 50 would, at this time, have a small unrealized loss of one point in his overall position: His loss on the common stock is 6 points, but he has a 5-point gain in the January 50 call. (This demonstrates that prior to expiration, a loss occurs at the "break-even" point.) If the stock should continue to fall from these levels, he could have a larger loss at expiration. The call, selling for one point, only affords one more point of downside protection. If a further stock price drop is anticipated, additional downside protection can be obtained by rolling down. In this example, if one were to buy back the January 50 call at 1 and sell the January 45 at 4, he would be rolling down. This would increase his protection by another three points - the credit generated by buying the 50 call at 1 and selling the 45 call at 4. Hence, his downside break-even point would be 42 after rolling down. Moreover, if the stock were to remain unchanged - that is, if XYZ were exactly 45 at January expiration - the writer would make an additional $300. If he had not rolled down, the most additional income that he could make, if XYZ remained unchanged, would be the remaining $100 from the January 50 call. So rolling down gives more downside protection against a further drop in stock price and may also produce additional income if the stock price stabilizes. In order to more exactly evaluate the overall effect that was obtained by rolling down in this example, one can either compute a profit table (Table 2-21) or draw a net profit graph (Figure 2-3) that compares the original covered write with the rolled-down position. Note that the rolled-down position has a smaller maximum profit potential than the original position did. This is because, by rolling down to a January 45 call, the writer limits his profits anywhere above 45 at expiration. He has committed himself to sell stock 5 points lower than the original position, which utilized a January 50 call and thus had limited profits above 50. Rolling down generally reduces the maximum TABLE 2·21. Profit table. XYZ Price at Profit from Profit from Expiration January 50 Write Rolled Position 40 -$500 -200 42 - 300 0 45 0 +300 48 + 300 +300 50 + 500 +300 60 + 500 +300 Chapter 2: Covered Call Writing FIGURE 2-3. Comparison: original covered write vs. rolled-down write. +$500 c: +$300 0 ~ ]- iii en en 0 ...J 5 -e a. $0 Original Write Rolled-Down Write 50 Stock Price at Expiration 73 profit potential of the covered write. Limiting the maximum profit may be a second­ ary consideration, however, when a stock is breaking downward. Additional downside protection is often a more pressing criterion in that case. Anywhere below 45 at expiration, the rolled-down position does $300 better than the original position, because of the $300 credit generated from rolling down. In fact, the rolled-down position will outperform the original position even if the stock rallies back to, but not above, a price of 48. At 48 at expiration, the two posi­ tions are equal, both producing a $300 profit. If the stock should reverse direction and rally back above 48 by expiration, the writer would have been better off not to have rolled down. All these facts are clear from Table 2-21 and Figure 2-3. Consequently, the only case in which it does not pay to roll down is the one in which the stock experiences a reversal - a rise in price after the initial drop. The selection of where to roll down is important, because rolling down too early or at an inappropriate price could limit the returns. Technical support levels of the stock are often useful in selecting prices at which to roll down. If one rolls down after techni­ cal support has been broken, the chances of being caught in a stock-price-reversal situation would normally be reduced. The above example is rather simplistic; in actual practice, more complicated sit­ uations may arise, such as a sudden and fairly steep decline in price by the underly­ ing stock. This may present the writer with what is called a locked-in loss. This means, simply, that there is no option to which the writer can roll down that will provide him 74 Part II: Call Option Strategies with enough premium to realize any profit if the stock were then called away at expi­ ration. These situations arise more commonly on lower-priced stocks, where the striking prices are relatively far apart in percentage terms. Out-of-the-money writes are more susceptible to this problem than are in-the-money writes. Although it is not emotionally satisfying to be in an investment position that cannot produce a profit - at least for a limited period of time - it may still be beneficial to roll down to protect as much of the stock price decline as possible. Example: For the covered write described as "buy XYZ at 20, sell the January 20 call at 2," the stock unexpectedly drops very quickly to 16, and the following prices exist: XYZ common, 16; XYZ January 20 call,½; and XYZ January 15 call, 2½. The covered writer is faced with a difficult choice. He currently has an unrealized loss of 2½ points - a 4-point losson the stock which is partially offset by a 1 ½-point gain on the January 20 call. This represents a fairly substantial percentage loss on his investment in a short period of time. He could do nothing, hoping for the stock to recover its loss. Unfortunately, this may prove to be wishful thinking. If he considers rolling down, he will not be excited by what he sees. Suppose that the writer wants to roll down from the January 20 to the January 15. He would thus buy the January 20 at ½ and sell the January 15 at 2½, for a net credit of 2 points. By rolling down, he is obligating himself to sell his stock at 15, the striking price of the January 15 call. Suppose XYZ were above 15 in January and were called away. How would the writer do? He would lose 5 points on his stock, since he origi­ nally bought it at 20 and is selling it at 15. This 5-point loss is substantially offset by his option profits, which amount to 4 points: 1 ½ points of profit on the January 20, sold at 2 and bought back at ½, plus the 2½ points received from the sale of the January 15. However, his net result is a 1-point loss, since he lost 5 points on the stock and made only 4 points on the options. Moreover, this 1-point loss is the best that he can hope for! This is true because, as has been demonstrated several times, a covered writing position makes its maximum profit anywhere above the striking price. Thus, by rolling down to the 15 strike, he has limited the position severely, to the extent of "locking in a loss." Even considering what has been shown about this loss, it is still correct for this writer to roll down to the January 15. Once the stock has fallen to 16, there is noth­ ing anybody can do about the unrealized losses. However, if the writer rolls down, he can prevent the losses from accumulating at a faster rate. In fact, he will do better by Chapter 2: Covered Call Writing 75 rolling down if the stock drops further, remains unchanged, or even rises slightly. Table 2-22 and Figure 2-4 compare the original write with the rolled-down position. It is clear from the figure that the rolled-down position is locked into a loss. However, the rolled-down position still outperforms the original position unless the stock ral­ lies back above 17 by expiration. Thus, if the stock continues to fall, if it remains unchanged, or even if it rallies less than 1 point, the rolled-down position actually outperforms the original write. It is for this reason that the writer is taking the most logical action by rolling down, even though to do so locks in a loss. TABLE 2-22. Profits of original write and rolled position. Stock Price at Profit from Expiration January 20 Write 10 -$800 15 - 300 18 0 20 + 200 25 + 200 FIGURE 2-4. Comparison: original write vs. 11 locked-in loss." c: +$200 Original Write ~ t «i ~ o -$100 ~ a.. 15 20 Stock Price at Expiration Profit from Rolled Position -$600 - 100 - 100 - 100 - 100 76 Part II: Call Option Strategies Technical analysis may be able to provide a little help for the writer faced with the dilemma of rolling down to lock in a loss or else holding onto a position that has no further downside protection. IfXYZ has broken a support level or important trend line, it is added evidence for rolling down. In our example, it is difficult to imagine the case in which a $20 stocksuddenly drops to become a $16 stock without sub­ stantial harm to its technical picture. Nevertheless, if the charts should show that there is support at 15½ or 16, it may be worth the writer's while to wait and see if that support level can hold before rolling down. Perhaps the best way to avoid having to lock in losses would be to establish posi­ tions that are less likely to become such a problem. In-the-money covered writes on higher-priced stocks that have a moderate amount of volatility will rarely force the writer to lock in a loss by rolling down. Of course, any stock, should it fall far enough and fast enough, could force the writer to lock in a loss if he has to roll down two or thr..ee times in a fairly short time span. However, the higher-priced stock has striking prices that are much closer together (in percentages); it thus presents the writer with the opportunity to utilize a new option with a lower striking price much sooner in the decline of the stock. Also, higher volatility should help in generating large enough premiums that substantial portions of the stock's decline can be hedged by rolling down. Conversely, low-priced stocks, especially nonvolatile ones, often present the most severe problems for the covered writer when they decline in price. A related point concerning order entry can be inserted here. When one simul­ taneously buys one call and sells another, he is executing a spread. Spreads in gener­ al are discussed at length later. However, the covered writer should be aware that whenever he rolls his position, the order can be placed as a spread order. This will normally help the writer to obtain a better price execution. AN ALTERNATIVE METHOD OF ROLLING DOWN There is another alternative that the covered writer can use to attempt to gain some additional downside protection without necessarily having to lock in a loss. Basically, the writer rolls down only part of his covered writing position. Example: One thousand shares of XYZ were bought at 20 and 10 January 20 calls were sold at 2 points each. As before, the stock falls to 16, with the following prices: XYZ January 20 call, ½; and XYZ January 15 call, 2½. As was demonstrated in the last section, if the writer were to roll all 10 calls down from the January 20 to the January 15, he would be locking in a loss. Although there may be some justification for this action, the writer would naturally rather not have to place himself in such a position. One can attempt to achieve some balance between added downside protection and upward profit potential by rolling down only part of the calls. In this example, Chapter 2: Covered Call Writing 77 the writer would buy back only 5 of the January 20's and sell 5 January 15 calls. He would then have this position: long 1,000 XYZ at 20; short 5 XYZ January 20's at 2; short 5 XYZ January 15's at 2½; and realized gain, $750 from 5 January 20's. This strategy is generally referred to a partial roll-down, in which only a portion of the original calls is rolled, as opposed to the more conventional complete roll-down. Analyzing the partially rolled position makes it clear that the writer no longer locks in a loss. IfXYZ rallies back above 20, the writer would, at expiration, sell 500 XYZ at 20 (breaking even) and 500 at 15 (losing $2,500 on this portion). He would make $1,000 from the five January 20's held until expiration, plus $1,250 from the five January 15's, plus the $750 of realized gain from the January 20's that were rolled down. This amounts to $3,000 worth of option profits and $2,500 worth of stock losses, or an overall net gain of $500, less commissions. Thus, the partial roll-down offers the writer a chance to make some profit if the stock rebounds. Obviously, the partial roll­ down will not provide as much downside protection as the complete roll-down does, but it does give more protection than not rolling down at all. To see this, compare the results given in Table 2-23 if XYZ is at 15 at expiration. TABLE 2-23. Stock at 15 at expiration. Strategy Original position Partial roll-down Complete roll-down Stock Loss -$5,000 - 5,000 - 5,000 Option Profit Total Loss +$2,000 -$3,000 + 3,000 - 2,000 + 4,000 - 1,000 In summary, the covered writer who would like to roll down, but who does not want to lock in a loss or who feels the stock may rebound somewhat before expira­ tion, should consider rolling down only part of his position. If the stock should con­ tinue to drop, making it evident that there is little hope of a strong rebound back to the original strike, the rest of the position can then be rolled down as well. 78 Part II: Call Option Strategies UTILIZING DIFFERENT EXPIRATION SERIES WHEN ROLLING DOWN In the examples thus far, the same expiration month has been used whenever rolling­ down action was taken. In actual practice, the writer may often want to use a more distant expiration month when rolling down and, in some cases, he may even want to use a nearer expiration month. The advantage of rolling down into a more distant expiration series is that more actual points of protection are received. This is a common action to take when the underlying stock has become somewhat worrisome on a technical or fundamental basis. However, since rolling down reduces the maximum profit potential - a fact that has been demonstrated several times - every roll-down should not be made to a more distant expiration series. By utilizing a longer-term call when rolling down, one is reducing his maximum profit potential for a longer period of time. Thus, the longer­ term·call should be used only if the writer has grown concerned over the stock's capa­ bility to hold current price levels. The partial roll-down strategy is particularly amenable to rolling down to a longer-term call since, by rolling down only part of the position, one has already left the door open for profits if the stock should rebound. Therefore, he can feel free to avail himself of the maximum protection possible in the part of his position that is rolled down. The writer who must roll down to lock in a loss, possibly because of circum­ stances beyond his control, such as a sudden fall in the price of the underlying stock, may actually want to roll down to a near-term option. This allows him to make back the available time premium in the short-term call in the least time possible. Example: A writer buys XYZ at 19 and sells a 6-month call for 2 points. Shortly there­ after, however, bad news appears concerning the common stock and XYZ falls quick­ ly to 14. At that time, the following prices exist for the calls with the striking price 15: XYZ common, 14: near-term call, l; middle-term call, 1 ½; and far-term call, 2. If the writer rolls down into any of these three calls, he will be locking in a loss. Therefore, the best strategy may be to roll down into the near-term call, planning to capture one point of time premium in 3 months. In this way, he will be beginning to work himself out of the loss situation by availing himself of the most potential time premium decay in the shortest period of time. When the near-term call expires 3 months from now, he can reassess the situation to decide if he wants to write Chapter 2: Covered Call Writing 79 another near-term call to continue taking in short-term premiums, or perhaps write a long-term call at that time. When rolling down into the near-term call, one is attempting to return to a potentially profitable situation in the shortest period of time. By writing short-term calls one or two times, the writer will eventually be able to reduce his stock cost near­ er to 15 in the shortest time period. Once his stock cost approaches 15, he can then write a long-term call with striking price 15 and return again to a potentially prof­ itable situation. He will no longer be locked into a loss. ACTION TO TAKE IF THE STOCK RISES A more pleasant situation for the covered writer to encounter is the one in which the underlying stock rises in price after the covered writing position has been estab­ lished. There are generally several choices available if this happens. The writer may decide to do nothing and to let his stock be called away, thereby making the return that he had hoped for when he established the position. On the other hand, if the underlying stock rises fairly quickly and the written call comes to parity, the writer may either close the position early or roll the call up. Each case is discussed. Example: Someone establishes a covered writing position by buying a stock at 50 and selling a 6-month call for 6 points. His maximum profit potential is 6 points anywhere above 50 at expiration, and his downside break-even point is 44. Furthermore, sup­ pose that the stock experiences a substantial rally and that it climbs to a price of 60 in a short period of time. With the stock at 60, the July 50 might be selling for 11 points and a July 60 might sell for as much as 7 points. Thus, the writer may consid­ er buying back the call that was originally written and rolling up to the call with a higher striking price. Table 2-24 summarizes the situation. TABLE 2·24. Comparison of original and current prices. Original Position Current Prices Buy XYZ at 50 XYZ common 60 Sell XYZ July 50 call at 6 XYZ July 50 11 XYZ Jul 60 7 If the writer were to roll-up - that is, buy back the July 50 and sell the July 60 - he would be increasing his profit potential. If XYZ were above 60 in July and were called away, he would make his option credits - 6 points from the July 50 plus 7 80 Part II: Call Option Strategies points from the July 60 - less the 11 points he paid to buy back the July 50. Thus, his option profits would amount to 2 points, which, added to the stock profit of 10 points, increases his maximum profit potential to 12 points anywhere above 60 at July expi­ ration. To increase his profit potential by such a large amount, the covered writer has given up some of his downside protection. The downside break-even point is always raised by the anwunt of the debit required to roll up. The debit required to roll up in this example is 4 points - buy the July 50 at 11 and sell the July 60 at 7. Thus, the break-even point is increased from the original 44 level to 48 after rolling up. There is another method of calculating the new profit potential and break-even point. In essence, the writer has raised his net stock cost to 55 by taking the realized 5-point loss on the July 50 call. Hence, he is essentially in a covered write whereby he has bought stock at 55 and has sold a July 60 call for 7. When expressed in this manner, it may be easier to see that the break-even point is 48 and the maximum profit poten­ tial, above 60, is 12 points. Note that when one rolls up, there is a debit incurred. That is, the investor must deposit additional cash into the covered writing position. This was not the case in rolling down, because credits were generated. Debits are considered by many investors to be a seriously negative aspect of rolling up, and they therefore prefer never to roll up for debits. Although the debit required to roll up may not be a neg­ ative aspect to every investor, it does translate directly into the fact that the break­ even point is raised and the writer is subjecting himself to a potential loss if the stock should pull back. It is often advantageous to roll to a more distant expiration when rolling up. This will reduce the debit required. The rolled-up position has a break-even point of 48. Thus, if XYZ falls back to 48, the writer who rolled up will be left with no profit. However, if he had not rolled up, he would have made 4 points with XYZ at 48 at expiration in the original position. A further comparison can be made between the original position and the rolled-up position. The two are equal at July expiration at a stock price of 54; both have a prof­ it of 6 points with XYZ at 54 at July expiration. Thus, although it may appear attrac­ tive to roll up, one should determine the point at which the rolled-up position and the original position will be equal at expiration. If the writer believes XYZ could be subject to a 10% correction by expiration from 60 to 54 - certainly not out of the question for any stock - he should stay with his original position. Figure 2-5 compares the original position with the rolled-up position. Note that the break-even point has moved up from 44 to 48; the maximum profit potential has increased from 6 points to 12 points; and at expiration the two writes are equal, at 54. In summary, it can be said that rolling up increases one's profit potential but also exposes one to risk of loss if a stock price reversal should occur. Therefore, an ele- Chapter 2: Covered Call Writing FIGURE 2-5. Comparison: original write vs. rolled-up position. +$1,200 Rolled-Up Write +$600 Original Write 54 60 Stock Price at Expiration 81 ment of risk is introduced as well as the possibility of increased rewards. Generally, it is not advisable to roll up if at least a 10% correction in the stock price cannot be withstood. One's initial goals for the covered write were set when the position was established. If the stock advances and these goals are being met, the writer should be very cautious about risking that profit. A SERIOUS BUT ALL-TOO-COMMON MISTAKE When an investor is overly intent on keeping his stock from being called away (per­ haps he is writing calls against stock that he really has no intention of selling), then he will normally roll up and/or forward to a more distant expiration month whenev­ er the stock rises to the strike of the written call. Most of these rolls incur a debit. If the stock is particularly strong, or if there is a strong bull market, these rolls for deb­ its begin to weigh heavily on the psychology of the covered writer. Eventually, he wears down emotionally and makes a mistake. He typically takes one of two roads: (1) He buys back all of the calls for a (large) debit, leaving the entire stock holding exposed to downside movements after it has risen dramatically in price and after he 82 Part II: Call Option Strategies has amassed a fairly large series of debits from previous rolls; or (2) he begins to sell some out-of-the-money naked puts to bring in credits to reduce the cost of continu­ ally rolling the calls up for debits. This latter action is even worse, because the entire position is now leveraged tremendously, and a sharp drop in the stock price may cause horrendous losses - perhaps enough to wipe out the entire account. As fate would have it, these mistakes are usually made when the stock is near a top in price. Any price decline after such a dramatic rise is usually a sharp and painful one. The best way to avoid this type of potentially serious mistake is to allow the stock to be called away at some point. Then, using the funds that are released, either establish a new position in another stock or perhaps even utilize another strategy for a while. If that is not feasible, at least avoid making a radical change in strategy after the stock has had a particularly strong rise. Leveraging the position through naked put sales on top of rolling the calls up for debits should expressly be avoided. The discussion to this point has been directed at rolling up before expiration. At or near expiration, when the time value premium has disappeared from the written call, one may have no choice but to write the next-higher striking price if he wants to retain his stock. This is discussed when we analyze action to take at or near expiration. If the underlying stock rises, one's choices are not necessarily limited to rolling up or doing nothing. As the stock increases in price, the written call will lose its time premium and may begin to trade near parity. The writer may decide to close the posi­ tion himself - perhaps well in advance of expiration - by buying back the written call and selling the stock out, hopefully near parity. Example: A customer originally bought XYZ at 25 and sold the 6-month July 25 for 3 points - a net of 22. Now, three months later, XYZ has risen to 33 and the call is trading at 8 (parity) because it is so deeply in-the-money. At this point, the writer may want to sell the stock at 33 and buy back the call at 8, thereby realizing an effective net of 25 for the covered write, which is his maximum profit potential. This is cer­ tainly preferable to remaining in the position for three more months with no more profit potential available. The advantage of closing a parity covered write early is that one is realizing the maximum return in a shorter period than anticipated. He is there­ by increasing his annualized return on the position. Although it is generally to the cash writer's advantage (margin writers read on) to take such action, there are a few additional costs involved that he would not experience if he held the position until the call expired. First, the commission for the option purchase (buy-back) is an addi­ tional expense. Second, he will be selling his stock at a higher price than the striking price, so he may pay a slightly higher commission on that trade as well. If there is a dividend left until expiration, he will not be receiving that dividend if he closes the Chapter 2: Covered Call Writing 83 write early. Of course, if the trade was done in a margin account, the writer will be reducing the margin interest that he had planned to pay in the position, because the debit will be erased earlier. In most cases, the increased commissions are very small and the lost dividend is not significant compared to the increase in annualized return that one can achieve by closing the position early. However, this is not always true, and one should be aware of exactly what his costs are for closing the position early. Obviously, getting out of a covered writing position can be as difficult as estab­ lishing it. Therefore, one should place the order to close the position with his bro­ kerage firm's option desk, to be executed as a "net" order. The same traders who facil­ itate establishing covered writing positions at net prices will also facilitate getting out of the positions. One would normally place the order by saying that he wanted to sell his stock and buy the option "at parity" or, in the example, at "25 net." Just as it is often necessary to be in contact with both the option and stock exchanges to estab­ lish a position, so is it necessary to maintain the same contacts to renwve a position at parity. ACTION TO TAKE AT OR NEAR EXPIRATION As expiration nears and the time value premium disappears from a written call, the covered writer may often want to roll forward, that is, buy back the currently written call and sell a longer-term call with the same striking price. For an in-the-money call, the optimum time to roll forward is generally when the time value premium has com­ pletely disappeared from the call. For an out-of-the-money call, the correct time to move into the more distant option series is when the return offered by the near-term option is less than the return offered by the longer-term call. The in-the-money case is quite simple to analyze. As long as there is time pre­ mium left in the call, there is little risk of assignment, and therefore the writer is earning time premium by remaining with the original call. However, when the option begins to trade at parity or a discount, there arises a significant probability of exer­ cise by arbitrageurs. It is at this time that the writer should roll the in-the-money call forward. For example, if XYZ were offered at 51 and the July 50 call were bid at 1, the writer should be rolling forward into the October 50 or January 50 call. The out-of-the-money case is a little more difficult to handle, but a relatively straightforward analysis can be applied to facilitate the writer's decision. One can compute the return per day remaining in the written call and compare it to the net return per day from the longer-term call. If the longer-term call has a higher return, one should roll forward. 84 Part II: Call Option Strategies Example: An investor previously entered a covered writing situation in which he wrote five January 30 calls against 500 XYZ common. The following prices exist cur­ rently, l month before expiration: XYZ common, 29¼; January 30 call,¼; and April 30 call, 2¼. The writer can only make ¼ a point more of time premium on this covered write for the time remaining until expiration. It is possible that his money could be put to bet­ ter use by rolling forward to the April 30 call. Commissions for rolling forward must be subtracted from the April 30's premium to present a true comparison. By remaining in the January 30, the writer could make, at most, $250 for the 30 days remaining until January expiration. This is a return of $8.33 per day. The com­ missions for rolling forward would be approximately $100, including both the buy­ back and the new sale. Since the current time premium in the April 30 call is $250 per option, this would mean that the writer would stand to make 5 times $250 less the $100 in commissions during the 120-day period until April expiration; $1,150 divided by 120 days is $9.58 per day. Thus, the per-day return is higher from the April 30 than from the January 30, after commissions are included. The writer should roll forward to the April 30 at this time. Rolling forward, since it involves a positive cash flow ( that is, it is a credit trans­ action) simultaneously increases the writer's maximum profit potential and lowers the break-even point. In the example above, the credit for rolling forward is 2 points, so the break-even point will be lowered by 2 points and the maximum profit potential is also increased by the 2-point credit. A simple calculator can provide one with the return-per-day calculation neces­ sary to make the decision concerning rolling forward. The preceding analysis is only directly applicable to rolling forward at the same striking price. Rolling-up or rolling­ down decisions at expiration, since they involve different striking prices, cannot be based solely on the differential returns in time premium values offered by the options in question. In the earlier discussion concerning rolling up, it was mentioned that at or near expiration, one may have no choice but to write the next higher striking price if he wants to retain his stock. This does not necessarily involve a debit transaction, how­ ever. If the stock is volatile enough, one might even be able to roll up for even money or a slight credit at expiration. Should this occur, it would be a desirable situation and should always be taken advantage of. Cbapter 2: Covered Ca# Writing Example: The following prices exist at January expiration: XYZ, 50; XYZ January 45 call, 5; and XYZ July 50 call, 7. 85 In this case, if one had originally written the January 45 call, he could now roll up to the July 50 at expiration for a credit of 2 points. This action is quite prudent, since the break-even point and the maximum profit potential are enhanced. The break­ even point is lowered by the 2 points of credit received from rolling up. The maxi­ mum profit potential is increased substantially - by 7 points - since the striking price is raised by 5 points and an additional 2 points of credit are taken in from the roll up. Consequently, whenever one can roll up for a credit, a situation that would normally arise only on more volatile stocks, he should do so. Another choice that may occur at or near expiration is that of rolling down. The case may arise whereby one has allowed a written call to expire worthless with the stock more than a small distance below the striking price. The writer is then faced with the decision of either writing a small-premium out-of-the-money call or a larg­ er-premium in-the-money call. Again, an example may prove to be useful. Example: Just after the January 25 call has expired worthless, XYZ is at 22, XYZ July 25 call at ¾, and XYZ July 20 call at 3½. If the investor were now to write the July 25 call, he would be receiving only¾ of a point of downside protection. However, his maximum profit potential would be quite large if XYZ could rally to 25 by expiration. On the other hand, the July 20 at 3½ is an attractive write that affords substantial downside protection, and its 1 ½ points of time value premium are twice that offered by the July 25 call. In a purely analytic sense, one should not base his decision on what his performance has been to date, but that is a difficult axiom to apply in practice. If this investor owns XYZ at a high­ er price, he will almost surely opt for the July 25 call. If, however, he owns XYZ at approximately the same price, he will have no qualms about writing the July 20 call. There is no absolute rule that can be applied to all such situations, but one is usual­ ly better off writing the call that provides the best balance between return and down­ side protection at all times. Only if one is bullish on the underlying stock should he write the July 25 call. 86 Part II: Call Option Strategies AVOIDING THE UNCOVERED POSITION There is a margin rule that the covered writer must be aware of if he is considering taking any sort of follow-up action on the day that the written call ceases trading. If another call is sold on that day, even though the written call is obviously going to expire worthless, the writer will be considered uncovered for margin purposes over the weekend and will be obligated to put forth the collateral for an uncovered option. This is usually not what the writer intends to do; being aware of this rule will elimi­ nate unwanted margin calls. Furthermore, uncovered options may be considered unsuitable for many covered writers. Example: A customer owns XYZ and has January 20 calls outstanding on the last day of trading of the January series (the third Friday of January; the calls actually do not expire until the following day, Saturday). IfXYZ is at 15 on the last day of trading, the January 20 call will almost certainly expire worthless. However, should the writer decide to sell a longer-term call on that day without buying back the January 20, he will be considered uncovered over the weekend. Thus, if one plans to wait for an option to expire totally worthless before writing another call, he must wait until the Monday after expiration before writing again, assuming that he wants to remain cov­ ered. The writer should also realize that it is possible for some sort of news item to be announced between the end of trading in an option series and the actual expira­ tion of the series. Thus, call holders might exercise because they believe the stock will jump sufficiently in price to make the exercise profitable. This has happened in the past, two of the most notable cases being IBM in January 1975 and Carrier Corp. in September 1978. WHEN TO LET STOCK BE CALLED AWAY Another alternative that is open to the writer as the written call approaches expira­ tion is to let the stock be called away if it is above the striking price. In many cases, it is to the advantage of the writer to keep rolling options forward for credits, there­ by retaining his stock ownership. However, in certain cases, it may be advisable to allow the stock to be called away. It should be emphasized that the writer often has a definite choice in this matter, since he can generally tell when the call is about to be exercised - when the time value premium disappears. The reason that it is normally desirable to roll forward is that, over time, the covered writer will realize a higher return by rolling instead of being called. The option commissions for rolling forward every three or six months are smaller than the commissions for buying and selling the underlying stock every three or six months, and therefore the eventual return will be higher. However, if an inferior return has Cl,opter 2: Covered Call Writing 87 to be accepted or the break-even point will be raised significantly by rolling forward, one must consider the alternative of letting the stock be called away. Example: A covered write is established by buying XYZ at 49 and selling an April 50 call for 3 points. The original break-even point was thus 46. Near expiration, suppose XYZ has risen to 56 and the April 50 is trading at 6. If the investor wants to roll for­ ward, now is the time to do so, because the call is at parity. However, he notes that the choices are somewhat limited. Suppose the following prices exist with XYZ at 56: XYZ October 50 call, 7; and XYZ October 60 call, 2. It seems apparent that the pre­ mium levels have declined since the original writing position was established, but that is an occurrence beyond the control of the writer, who must work in the current market environment. If the writer attempts to roll forward to the October 50, he could make at most 1 additional point of profit until October (the time premium in the call). This repre­ sents an extremely low rate of return, and the writer should reject this alternative since there are surely better returns available in covered writes on other securities. On the other hand, if the writer tries to roll up and forward, it will cost 4 points to do so - 6 points to buy back the April 50 less 2 points received for the October 60. This debit transaction means that his break-even point would move up from the orig­ inal level of 46 to a new level of 50. If the common declines below 54, he would be eating into profits already at hand, since the October 60 provides only 2 points of pro­ tection from the current stock price of 56. If the writer is not confidently bullish on the outlook for XYZ, he should not roll up and forward. At this point, the writer has exhausted his alternatives for rolling. His remaining choice is to let the stock be called away and to use the proceeds to establish a cov­ ered write in a new stock, one that offers a more attractive rate of return with rea­ sonable downside protection. This choice of allowing the stock to be called away is generally the wisest strategy if both of the following criteria are met: 1. Rolling forward offers only a minimal return. 2. Rolling up and forward significantly raises the break-even point and leaves the position relatively unprotected should the stock drop in price. SPECIAL WRITING SITUATIONS Our discussions have pertained directly to writing against common stock. However, one may also write covered call options against convertible securities, warrants, or LEAPS. In addition, a different type of covered writing strategy - the incremental 88 Part II: Call Option Strategies return concept - is described that has great appeal to large stockholders, both indi­ viduals and institutions. COVERED WRITING AGAINST A CONVERTIBLE SECURITY It may be more advantageous to buy a security that is convertible into common stock than to buy the stock itself, for covered call writing purposes. Convertible bonds and convertible preferred stocks are securities commonly used for this purpose. One advantage of using the convertible security is that it often has a higher yield than does the common stock itself. Before describing the covered write, it may be beneficial to review the basics of convertible securities. Suppose XYZ common stock has an XYZ convertible Preferred A stock that is convertible into 1.5 shares of common. The number of shares of com­ mon that the convertible security converts into is an important piece of information that the writer must know. It can be found in a Standard & Poor's Stock Guide (or Bond Guide, in the case of convertible bonds). The writer also needs to determine how many shares of the convertible securi­ ty must be owned in order to equal 100 shares of the common stock. This is quickly determined by dividing 100 by the conversion ratio - 1.5 in our XYZ example. Since 100 divided by 1.5 equals 66.666, one must own 67 shares of XYZ cv Pfd A to cover the sale of one XYZ option for 100 shares of common. Note that neither the market prices of XYZ common nor the convertible security are necessary for this computa­ tion. When using a convertible bond, the conversion information is usually stated in a form such as, "converts into 50 shares at a price of 20." The price is irrelevant. What is important is the number of shares that the bond converts into - 50 in this case. Thus, if one were using these bonds for covered writing of one call, he would need two (2,000) bonds to own the equivalent of 100 shares of stock. Once one knows how much of the convertible security must be purchased, he can use the actual prices of the securities, and their yields, to determine whether a covered write against the common or the convertible is more attractive. Example: The following information is known: XYZ common, 50; XYZ CV Pfd A, 80; XYZ July 50 call, 5; XYZ dividend, 1.00 per share annually; and XYZ cv Pfd A dividend, 5.00 per share annually. Chapter 2: Covered CaH Writing 89 Note that, in either case, the same call - the July 50 -would be written. The use of the convertible as the underlying security does not alter the choice of which option to use. To make the comparison of returns easier, commissions are ignored in the cal­ culations given in Table 2-25. In reality, the commissions for the stock purchase, either common or preferred, would be very similar. Thus, from a numerical point of view, it appears to be more advantageous to write against the convertible than against the common. TABLE 2-25. Comparison of common and convertible writes. Write against Common Write against Convertible Buy underlying security $5,000(100 XYZ) $5,360 (67 XYZ CV Pfd A) Sell one July 50 call 500 - 500 Net cash investment $4,500 $4,860 Premium collected $ 500 $ 500 Dividends until July 50 250 Maximum profit potential $ 550 $ 750 Return (profit divided by investment) 12.2% 15.4% When writing against a convertible security, additional considerations should be looked at. The first is the premium of the convertible security. In the example, with XYZ selling at 50, the XYZ cv Pfd A has a true value of 1.5 times 50, or $75 per share. However, it is selling at 80, which represents a premium of 5 points above its com­ puted value of 75. Normally, one would not want to buy a convertible security if the premium is too large. In this example, the premium appears quite reasonable. Any convertible premium greater than 15% above computed value might be considered to be too large. Another consideration when writing against convertible securities is the han­ dling of assignment. If the writer is assigned, he may either (1) convert his preferred stock into common and deliver that, or (2) sell the preferred in the market and use the proceeds to buy 100 shares of common stock in the market for delivery against the assignment notice. The second choice is usually preferable if the convertible security has any premium at all, since converting the preferred into common causes the loss of any premium in the convertible, as well as the loss of accrued interest in the case of a convertible bond. 90 Part II: Call Option Strategies The writer should also be aware of whether or not the convertible is catlable and, if so, what the exact terms are. Once the convertible has been called by the com­ pany, it will no longer trade in relation to the underlying stock, but will instead trade at the call price. Thus, if the stock should climb sharply, the writer could be incur­ ring losses on his written option without any corresponding benefit from his con­ vertible security. Consequently, if the convertible is called, the entire position should normally be closed immediately by selling the convertible and buying the option back. Other aspects of covered writing, such as rolling down or forward, do not change even if the option is written against a convertible security. One would take action based on the relationship of the option price and the common stock price, as usual. WRITING AGAINST WARRANTS It is also possible to write covered call options against warrants. Again, one must own enough warrants to convert into 100 shares of the underlying stock; generally, this would be 100 warrants. The transaction must be a cash transaction, the warrants must be paid for in full, and they have no loan value. Technically, listed warrants may be marginable, but many brokerage houses still require payment in full. There may be an additional investment requirement. Warrants also have an exercise price. If the exercise price of the warrant is higher than the striking price of the call, the covered writer must also deposit the difference between the two as part of his investment. The advantage of using warrants is that, if they are deeply in-the-money, they may provide the cash covered writer with a higher return, since less of an investment is involved. Example: XYZ is at 50 and there are XYZ warrants to buy the common at 25. Since the warrant is so deeply in-the-money, it will be selling for approximately $25 per warrant. XYZ pays no dividend. Thus, if the writer were considering a covered write of the XYZ July 50, he might choose to use the warrant instead of the common, since his investment, per 100 shares of common, would only be $2,500 instead of the $5,000 required to buy 100 XYZ. The potential profit would be the same in either case because no dividend is involved. Even if the stock does pay a dividend (warrants themselves have no dividend), the writer may still be able to earn a higher return by writing against the warrant than against the common because of the smaller investment involved. This would depend, of course, on the exact size of the dividend and on how deeply the warrant is in-the­ money. Cbapter 2: Covered Call Writing 91 Covered writing against warrants is not a frequent practice because of the small number of warrants on optionable stocks and the problems inherent in checking available returns. However, in certain circumstances, the writer may actually gain a decided advantage by writing against a deep in-the-money warrant. It is often not advisable to write against a warrant that is at- or out-of-the-money, since it can decline by a large percentage if the underlying stock drops in price, producing a high­ risk position. Also, the writer's investment may increase in this case if he rolls down to an option with a striking price lower than the warrant's exercise price. WRITING AGAINST LEAPS A form of covered call writing can be constructed by buying LEAPS call options and selling shorter-term out-of-the-money calls against them. This strategy is much like writing calls against warrants. This strategy is discussed in more detail in Chapter 25 on LEAPS, under the subject of diagonal spreads. PERCS The PERCS (Preferred Equity Redemption Cumulative Stock) is a form of covered writing. It is discussed in Chapter 32. THE INCREMENTAL RETURN CONCEPT OF COVERED WRITING The incremental return concept of covered call writing is a way in which the covered writer can earn the full value of stock appreciation between todays stock price and a target sale price, which may be substantially higher. At the same time, the writer can earn an incremental, positive return from writing options. Many institutional investors are somewhat apprehensive about covered call writing because of the upside limit that is placed on profit potential. If a call is writ­ ten against a stock that subsequently declines in price, most institutional managers would not view this as an unfavorable situation, since they would be outperforming all managers who owned the stock and who did not write a call. However, if the stock rises substantially after the call is written, many institutional managers do not like having their profits limited by the written call. This strategy is not only for institu­ tional money managers, although one should have a relatively substantial holding in an underlying stock to attempt the strategy - at least 500 shares and preferably 1,000 shares or more. The incremental return concept can be used by anyone who is plan­ ning to hold his stock, even if it should temporarily decline in price, until it reaches a predetermined, higher price at which he is willing to sell the stock. 92 Part II: Call Option Strategies The basic strategy involves, as an initial step, selecting the target price at which the writer is willing to sell his stock. Example: A customer owns 1,000 shares of XYZ, which is currently at 60, and is will­ ing to sell the stock at 80. In the meantime, he would like to realize a positive cash flow from writing options against his stock. This positive cash flow does not neces­ sarily result in a realized option gain until the stock is called away. Most likely, with the stock at 60, there would not be options available with a striking price of 80, so one could not write 10 July 80's, for example. This would not be an optimum strategy even if the July 80's existed, for the investor would be receiving so little in option pre­ miums - perhaps 10 cents per call - that writing might not be worthwhile. The incre­ mental return strategy allows this investor to achieve his objectives regardless of the existence of options with a higher striking price. The foundation of the incremental return strategy is to write against only a part of the entire stock holding initially, and to write these calls at the striking price near­ est the current stock price. Then, should the stock move up to the next higher strik­ ing price, one rolls up for a credit by adding to the number of calls written. Rolling for a credit is mandatory and is the key to the strategy. Eventually, the stock reaches the target price and the stock is called away, the investor sells all his stock at the tar­ get price, and in addition earns the total credits from all the option transactions. Example: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One might begin by selling three of the longest-term calls at 60 for 7 points apiece. Table 2-26 shows how a poor case - one in which the stock climbs directly to the target price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three original calls would be bought back and enough calls at 70 would be sold to produce a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month, the 5 calls would be bought back and the entire position - 10 calls - would be writ­ ten against the target price. If XYZ remains above 80, the stock will be called away and all 1,000 shares will be sold at the target price of 80. In addition, the investor will earn all the option cred­ its generated along the way. These amount to $2,800. Thus, the writer obtained the full appreciation of his stock to the target price plus an incremental, positive return from option writing. In a flat market, the strategy is relatively easy to monitor. If a written call loses its time value premium and therefore might be subject to assignment, the writer can roll forward to a more distant expiration series, keeping the quantity of written calls constant. This transaction would generate additional credits as well. C1,,,pter 2: Covered Call Writing TABLE 2-26. Two months of incremental return strategy. Day 1 : XYZ = 60 Sell 3 XYZ October 60's at 7 One month later: XYZ = 70 Buy back the 3 XYZ Oct 60's at 11 and sell 5 XYZ Oct 70's at 7 Two months later: XYZ = 80 Buy back the 5 Oct 70's at 11 and sell 10 XYZ Oct 80's at 6 COVERED CALL WRITING SUMMARY 93 +$2, 100 credit -$3,300 debit +$3,500 credit -$5 ,500 debit +$6.000 credit +$2,800 credit This concludes the chapter on covered call writing. The strategy will be referred to later, when compared with other strategies. Here is a brief summary of the more important points that were discussed. Covered call writing is a viable strategy because it reduces the risk of stock own­ ership and will make one's portfolio less volatile to short-term market movements. It should be understood, however, that covered call writing may underperform stock ownership in general because of the fact that stocks can rise great distances, while a covered write has limited upside profit potential. The choice of which call to write can make for a more aggressive or more conservative write. Writing in-the-money calls is strategically more conservative than writing out-of-the-money calls, because of the larger amount of downside protection received. The total return concept of covered call writing attempts to achieve the maximum balance between income from all sources - option premiums, stock ownership, and dividend income - and down­ side protection. This balance is usually realized by writing calls when the stock is near the striking price, either slightly in- or slightly out-of-the-money. The writer should compute various returns before entering into the position: the return if exercised, the return if the stock is unchanged at expiration, and the break-even point. To truly compare various writes, returns should be annualized, and all commissions and dividends should be included in the calculations. Returns will be increased by taking larger positions in the underlying stock - 500 or 1,000 shares. Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the stock and selling the call at a specified net price differential, one will receive better executions and realize higher returns in the long run. 92 Part II: Call Option Strategies The basic strategy involves, as an initial step, selecting the target price at which the writer is willing to sell his stock Example: A customer owns 1,000 shares ofXYZ, which is currently at 60, and is will­ ing to sell the stock at 80. In the meantime, he would like to realize a positive cash flow from writing options against his stock This positive cash flow does not neces­ sarily result in a realized option gain until the stock is called away. Most likely, with the stock at 60, there would not be options available with a striking price of 80, so one could not write 10 July 80's, for example. This would not be an optimum strategy even if the July 80's existed, for the investor would be receiving so little in option pre­ miums - perhaps 10 cents per call - that writing might not be worthwhile. The incre­ mental return strategy allows this investor to achieve his objectives regardless of the existence of options with a higher striking price. The foundation of the incremental return strategy is to write against only a part of the entire stock holding initially, and to write these calls at the striking price near­ est the current stock price. Then, should the stock move up to the next higher strik­ ing price, one rolls up for a credit by adding to the number of calls written. Rolling for a credit is mandatory and is the key to the strategy. Eventually, the stock reaches the target price and the stock is called away, the investor sells all his stock at the tar­ get price, and in addition earns the total credits from all the option transactions. Example: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One might begin by selling three of the longest-term calls at 60 for 7 points apiece. Table 2-26 shows how a poor case - one in which the stock climbs directly to the target price - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three original calls would be bought back and enough calls at 70 would be sold to produce a credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month, the 5 calls would be bought back and the entire position - 10 calls - would be writ­ ten against the target price. IfXYZ remains above 80, the stock will be called away and all 1,000 shares will be sold at the target price of 80. In addition, the investor will earn all the option cred­ its generated along the way. These amount to $2,800. Thus, the writer obtained the full appreciation of his stock to the target price plus an incremental, positive return from option writing. In a flat market, the strategy is relatively easy to monitor. If a written call loses its time value premium and therefore might be subject to assignment, the writer can roll f01ward to a more distant expiration series, keeping the quantity of written calls constant. This transaction would generate additional credits as well. O.,,er 2: Covered Call Writing TABLE 2-26. Two months of incremental return strategy. Doy 1 : XYZ = 60 Sell 3 XYZ October 60's at 7 One month later: XYZ = 70 Buy back the 3 XYZ Oct 60's at 11 and sell 5 XYZ Oct 70's at 7 Twa months later: XYZ = 80 Buy back the 5 Oct 70's at 11 and sell 10 XYZ Oct 80's at 6 COVERED CALL WRITING SUMMARY 93 +$2, 100 credit -$3 ,300 debit +$3,500 credit -$5 ,500 debit +$6,000 credit +$2,800 credit This concludes the chapter on covered call writing. The strategy will be referred to later, when compared with other strategies. Here is a brief summary of the more important points that were discussed. Covered call writing is a viable strategy because it reduces the risk of stock own­ ership and will make one's portfolio less volatile to short-term market movements. It should be understood, however, that covered call writing may underperform stock ownership in general because of the fact that stocks can rise great distances, while a covered write has limited upside profit potential. The choice of which call to write can make for a more aggressive or more conservative write. Writing in-the-money calls is strategically more conservative than writing out-of-the-money calls, because of the larger amount of downside protection received. The total return concept of covered call writing attempts to achieve the maximum balance between income from all sources - option premiums, stock ownership, and dividend income - and down­ side protection. This balance is usually realized by writing calls when the stock is near the striking price, either slightly in- or slightly out-of-the-money. The writer should compute various returns before entering into the position: the return if exercised, the return if the stock is unchanged at expiration, and the break-even point. To truly compare various writes, returns should be annualized, and all commissions and dividends should be included in the calculations. Returns will be increased by taking larger positions in the underlying stock - 500 or 1,000 shares. Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the stock and selling the call at a specified net price differential, one will receive better executions and realize higher returns in the long run. 94 Part II: Call Option Strategies The selection of which call to write should be made on a comparison of avail­ able returns and downside protection. One can sometimes write part of his position out-of-the-money and the other part in-the-money to force a balance between return and protection that might not otherwise exist. Finally, one should not write against an underlying stock if he is bearish on the stock. The writer should be slightly bullish, or at least neutral, on the underlying stock. Follow-up action can be as important as the selection of the initial position itself. By rolling down if the underlying stock drops, the investor can add downside protection and current income. If one is unwilling to limit his upside potential too severely, he may consider rolling down only part of his call writing position. As the written call expires, the writer should roll forward into a more distant expiration month if the stock is relatively close to the original striking price. Higher consistent returns are achieved in this manner, because one is not spending additional stock commissions by letting the stock be called away. An aggressive follow-up action can also be taken when the underlying stock rises in price: The writer can roll up to a higher striking price. This action increases the maximum profit potential but also exposes the position to loss if the stock should subsequently decline. One would want to take no follow-up action and let his stock be called if it is above the striking price and if there are better returns available elsewhere in other securities. Covered call writing can also be done against convertible securities - bonds or preferred stocks. These convertibles sometimes offer higher dividend yields and therefore increase the overall return from covered writing. Also, the use of warrants or LEAPS in place of the underlying stock may be advantageous in certain circum­ stances, because the net investment is lowered while the profit potential remains the same. Therefore, the overall return could be higher. Finally, the larger individual stockholder or institutional investor who wants to achieve a certain price for his stock holdings should operate his covered writing strat­ egy under the incremental return concept. This will allow him to realize the full prof­ it potential of his underlying stock, up to the target sale price, and to earn additional positive income from option writing. Call Buying The success of a call buying strategy depends primarily on one's ability to select stocks that will go up and to time the selection reasonably well. Thus, call buying is not a strategy in the same sense of the word as most of the other strategies discussed in this text. Most other strategies are designed to remove some of the exactness of stock picking, allowing one to be neutral or at least to have some room for error and still make a profit. Techniques of call buying are important, though, because it is nec­ essary to understand the long side of calls in order to understand more complex strategies correctly. Call buying is the simplest form of option investment, and therefore is the most frequently used option "strategy" by the public investor. The following section out­ lines the basic facts that one needs to know to implement an intelligent call buying program. WHY BUY? The main attraction in buying calls is that they provide the speculator with a great deal of leverage. One could potentially realize large percentage profits from only a modest rise in price by the underlying stock. Moreover, even though they may be large percentagewise, the risks cannot exceed a fixed dollar amount - the price orig­ inally paid for the call. Calls must be paid for in full; they have no margin value and do not constitute equity for margin purposes. Note: The preceding statements regarding payment for an option in full do not necessarily apply to LEAPS options, which were declared marginable in 1999. The following simple example illustrates how a call purchase might work. 95 96 Part II: Call Option Strategies Example: Assume that XYZ is at 48 and the 6-month call, the July 50, is selling for 3. Thus, with an investment of $300, the call buyer may participate, for 6 months, in a move upward in the price ofXYZ common. IfXYZ should rise in price by 10 points (just over 20%), the July 50 call will be worth at least $800 and the call buyer would have a 167% profit on a move in the stock of just over 20%. This is the leverage that attracts speculators to call buying. At expiration, if XYZ is below 50, the buyer's loss is total, but is limited to his initial $300 investment, even if XYZ declines in price sub­ stantially. Although this risk is equal to 100% of his initial investment, it is still small dollarwise. One should nornwlly not invest more than 15% of his risk capital in call buying, because of the relatively large percentage risks involved. Some investors participate in call buying on a limited basis to add some upside potential to their portfolios while keeping the risk to a fixed amount. For example, if an investor normally only purchased low-volatility, conservative stocks because he wanted to limit his downside risk, he might consider putting a small percentage of his cash into calls on more volatile stocks. In this manner, he could "trade" higher-risk stocks than he might normally do. If these volatile stocks increase in price, the investor will profit handsomely. However, if they decline substantially - as well they might, being volatile - the investor has limited his dollar risk by owning the calls rather than the stock. Another reason some investors buy calls is to be able to buy stock at a reason­ able price without missing a market. Example: With XYZ at 75, this investor might buy a call on XYZ at 80. He would like to own XYZ at 80 if it can prove itself capable of rallying and be in-the-money at expi­ ration. He would exercise the call in that case. On the other hand, if XYZ declines in price instead, he has not tied up money in the stock and can lose only an amount equal to the call premium that he paid, an amount that is generally much less than the price of the stock itself. Another approach to call buying is sometimes utilized, also by an investor who does not want to "miss the market." Suppose an investor knows that, in the near future, he will have an amount of money large enough to purchase a particular stock; perhaps he is closing the sale of his house or a certificate of deposit is maturing. However, he would like to buy the stock now, for he feels a rally is imminent. He might buy calls at the present time if he had a small amount of cash available. The call purchases would require an investment much smaller than the stock purchase. Then, when he receives the cash that he knew was forthcoming, he could exercise the calls and buy the stock. In this way, he might have participated in a rally by the stock before he actually had the money available to pay for the stock in full. Cl,opter 3: Call Buying 97 RISK AND REWARD FOR THE CALL BUYER The most important fact for the call buyer to realize is that he will normally win only if the stock rises in price. All the worthwhile analysis in the world spent in selecting which call to buy will not produce profits if the underlying stock declines. However, this fact should not dissuade one from making reasonable analyses in his call buying selections. Too often, the call buyer feels that a stock will move up, and is correct in that part of his projection, but still loses money on his call purchase because he failed to analyze the risk and rewards involved with the various calls available for purchase at the time. He bought the wrong call on the right stock. Since the best ally that the call buyer has is upward movement in the underly­ ing stock, the selection of the underlying stock is the most important choice the call buyer has to make. Since timing is so important when buying calls, the technical fac­ tors of stock selection probably outweigh the fundamentals; even if positive funda­ mentals do exist, one does not know how long it will take in order for them to be reflected in the price of the stock. One must be bullish on the underlying stock in order to consider buying calls on that stock. Once the stock selection has been made, only then can the call buyer begin to consider other factors, such as which striking price to use and which expiration to buy. The call buyer may have another ally, but not one that he can normally predict: If the stock on which he owns a call becomes more volatile, the call's price will rise to reflect that change. The purchase of an out-of-the-money call generally offers both larger potential risk and larger potential reward than does the purchase of an in-the-money call. Many call buyers tend to select the out-of-the-money call merely because it is cheap­ er in price. Absolute dollar price should in no way be a deciding factor for the call buyer. If one's funds are so limited that he can only afford to buy the cheapest calls, he should not be speculating in this strategy. If the underlying stock increases in price substantially, the out-of-the-money call will naturally provide the largest rewards. However, if the stock advances only moderately in price, the in-the-money call may actually perform better. Example: XYZ is at 65 and the July 60 sells for 7 while the July 70 sells for 3. If the stock moves up to 68 relatively slowly, the buyer of the July 70 - the out-of-the­ money call - may actually experience a loss, even if the call has not yet expired. However, the holder of the in-the-money July 60 will definitely have a profit because the call will sell for at least 8 points, its intrinsic value. The point is that, percentage­ wise, an in-the-rrwney call will offer better rewards for a rrwdest stock gain, and an out-ofthe-rrwney call is better for larger stock gains. 98 Part II: Call Option Strategies When risk is considered, the in-the-money call clearly has less probability of risk. In the prior example, the in-the-money call buyer would not lose his entire investment unless XYZ fell by at least 5 points. However, the buyer of the out-of-the­ money July 70 would lose all of his investment unless the stock advanced by more than 5 points by expiration. Obviously, the probability that the in-the-money call will expire worthless is much smaller than that for the out-of-the-money call. The time remaining to expiration is also relevant to the call buyer. If the stock is fairly close to the striking price, the near-term call will most closely follow the price movement of the underlying stock, so it has the greatest rewards and also the great­ est risks. The far-term call, because it has a large amount of time remaining, offers the least risk and least percentage reward. The intermediate-temi call offers a mod­ erate amount of each, and is therefore often the most attractive one to buy. Many times an investor will buy the longer-term call because it only costs a point or a point and a half more than the intermediate-term call. He feels that the extra price is a bar­ gain to pay for three extra months of time. This line of thought may prove somewhat misleading, however, because most call buyers don't hold calls for more than 60 or 90 days. Thus, even though it looks attractive to pay the extra point for the long-term call, it may prove to be an unnecessary expense if, as is usually the case, one will be selling the call in two or three months. CERTAINTY OF TIMING The certainty with which one expects the underlying stock to advance may also help to play a part in his selection of which call to buy. If one is fairly sure that the under­ lying stock is about to rise immediately, he should strive for more reward and not be as concerned about risk. This would mean buying short-term, slightly out-of-the­ money calls. Of course, this is only a general rule; one would not normally buy an out­ of-the-money call that has only one week remaining until expiration, in any case. At the opposite end of the spectrum, if one is very uncertain about his timing, he should buy the longest-term call, to moderate his risk in case his timing is wrong by a wide margin. This situation could easily result, for example, if one feels that a positive fun­ damental aspect concerning the company will assert itself and cause the stock to increase in price at an unknown time in the future. Since the buyer does not know whether this positive fundamental will come to light in the next month or six months from now, he should buy the longer-term call to allow room for error in timing. In many cases, one is not intending to hold the purchased call for any signifi­ cant period of time; he is just looking to capitalize on a quick, short-term movement by the underlying stock. In this case, he would want to buy a relatively short-term in­ the-money call. Although such a call may be more ex-pensive than an out-of-the- Cl,apter 3: Call Buying 99 money call on the same underlying stock, it will most surely move up on any increase in price by the underlying stock. Thus, the short-term trader would profit. THE DELTA The reader should by now be familiar with basic facts concerning call options: The time premium is highest when the stock is at the striking price of the call; it is lowest deep in- or out-of-the-money; option prices do not decay at a linear rate -the time pre­ mium disappears more rapidly as the option approaches expiration. As a further means of review, the option pricing curve introduced in Chapter 1 is reprinted here. Notice that all the facts listed above can be observed from Figure 3-1. The curves are much nearer the "intrinsic value" line at the ends than they are in the middle, implying that the time value premium is greatest when the stock is at the strike, and is least when the stock moves away from the strike either into- or out-of-the-money. Furthermore, the fact that the curve for the 3-month option lies only about halfway between the intrinsic value line and the curve of the 9-month option implies that the rate of decay of an at- or near-the-money option is not linear. The reader may also want to refer back to the graph of time value premium decay in Chapter 1 (Figure 1-4). There is another property of call options that the buyer should be familiar with, the delta of the option (also called the hedge ratio). Simply stated, the delta of an option is the arrwunt by which the call will increase or decrease in price if the under­ lying stock moves by 1 point. FIGURE 3-1. Option pricing curve; 3-, 6-, and 9-month calls. Q) 0 ~ C: 0 a 0 9-Month Curve 6-Month Curve 3-Month Curve / Intrinsic Value Striking Price Stock Price As expiration date draws closer, the lower curve merges with the intrinsic value line. The option price then equals its intrinsic value. 100 Part II: Call Option Strategies Example: The delta of a call option is close to 1 when the underlying stock is well above the striking price of the call. If XYZ were 60 and the XYZ July 50 call were 101/s, the call would change in price by nearly 1 point ifXYZ moved by 1 point, either up or down. A deeply out-of-the-money call has a delta of nearly zero. If XYZ were 40, the July 50 call might be selling at¼ of a point. The call would change very little in price if XYZ moved by one point, to either 41 or 39. When the stock is at the strik­ ing price, the delta is usually between one-half of a point and five-eighths of a point. Very long-term calls may have even larger at-the-money deltas. Thus, if XYZ were 50 and the XYZ July 50 call were 5, the call might increase to 5½ if XYZ rose to 51 or decrease to 4½ if XYZ dropped to 49. Actually, the delta changes each time the underlying stock changes even frac­ tionally in price; it is an exact mathematical derivation that is presented in a later chapter. This is most easily seen by the fact that a deep in-the-money option has a delta of 1. However, if the stock should undergo a series of I-point drops down to the striking price, the delta will be more like½, certainly not 1 any longer. In reality, the delta changed instantaneously all during the price decline by the stock. For those who are geometrically inclined, the preceding option price curve is useful in deter­ mining a graphic representation of the delta. The delta is the slope of the tangent line to the price curve. Notice that a deeply in-the-money option lies to the upper right side of the curve, very nearly on the intrinsic value line, which has a slope of 1 above the strike. Similarly, a deeply out-of-the-money call lies to the left on the price curve, again near the intrinsic value line, which has a slope of zero below the strike. Since it is more common to relate the option's price change to a full point change in the underlying stock (rather than to deal in "instantaneous" price changes), the concepts of up delta and down delta arise. That is, if the underlying stock moves up by 1 full point, a call with a delta of .50 might increase by 5/s. However, should the stock fall by one full point, the call might decrease by only 3/s. There is a different net price change in the call when the stock moves up by 1 full point as opposed to when it falls by a point. The up delta is observed to be 5/s while the down delta is 3/s. In the true mathematical sense, there is only one delta and it measures "instantaneous" price change. The concepts of up delta and down delta are practical, rather than the­ oretical, concepts that merely illustrate the fact that the true delta changes whenev­ er the stock price changes, even by as little as 1 point. In the following examples and in later chapters, only one delta is referred to. The delta is an important piece of information for the call buyer because it can tell him how much of an increase or decrease he can expect for short-term moves by the underlying stock. This piece of information may help the buyer decide which call to buy. Chapter 3: Call Buying 101 Example: If XYZ is 4 7½ and the call buyer expects a quick, but possibly limited, rise in price in the underlying stock, should he buy the 45 call or the 50 call? The delta may help him decide. He has the following information: XYZ: 471/2 XYZ July 45 call: price = 31/2, XYZ July 50 call: price = 1, delta = 5/a delta = 1/4 It will make matters easier to make a slightly incorrect, but simplifying, assumption that the deltas remain constant over the short term. Which call is the better buy if the buyer expects the stock to quickly rise to 49? This would represent a 1 ½-point increase in XYZ, which would translate into a 15/16 increase in the July 45 (l½ times 5/s) or a 3/s increase in the July 50 (1 ½ times ¼). Consequently, the July 45, if it increased in price by 15/16, would appreciate by 27%. The July 50, if it increased by 3/a, would appreciate by over 37%. Thus, the July 50 appears to be the better buy in this simple example. Commissions should, of course, be included when making an analysis for actual investment. The investor does not have to bother with computing deltas for himself. Any good call-buying data service will supply the information, and some brokerage hous­ es provide this information free of charge. More advanced applications of deltas are described in many of the succeeding chapters, as they apply to a variety of strategies. WHICH OPTION TO BUY? There are various trading strategies, some short-term, some long-term (even buy and hold). If one decides to use an option to implement a trading strategy, the time hori­ zon of the strategy itself often dictates the general category of option that should be bought - in-the-money versus out-of-the-money, near-term versus long-term, etc. This statement is true whether one is referring to stock, index, or futures options. The general rule is this: The shorter-term the strategy, the higher the delta should be of the instrument being used to trade the strategy. DAY TRADING For example, day trading has become a popular endeavor. Statistics have been pro­ duced that indicate that most day traders lose money. In fact, there are profitable day traders; it simply requires more and harder work than many are willing to invest. Many day traders have attempted to use options in their strategies. These day traders 102 Part II: Call Option Strategies apparently are attracted by the leverage available from options, but they often lose money via option trading as well. What many of these option-oriented day traders fail to realize is that, for day­ trading purposes, the instrument with the highest possible delta should be used. That instrument is the underlying, for it has a delta of 1.0. Day trading is hard enough without complicating it by trying to use options. So of you're day trading Microsoft (MSFT), trade the stock, not an option. What makes options difficult in such a short-term situation is their relatively wide bid-asked spread, as compared to that of the underlying instrument itself. Also, a day trader is looking to capture only a small part of the underlying's daily move; an at-the-money or out-of-the-money option just won't respond well enough to those movements. That is, if the delta is too low, there just isn't enough room for the option day trader to make money. If a day trader insists on using options, a short-term, in-the-money should be bought, for it has the largest delta available - preferably something approaching .90 or higher. This option will respond quickly to small movements by the underlying. SHORT-TERM TRADING Suppose one employs a strategy whereby he expects to hold the underlying for approximately a week or two. In this case, just as with day trading, a high delta is desirable. However, now that the holding period is more than a day, it may be appro­ priate to buy an option as opposed to merely trading the underlying, because the option lessens the risk of a surprisingly large downside move. Still, it is the short­ term, in-the-money option that should be bought, for it has the largest delta, and will thus respond most closely to the movement in the underlying stock. Such an option has a very high delta, usually in excess of .80. Part of the reason that the high-delta options make sense in such situations is that one is fairly certain of the timing of day trading or very short-term trading systems. When the system being used for selection of which stock to trade has a high degree of timing accuracy, then the high-delta option is called for. INTERMEDIATE-TERM TRADING As the time horizon of one's trading strategy lengthens, it is appropriate to use an option with a lesser delta. This generally means that the timing of the selection process is less exact. One might be using a trading system based, for ernmple, on sen­ timent, which is generally not an exact timing indicator, but rather one that indicates a general trend change at major turning points. The timing of the forthcoming move Gapter 3: Call Buying 103 is not exact, because it often takes time for an extreme change in sentiment to reflect itself in a change of direction by the underlying. Hence, for a strategy such as this, one would want to use an option with a small­ er delta. The investor would limit his risk by using such an option, knowing that large moves are possible since the position is going to be held for several weeks or perhaps even a couple of months or more. Therefore, an at-the-money option can be used in such situations. I.ONG-TERM TRADING If one's strategy is even longer-term, an option with a lower delta can be considered. Such strategies would generally have only vague timing qualities, such as selecting a stock to buy based on the general fundamental outlook for the company. In the extreme, it would even apply to "buy and hold" strategies. Generally, buying out-of-the-money options is not recommended; but for very long-term strategies, one might consider something slightly out-of-the-money, or at least a fairly long-term at-the-money option. In either case, that option will have a lower delta as compared to the options that have been recommended for the other strategies mentioned above. Alternatively, LEAPS options might be appropriate for stock strategies of this type. ADVANCED SELECTION CRITERIA The criteria presented previously represented elementary techniques for selecting which call to buy. In actual practice, one is not usually bullish on just one stock at a time. In fact, the investor would like to have a list of the "best" calls to buy at any given time. Then, using some method of stock selection, either technical or funda­ mental, he can select three or four calls that appear to offer the best rewards. This list should be ranked in order of the best potential rewards available, but the con­ struction of the list itself is important. Call option rankings for buying purposes must be based on the volatilities of the underlying stocks. This is not easy to do mathematically, and as a result many pub­ lished rankings of calls are based strictly on percentage change in the underlying stock. Such a list is quite misleading and can lead one to the wrong conclusions. Example: There are two stocks with listed calls: NVS, which is not volatile, and VVS, which is quite volatile. Since a call on the volatile stock will be higher-priced than a call on the nonvolatile stock, the following prices might exist: 104 Part II: Call Option Strategies NVS: 40 VVS: 40 NVS July 40 call: 2 VVS July 40 call: 4 If these two calls are ranked for buying purposes, based strictly on a percentage change in the underlying stock, the NVS call will appear to be the better buy. For example, one might see a list such as "best call buys if the underlying stock advances by 10%." In this example, if each stock advanced 10% by expiration, both NVS and WS would be at 44. Thus, the NVS July 40 would be worth 4, having doubled in price, for a 100% potential profit. Meanwhile, the WS July 40 would be worth 4 also, for a 0% profit to the call buyer. This analysis would lead one to believe that the NVS July 40 is the better buy. Such a conclusion may be wrong, because an incorrect assumption was made in the ranking of the potentials of the two stocks. It is not right to assume that both stocks have the same probability of moving 10% by expiration. Certainly, the volatile stock has a much better chance of advancing by 10% ( or more) than the nonvolatile stock does. Any ranking based on equal percentage changes in the underlying stock, without regard for their volatilities, is useless and should be avoided. The correct method of comparing these two July 40 calls is to utilize the actual volatilities of the underlying stocks. Suppose that it is known that the volatile stock, WS, could expect to move 15% in the time to July expiration. The nonvolatile stock, NVS, however, could only expect a move of 5% in the same period. Using this infor­ mation, the call buyer can arrive at the conclusion that WS July 40 is the better call to buy: Stock Price in July VVS: 46 (up 15%) NVS: 42 (up 5%) Coll Price VVS July 40: 6 (up 50%) NVS July 40: 2 (unchanged) By assuming that each stock can rise in accordance with its volatility, we can see that the WS July 40 has the better reward potential, despite the fact that it was twice as expensive to begin with. This method of analysis is much more realistic. One more refinement needs to be made in this ranking process. Since most call purchases are made for holding periods of from 30 to 90 days, it is not correct to assume that the calls will be held to expiration. That is, even if one buys a 6-month call, he will normally liquidate it, to take profits or cut losses, in 1 to 3 months. The call buyer's list should thus be based on how the call will peiform if held for a realis­ tic time period, such as 90 days. Chapter 3: Call Buying 105 Suppose the volatile stock in our example, WS, has the potential to rise by 12% in 90 days, while the less volatile stock, NVS, has the potential of rising only 4% in 90 days. In 90 days, the July 40 calls will not be at parity, because there will be some time remaining until July expiration. Thus, it is necessary to attempt to predict what their prices will be at the end of the 90-day holding period. Assume that the following prices are accurate estimates of what the July 40 calls will be selling for in 90 days, if the underlying stocks advance in relation to their volatilities: Stock Price in 90 Days VVS: 44.8 (up 12%) NVS: 41 .6 (up 4%) Coll Price VVS July 40: 6 (up 50%) NVS July 40: 21/2 (up 25%) With some time remaining in the calls, they would both have time value premium at the end of 90 days. The bigger time premium would be in the WS call, since the underlying stock is more volatile. Under this method of analysis, the WS call is still the better one to buy. The correct method of ranking potential reward situations for call buyers is as follows: 1. Assume each underlying stock can advance in accordance with its volatility over a fixed period (30, 60, or 90 days). 2. Estimate the call prices after the advance. 3. Rank all potential call purchases by highest percentage reward opportunity for aggressive purchases. 4. Assume each stock can decline in accordance with its volatility. 5. Estimate the call prices after the decline. 6. Rank all purchases by reward/risk ratio ( the percentage gain from item 2 divided by the percentage loss from item 5). The list from item 3 will generate more aggressive purchases because it incorporates potential rewards only. The list from item 6 would be a less speculative one. This method of analysis automatically incorporates the criteria set forth earlier, such as buying short-term out-of-the-money calls for aggressive purchases and buying longer-term in-the-money calls for a more conservative purchase. The delta is also a function of the volatility and is essentially incorporated by steps 1 and 4. It is virtually impossible to perform this sort of analysis without a computer. The call buyer can generally obtain such a list from a brokerage firm or from a data serv­ ice. For those individuals who have access to a computer and would like to generate 106 Part II: Call Option Strategies such an analysis for themselves, the details of computing a stock's volatility and pre­ dicting the call prices are provided in Chapter 28 on mathematical techniques. OVERPRICED OR UNDERPRICED CALLS Formulae exist that are capable of predicting what a call should be selling for, based on the relationship of the stock price and the striking price, the time remaining to expiration, and the volatility of the underlying stock. These are useful, for example, in performing the second step in the foregoing analysis, estimating the call price after an advance in the underlying stock. In reality, a call's actual price may deviate some­ what from the price computed by the formula. If the call is actually selling for more than the "fair" ( computed) price, the call is said to be overvalued. An undervalued call is one that is actually trading at a price that is less than the "fair" price. If the calls are truly overpriced, there may be a strategy that can help reduce their cost while still preserving upside profit potential. This strategy, however, requires the addition of a put spread to the call purchase, so it is beyond the scope of the subject matter at the current time. It is described in Chapter 23 on spreads combining calls and puts. Generally, the amount by which a call is overvalued or undervalued may be only a small fraction of a point, such as 10 or 20 cents. In theory, the call buyer who pur­ chases an undervalued call has gained a slight advantage in that the call should return to its "fair" value. However, in practice, this information is most useful only to mar­ ket-makers or firm traders who pay little or no commissions for trading options. The general public cannot benefit directly from the knowledge that such a small discrep­ ancy exists, because of commission costs. One should not base his call buying decisions merely on the fact that a call is underpriced. It is small solace to the call buyer to find that he bought a "cheap" call that subsequently declined in price. The method of ranking calls for purchase that has been described does, in fact, give some slight benefit to underpriced calls. However, under the recommended method of analysis, a call will not automatically appear as an attractive purchase just because it is slightly undervalued. TIME VALUE PREMIUM IS A MISNOMER This is a topic that will be mentioned several times throughout the book, most notably in conjunction with volatility trading. It is introduced here because even the inexperienced option trader must understand that the portion of an option's price that is not intrinsic value - the part that we routinely call "time value premium" - is really composed of much more than just time value. Yes, time will eventually wear Chpter 3: Call Buying 107 away that portion of the option's price as expiration approaches. However, when an option has a considerable amount of time remaining until its expiration, the more important component of the option value is really volatility. If traders expect the underlying stock to be volatile, the option will be expensive; if they expect the oppo­ site, the option will be cheap. This expensiveness and cheapness is reflected in the portion of the option that is not intrinsic value. For example, a six-month option will not decay much in one day's time, but a quick change in volatility expectations by option traders can heavily affect the price of the option, especially one with a good deal of time remaining. So an option buyer should carefully assess his purchases, not just view them as something that will waste away. With careful analysis, option buy­ ers can do very well, if they consider what can happen during the life of the option, and not merely what will happen at expiration. CALL BUYERS' FRUSTRATIONS Despite one's best efforts, it may often seem that one does not make much money when a fairly volatile stock makes a quick move of 3 or 4 points. The reasons for this are somewhat more complex than can be addressed at this time, although they relate strongly to delta, time decay, and the volatility of the underlying stock. They are dis­ cussed in Chapter 36, 'The Basics of Volatility Trading." If one plans to conduct a serious call buying strategy, he should read that chapter before embarking on a pro­ gram of extensive call buying. FOLLOW-UP ACTION The simplest follow-up action that the call buyer can implement when the underly­ ing stock drops is to sell his call and cut his losses. There is often a natural tendency to hold out hope that the stock can rally back to or above the striking price. Most of the time, the buyer does best by cutting his losses in situations in which the stock is performing poorly. He might use a "mental" stop price or could actually place a sell stop order, depending on the rules of the exchange where the call is traded. In gen­ eral, stop orders for options result in poor executions, so using a "mental" stop is bet­ ter. That is, one should base his exit point on the technical pattern of the underlying stock itself. If it should break down below support, for example, then the option holder should place a market (not held) order to sell his call option. If the stock should rise, the buyer should be willing to take profits as well. Most buyers will quite readily take a profit if, for example, a call that was bought for 5 points had advanced to be worth 10 points. However, the same investor is often 108 Part II: Call Option Strategies reluctant to sell a call at 2 that he had previously bought for 1 point, because "I've only made a point." The similarity is clear - both cases resulted in approximately a 100% profit - and the investor should be as willing to accept the one as he is the other. This is not to imply that all calls that are bought at 1 should be sold when and if they get to 2, but the same factors that induce one to sell the 10-point call after doubling his money should apply to the 2-point call as well. In fact, taking partial profits after a call holding has increased in value is often a wise plan. For example, if someone bought a number of calls at a price of 3, and they later were worth 5, it might behoove the call holder to sell one-third to one-half of his position at 5, thereby taking a partial profit. Having done that, it is often easi­ er to let the profits run on the balance, and letting profits run is generally one of the keys to successful trading. It is rarely to the call buyer's benefit to exercise the call if he has to pay com­ missions. When one exercises a call, he pays a stock commission to buy the stock at the striking price. Then when the stock is sold, a stock sale commission must also be paid. Since option commissions are much smaller, dollarwise, than stock commis­ sions, the call holder will usually realize more net dollars by selling the call in the option market than by exercising it. LOCKING IN PROFITS When the call buyer is fortunate enough to see the underlying stock advance rela­ tively quickly, he can implement a number of strategies to enhance his position. These strategies are often useful to the call buyer who has an unrealized profit but is torn between taking the profit or holding on in an attempt to generate more profits if the underlying stock should continue to rise. Example: A call buyer bought an XYZ October 50 call for 3 points when the stock was at 48. Then the stock rises to 58. The buyer might consider selling his October 50 (which would probably be worth about 9 points) or possibly taking one of several actions, some of which might involve the October 60 call, which may be selling for 3 points. Table 3-1 summarizes the situation. At this point, the call buyer might take one of four basic actions: 1. Liquidate the position by selling the long call for a profit. 2. Sell the October 50 that he is currently long and use part of the proceeds to pur­ chase October 60's. 3. Create a spread by selling the October 60 call against his long October 50. 4. Do nothing and remain long the October 50 call. Gapter 3: Call Buying TABLE 3-1. Present situation on XYZ October calls. Original Trade XYZ common: 48 Bought XYZ October 50 at 3 109 Current Prices XYZ Common: 58 XYZ October 50: 9 XYZ October 60: 3 Each of these actions would produce different levels of risk and reward from this point forward. If the holder sells the October 50 call, he makes a 6-point profit, less commissions, and terminates the position. He can realize no further appreciation from the call, nor can he lose any of his current profits; he has realized a 6-point gain. This is the least aggressive tactic of the four: If the underlying stock continues to advance and rises above 63, any of the other three strategies will outperform the complete liquidation of the call. However, if the underlying stock should instead decline below 50 by expiration, this action would have provided the most profit of the four strategies. The other simple tactic, the fourth one listed, is to do nothing. If the call is then held to expiration, this tactic would be the riskiest of the four: It is the only one that could produce a loss at expiration if XYZ fell back below 50. However, if the under­ lying stock continues to rise in price, more profits would accrue on the call. Every call buyer realizes the ramifications of these two tactics - liquidating or doing nothing and is generally looking for an alternative that might allow him to reduce some of his risk without cutting off his profit potential completely. The remaining two tactics are geared to this purpose: limiting the total risk while providing the opportunity for fur­ ther profits of an amount greater than those that could be realized by liquidating. The strategy in which the holder sells the call that he is currently holding, the October 50, and uses part of the proceeds to buy the call at the next higher strike is called rolling up. In this example, he could sell the October 50 at 9, pocket his initial 3-point investment, and use the remaining proceeds to buy two October 60 calls at 3 points each. Thus, it is sometimes possible for the speculator to recoup his entire original investment and still increase the number of calls outstanding by rolling up. Once this has been done, the October 60 calls will represent pure profits, whatever their price. The buyer who "rolls up" in this rrwnner is essentially speculating with someone else's money. He has put his own money back in his pocket and is using accrued profits to attempt to realize further gains. At expiration, this tactic would perform best if XYZ increased by a substantial amount. This tactic turns out to be the 110 Part II: Call Option Strategies worst of the four at expiration if XYZ remains near its current price, staying above 53 but not rising above 63 in this example. The other alternative, the third one listed, is to continue to hold the October 50 call but to sell the October 60 call against it. This would create what is known as a bull spread, and the tactic can be used only by traders who have a margin account and can meet their firm's minimum equity requirement for spreading (generally $2,000). This spread position has no risk, for the long side of the spread - the October 50 cost 3 points, and the short side of the spread - the October 60 - brought in 3 points via its sale. Even if the underlying stock drops below 50 by expiration and all the calls expire worthless, the trader cannot lose anything except commissions. On the other hand, the maximum potential of this spread is 10 points, the difference between the striking prices of 50 and 60. This maximum potential would be realized if XYZ were anywhere above 60 at expiration, for at that time the October 50 call would be worth 10 points more than the October 60 call, regardless of how far above 60 the underlying stock had risen. This strategy will be the best peiformer of the four if XYZ remains relative­ ly unchanged, above the lower strike but not much above the higher strike by expira­ tion. It is interesting to note that this tactic is never the worst peiforrner of the four tactics, no matter where the stock is at expiration. For example, if XYZ drops below 50, this strategy has no risk and is therefore better than the "do nothing" strategy. If XYZ rises substantially, this spread produces a profit of 10 points, which is better than the 6 points of profit offered by the "liquidate" strategy. There is no definite answer as to which of the four tactics is the best one to apply in a given situation. However, if a call can be sold against the currently long call to produce a bull spread that has little or no risk, it may often be an attractive thing to do. It can never tum out to be the worst decision, and it would produce the largest profits if XYZ does not rise substantially or fall substantially from its current levels. Tables 3-2 and 3-3 summarize the four alternative tactics, when a call holder has an unrealized profit. The four tactics, again, are: 1. "Do nothing" - continue to hold the currently long call. 2. "Liquidate" - sell the long call to take profits and do not reinvest. 3. "Roll up" - sell the long call, pocket the original investment, and use the remain­ ing proceeds to purchase as many out-of-the-money calls as possible. 4. "Spread" - create a bull spread by selling the out-of-the-money call against the currently profitable long call, preferably taking in at least the original cost of the long call. Cl,apter 3: Call Buying 111 TABLE 3-2. Comparison of the four alternative strategies. If the underlying stock then. . . The best tactic was. . . And the worst tactic was ... continues to rise dramatic­ ally ... "roll up" rises moderately above the do nothing next strike ... remains relatively unchanged . .. spread falls back below the original liquidate strike ... TABLE 3-3. Results at expiration. XYZ Price at "Roll-up" "Do Nothing" Expiration Profit Profit 50 or below $ 0 -$ 300(W) 53 0(W) 0(W) 56 0(W) + 300 60 0(W) + 700 63 + 600(W) + 1,000(B) 67 + 1,400(B) + 1,400(B) 70 + 2,000(B) + 1,700 liquidate liquidate or "roll up" "roll up" do nothing "Spread" Profit $ 0 + 300 + 600(B) + 1,000(B) + 1,000(B) + 1,000 + 1,000 Liquidating Profit +$600(B) + 600(B) + 600(B) + 600 + 600(W) + 600(W) + 600(W) Note that each of the four tactics proves to be the best tactic in one case or another, but that the spread tactic is never the worst one. Tables 3-2 and 3-3 represent the results from holding until expiration. For those who prefer to see the actual numbers involved in making these comparisons between the four tactics, Table 3-3 summa­ rizes the potential profits and losses of each of the four tactics using the prices from the example above. 'W" indicates that the tactic is the worst one at that price, and "B" indicates that it is the best one. There are, of course, modifications that an investor might make to any of these tactics. For example, he might decide to sell out half of his long call position, recov­ ering a major part of his original cost, and continue to hold the remainder of the long calls. This still leaves room for further appreciation. 112 Part II: Call Option Strategies DEFENSIVE ACTION Two follow-up strategies are sometimes employed by the call buyer when the under­ lying stock declines in price. Both involve spread strategies; that is, being long and short two different calls on the same underlying stock simultaneously. Spreads are discussed in detail in later chapters. This discussion of spreads applies only to their use by the call buyer. ·"Rolling Down." If an option holder owns an option at a currently unreal­ ized loss, it may be possible to greatly increase the chances of making a limited profit on a relatively small rebound in the stock price. In certain cases, the investor may be able to implement such a strategy at little or no increase in risk. Many call buyers have encountered a situation such as this: An XYZ October 35 call was originally bought for 3 points in hopes of a quick rise in the stock price. However, because of downward movements in the stock- to 32, say- the call is now at 1 ½ with October expiration nearer. If the call buyer still expects a mild rally in the stock before expiration, he might either hold the call or possibly "average down" (buy more calls at I½). In either case he will need a rally to nearly 38 by expiration in order to break even. Since this would necessitate at least a 15% upward move by the stock before expiration, it cannot be considered very likely. Instead, the buyer should consider implementing the following strategy, which will be explained through the use of an example. Example: The investor is long the October 35 call at this time: XYZ, 32; XYZ October 35 call, 1 ½; and XYZ October 30 call, 3. One could sell two October 35's and, at the same time, buy one October 30 for no additional investment before commissions. That is, the sale of 2 October 35's at $150 each would bring in $300, exactly the cost, before commissions, of buying the October 30 call. This is the key to implementing the roll-down strategy: that one be able to buy the lower strike call and sell two of the higher strike calls for nearly even money. Note that the investor is now short the call that he previously owned, the October 35. Where he previously owned one October 35, he has now sold two of them. He is also now long one October 30 call. Thus, his position is: 0.,,., 3: Call Buying long 1 XYZ October 30 call, 1hort 1 XYZ October 35 call. 113 This is technically known as a bull spread, but the terminology is not important. Table 3-4 summarizes the transactions that the buyer has made to acquire this spread. The trader now "owns" the spread at a cost of $300, plus commissions. By making this trade, he has lowered his break-even point significantly without increas­ ing his risk. However, the maximum profit potential has also been limited; he can no longer capitalize on a strong rebound by the underlying stock. In order to see that the break-even point has been lowered, consider what the results are~ is at 33 at October expiration. The October 30 call would be worth 3 points and the October 35 would expire worthless with XYZ at 33. Thus, the October 30 call could be sold to bring in $300 at that time, and there would not be any expense to buy back the October 35. Consequently, the spread could be liqui­ dated for $300, exactly the amount for which it was "bought." The spread then breaks even at 33 at expiration. If the call buyer had not rolled down, his break-even point would be 38 at expiration, for he paid 3 points for the original October 35 call and he would thus need XYZ to be at 38 in order to be able to liquidate the call for 3 points. Clearly, the stock has a better chance of recovering to 33 than to 38. Thus, the call buyer significantly lowers his break-even point by utilizing this strategy. Lowering the break-even point is not the investor's only concern. He must also be aware of what has happened to his profit and loss opportunities. The risk remains essentially the same the $300 in debits, plus commissions, that has been paid out. The risk has actually increased slightly, by the amount of the commissions spent in "rolling down." However, the stock price at which this maximum loss would be real­ ized has been lowered. With the original long call, the October 35, the buyer would lose the entire $300 investment anywhere below 35 at October expiration. The TABLE 3-4. Transactions in bull spread. Original trade Later trade Net position Trade Buy 1 October 35 call at 3 Sell 2 October 35 calls at 1 1/2 Buy 1 October 30 call at 3 Long 1 October 30 call Short 1 October 35 call Cost before Commissions $300 debit $300 credit $300 debit $300 debit 114 Part II: Call Option Strategies spread strategy, however, would result in a total loss of $300 only if XYZ were below 30 at October expiration. With XYZ above 30 in October, the long side of the spread could be liquidated for some value, thereby avoiding a total loss. The investor has reduced the chance of realizing the maximum loss, since the stock price at which that loss would occur has been lowered by 5 points. As with most investments, the improvement of risk exposure - lowering the break-even point and lowering the maximum loss price - necessitates that some potential reward be sacrificed. In the original long call position (the October 35), the maximum profit potential was unlimited. In the new position, the potential profit is limited to 2 points if XYZ should rally back to, or anywhere above, 35 by October expiration. To see this, assume XYZ is 35 at expiration. Then the long October 30 call would be worth 5 points, while the October 35 would expire worthless. Thus, the spread could be liquidated for 5 points, a 2-point profit over the 3 points paid for the spread. This is the limit of profit for the spread, however, since if XYZ is above 35 at expiration, any further profits in the long October 30 call would be offset by a corre­ sponding loss on the short October 35 call. Thus, if XYZ were to rally heavily by expi­ ration, the "rolled down" position would not realize as large a profit as the original long call position would have realized. Table 3-5 and Figure 3-2 summarize the original and new positions. Note that the new position is better for stock prices between 30 and 40. Below 30, the two posi­ tions are equal, except for the additional commissions spent. If the stock should rally back above 40, the original position would have worked out better. The new position is an improvement, provided that XYZ does not rally back above 40 by expiration. The chances that XYZ could rally 8 points, or 25%, from 32 to 40 would have to be considered relatively remote. Rolling the long call down into the spread would thus appear to be the correct thing to do in this case. This example is particularly attractive, because no additional money was required to establish the spread. In many cases, however, one may find that the long call cannot be rolled into the spread at even money. Some debit may be required. This fact should not necessarily preclude making the change, since a small addition­ al investment may still significantly increase the chance of breaking even or making a profit on a rebound. Example: The following prices now exist, rather than the ones used earlier. Only the October 30 call price has been altered: XYZ, 32; XYZ October 35 call, 1 ½; and XYZ October 30 call, 4. O.,ter 3: Call Buying TABLE 3-5. Original and spread positions compared. Stock Price Long Call at Expiration Result 25 -$300 30 - 300 33 - 300 35 - 300 38 0 40 + 200 45 + 700 FIGURE 3-2. Companion: original call purchase vs. spread. § ~ +$200 ·5.. ~ al tJ) .3 0 :1: e c.. -$300 Stock Price at Expiration Spread Result -$300 - 300 0 + 200 + 200 + 200 + 200 115 With these prices, a 1-point debit would be required to roll down. That is, selling 2 October 35 calls would bring in $300 ($150 each), but the cost of buying the October 30 call is $400. Thus, the transaction would have to be done at a cost of $100, plus commissions. With these prices, the break-even point after rolling down would be 34, still well below the original break-even price of 38. The risk has now been increased by the additional 1 point spent to roll down. If XYZ should drop below 30 at October expiration, the investor would have a total loss of 4 points plus commissions. The maximum loss with the original long October 35 call was limited to 3 points plus a smaller amount of commissions. Finally, the maximum amount of money that the 116 Part II: Call Option Strategies spread could make is now $100, less commissions. The alternative in this example is not nearly as attractive as the previous one, but it might still be worthwhile for the call buyer to invoke such a spread if he feels that XYZ has limited rally potential up to October expiration. One should not automatically discard the use of this strategy merely because a debit is required to convert the long call to a spread. Note that to "average down" by buying an additional October 35 call at 1 ½ would require an additional investment of $150. This is more than the $100 required to convert into the spread position in the immediately preceding example. The break-even point on the position that was "averaged down" would be over 37 at expiration, whereas the break-even point on the spread is 34. Admittedly, the averaged-down position has much more profit potential than the spread does, but the conversion to the spread is less expensive than "aver­ aging down" and also provides a lower break-even price. In summary, then, if the call buyer finds himself with an unrealized loss because the stock has declined, and yet is unwilling to sell, he may be able to improve his chances of breaking even by "rolling down" into a spread. That is, he would sell 2 of the calls that he is currently long - the one that he owns plus another one - and simultaneously buy one call at the next lower striking price. If this transaction of sell­ ing 2 calls and buying 1 call can be done for approximately even money, it could def­ initely be to the buyer's benefit to implement this strategy, because the break-even point would be lowered considerably and the buyer would have a much better chance of getting out even or making a small profit should the underlying stock have a small rebound. Creating a Calendar Spread. A different type of defensive spread strategy is sometimes used by the call buyer who finds that the underlying stock has declined. In this strategy, the holder of an intermediate- or long-term call sells a near-term call, with the same striking price as the call he already owns. This creates what is known as a calendar spread. The idea behind doing this is that if the short-term call expires worthless, the overall cost of the long call will be reduced to the buyer. Then, if the stock should rally, the call buyer has a better chance of making a profit. Example: Suppose that an investor bought an XYZ October 35 call for 3 points some­ time in April. By June the stock has fallen to 32, and it appears that the stock might remain depressed for a while longer. The holder of the October 35 call might con­ sider selling a July 35 call, perhaps for a price of 1 point. Should XYZ remain below 35 until July expiration, the short call would expire worthless, earning a small, 1-point profit. The investor would still own the October 35 call and would then hope for a rally by XYZ before October in order to make profits on that call. Even if XYZ does Chpter 3: Call Buying 117 not rally by October, he has decreased his overall loss by the amount received for the sale of the July 35 call. This strategy is not as attractive to use as the previous one. If XYZ should rally before July expiration, the investor might find himself with two losing positions. For example, suppose that XYZ rallied back to 36 in the next week. His short call that he sold for 1 point would be selling for something more than that, so he would have an unrealized loss on the short July 35. In addition, the October 35 would probably not have appreciated back to its original price of 3, and he would therefore have an unre­ alized loss on that side of the spread as well. Consequently, this strategy should be used with great caution, for if the under­ lying stock rallies quickly before the near-term expiration, the spread could be at a loss on both sides. Note that in the former spread strategy, this could not happen. Even if XYZ rallied quickly, some profit would be made on the rebound. A FURTHER COMMENT ON SPREADS Anyone not familiar with the margin requirements for spreads, under both the exchange margin rules and the rules of the brokerage firm he is dealing with, should not attempt to utilize a spread transaction. Later chapters on spreads outline the more common requirements for spread transactions. In general, one must have a margin account to establish a spread and must have a minimum amount of equity in the account. Thus, the call buyer who operates in a cash account cannot necessarily use these spread strategies. To do so might incur a margin call and possible restric­ tion of one's trading account. Therefore, check on specific requirements before uti­ lizing a spread strategy. Do not assume that a long call can automatically be "rolled" into any sort of spread. Other Call Buying Strategies In this chapter, two additional strategies that utilize the purchase of call options are described. Both of these strategies involve buying calls against the short sale of the underlying stock. When listed puts are traded on the underlying stock, these strate­ gies are often less effective than when they are implemented with the use of put options. However, the concept is important, and sometimes these strategies are more viable in markets where calls are ve:iy liquid but puts are not. These strategies are generally known as "synthetic" strategies. THE PROTECTED SHORT SALE (OR SYNTHETIC PUT) Purchasing a call at the same time that one is short the underlying stock is a means of limiting the risk of the short sale to a fixed amount. Since the risk is theoretically unlimited in a short sale, many investors are reluctant to use the strategy. Even for those investors who do sell stock short, it can be rather upsetting if the stock rises in price. One may be forced into an emotional - and perhaps incorrect - decision to cover the short sale in order to relieve the psychological pressure. By owning a call at the same time he is short, the investor limits the risk to a fixed and generally small amount. Example: An investor sells XYZ short at 40 and simultaneously purchases an XYZ July 40 call for 3 points. If XYZ falls in price, the short seller will make his profit on the short sale, less the 3 points paid for the call, which will expire worthless. Thus, by buying the call for protection, a small amount of profit potential is sacrificed. However, the advantage of owning the call is demonstrated when the results are examined for a stock rise. IfXYZ should rise to any price above 40 by July expiration, 118 Cl,apter 4: Other Call Buying Strategies 119 the short seller can cover his short by exercising the long call and buying stock at 40. Thus, the maximum risk that the short seller can incur in this example is the 3 points paid for the call. Table 4-1 and Figure 4-1 depict the results at expiration from uti­ lizing this strategy. Commissions are not included. Note that the break-even point is 37 in this example. That is, if the stock drops 3 points, the protected short sale posi­ tion will break even because of the 3-point loss on the call. The short seller who did not spend the extra money for the long call would, of course, have a 3-point profit at 37. To the upside, however, the protected short sale outperforms a regular short sale if the stock climbs anywhere above 43. At 43, both types of short sales have $300 loss­ es. But above that level, the loss would continue to grow for a regular short sale, while it is fixed for the short seller who also bought a call. In either case, the short seller's risk is increased slightly by the fact that he is obligated to pay out the dividends on the underlying stock, if any are declared. A simple formula is available for determining the maximum amount of risk when one protects a short sale by buying a call option: Risk = Striking price of purchased call + Call price - Stock price Depending on how much risk the short seller is willing to absorb, he might want to buy an out-of-the-money call as protection rather than an at-the-money call, as was shown in the example above. A smaller dollar amount is spent for the protection when one buys an out-of-the-money call, so that the short seller does not give away as much of his profit potential. However, his risk is larger because the call does not start its protective qualities until the stock goes above the striking price. Example: With XYZ at 40, the short seller of XYZ buys the July 45 call at ½ for pro­ tection. His maximum possible loss, if XYZ is above 45 at July expiration, would be TABLE 4-1. Results at expiration-protected short sale. XYZ Price at Profit Call Price at Profit Total Expiration on XYZ Expiration on Call Profit 20 +$2,000 0 -$ 300 +$1,700 30 + 1,000 0 - 300 + 700 37 + 300 0 - 300 0 40 0 0 - 300 300 50 - 1,000 10 + 700 300 60 - 2,000 20 + 1,700 300 120 FIGURE 4-1. Protected short sale. C: 0 .:; ~ 'a.. X UJ 1o +$0 en en 0 ...J 0 -e 0.-$300 40' ', Stock Price at Expiration ' Part II: Call Option Strategies 43 ', ', ' ', ' ', Short ', ' Sale 'll 5½ points - the five points between the current stock price of 40 and the striking price of 45, plus the amount paid for the call. On the other hand, if XYZ declines, the protected short seller will make nearly as much as the short seller who did not pro­ tect, since he only spent ½ point for the long call. If one buys an in-the-nwney call as protection for the short sale, his risk will be quite minimal. However, his profit potential will be severely limited. As an example, with XYZ at 40, if one had purchased a July 35 call at 5½, his risk would be limited to½ point anywhere above 35 at July expiration. Unfortunately, he would not realize any profit on the position until the stock went below 34½, a drop of 5½ points. This is too much protection, for it limits the profit so severely that there is only a small hope of making a profit. Generally, it is best to buy a call that is at-the-nwney or only slightly out-of the­ money as the protection for the short sale. It is not of much use to buy a deeply out­ of-the-money call as protection, since it does very little to moderate risk unless the stock climbs quite dramatically. Normally, one would cover a short sale before it went heavily against him. Thus, the money spent for such a deeply out-of-the-money call is wasted. However, if one wants to give a short sale plenty of room to "work" and Cl,opter 4: Other Call Buying Strategies 121 feels ve:ry certain that his bearish view of the stock is the correct view, he might then buy a fairly deep out-of-the-money call just as disaster protection, in case the stock suddenly bolted upward in price (if it received a takeover bid, for example). MARGIN REQUIREMENTS The newest margin rules now allow one to receive favorable margin treatment when a short sale of stock is protected by a long call option. The margin required is the lower of (1) 10% of the call's striking price plus any out-of-the-money amount, or (2) 30% of the current short stock's market value. The position will be marked to market daily, and most brokers will require that the short sale be margined at "normal" rates if the stock is below the strike price. Example: Suppose the following prices exist: XYZ Common stock: 47 Oct 40 call: 8 Oct 50 call: 3 Oct 60 call: 1 Suppose that one is considering a short sale of 100 shares of XYZ at 47 and the purchase of one of the calls as protection. Here are the margin requirements for the various strike prices. (Note that the option price, per se, is not part of the margin requirement, but all options must be paid for in full, initially). Position Short XYZ, long Oct 40 call Short XYZ, long Oct 50 call Short XYZ, long Oct 60 call l 0% strike + out-of-the-money 400 + 0 = 400* 500 + 300 = 800* 600 + 1,300 = 1,900 30% stock price 1,410 1,410 1,41 0* *Since the margin requirement is the lower of the two figures, the items marked with an asterisk in this table are the margin requirements. Again, remember that the long call would have to be paid for in full, and that most brokers impose a maintenance requirement of at least the value of the short sale itself as long as the stock is below the strike price of the long call, in addition to the above requirements. 122 Part II: Call Option Strategies FOLLOW-UP ACTION There is little that the protected short seller needs to perform in the way of follow­ up action in this strategy, other than closing out the position. If the underlying stock moves down quickly and it appears that it might rebound, the short sale could be cov­ ered without selling the long call. In this manner, one could potentially profit on the call side as well if the stock came back above the original striking price. If the under­ lying stock rises in price, a similar strategy of taking off only the profitable call side of the transaction is not recommended. That is, if XYZ climbed from 40 to 50 and the July 40 call also rose from 3 to 10, it is not advisable to take the 7-point profit in the call, hoping for a drop in the stock price. The reason for this is that one is entering into a highly risk-oriented situation by removing his protection when the call is in­ the-money. Thus, when the stock drops, it is all right - perhaps even desirable - to take the profit, because there is little or no additional risk if the stock continues to drop. However, when the stock rises, it is not an equivalent situation. In that case, if the short seller sells his call for a profit and the stock subsequently rises even further, large losses could result. It may often be advisable to close the position if the call is at or near parity, in-the-money, by exercising the call. In most strategies, the option holder has no advantage in exercising the call because of the large dollar difference between stock commissions and option commissions. However, in the protected short sale strategy, the short seller is eventually going to have to cover the short stock in any case and incur the stock commission by so doing. It may be to his advantage to exercise the call and buy his stock at the striking price, thereby buying stock at a lower price and perhaps paying a slightly lower commission amount. Example: XYZ rises to 50 from the original short sale price of 40, and the XYZ July 40 call is selling at 10 somewhere close to expiration. The position could be liquidat­ ed by either (1) buying the stock back at 50 and selling the call at 10, or (2) exercis­ ing the call to buy stock at 40. In the first case, one would pay a stock commission at a price of $50 per share plus an option commission on a $10 option. In the second case, the only commission would be a stock commission at the price of $40 per share. Since both actions accomplish the same end result - closing the position entirely for 40 points plus commissions - clearly the second choice is less costly and therefore more desirable. Of course, if the call has time value premium in it of an amount greater than the commission savings, the first alternative should be used. Orapter 4: Other Call Buying Strategies 123 THE REVERSE HEDGE (SIMULATED STRADDLE) There is another strategy involving the purchase of long calls against the short sale of stock. In this strategy, one purchases calls on more shares than he has sold short. The strategist can profit if the underlying stock rises far enough or falls far enough dur­ ing the life of the calls. This strategy is generally referred to as a reverse hedge or sim­ ulated straddle. On stocks for which listed puts are traded, this strategy is outmoded; the same results can be better achieved by buying a straddle (a call and a put). Hence, the name "simulated straddle" is applied to the reverse hedge strategy. This strategy has limited loss potential, usually amounting to a moderate per­ centage of the initial investment, and theoretically unlimited profit potential. When properly selected (selection criteria are described in great detail in Chapter 36, which deals with volatility trading), the percentage of success can be quite high in straddle or synthetic straddle buying. These features make this an attractive strategy, especially when call premiums are low in comparison to the volatility of underlying stock. Example: XYZ is at 40 and an investor believes that the stock has the potential to move by a relatively large distance, but he is not sure of the direction the stock will take. This investor could short XYZ at 40 and buy 2 XYZ July 40 calls at 3 each to set up a reverse hedge. If XYZ moves up by a large distance, he will incur a loss on his short stock, but the fact that he owns two calls means that the call profits will outdis­ tance the stock loss. If, on the other hand, XYZ drops far enough, the short sale prof­ it will be larger than the loss on the calls, which is limited to 6 points. Table 4-2 and Figure 4-2 show the possible outcomes for various stock prices at July expiration. If XYZ falls, the stock profits on the short sale will accumulate, but the loss on the two calls is limited to $600 (3 points each) so that, below 34, the reverse hedge can make ever-increasing profits. To the upside, even though the short sale is incurring losses, the call profits grow faster because there are two long calls. For example, at 60 at expiration, there will be a 20-point ($2,000) loss on the short stock, but each XYZ July 40 call will be worth 20 points with the stock at 60. Thus, the two calls are worth $4,000, representing a profit of $3,400 over the initial cost of $600 for the calls. Table 4-2 and Figure 4-2 illustrate another important point: The maximum loss would occur if the stock were exactly at the striking price at expiration of the calls. This maximum loss would occur if XYZ were at 40 at expiration and would amount to $600. In actual practice, since the short seller must pay out any dividends paid by the under­ lying stock, the risk in this strategy is increased by the amount of such dividends. 124 TABLE 4-2. Reverse hedge at July expiration. XYZ Price at Stock Expiration Profit 20 +$2,000 25 + 1,500 30 + 1,000 34 + 600 40 0 46 600 50 - 1,000 55 - 1,500 60 - 2,000 FIGURE 4-2. Reverse hedge {simulated straddle). C: 0 ~ ! co (/) (/) .3 ~-$600 e a. Profit on 2 Calls -$ 600 600 600 600 600 + 600 + 1,400 + 2,400 + 3,400 Stock Price at Expiration Part II: Call Option Strategies Total Profit +$ l ,400 + 900 + 400 0 600 0 + 400 + 900 + 1,400 The net margin required for this strategy is 50% of the underlying stock plus the full purchase price of the calls. In the example above, this would be an initial investment of $2,000 (50% of the stock price) plus $600 for the calls, or $2,600 total plus commissions. The short sale is marked to market, so the collateral requirement would grow if the stock rose. Since the maximum risk, before commissions, is $600, this means that the net percentage risk in this transaction is $600/$2,600, about 23%. Cl,opter 4: Other Call Buying Strategies 125 This is a relatively small percentage risk in a position that could have very large prof­ its. There is also very little chance that the entire maximum loss would ever be real­ ized since it occurs only at one specific stock price. One should not be deluded into thinking that this strategy is a sure money-maker. In general, stocks do not move very far in a 3- or 6-month period. With careful selection, though, one can often find sit­ uations in which the stock will be able to move far enough to reach the break-even points. Even when losses are taken, they are counterbalanced by the fact that signif­ icant gains can be realized when the stock moves by a great distance. It is obvious from the information above that profits are made if the stock moves far enough in either direction. In fact, one can determine exactly the prices beyond which the stock would have to move by expiration in order for profits to result. These prices are 34 and 46 in the foregoing example. The downside break-even point is 34 and the upside break-:even point is 46. These break-even points can easily be com­ puted. First, the maximum risk is computed. Then the break-even points are deter­ mined. Maximum risk = Striking price + 2 x Call price - Stock price Upside break-even point = Striking price + Maximum risk Downside break-even point = Striking price - Maximum risk In the preceding example, the striking price was 40, the stock price was also 40, and the call price was 3. Thus, the maximum risk = 40 + 2 x 3 - 40 = 6. This con­ firms that the maximum risk in the position is 6 points, or $600. The upside break­ even point is then 40 + 6, or 46, and the downside break-even point is 40 - 6, or 34. These also agree with Table 4-2 and Figure 4-2. Before expiration, profits can be made even closer to the striking price, because there will be some time value premium left in the purchased calls. Example: IfXYZ moved to 45 in one month, each call might be worth 6. If this hap­ pened, the investor would have a 5-point loss on the stock, but would also have a 3- point gain on each of the two options, for a net overall gain of 1 point, or $100. Before expiration, the break-even point is clearly somewhere below 46, because the position is at a profit at 45. Ideally, one would like to find relatively underpriced calls on a fairly volatile stock in order to implement this strategy most effectively. These situations, while not prevalent, can be found. Normally, call premiums quite accurately reflect the volatil­ ity of the underlying stock. Still, this strategy can be quite viable, because nearly every stock, regardless of its volatility, occasionally experiences a straight-line, fairly large move. It is during these times that the investor can profit from this strategy. 126 Part II: Call Option Strategies Generally, the underlying stock selected for the reverse hedge should be volatile. Even though option premiums are larger on these stocks, they can still be outdistanced by a straight-line move in a volatile situation. Another advantage of uti­ lizing volatile stocks is that they generally pay little or no dividends. This is desirable for the reverse hedge, because the short seller will not be required to pay out as much. The technical pattern of the underlying stock can also be useful when selecting the position. One generally would like to have little or no technical support and resistance within the loss area. This pattern would facilitate the stock's ability to make a fairly quick move either up or down. It is sometimes possible to find a stock that is in a wide trading range, frequently swinging from one side of the range to the other. If a reverse hedge can be set up that has its loss area well within this trading range, the position may also be attractive. Example: The XYZ stock in the previous example is trading in the range 30 to 50, perhaps swinging to one end and then the other rather frequently. Now the reverse hedge example position, which would make profits above 46 or below 34, would appear more attractive. FOLLOW-UP ACTION Since the reverse hedge has a built-in limited loss feature, it is not necessary to take any follow-up action to avoid losses. The investor could quite easily put the position on and take no action at all until expiration. This is often the best method of follow­ up action in this strategy. Another follow-up strategy can be applied, although it has some disadvantages associated with it. This follow-up strategy is sometimes known as trading against the straddle. When the stock moves far enough in either direction, the profit on that side can be taken. Then, if the stock swings back in the opposite direction, a profit can also be made on the other side. Two examples \vill show how this type of follow-up strategy works. Example 1: The XYZ stock in the previous example quickly moves down to 32. At that time, an 8-point profit could be taken on the short sale. This would leave two long calls. Even if they expired worthless, a 6-point loss is all that would be incurred on the calls. Thus, the entire strategy would still have produced a profit of 2 points. However, if the stock should rally above 40, profits could be made on the calls as well. A slight variation would be to sell one of the calls at the same time the stock profit is taken. This would result in a slightly larger realized profit; but if the stock rallied back Cl,apter 4: Other Call Buying Strategies 127 above 40, the resulting profits there would be smaller because the investor would be long only one call instead of two. Example 2: XYZ has moved up to a price at which the calls are each worth 8 points. One of the calls could then be sold, realizing a 5-point profit. The resulting position would be short 100 shares of stock and long one call, a protected short sale. The pro­ tected short sale has a limited risk, above 40, of 3 points (the stock was sold short at 40 and the call was purchased for 3 points). Even if XYZ remains above 40 and the maximum 3-point loss has to be taken, the overall reverse hedge would still have made a profit of 2 points because of the 5-point profit taken on the one call. Conversely, if XYZ drops below 40, the protected short sale position could add to the profits already taken on the call. There is a variation of this upside protective action. Example 3: Instead of selling the one call, one could instead short an additional 100 shares of stock at 48. If this was done, the overall position would be short 200 shares of stock (100 at 40 and the other 100 at 48) and long two calls - again a protected short sale. If XYZ remained above 40, there would again be an overall gain of 2 points. To see this, suppose that XYZ was above 40 at expiration and the two calls were exercised to buy 200 shares of stock at 40. This would result in an 8-point prof­ it on the 100 shares sold short at 48, and no gain or loss on the 100 shares sold short at 40. The initial call cost of 6 points would be lost. Thus, the overall position would profit by 2 points. This means of follow-up action to the upside is more costly in com­ missions, but would provide bigger profits if XYZ fell back below 40, because there are 200 shares of XYZ short. In theory, if any of the foregoing types of follow-up action were taken and the underlying stock did indeed reverse direction and cross back through the striking price, the original position could again be established. Suppose that, after covering the short stock at 32, XYZ rallied back to 40. Then XYZ could be sold short again, reestablishing the original position. If the stock moved outside the break-even points again, further follow-up action could be taken. This process could theoretically be repeated a number of times. If the stock continued to whipsaw back and forth in a trading range, the repeated follow-up actions could produce potentially large profits on a small net change in the stock price. In actual practice, it is unlikely that one would be fortunate enough to find a stock that moved that far that quickly. The disadvantage of applying these follow-up strategies is obvious: One can never make a large profit if he continually cuts his profits off at a small, limited 128 Part II: Call Option Strategies amount . .. When XYZ falls to 32, the stock can be covered to ensure an overall profit of 2 points on the transaction. However, if XYZ continued to fall to 20, the investor who took no follow-up action would make 14 points while the one who did take fol­ low-up action would make only 2 points. Recall that it was stated earlier that there is a high probability of realizing limited losses in the reverse hedge strategy, but that this is balanced by the potentially large profits available in the remaining cases. If one takes follow-up action and cuts off these potentially large profits, he is operating at a distinct disadvantage unless he is an extremely adept trader. Proponents of using the follow-up strategy often counter with the argument that it is frustrating to see the stock fall to 32 and then return back to nearly 40 again. If no follow-up action were taken, the unrealized profit would have dissolved into a loss when the stock rallied. This is true as far as it goes, but it is not an effective enough argument to counterbalance the negative effects of cutting off one's profits. ALTERING THE RATIO OF LONG CALLS TO SHORT STOCK Another aspect of this strategy should be discussed. One does not have to buy exact­ ly two calls against 100 shares of short stock. More bullish positions could be con­ structed by buying three or four calls against 100 shares short. More bearish positions could be constructed by buying three calls and shorting 200 shares of stock. One might adopt a ratio other than 2:1, because he is more bullish or bearish. He also might use a different ratio if the stock is between two striking prices, but he still wants to create a position that has break-even points spaced equidistant from the cur­ rent stock price. A few examples will illustrate these points. Example: XYZ is at 40 and the investor is slightly bullish on the stock but still wants to employ the reverse hedge strategy, because he feels there is a chance the stock could drop sharply. He might then short 100 shares of XYZ at 40 and buy 3 July 40 calls for 3 points apiece. Since he paid 9 points for the calls, his maximum risk is that 9 points if XYZ were to be at 40 at expiration. This means his downside break-even price is 31, for at 31 he would have a 9-point profit on the short sale to offset the 9- point loss on the calls. To the upside, his break-even is now 44½. IfXYZ were at 44½ and the calls at 4½ each at expiration, he would lose 4½ points on the short sale, but would make l ½ on each of the three calls, for a total call profit of 4½. A more bearish investor might short 200 XYZ at 40 and buy 3 July 40 calls at 3. His break-even points would be 35½ on the downside and 49 on the upside, and his maximum risk would be 9 points. There is a general formula that one can always Cbapter 4: Other Call Buying Strategies 129 apply to calculate the maximum risk and the break-even points, regardless of the ratios involved. Maximum risk= (Striking price Stock price) x Round lots shorted + Number of calls bought x Call price U .d b ak S .ki . Maximum risk psi e re -even = tn ng pnce + ( b f all b h Num er o c s oug t - Number of round lots short) D .d b k St .ki . Maximum risk owns1 e rea -even = n ng pnce - b f d l h Num er o roun ots s ort To verify this, use the numbers from the example in which 100 XYZ were shorted at 40 and three July 40 calls were purchased for 3 each. Maximum risk= (40-40) x 1 + 3 x 3 = 9 Upside break-even = 40 + 9/(3 - 1) = 40 + 4¼ = 44¼ Downside break-even= 40- 9/1 = 31 · It was stated earlier that one might use an adjusted ratio in order to space the break­ even points evenly around the current stock price. Example: Suppose XYZ is at 38 and the XYZ July 40 call is at 2. If one wanted to set up a reverse hedge that would profit if XYZ moved either up or down by the same distance, he could not use the 2:1 ratio. The 2:1 ratio would have break-even points of 34 and 46. Thus, the stock would start out much closer to the downside break-even point - only 4 points away - than to the upside break-even point, which is 8 points away. By altering the ratio, the investor can set up a reverse hedge that is more neu­ tral on the underlying stock. Suppose that the investor shorted 100 shares of XYZ at 38 and bought three July 40 calls at 2 each. Then his break-even points would be 32 on the downside and 44 on the upside. This is a more neutral situation, with the downside break-even point being 6 points below the current stock price and the upside break-even point being 6 points away. The formulae above can be used to ver­ ify that, in fact, the break-evens are 32 and 44. Note that the 3: 1 ratio has a maximum risk of 8 points, while the 2:1 ratio only had 6 points maximum risk. A final adjustment that can be applied to this strategy is to short the stock and buy two calls, but with the calls having different striking prices. If XYZ were at 37¼ to start with, one would have to use a ratio other than 2:1 to set up a position with break­ even points spaced equidistant from the current stock price. When these higher ratios are used, the maximum risk is increased and the investor has to adopt a bullish or bear­ ish stance. One may be able to create a position with equidistant break-even points and a smaller maximum risk by utilizing two different striking prices. 130 Example: The following prices exist: XYZ, 37½; XYZ July 40 call, 2; and XYZ July 35 call, 4. Part II: Call Option Strategies If one were to short 100 XYZ at 37½ and to buy one July 40 call for 2 and one July 35 call for 4, he would have a position that is similar to a reverse hedge except that the maximum risk would be realized anywhere between 35 and 40 at expiration. Although this risk is over a much wider range than in the normal reverse hedge, it is now much smaller in dimension. Table 4-3 and Figure 4-3 show the results from this type of position at expiration. The maximum loss is 3½ points ($350), which is a smaller amount than could be realized using any ratio strictly with the July 35 or the July 40 call. However, this maximum loss is realizable over the entire range, 35 to 40. Again, large potential profits are available if the stock moves far enough either to the upside or to the downside. This form of the strategy should only be used when the stock is nearly centered between two strikes and the strategist wants a neutral positioning of the break-even points. Similar types of follow-up action to those described earlier can be applied to this form of the reverse hedge strategy as well. TABLE 4-3. Reverse hedge using two strikes. XYZ Price at Stock July 40 Coll July 35 Coll Total Expiration Profit Profit Profit Profit 25 +$1,250 -$200 -$ 400 +$ 650 30 + 750 - 200 400 + 150 31 1/2 + 600 - 200 400 0 35 + 250 - 200 400 350 371/2 0 - 200 150 350 40 - 250 - 200 + 100 350 431/2 - 600 + 150 + 450 0 45 - 750 + 300 + 600 + 150 50 - 1,250 + 800 + 1,100 + 650 Gapter 4: Other Call Buying Strategies 131 FIGURE 4-3. Reverse hedge using two strikes (simulated combination purchase). C: ~ ·5. in ~ l/l .3 0 i.l::-$350 e a. SUMMARY 40 Stock Price at Expiration The strategies described in this chapter would not normally be used if the underly­ ing stock has listed put options. However, if no puts exist, or the puts are very illiq­ uid, and the strategist feels that a volatile stock could move a relatively large distance in either direction during the life of a call option, he should consider using one of the forms of the reverse hedge strategy - shorting a quantity of stock and buying calls on more shares than he is short. If the desired movement does develop, potentially large profits could result. In any case, the loss is limited to a fixed amount, generally around 20 to 30% of the initial investment. Although it is possible to take follow-up action to lock in small profits and attempt to gain on a reversal by the stock, it is wiser to let the position run its course to capitalize on those occasions when the profits become large. Normally a 2:1 ratio (long 2 calls, short 100 shares of stock) is used in this strategy, but this ratio can be adjusted if the investor wants to be more bullish or more bearish. If the stock is initially between two striking prices, a neutral profit range can be set up by shorting the stock and buying calls at both the next higher strike and the next lower strike. CHAPTER 5 Naked Call Writing The next two chapters will concentrate on various aspects of writing uncovered call options. These strategies have risk ofloss if the underlying stock should rise in price, but they offer profits if the underlying stock declines in price. This chapter on naked, or uncovered, call writing - demonstrates some of the risks and rewards inherent in this aggressive strategy. Novice option traders often think that selling naked options is the "best" way to make money, because of time decay. In addition, they often assume that market-makers and other professionals sell a lot of naked options. In reality, neither is true. Yes, options do eventually lose their premium if held all the way until expiration. However, when an option has a good deal of life remaining, its excess value above intrinsic value what we call "time value premium" - is, in reality, heavily influenced by the volatility estimate of the stock. This is called implied volatility and is discussed at length later in the book. For now, though, it is sufficient to understand that a lot can go wrong when one writes a naked option, before it eventually expires. As to professionals selling a lot of naked options, the fact is that most market-makers and other full-time option traders attempt to reduce their exposure to large stock price movements if possible. Hence, they may sell some options naked, but they generally try to hedge them by buying other options or by buying the underlying stock. Many novice option traders hold these misconceptions, probably because there is a general belief that most options expire worthless. Occasionally, one will even hear or see a statement to this effect in the mainstream media, but it is not true that most options expire worthless. In fact, studies conducted by McMillan Analysis Corp. in both bull and bear months indicate that about 65% to 70% of all options have some value (at least half a point) when they expire. This is not to say that all option buyers make money, either, but it does serve to show that many more options do not expire worthless than do. 132 Qapter 5: Naked Call Writing 133 THE UNCOVERED (NAKED) CALL OPTION When one sells a call option without owning the underlying stock or any equivalent security (convertible stock or bond or another call option), he is considered to have written an uncovered call option. This strategy has limited profit potential and theo­ retically unlimited loss. For this reason, this strategy is unsuitable for some investors. This fact is not particularly attractive, but since there is no actual cash investment required to write a naked call ( the position can be financed with collateral loan value of marginable securities), the strategy can be operated as an adjunct to many other investment strategies. A simple example will outline the basic profit and loss potential from naked writing. Example: XYZ is selling at 50 and a July 50 call is selling for 5. If one were to sell the July 50 call naked - that is, without owning XYZ stock, or any security convertible into XYZ, or another call option on XYZ - he could make, at most, 5 points of profit. This profit would accrue if XYZ were at or anywhere below 50 at July expiration, as the call would then expire worthless. If XYZ were to rise, however, the naked writer could potentially lose large sums of money. Should the stock climb to 100, say, the call would be at a price of 50. If the writer then covered (bought back) the call for a price of 50, he would have a loss of 45 points on the transaction. In theory, this loss is unlimited, although in practice the loss is limited by time. The stock cannot rise an infinite amount during the life of the call. Clearly, defensive strategies are important in this approach, as one would never want to let a loss run as far as the one here. Table 5-1 and Figure 5-1 (solid line) depict the results of this position at July expira­ tion. Note that the break-even point in this example is 55. That is, if XYZ rose 10%, or 5 points, at expiration, the naked writer would break even. He could buy the call back at parity, 5 points, which is exactly what he sold it for. There is some room for error to the upside. A naked write will not necessarily lose money if the stock moves up. It will only lose if the stock advances by more than the amount of the time value premium that was in the call when it was originally written. Naked writing is not the same as a short sale of the underlying stock. While both strategies have large potential risk, the short sale has much higher reward potential, but the naked write will do better if the underlying stock remains relatively unchanged. It is possible for the naked writer to make money in situations when the short seller would have lost money. Using the example above, suppose one investor had written the July 50 call naked for 5 points while another investor sold the stock short at 50. If XYZ were at 52 at expiration, the naked writer could buy the call back at parity, 2 points, for a 3-point profit. The short seller would have a 2-point loss. 134 TABLE 5-1. Position at July expiration. XYZ Price at Call Price at Expiration Expiration 30 0 40 0 50 0 55 5 60 10 70 20 80 30 FIGURE 5-1. Uncovered (naked) call write. +$500 C 0 ~ ·15.. X w cu (/J ~ ...I 0 lt, .... ...... ", Naked Write 45 SO', .... .. .... .. .. Short Sale ,, .. .. Stock Price at Expiration .. Part II: Call Option Strategies Profit on Naked Write +$ 500 + 500 + 500 0 500 - 1,500 - 2,500 .. .... .. ~ Moreover, the short seller pays out the dividends on the underlying stock, whereas the naked call writer does not. The naked call will expire, of course, but the short sale does not. This is a situation in which the naked write outperforms the short sale. However, ifXYZ were to fall sharply- to 20, say- the naked writer could only make 5 points while the short seller would make 30 points. The dashed line in Figure 5-1 shows how the short sale of XYZ at 50 would compare with the naked write of the July 50 call. Notice that the two strategies are equal at 45 at expiration; they both Cl,apter 5: Naked Call Writing 135 make a 5-point profit there. Above 45, the naked write does better; it has larger prof­ its and smaller losses. Below 45, the short sale does better, and the farther the stock falls, the better the short sale becomes in comparison. As will be seen later, one can more closely simulate a short sale by writing an in-the-money naked call. INVESTMENT REQUIRED The margin requirements for writing a naked call are 20% of the stock price plus the call premium, less the amount by which the stock is below the striking price. If the stock is below the striking price, the differential is subtracted from the requirement. However, a minimum of 10% of the stock price is required for each call, even if the C-'Omputation results in a smaller number. Table 5-2 gives four examples of how the ini­ tial margin requirement would be computed for four different stock prices. The 20% collateral figure is the minimum exchange requirement and may vary somewhat among different brokerage houses. The call premium may be applied against the requirement. In the first line of Table 5-2, if the XYZ July 50 call were selling for 7 points, the $700 call premium could be applied against the $1,800 margin requirement, reducing the actual amount that the investor would have to put up as collateral to $1,100. TABLE 5-2. Initial collateral requirements for four stock prices. Coll Written XYZ July 50 XYZ July 50 XYZ July 50 XYZ July 50 Stock Price When Coll Written 55 50 46 40 *Requirement cannot be less than 10%. Coll Price $700 400 200 100 20% of Stock Price $1,100 1,000 920 800 Out-of-the­ Money Differential $ 0 0 400 - 1,000 Total Margin Requirement $1,800 1,400 720 400* In addition to the basic requirements, a brokerage firm may require that for a customer to participate in uncovered writing, he have a minimum equity in his account. This equity requirement may range from as low as $2,000 to as high as $100,000. Since naked call writing is a high-risk strategy, some brokerage firms require that the customer be able to show both financial wherewithal and option 136 Part II: Call Option Strategies trading experience before the account can be approved for naked call writing. In addition, some brokers require that a maintenance requirement be applied against each option written naked. This requirement, sometimes called a kicker, is usually less than $250 per call and is generally used by the broker to ensure that, should the customer fail to respond to an assignment notice against his naked call, the commis­ sion costs for buying and selling the underlying stock would be defrayed. Naked Option Positions Are Marked to the Market Daily. This means that the collateral requirement for the position is recomputed daily, just as in the short sale of stock. The same margin formula that was described above is applied and, if the stock has risen far enough, the customer will be required to deposit addi­ tional collateral or close the position. The need for such a mark to market is obvious. If the underlying stock should rise, the brokerage firm must ensure that the customer has enough collateral to cover the eventuality of buying the stock in the open market and selling it at the striking price if an assignment notice should be received against the naked call. The mark to market works to the customer's favor if the stock falls in price. Excess collateral is then released back into the customer's margin account, and may be used for other purposes. It is important to realize that, in order to write a naked call, collateral is all that is required. No cash need be "invested" if one owns securities with sufficient collat­ eral loan value. Example: An investor owns 100 shares of a stock selling at $60 per share. This stock is worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has a collat­ eral loan value equal to 50% of $6,000, or $3,000. This investor could write any of the naked calls in Table 5-2 without adding cash or securities to his account. Moreover, he would have satisfied a minimum equity requirement of at least $6,000, since his stock is equity. This aspect of naked call writing - using collateral value to finance the writing - is attractive to many investors, since one is able to write calls and bring in premi­ ums without disturbing his existing portfolio. Of course, if the stock underlying the naked call should rise too far in price, additional collateral may be called for by the broker because of the mark to market. Moreover, there is risk whether cash or col­ lateral is used. If one buys in a naked call at a loss, he will then be spending cash, cre­ ating a debit in his account. Regardless of how one finances a naked option position, it is generally a good idea to allow enough collateral so that the stock can move all the way to the point at which one would cover the option or take follow-up action. For example, suppose a 136 Part II: Call Option Strategies trading experience before the account can be approved for naked call writing. In addition, some brokers require that a maintenance requirement be applied against each option written naked. This requirement, sometimes called a kicker, is usually less than $250 per call and is generally used by the broker to ensure that, should the customer fail to respond to an assignment notice against his naked call, the commis­ sion costs for buying and selling the underlying stock would be defrayed. Naked Option Positions Are Marked to the Market Daily. This means that the collateral requirement for the position is recomputed daily, just as in the short sale of stock. The same margin formula that was described above is applied and, if the stock has risen far enough, the customer will be required to deposit addi­ tional collateral or close the position. The need for such a mark to market is obvious. If the underlying stock should rise, the brokerage firm must ensure that the customer has enough collateral to cover the eventuality of buying the stock in the open market and selling it at the striking price if an assignment notice should be received against the naked call. The mark to market works to the customer's favor if the stock falls in price. Excess collateral is then released back into the customer's margin account, and may be used for other purposes. It is important to realize that, in order to write a naked call, collateral is all that is required. No cash need be "invested" if one owns securities with sufficient collat­ eral loan value. Example: An investor owns 100 shares of a stock selling at $60 per share. This stock is worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has a collat­ eral loan value equal to 50% of $6,000, or $3,000. This investor could write any of the naked calls in Table 5-2 without adding cash or securities to his account. Moreover, he would have satisfied a minimum equity requirement of at least $6,000, since his stock is equity. This aspect of naked call writing - using collateral value to finance the writing - is attractive to many investors, since one is able to write calls and bring in premi­ ums without disturbing his existing portfolio. Of course, if the stock underlying the naked call should rise too far in price, additional collateral may be called for by the broker because of the mark to market. Moreover, there is risk whether cash or col­ lateral is used. If one buys in a naked call at a loss, he will then be spending cash, cre­ ating a debit in his account. Regardless of how one finances a naked option position, it is generally a good idea to allow enough collateral so that the stock can move all the way to the point at which one would cover the option or take follow-up action. For example, suppose a 136 Part II: Call Option Strategies trading experience before the account can be approved for naked call writing. In addition, some brokers require that a maintenance requirement be applied against each option written naked. This requirement, sometimes called a kicker, is usually less than $250 per call and is generally used by the broker to ensure that, should the customer fail to respond to an assignment notice against his naked call, the commis­ sion costs for buying and selling the underlying stock would be defrayed. Naked Option Positions Are Marked to the Market Daily. This means that the collateral requirement for the position is recomputed daily, just as in the short sale of stock. The same margin formula that was described above is applied and, if the stock has risen far enough, the customer will be required to deposit addi­ tional collateral or close the position. The need for such a mark to market is obvious. If the underlying stock should rise, the brokerage firm must ensure that the customer has enough collateral to cover the eventuality of buying the stock in the open market and selling it at the striking price if an assignment notice should be received against the naked call. The mark to market works to the customer's favor if the stock falls in price. Excess collateral is then released back into the customer's margin account, and may be used for other purposes. It is important to realize that, in order to write a naked call, collateral is all that is required. No cash need be "invested" if one owns securities with sufficient collat­ eral loan value. Example: An investor owns 100 shares of a stock selling at $60 per share. This stock is worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has a collat­ eral loan value equal to 50% of $6,000, or $3,000. This investor could write any of the naked calls in Table 5-2 without adding cash or securities to his account. Moreover, he would have satisfied a minimum equity requirement of at least $6,000, since his stock is equity. This aspect of naked call writing - using collateral value to finance the writing - is attractive to many investors, since one is able to write calls and bring in premi­ ums without disturbing his existing portfolio. Of course, if the stock underlying the naked call should rise too far in price, additional collateral may be called for by the broker because of the mark to market. Moreover, there is risk whether cash or col­ lateral is used. If one buys in a naked call at a loss, he will then be spending cash, cre­ ating a debit in his account. Regardless of how one finances a naked option position, it is generally a good idea to allow enough collateral so that the stock can move all the way to the point at which one would cover the option or take follow-up action. For example, suppose a Gapter 5: Naked Call Writing 137 stock is trading at 50 and one sells an April 60 call naked, figuring that he will cover the call if the stock rises to 60 ( that is, if the option becomes an in-the-money option). He should set aside enough collateral to margin the position as if the stock were at 60 (even though the actual margin requirement will be smaller than that). If he allows that extra collateral, then he will never be forced into a margin call at a stock price prior to (that is, below) where he wanted to take follow-up action. Simply stat­ ed, let the market take you out of a position, not a margin call. THE PHILOSOPHY OF SELLING NAKED OPTIONS The first and foremost question one must address when thinking about selling naked options (or any strategy, for that matter) is: "Can I psychologically handle the thought of naked options in my account?" Notice that the question does not have anything to do with whether one has enough collateral or margin to sell calls (although that, too, is important) nor does it ask how much money he will make. First, one must decide if he can be comfortable with the risk of the strategy. Selling naked options means that there is theoretically unlimited risk if the underlying instrument should make a large, sudden, adverse move. It is one's attitude regarding that fact alone that deter­ mines whether he should consider selling naked options. If one feels that he won't be able to sleep at night, then he should not sell naked options, regardless of any profit projections that might seem attractive. If one feels that the psychological suitability aspect is not a roadblock, then he can consider whether he has the financial wherewithal to write naked options. On the surface, naked option margin requirements are not large (although in equity and index options, they are larger than they were prior to the crash of 1987). In general, one would prefer to let the naked options expire worthless, if at all possible, without disturbing them, unless the underlying instrument makes a signifi­ cant adverse move. So, out-of-the-money options are the usual choice for naked sell­ ing. Then, in order to reduce ( or almost eliminate) the chance of a margin call, one should set aside the margin requirement as if the underlying had already rrwved to the strike price of the option sold. By allowing margin as if the underlying were already at the strike, one will almost never experience a margin call before the under­ lying price trades up to the strike price, at which time it is best to close the position or to roll the call to another strike. Thus, for naked equity call options, allow as collateral 20% of the highest naked strike price. In this author's opinion, the biggest mistake a trader can make is to ini­ tiate trades because of margin or taxes. Thus, by allowing the "maximum" margin, one can make trading decisions based on what's happening in the market, as opposed to reacting to a margin call from his broker. 138 Part II: Call Option Strategies "Suitability" also means not risking nwre nwney than one can afford to lose. If one allows the "maximum" margin, then he won't be risking a large portion of his equity unless he is unable to cover when the underlying trades through the strike price of his naked option. Gaps in trading prices would be the culprits that could pre­ vent one from covering. Gaps are common in stocks, less common in futures, and almost nonexistent in indices. Hence, index options are the options of choice when it comes to naked writing. Index options are discussed later in the book. Finally, there is one more "rule" that a naked option writer must follow: Someone has to be watching the position at all times. Disasters could occur if one were to go on vacation and not pay attention to his naked options. Usually, one's bro­ ker can watch the position, even if the trader has to call him from his vacation site. In sum, then, to write naked options, one needs to be prepared psychological­ ly, have sufficient funds, be willing to accept the risk, be able to monitor the position every day, sell options whose implied volatility is extremely high, and cover any naked options that become in-the-money options. RISK AND REWARD One can adjust the apparent risks and rewards from naked call writing by his selec­ tion of an in-the-money or out-of-the-money call. Writing an out-of-the-money call naked, especially one quite deeply out-of-the-money, offers a high probability of achieving a small profit. Writing an in-the-money call naked has the most profit potential, but it also has higher risks. Example: XYZ is selling at 40 and the July 50 is selling for½. This call could be sold naked. The probability that XYZ could rise to 50 by expiration has to be considered small, especially if there is not a large amount of time remaining in the life of the call. In fact, the stock could rise 25%, or 10 points, by expiration to a price of 50, and the call would still expire worthless. Thus, this naked writer has a good chance of realiz­ ing a $50 profit, less commissions. There could, of course, be substantial risk in terms of potential profit versus potential loss if the stock rises substantially in price by expi­ ration. Still, this apparent possibility of achieving additional limited income with a high probability of success has led many investors to use the collateral value of their portfolios to sell deeply out-of-the-money naked calls. For those employing this technique, a favored position is to have a stock at or just about 15 and then sell the near-term option with striking price 20 naked. This option would sell for one-eighth or one-quarter, perhaps, although at times there might not be any bid at all. At this price, the stock would have to rally nearly one- C.,,er 5: Naked Call Writing 139 third, or 33%, for the writer to lose money. Although there are not usually many optionable stocks selling at or just above $10 per share, these same out-of-the-money writers would also be attracted to selling a call with a striking price 15 when the stock is at 10, because a 50% upward move by the stock would be required for a loss to be realized. This strategy of selling deeply out-of-the-money calls has its apparent attraction in that the writer is assured of a profit unless the underlying stock can rally rather substantially before the call expires. The danger in this strategy is that one or two losses, perhaps amounting to only a couple of points each, could wipe out many peri­ ods of profits. The stock market does occasionally rally heavily in a short period, as witnessed repeatedly throughout history. Thus, the writer who is adopting this strat­ egy cannot regard it as a sure thing and certainly cannot afford to establish the writes and forget them. Close monitoring is required in case the market begins to rally, and by no means should losses be allowed to accumulate. The opposite end of the spectrum in naked call writing is the writing of fairly deeply in-the-money calls. Since an in-the-money call would not have much time value premium in it, this writer does not have much leeway to the upside. If the stock rallies at all, the writer of the deeply in-the-money naked call will normally experience a loss. However, should the stock drop in price, this writer will make larger dollar profits than will the writer of the out-of-the-money call. The sale of the deeply in-the-money call simulates the profits that a short seller could make, at least until the stock drops close to the striking price, since the delta of a deeply in-the­ money call is close to 1. Example: XYZ is selling at 60 and the July 50 call is selling for 10½. IfXYZ rises, the naked writer will lose money, because there is only ½ of a point of time value pre­ mium in the call. If XYZ falls, the writer will make profits on a point-for-point basis until the stock falls much closer to 50. That is, if XYZ dropped from 60 to 57, the call price would fall by almost 3 points as well. Thus, for quick declines by the stock, the deeply in-the-money write can provide profits nearly equal to those that the short seller could accumulate. Notice that if XYZ falls all the way to 50, the profits on the written call will be large, but will be accumulating at a slower rate as the time value premium builds up with the stock near the striking price. If one is looking to trade a stock on the short side for just a few points of nwve­ ment, he might use a deeply in-the-nwney naked write instead of shorting the stock. His investment will be smaller - 20% of the stock price for the write as compared to 50% of the stock price for the short sale - and his return will thus be larger. (The requirement for the in-the-money amount is offset by applying the call's premium.) 140 Part II: Call Option Strategies The writer should take great caution in ascertaining that the call does have some time premium in it. He does not want to receive an assignment notice on the written call. It is easiest to find time premium in the more distant expiration series, so the writer would normally be safest from assignment by writing the longest-term deep in-the­ money call if he wants to make a bearish trade in the stock. Example: An investor thinks that XYZ could fall 3 or 4 points from its current price of 60 in a quick downward move, and wants to capitalize on that move by writing a naked call. If the April 40 were the near-term call, he might have the choice of sell­ ing the April 40 at 20, the July 40 at 20¼, or the October 40 at 20½. Since all three calls will drop nearly point for point with the stock in a move to 56 or 57, he should write the October 40, as it has the least risk of being assigned. A trader utilizing this strategy should limit his losses in much the same way a short seller would, by cover­ ing if the stock rallies, perhaps breaking through overhead technical resistance. ROLLING FOR CREDITS Most writers of naked calls prefer to use one of the two strategies described above. The strategy of writing at-the-money calls, when the stock price is initially close to the striking price of the written call, is not widely utilized. This is because the writer who wants to limit risk will write an out-of-the-money call, whereas the writer who wants to make larger, quick trading profits will write an in-the-money call. There is, how­ ever, a strategy that is designed to utilize the at-the-money call. This strategy offers a high degree of eventual success, although there may be an accumulation of losses before the success point is reached. It is a strategy that requires large collateral back­ ing, and is therefore only for the largest investors. We call this strategy "rolling for credits." The strategy is described here in full, although it can, at times, resemble a Martingale strategy; that is, one that requires "doubling up" to succeed, and one that can produce ruin if certain physical limits are reached. The classic Martingale strat­ egy is this: Begin by betting one unit; if you lose, double your bet; if you win that bet, you'll have netted a profit of one unit (you lost one, but won two); if you lost the sec­ ond bet, double your bet again. No matter how many times you lose, keep doubling your bet each time. When you eventually win, you will profit by the amount of your original bet (one unit). Unfortunately, such a strategy cannot be employed in real life. For example, in a gambling casino, after enough losses, one would bump up against the table limit and would no longer be able to double his bet. Consequently, the strat­ egy would be ruined just when it was at its worst point. While "rolling for credits" doesn't exactly call for one to double the number of written calls each time, it does require that one keep increasing his risk exposure in order to profit by the amount of that original credit sold. In general, Martingale strategies should be avoided. Cl,apter 5: Naked Call Writing 141 In essence, the writer who is rollingf or credits sells the most time premium that he can at any point in time. This would generally be the longest-term, at-the-money call. If the stock declines, the writer makes the time premium that he sold. However, if the stock rises in price, the writer rolls up for a credit. That is, when the stock reaches the next higher striking price, the writer buys back the calls that were origi­ nally sold and sells enough long-term calls at the higher strike to generate a credit. In this way, no debits are incurred, although a realized loss is taken on the rolling up. If the stock persists and rises to the next striking price, the process is repeated. Eventually, the stock will stop rising - they always do - and the last set of written options will expire worthless. At that time, the writer would make an overall profit consisting of an amount equal to all the credits that he had taken in so far. In reality, most of that credit will simply be the initial credit received. The "rolls" are done for even money or a small credit. In essence, the increased risk generated by continual­ ly rolling up is all geared toward eventually capturing that initial credit. The similar­ ity to the Martingale strategy is strongest in this regard: One continually increases his risk, knowing that when he eventually wins (i.e., the last set of options expires worth­ less), he profits by the amount of his original "bet." There are really only two requirements for success in this strategy. The first is that the underlying stock eventually fall back, that it does not rise indefinitely. This is hardly a requirement; it is axiomatic that all stocks will eventually undergo a correc­ tion, so this is a simple requirement to satisfy. The second requirement is that the investor have enough collateral backing to stay with the strategy even if the stock runs up heavily against him. This is a much harder requirement to satisfy, and may in fact tum out to be nearly impossible to satisfy. If the stock were to experience a straight-line upward move, the number of calls written might grow so substantially that they would require an unrealistically large amount of collateral (margin). At a minimum, this strategy is applicable only for the largest investors. For such well-collateralized investors, this strategy can be thought of as a way to add income to a portfolio. That is, a large stock portfolio's equity may be used to finance this strategy through its loan value. There would be no margin interest charges, because all transactions are cred­ it transactions. (No debits are created, as long as the Martingale "limits" are not reached.) The securities portfolio would not have to be touched unless the strategy were terminated before the last set of calls expired worthless. This is where the danger comes in: If the stock upon which the calls are written rises so fast that one completely uses up all of his collateral value to finance the naked calls, and then one is required to roll again, the strategy could result in large losses. For a while, one could simply continue to roll the same number of calls up for deb­ its, but eventually those debits would mount in size if the stock persisted in rising. At 142 Part II: Call Option Strategies this point, even if the stock did finally decline enough for the last set of calls to expire worthless, the overall strategy might still have been operated at a loss. Example: The basic strategy in the case of rising stock is shown in Table 5-3. Note that each transaction is a credit and that all ( except the last) involve taking a realized loss. This example assumes that the stock rose so quickly that a longer-term call was never available to roll into. That is, the October calls were always utilized. If there were a longer-term call available (the January series, for example), the writer should roll up and out as well. In this way, larger credits could be generated. The number of calls written increased from 5 to 15 and the collateral required as backing for the writing of the naked calls also increased heavily. Recall that the collateral require­ ment is equal to 20% of the stock price plus the call premium, less the amount by which the call is out-of-the-money. The premium may be used against the collateral requirements. Using the stock and call prices of the example above, the investment is computed in Table 5-4. While the number of written calls has tripled from 5 to 15, the collateral requirement has more than quadrupled from $5,000 to $21,000. This is why the investor must have ample collateral backing to utilize this strategy. The gen­ eral philosophy of the large investors who do apply this strategy is that they hope to eventually make a profit and, since they are using the collateral value of large securi­ ty positions already held, they are not investing any more money. The strategy does not really "cost" these investors anything. All profits represent additional income and do not in any way disturb the underlying security portfolio. Unfortunately, losses taken due to aborting the strategy could seriously affect the portfolio. This is why the investor must have sufficient collateral to carry through to completion. The sophisticated strategist who implements this strategy will generally do more rolling than that discussed in the simple example above. First, if the stock drops, the calls will be rolled down to the next strike - for a credit - in order to con­ stantly be selling the most time premium, which is always found in the longest-term at-the-money call. Furthermore, the strategist may want to roll out to a more distant expiration series whenever the opportunity presents itself. This rolling out, or for­ ward, action is only taken when the stock is relatively unchanged from the initial price and there is no need to roll up or down. This strategy seems ve:ry attractive as long as one has enough collateral backing. Should one use up all of his available collateral, the strategy could collapse, causing substantial losses. It may not necessarily generate large rates of return in rising mar­ kets, but in stable or declining markets the generation of additional income can be quite substantial. Since the investor is not putting up any additional cash but is uti- Cl,apter 5: Naked Call Writing TABLE 5-3. Rolling for credits when stock is rising. Initially: XYZ = 50 Sell 5 XYZ October 50's at 7 later: XYZ rises to 60 Buy 5 XYZ October 50's at 11 and sell 8 XYZ October 60's at 7 Later: XYZ rises further to 70 Buy 8 XYZ October 60's at 11 and sell 15 XYZ October 70's at 6 Finally: XYZ falls and the October 70's expire worthless TABLE 5-4. Increase in collateral requirement. Initially: XYZ = 50 Sell 5 XYZ October 50's at 7 ($3,500 net credit) Later: . XYZ = 60 Sell 8 XYZ October 60's at 7 Buy 5 October 50's at 11 ($3,600 net credit to date) Later: XYZ = 70 Sell 15 XYZ October 70's at 6 Buy 8 XYZ October 60' s at 1 1 ($3,800 net credit to date) 143 +$3,500 credit - 5,500 debit + 5,600 credit - 8,800 debit + 9,000 credit Net gain = +$3,800 $ 5,000 collateral required $ 9,600 collateral required $21,000 collateral required lizing the collateral power of his present securities, his "investment" is actually zero. Any profits represent additional income. The investor must be aware of one other factor that can upset the strategy. If a stock should rise so far as to require the num­ ber of calls to exceed the position limits set by the OCC, the strategy is ruined. In the example above, XYZ would probably have to rise to about a price of over 200, with­ out a correction, before the sale of"' 1,000 calls would be required. If the strategist originally started with too many naked calls, he could potentially exceed the limit in a short time period. Rather than attempting to sell too many calls initially in any one "Position limits are higher now. 144 Part II: Call Option Strategies security, the strategist should diversify several moderately sized positions throughout a variety of underlying stocks. If he does this, he will probably never have to exceed the position limit of contracts short in any one security. Even with as many precautions as one might take, there is no guarantee that one would have the collateral available to withstand a gain of 1000% or more, such as is occasionally seen with high-flying tech stocks or new IPOs. One would probably be best served, if he really wants to operate this strategy, to stick with stocks that are well capitalized (some of the biggest in the industry), so that they are less suscepti­ ble to such violent upside moves. Even then, though, there is no guarantee that one will not run out of collateral in a sharply rising market, because it is impossible to esti­ mate with complete certainty just how far any one stock might advance in a particu­ lar period of time. TIME VALUE PREMIUM IS A MISNOMER Once again, the topic of time value premium is discussed, as it was in Chapter 3. Many novice option traders think that if they sell an out-of-the-money option (whether covered or naked), all they have to do is sit back and wait to collect the pre­ mium as time wears it away. However, a lot of things can happen between the time an option is sold and its expiration date. The stock can move a great deal, or implied volatility can skyrocket. Both are bad for the option seller and both completely coun­ teract any benefit that time decay might be imparting. The option seller must con­ sider what might happen during the life of the option, and not simply view it as a strategy to hold the option until expiration. Naked call writers, especially, should operate with that thought in mind, but so should covered call writers, even though most don't. What the covered writer gives away is the upside; and if he constantly sells options without regard to the possibilities of volatility or stock price increases, he will be doing himself a disservice. So, while it is still proper to refer to the part of an option's price that is not intrinsic value as "time value premium," the knowledgeable option trader under­ stands that it is also more heavily influenced by volatility and stock price movement than by time. SUMMARY In a majority of cases, naked call writing is applied as a deeply out-of-the-money strategy in which the investor uses the collateral value of his security holdings to par­ ticipate in a strategy that offers a large probability of making a very limited profit. It is a poor strategy, because one loss may wipe out many profits. The trader who Oapter 5: Naked Call Wdting 145 desires an alternative to a short sale may use the sale of an in-the-money naked call in order to attempt to make a quick profit on a smaller investment than the short sell­ er would have to make. Both of these strategies could entail large risk if one does not have sufficient capital backing. An alternative strategy, but one that is available only to very large investors, is to sell at-the-money calls naked, rolling up and forward for credits if the underlying stock rises in price. This strategy, however, can become disastrous if it takes on Martingale-like qualities during a rocketing rise by the underlying stock. Ratio Call Writing Two basic types of call writing have been described in previous chapters: covered call writing, in which one owns the underlying stock and sells a call; and naked call writ­ ing. Ratio writing is a combination of these two types of positions. THE RATIO WRITE Simply stated, ratio call writing is the strategy in which one owns a certain number of shares of the underlying stock and sells calls against more shares than he owns. Thus, there is a ratio of calls written to stock owned. The most common ratio is the 2:1 ratio, whereby one owns 100 shares of the underlying stock and sells 2 calls. Note that this type of position involves writing a number of naked call options as well as a number of covered options. This resulting position has both downside risk, as does a covered write, and unlimited upside risk, as does a naked write. The ratio write gen­ erally wilI provide much larger profits than either covered writing or naked writing if the underlying stock remains relatively unchanged during the life of the calls. However, the ratio write has two-sided risk, a quality absent from either covered or naked writing. Generally, when an investor establishes a ratio write, he attempts to be neutral in outlook regarding the underlying stock. This means that he writes the calls with striking prices closest to the current stock price. Example: A ratio write is established by buying 100 shares of XYZ at 49 and selling two XYZ October 50 calls at 6 points each. If XYZ should decline in price and be anywhere below 50 at October expiration, the calls will expire worthless and the writer will make 12 points from the sale of the calls. Thus, even if XYZ drops 12 points to a price of 37, the ratio writer will break even. The stock loss of 12 points 146 Otapter 6: Ratio Call Writing 147 would be offset by a 12-point gain on the calls. As with any strategy in which calls are sold, the maximum profit occurs at the striking price of the written calls at expiration. In this example, if XYZ were at 50 at expiration, the calls would still expire worthless for a 12-point gain and the writer would have a 1-point profit on his stock, which has moved up from 49 to 50, for a total gain of 13 points. This position therefore has ample downside protection and a relatively large potential profit. Should XYZ rise above 50 by expiration, the profit will decrease and eventually become a loss if the stock rises too far. To see this, suppose XYZ is at 63 at October expiration. The calls will be at 13 points each, representing a 7-point loss on each call, because they were originally sold for 6 points apiece. However, there would be a 14-poirit gain on the stock, which has risen from 49 to 63. The overall net is a break-even situation at 63 - a 14-point gain on the stock offset by 14 points ofloss on the options (7 points each). Table 6-1 and Figure 6-1 summarize the profit and loss potential of this example at October expiration. The shape of the graph resembles a roof with its peak located at the striking price of the written calls, or 50. It is obvious that the position has both large upside risk above 63 and large downside risk below 37. Therefore, it is imper­ ative that the ratio writer plan to take follow-up action if the stock should move out­ side these prices. Follow-up action is discussed later. If the stock remains within the range 37 to 63, some profit will result before commission charges. This range between the downside break-even point and the upside break-even point is called the profit range. This example represents essentially a neutral position, because the ratio writer will make some profit unless the stock falls by more than 12 points or rises by more than 14 points before the expiration of the calls in October. This is frequently an attractive type of strategy to adopt because, normally, stocks do not move very far in TABLE 6-1. Profit and loss at October expiration. XYZ Price at Stock Call Profit Total Expiration Profit Price on Calls Profit 30 -$1,900 0 +$1,200 -$ 700 37 - 1,200 0 + 1,200 0 45 400 0 + 1,200 + 800 50 + 100 0 + 1,200 + 1,300 55 + 600 5 + 200 + 800 63 + 1,400 13 - 1,400 0 70 + 2,100 20 - 2,800 - 700 148 FIGURE 6-1. Ratio write (2: 1 ). +$1,300 C 0 e ·5. X LU al rn rn .3 0 -e a. Part II: Call Option Strategies Stock Price at Expiration a 3- or 6-month time period. Consequently, this strategy has a rather high probabili­ ty of making a limited profit. The profit in this example would, of course, be reduced by commission costs and margin interest charges if the stock is bought on margin. Before discussing the specifics of ratio writing, such as investment required, selection criteria, and follow-up action, it may be beneficial to counter two fairly common objections to this strategy. The first objection, although not heard as fre­ quently today as when listed options first began trading, is "Why bother to buy 100 shares of stock and sell 2 calls? You will be naked one call. Why not just sell one naked call?" The ratio writing strategy and the naked writing strategy have very little in common except that both have upside risk. The profit graph for naked writing (Figure 5-1) bears no resemblance to the roof-shaped profit graph for a ratio write (Figure 6-1). Clearly, the two strategies are quite different in profit potential and in many other respects as well. The second objection to ratio writing for the conservative investor is slightly more valid. The conservative investor may not feel comfortable with a position that has risk if the underlying stock moves up in price. This can be a psychological detri­ ment to ratio writing: When stock prices are rising and everyone who owns stocks is happy and making profits, the ratio writer is in danger of losing money. However, in a purely strategic sense, one should be willing to assume some upside risk in exchange for larger profits if the underlying stock does not rise heavily in price. The Chapter 6: Ratio Call Writing 149 covered writer has upside protection all the way to infinity; that is, he has no upside risk at all. This cannot be the mathematically optimum situation, because stocks never rise to infinity. Rather, the ratio writer is engaged in a strategy that makes its profits in a price range more in line with the way stocks actually behave. In fact, if one were to try to set up the optimum strategy, he would want it to make its most profits in line with the most probable outcomes for a stock's movement. Ratio writ­ ing is such a strategy. Figure 6-2 shows a simple probability curve for a stock's movement. It is most likely that a stock will remain relatively unchanged and there is very little chance that it will rise or fall a great distance. Now compare the results of the ratio writing strat­ egy with the graph of probable stock outcomes. Notice that the ratio write and the probability curve have their "peaks" in the same area; that is, the ratio write makes its profits in the range of most likely stock prices, because there is only a small chance that any stock will increase or decrease by a large amount in a fixed period of time. The large losses are at the edges of the graph, where the probability curve gets very low, approaching zero probability. It should be noted that these graphs show the prof­ it and probability at expiration. Prior to expiration, the break-even points are closer to the original purchase price of the stock because there will still be some time value premium remaining on the options that were sold. FIGURE 6-2. Stock price probability curve overlaid on profit graph of ratio write. +$1,300 Probability Curve Stock Price 150 Part II: Call Option Strategies INVESTMENT REQUIRED The ratio writer has a combination of covered writes and naked writes. The margin requirements for each of these strategies have been described previously, and the requirements for a ratio writing strategy are the sum of the requirements for a naked write and a covered write. Ratio writing is normally done in a margin account, although one could technically keep the stock in a cash account. Example: Ignoring commissions, the investment required can be computed as fol­ lows: Buy 100 XYZ at 49 on 50% margin and sell 2 XYZ October 50 calls at 6 points each (Table 6-2). The commissions for buying the stock and selling the calls would be added to these requirements. A shorter formula (Table 6-3) is actually more desirable to use. It is merely a combination of the investment requirements listed in Table 6-2. In addition to the basic requirement, there may be minimum equity require­ ments and maintenance requirements, since naked calls are involved. As these vary from one brokerage firm to another, it is best for the ratio writer to check with his broker to determine the equity and maintenance requirements. Again, since naked calls are involved in ratio writing, there will be a mark to market of the position. If the stock should rise in price, the investor will have to put up more collateral. It is conceivable that the ratio writer would want to stay with his original posi­ tion as long as the stock did not penetrate the upside break-even point of 63. TABLE 6-2. Investment required. Covered writing portion (buy 100 XYZ and sell 1 call) 50% of stock price Less premium received Requirement for covered portion Naked writing portion (sell 1 XYZ call) 20% of stock price Less out-of-the-money amount Plus call premium Less premium received Requirement for naked portion Total requirement for ratio write $2,450 600 $1,850 $ 980 100 + 600 600 $ 880 $2,730 Cl,apter 6: Ratio Call Writing TABLE 6-3. Initial investment required for a ratio write. 70% of stock cost (XYZ = 49) Plus naked call premiums Less total premiums received Plus or minus striking price differential on naked calls $3,430 + 600 - 1,200 100 151 Total requirement $2,730 (plus commissions) TABLE 6-4. Collateral required with stock at upside break-even point of 63. Covered writing requirement $1,850 (see Table 6-2) 20% of stock price (XYZ = 63) 1,260 Plus call premium Less initial call premium received Total requirement with XYZ at 63 1,400 600 $3,910 Therefore, he should allow for enough collateral to cover the eventuality of a move to 63. Assuming the October 50 call is at 14 in this case, he would need $3,910 (see Table 6-4). This is the requirement that the ratio writer should be concerned with, not the initial collateral requirement, and he should therefore plan to invest $3,910 in this position, not $2,730 ( the initial requirement). Obviously, he only has to put up $2,730, but from a strategic point of view, he should allow $3,910 for the position. If the ratio writer does this with all his positions, he would not receive a margin call even if all the stocks in his portfolio climbed to their upside break-even points. SELECTION CRITERIA To decide whether a ratio write is a desirable position, the writer must first determine the break-even points of the position. Once the break-even points are known, the writer can then decide if the position has a wide enough profit range to allow for defensive action if it should become necessary. One simple way to determine if the profit range is wide enough is to require that the next higher and lower striking prices be within the profit range. 152 Part II: Call Option Strategies Example: The writer is buying 100 XYZ at 49 and selling 2 October 50 calls at 6 points apiece. It was seen, by inspection, that the break-even points in the position are 37 on the downside and 63 on the upside. A mathematical formula allows one to quickly compute the break-even points for a 2:1 ratio write. Points of maximum profit = Strike price - Stock price + 2 x Call price Downside break-even point = Strike price - Points of maximum profit = Stock price - 2 x Call price Upside break-even point = Strike price + Points of maximum profit In this example, the points of maximum profit are 50 - 49 + 2 x 6, or 13. Thus, the downside break-even point would be 37 (50 - 13) and the upside break-even point would be 63 (50 + 13). These numbers agree with the figures determined ear­ lier by analyzing the position. This profit range is quite clearly wide enough to allow for defensive action should the underlying stock rise to the next highest strikes of 55 or 60, or fall to the next two lower strikes, at 45 and 40. In practice, a ratio write is not automatically a good position merely because the profit range extends far enough. Theoretically, one would want the profit range to be wide in relation to the volatility of the under­ lying stock. If the range is wide in relation to the volatility and the break-even points encompass the next higher and lower striking prices, a desirable position is available. Volatile stocks are the best candidates for ratio writing, since their pre­ miums will more easily satisfy both these conditions. A nonvolatile stock may, at times, have relatively large premiums in its calls, but the resulting profit range may still not be wide enough numerically to ensure that follow-up action could be taken. Specific measures for determining volatility may be obtained from many data serv­ ices and brokerage firms. Moreover, methods of computing volatility are present­ ed later in the chapter on mathematical applications, and probabilities are further addressed in the chapters on volatility trading. Technical support and resistance levels are also important in establishing the position. If both support and resistance lie within the profit range, there is a better chance that the stock will remain within the range. A position should not necessarily be rejected if there is not support and resistance within the profit range, but the writer is then subjecting himself to a possible undeterred move by the stock in one direction or the other. The ratio writer is generally a neutral strategist. He tries to take in the most time premium that he can to earn the premium erosion while the stock remains rel­ atively unchanged. If one is more bullish on a particular stock, he can set up a 2:1 ratio write with out-of~the-money calls. This allows more room to the upside than to the downside, and therefore makes the position slightly more bullish. Conversely, if Cl,apter 6: Ratio Call Writing 153 one is more bearish on the underlying stock, he can write in-the-money calls in a 2:1 ratio. There is another way to produce a slightly more bullish or bearish ratio write. This is to change the ratio of calls written to stock purchased. This method is also used to construct a neutral profit range when the stock is not close to a striking price. Example: An investor is slightly bearishly inclined in his outlook for the underlying stock, so he might write more than two calls for each 100 shares of stock purchased. His position might be to buy 100 XYZ at 49 and sell 3 XYZ October 50 calls at 6 points each. This position breaks even at 31 on the downside, because if the stock dropped by 18 points at expiration, the call profits would amount to 18 points and would pro­ duce a break-even situation. To the upside, the break-even point lies at 59½ for the stock at expiration. Each call would be worth 9½ at expiration with the stock at 59½, and each call would thus lose 3½ points, for a total loss of 10½ points on the three calls. However, XYZ would have risen from 49 to 59½ - a 10½-point gain - therefore producing a break-even situation. Again, a formula is available to aid in determining the break-even point for any ratio. Maximum profit= (Striking price - Stock price) x Round lots purchased+ Number of calls written x Call price D •d b ak Striking Maximum profit owns1 e re -even = - ------~~----price Number of round lots purchased U .d b ak Striking Maximum profit psi e re -even = + price ( Calls written - Round lots purchased) Note that in the case of a 2:1 ratio write, where the number of round lots purchased equals 1 and the number of calls written equals 2, these formulae reduce to the ones given earlier for the more common 2:1 ratio write. To verify that the formulae above are correct, insert the numbers from the most recent example. Example: Three XYZ October 50 calls at a price of 6 were sold against the purchase of 100 XYZ at 49. The number of round lots purchased is 1. Maximum profit = (50 - 49) x 1 + 3 x 6 = 19 Downside break-even= 50-19/1 = 31 Upside break-even= 50 + 19/(3 1) = 59½ In the 2:1 ratio writing example given earlier, the break-even points were 37 and 63. The 3:1 write has lower break-even points of 31 and 59½, reflecting the more bear­ ish posture on the underlying stock. 154 Part II: Call Option Strategies A more bullish write is constructed by buying 200 shares of the underlying stock and writing three calls. To quickly verify that this ratio (3:2) is more bullish, again use 49 for the stock price and 6 for the call price, and now assume that two round lots were purchased. Maximum profit= (50-49) x 2 + 3 x 6 = 20 Downside break-even = 50 - 20/2 = 40 Upside break-even= 50 + 20/(3 - 2) = 70 Thus, this ratio of 3 calls against 200 shares of stock has break-even points of 40 and 70, reflecting a more bullish posture on the underlying stock. A 2: 1 ratio may not necessarily be neutral. There is, in fact, a mathematically correct way of determining exactly what a neutral ratio should be. The neutral ratio is determined by dividing the delta of the written call into 1. Assume that the delta of the XYZ October 50 call in the previous example is .60. Then the neutral ratio is 1.0/.60, or 5 to 3. This means that one might buy 300 shares and sell 5 calls. Using the formulae above, the details of this position can be observed: Maximum profit= (50 -49) x 3 + 5 x 6 = 33 Downside break-even = 50 - 33/3 = 39 Upside break-even = 50 + 33/(5 --3) = 66½ According to the mathematics of the situation, then, this would be a neutral position initially. It is often the case that a 5:3 ratio is approximately neutral for an at-the­ money call. By now, the reader should have recognized a similarity between the ratio writ­ ing strategy and the reverse hedge (or simulated straddle) strategy presented in Chapter 4. The two strategies are the reverse of each other; in fact, this is how the reverse hedge strategy acquired its name. The ratio write has a profit graph that looks like a roof, while the reverse hedge has a profit graph that looks like a trough - the roof upside down. In one strategy the investor buys stock and sells calls, while the other strategy is just the opposite - the investor shorts stock and buys calls. Which one is better? The answer depends on whether the calls are "cheap" or "expensive." Even though ratio writing has limited profits and potentially large losses, the strate­ gy will result in a profit in a large majority of cases, if held to expiration. However, one may be forced to make adjustments to stock moves that occur prior to expiration. The reverse hedge strategy, with its limited losses and potentially large profits, pro­ vides profits only on large stock moves - a less frequent event. Thus, in stable mar­ kets, the ratio writing strategy is generally superior. However, in times of depressed option premiums, the reverse hedge strategy gains a distinct advantage. If calls are Chapter 6: Ratio Call Writing 155 underpriced, the advantage lies with the buyer of calls, and that situation is inherent in the reverse hedge strategy. The summaries stated in the above paragraph are rather simplistic ones, refer­ ring mostly to what one can expect from the strategies if they are held until expira­ tion, without adjustment. In actual trading situations, it is much more likely that one would have to make adjustments to the ratio write along the way, thus disturbing or perhaps even eliminating the profit range. Such travails do not befall the reverse hedge (simulated straddle buy). Consequently, when one takes into consideration the stock movements that can take place prior to expiration, the ratio write loses some of its attractiveness and the reverse hedge gains some. THE VARIABLE RATIO WRITE In ratio writing, one generally likes to establish the position when the stock is trading relatively close to the striking price of the written calls. However, it is sometimes the case that the stock is nearly exactly between two striking prices and neither the in­ the-money nor the out-of-the-money call offers a neutral profit range. If this is the case, and one still wants to be in a 2:1 ratio of calls written to stock owned, he can sometimes write one in-the-money call and one out-of-the-money call against each 100 shares of common. This strategy, often termed a variable ratio write or trape­ zoidal hedge, serves to establish a more neutral profit range. Example: Given the following prices: XYZ common, 65; XYZ October 60 call, 8; and XYZ October 70 call, 3. If one were to establish a 2:1 ratio write with only the October 60's, he would have a somewhat bearish position. His profit range would be 49 to 71 at expiration. Since the stock is already at 65, this means that he would be allowing room for 16 points of downside movement and only 6 points on the upside. This is certainly not neutral. On the other hand, if he were to attempt to utilize only the October 70 calls in his ratio write, he would have a bullish position. This profit range for the October 70 ratio write would be 59 to 81 at expiration. In this case, the stock at 65 is too close to the downside break-even point in comparison to its distance from the upside break-even point. A more neutral position can be established by buying 100 XYZ and selling one October 60 and one October 70. This position has a profit range that is centered about the current stock price. Moreover, the new position has both an upside and a downside risk, as does a more normal ratio write. However, now the maximum prof­ it can be obtained anywhere between the two strikes at expiration. To see this, note 156 Part II: Call Option Strategies that if XYZ is anywhere between 60 and 70 at expiration, the stock will be called away at 60 against the sale of the October 60 call, and the October 70 call will expire worth­ less. It makes no difference whether the stock is at 61 or at 69; the same result will occur. Table 6-5 and Figure 6-3 depict the results from this variable hedge at expira­ tion. In the table, it is assumed that the option is bought back at parity to close the position, but if the stock were called away, the results would be the same. Note that the shape of Figure 6-3 is something like a trapezoid. This is the source of the name "trapezoidal hedge," although the strategy is more commonly known as a variable hedge or variable ratio write. The reader should observe that the maximum profit is indeed obtained if the stock is anywhere between the two strikes at eiqJiration. The maximum profit potential in this position, $600, is smaller than the maximum profit potential available from writing only the October 60's or only the October 70's. However, there is a vastly greater probability of realizing the maximum profit in a variable ratio write than there is of realizing the maximum profit in a nor­ mal ratio write. The break-even points for a variable ratio write can be computed most quickly by first computing the maximum profit potential, which is equal to the time value that the writer takes in. The break-even points are then computed directly by sub­ tracting the points of maximum profit from the lower striking price to get the down­ side break-even point and adding the points of maximum profit to the upper striking price to arrive at the upside break-even point. This is a similar procedure to that fol­ lowed for a normal ratio write: TABLE 6-5. Results at expiration of variable hedge. XYZ Price at XYZ October 60 October 70 Total Expiration Profit Profit Profit Profit 45 -$2,000 +$ 800 +$ 300 -$900 50 - 1,500 + 800 + 300 - 400 54 - 1,100 + 800 + 300 0 60 500 + 800 + 300 + 600 65 0 + 300 + 300 + 600 70 + 500 - 200 + 300 + 600 76 + 1,100 - 800 300 0 80 + 1,500 -$1,200 700 - 400 85 + 2,000 -1,700 - 1,200 - 900 Gopter 6: Ratio Call Writing FIGURE 6-3. Variable ratio write (trapezoidal hedge). +$600 C: i $ al "' "' .3 5 ;t: e 0. $0 Stock Price at Expiration Points of maximum profit = Total option premiums + Lower striking price - Stock price Downside break-even point = Lower striking price - Points of maximum profit Upside break-even point = Higher striking price + Points of maximum profit 157 Substituting the numbers from the example above will help to verify the formula. The total points of option premium brought in were 11 (8 for the October 60 and 3 for the October 70). The stock price was 65, and the striking prices involved were 60 and 70. Points of maximum profit = 11 + 60 - 65 = 6 Downside break-even point= 60- 6 = 54 Upside break-even point= 70 + 6 = 76 Thus, the break-even points as computed by the formula agree with Table 6-5 and Figure 6-3. Nate that the formula applies only if the stock is initially between the two striking prices and the ratio is 2:1. If the stock is above both striking prices, the for­ mula is not correct. However, the writer should not be attempting to establish a vari­ able ratio write with two in-the-money calls. 158 Part II: Call Option Strategies FOLLOW-UP ACTION Aside from closing the position completely, there are three reasonable approaches to follow-up action in a ratio writing situation. The first, and most popular, is to roll the written calls up if the stock rises too far, or to roll down if the stock drops too far. A second method uses the delta of the written calls. The third follow-up method is to utilize stops on the underlying stock to alter the ratio of the position as the stock moves either up or down. In addition to these types of defensive follow-up action, the investor must also have a plan in mind for taking profits as the written calls approach expiration. These types of follow-up action are discussed separately. ROLLING UP OR DOWN AS A DEFENSIVE ACTION The reader should already be familiar with the definition of a rolling action: The cur­ rently written calls are bought back and calls at a different striking price are written. The ratio writer can use rolling actions to his advantage to readjust his position if the underlying stock moves to the edges of his profit range. The reason one of the selection criteria for a ratio write was the availability of both the next higher and next lower striking prices was to facilitate the rolling actions that might become necessary as a follow-up measure. Since an option has its great­ est time premium when the stock price and the striking price are the same, one would normally want to roll exactly at a striking price. Example: A ratio writer bought 100 XYZ at 49 and sold two October 50 calls at 6 points each. Subsequently, the stock drops in price and the following prices exist: XYZ, 40; XYZ October 50, l; and XYZ October 40, 4. One would roll down to the October 40 calls by buying back the 2 October 50's that he is short and selling 2 October 40's. In so doing, he would reestablish a somewhat neutral position. His profit on the buy-back of the October 50 calls would be 5 points each - they were originally sold for 6 - and he would realize a 10-point gain on the two calls. This 10-point gain effectively reduces his stock cost from 49 to 39, so that he now has the equivalent of the following position: long 100 XYZ at 39 and short 2 XYZ October 40 calls at 4. This adjusted ratio write has a profit range of 31 to 49 and is thus a new, neutral position with the stock currently at 40. The investor is now in a position to make profits if XYZ remains near this level, or to take further defensive action if the stock experiences a relatively large change in price again. Defensive action to the upside - rolling up -works in much the same manner. Chapter 6: Ratio Call Writing 159 Example: The initial position again consists of buying 100 XYZ at 49 and selling two October 50 calls at 6. If XYZ then rose to 60, the following prices might exist: XYZ, 60; XYZ October 50, 11; and XYZ October 60, 6. The ratio writer could thus roll this position up to reestablish a neutral profit range. If he bought back the two October 50 calls, he would take a 5-point loss on each one for a net loss on the calls of 10 points. This would effectively raise his stock cost by 10 points, to a price of 59. The rolled-up position would then be long 100 XYZ at 59 and short 2 October 60 calls at 6. This new, neutral position has a profit range of 47 to 73 at October expiration. In both of the examples above, the writer could have closed out the ratio write at a very small profit of about 1 point before commissions. This would not be advis­ able, because of the relatively large stock commissions, unless he expects the stock to continue to move dramatically. Either rolling up or rolling down gives the writer a fairly wide new profit range to work with, and he could easily expect to make more than 1 point of profit if the underlying stock stabilizes at all. Having to take rolling defensive action immediately after the position is estab­ lished is the most detrimental case. If the stock moves very quickly after having set up the position, there will not be much time for time value premium erosion in the written calls, and this will make for smaller profit ranges after the roll is done. It may be useful to use technical support and resistance levels as keys for when to take rolling action if these levels are near the break-even points and/or striking prices. It should be noted that this method of defensive action - rolling at or near strik­ ing prices - automatically means that one is buying back little or no time premium and is selling the greatest amount of time premium currently available. That is, if the stock rises, the call's premium will consist mostly of intrinsic value and very little of time premium value, since it is substantially in-the-money. Thus, the writer who rolls up by buying back this in-the-money call is buying back mostly intrinsic value and is selling a call at the next strike. This newly sold call consists mostly of time value. By continually buying back "real" or intrinsic value and by selling "thin air" or time value, the writer is taking the optimum neutral action at any given time. If a stock undergoes a dramatic move in one direction or the other, the ratio writer will not be able to keep pace with the dramatic movement by remaining in the same ratio. Example: If XYZ was originally at 49, but then undergoes a fairly straight-line move to 80 or 90, the ratio writer who maintains a 2:1 ratio will find himself in a deplorable situation. He will have accumulated rather substantial losses on the calls and will not be able to compensate for these losses by the gain in the underlying stock. A similar 160 Part II: Call Option Strategies situation could arise to the downside. If:X'YZ were to plunge from 49 to 20, the ratio writer would make a good deal of profit from the calls by rolling down, but may still have a larger loss in the stock itself than the call profits can compensate for. Many ratio writers who are large enough to diversify their positions into a num­ ber of stocks will continue to maintain 2:1 ratios on all their positions and will simply close out a position that has gotten out of hand by running dramatically to the upside or to the downside. These traders believe that the chances of such a dramatic move occurring are small, and that they will take the infrequent losses in such cases in order to be basically neutral on the other stocks in their portfolios. There is, however, a way to combat this sort of dramatic move. This is done by altering the ratio of the covered write as the stock moves either up or down. For example, as the underlying stock moves up dramatically in price, the ratio writer can decrease the number of calls outstanding against his long stock each time he rolls. Eventually, the ratio might decrease as far as 1:1, which is nothing more than a cov­ ered writing situation. As long as the stock continues to move in the same upward direction, the ratio writer who is decreasing his ratio of calls outstanding will be giv­ ing more and more weight to the stock gains in the ratio write and less and less weight to the call losses. It is interesting to note that this decreasing ratio effect can also be produced by buying extra shares of stock at each new striking price as the stock moves up, and simultaneously keeping the number of outstanding calls written con­ stant. In either case, the ratio of calls outstanding to stock owned is reduced. When the stock moves down dramatically, a similar action can be taken to increase the number of calls written to stock owned. Normally, as the stock falls, one would sell out some of his long stock and roll the calls down. Eventually, after the stock falls far enough, he would be in a naked writing position. The idea is the same here: As the stock falls, more weight is given to the call profits and less weight is given to the stock losses that are accumulating. This sort of strategy is more oriented to extremely large investors or to firm traders, market-makers, and the like. Commissions will be exorbitant if frequent rolls are to be made, and only those investors who pay very small commissions or who have such a large holding that their commissions are quite small on a percentage basis will be able to profit substantially from such a strategy. ADJUSTING WITH THE DELTA The delta of the written calls can be used to determine the correct ratio to be used in this ratio-adjusting defensive strategy. The basic idea is to use the call's delta to remain as neutral as possible at all times. Cl,apter 6: Ratio Call Writing 161 Example: An investor initially sets up a neutral 5:3 ratio of XYZ October 50 calls to XYZ stock, as was determined previously. The stock is at 49 and the delta is .60. Furthermore, suppose the stock rises to 57 and the call now has a delta of .80. The neutral ratio would currently be 1/.80 ( = 1.20) or 5:4. The ratio writer could thus buy another 100 shares of the underlying stock. Alternatively, he might buy in one of the short calls. In this particular example, buying in one call would produce a 4:3 ratio, which is not absolutely correct. If he had had a larger position initially, it would be easier to adjust to fractional ratios. When the stock declines, it is necessary to increase the ratio. This can be accom­ plished by either selling more calls or selling out some of the long stock. In theory, these adjustments could be made constantly to keep the position neutral. In practice, one would allow for a few points of movement by the underlying stock before adjust­ ing. If the underlying stock rises too far, it may be logical for the neutral strategist to adjust by rolling up. Similarly, he would roll down if the stock fell to or below the next lower strike. The neutral ratio in that case is determined by using the delta of the option into which he is rolling. Example: With XYZ at 57, an investor is contemplating rolling up to the October 60's from his present position of long 300 shares and short 5 XYZ October 50's. If the October 60 has a delta of .40, the neutral ratio for the October 60's is 2.5:l (1 + .40). Since he is already long 300 shares of stock, he should now be short 7.5 calls (3 x 2.5). Obviously, he would sell 7 or 8, probably depending on his short-term outlook for the stock. If one prefers to adopt an even more sophisticated approach, he can make adjustments between striking prices by altering his stock position, and can make adjustments by rolling up or down if the stock reaches a new striking price. For those who prefer formulae, the following ones summarize this information: 1. When establishing a new position or when rolling up or down, at the next strike: N b f all t 11 Round lots held long um er o c s o se = Delta of call to be sold Note: When establishing a new position, one must first decide how many shares of the underlying stock he can buy before utilizing the formula; 1,000 shares would be a workable amount. 2. When adjusting between strikes by buying or selling stock: 162 Part II: Call Option Strategies Number of round lots = Current delta x Number of short calls - Round lots held long to buy Note: If a negative number results, stock should be sold, not bought. These formulae can be verified by using the numbers from the examples above. For example, when the delta of the October 50 was .80 with the stock at 57, it was seen that buying 100 shares of stock would reestablish a neutral ratio. Number of round lots to buy= .80 x 5 3 = 4- 3 = 1 Also, if the position was to be rolled up to the October 60 (delta = .40), it was seen that 7.5 October 60's would theoretically be sold: Number of calls to sell = __l_ = 7.5 .40 There is a more general approach to this problem, one that can be applied to any strategy, no matter how complicated. It involves computing whether the position is net short or net long. The net position is reduced to an equivalent number of shares of common stock and is commonly called the "equivalent stock position" (ESP). Here is a simple formula for the equivalent stock position of any option position: ESP = Option quantity x Delta x Shares per option Example: Suppose that one is long 10 XYZ July 50 calls, which currently have a delta of .45. The option is an option on 100 shares of XYZ. Thus, the ESP can be computed: ESP = 10 x .45 x 100 = 450 shares This is merely saying that owning 10 of these options is equivalent to owning 450 shares of the underlying common stock, XYZ. The reader should already understand this, in that an option with a delta of .45 would appreciate by .45 points if the com­ mon stock moved up 1 dollar. Thus, 10 options would appreciate by 4.5 points, or $450. Obviously, 450 shares of common stock would also appreciate by $450 if they moved up by one point. Note that there are some options - those that result from a stock split- that are for more than 100 shares. The inclusion of the term "shares per option" in the for­ mula accounts for the fact that such options are equivalent to a different amount of stock than most options. The ESP of an entire option and stock position can be computed, even if sev­ eral different options are included in the position. The advantage of this simple cal- Chapter 6: Ratio Call Writing 163 culation is that an entire, possibly complex option position can be reduced to one number. The ESP shows how the position will behave for short-term market move­ ments. Look again at the previous example of a ratio write. The position was long 300 shares and short 5 options with a current delta of .80 after the stock had risen to 57. The ESP of the 5 October 50's is short 400 shares (5 x .80 x 100 shares per option). The position is also long 300 shares of stock, so the total ESP of this ratio write is short 100 shares. This figure gives the strategist a measure of perspective on his position. He now knows that he has a position that is the equivalent of being short 100 shares of XYZ. Perhaps he is bearish on XYZ and therefore decides to do nothing. That would be fine; at least he knows that his position is short. Normally, however, the strategist would want to adjust his position. Again returning to the previous example, he has several choices in reducing the ESP back to neutral. An ESP of O is considered to be a perfectly neutral position. Obviously, one could buy 100 shares of XYZ to reduce the 100-share delta short. Or, given that the delta of the October 50 call is .80, he could buy in 1.25 of these short calls (obvi­ ously he could only buy l; fractional options cannot be purchased). Later chapters include more discussions and examples using the ESP. It is a vital concept that no strategist who is operating positions involving multiple options should be without. The only requirement for calculating it is to know the delta of the options in one's position. Those are easily obtainable from one's broker or from a number of computer services, software programs, or Web sites. For investors who do not have the funds or are not in a position to utilize such a ratio adjusting strategy, there is a less time-consuming method of taking defensive action in a ratio write. USING STOP ORDERS AS A DEFENSIVE STRATEGY A ratio writer can use buy or sell stops on his stock position in order to automatical­ ly and unemotionally adjust the ratio of his position. This type of defensive strategy is not an aggressive one and will provide some profits unless a whipsaw occurs in the underlying stock. As an example of how the use of stop orders can aid the ratio writer, let us again assume that the same basic position was established by buying XYZ at 49 and selling two October 50 calls at 6 points each. This produces a profit range of 37 to 63 at expi­ ration. If the stock begins to move up too far or to fall too far, the ratio writer can adjust the ratio of calls short to stock long automatically, through the use of stop orders on his stock. 164 Part II: Call Option Strategies Example: An investor places a "good until canceled" stop order to buy 100 shares of XYZ at 57 at the same time that he establishes the original position. If XYZ should get to 57, the stop would be set off and he would then own 200 shares ofXYZ and be short 2 calls. That is, he would have a 200-share covered write of XYZ October 50 calls. To see how such an action affects his overall profit picture, note that his average stock cost is now 53; he paid 49 for the first 100 shares and paid 57 for the second 100 shares bought via the stop order. Since he sold the calls at 6 each, he essentially has a covered write in which he bought stock at 53 and sold calls for 6 points. This does not represent a lot of profit potential, but it will ensure some profit unless the stock falls back below the new break-even point. This new break-even point is 47 - the stock cost, 53, less the 6 points received for the call. He will realize the maximum profit potential from the covered write as long as the stock remains above 50 until expira­ tion. Since the stock is already at 57, the probabilities are relatively strong that it will remain above 50, and even stronger that it will remain above 47, until the expiration date. If the buy stop order was placed just above a technical resistance area, this prob­ ability is even better. Hence, the use of a buy stop order on the upside allows the ratio writer to auto­ matically convert the ratio write into a covered write if the stock moves up too far. Once the stop goes off, he has a position that will make some profit as long as the stock does not experience a fairly substantial price reversal. Downside protective action using a sell stop order works in a similar manner. Example: The investor placed a "good until canceled" sell stop for 100 shares of stock after establishing the original position. If this sell stop were placed at 41, for example, the position would become a naked call writer's position if the stock fell to 41. At that time, the 100 shares of stock that he owned would be sold, at an 8-point loss, but he would have the capability of making 12 points from the sale of his two calls as long as the stock remained below 50 until expiration. In fact, his break-even point after converting into the naked write would actually be 52 at expiration, since at that price, the calls could be bought back for 2 points each, or 8 points total prof­ it, to offset the 8-point loss on the stock. This action limits his profit potential, but will allow him to make some profit as long as the stock does not experience a strong price reversal and climb back above 52 by expiration. There are several advantages for inexperienced ratio writers to using this method of protection. First, the implementation of the protective strategies - buying an extra 100 shares of stock if the stock moves up, or selling out the 100 shares that are long if the stock moves down - is unemotional if the stop orders are placed at the Chapter 6: Ratio Call Writing 165 same time that the original position is established. This prevents the writer from attempting to impose his own market judgment in the heat of battle. That is, if XYZ has moved up to 57, the writer who has not placed a buy stop order may be tempted to wait just a little longer, hoping for the stock to fall in price. If the stop orders are placed as soon as the position is established, a great deal of emotion is removed. Second, this strategy will produce some profit - assuming that the stops are proper­ ly placed as long as the stock does not whipsaw or experience a price reversal and go back through the striking price in the other direction. Most follow-up actions in any writing strategy, whether they involve rolling actions or the use of stops, are sub­ ject to losses if the stock whipsaws back and forth. The disadvantage to using this type of protective action is that the writer may be tying up relatively large amounts of capital in order to make only a small profit after the stop order is set off. However, in a diversified portfolio, only a small per­ centage of the stocks may go through their stop points, thereby still allowing the ratio writer plenty of profit potential on his other positions. Once either the buy stop or the sell stop is set off, the writer still needs to watch the position. His first action after one stop is touched should be to cancel the other stop order, because the stops are good orders until they are canceled. From that time on, the writer need do nothing if the stock does not experience a price reversal. In fact, he would just as soon have the stock experience a greater move in the same direction to minimize the chances of a price reversal. If a price reversal does occur, the most conservative action is to close out the position just after the stock crosses back through the striking price. This will normal­ ly result in a small loss, but, again, it should happen in only a relatively small number of his positions. Recall that .in a limited profit strategy such as ratio writing, it is important to limit losses as well. If the stock does indeed whipsaw and the position is closed, the writer will still have most of his original equity and can then reestablish a new position in another underlying stock. Placement of Stops. The writer would ideally like to place his stops at prices that allow a reasonable rate of return to be made, while also having the stops far enough away from the original striking price to reduce the chances of a whipsaw occurring. It is a fairly simple matter to calculate the returns that could be made, after commissions are included, if one or the other of the stops goes off. Dividends should be included as well, since they will accrue to the writer. If the writer is willing to accept returns as low as 5% annually for those positions that go through their stop points, he will be able to place his stops far­ ther from the original striking price. If he feels that he needs a higher return when the stops go off, the stops must be placed closer in. As with any stock or 166 Part II: Call Option Strategies option investment, the writer who operates in large size will experience less of a commission charge, percentagewise. That is, the writer who is buying 500 shares of stock and selling 10 calls to start with will be able to place his stop points far­ ther out than the writer who is buying 100 shares of stock and selling 2 calls. Technical analysis can be helpful in selecting the stop points as well. If there is resistance overhead, the buy stop should be placed above that resistance. Similarly, if there is support, the sell stop should be placed beneath the support point. Later, when straddles are discussed, it will be seen that this type of strategy can be operat­ ed at less of a net commission charge, since the purchase and sale of stock will not be involved. CLOSING OUT THE WRITE The methods of follow-up action discussed above deal ,vith the eventuality of pre­ venting losses. However, if all goes well, the ratio write will begin to accrue profits as the stock remains relatively close to the original striking price. To retain these paper profits that have accrued, it is necessary to move the protective action points closer together. Example: XYZ is at 51 after some time has passed, and the calls are at 3 points each. The writer would, at this time, have an unrealized profit of $800 - $200 from the stock purchase at 49, and $300 each on the two calls, which were originally sold at 6 points each. Recall that the maximum potential profit from the position, ifXYZ were exactly at 50 at expiration, is $1,300. The writer would like to adjust the protective points so that nearly all of the $800 paper profit might be retained while still allow­ ing for the profit to grow to the $1,300 maximum. At expiration, $800 profit would be realized ifXYZ were at 45 or at 55. This can be verified by referring again to Table 6-1 and Figure 6-1. The 45 to 55 range is now the area that the writer must be concerned with. The original profit range of 39 to 61 has become meaningless, since the position has performed well to this point in time. If the writer is using the rolling method of protection, he would roll forward to the next expiration series if the stock were to reach 45 or 55. If he is using the stop-out method of protection, he could either close the position at 45 or 55 or he could roll to the next expiration series and readjust his stop points. The neutral strategist using deltas would determine the number of calls to roll forward to by using the delta of the longer-term call. By moving the protective action points closer together, the ratio writer can then adjust his position while he still has a profit; he is attempting to "lock in" his profit. As even more time passes and expiration draws nearer, it may be possible to move Chapter 6: Ratio Call Writing 167 the protective points even closer together. Thus, as the position continues to improve over time, the writer should be constantly "telescoping" his action points and finally roll out to the next expiration series. This is generally the more prudent move, because the commissions to sell stock to close the position and then buy another stock to establish yet another position may prove to be prohibitive. In summary, then, as a ratio write nears expiration, the writer should be concerned with an ever-nar­ rowing range within which his profits can grow but outside of which his profits could dissipate if he does not take action. COMMENTS ON DELTA-NEUTRAL TRADING Since the concept of delta-neutral positions was introduced in this chapter, this is an appropriate time to discuss them in a general way. Essentially, a delta-neutral position is a hedged position in which at least two securities are used - two or more different options, or at least one option plus the underlying. The deltas of the two securities offset each other so that the position starts out with an "equivalent stock position" (ESP) of 0. Another term for ESP is "position delta." Thus, in theory, there is no price risk to begin with; the position is neutral with respect to price movement of the underlying. That definition lasts for about a nanosecond. As soon as time passes, or the stock moves, or implied volatility changes, the deltas change and therefore the position is no longer delta-neutral. Many people seem to have the feeling that a delta-neutral position is somehow one in which it is easy to make money without predicting the price direction of the underlying. That is not true. Delta-neutral trading is not "easy": Either (1) one assumes some price risk as soon as the stock begins to move, or (2) one keeps constantly adjusting his deltas to keep them neutral. Method 2 is not feasible for public traders because of commis­ sions. It is even difficult for market-makers, who pay no commissions. Most public practitioners of delta-neutral trading establish a neutral position, but then refrain from adjusting it too often. A common mistake that novice traders make with delta-neutral trading is to short options in a neutral manner, figuring that they have little exposure to price change because the position is delta-neutral. However, a sizeable move by the under­ lying (which often happens in a short period of time) ruins the neutrality of the posi­ tion and inevitably costs the trader a lot of money. A simple example: If one sells a naked straddle (i.e., he sells a naked put and a naked call with both having the same striking price) with the stock initially just below the strike price, that's a delta-ne~tral 168 Part II: Call Option Strategies position. However, the position has naked options on both sides, and therefore has tremendous liability. In practice, professionals watch more than just the delta; they also watch other measures of the risk of a position. Even then, price and volatility changes can cause problems. Advanced risk concepts are addressed more fully in the chapter on Advanced Concepts. SUMMARY Ratio writing is a viable, neutral strategy that can be employed with differing levels of sophistication. The initial ratio of short calls to long stock can be selected simplis­ tically by comparing one's opinion for the underlying stock with projected break-even points from the position. In a more sophisticated manner, the delta of the written calls can be used to determine the ratio. Since the strategy has potentially large losses either to the upside or the down­ side, follow-up action is mandatory. This action can be taken by simple methods such as rolling up or down in a constant ratio, or by placing stop orders on the underlying stock. A more sophisticated technique involves using the delta of the option to either adjust the stock position or roll to another call. By using the delta, a theoretically neu­ tral position can be maintained at all times. Ratio writing is a relatively sophisticated strategy that involves selling naked calls. It is therefore not suitable for all investors. Its attractiveness lies in the fact that vast quantities of time value premium are sold and the strategy is profitable for the most probable price outcomes of the underlying stock. It has a relatively large prob­ ability of making a limited profit, if the position can be held until expiration without frequent adjustment. AN INTRODUCTION TO CALL SPREAD STRATEGIES A spread is a transaction in which one simultaneously buys one option and sells another option, with different terms, on the same underlying security. In a call spread, the options are all calls. The basic idea behind spreading is that the strategist is using the sale of one call to reduce the risk of buying another call. The short call in a spread is considered covered, for margin purposes, only if the long call has an expi­ ration date equal to or longer than the short call. Before delving into the individual types of spreads, it may be beneficial to cover some general facts that pertain to most spread situations. Chapter 6: Ratio Call Writing 169 All spreads fall into three broad categories: vertical, horizontal, or diagonal. A vertical spread is one in which the calls involved have the same expiration date but different striking prices. An example might be to buy the XYZ October 30 and sell the October 35 simultaneously. A horizontal spread is one in which the calls have the same striking price but different expiration dates. This is a horizontal spread: Sell the XYZ January 35 and buy the XYZ April 35. A diagonal spread is any combination of vertical and horizontal and may involve calls that have different expiration dates as well as different striking prices. These three names that classify the spreads can be related to the way option prices are listed in any newspaper summary of closing option prices. A vertical spread involves two options from the same column in a news­ paper listing. Newspaper columns run vertically. A horizontal spread involves two calls whose prices are listed in the same row in a newspaper listing; rows are hori­ zontal. This relationship to the listing format in newspapers is not important, but it is an easy way to remember what vertical spreads and horizontal spreads are. There are many types of vertical and horizontal spreads, and several of them are discussed in detail in later chapters. SPREAD ORDER The term "spread" designates not only a type of strategy, but a type of order as well. All spread transactions in which both sides of the spread are opening (initial) trans­ actions must be done in a margin account. This means that the customer must gen­ erally maintain a minimum equity in the account, normally $2,000. Some brokerage houses may also have a maintenance requirement, or "kicker." It is possible to transact a spread in a cash account, but one of the sides must be a closing transaction. In fact, many of the follow-up actions taken in the covered writ­ ing strategy are actually spread transactions. Suppose a covered writer is currently short one XYZ April call against 100 shares of the underlying stock. If he wants to roll forward to the July 35 call, he will be buying back the April 35 and selling the July 35 simultaneously. This is a spread transaction, technically, since one call is being bought and the other is being sold. However, in this transaction, the buy side is a closing transaction and the sell side is an opening transaction. This type of spread could be done in a cash account. Whenever a covered writer is rolling - up, down, or fmward he should place the order as a spread order to facilitate a better price execution. The spreads discussed in the following chapters are predominantly spread strategies, ones in which both sides of the spread are opening transactions. These are designed to have their own profit and risk potentials, and are not merely follow-up actions to some previously discussed strategy. 170 Part II: Call Option Strategies When a spread order is entered, the options being bought and sold must be specified. Two other items must be specified as well: the price at which the spread is to be executed, and whether that price is a credit or a debit. If the total price of the spread results in a cash inflow to the spread strategist, the spread is a credit spread. This merely means that the sell side of the spread brings in a higher price than is paid for the buy side of the spread. If the reverse is true - that is, there is a cash outflow from the spread transaction - the spread is said to be a debit spread. This means that the buy side of the spread costs more than is received from the sell side. It is also common to refer to the purchased side of the spread as the long side and to refer to the written side of the spread as the short side. The price at which a certain spread can be executed is generally not the differ­ ence between the last sale prices of the two options involved in the spread. Example: An investor wants to buy an XYZ October 30 and simultaneously sell an XYZ October 35 call. If the last sale price of the October 30 was 4 points and the last sale price of the October 35 was 2 points, it does not necessarily mean that the spread could be done for a 2-point debit (the difference in the last sale prices). In fact, the only way to detennine the market price for a spread transaction is to know what the bid and asked prices of the options involved are. Suppose the following quotes are available on these two calls: October 30 call October 35 call Bid 37/s F/s Asked 41/s 2 Lost Sole 4 2 Since the spread in question involves buying the October 30 call and selling the October 35, the spreader will, at market, have to pay 41/s for the October 30 ( the asked or offering quote) and will receive only F/s (the bid quote) for the October 35. This results in a debit of 2¼ points, significantly more than the 2-point difference in the last sale prices. Of course, one is free to specify any price he wants for any type of transaction. One might enter this spread order at a 21/s-point debit and could have a reasonable chance of having the order filled if the floor broker can do better than the bid side on the October 35 or better than the offering side on the October 30. The point to be learned here is that one cannot assume that last sale prices are indicative of the price at which a spread transaction can be executed. This makes computer analysis of spread transactions via closing price data somewhat difficult. Some computer data services offer (generally at a higher cost) closing bid and asked prices as well as closing sale prices. If a strategist is forced to operate with closing O,apter 6: Ratio Call Writing 171 prices only, however, he should attempt to build some screens into his output to allow for the fact that last sale prices might not be indicative of the price at which the spread can be executed. One simple method for screening is to look only at relative­ ly liquid options - that is, those that have traded a substantial number of contracts during the previous trading day. If an option is experiencing a great deal of trading activity, there is a much better chance that the current quote is "tight," meaning that the bid and offering prices are quite close to the last sale price. In the early days of listed options, it was somewhat common practice to "leg" into a spread. That is, the strategist would place separate buy and sell orders for the two transactions comprising his spread. As the listed markets have developed, adding depth and liquidity, it is generally a poor idea to leg into a spread. If the floor broker handling the transaction knows the entire transaction, he has a much better chance of "splitting a quote," buying on the bid, or selling on the offering. Splitting a quote merely means executing at a price that is between the current bid and asked prices. For example, if the bid is 37/s and the offering is 41/s, a transaction at a price of 4 would be "splitting the quote." The public customer must be aware that spread transactions may involve sub­ stantially higher commission costs, because there are twice as many calls involved in any one transaction. Some brokers offer slightly lower rates for spread transactions, but these are not nearly as low as spreads in commodity trading, for example. CHAPTER 7 Bull Spreads The bull spread is one of the most popular forms of spreading. In this type of spread, one buys a call at a certain striking price and sells a call at a higher striking price. Generally, both options have the same expiration date. This is a vertical spread. A bull spread tends to be profitable if the underlying stock rrwves up in price; hence, it is a bullish position. The spread has both limited profit potential and limited risk. Although both can be substantial percentagewise, the risk can never exceed the net investment. In fact, a bull spread requires a smaller dollar investment and therefore has a smaller maximum dollar loss potential than does an outright call purchase of a similar call. Example: The following prices exist: XYZ common, 32; XYZ October 30 call, 3; and XYZ October 35 call, 1. A bull spread would be established by buying the October 30 call and simultaneous­ ly selling the October 35 call. Assume that this could be done at the indicated 2-point debit. A call bull spread is always a debit transaction, since the call with the lower striking price must always trade for more than a call with a higher price, if both have the same expiration date. Table 7-1 and Figure 7-1 depict the results of this transac­ tion at expiration. The indicated call profits or losses would be realized if the calls were liquidated at parity at expiration. Note that the spread has a maximum profit and this profit is realized if the stock is anywhere above the higher striking price at expiration. The maxipmm loss is realized if the stock is anywhere below the lower strike at expiration, and is equal to the net investment, 2 points in this example. 172 Chapter 7: Bull Spreads 173 Moreover, there is a break-even point that always lies between the two striking prices at expiration. In this example, the break-even point is 32. All bull spreads have prof­ it graphs with the same shape as the one shown in Figure 7-1 when the expiration dates are the same for both calls. The investor who establishes this position is bullish on the underlying stock, but is generally looking for a way to hedge himself. If he were rampantly bullish, he TABLE 7-1. Results at expiration of bull spread. XYZ Price of Expiration 25 30 32 35 40 45 FIGURE 7-1. Bull spread. c: +$300 .Q ~ -~ w October 30 Profit -$ 300 - 300 100 + 200 + 700 + 1,200 October 35 Profit +$100 + 100 + 100 + 100 - 400 - 900 ,, ,,,' ;ff ,,,' ,,' iii ~ ,,,,' $01---------'----J...__.... _ ___. _____ _ 30 3:?,,' 35 0 ::: -$200 e 0..-$300 , , ..------,,,,,' Call Purchase •-----------,' Stock Price at Expiration Total Profit -$200 - 200 0 + 300 + 300 + 300 174 Part II: Call Option Strategies would merely buy the October 30 call outright. However, the sale of the October 35 call against the purchase of the October 30 allows him to take a position that will out­ perform the outright purchase of the October 30, dollarwise, as long as the stock does not rise above 36 by expiration. This fact is demonstrated by the dashed line in Figure 7-1. Therefore, the strategist establishing the bull spread is bullish, but not overly so. To verify that this comparison is correct, note that if one bought the October 30 call outright for 3 points, he would have a 3-point profit at expiration if XYZ were at 36. Both strategies have a 3-point profit at 36 at expiration. Below 36, the bull spread does better because the sale of the October 35 call brings in the extra point of pre­ mium. Above 36 at expiration, the outright purchase outperforms the bull spread, because there is no limit on the profits that can occur in an outright purchase situa­ tion. The net investment required for a bull spread is the net debit plus commissions. Since. the spread must be transacted in a margin account, there will generally be a minimum equity requirement imposed by the brokerage firm. In addition, there may be a maintenance requirement by some brokers. Suppose that one was establishing 10 spreads at the prices given in the example above. His investment, before com­ missions, would be $2,000 ($200 per spread), plus commissions. It is a simple matter to compute the break-even point and the maximum profit potential of a call bull spread: Break-even point= Lower striking price+ Net debit of spread Maximum profit _ Higher striking _ Lower striking _ Net debit potential - price price of spread In the example above, the net debit was 2 points. Therefore, the break-even point would be 30 + 2, or 32. The maximum profit potential would be 35 - 30 - 2, or 3 points. These figures agree with Table 7-1 and Figure 7-1. Commissions may rep­ resent a significant percentage of the profit and net investment, and should therefore be calculated before establishing the position. If these commissions are included in the net debit to establish the spread, they conveniently fit into the preceding formu­ lae. Commission charges can be reduced percentagewise by spreading a larger quan­ tity of calls. For this reason, it is generally advisable to spread at least 5 options at a time. Chapter 7: Bull Spreads 175 DEGREES OF AGGRESSIVENESS AGGRESSIVE BULL SPREAD Depending on how the bull spread is constructed, it may be an extremely aggressive or more conservative position. The most commonly used bull spread is of the aggres­ sive type; the stock is generally well below the higher striking price when the spread is established. This aggressive bull spread generally has the ability to generate sub­ stantial percentage returns if the underlying stock should rise in price far enough by expiration. Aggressive bull spreads are most attractive when the underlying common stock is relatively close to the lower striking price at the time the spread is established. A bull spread established under these conditions will generally be a low-cost spread with substantial profit potential, even after commissions are included. EXTREMELY AGGRESSIVE BULL SPREAD An extremely aggressive type of bull spread is the "out-of-the-money" spread. In such a spread, both calls are out-of-the-money when the spread is established. These spreads are extremely inexpensive to establish and have large potential profits if the stock should climb to the higher striking price by expiration. However, they are usu­ ally quite deceptive in nature. The underlying stock has only a relatively remote chance of advancing such a great deal by expiration, and the spreader could realize a 100% loss of his investment even if the underlying stock advances moderately, since both calls are out-of-the-money. This spread is akin to buying a deeply out-of-the­ money call as an outright speculation. It is not recommended that such a strategy be pursued with more than a very small percentage of one's speculative funds. LEAST AGGRESSIVE BULL SPREAD Another type of bull spread can be found occasionally - the "in-the-money" spread. In this situation, both calls are in-the-money. This is a much less aggressive position, since it offers a large probability of realizing the maximum profit potential, although that profit potential will be substantially smaller than the profit potentials offered by the more aggressive bull spreads. Example: XYZ is at 37 some time before expiration, and the October 30 call is at 7 while the October 35 call is at 4. Both calls are in-the-money and the spread would cost 3 points (debit) to establish. The maximum profit potential is 2 points, but it would be realized as long as XYZ were above 35 at expiration. That is, XYZ could fall by 2 points and the spreader would still make his maximum profit. This is certainly a more conservative position than the aggressive spread described above. The com- 176 Part II: Call Option Strategies mission costs in this spread would be substantially larger than those in the spreads above, which involve less expensive options initially, and they should therefore be fig­ ured into one's profit calculations before entering into the spread transaction. Since this stock would have to decline 7 points to fall below 30 and cause a loss of the entire investment, it would have to be considered a rather low-probability event. This fact adds to the less aggressive nature of this type of spread. RANKING BULL SPREADS To accurately compare the risk and reward potentials of the many bull spreads that are available in a given day, one has to use a computer to perform the mass calcula­ tions. It is possible to use a strictly arithmetic method of ranking bull spreads, but such a list will not be as accurate as the correct method of analysis. In reality, it is necessary to incorporate the volatility of the underlying stock, and possibly the expected return from the spread as well, into one's calculations. The concept of expected return is described in detail in Chapter 28, where a bull spread is used as an example. The exact method for using volatility and predicting an option's price after an upward movement are presented later. Many data services offer such information. However, if the reader wants to attempt a simpler method of analysis, the following one may suffice. In any ranking of bull spreads, it is important not to rank the spreads by their maximum potential profits at expiration. Such a ranking will always give the most weight to deeply out-of-the-money spreads, which can rarely achieve their max­ imum profit potential. It would be better to screen out any spreads whose maximum profit prices are too far away from the current stock price. A simple method of allow­ ing for a stock's movement might be to assume that the stock could, at expiration, advance by an amount equal to twice the time value premium in an at-the-money call. Since more volatile stocks have options with greater time value premium, this is a simple attempt to incorporate volatility into the analysis. Also, since longer-term options have more time value premium than do short-term options, this will allow for larger movements during a longer time period. Percentage returns should include commission costs. This simple analysis is not completely correct, but it may prove useful to those traders looking for a simple arithmetic method of analysis that can be computed quickly. FURTHER CONSIDERATIONS The bull spreads described in previous examples utilize the same expiration date for both the short call and the long call. It is sometimes useful to buy a call with a longer Chapter 7: Bull Spreads 177 time to maturity than the short call has. Such a position is known as a diagonal bull spread and is discussed in a later chapter. Experienced traders often tum to bull spreads when options are expensive. The sale of the option at the higher strike partially mitigates the cost of buying an expen­ sive option at the lower strike. However, one should not always use the bull spread approach just because the options have a lot of time value premium, for he would be giving up a lot of upside profit potential in order to have a hedged position. With most types of spreads, it is necessary for some time to pass for the spread to become significantly profitable, even if the underlying stock moves in favor of the spreader. For this reason, bull spreads are not for traders unless the options involved are very short-term in nature. If a speculator is bullishly oriented for a short-term upward move in an underlying stock, it is generally better for him to buy a call out­ right than to establish a bull spread. Since the spread differential changes mainly as a function of time, small movements in price by the underlying stock will not cause much of a short-term change in the price of the spread. However, the bull spread has a distinct advantage over the purchase of a call if the underlying stock advances mod­ erately by expiration. In the previous example, a bull spread was established by buying the XYZ October 30 call for 3 points and simultaneously selling the October 35 call for 1 point. This spread can be compared to the outright purchase of the XYZ October 30 alone. There is a short-term advantage in using the outright purchase. Example: The underlying stock jumps from 32 to 35 in one day's time. The October 30 would be selling for approximately 5½ points if that happened, and the outright purchaser would be ahead by 2½ points, less one option commission. The long side of the bull spread would do as well, of course, since it utilizes the same option, but the short side, the October 35, would probably be selling for about 2½ points. Thus, the bull spread would be worth 3 points in total (5½ points on the long side, less 2½ points loss on the short side). This represents a 1-point profit to the spreader, less two option commissions, since the spread was initially established at a debit of 2 points. Clearly, then, for the shortest time period one day - the outright purchase outper­ forms the bull spread on a quick rise. For a slightly longer time period, such as 30 days, the outright purchase still has the advantage if the underlying stock moves up quickly. Even if the stock should advance above 35 in 30 days, the bull spread will still have time premium in it and thus will not yet have reached its maximum spread potential of 5 points. Recall that the maximum potential of a bull spread is always equal to the difference between the striking prices. Clearly, the outright purchaser will do very well if the underlying stock should advance that far in 30 days' time. When risk is considered, however, it 178 Part II: Call Option Strategies must be pointed out that the bull spread has fewer dollars at risk and, if the under­ lying stock should drop rather than rise, the bull spread will often have a smaller loss than the outright call purchase would. The longer it takes for the underlying stock to advance, the more the advantage swings to the spread. Suppose XYZ does not get to 35 until expiration. In this case, the October 30 call would be worth 5 points and the October 35 call would be worth­ less. The outright purchase of the October 30 call would make a 2-point profit less one commission, but the spread would now have a 3-point profit, less two commis­ sions. Even with the increased commissions, the spreader will make more of a prof­ it, both dollarwise and percentagewise. Many traders are disappointed with the low profits available from a bull spread when the stock rises almost immediately after the position is established. One way to partially off set the problem with the spread not widening out right away is to use a greater distance between the two strikes. When the distance is great, the spread has room to widen out, even though it won't reach its maximum profit potential right away. Still, since the strikes are "far apart," there is more room for the spread to widen even if the underlying stock rises immediately. The conclusion that can be drawn from these examples is that, in general, the outright purchase is a better strategy if one is looking for a quick rise by the under­ lying stock. Overall, the bull spread is a less aggressive strategy than the outright pur­ chase of a call. The spread will not produce as much of a profit on a short-term move, or on a sustained, large upward move. It will, however, outperform the outright pur­ chase of a call if the stock advances slowly and moderately by expiration. Also, the spread always involves fewer actual dollars of risk, because it requires a smaller debit to establish initially. Table 7-2 summarizes which strategy has the upper hand for var­ ious stock movements over differing time periods. TABLE 7-2. Bull spread and outright purchase compared. If the underlying stock ... Remains Relatively Advonces Advances Declines Unchanged Moderately Substantially in ... 1 week Bull spread Bull spread Outright purchase Outright purchase 1 month Bull spread Bull spread Outright purchase Outright purchase At expiration Bull spread Bull spread Bull spread Outright purchase Chapter 7: Bull Spreads FOLLOW-UP ACTION 179 Since the strategy has both limited profit and limited risk, it is not mandatory for the spreader to take any follow-up action prior to expiration. If the underlying stock advances substantially, the spreader should watch the time value premium in the short call closely in order to close the spread if it appears that there is a possibility of assignment. This possibility would increase substantially if the time value premium disappeared from the short call. If the stock falls, the trader may want to close the spread in order to limit his losses even further. When the spread is closed, the order should also be entered as a spread trans­ action. If the underlying stock has moved up in price, the order to liquidate would be a credit spread involving two closing transactions. The maximum credit that can be recovered from a bull spread is an amount equal to the difference between the striking prices. In the previous example, if XYZ were above 35 at expiration, one might enter an order to liquidate the spread as follows: Buy the October 35 (it is common practice to specify the buy side of a spread first when placing an order); sell the October 30 at a 5-point credit. In reality, because of the difference between bids and offers, it is quite difficult to obtain the entire 5-point credit even if expira­ tion is quite near. Generally, one might ask for a 4¼ or 47/s credit. It is possible to close the spread via exercise, although this method is normally advisable only for traders who pay little or no commissions. If the short side of a spread is assigned, the spreader may satisfy the assignment notice by exercising the long side of his spread. There is no margin required to do so, but there are stock commissions involved. Since these stock commissions to a public customer would be substantial­ ly larger than the option commissions involved in closing the spread by liquidating the options, it is recommended that the public customer attempt to liquidate rather than exercise. A minor point should be made here. Since the amount of commissions paid to liquidate the spread would be larger if higher call prices are involved, the actual net maximum profit point for a bull spread is for the stock to be exactly at the higher striking price at expiration. If the stock exceeds the higher striking price by a great deal, the gross profit will be the same (it was demonstrated earlier that this gross profit is the same anywhere above the higher strike at expiration), but the net profit will be slightly smaller, since the investor will pay more in commissions to liquidate the spread. Some spreaders prefer to buy back the short call if the underlying stock drops in price, in order to lock in the profit on the short side. They will then hold the long call in hopes of a rise in price by the underlying stock, in order to make the long side of the spread profitable as well. This amounts to "legging" out of the spread, although 180 Part II: Call Option Strategies the overall increase in risk is small - the amount paid to repurchase the short call. If he attempts to "leg" out of the spread in such a manner, the spreader should not attempt to buy back the short call at too high a price. If it can be repurchased at 1/s or 1/16, the spreader will be giving away virtually nothing by buying back the short call. However, he should not be quick to repurchase it if it still has much more value than that, unless he is closing out the entire spread. At no time should one attempt to "leg" out after a stock price increase, taking the profit on the long side and hoping for a stock price decline to make the short side profitable as well. The risk is too great. Many traders find themselves in the somewhat perplexing situation of having seen the underlying make a large, quick move, only to find that their spread has not widened out much. They often try to figure out a way to perhaps lock in some gains in case the underlying subsequently drops in price, but they want to be able to wait around for the spread to widen out more toward its maximum profit potential. There really isn't any hedge that can accomplish all of these things. The only position that can lock in the profits in a call bull spread is to purchase the accompanying put bear spread. This strategy is discussed in Chapter 23, Spreads Combining Calls and Puts. OTHER USES OF BULL SPREADS Superficially, the bull spread is one of the simplest forms of spreading. However, it can be an extremely useful tool in a wide variety of situations. Two such situations were described in Chapter 3. If the outright purchaser of a call finds himself with an unrealized loss, he may be able to substantially improve his chances of getting out even by "rolling down" into a bull spread. If, however, he has an unrealized profit, he may be able to sell a call at the next higher strike, creating a bull spread, in an attempt to lock in some of his profit. In a somewhat similar manner, a common stockholder who is faced with an unrealized loss may be able to utilize a bull spread to lower the price at which he can break even. He may often have a significantly better chance of breaking even or making a profit by using options. The following example illustrates the stockholder's strategy. Example: An investor buys 100 shares of XYZ at 48, and later finds himself with an unrealized loss with the stock at 42. A 6-point rally in the stock would be necessary in order to break even. However, if XYZ has listed options trading, he may be able to significantly reduce his break-even price. The prices are: Chapter 7: Bull Spreads XYZ common, 42; XYZ October 40, 4; and XYZ October 45, 2. 181 The stock owner could enhance his overall position by buying one October 40 call and selling two October 45 calls. Note that no extra money, except commissions, is required for this transaction, because the credit received from selling two October 45's is $400 and is equal to the cost of buying the October 40 call. However, mainte­ nance and equity requirements still apply, because a spread has been established. The resulting position does not have an uncovered, or naked, option in it. One of the October 45 calls that was sold is covered by the underlying stock itself. The other is part of a bull spread with the October 40 call. It is not particularly important that the resulting position is a combination of both a bull spread and a covered write. What is important is the profit characteristic of this new total position. If XYZ should continue to decline in price and be below 40 at October expira­ tion, all the calls will expire worthless, and the resulting loss to the stock owner will be the same (except for the option commissions spent) as if he had merely held onto his stock without having done any option trading. Since both a covered write and a bull spread are strategies with limited profit potential, this new position obviously must have a limited profit. If XYZ is anywhere above 45 at October expiration, the maximum profit will be realized. To determine the size of the maximum profit, assume that XYZ is at exactly 45 at expiration. In that case, the two short October 45's would expire worthless and the long October 40 call would be worth 5 points. The option trades would have resulted in a $400 profit on the short side ($200 from each October 45 call) plus a $100 profit on the long side, for a total profit of $500 from the option trades. Since the stock was originally bought at 48 in this example, the stock portion of the position is a $300 loss with XYZ at 45 at expiration. The overall profit of the position is thus $500 less $300, or $200. For stock prices between 40 and 45 at expiration, the results are shown in Table 7-3 and Figure 7-2. Figure 7-2 depicts the two columns from the table labeled "Profit on Stock" and "Total Profit," so that one can visualize how the new total posi­ tion compares with the original stockholder's profit. Several points should be noted from either the graph or the table. First, the break-even point is lowered from 48 to 44. The new total position breaks even at 44, so that only a 2-point rally by the stock by expiration is necessary in order to break even. The two strategies are equal at 50 at expiration. That is, the stock would have to rally more than 8 points, from 42 to 50, by expiration for the original stockholder's position to outperform the new posi- 182 Part II: Call Option Strategies TABLE 7-3. Lowering the break-even price on common stock. XYZ Price at Profit on Profit on Short Profit on long Total Expiration Stock October 45's October 40 Profit 35 -$1,300 +$400 -$400 -$1,300 38 - 1,000 + 400 - 400 - 1,000 40 800 + 400 - 400 800 42 600 + 400 - 200 400 43 500 + 400 - 100 200 44 400 + 400 0 0 45 300 + 400 + 100 + 200 48 0 - 200 + 400 + 200 50 + 200 - 600 + 600 + 200 tion. Below 40, the two strategies produce the same result. Finally, between 40 and 50, the new position outperforms the original stockholder's position. In summary, then, the stockholder stands to gain much and gives away very lit­ tle by adding the indicated options to his stock position. If the stock stabilizes at all - anywhere between 40 and 50 in the example above - the new position would be an improvement. Moreover, the investor can break even or make profits on a small rally. If the stock continues to drop heavily, nothing additional will be lost except for option commissions. Only if the stock rallies very sharply will the stock position outperform the total position. This strategy- combining a covered write and a bull spread - is sometimes used as an initial ( opening) trade as well. That is, an investor who is considering buying XYZ at 42 might decide to buy the October 40 and sell two October 45's (for even money) at the outset. The resulting position would not be inferior to the outright pur­ chase of XYZ stock, in terms of profit potential, unless XYZ rose above 46 by October expiration. Bull spreads may also be used as a "substitute" for covered writing. Recall from Chapter 2 that writing against warrants can be useful because of the smaller invest­ ment required, especially if the warrant was in-the-money and was not selling at much of a premium. The same thinking applies to call options. If there is an in-the­ money call with little or no time premium remaining in it, its purchase may be used as a substitute for buying the stock itself Of course, the call will expire, whereas the stock will not; but the profit potential of owning a deeply in-the-money call can be Chapter 7: Bull Spreads FIGURE 7-2. Lowering the break-even price on common stock. C: 0 I +$200 iii (/) $0 (/) .:l 0 i5 e Q. -$800 40 Profit with Options , ,,,' , , ,,,' 50 Stock Price at Expiration 183 ;f ,, very similar to owning the stock. Since such a call costs less to purchase than the stock itself would, the buyer is getting essentially the same profit or loss potential with a smaller investment. It is natural, then, to think that one might write another call - one closer to the money- against the deeply in-the-money purchased call. This posi­ tion would have profit characteristics much like a covered write, since the long call "simulates" the purchase of stock This position really is, of course, a bull spread, in which the purchased call is well in-the-money and the written call is closer to the money. Clearly, one would not want to put all of his money into such a strategy and forsake covered writing, since, with bull spreads, he could be entirely wiped out in a moderate market decline. In a covered writing strategy, one still owns the stocks even after a severe market decline. However, one may achieve something of a compromise by investing a much smaller amount of money in bull spreads than he might have invested in covered writes. He can still retain the same profit potential. The balance of the investor's funds could then be placed in interest-bearing securities. 184 Example: The following prices exist: XYZ common, 49; XYZ April 50 call, 3; and XYZ April 35 call, 14. Part II: Call Option Strategies Since the deeply in-the-money call has no time premium, its purchase will perform much like the purchase of the stock until April expiration. Table 7-4 summarizes the profit potential from the covered write or the bull spread. The profit potentials are the same from a cash covered write or the bull spread. Both would yield a $400 prof­ it before commissions if XYZ were above 50 at April expiration. However, since the bull spread requires a much smaller investment, the spreader could put $3,500 into interest-bearing securities. This interest could be considered the equivalent of receiving the dividends on the stock. In any case, the spreader can lose only $1,100, even if the stock declines substantially. The covered writer could have a larger unre­ alized loss than that if XYZ were below 35 at expiration. Also, in the bull spread sit­ uation, the writer can "roll down" the April 50 call if the stock declines in price, just as he might do in a covered writing situation. TABLE 7-4. Results for covered write and bull spread compared. Maximum profit potential (stock over 50 in April) Break-even point Investment Covered Write: Buy XYZ and Sell April 50 Coll $ 400 46 $4,600 Bull Spread: Buy XYZ April 35 Call and Sell April 50 Coll $ 400 46 $1,100 Thus, the bull spread offers the same dollar rewards, the same break-even point, smaller commission costs, less potential risk, and interest income from the fixed-income portion of the investment. While it is not always possible to find a deeply in-the-money call to use as a "substitute" for buying the stock, when one does exist, the strategist should consider using the bull spread instead of the covered write. Chapter 7: Bull Spreads SUMMARY 185 The bull spread is one of the simplest and most popular forms of spreading. It will generally perform best in a moderately bullish environment. A bull spread will not widen out to its maximum profit potential right away, though; so for short-term trades, the outright purchase of a call is a better choice. The bull spread can also be applied for more sophisticated purposes in a far wider range of situations than mere­ ly wanting to attempt to capitalize on a moderate advance by the underlying stock. Both call buyers and stock buyers may be able to use bull spreads to "roll down" and produce lower break-even points for their positions. The covered writer may also be able to use bull spreads as a substitute for covered writes in certain situations in which a deeply in-the-money call exists. Bear Spreads Using Call Options Options are versatile investment vehicles. For every type of bullish position that can be established, there is normally a corresponding bearish type of strategy. For every neutral strategy, there is an aggressive strategy for the investor with an opposite opin­ ion. One such case has already been explored in some detail; the straddle buy or reverse hedge strategy is the opposite side of the spectrum. For many of the strate­ gies to be described from this point on, there is a corresponding strategy designed for the strategist with the opposite point of view. In this vein, a bear spread is the oppo­ site of a bull spread. THE BEAR SPREAD In a call bear spread, one buys a call at a certain striking price and sells a call at a lower striking price. This is a vertical spread, as was the bull spread. The bear spread tends to be profitable if the underlying stock declines in price. Llke the bull spread, it has limited profit and loss potential. However, unlike the bull spread, the bear spread is a credit spread when the spread is set up with call options. Since one is sell­ ing the call with the lower strike, and a call at a lower strike always trades at a high­ er price than a call at a higher strike with the same expiration, the bear spread must be a credit position. It should be pointed out that most bearish strategies that can be established with call options may be more advantageously constructed using put options. Many of these same strategies are therefore discussed again in Part III. 186 Chapter 8: Bear Spreads Using Call Options 187 Example: An investor is bearish on XYZ. Using the same prices that were used for the examples in Chapter 7, an example of a bear spread can be constructed for: XYZ common, 32; XYZ October 30 call, 3; and XYZ October 35 call, 1. A bear spread would be established by buying the October 35 call and selling the October 30 call. This would be done for a 2-point credit, before commissions. In a bear spread situation, the strategist is hoping that the stock will drop in price and that both options will expire worthless. If this happens, he will not have to pay anything to close his spread; he will profit by the entire amount of the original credit taken in. In this example, then, the maximum profit potential is 2 points, since that is the amount of the initial credit. This profit would be realized if XYZ were anywhere below 30 at expiration, because both options would expire worthless in that case. If the spread expands in price, rather than contracts, the bear spreader will be losing money. This expansion would occur in a rising market. The maximum amount that this spread could expand to is 5 points - the difference between the striking prices. Hence, the most that the bear spreader would have to pay to buy back this spread would be 5 points, resulting in a maximum potential loss of 3 points. This loss would be realized if XYZ were anywhere above 35 at October expiration. Table 8-1 and Figure 8-1 depict the actual profit and loss potential of this example at expiration (commissions are not included). The astute reader will note that the figures in the table are exactly the reverse of those shown for the bull spread example in Chapter 7. Also, the profit graph of the bear spread looks like a bull spread profit graph that has been turned upside down. All bear spreads have a profit graph with the same shape at expiration as the graph shown in Figure 8-1. TABLE 8-1. Bear spread. XYZ Price at October 30 October 35 Total Expiration Profit Profit Profit 25 +$300 -$100 +$200 30 + 300 - 100 + 200 32 + 100 - 100 0 35 - 200 - 100 - 300 40 - 700 + 400 - 300 188 FIGURE 8-1. Bear spread • . § +$200 "it! -~ w CJ) 30 ig ..J 0 :!: e a. -$300 Part II: Call Option Strategies Stock Price at Expiration The break-even point, maximum profit potential, and investment required are all quite simple computations for a bear spread. Maximum profit potential== Net credit received Break-even point== Lower striking price + Amount of credit Maximum Collateral investment = = risk required Difference in striking prices Credit + Commissions received In the example above, the net credit received from the sale of the October 30 call at 3 and the purchase of the October 35 call at 1 was two points. This is the max­ imum profit potential. The break-even point is then easily computed as the lower striking price, 30, plus the amount of the credit, 2, or 32. The risk is equal to the investment. It is the difference between the striking prices - 5 points - less the net credit received - 2 points - for a total investment of 3 points plus commissions. Since this spread involves a call that is not "covered" by a long call with a striking price equal to or lower than that of the short call, some brokerage firms may require a higher maintenance requirement per spread than would be required for a bull spread. Again, since a spread must be done in a margin account, most brokerage firms require that a minimum amount of equity be in the account as well. Since this is a credit spread, the investor does not really "spend" any dollars to establish the spread. The investment is really a reduction in the buying power of the customer's margin account, but it does not actually require dollars to be spent when the transaction is initiated. Chapter 8: Bear Spreads Using Call Options SELECTING A BEAR SPREAD 189 Depending on where the underlying stock is trading with respect to the two striking prices, the bear spread may be very aggressive, with a high profit potential, or it may be less aggressive, with a low profit potential. If a large credit is initially taken in, there is obviously the potential for a good deal of profit. However, for the spread to take in a large credit, the underlying stock must be well above the lower striking price. This means that a relatively substantial downward move would be necessary in order for the maximum profit potential to be realized. Thus, a large credit bear spread is usually an aggressive position; the spreader needs a substantial move by the underlying stock in order to make his maximum profit. The probabilities of this occurring cannot be considered large. A less aggressive type of bear spread is one in which the underlying stock is actually below the lower striking price when the spread is established. The credit received from establishing a bear spread in such a situation would be small, but the spreader would realize his maximum profit even if the underlying stock remained unchanged or actually rose slightly in price by expiration. Example: XYZ is trading at a price of 25. The October 30 call might be sold for 1 ½ points and the October 35 call bought for½ point with the stock at 29. While the net credit, and hence the maximum profit potential, is a small dollar amount, 1 point, it will be realized even if XYZ rises slightly by expiration, as long as it does not rise above 30. It is not always clear which type of spread is better, the large credit bear spread or the small credit bear spread. One has a small probability of making a large profit and the other has a much larger probability of making a much smaller profit. In gen­ eral, bear spreads established when the underlying stock is closer to the lower strik­ ing price will be the best ones. To see this, note that if a bear spread is initiated when the stock is at the higher striking price, the spreader is selling a call that has mostly intrinsic value and little time value premium (since it is in-the-money), and is buying a call that is nearly all time value. This is just the opposite of what the option strate­ gist should be attempting to do. The basic philosophy of option strategy is to sell time value and buy intrinsic value. For this reason, the large credit bear spread is not an optimum strategy. It will be interesting to observe later that bear spreads with puts are more attractive when the underlying stock is at the higher striking price! A bear spread will not collapse right away, even if the underlying stock drops in price. This is somewhat similar to the effect that was observed with the call bull spreads in Chapter 7. They, too, do not accelerate to their maximum profit potential right away. Of course, as time winds down and expiration approaches, then the spread 190 Part II: Call Option Strategies will approach its maximum profit potential. This is important to understand because, if one is expecting a quick move down by the underlying stock, he might need to use a call bear spread in which the lower strike is actually somewhat deeply in-the­ money, while the upper strike is out-of-the-money. In this case, the in-the-money call will decline in value as the stock moves down, even if that downward move happens immediately. Meanwhile, the out-of-the-money long call protects against a disastrous upside breakout by the stock. This type of bear spread is really akin to selling a deep in-the-money call for its raw downside profit potential and buying an out-of-the­ money call merely as disaster insurance. FOLLOW-UP ACTION Follow-up strategies are not difficult, in general, for bear spreads. The major thing that the strategist must be aware of is impending assignment of the short call. If the short side of the spread is in-the-money and has no time premium remaining, the spread should be closed regardless of how much time remains until expiration. This disappearance of time value premium could be caused either by the stock being significantly above the striking price of the stock call, or by an impending dividend payment. In either case, the spread should be closed to avoid assignment and the resultant large commission costs on stock transactions. Note that the large credit bear spread (one established with the stock well above the lower striking price) is dangerous from the viewpoint of early assignment, since the time value premium in the call will be small to begin with. SUMMARY The call bear spread is a bearishly oriented strategy. Since the spread is a credit spread, requiring only a reduction in buying power but no actual layout of cash to establish, it is a moderately popular strategy. The bear spread using calls may not be the optimum type of bearish spread that is available; a bear spread using put options maybe. Calendar Spreads A calendar spread, also frequently called a time spread, involves the sale of one option and the simultaneous purchase of a more distant option, both with the same striking price. In the broad definition, the calendar spread is a horizontal spread. The neutral philosophy for using calendar spreads is that time will erode the value of the near-term option at a faster rate than it will the far-term option. If this happens, the spread will widen and a profit may result at near-term expiration. With call options, one may construct a more aggressive, bullish calendar spread. Both types of spreads are discussed. Example: The following prices exist sometime in late January: XYZ:50 April 50 Call (3-month call) 5 July 50 Call (6-month call) 8 October 50 Call (9-month call) 10 If one sells the April 50 call and buys the July 50 at the same time, he will pay a debit of 3 points - the difference in the call prices plus commissions. That is, his invest­ ment is the net debit of the spread plus commissions. Furthermore, suppose that in 3 months, at April expiration, XYZ is unchanged at 50. Then the 3-month call should be worth 5 points, and the 6-month call should be worth 8 points, as they were pre­ viously, all other factors being equal. XYZ:50 April 50 Call (Expiring) 0 July 50 Call (3-month call) 5 October 50 Call (6-month call) 8 191 192 Part II: Call Option Strategies The spread between the April 50 and the July 50 has now widened to 5 points. Since the spread cost 3 points originally, this widening effect has produced a 2-point prof­ it. The spread could be closed at this time in order to realize the profit, or the spread­ er may decide to continue to hold the July 50 call that he is long. By continuing to hold the July 50 call, he is risking the profits that have accrued to date, but he could profit handsomely if the underlying stock rises in price over the next 3 months, before July expiration. It is not necessary for the underlying stock to be exactly at the striking price of the options at near-term expiration for a profit to result. In fact, some profit can be made in a range that extends both below and above the striking price. The risk in this type of position is that the stock will drop a great deal or rise a great deal, in which case the spread between the two options will shrink and the spreader will lose money. Since the spread between two calls at the same strike cannot shrink to less than zero, however, the risk is limited to the amount of the original debit spent to establish the spread, plus commissions. THE NEUTRAL CALENDAR SPREAD As mentioned earlier, the calendar spreader can either have a neutral outlook on the stock or he can construct the spread for an aggressively bullish outlook. The neutral outlook is described first. The calendar spread that is established when the underly­ ing stock is at or near the striking price of the options used is a neutral spread. The strategist is interested in selling time and not in predicting the direction of the under­ lying stock. If the stock is relatively unchanged when the near-term option expires, the neutral spread will make a profit. In a neutral spread, one should initially have the intent of closing the spread by the time the near-tenn option expires. Let us again tum to our example calendar spread described earlier in order to more accurately demonstrate the potential risks and rewards from that spread when the near-term, April, call expires. To do this, it is necessary to estimate the price of the July 50 call at that time. Notice that, with XYZ at 50 at expiration, the results agree with the less detailed example presented earlier. The graph shown in Figure 9-1 is the "total profit" from Table 9-1. The graph is a curved rather than straight line, since the July 50 call still has time premium. There is a slightly bullish bias to this graph: The profit range extends slightly farther above the striking price than it does below the striking price. This is due to the fact that the spread is a call spread. If puts had been used, the profit range would have a bearish bias. The total width of the profit range is a function of the volatility of the underlying stock, since that will determine the price Chapter 9: Calendar Spreads FIGURE 9-1. Calendar spread at near-term expiration. C: i +$200 $ 1i:i ~ 0 ~ o. -$300 Stock Price at Expiration TABLE 9-1. Estimated profit or losses at April expiration. XYZ Stock April 50 April 50 July 50 Price Price Profit Price 40 0 +$500 1/2 45 0 + 500 21/2 48 0 + 500 4 50 0 + 500 5 52 2 + 300 6 55 5 0 8 60 10 - 500 l 01/2 193 July 50 Total Profit Profit -$750 -$250 - 550 - 50 - 400 + 100 - 300 + 200 - 200 + 100 0 0 + 250 - 250 of the remaining long call at expiration, as well as a function of the time remaining to near-term expiration. Table 9-1 and Figure 9-1 clearly depict several of the more significant aspects of the calendar spread. There is a range within which the spread is profitable at near­ term expiration. That range would appear to be about 46 to 55 in the example. Outside that range, losses can occur, but they are limited to the amount of the initial debit. Notice in the example that the stock would have to be well below 40 or well 194 Part II: Call Option Strategies above 60 for the maximum loss to occur. Even if the stock is at 40 or 60, there is some time premium left in the longer-term option, and the loss is not quite as large as the maximum possible loss of $300. This type of calendar spread has limited profits and relatively large commission costs. It is generally best to establish such a spread 8 to 12 weeks before the near­ term option expires. If this is done, one is capitalizing on the maximum rate of decay of the near-term option with respect to the longer-term option. That is, when a call has less than 8 weeks of life, the rate of decay of its time value premium increases substantially with respect to the longer-term options on the same stock. THE EFFECT OF VOLATILITY The implied volatility of the options (and hence the actual volatility of the underly­ ing stock) will have an effect on the calendar spread. As volatility increases, the spread widens; as volatility contracts, the spread shrinks. This is important to know. In effect, buying a calendar spread is an antivolatility strategy: One wants the under­ lying to remain somewhat unchanged. Sometimes, calendar spreads look especially attractive when the underlying stock is volatile. However, this can be misleading for two reasons. First of all, since the stock is volatile, there is a greater chance that it will move outside of the profit area. Second, if the stock does stabilize and trades in a range near the striking price, the spread will lose value because of the decrease in volatility. That loss may be greater than the gain from time decay! FOLLOW-UP ACTION Ideally, the spreader would like to have the stock be just below the striking price when the near-term call expires. If this happens, he can close the spread with only one commission cost, that of selling out the long call. If the calls are in-the-money at the expiration date, he will, of course, have to pay two commissions to close the spread. As with all spread positions, the order to close the spread should be placed as a single order. "Legging" out of a spread is highly risky and is not recommended. Prior to expiration, the spreader should close the spread if the near-term short call is trading at parity. He does this to avoid assignment. Being called out of spread position is devastating from the viewpoint of the stock commissions involved for the public customer. The near-term call would not normally be trading at parity until quite close to the last day of trading, unless the stock has undergone a substantial rise in price. In the case of an early downside breakout by the underlying stock, the spread­ er has several choices. He could immediately close the spread and take a small loss Chapter 9: Calendar Spreads 195 on the position. Another choice is to leave the spread alone until the near-term call expires and then to hope for a partial recovery from the stock in order to be able to recover some value from the long side of the spread. Such a holding action is often better than the immediate close-out, because the expense of buying back the short call can be quite large percentagewise. A riskier downside defensive action is to sell out the long call if the stock begins to break down heavily. In this way, the spreader recovers something from the long side of his spread immediately, and then looks for the stock to remain depressed so that the short side of the spread will expire worth­ less. This action requires that one have enough collateral available to margin the resulting naked call, often an amount substantially in excess of the original debit paid for the spread. Moreover, if the underlying stock should reverse direction and rally back to or above the striking price, the short side of the spread is naked and could produce substantial losses. The risk assumed by such a follow-up violates the initial neutral premise of the spread, and should therefore be avoided. Of these three types of downside defensive action, the easiest and rrwst conservative one is to do nothing at all, letting the short call expire worthless and then hoping for a recovery by the underlying stock. If this tack is taken, the risk remains fixed at the original debit paid for the spread, and occasionally a rally may produce large profits on the long call. Although this rally is a nonfrequent event, it generally costs the spreader very little to allow himself the opportunity to take advantage of such a rally if it should occur. In fact, the strategist can employ a slight modification of this sort of action, even if the spread is not at a large loss. If the underlying stock is moderately below the striking price at near-term expiration, the short option will expire worthless and the spreader will be left holding the long option. He could sell the long side immediate­ ly and perhaps take a small gain or loss. However, it is often a reasonable strategy to sell out a portion of the long side - recovering all or a substantial portion of the ini­ tial investment - and hold the remainder. If the stock rises, the remaining long posi­ tion may appreciate substantially. Although this sort of action deviates from the true nature of the time spread, it is not overly risky. An early breakout to the upside by the underlying stock is generally handled in much the same way as a downside breakout. Doing nothing is often the best course of action. If the underlying stock rallies shortly after the spread is established, the spread will shrink by a small amount, but not substantially, because both options will hold premium in a rally. If the spreader were to rush in to close the position, he would be paying commissions on two rather expensive options. He will usually do better to wait and give himself as much of a chance for a reversal as possible. In fact, even at near-term expiration, there will normally be some time premium left in the long option so that the maximum loss would not have to be realized. A highly risk­ oriented upside defensive action is to cover the short call on a technical breakout and 196 Part II: Call Option Strategies continue to hold the long call. This can become disastrous if the breakout fails and the stock drops, possibly resulting in losses far in excess of the original debit. Therefore, this action cannot be considered anything but extremely aggressive and illogical for the neutral strategist. If a breakout does not occur, the spreader will normally be making unrealized profits as time passes. Should this be the case, he may want to set some mental stop­ out points for himself. For example, if the underlying stock is quite close to the strik­ ing price with only two weeks to go, there will be some more profit potential left in the spread, but the spreader should be ready to close the position quickly if the stock begins to get too far away from the striking price. In this manner, he can leave room for more profits to accrue, but he is also attempting to protect the profits that have already built up. This is somewhat similar to the action that the ratio writer takes when he narrows the range of his action points as more and more time passes. THE BULLISH CALENDAR SPREAD A less neutral and more bullish type of calendar spread is preferred by the more aggressive investor. In a bullish calendar spread, one sells the near-term call and buys a longer-term call, but he does this when the underlying stock is some distance below the striking price of the calls. This type of position has the attractive features of low dollar investment and large potential profits. Of course, there is risk involved as well. Example: One might set up a bullish calendar spread in the following manner: XYZ common, 45; sell the XYZ April 50 for l; and buy the XYZ July 50 for 1 ½. This investor ideally wants two things to happen. First, he would like the near­ term call to expire worthless. That is why the bullish calendar spread is established with out-of-the-money calls: to increase the chances of the short call expiring worth­ less. If this happens, the investor will then own the longer-term call at a net cost of his original debit. In this example, his original debit was only ½ of a point to create the spread. If the April 50 call expires worthless, the investor will own the July 50 call at a net cost of ½ point, plus commissions. The investor now needs a second criterion to be fulfilled: The stock must rise in price by the time the July 50 call expires. In this example, even if XYZ were to rally to only 52 between April and July, the July 50 call could be sold for at least 2 points. This represents a substantial percentage gain, because the cost of the call has been Chapter 9: Calendar Spreads 197 reduced to ¼ point. Thus, there is the potential for large profits in bullish calendar spreads if the underlying stock rallies above the striking price before the longer-term call expires, provided that the short-term call has already expired worthless. What chance does the investor have that both ideal conditions will occur? There is a reasonably good chance that the written call will expire worthless, since it is a short-term call and the stock is below the striking price to start with. If the stock falls, or even rises a little - up to, but not above, the striking price the first condition will have been met. It is the second condition, a rally above the striking price by the underlying stock before the longer-term expiration date, that normally presents the biggest problem. The chances of this happening are usually small, but the rewards can be large when it does happen. Thus, this strategy offers a small probability of making a large profit. In fact, one large profit can easily offset several losses, because the losses are small, dollarwise. Even if the stock remains depressed and the July 50 call in the example expires worthless, the loss is limited to the initial debit of¼ point. Of course, this loss represents 100% of the initial investment, so one cannot put all his money into bullish calendar spreads. This strategy is a reasonable way to speculate, provided that the spreader adheres to the following criteria when establishing the spread: 1. Select underlying stocks that are volatile enough to move above the striking price within the allotted time. Bullish calendar spreads may appear to be very "cheap" on nonvolatile stocks that are well below the striking price. But if a large stock move, say 20%, is required in only a few months, the spread is not worthwhile for a nonvolatile stock. 2. Do not use options more than one striking price above the current market. For example, if XYZ were 26, use the 30 strike, not the 35 strike, since the chances of a rally to 30 are many times greater than the chances of a rally to 35. 3. Do not invest a large percentage of available trading capital in bullish calendar spreads. Since these are such low-cost spreads, one should be able to follow this rule easily and still diversify into several positions. FOLLOW-UP ACTION If the underlying stock should rally before the near-term call expires, the bullish cal­ endar spreader must never consider "legging" out of the spread, or consider cover­ ing the short call at a loss and attempting to ride the long call. Either action could turn the initial small, limited loss into a disastrous loss. Since the strategy hinges on 198 Part II: Call Option Strategies the fact that all the losses will be small and the infrequent large profits will be able to overcome these small losses, one should do nothing to jeopardize the strategy and possibly generate a large loss. The only reasonable sort of follow-up action that the bullish calendar spreader can take in advance of expiration is to close the spread if the underlying stock has moved up in price and the spread has widened to become profitable. This might occur if the stock moves up to the striking price after some time has passed. In the example above, if XYZ moved up to 50 with a month or so of life left in the April 50 call, the call might be selling for I½ while the July 50 call might be selling for 3 points. Thus, the spread could be closed at I½ points, representing a I-point gain over the initial debit of 1/2 point. Two commissions would have to be paid to close the spread, of course, but there would still be a net profit in the spread. USING ALL THREE EXPIRATION SERIES In either the neutral calendar spread or the bullish calendar spread, the investor has three choices of which months to use. He could sell the nearest-term call and buy the intermediate-term call. This is usually the most common way to set up these spreads. However, there is no rule that prevents him from selling the intermediate-term and buying the longest-term, or possibly selling the near-term and buying the long-term. Any of these situations would still be calendar spreads. Some proponents of calendar spreads prefer initially to sell the near-term and buy the long-term call. Then, if the near-term call expires worthless, they have an opportunity to sell the intermediate-term call if they so desire. Example: An investor establishes a calendar spread by selling the April 50 call and buying the October 50 call. The April call would have less than 3 months remaining and the October call would be the long-term call. At April expiration, if XYZ is below 50, the April call will expire worthless. At that time, the July 50 call could be sold against the October 50 that is held long, thereby creating another calendar spread with no additional commission cost on the long side. The advantage of this type of strategy is that it is possible for the two sales (April 50 and July 50 in this example) to actually bring in more credits than were spent for the one purchase (October 50). Thus, the spreader might be able to create a position in which he has a guaranteed profit. That is, if the sum of his transactions is actually a credit, he cannot lose money in the spread (provided that he does not attempt to "leg" out of the spread). The disadvantage of using the long-term call in the calendar spread is that the initial debit is larger, and therefore more dollars are initially at risk. Chapter 9: Calendar Spreads 199 If the underlying stock moves substantially up or down in the first 3 months, the spreader could realize a larger dollar loss with the October/ April spread because his loss will approach the initial debit. The remaining combination of the expiration series is to initially buy the longest-term call and sell the intermediate-term call against it. This combination will generally require the smallest initial debit, but there is not much profit potential in the spread until the intermediate-term expiration date draws near. Thus, there is a lot of time for the underlying stock to move some distance away from the initial strik­ ing price. For this reason, this is generally an inferior approach to calendar spread­ ing. SUMMARY Calendar spreading is a low-dollar-cost strategy that is a nonaggressive approach, pro­ vided that the spreader does not invest a large percentage of his trading capital in the strategy, and provided that he does not attempt to "leg" into or out of the spreads. The neutral calendar spread is one in which the strategist is mainly selling time; he is attempting to capitalize on the known fact that the near-term call will lose time pre­ mium more rapidly than will a longer-term call. A more aggressive approach is the bullish calendar spread, in which the speculator is essentially trying to reduce the net cost of a longer-term call by the amount of credits taken in from the sale of a nearer­ term call. This bullish strategy requires that the near-term call expire worthless and then that the underlying stock rise in price. In either strategy, the most common approach is to sell the nearest-term call and buy the intermediate-term call. However, it may sometimes prove advantageous to sell the near-term and buy the longest-term initially, with the intention of letting the near-term expire and then pos­ sibly writing against the longer-term call a second time. . CHAPTER 10 The Butterfly Spread The recipient of one of the more exotic names given to spread positions, the butter­ fly spread is a neutral position that is a combination of both a bull spread and a bear spread. This spread is for the neutral strategist, one who thinks the underlying stock will not experience much of a net rise or decline by expiration. It generally requires only a small investment and has limited risk. Although profits are limited as well, they are larger than the potential risk. For this reason, the butterfly spread is a viable strat­ egy. However, it is costly in terms of commissions. In this chapter, the strategy is explained using only calls. The strategy can also be implemented using a combination of puts and calls, or with puts only, as will be demonstrated later. There are three striking prices involved in a butterfiy spread. Using only calls, the butterfly spread consists of buying one call at the lowest striking price, selling two calls at the middle striking price, and buying one call at the highest striking price. The following example will demonstrate how the butterfly spread works. Example: A butterfly spread is established by buying a July 50 call for 12, selling 2 July 60 calls for 6 each, and buying a July 70 call for 3. The spread requires a rela­ tively low debit of $300 (Table 10-1), although there are four option commissions involved and these may represent a substantial percentage of the net investment. As usual, the maximum amount of profit is realized at the striking price of the written calls. With most types of spreads, this is a useful fact to remember, for it can aid in quick computation of the potential of the spread. In this example, if the stock were at the striking price of the written options at expiration (60), the two July 60's that are short would expire worthless for a $1,200 gain. The long July 70 call would expire worthless for a $300 loss, and the long July 50 call would be worth 10 points, for a $200 loss on that call. The sum of the gains and losses would thus be a $700 gain, less commissions. This is the maximum profit potential of the spread. 200 Chapter 10: The Butterfly Spread TABLE 10-1. Butterfly spread example. Current prices: XYZ common: XYZ July 50 call: XYZ July 60 call: XYZ July 70 call: Butterfly spread: Buy 1 July 50 call Sell 2 July 60 calls Buy 1 July 70 call Net debit 60 12 6 3 $1 ,200 debit $1,200 credit $300 debit $300 (plus commissions) 201 The risk is limited in a butterfly spread, both to the upside and to the downside, and is equal to the amount of the net debit required to establish the spread. In the example above, the risk is limited to $300 plus commissions. Table 10-2 and Figure 10-1 depict the results of this butterfly spread at various prices at expiration. The profit graph resembles that of a ratio write, except that the loss is limited on both the upside and the downside. There is a profit range within which the butterfly spread makes money - 53 to 67 in the example, before commis­ sions are included. Outside this profit range, losses will occur at expiration, but these losses are limited to the amount of the original debit plus commissions. In accordance with more lenient margin requirements passed in 2000, the investment required for a butterfly spread is equal to the net debit expended, which is the risk in the spread. When the options expire in the same month and the strik­ ing prices are evenly spaced (the spacing is 10 points in this example), the following formulae can be used to quickly compute the important details of the butterfly spread: Net investment= Net debit of the spread Maximum profit = Distance between strikes - Net debit Downside break-even= Lowest strike+ Net debit Upside break-even= Highest strike - Net debit In the example, the distance between strikes is 10 points, the net debit is 3 points (before commissions), the lowest strike used is 50, and the highest strike is 70. These formulae would then yield the following results for this example spread. 202 Part II: Call Option Strategies Net investment= 3 points= $300 Maximum profit =10-3 = $700 Downside break-even= 50 + 3 = 53 FIGURE 10-1. Butterfly spread. +$700 Upside break-even = 70 - 3 = 67 $0 ___ .....__ _____ _._ __ --' __ _,_ ____ _ 70 0 :E -$300---- J: Stock Price at Expiration TABLE 10-2. Results of butterfly spread at expiration. XYZ Price at July 50 July 60 July 70 Expiration Profit Profit Profit 40 -$1,200 +$1,200 -$300 50 - 1,200 + 1,200 - 300 53 900 + 1,200 - 300 56 600 + 1,200 - 300 60 200 + 1,200 - 300 64 + 200 + 400 - 300 67 + 500 200 - 300 70 + 800 800 - 300 80 + 1,800 - 2,800 + 700 Total Profit -$300 - 300 0 + 300 + 700 + 300 0 - 300 - 300 Chapter 10: The Butterfly Spread 203 Note that all of these answers agree with the results that were previously obtained by analyzing the example spread in detail. In this example, the maximum profit potential is $700, the maximum risk is $300, and the investment required is also $300, commissions excluded. In percent­ age terms, this means that the butterfly spread has a loss limited to about 100% of capital invested and could make profits of nearly 133% in this case. These represent an attractive risk/reward relationship. This is, however, just an example, and two fac­ tors that exist in the actual marketplace may greatly affect these numbers. First, com­ missions are large; it is possible that eight commissions might have to be paid to establish and liquidate the spread. Second, depending on the level of premiums to be found in the market at any point in time, it may not be possible to establish a spread for a debit as low as 3 points when the strikes are 10 points apart. SELECTING THE SPREAD Ideally, one would want to establish a butterfly spread at as small of a debit as pos­ sible in order to limit his risk to a small amount, although that risk is still equal to 100% of the dollars invested in the spread. One would also like to have the stock be near the middle striking price to begin with, because he will then be in his maximum profit area if the stock remains relatively unchanged. Unfortunately, it is difficult to satisfy both conditions simultaneously. The smallest-debit butterfly spreads are those in which the stock is some dis­ tance away from the middle striking price. To see this, note that if the stock were well above the middle strike and all the options were at parity, the net debit would be zero. Although no one would attempt to establish a butterfly spread with parity options because of the risk of early assignment, it may be somewhat useful to try to obtain a small debit by taking an opinion on the underlying stock. For example, if the stock is close to the higher striking price, the debit would be small normally, but the investor would have to be somewhat bearish on the underlying stock in order to maximize his profit; that is, the stock would have to decline in price from the upper striking price to the middle striking price for the maximum profit to be realized. An analogous situation exists when the underlying stock is originally close to the lower striking price. The investor could establish the spread for a small debit in this case also, but he would now have to be somewhat bullish on the underlying stock in order to attempt to realize his maximum profit. Example: XYZ is at 70. One may be able to establish a low-debit butterfly spread with the 50's, 60's, and 70's if the following prices exist: 204 XYZ common, 70; XYZ July 50, 20; XYZ July 60, 12; and XYZ July 70, 5. Part II: Call Option Strategies The butterfly spread would require a debit of only $100 plus commissions to estab­ lish, because the cost of the calls at the higher and lower strike is 25 points, and a 24- point credit would be obtained by selling two calls at the middle strike. This is indeed a low-cost butterfly spread, but the stock will have to move down in price for much of a profit to be realized. The maximum profit of $900 less commissions would be realized at 60 at expiration. The strategist would have to be bearish on XYZ to want to establish such a spread. Without the aid of an example, the reader should be able to determine that if XYZ were originally at 50, a low-cost butterfly spread could be established by buying the 50, selling two 60's, and buying a 70. In this case, however, the investor would have to be bullish on the stock, because he would want it to move up to 60 by expi­ ration in order for the maximum profit to be realized. In general, then, if the butterfly spread is to be established at an extremely low debit, the spreader will have to make a decision as to whether he wants to be bullish or bearish on the underlying stock. Many strategists prefer to remain as neutral as possible on the underlying stock at all times in any strategy. This philosophy would lead to slightly higher debits, such as the $300 debit in the example at the beginning of this chapter, but would theoretically have a better chance of making money because there would be a profit if the stock remained relatively unchanged, the most probable occurrence. In either philosophy, there are other considerations for the butterfly spread. The best butterfly spreads are generally found on the more expensive and/or more volatile stocks that have striking prices spaced 10 or 20 points apart. In these situa­ tions, the maximum profit is large enough to overcome the weight of the commission costs involved in the butterfly spread. When one establishes butterfly spreads on lower-priced stocks whose striking prices are only 5 points apart, he is normally put­ ting himself at a disadvantage unless the debit is extremely small. One exception to this rule is that attractive situations are often found on higher-priced stocks with striking prices 5 points apart (50, 55, and 60, for example). They do exist from time to time. In analyzing butterfly spreads, one commonly works with closing prices. It was mentioned earlier that using closing prices for analysis can prove somewhat mislead­ ing, since the actual execution will have to be done at bid and asked prices, and these Chapter 10: The Butterfly Spread 205 may differ somewhat from closing prices. Normally, this difference is small, but since there are three different calls involved in a butterfly spread, the difference could be substantial. Therefore, it is usually necessary to check the appropriate bid and asked price for each call before entering the spread, in order to be able to place a reason­ able debit on the order. As with other types of spreads, the butterfly spread order can be placed as one order. Before moving on to discuss follow-up action, it may be worthwhile to describe a tactic for stocks with 5 points between striking prices. For example, the butterfly spreader might work with strikes of 45, 50, and 60. If he sets up the usual type of but­ terfly spread, he would end up with a position that has too much risk near 60 and very little or none at all near 45. If this is what he wants, fine; but if he wants to remain neutral, the standard type of butterfly spread will have to be modified slightly. Example: The following prices exist: XYZ common, 50; July 45 call, 7; July 50 call, 5; and July 60 call, 2. The normal type of butterfly spread- buying one 45, selling two 50's, and buying one 60 - can actually be done for a credit of 1 point. However, the profitability is no longer symmetric about the middle striking price. In this example, the investor can­ not lose to the downside because, even if the stock collapses and all the calls expire worthless, he will still make his I-point credit. However, to the upside, there is risk: If XYZ is anywhere above 60 at expiration, the risk is 4 points. This is no longer a neu­ tral position. The fact that the lower strike is only 5 points from the middle strike while the higher strike is 10 points away has made this a somewhat bearish position. If the spreader wants to be neutral and still use these striking prices, he will have to put on two bull spreads and only one bear spread. That is, he should: Buy 2 July 45's: Sell 3 July 50's: Buy 1 July 60: $1,400 debit $1,500 credit $200 debit This position now has a net debit of $100 but has a better balance of risk at either end. If XYZ drops and is below 45 at expiration, the spreader will lose his $100 ini­ tial debit. But now, if XYZ is at or above 60 at expiration, he will lose $100 in that range also. Thus, by establishing two bull spreads with a 5-point difference between 206 Part II: Call Option Strategies strikes versus one bear spread with a IO-point difference between strikes, the risk has been balanced at both ends. When one uses strike prices that are not evenly spaced apart, his margin requirement increases substantially. In such a case, one has to mar­ gin the individual component spreads separately. Therefore, in this example, he would have to pay for the two bull spreads ( $200 each, for a total of $400) and then margin the additional call bear spread ($700: the $1,000 difference in the strikes, less the $300 credit taken in for that portion of the spread). Hence, in this example, the margin requirement would be $1,100, even though the risk is only $100. Technically, of that $1,100 requirement, the spread trader pays out only $100 in cash (the actual debit of the spread), and the rest of the requirement can be satisfied with excess equity in his account. The same analysis obviously applies whenever 5-point striking price intervals exist. There are numerous combinations that could be worked out for lower-priced stocks by merely skipping over a striking price ( using the 25's, 30's, and 40's, for exam­ ple). Although there are not normally many stocks trading over $100 per share, the same analysis is applicable using 130's, 140's, and 160's, for example. FOLLOW-UP ACTION Since the butterfly spread has limited risk by its construction, there is usually little that the spreader has to do in the way of follow-up action other than avoiding early exercise or possibly dosing out the position early to take profits or limit losses even further. The only part of the spread that is subject to assignment is the call at the mid­ dle strike. If this call trades at or near parity, in-the-money, the spread should be closed. This may happen before expiration if the underlying stock is about to go ex­ dividend. It should be noted that accepting assignment will not increase the risk of the spread (because any short calls assigned would still be protected by the remain­ ing long calls). However, the margin requirement would change substantially, since one would now have a synthetic put (long calls, short stock) in place. Plus, there may be more onerous commissions for trading stock. Therefore, it is usually wise to avoid assignment in a butterfly spread, or in any spread, for that matter. If the stock is near the middle strike after a reasonable amount of time has passed, an unrealized profit will begin to accrue to the spreader. If one feels that the underlying stock is about to move away from the middle striking price and thereby jeopardize these profits, it may be advantageous to close the spread to take the avail­ able profit. Be certain to include commission costs when determining if an unreal­ ized profit exists. As a general rule of thumb, if one is doing 10 spreads at a time, he Chapter 10: Tire Butterfly Spread 207 can estimate that the commission cost for each option is about 1/s point. That is, if one has 10 butterfly spreads and the spread is currently at 6 points, he could figure that he would net about 5½ points after commissions to close the spread. This 1/s estimate is only valid if the spreader has at least 10 options at each strike involved in a spread. Normally, one would not close the spread early to limit losses, since these loss­ es are limited to the original net debit in any case. However, if the original debit was large and the stock is beginning to break out above the higher strike or to break down below the lower strike, the spreader may want to close the spread to limit losses even further. It has been repeatedly stated that one should not attempt to ''leg" out of a spread because of the risk that is incurred if one is wrong. However, there is a method of legging out of a butterfly spread that is acceptable and may even be pru­ dent. Since the spread consists of both a bull spread and a bear spread, it may often be the case that the stock experiences a relatively substantial move in one direction or the other during the life of the butterfly spread, and that the bull spread portion or the bear spread portion could be closed out near their maximum profit potentials. If this situation arises, the spreader may want to take advantage of it in order to be able to profit more if the underlying stock reverses direction and comes back into the profit range. Exampk: This strategy can be explained by using the initial example from this chap­ ter and then assuming that the stock falls from 60 to 45. Recall that this spread was initially established with a 3-point debit and a maximum profit potential of 7 points. The profit range was 53 to 67 at July expiration. However, a rather unpleasant situa­ tion has occurred: The stock has fallen quickly and is below the profit range. If the spreader does nothing and keeps the spread on, he will lose 3 points at most if the stock remains below 50 until July expiration. However, by increasing his risk slightly, he may be able to improve his position. Notice in Table 10-3 that the bear spread por­ tion of the overall spread - short July 60, long July 70 - has very nearly reached its maximum potential. The bear spread could be bought back for ½ point total (pay 1 point to buy back the July 60 and receive½ point from selling out the July 70). Thus, the spreader could convert the butterfly spread to a bull spread by spending ½ point. What would such an action do to his overall position? First, his risk would be increased by the ½ point spent to close the bear spread. That is, if XYZ continues to remain below 50 until July expiration, he would now lose 3½ rather than 3 points, plus commissions in either case. He has, however, potentially helped his chances of realizing something close to the maximum profit available from the original butterfly spread. 208 Part II: Call Option Strategies TABLE 10-3. Initial spread and current prices. Initial Spread Current Prices XYZ common: 60 XYZ common: 45 July 50 call: 12 July 50 call: 2 July 60 call: 6 July 60 call: 1 July 70 call: 3 July 70 call: 1/2 After buying back the bear spread, he is left with the following bull spread: Long July 50 call _ N t d b·t 3u, . t h l all e e 1 ,2 pom s S ort Ju y 60 c He has a bull spread at the total cost paid to date - 3½ points. From the earlier dis­ cussion of bull spreads, the reader should know that the break-even point for this position is 53½ at expiration, and it could make a 6½ point profit if XYZ is anywhere over 60 at July expiration. Hence, the break-even point for the position was raised from 53 to 53½ by the expense of the ½ point to buy back the bear spread. However, if the stock should rally back above 60, the strategist will be making a profit nearly equal to the original maximum profit that he was aiming for (7 points). Moreover, this profit is now available anywhere over 60, not just exactly at 60 as it was in the origi­ nal position. Although the chances of such a rally cannot be considered great, it does not cost the spreader much to restructure himself into a position with a much broad­ er maximum profit area. A similar situation is available if the underlying stock moves up in price. In that case, the bull spread may be able to be removed at nearly its maximum profit poten­ tial, thereby leaving a bear spread. Again, suppose that the same initial spread was established but that XYZ has risen to 75. When the underlying stock advances sub­ stantially, the bull spread portion of the butterfly spread may expand to near its max­ imum potential. Since the strikes are 10 points apart in this bull spread, the widest it can grow to is 10 points. At the prices shown in Table 10-4, the bull spread - long July 50 and short July 60 - has grown to 9½ points. Thus, the bull spread position could be removed within ½ point of its maximum profit potential and the original butterfly spread would become a bear spread. Note that the closing of the bull spread portion generates a 9½ point credit: The July 50 is sold at 25½ and the July 60 is bought back at 16. The original butterfly spread was established at a 3-point debit, so the net position is the remaining position: Chapter 10: The BatterRy Spread 209 Long July 70 call . Short July 60 call - Net credit 6½ points This bear spread has a maximum profit potential of 6½ points anywhere below 60 at July expiration. The maximum risk is 3½ points anywhere above 70 at expiration. Thus, the original butterfly spread was again converted into a position such that a stock price reversal to any price below 60 could produce something close to the max­ imum profit. Moreover, the risk was only increased by an additional ½ point. TABLE 10-4. Initial spread and new current prices. I nitiol Spread XYZ common: 60 XYZ July 50 call: 12 July 60 call: 6 July 70 call: 3 SUMMARY Current Prices XYZ common: July 50 call: July 60 call: July 70 call: 75 251/2 16 7 The butterfly spread is a viable, low-cost strategy with both limited profit potential and limited risk. It is actually a combination of a bull spread and a bear spread, and involves using three striking prices. The risk is limited should the underlying stock fall below the lowest strike or rise above the highest strike. The maximum profit is obtained at the middle strike. One can keep his initial debits to a minimum by ini­ tially assuming a bullish or bearish posture on the underlying stock. If he would rather remain neutral, he will normally have to pay a slightly larger debit to establish the spread, but may have a better chance of making money. If the underlying stock experiences a large move in one direction or the other prior to expiration, the spread­ er may want to close the profitable side of his butterfly spread near its maximum profit potential in order to be able to capitalize on a stock price reversal, should one occur. Ratio Call Spreads A ratio call spread is a neutral strategy in which one buys a number of calls at a lower strike and sells more calls at a higher strike. It is somewhat similar to a ratio write in concept, although the spread has less downside risk and normally requires a smaller investment than does a ratio write. The ratio spread and ratio write are similar in that both involve uncovered calls, and both have profit ranges within which a profit can be made at expiration. Other comparisons are demonstrated throughout the chapter. Example: The following prices exist: XYZ common, 44; XYZ April 40 call, 5; and XYZ April 45 call, 3. A 2:1 ratio call spread could be established by buying one April 40 call and simulta­ neously selling two April 45's. This spread would be done for a credit of 1 point - the sale of the two April 45's bringing in 6 points and the purchase of the April 40 cost­ ing 5 points. This spread can be entered as one spread order, specifying the net cred­ it or debit for the position. In this case, the spread would be entered at a net credit of 1 point. Ratio spreads, unlike ratio writes, have a relatively small, limited downside risk. In fact, if the spread is established at an initial credit, there is no downside risk at all. In a ratio spread, the profit or loss at expiration is constant below the lower striking price, because both options would be worthless in that area. In the example above, if XYZ is below 40 at April expiration, all the options would expire worthless and the spreader would have made a profit of his initial I-point credit, less commissions. This I-point gain would occur anywhere below 40 at expiration; it is a constant. 210 Chapter 11: Ratio Call Spreads 211 The maximum profit at expiration for a ratio spread occurs if the stock is exact­ ly at the striking price of the written options. This is true for nearly all types of strate­ gies involving written options. In the example, if XYZ were at 45 at April expiration, the April 45 calls would expire worthless for a gain of $600 on the two of them, and the April 40 call would be worth 5 points, resulting in no gain or loss on that call. Thus, the total profit would be $600 less commissions. The greatest risk in a ratio call spread lies to the upside, where the loss may the­ oretically be unlimited. The upside break-even point in this example is 51, as shown in Table 11-1. The table and Figure 11-1 illustrate the statements made in the pre­ ceding paragraphs. In a 2:1 ratio spread, two calls are sold for each one purchased. The maximum profit amount and the upside break-even point can easily be computed by using the following formulae: Points of maximum profit = Initial credit + Difference between strikes or = Difference between strikes - Initial debit Upside break-even point= Higher strike price+ Points of maximum profit In the preceding example, the initial credit was 1 point, so the points of maxi­ mum profit = 1 + 5 = 6, or $600. The upside break-even point is then 45 + 6, or 51. This agrees with the results determined earlier. Note that if the spread is established at a debit rather than a credit, the debit is subtracted from the striking price differ­ ential to determine the points of maximum profit. Many neutral investors prefer ratio spreads over ratio writes for two reasons: TABLE 11-1. Ratio call spread. XYZ Price of April 40 Coll April 45 Coll Total Expiration Profits Profits Profits 35 -$ 500 +$ 600 +$100 40 - 500 + 600 + 100 42 - 300 + 600 + 300 45 0 + 600 + 600 48 + 300 0 + 300 51 + 600 - 600 0 55 +1,000 -1,400 - 400 60 + 1,500 -2,400 - 900 212 Part II: Call Option Strategies FIGURE 11 • 1. Ratio call spread (2: 1 ). Stock Price at Expiration 1. The downside risk or gain is predetermined in the ratio spread at expiration, and therefore the position does not require much monitoring on the downside. 2. The margin investment required for a ratio spread is normally smaller than that required for a ratio write, since on the long side one is buying a call rather than buying the common stock itself. For margin purposes, a ratio spread is really the combination of a bull spread and a naked call write. There is no margin requirement for a bull spread other than the net debit to establish the bull spread. The net investment for the ratio spread is thus equal to the collateral required for the naked calls in the spread plus or minus the net debit or credit of the spread. In the example above, there is one naked call. The requirement for the naked call is 20% of the stock price plus the call premium, less the out-of-the-money amount. So the requirement in the example would be 20% of 44, or $880, plus the call premium of $300, less the one point that the stock is below the striking price - a $1,080 requirement for the naked call. Since the spread was established at a credit of one point, this credit can also be applied against the ini­ tial requirement, thereby reducing that requirement to $980. Since there is a naked call in this spread, there will be a mark to market if the stock moves up. Just as was recommended for the ratio write, it is recommended that the ratio spreader allow at least enough collateral to reach the upside break-even point. Since the upside break­ even point is 51 in this example, the spreader should allow 20% of 51, or $1,020, plus Chapter 11: Ratio Call Spreads 213 the 6 points that the call would be worth less the 1-point initial net credit - a total of $1,520 for this spread ($1,020 + $600 - $100). DIFFERING PHILOSOPHIES For many strategies, there is more than one philosophy of how to implement the strategy. Ratio spreads are no exception, with three philosophies being predominant. One philosophy holds that ratio spreading is quite similar to ratio writing - that one should be looking for opportunities to purchase an in-the-money call with little or no time premium in it so that the ratio spread simulates the profit opportunities from the ratio write as closely as possible with a smaller investment. The ratio spreads established under this philosophy may have rather large debits if the purchased call is substantially in-the-money. Another philosophy of ratio spreading is that spreads should be established for credits so that there is no chance of losing money on the downside. Both philosophies have merit and both are described. A third philosophy, called the "delta spread," is more concerned with neutrality, regardless of the initial debit or credit. It is also described. RATIO SPREAD AS RATIO WRITE There are several spread strategies similar to strategies that involve common stock. In this case, the ratio spread is similar to the ratio write. Whenever such a similarity exists, it may be possible for the strategist to buy an in-the-money call with little or no time premium as a substitute for buying the common stock. This was seen earlier in the covered call writing strategy, where it was shown that the purchase of in-the­ money calls or warrants might be a viable substitute for the purchase of stock. If one is able to buy an in-the-rrwney call as a substitute for the stock, he will not affect his profit potential substantially. When comparing a ratio spread to a ratio write, the max­ imum profit potential and the profit range are reduced by the time value premium paid for the long call. If this call is at parity (the time value premium is thus zero), the ratio spread and the ratio write have exactly the same profit potential. Moreover, the net investment is reduced and there is less downside risk should the stock fall in price below the striking price of the purchased call. The spread also involves smaller com­ mission costs than does the ratio write, which involves a stock purchase. The ratio writer does receive stock dividends, if any are paid, whereas the spreader does not. Example: XYZ is at 50, and an XYZ July 40 call is selling for 11 while an XYZ July 50 call is selling for 5. Table 11-2 compares the important points between the ratio write and the ratio spread. 214 TABLE 11-2. Ratio write and ratio spread compared. Profit range Maximum profit Downside risk Upside risk Initial investment Ratio Write: Buy XYZ of 50 and Sell 2 July SO's at 5 40 to 60 10 points 40 points 40 points $3,000 Part II: Call Option Strategies Ratio Spread: Buy 1 July 40 of 11 and Sell 2 July SO's at 5 41 to 59 9 points 1 point Unlimited $1,600 In Chapter 6, it was pointed out that ratio writing was one of the better strate­ gies from a probability of profit viewpoint. That is, the profit potential conforms well to the expected movement of the underlying stock. The same statement holds true for ratio spreads as substitutes for ratio writes. In fact, the ratio spread may often be a better position than the ratio write itself, when the long call can be purchased with little or no time value premium in it. RATIO SPREAD FOR CREDITS The second philosophy of ratio spreads is to establish them only for credits. Strategists who follow this philosophy generally want a second criterion fulfilled also: that the underlying stock be below the striking price of the written calls when the spread is established. In fact, the farther the stock is below the strike, the more attractive the spread would be. This type of ratio spread has no downside risk because, even if the stock collapses, the spreader will still make a profit equal to the initial credit received. This application of the ratio spread strategy is actually a sub­ case of the application discussed above. That is, it may be possible both to buy a long call for little or no time premium, thereby simulating a ratio write, and also to be able to set up the position for a credit. Since the underlying stock is generally below the maximum profit point when one establishes a ratio spread for a credit, this is actually a mildly bullish position. The investor would want the stock to move up slightly in order for his maximum prof­ it potential to be realized. Of course, the position does have unlimited upside risk, so it is not an overly bullish strategy. Chapter 11: Ratio Call Spreads 215 These two philosophies are not mutually exclusive. The strategist who uses ratio spreads without regard for whether they are debit or credit spreads will generally have a broader array of spreads to choose from and will also be able to assume a more neutral posture on the stock. The spreader who insists on generating credits only will be forced to establish spreads on which his return will be slightly smaller if the under­ lying stock remains relatively unchanged. However, he will not have to worry about downside defensive action, since he has no risk to the downside. The third philoso­ phy, the "delta spread," is described after the next section, in which the uses of ratios other than 2: 1 are described. ALTERING THE RATIO Under either of the two philosophies discussed above, the strategist may find that a 3:1 ratio or a 3:2 ratio better suits his purposes than the 2:1 ratio. It is not common to write in a ratio of greater than 4: 1 because of the large increase in upside risk at such high ratios. The higher the ratio that is used, the higher will be the credits of the spread. This means that the profits to the downside will be greater if the stock collapses. The lower the ratio that is used, the higher the upside break-even point will be, thereby reducing upside risk. Example: If the same prices are used as in the initial example in this chapter, it will be possible to demonstrate these facts using three different ratios (Table 11-3): XYZ common, 44; XYZ April 40 call, 5; and XYZ April 45 call, 3. TABLE 11-3. Comparison of three ratios. Price of spread (downside risk) Upside break-even Downside break-even Maximum profit 3:2 Ratio: Buy 2 April 40's Sell 3 April 45's 1 debit 54 401/2 9 2:1 Ratio: 3:1 Ratio: By 1 April 40 Buy 1 April 40 Sell 2 April 45's Sell 3 April 45's 1 credit 4 credit 51 49½ None None 6 9 216 Part II: Call Option Strategies In Chapter 6 on ratio writing, it was seen that it was possible to alter the ratio to adjust the position to one's outlook for the underlying stock The altering of the ratio in a ratio spread accomplishes the same objective. In fact, as will be pointed out later in the chapter, the ratio may be adjusted continuously to achieve what is con­ sidered to be a "neutral spread." A similar tactic, using the option's delta, was described for ratio writes. The following formulae allow one to determine the maximum profit potential and upside break~even point for any ratio: Points of maximum = Net credit+ Number oflong calls x profit Difference in striking prices or = Number of long calls X Difference in striking prices - Net debit Upside break-even = Points of maximum profit ff h t "ki . point Number of naked calls + ig er s n ng pnce These formulae can easily be verified by checking the numbers in Table 11-3. THE "DELTA SPREAD" The third philosophy of ratio spreading is a more sophisticated approach that is often referred to as the delta spread, because the deltas of the options are used to estab­ lish and monitor the spread. Recall that the delta of a call option is the amount by which the option is expected to increase in price if the underlying stock should rise by one point. Delta spreads are neutral spreads in that one uses the deltas of the two calls to set up a position that is initially neutral. Example: The deltas of the two calls that appeared in the previous examples were .80 and .50 for the April 40 and April 45, respectively. If one were to buy 5 of the April 40's and simultaneously sell 8 of the April 45's, he would have a delta-neutral spread. That is, if XYZ moved up by one point, the 5 April 40 calls would appreciate by .80 point each, for a net gain of 4 points. Similarly, the 8 April 45 calls that he is short would each appreciate by .50 point for a net loss of 4 points on the short side. Thus, the spread is initially neutral - the long side and the short side will offset each other. The idea of setting up this type of neutral spread is to be able to capture the time value premium decay in the preponderance of short calls without subjecting the spread to an inordinate amount of market risk. The actual credit or debit of the spread is not a determining factor. Chapter 11: Ratio Call Spreads 217 It is a fairly simple matter to determine the correct ratio to use in the delta spread: Merely divide the delta of the purchased call by the delta of the written call. In the example, this implies that the neutral ratio is .80 divided by .50, or 1.6:1. Obviously, one cannot sell 1.6 calls, so it is common practice to express that ratio as 16:10. Thus, the neutral spread would consist of buying 10 April 40's and selling 16 April 45's. This is the same as an 8:5 ratio. Notice that this calculation does not include anything about debits or credits involved in the spread. In this example, an 8:5 ratio would involve a small debit of one point (5 April 40's cost 25 points and 8 April 45's bring in 24 points). Generally, reasonably selected delta spreads involve small debits. Certain selection criteria can be offered to help the spreader eliminate some of the myriad possibilities of delta spreads on a day-to-day basis. First, one does not want the ratio of the spread to be too large. An absolute limit, such as 4:1, can be placed on all spread candidates. Also, if one eliminates any options selling for less than ½ point as candidates for the short side of the spread, the higher ratios will be eliminated. Second, one does not want the ratio to be too small. If the delta-neutral ratio is less than 1.2:1 (6:5), the spread should probably be rejected. Finally, if one is concerned with downside risk, he might want to limit the total debit outlay. This might be done with a simple parameter, such as not paying a debit of more than 1 point per long option. Thus, in a spread involving 10 long calls, the total debit must be 10 points or less. These screens are easily applied, especially with the aid of a com­ puter analysis. One merely uses the deltas to determine the neutral ratio. Then, if it is too small or too large, or if it requires the outlay of too large a debit, the spread is rejected from consideration. If not, it is a potential candidate for investment. FOLLOW-UP ACTION Depending on the initial credit or debit of the spread, it may not be necessary to take any downside defensive action at all. If the initial debit was large, the writer may roll down the written calls as in a ratio write. Example: An investor has established the ratio write by buying an XYZ July 40 call and selling two July 60 calls with the stock near 60. He might have done this because the July 40 was selling at parity. If the underlying stock declines, this spreader could roll down to the 50's and then to the 45's, in the same manner as he would with a ratio write. On the other hand, if the spread was initially set up with contiguous striking prices, the lower strike being just below the higher strike, no rolling-down action would be necessary. 218 Part II: Call Option Strategies REDUCING THE RATIO Upside fallow-up action does not normally consist of rolling up as it does in a ratio write. Rather, one should usually buy some more long calls to reduce the ratio in the spread. Eventually, he would want to reduce the spread to 1:1, or a normal bull spread. An example may help to illustrate this concept. Example: In the initial example, one April 40 call was bought and two April 45's were sold, for a net credit of one point. Assume that the spreader is going to buy one more April 40 as a means of upside defensive action if he has to. When and if he buys this second long call, his total position will be a normal bull spread - long 2 April 40's and short 2 April 45's. The liquidating value of this bull spread would be 10 points if XYZ were above 45 at April expiration, since each of the two bull spreads would widen to its maximum potential (5 points) with the stock above 45 in April. The ratio spread­ er originally brought in a one-point credit for the 2:1 spread. If he were later to pay 11 points to buy the additional long April 40 call, his total outlay would have been 10 points. This would represent a break-even situation at April expiration if XYZ were above 45 at that time, since it was just shown that the spread could be liquidated for 10 points in that case. So the ratio spreader could wait to take defensive action until the April call was selling for 11 points. This is a dynamic type of follow-up action, one that is dependent on the options' price, not the stock price per se. This outlay of 11 points for the April 40 would leave a break-even situation as long as the stock did not reverse and fall in price below 45 after the call was bought. The spreader may decide that he would rather leave some room for upside profit rather than merely trying to break even if the stock rallies too far. He might thus decide to buy the additional long call at 9 or 10 points rather than waiting for it to get to 11. Of course, this might increase the chances of a whipsaw occurring, but it would leave some room for upside profits if the stock continues to rise. Where ratios other than 2:1 are involved initially, the same thinking can be applied. In fact, the purchase of the additional long calls might take place in a two­ step process. Example: If the spread was initially long 5 calls and short 10 calls, the spreader would not necessarily have to wait until the April 40's were selling at 11 and then buy all 5 needed to make the spread a normal bull spread. He might decide to buy 2 or 3 at a lower price, thereby reducing his ratio somewhat. Then, if the stock rallied even further, he could buy the needed long calls. By buying a few at a cheaper price, the spreader gives himself the leeway to wait considerably longer to the upside. In essence, all 5 additional long calls in this spread would have to be bought at an aver­ age price of 11 or lower in order for the spread to break even. However, if the first 2 Chapter 11: Ratio Call Spreads 219 of them are bought for 8 points, the spreader would not have to buy the remaining 3 until they were selling around 13. Thus, he could wait longer to the upside before reducing the spread ratio to 1:1 (a bull spread). A formula can be applied to deter­ mine the price one would have to pay for the additional long calls, to convert the ratio spread into a bull spread. If the calls are bought, such a bull spread would break even with the stock above the higher striking price at expiration: Break-even cost of Number of short calls x Difference in strikes -Total debit to date long calls - Number of naked calls In the simple 2: 1 example, the number of short calls was 2, the difference in the strikes was 5, the total debit was minus one (-1) (since it was actually a 1.:.point cred­ it), and the number of naked calls is 1. Thus, the break-even cost of the additional long call is [2 x 5- (-1)(1)]/l = 11. As another verification of the formula, consider the 10:5 spread at the same prices. The initial credit of this spread would be 5 points, and the break-even cost of the five additional long calls is 11 points each. Assume that the spreader bought two additional April 40's for 8 points each (16 debit). This would make the total debit to date of the spread equal to 11 points, and reduce the number of naked calls to 3. The break-even cost of the remaining 3 long calls that would need to be purchased if the stock continued to rally would be (10 x 5 - 11)/3 = 13. This agrees with the observation made earlier. This formula can be used before actual fol­ low-up action is implemented. For example, in the 10:5 spread, if the April 40's were . selling for 8, the spreader might ask: "To what would I raise the purchase price of the remaining long calls if I buy 2 April 40's for 8 right now?" By using the formula, he could easily see that the answer would be 13. ADJUSTING WITH THE DELTA The theoretically-oriented spreader can use the delta-neutral ratio to monitor his spreads as well as to establish them. If the underlying stock moves up in price too far or down in price too far, the delta-neutral ratio of the spread will change. The spread­ er can then readjust his spread to a neutral status by buying some additional long calls on an upside movement by the stock, or by selling some additional short calls on a downward movement by the stock Either action will serve to make the spread delta­ neutral again. The public customer who is employing the delta-neutral adjustment method of follow-up action should be careful not to overadjust, because the com­ mission costs would become prohibitive. A more detailed description of the use of deltas as a means of follow-up action is contained in Chapter 28 on mathematical applications, under the heading "Facilitation or Institutional Block Positioning." The general concept, however, is the same as that shown earlier for ratio writing. 220 Part II: Call Option Strategies Example: Early in this chapter, when selection criteria were described, a neutral ratio was determined to be 16:10, with XYZ at 44. Suppose, after establishing the spread, that the common rallied to 4 7. One could use the current deltas to adjust. This information is summarized in Table 11-4. The current neutral ratio is approxi­ mately 14:10. Thus, two of the short April 45's could be bought closing. In practice, one usually decreases his ratio by adding to the long side. Consequently, one would buy two April 40's, decreasing his overall ratio to 16:12, which is 1.33 and is close to the actual neutral ratio of 1.38. The position would therefore be delta-neutral once more. An alternative way of looking at this is to use the equivalent stock position (ESP), which, for any option, is the multiple of the quantity times the delta times the shares per option. The last three lines of Table 11-4 show the ESP for each call and for the position as a whole. Initially, the position has an ESP of 0, indicating that it is perfectly delta-neutral. In the current situation, however, the position is delta short 140 shares. Thus, one could adjust the position to be delta-neutral by buying 140 shares of XYZ. If he wanted to use the options rather than the stock, he could buy two April 45's, which would add a delta long of 130 ESP (2 x .65 x 100), leaving the position delta short 10 shares, which is very near neutral. As pointed out in the above paragraph, the spreader probably should buy the call with the most intrinsic value - the April 40. Each one of these has an ESP of 90 (1 x .9 x 100). Thus, if one were bought, the position would be delta short 50 shares; if two were bought, the total position would be delta long 40 shares. It would be a matter of individual preference whether the spreader wanted to be long or short the "odd lot" of 40 or 50 shares, respectively. TABLE 11-4. Original and current prices and deltas. XYZ common April 40 call April 45 call April 40 delta April 45 delta Neutral ratio April 40 ESP April 45 ESP Total ESP Original Situation 44 5 3 .80 .50 16:10 (.80/.50) 800 long (l Ox .8 x 100) 800 shrt ( 16 x .5 x l 00) 0 (neutral) Current Situation 47 8 5 .90 .65 14:10 (.90/.65 = 1.38) 900 long (10 x .9 x 100) l ,040 shrt ( 16 x .65 x l 00) 140 shrt Chapter 11: Ratio Call Spreads 221 The ESP method is merely a confirmation of the other method. Either one works well. The spreader should become familiar with the ESP method because, in a position with many different options, it reduces the exposure of the entire position to a single number. TAKING PROFITS In addition to defensive action, the spreader may find that he can close the spread early to take a profit or to limit losses. If enough time has passed and the underlying stock is close to the maximum profit point - the higher striking price - the spreader may want to consider closing the spread and taking his profit. Similarly, if the under­ lying stock is somewhere between the two strikes as expiration draws near, the writer will normally find himself with a profit as the long call retains some intrinsic value and the short calls are nearly worthless. If at this time one feels that there is little to gain (a price decline might wipe out the long call value), he should close the spread and take his profit. SUMMARY Ratio spreads can be an attractive strategy, similar in some ways to ratio writing. Both strategies offer a large probability of making a limited profit. The ratio spread has limited downside risk, or possibly no downside risk at all. In addition, if the long call(s) in the spread can be bought with little or no time value premium in them, the ratio spread becomes a superior strategy to the ratio write. One can adjust the ratio used to reflect his opinion of the underlying stock or to make a neutral profit range if desired. The ratio adjustment can be accomplished by using the deltas of the options. In a broad sense, this is one of the more attractive forms of spreading, since the strategist is buying mostly intrinsic value and is selling a relatively large amount of time value. Cotnbining Calendar and Ratio Spreads The previous chapters on spreading introduced the basic types of spreads. The sim­ plest forms of bull spreads, bear spreads, or calendar spreads can often be combined to produce a position with a more attractive potential. The butterfly spread, which is a combination of a bull spread and a bear spread, is an example of such a combina­ tion. The next three chapters are devoted to describing other combinations of spreads, wherein the strategist not only mixes basic strategies ..:... bull, bear, and calen­ dar - but uses varying expiration dates as well. Although they may seem overly com­ plicated at first glance, these combinations are often employed by professionals in the field. RATIO CALENDAR SPREAD The ratio cdendar spread is a combination of the techniques used in the calendar and ratio spreads. Recall that one philosophy of the calendar spread strategy was to sell the near-term call and buy a longer-term call, with both being out-of-the-money. This is a bullish calendar spread. If the underlying stock never advances, the spread­ er loses the entire amount of the relatively small debit that he paid for the spread. However, if the stock advances after the near-term call expires worthless, large prof­ its are possible. It was stated that this bullish calendar spread philosophy had a small probability of attaining large profits, and that the few profits could easily exceed the preponderance of small losses. The ratio calendar spread is an attempt to raise the probabilities while allowing for large potential profits. In the ratio calendar spread, one sells a number of near- 222 Chapter 12: Combining Calendar and Ratio Spreads 223 term calls while buyingfewer of the intermediate-term or long-term calls. Since more calls are being sold than are being bought, naked options are involved. It is often pos­ sible to set up a ratio calendar spread for a credit, meaning that if the underlying stock never rallies above the strike, the strategist will still make money. However, since naked calls are involved, the collateral requirements for participating in this strategy may be large. Example: As in the bullish calendar spreads described in Chapter 9, the prices are: XYZ common, 45; XYZ April 50 call, l; and XYZ July 50 call, l½. In the bullish calendar spread strategy, one July 50 is bought for each April 50 sold. This means that the spread is established for a debit of½ point and that the invest­ ment is $50 per spread, plus commissions. The strategist using the ratio calendar / spread has essentially the same philosophy as the bullish calendar spreader: The stock will remain below 50 until April expiration and may then rally. The ratio calen­ dar spread might be set up as follows: Buy 1 XYZ July 50 call at l½ Sell 2 XYZ April 50 calls at 1 each Net l½ debit 2 credit ½ credit Although there is no cash involved in setting up the ratio spread since it is done for a credit, there is a collateral requirement for the naked April 50 call. If the stock remains below 50 until April expiration, the long call - the July 50 - will be owned free. After that, no matter what happens to the underlying stock, the spread cannot lose money. In fact, if the underlying stock advances dramatically after near-term expiration, large profits will accrue as the July 50 call increases in value. Of course, this is entirely dependent on the near-term call expiring worthless. If the underlying stock should rally above 50 before the April calls expire, the ratio calen­ dar spread is in danger of losing a large amount of money because of the naked calls, and defensive action must be taken. Follow-up actions are described later. The collateral required for the ratio calendar spread is equal to the amount of collateral required for the naked calls less the credit taken in for the spread. Since naked calls will be marked to market as the stock moves up, it is always best to allow enough collateral to get to a defensive action point. In the example above, suppose that one felt he would definitely be taking defensive action if the stock rallied to 53 224 Part II: Call Option Strategies before April expiration. He should then figure his collateral requirement as if the stock were at 53, regardless of what the collateral requirement is at the current time. This is a prudent tactic whenever naked options are involved, since the strategist will never be forced into an unwanted close-out before his defensive action point is reached. The collateral required for this example would then be as follows, assuming the call is trading at 3½: 20% of 53 Call premium Less initial credit Total collateral to set aside $1,060 + 350 -___fill $1,360 The strategist is not really "investing" anything in this strategy, because his require­ ment is in the form of collateral, not cash. That is, his current portfolio assets need not be disturbed to set up this spread, although losses would, of course, create deb­ its in the account. Many naked option strategies are similar in this respect, and the strategist may earn additional money from the collateral value of his portfolio with­ out disturbing the portfolio itself. However, he should take care to operate such strategies in a conservative manner, since any income earned is "free," but losses may force him to disturb his portfolio. In light of this fact, it is always difficult to compute returns on investment in a strategy that requires only collateral to operate. One can, of course, compute the return on the maximum collateral required during the life of the position. The large investor participating in such a strategy should be satisfied with any sort of positive return. Returning to the example above, the strategist would make his $50 credit, less commissions, if the underlying stock remained below 50 until July expiration. It is not possible to determine the results to the upside so definitively. If the April 50 calls expire worthless and then the stock rallies, the potential profits are limited only by time. The case in which the stock rallies before April expiration is of the most con­ cern. If the stock rallies immediately, the spread will undoubtedly show a loss. If the stock rallies to 50 more slowly, but still before April expiration, it is possible that the spread will not have changed much. Using the same example, suppose that XYZ ral­ lies to 50 with only a few weeks of life remaining in the April 50 calls. Then the April 50 calls might be selling at l ½ while the July 50 call might be selling at 3. The ratio spread could be closed for even money at that point; the cost of buying back the 2 April 50's would equal the credit received from selling the one July 50. He would thus make½ point, less commissions, on the entire spread transaction. Finally, at the expi­ ration date of the April 50 calls, one can estimate where he would break even. Suppose one estimated that the July 50 call would be selling for 5½ points if XYZ were at 53 at April expiration. Since the April 50 calls would be selling for 3 at that Chapter 12: Combining Calendar and Ratio Spreads 225 time (they would be at parity), there would be a debit of½ point to close the ratio spread. The two April 50 calls would be bought for 6 points and the July 50 call sold for 5½ - a ½ debit. The entire spread transaction would thus have broken even, less commissions, at 53 at April expiration, since the spread was put on for a ½ credit and was taken off for a ½ debit. The risk to the upside depends clearly, then, on how quickly the stock rallies above 50 before April expiration. CHOOSING THE SPREAD Some of the same criteria used in setting up a bullish calendar spread apply here as well. Select a stock that is volatile enough to move above the striking price in the allotted time - after the near-term expires, but before the long call expires. Do not use calls that are so far out-of-the-money that it would be virtually impossible for the stock to reach the striking price. Always set up the spread for a credit, commissions included. This will assure that a profit will be made even if the stock goes nowhere. However, if the credit has to be generated by using an extremely large ratio - greater than 3 short calls to every long one - one should probably reject that choice, since the potential losses in an immediate rally would be large. The upside break-even point prior to April expiration should be determined using a pricing model. Such a model, or the output from one, can generally be obtained from a data service or from some brokerage firms. It is useful to the strate­ gist to know exactly how much room he has to the upside if the stock begins to rally. This will allow him to take defensive action in the form of closing out the spread before his break-even point is reached. Since a pricing model can estimate a call price for any length of time, the strategist can compute his break-even points at April expiration, 1 month before April expiration, 6 weeks before, and so on. When the long option in a spread expires at a different time from the short option, the break-even point is dynamic. That is, it changes with time. Table 12-1 shows how this information might be accumulated for the example spread used above. Since this example spread was established for a ½-point credit with the stock at 45, the break-even points would be at stock prices where the spread could be removed for a ½-point debit. Suppose the spread was initiated with 95 days remaining until April expiration. In each line of the table, the cost for buying 2 April 50's is ½ point more than the price of the July 50. That is, there would be a ½-point debit involved in closing the spread at those prices. Notice that the break-even price increases as time passes. Initially, the spread would show a loss if the stock moved up at all. This is to be expected, since an immediate move would not allow for any erosion in the time value premium of the near-term calls. As more and more time passes, time weighs 226 Part II: Call Option Strategies more heavily on the near-term April calls than on the longer-term July call. Once the strategist has this information, he might then look at a chart of the underlying stock. If there is resistance for XYZ below 53, his eventual break-even point at April expi­ ration, he could then feel more confident about this spread. FOLLOW-UP ACTION The main purpose of defensive action in this strategy is to limit losses if the stock should rally before April e:xJ)iration. The strategist should be quick to close out the spread before any serious losses accrue. The long call quite adequately compen­ sates for the losses on the short calls up to a certain point, a fact demonstrated in Table 12-1. However, the stock cannot be allowed to run. A rule of thumb that is often useful is to close the spread if the stock breaks out above technical resistance or if it breaks above the eventual break-even point at expiration. In the example above, the strategist would close the spread if, at any time, XYZ rose above 53 (before April expiration, of course). If a significant amount of time has passed, the strategist might act even more quickly in closing the spread. As was shown earlier, if the stock rallies to 50 with only a few weeks of time remaining, the spread may actually be at a slight profit at that time. It is often the best course of action to take the small profit, if the stock rises above the striking price. TABLE 12-1. Break-even points changing over time. Estimated Estimated Days Remaining until Break-Even Point April 50 July 50 April Expiration (Stock Price) Price Price 90 45 11/2 60 48 Jl/2 21/2 30 51 21/2 4 1/2 0 53 3 51/2 THE PROBABILITIES ARE GOOD This is a strategy with a rather large probability of profit, provided that the defensive action described above is adhered to. The spread will make money if the stock never rallies above the striking price, since the spread is established for a credit. This in Chapter 12: Combining Calendar and Ratio Spreads 227 itself is a rather high-probability event, because the stock is initially below the strik­ ing price. In addition, the spread can make large potential profits if the stock rallies after the near-term calls expire. Although this is a much less probable event, the prof­ its that can accrue add to the expected return of the spread. The only time the spread loses is when the stock rallies quickly, and the strategist should close out the spread in that case to limit losses. Although Table 12-2 is not mathematically definitive, it can be seen that this strategy has a positive expected return. Small profits occur more frequently than small losses do, and sometimes large profits can occur. These expected outcomes, when coupled with the fact that the strategist may utilize collateral such as stocks, bonds, or government securities to set up these spreads, demonstrate that this is a viable strategy for the advanced investor. TABLE 12-2. Profitability of ratio calendar spreading. Event Stock never rallies above strike Stock rallies above strike in a short time Stock rallies above strike after near-term call expires Outcome Small profit. Small loss if defensive action employed Large potential profit DELTA-NEUTRAL CALENDAR SPREADS Probability Large probability Small probability Small probability The preceding discussion dealt with a specific kind of ratio calendar spread, the out­ of-the-money call spread. A more accurate ratio can be constructed using the deltas of the calls involved, similar to the ratio spreads in Chapter 11. The spread can be created with either out-of-the-money calls or in-the-money calls. The former has naked calls, while the latter has extra long calls. Both types of ratio calendars are described. In either case, the number of calls to sell for each one purchased is determined by dividing the delta of the long call by the delta of the short call. This is the same for any ratio spread, not just calendars. Example: Suppose XYZ is trading at 45 and one is considering using the July 50 call and the April 50 call to establish a ratio calendar spread. This is the same situation 228 Part II: Call Option Strategies that was described earlier in this chapter. Furthermore, assume that the deltas of the calls in question are .25 for the July and .15 for the April. Given that information, one can compute the neutral ratio to be 1.667 to 1 (.25/.15). That is, one would sell 1.667 calls for each one he bought; restated, he would sell 5 for each 3 bought. This out-of-the-money neutral calendar is typical. One normally sells more calls than he buys to establish a neutral calendar when the calls are out-of-the-money. The ramifications of this strategy have already been described in this chapter. Follow-up strategy is slightly different, though, and is described later. THE IN-THE-MONEY CALENDAR SPREAD When the calls are in-the-money, the neutral spread has a distinctly different look. An example will help in describing the situation. Example: XYZ is trading at 49, and one wants to establish a neutral calendar spread using the July 45 and April 45 calls. The deltas of these in-the-money calls are .8 for the April and .7 for the July. Note that for in-the-rrwney calls, a shorter-term call has a higher delta than a longer-term call. The neutral ratio for this in-the-money spread would be .875 to 1 (.7/.8). This means that .875 calls would be sold for each one bought; restated, 7 calls would be sold and 8 bought. Thus, the spreader is buying more calls than he is selling when establishing an in-the-money neutral calendar. In some sense, one is establishing some "regular'' calendar spreads (seven of them, in this example) and simultaneous­ ly buying a few extra long calls to go along with them ( one extra long call, in this example). This type of position can be quite attractive. First of all, there is no risk to the upside as there is with the out-of-the-money calendar; the in-the-money calendar would make money, because there are extra long calls in the position. Thus, if there were to be a large gap to the upside in XYZ perhaps caused by a takeover attempt - the in-the-money calendar would make money. If, on the other hand, XYZ stays in the same area, then the regular calendar spread portion of the strategy will make money. Even though the extra call would probably lose some time value premium in that event, the other seven spreads would make a large enough profit to easily com­ pensate for the loss on the one long call. The least desirable result would be for XYZ to drop precipitously. However, in that case, the loss is limited to the amount of the initial debit of the spread. Even in the case of XYZ dropping, though, follow-up action can be taken. There are no naked calls to margin with this strategy, making it attractive to many smaller investors. In the above example, one would need to pay for the entire debit of the position, but there would be no further requirements. Chapter 12: Combining Calendar and Ratio Spreads FOLLOW-UP ACTION 229 If one decides to preserve a neutral strategy with follow-up action in either type of ratio call calendar, he would merely need to look at the deltas of the calls and keep the ratio neutral. Doing so might mean that one would switch from one type of cal­ endar spread to the other, from the out-of-the-money with naked calls to the in-the­ money with extra long calls, or vice versa. For example, if XYZ started at 45, as in the first example, one would have sold more calls than he bought. If XYZ then rallied above 50, he would have to move his position into the in-the-money ratio and get long more calls than he is short. While such follow-up action is strategically correct maintaining the neutral ratio - it might not make sense practically, especially if the size of the original spread were small. If one had originally sold 5 and bought 3, he would be better to adhere to the follow-up strategy outlined earlier in this chapter. The spread is not large enough to dictate adjusting via the delta-neutral ratios. If, however, a large trader had originally sold 500 calls and bought 300, then he has enough profitability in the spread to make several adjustments along the way. In a similar manner, the spreader who had established a small in-the-money cal­ endar might decide not to bother rationing the spread if the stock dropped below the strike. He knows his risk is limited to his initial debit, and that would be small for a small spread. He might not want to introduce naked options into the position if XYZ declines. However, if the same spread were established by a large trader, it should be adjusted because of the greater tolerance of the spread to being adjusted, merely because of its size. Reverse Spreads In general, when a strategy has the term "reverse" in its name, the strategy is the opposite of a more commonly used strategy. The reader should be familiar with this nomenclature from the earlier discussions comparing ratio writing (buying stock and selling calls) with reverse hedging (shorting stock and buying calls). If the reverse strategy is sufficiently well-known, it usually acquires a name of its own. For exam­ ple, the bear spread is really the reverse of the bull spread, but the bear spread is a popular enough strategy in its own right to have acquired a shorter, unique name. REVERSE CALENDAR SPREAD The reverse calendar spread is an infrequently used strategy, at least for public cus­ tomers trading stock or index options, because of the margin requirements. However, even then, it does have a place in the arsenal of the option strategist. Meanwhile, pro­ fessionals and futures option traders use the strategy with more frequency because the margin treatment is more favorable for them. As its name implies, the reverse calendar spread is a position that is just the opposite of a "normal" calendar spread. In the reverse calendar spread, one sells a long-term call option and simultaneously buys a shorter-term call option. The spread can be constructed with puts as well, as will be shown in a later chapter. Both calls have the same striking price. This strategy will make money if one of two things happens: Either (1) the stock price moves away from the striking price by a great deal, or (2) the inplied volatility of the options involved in the spread shrinks. For readers familiar with the "normal" calendar spread strategy, the first way to profit should be obvious, because a "normal" 230 Chapter 13: Reverse Spreads 231 calendar spread makes the most money if the stock is right at the strike price at expi­ ration, and it loses money if the stock rises or falls too far. As with any spread involving options expiring in differing months, it is common practice to look at the profitability of the position at or before the near-term expira­ tion. An example will show how this strategy can profit. Example: Suppose the current month is April and that XYZ is trading at 80. Furthermore, suppose that XYZ's options are quite expensive, and one believes the underlying stock will be volatile. A reverse calendar spread would be a way to profit from these assumptions. The following prices exist: XYZ December 80 call: 12 XYZ July 80 call: 7 A reverse calendar spread is established by selling the December 80 call for 12 points, and buying the July 80 call for 7, a net credit of 5 points for the spread. If, later, XYZ falls dramatically, both call options will be nearly worthless and the spread could be bought back for a price well below 5. For example, if XYZ were to fall to 50 in a month or so, the July 80 call would be nearly worthless and the December 80 call could be bought back for about a point. Thus, the spread would have shrunk from its initial price of 5 to a price of about 1, a profit of 4 points. The other way to make money would be for implied volatility to decrease. Suppose implied volatility dropped after a month had passed. Then the spread might be worth something like 4 points - an unrealized profit of about 1 point, since it was sold for a price of 5 initially. The profit graph in Figure 13-1 shows the profitability of the reverse calendar. There are two lines on the graph, both of which depict the results at the expiration of the near-term option (the July 80 call in the above example). The lower line shows where profits and losses would occur if implied volatility remained unchanged. You can see that the position could profit if XYZ were to rise above 98 or fall below 70. In addition, the higher curve on the graph shows where profits would lie if implied volatility fell prior to expiration of the near-term options. In that case, additional prof­ its would accrue, as depicted on the graph. So there are two ways to make money with this strategy, and it is therefore best to establish it when implied volatility is high and the underlying has a tendency to be volatile. The problem with this spread, for stock and index option traders, is that the call that is sold is considered to be naked. This is preposterous, of course, since the short­ term call is a perfectly valid hedge until it expires. Yet the margin requirements remain onerous. When they were overhauled recently, this glaring inefficiency was 232 Part II: Call Option Strategies Figure 13-1 • Calendar spread sale at near-term expiration. $400 $300 Implied Volatility Lower $200 \ f/) $100 f/) 0 ~ $0 50 60 110 120 a. -$100 -$200 -$300 Implied Volatility -$400 Remains High -$500 Underlying Price allowed to stand because none of the member firms cared about changing it. Still, if one has excess collateral - perhaps from a large stock portfolio - and is interested in generating excess income in a hedged manner, then the strategy might be applicable for him as well. Futures option traders receive more favorable margin requirements, and it thus might be a more economical strategy for them. REVERSE RATIO SPREAD (BACKSPREAD) A more popular reverse strategy is the reverse ratio call spread, which is comrrwnly known as a backspread. In this type of spread, one would sell a call at one striking price and then would buy several calls at a higher striking price. This is exactly the opposite of the ratio spread described in Chapter 11. Some traders refer to any spread with unlimited profit potential on at least one side as a backspread. Thus, in most backspreading strategies, the spreader wants the stock to rrwve dramatically. He does not generally care whether it moves up or down. Recall that in the reverse hedge strategy (similar to a straddle buy) described in Chapter 4, the strategist had the potential for large profits if the stock moved either up or down by a great deal. In the backspread strategy discussed here, large potential profits exist if the stock moves up dramatically, but there is limited profit potential to the downside. Example: XYZ is selling for 43 and the July 40 call is at 4, with the July 45 call at l. A reverse ratio spread would be established as follows: · Chapter 13: Reverse Spreads Buy 2 July 45 calls at 1 each Sell 1 July 40 call at 4 Net 2 debit 4 credit 2 credit 233 These spreads are generally established for credits. In fact, if the spread cannot be initiated at a credit, it is usually not attractive. If the underlying stock drops in price and is below 40 at July expiration, all the calls will expire worthless and the strategist will make a profit equal to his initial credit. The maximum downside poten­ tial of the reverse ratio spread is equal to the initial credit received. On the other hand, if the stock rallies substantially, the potential upside profits are unlimited, since the spreader owns more calls than he is short. Simplistically, the investor is bullish and is buying out-of the-money calls but is simultaneously hedging himself by selling another call. He can profit if the stock rises in price, as he thought it would, but he also profits if the stock collapses and all the calls expire worthless. This strategy has limited risk. With most spreads, the maximum loss is attained at expiration at the striking price of the purchased call. This is a true statement for backspreads. Example: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth­ less for a loss of $200 and the July 40 call will have to be bought back for 5 points, a $100 loss on that call. The total loss would thus be $300, and this is the most that can be lost in this example. If the underlying stock should rally dramatically, this strategy has unlimited profit potential, since there are two long calls for each short one. In fact, one can always compute the upside break-even point at expiration. That break­ even point happens to be 48 in this example. At 48 at July expiration, each July 45 call would be worth 3 points, for a net gain of $400 on the two of them. The July 40 call would be worth 8 with the stock at 48 at expiration, representing a $400 loss on that call. Thus, the gain and the loss are offsetting and the spread breaks even, except for commissions, at 48 at expiration. If the stock is higher than 48 at July expiration, profits will result. Table 13-1 and Figure 13-2 depict the potential profits and losses from this example of a reverse ratio spread. Note that the profit graph is exactly like the prof­ it graph of a ratio spread that has been rotated around the stock price axis. Refer to Figure 11-1 for a graph of the ratio spread. There is actually a range outside of which profits can be made - below 42 or above 48 in this example. The maximum loss occurs at the striking price of the purchased calls, or 45, at expiration. There are no naked calls in this strategy, so the investment is relatively small. The strategy is actually a long call added to a bear spread. In this example, the bear 234 Part II: Call Option Strategies TABLE 13·1. Profits and losses for reverse ratio spread. XYZ Price at Profit on Profit on Total July Expiration 1 July 40 2 July 45's Profit 35 +$ 400 -$ 200 +$ 200 40 + 400 200 + 200 42 + 200 200 0 45 100 200 300 48 400 + 400 0 55 - 1,100 + 1,800 + 700 70 - 2,600 + 4,800 + 2,200 spread portion is long the July 45 and short the July 40. This requires a $500 collat­ eral requirement, because there are 5 points difference in the striking prices. The credit of $200 received for the entire spread can be applied against the initial requirement, so that the total requirement would be $300 plus commissions. There is no increase or decrease in this requirement, since there are no naked calls. Notice that the concept of a delta-neutral spread can be utilized in this strate­ gy, in much the same way that it was used for the ratio call spread. The number of calls to buy and sell can be computed mathematically by using the deltas of the options involved. Example: The neutral ratio is determined by dividing the delta of the July 45 into the delta of the July 40. Prices XYZ common: = 43 XYZ July 40 call: 4 XYZ July 45 call: Delta .80 .35 In this case, that would be a ratio of 2.29:1 (.80/.35). That is, if one sold 5 July 40's, he would buy 11 July 45's (or if he sold 10, he would then buy 23). By beginning with a neutral ratio, the spreader should be able to make money on a quick move by the stock in either direction. The neutral ratio can also help the spreader to avoid being too bearish or too bullish to begin with. For example, a spreader would not be bullish enough if he Chapter 13: Reverse Spreads FIGURE 13-2. Reverse ratio spread (backspread). C: ~ +$200 ;% :!:: e a. -$300 Stock Price at Expiration 235 merely used a 2:1 ratio for convenience, instead of using the 2.3:l ratio. If anything, one might normally establish the spread with an extra bullish emphasis, since the largest profits are to the upside. There is little reason for the spreader to have too lit­ tle bullishness in this strategy. Thus, if the deltas are correct, the neutral ratio can aid the spreader in the determination of a more accurate initial ratio. The strategist must be alert to the possibility of early exercise in this type of spread, since he has sold a call that is in-the-money. Aside from watching for this pos­ sibility, there is little in the way of defensive follow-up action that needs to be imple­ mented, since the risk is limited by the nature of the position. He might take profits by closing the spread if the stock rallies before expiration. This strategy presents a reasonable method of attempting to capitalize on a large stock movement with little tie-up of collateral. Generally, the strategist would seek out volatile stocks for implementation of this strategy, because he would want as much potential movement as possible by the time the calls expire. In Chapter 14, it will be shown that this strategy can become more attractive by buying calls with a longer maturity than the calls sold. CH.APTER 14 Diagonalizing a Spread When one uses both different striking prices and different expiration dates in a spread, it is a diagonal spread. Generally, the long side of the spread would expire later than the short side of the spread. Note that this is within the definition of a spread for margin purposes: The long side must have a maturity equal to or longer than the maturity of the short side. With the exception of calendar spreads, all the previous chapters on spreads have described ones in which the expiration dates of the short call and the long call were the same. However, any of these spreads can be diag­ onalized; one can replace the long call in any spread with one expiring at a later date. In general, diagonalizing a spread in this manner makes it slightly rrwre bear­ ish at near-term expiration. This can be seen by observing what would happen if the stock fell or rose substantially. If the stock falls, the long side of the spread will retain some value because of its longer maturity. Thus, a diagonal spread will generally do better to the downside than will a regular spread. If the stock rises substantially, all calls will come to parity. Thus, there is no advantage in the long-term call; it will be selling for approximately the same price as the purchased call in a normal spread. However, since the strategist had to pay more originally for the longer-term call, his upside profits would not be as great. A diagonalized position has an advantage in that one can reestablish the posi­ tion if the written calls expire worthless in the spread. Thus, the increased cost of buying a longer-term call initially may prove to be a savings if one can write against it twice. These tactics are described for various spread strategies. THE DIAGONAL BULL SPREAD A vertical call bull spread consists of buying a call at a lower striking price and sell­ ing a call at a higher striking price, both with the same expiration date. The diagonal 236 Chapter 14: Diagonalizing a Spread 231 bull spread would be similar except that one would buy a longer-tenn call at the lower strike and would sell a near-tenn call at the higher strike. The number of calls long and short would still be the same. By diagonalizing the spread, the position is hedged somewhat on the downside in case the stock does not advance by near-term expira­ tion. Moreover, once the near-term option expires, the spread can often be reestab­ lished by selling the call with the next maturity. Example: The following prices exist: Strike April Ju~ October Stock Price XYZ 30 3 4 5 32 XYZ 35 11/2 2 32 A vertical bull spread could be established in any of the expiration series by buying the call with 30 strike and selling the call with 35 strike. A diagonal bull spread would consist of buying the July 30 or October 30 and selling the April 35. To compare a vertical bull spread with a diagonal spread, the following two spreads will be used: Vertical bull spread: buy the April 30 call, sell the April 35 - 2 debit Diagonal bull spread: buy the July 30 call, sell the April 35 3 debit The vertical bull spread has a 3-point potential profit if XYZ is above 35 at April expi­ ration. The maximum risk in the normal bull spread is 2 points (the original debit) if XYZ is anywhere below 30 at April expiration. By diagonalizing the spread, the strate­ gist lowers his potential profit slightly at April expiration, but also lowers the proba­ bility of losing 2 points in the position. Table 14-1 compares the two types of spreads at April expiration. The price of the July 30 call is estimated in order to derive the estimated profits or losses from the diagonal bull spread at that time. If the underly­ ing stock drops too far - to 20, for example - both spreads will experience nearly a total loss at April expiration. However, the diagonal spread will not lose its entire value if XYZ is much above 24 at expiration, according to Table 14-1. The diagonal spread actually has a smaller dollar loss than the normal spread between 27 and 32 at expiration, despite the fact that the diagonal spread was more expensive to estab­ lish. On a percentage basis, the diagonal spread has an even larger advantage in this range. If the stock rallies aboye 35 by expiration, the normal spread will provide a larger profit. There is an interesting characteristic of the diagonal spread that is shown in Table 14-1. If the stock advances substantially and all the calls come to par­ ity, the profit on the diagonal spread is limited to 2 points. However, if the stock is near 35 at April expiration, the long call will have some time premium in it and the 238 Part II: Call Option Strategies TABLE 14-1. Comparison of spreads at expiration. Vertical Bull XYZ Price at April 30 April 35 July 30 Spread Diagonal April Expiration Price Price Price Profit Spread Profit 20 0 0 0 -$200 -$300 24 0 0 1/2 - 200 - 250 27 0 0 1 - 200 - 200 30 0 0 2 - 200 - 100 32 2 0 3 0 0 35 5 0 51/2 + 300 + 250 40 10 5 10 + 300 + 200 45 15 10 15 + 300 + 200 spread will actually widen to more than 5 points. Thus, the maximum area of profit at April expiration for the diagonal spread is to have the stock near the striking price of the written call. The figures demonstrate that the diagonal spread gives up a small portion of potential upside profits to provide a hedge to the downside. Once the April 35 call expires, the diagonal spread can be closed. However, if the stock is below 35 at that time, it may be more prudent to then sell the July 35 call against the July 30 call that is held long. This would establish a normal bull spread for the 3 months remaining until July expiration. Note that ifXYZ were still at 32 at April expiration, the July 35 call might be sold for 1 point if the stock's volatility was about the same. This should be true, since the April 35 call was worth 1 point with the stock at 32 three months before expiration. Consequently, the strategist who had pursued this course of action would end up with a normal July bull spread for a net debit of 2 points: He originally paid 4 for the July 30 call, but then sold the April 35 for 1 point and subsequently sold the July 35 for 1 point. By looking at the table of prices for the first example in this chapter, the reader can see that it would have cost 2½ points to set up the normal July bull spread originally. Thus, by diagonalizing and having the near-term call expire worthless, the strategist is able to acquire the normal July bull spread at a cheaper cost than he could have originally. This is a specific example of how the diagonalizing effect can prove beneficial if the writer is able to write against the same long call two times, or three times if he originally purchased the longest­ term call. In this example, if XYZ were anywhere between 30 and 35 at April expira­ tion, the spread would be converted to a normal July bull spread. If the stock were above 35, the spread should be closed to take the profit. Below 30, the July 30 call would probably be closed or left outright long. Chapter 14: Diagonalizing a Spread 239 In summary, the diagonal bull spread may often be an improvement over the normal bull spread. The diagonal spread is an improvement when the stock remains relatively unchanged or falls, up until the near-term written call expires. At that time, the spread can be converted to a normal bull spread if the stock is at a favorable price. Of course, if at any time the underlying stock rises above the higher striking price at an expiration date, the diagonal spread will be profitable. OWNING A CALL FOR "FREE" Diagonalization can be used in other spread strategies to accomplish much the same purposes already described; but in addition, it may also be possible for the spreader to wind up owning a long call at a substantially reduced cost, possibly even for free. The easiest w~y to see this would be to consider a diagonal bear spread. Example: XYZ is at 32 and the near-term April 30 call is selling for 3 points while the longer-term July 35 call is selling for 1 ½ points. A diagonal bear spread could be established by selling the April 30 and buying the July 35. This is still a bear spread, because a call with a lower striking price is being sold while a call at a higher strike is being purchased. However, since the purchased call has a longer maturity date than the written call, the spread is diagonalized. This diagonal bear spread will make money ifXYZ falls in price before the near­ term April call expires. For example, ifXYZ is at 29 at expiration, the written call will expire worthless and the July 35 will still have some value, perhaps ½. Thus, the prof­ it would be 3 points on the April 30, less a 1-point loss on the July 35, for an overall profit of 2 points. The risk in the position lies to the upside, just as in a regular bear spread. If XYZ should advance by a great deal, both options would be at parity and the spread would have widened to 5 points. Since the initial credit was 1 ½ points, the loss would be 5 minus 1 ½, or 3½ points in that case. As in all diagonal spreads, the spread will do slightly better to the downside because the long call will hold some value, but it will do slightly worse to the upside if the underlying stock advances sub­ stantially. The reason that a strategist might attempt a diagonal bear spread would not be for the slight downside advantage that the diagonalizing effect produces. Rather it would be because he has a chance of owning the July 35 call - the longer-term call - for a substantially reduced cost. In the example, the cost of the July 35 call was 1 ½ points and the premium received from the sale of the April 30 call was 3 points. If the spreader can make 1 ½ points from the sale of the April 30 call, he will have com­ pletely covered the cost of his July option. He can then sit back and hope for a rally 240 Part II: Call Option Strategies by the underlying stock. If such a rally occurred, he could make unlimited profits on the long side. If it did not, he loses nothing. Example: Assume that the same spread was established as in the last example. Then, if XYZ is at or below 31 ½ at April expiration, the April 30 call can be purchased for 1 ½ points or less. Since the call was originally sold for 3, this would represent a prof­ it of at least 1 ½ points on the April 30 call. This profit on the near-term option cov­ ers the entire cost of the July 35. Consequently, the strategist owns the July 35 for free. If XYZ never rallies above 35, he would make nothing from the overall trade. However, if XYZ were to rally above 35 after April expiration (but before July expi­ ration, of course), he could make potentially large profits. Thus, when one establish­ es a diagonal spread for a credit, there is always the potential that he could own a call for free. That is, the profits from the sale of the near-term call could equal or exceed the original cost of the long call. This is, of course, a desirable position to be in, for if the underlying stock should rally substantially after profits are realized on the short side, large profits could accrue. DIAGONAL BACKSPREADS In an analogous strategy, one might buy more than one longer-term call against the short-term call that is sold. Using the foregoing prices, one might sell the April 30 for 3 points and buy 2 July 35's at 1 ½ points each. This would be an even money spread. . The credits equal the debits when the position is established. If the April 30 call expires worthless, which would happen if the stock was below 30 in April, the spread­ er would own 2 July 35 calls for free. Even if the April 30 does not expire totally worthless, but if some profit can be made on the sale of it, the July 35's will be owned at a reduced cost. In Chapter 13, when reverse spreads were discussed, the strategy in which one sells a call with a lower strike and then buys more calls at a higher strike was termed a reverse ratio spread, or backspread. The strategy just described is merely the diagonalizing of a backspread. This is a strategy that is favored by some professionals, because the short call reduces the risk of owning the longer-term calls if the underlying stock declines. Moreover, if the underlying stock advances, the pre­ ponderance of long calls with a longer maturity will certainly outdistance the losses on the written call. The worst situation that could result would be for the underlying stock to rise very slightly by near-term expiration. If this happened, it might be pos­ sible to lose money on both sides of the spread. This would have to be considered a rather low-probability event, though, and would still represent a limited loss, so it does not substantially offset the positive aspects of the strategy. 0.,ter 14: Diagonalizing a Spread 241 Any type of spread may be diagonalized. There are some who prefer to diago­ nalize even butterfly spreads, figuring that the extra time to maturity in the purchased calls will be of benefit. Overall, the benefits of diagonalizing can be generalized by recalling the way in which the decay of the time value premium of a call takes place. Recall that it was determined that a call loses most of its time value premium in the last stages of its life. When it is a very long-term option, the rate of decay is small. Knowing this fact, it makes sense that one would want to sell options with a short life remaining, so that the maximum benefit of the decay could be obtained. Correspondingly, the purchase of a longer-term call would mean that the buyer is not subjecting himself to a substantial loss in time value premium, at least over the first three months of ownership. A diagonal spread encompasses both of these features - selling a short-term call to try to obtain the maximum rate of time decay, while buy­ ing a longer-term call to try to lessen the effect of time decay on the long side. CALL OPTION SUMMARY This concludes the description of strategies that utilize only call options. The call option has been seen to be a vehicle that the astute strategist can use to set up a wide variety of positions. He can be bullish or bearish, aggressive or conservative. In addi­ tion, he can attempt to be neutral, trying to capitalize on the probability that a stock will not move very far in a short time period. The investor who is not familiar with options should generally begin with a sim­ ple strategy, such as covered call writing or outright call purchases. The simplest types of spreads are the bull spread, the bear spread, and the calendar spread. The more sophisticated investor might consider using ratios in his call strategies - ratio writing against stock or ratio spreading using only calls. Once the strategist feels that he understands the risk and reward relationships between longer-term and short-term calls, between in-the-money and out-of-the­ money calls, and between long calls and short calls, he could then consider utilizing the most advanced types of strategies. This might include reverse ratio spreads, diag­ onal spreads, and more advanced types of ratios, such as the ratio calendar spread. A great deal of information, some of it rather technical in detail, has been pre­ sented in preceding chapters. The best pattern for an investor to follow would be to attempt only strategies that he fully comprehends. This does not mean that he mere­ ly understands the profitability aspects (especially the risk) of the strategy. One must also be able to readily understand the potential effects of early assignments, large div­ idend payments, striking price adjustments, and the like, if he is going to operate advanced strategies. Without a full understanding of how these things might affect one's position, one cannot operate an advanced strategy correctly. ' ' ; ' ; +•-•~/ ----~-•~ •"~•#•:,,,,!., --.-m~,~ : i : ~»•~•= ' "'''''''"'''''"'''''''~--->-' ,,,_,_0-,o-, , ___ ,,,,,cco,,,,,,_, __ ,,,_o,co-ooc0-000,,0-0 -• ~ - ~ d,M,,,"~'-'"'' ~,·,w~ ' ,n - n,-,,• "•-•-' "'''"'- ,,._._,,.,~~n'""~•-••-- • oco-oc°"oo.o~,.,,o, ''o,o 0 o- ',,,-;,,.,_ oo,ooooyo0°,, ,;,., , _ _,,,, INTRODUCTION A put option gives the holder the right to sell the underlying security at the striking price at any time until the expiration date of the option. Listed put options are slightly newer than listed call options, having been introduced on June 3, 1977. The introduction of listed puts has provided a much wider range of strategies for both conservative and aggressive investors. The call option is least effective in strategies in which downward price movement by the underlying stock is concerned. The put option is a useful tool in that case. All stocks with listed call options have listed put options as well. The use of puts or the combination of puts and calls can provide more versatility to the strategist. When listed put options exist, it is no longer necessary to implement strategies involving long calls and short stock. Listed put options can be used more efficiently in such situations. There are many similarities between call strategies and put strategies. For example, put spread strategies and call spread strategies employ sim­ ilar tactics, although there are technical differences, of course. In certain strategies, the tactics for puts may appear largely to be a repetition of those used for calls, but they are nevertheless spelled out in detail here. The strategies that involve the use of both puts and calls together - straddles and combinations - have techniques of their own, but even in these cases the reader will recognize certain similarities to strategies previously discussed. Thus, the introduction of put options not only widens the realm of potential strategies, but also makes more efficient some of the strategies previously described. 244 CH.APTER 15 Put Option Basics Much of the same terminology that is applied to call options also pertains to put options. Underlying security, striking price, and expiration date are all terms that have the same meaning for puts as they do for calls. The expiration dates of listed put options agree with the expiration dates of the calls on the same underlying stock. In addition, puts and calls have the same striking prices. This means that if there are options at a certain strike, say on a particular underlying stock that has both listed puts and calls, both calls at 50 and puts at 50 will be trading, regardless of the price of the underlying stock. Note that it is no longer sufficient to describe an option as an "XYZ July 50." It must also be stated whether the option is a put or a call, for an XYZ July 50 call and an XYZ July 50 put are two different securities. In many respects, the put option and its associated strategies will be very near­ ly the opposite of corresponding call-oriented strategies. However, it is not correct to say that the put is exactly the opposite of a call. In this introductory section on puts, the characteristics of puts are described in an attempt to show how they are similar to calls and how they are not. PUT STRATEGIES In the simplest terms, the outright buyer of a put is hoping for a stock price decline in order for his put to become more valuable. If the stock were to decline well below the striking price of the put option, the put holder could make a profit. The holder of the put could buy stock in the open market and then exercise his put to sell that stock for a profit at the striking price, which is higher. Example: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, for the put grants the holder the right to sell XYZ at 50 - 10 points above its current 245 INTRODUCTION A put option gives the holder the right to sell the underlying security at the striking price at any time until the expiration date of the option. Listed put options are slightly newer than listed call options, having been introduced on June 3, 1977. The introduction of listed puts has provided a much wider range of strategies for both conservative and aggressive investors. The call option is least effective in strategies in which downward price movement by the underlying stock is concerned. The put option is a useful tool in that case. All stocks with listed call options have listed put options as well. The use of puts or the combination of puts and calls can provide more versatility to the strategist. When listed put options exist, it is no longer necessary to implement strategies involving long calls and short stock. Listed put options can be used more efficiently in such situations. There are many similarities between call strategies and put strategies. For example, put spread strategies and call spread strategies employ sim­ ilar tactics, although there are technical differences, of course. In certain strategies, the tactics for puts may appear largely to be a repetition of those used for calls, but they are nevertheless spelled out in detail here. The strategies that involve the use of both puts and calls together - straddles and combinations - have techniques of their own, but even in these cases the reader will recognize certain similarities to strategies previously discussed. Thus, the introduction of put options not only widens the realm of potential strategies, but also makes more efficient some of the strategies previously described. 244 CHAPTER 15 Put Option Basics Much of the same terminology that is applied to call options also pertains to put options. Underlying security, striking price, and expiration date are all terms that have the same meaning for puts as they do for calls. The expiration dates of listed put options agree with the expiration dates of the calls on the same underlying stock. In addition, puts and calls have the same striking prices. This means that if there are options at a certain strike, say on a particular underlying stock that has both listed puts and calls, both calls at 50 and puts at 50 will be trading, regardless of the price of the underlying stock. Note that it is no longer sufficient to describe an option as an "XYZ July 50." It must also be stated whether the option is a put or a call, for an XYZ July 50 call and an XYZ July 50 put are two different securities. In many respects, the put option and its associated strategies will be very near­ ly the opposite of corresponding call-oriented strategies. However, it is not correct to say that the put is exactly the opposite of a call. In this introductory section on puts, the characteristics of puts are described in an attempt to show how they are similar to calls and how they are not. PUT STRATEGIES In the simplest terms, the outright buyer of a put is hopingfor a stock price decline in order for his put to become more valuable. If the stock were to decline well below the striking price of the put option, the put holder could make a profit. The holder of the put could buy stock in the open market and then exercise his put to sell that stock for a profit at the striking price, which is higher. Example: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, for the put grants the holder the right to sell XYZ at 50 10 points above its current 245 246 Part Ill: Put Option Strategies price. On the other hand, if the stock price were above the striking price of the put option at expiration, the put would be worthless. No one would logically want to exer­ cise a put option to sell stock at the striking price when he could merely go to the open market and sell the stock for a higher price. Thus, as the price of the underly­ ing stock declines, the put becomes more valuable. This is, of course, the opposite of a call option's price action. The meaning of in-the-money and out-of-the-money are altered when one is speaking of put options. A put is considered to be in-the-money when the underlying stock is below the striking price of the put option; it is out-of the-money when the stock is above the striking price. This, again, is the opposite of the call option. IfXYZ is at 45, the XYZ July 50 put is in-the-money and the XYZ July 50 call is out-of-the­ money. However, ifXYZ were at 55, the July 50 put would be out-of-the-money while the July 50 call would be in-the-money. The broad definition of an in-the-money option as "an option that has intrinsic value" would cover the situation for both puts and calls. Note that a put option has intrinsic value when the underlying stock is below the striking price of the put. That is, the put has some "real" value when the stock is below the striking price. The intrinsic value of an in-the-money put is merely the difference between the striking price and the stock price. Since the put is an option (to sell), it will gen­ erally sell for more than its intrinsic value when there is time remaining until the expiration date. This excess value over its intrinsic value is referred to as the time value premium, just as is the case with calls. Example: XYZ is at 47 and the XYZ July 50 put is selling for 5, the intrinsic value is 3 points (50- 47), so the time value premium must be 2 points. The time value pre­ mium of an in-the-money put option can always be quickly computed by the follow­ ing formula: Time value premium p . S k · St "ki · • ) == ut option + toe pnce - n ng pnce (m-the-money put This is not the same formula that was applied to in-the-money call options, although it is always true that the time value premium of an option is the excess value over intrinsic value. Time value premium Call ti S ·ki · St k · . all == op on + tn ng pnce - oc pnce (m-the-money c ) If the put is out-of-the-money, the entire premium of the put is composed of time value premium, for the intrinsic value of an out-of-the-money option is always zero. O.,,ter 15: Put Option Basks 247 The time value premium of a put is largest when the stock is at the striking price of the put. As the option becomes deeply in-the-money or deeply out-of-the-money, the time value premium will shrink substantially. These statements on the magnitude of the time value premium are true for both puts and calls. Table 15-1 will help to illus­ trate the relationship of stock price and option price for both puts and calls. The reader may want to refer to Table 1-1, which described the time value premium rela­ tionship for calls. Table 15-1 describes the prices of an XYZ July 50 call option and an XYZ July 50 put option. Table 15-1 demonstrates several basic facts. As the stock drops, the actual price of a call option decreases while the value of the put option increases. Conversely, as the stock rises, the call option increases in value and the put option decreases in value. Both the put and the call have their maximum time value premium when the stock is exactly at the striking price. However, the call will generally sell for rrwre than the put when the stock is at the strike. Notice in Table 15-1 that, with XYZ at 50, the call is worth 5 points while the put is worth only 4 points. This is true in general, except in the case of a stock that pays a large dividend. This phenomenon has to do with the cost of carrying stock. More will be said about this effect later. Table 15-1 also describes an effect of put options that normally holds true: An in-the-rrwney put ( stock is below strike) loses time value premium rrwre quickly than an in-the-rrwney call does. Notice that with XYZ at 43 in Table 15-1, the put is 7 points in-the-money and has lost all its time value premium. But when the call is 7 points in-the-money, XYZ at 57, the call still has 2 points of time value premium. Again, this is a phenom­ enon that could be affected by the dividend payout of the underlying stock, but is true in general. PRICING PUT OPTIONS The same factors that determine the price of the call option also determine the price of the put option: price of the underlying stock, striking price of the option, time remaining until expiration, volatility of the underlying stock, dividend rate of the underlying stock, and the current risk-free interest rate (Treasury bill rate, for exam­ ple). Market dynamics - supply, demand, and investor psychology - play a part as well. Without going into as much detail as was shown in Chapter 1, the pricing curve of the put option can be developed. Certain facts remain true for the put option as they did for the call option. The rate of decay of the put option is not linear; that is, the time value premium will decay more rapidly in the weeks immediately preced­ ing expiration. The more volatile the underlying stock, the higher will be the price 248 Part Ill: Put Option Strategies TABLE 15-1. Call and put options compared. XYZ XYZ Coll Coll XYZ Put Put Stock July 50 Intrinsic Time Value July 50 Intrinsic Time Value Price Coll Price Value Premium Put Price Value Premium 40 1/2 0 1/2 93/4 10 -1/4* 43 1 0 1 7 7 0 45 2 0 2 6 5 47 3 0 3 5 3 2 50 5 0 5 4 0 4 53 7 3 4 3 0 3 55 8 5 3 2 0 2 57 9 7 2 0 60 101/2 10 1/2 1/2 0 l/2 70 193/4 20 -1/4 * 1/4 0 1/4 * A deeply in-the-money option may actually trade at a discount from intrinsic value in advance of expiration. of its options, both puts and calls. Moreover, the marketplace may at any time value options at a higher or lower volatility than the underlying stock actually exhibits. This is called implied volatility, as distinguished from actual volatility. Also, the put option is usually worth at least its intrinsic value at any time, and should be worth exactly its intrinsic value on the day that it expires. Figure 15-1 shows where one might expect the XYZ July 50 put to sell, for any stock price, if there are 6 months remaining until expiration. Compare this with the similar pricing curve for the call option (Figure 15-2). Note that the intrinsic value line for the put option faces in the opposite direction from the intrinsic value line for call options; that is, it gains value as the stock falls below the striking price. This put option pricing curve demonstrates the effect mentioned earlier, that a put option loses time value pre­ mium more quickly when it is in-the-money, and also shows that an out-of-the­ money put holds a great deal of time value premium. THE EFFECT OF DIVIDENDS ON PUT OPTION PREMIUMS The dividend of the underlying stock is a negative factor on the price of its call options. The opposite is true for puts. The larger the dividend, the nwre valuable the puts will be. This is true because, as the stock goes ex-dividend, it will be reduced in Cl,opter 15: Put Option Basics FIGURE 1 5-1. Put option price curve. ~ it C: .Q a. 0 FIGURE 1 5-2. Call option price curve. ~ ct C: 0 11 10 9 8 7 6 a 5 Striking Price (50) Greatest Value for Time Value Stock Price 0 4 ---------------------- 3 2 1 0 40 45 represents the option's time value premium. ________ L ________ _ 50\ 55 60 Stock Price Intrinsic value remains at zero until striking price is passed. 249 price by the amount of the dividend. That is, the stock will decrease in price and therefore the put will become more valuable. Consequently, the buyer of the put will be willing to pay a higher price for the put and the seller of the put will also demand a higher price. As with listed calls, listed puts are not adjusted for the payment of cash dividends on the underlying stock. However, the price of the option itself will reflect the dividend payments on the stock. 250 Part Ill: Put Option Strategies Example: XYZ is selling for $25 per share and will pay $1 in dividends over the next 6 months. Then a 6-month put option with strike 25 should automatically be worth at least $1, regardless of any other factor concerning the underlying stock. During the next 6 months, the stock will be reduced in price by the amount of its dividends- $1 - and if everything else remained the same, the stock would then be at 24. With the stock at 24, the put would be 1 point in-the-money and would thus be worth at least its intrinsic value of 1 point. Thus, in advance, this large dividend payout of the underlying stock will help to increase the price of the put options on this stock. On the day before a stock goes ex-dividend, the time value premium of an in­ the-money put should be at least as large as the impending cash dividend payment. That is, if XYZ is 40 and is about to pay a $.50 dividend, an XYZ January 50 put should sell for at least l 0½. This is true because the stock will be reduced in price by the amount of its dividend on the day of the ex-dividend. EXERCISE AND ASSIGNMENT When the holder of a put option exercises his option, he sells stock at the striking price. He may exercise this right at any time during the life of the put option. When this happens, the writer of a put option with the same terms is assigned an obligation to buy stock at the striking price. It is important to notice the difference between puts and calls in this case. The call holder exercises to buy stock and the call writer is obligated to sell stock. The reverse is true for the put holder and writer. The methods of assignment via the OCC and the brokerage firm are the same for puts and calls; any fair method of random or first-in/first-out assignment is allowed. Stock commissions are charged on both the purchase and sale of the stock via the assignment and exercise. When the holder of a put option exercises his right to sell stock, he may be sell­ ing stock that he currently holds in his portfolio. Second, he may simultaneously go into the open market and buy stock for sale via the put exercise. Finally, he may want to sell the stock in his short stock account; that is, he may short the underlying stock by exercising his put option. He would have to be able to borrow stock and supply the margin collateral for a short sale of stock if he chose this third course of action. The writer of the put option also has several choices in how he wants to handle the stock purchase that he is required to make. The put writer who is assigned must receive stock. (The call writer who is assigned delivers stock.) The put writer may cur­ rently be short the underlying stock, in which case he will merely use the receipt of stock from the assignment to cover his short sale. He may also decide to immediate- 0.,ter 15: Put Option Basics 251 ly sell stock in the open market to offset the purchase that he is forced to make via the put assignment. Finally, he may decide to retain the stock that is delivered to him; he merely keeps the stock in his portfolio. He would, of course, have to pay for ( or margin) the stock if he decides to keep it. The mechanics as to how the put holder wants to deliver the stock and how the put writer wants to receive the stock are relatively simple. Each one merely notifies his brokerage firm of the way in which he wants to operate and, provided that he can meet the margin requirements, the exercise or assignment will be made in the desired manner. ANTICIPATING ASSIGNMENT The writer of a put option can anticipate assignment in the same way that the writer of a call can. When the time value premium of an in-the-money put option disappears, there is a risk of assignment, regardless of the time remaining until expiration. In Chapter 1, a form of arbitrage was described in which market-makers or firm traders, who pay little or no commissions, can take advantage of an in-the-money call selling at a discount to parity. Similarly, there is a method for these traders to take advantage of an in-the-money put selling at a discount to parity. Example: XYZ is at 40 and an XYZ July 50 put is selling for 9¾ a ¼ discount from parity. That is, the option is selling for ¼ point below its intrinsic value. The arbi­ trageur could take advantage of this situation through the following actions: 1. Buy the July put at 9¾. 2. Buy XYZ common stock at 40. 3. Exercise the put to sell XYZ at 50. The arbitrageur makes 10 points on the stock portion of the transaction, buying the common at 40 and selling it at 50 via exercise of his put. He paid 9¾ for the put option and he loses this entire amount upon exercise. However, his overall profit is thus ¼ point, the amount of the original discount from parity. Since his commission costs are minimal, he can actually make a net profit on this transaction. As was the case with deeply in-the-money calls, this type of arbitrage with deeply in-the-money puts provides a secondary market that might not otherwise exist. It allows the public holder of an in-the-money put to sell his option at a price near its intrinsic value. Without these arbitrageurs, there might not be a reasonable secondary market in which public put holders could liquidate. 252 Part Ill: Put Option Strategies Dividend payment dates may also have an effect on the frequency of assign­ ment. For call options, the writer might expect to receive an assignment on the day the stock goes ex-dividend. The holder of the call is able to collect the dividend by so exercising. Things are slightly different for the writer of puts. He might expect to receive an assignment on the day after the ex-dividend date of the underlying stock. Since the writer of the put is obligated to buy stock, it is unlikely that any­ one would put the stock to him until after the dividend has been paid. In any case, the writer of the put can use a relatively simple gauge to anticipate assignment near the ex-dividend date. If the time value premium of an in-the-money put is less than the amount of the dividend to be paid, the writer may often anticipate that he will be assigned immediately after the ex-dividend of the stock. An example will show why this is true. Example: XYZ is at 45 and it will pay a $.50 dividend. Furthermore, the XYZ July 50 put is selling at 5¼. Note that the time value premium of the July 50 put is ¼ point - less than the amount of the dividend, which is ½ point. An arbitrageur could take the following actions: 1. Buy XYZ at 45. 2. Buy the July 50 put at 5¼. 3. Collect the ½-point dividend (he must hold the stock until the ex-date to collect the dividend). 4. Exercise his put to sell XYZ at 50 ( writer would receive assignment on the day after the ex-date). The arbitrageur makes 5 points on the stock trades, buying XYZ at 45 and selling it at 50 via exercise of the put. He also collects the ½-point dividend, making his total intake equal to 5½ points. He loses the 5¼ points that he paid for the put but still has a net profit of ¼ point. Thus, as the ex-dividend date of a stock approaches, the time value premium of all in-the-money puts on that stock will tend to equal or exceed the amount of the dividend payment. This is quite different from the call option. It was shown in Chapter 1 that the call writer only needs to observe whether the call was trading at or below parity, regardless of the amount of the dividend, as the ex-dividend date approaches. The put writer must determine if the time value premium of the put exceeds the amount of the dividend to be paid. If it does, there is a much smaller chance of assignment because of the dividend. In any case, the put writer can anticipate the assignment if he carefully monitors his position. O.,ter 15: Put Option Basics POSITION LIMITS 253 Recall that the position limit rule states that one cannot have a position of more than the limit of options on the same side of the market in the same underlying security. The limit varies depending on the trading activity and volatility of the underlying stock and is set by the exchange on which the options are traded. The actual limits are 13,500, 22,500, 31,500, 60,000, or 75,000 contracts, depending on these factors. One cannot have more than 75,000 option contracts on the bullish side of the market - long calls and/or short puts - nor can he have more than 75,000 contracts on the bearish side of the market - short calls and/or long puts. He may, however, have 75,000 con­ tracts on each side of the market; he could simultaneously be long 75,000 calls and long 75,000 puts. For the following examples, assume that one is concerned with an underlying stock whose position limit is 75,000 contracts. Long 75,000 calls, long 75,000 puts - no violation; 75,000 contracts bullish (long calls) and 75,000 contracts bearish (long puts). Long 38,000 calls, short 37,000 puts - no violation; total of 75,000 contracts bullish. Long 38,000 calls, short 38,000 puts - violation; total of 76,000 contracts bullish. Money managers should be aware that these position limits apply to all "related" accounts, so that someone managing several accounts must total all the accounts' positions when considering the position limit rule. CONVERSION Many of the relationships between call prices and put prices relate to a process known as a conversion. This term dates back to the over-the-counter option days when a dealer who owned a put ( or could buy one) was able to satisfy the needs of a potential call buyer by "converting" the put to a call. This terminology is somewhat confusing, and the actual position that the dealer would take is little more than an arbitrage position. In the listed market, arbitrageurs and firm traders can set up the same position that the converter did. The actual details of the conversion process, which must include the carrying cost of owning stock and the inclusion of all dividends to be paid by the stock during the time the position is held, are described later. However, it is important for the put option trader to understand what the arbitrageur is attempting to do in order for him to fully understand the relationship between put and call prices in the listed option market. 254 Part Ill: Put Option Strategies A conversion position has no risk. The arbitrageur will do three things: 1. Buy 100 shares of the underlying stock. 2. Buy 1 put option at a certain striking price. 3. Sell l call option at the same striking price. The arbitrageur has no risk in this position. If the underlying stock drops, he can always exercise his long put to sell the stock at a higher price. If the underlying stock rises, his long stock offsets the loss on his short call. Of course, the prices that the arbitrageur pays for the individual securities determine whether or not a conversion will be profitable. At times, a public customer may look at prices in the newspaper and see that he could establish a position similar to the foregoing one for a profit, even after commissions. However, unless prices are out of line, the public customer would not normally be able to make a better return than he could by putting his money into a bank or a Treasury bill, because of the commission costs he would pay. Without needing to understand, at this time, exactly what prices would make an attractive conversion, it is possible to see that it would not always be possible for the arbitrageur to do a conversion. The mere action of many arbitrageurs doing the same conversion would force the prices into line. The stock price would rise because arbi­ trageurs are buying the stock, as would the put price; and the call price would drop because of the preponderance of sellers. When this happens, another arbitrage, known as a reversal ( or reverse conver­ sion), is possible. In this case, the arbitrageur does the opposite: He shorts the under­ lying stock, sells 1 put, and buys 1 call. Again, this is a position with no risk. If the stock rises, he can always exercise his call to buy stock at a lower price and cover his short sale. If the stock falls, his short stock will offset any losses on his short put. The point of introducing this information, which is relatively complicated, at this place in the text is to demonstrate that there is a relationship between put and call prices, when both have the same striking price and expiration date. They are not independent of one another. If the put becomes "cheap" with respect to the call, arbi­ trageurs will move in to do conversions and force the prices back in line. On the other hand, if the put becomes expensive with relationship to the call, arbitrageurs will do reversals until the prices move back into line. Because of the way in which the carrying cost of the stock and the dividend rate of the stock are involved in doing these conversions or reversals, two facts come to light regarding the relationship of put prices and call prices. Both of these facts have to do with the carrying costs incurred during the conversion. First, a put option will generally sell for less than a call option when the underlying stock is exactly at the striking price, unless the stock pays a large dividend. In the older over-the-counter a,,pter 15: Put Option Basics 255 option market, it was often stated that the reason for this relationship was that the demand for calls was larger than the demand for puts. This may have been partially true, but certainly it is no longer true in the listed option targets, where a large sup­ ply of both listed puts and calls is available through the OCC. Arbitrageurs again serve a useful function in increasing supply and demand where it might not other­ wise exist. The second fact concerning the relationship of puts and calls is that a put option will lose its time value premium much more quickly in-the-money than a call option will (and, conversely, a put option will generally hold out-of-the-money time value premium better than a call option will). Again, the conversion and reversal processes play a large role in this price action phenomenon of puts and calls. Both of these facts have to do with the carrying costs involved in the conversion. In the chapter on Arbitrage, exact details of conversions and reversals will be spelled out, with specific reasons why these procedures affect the relationship of put and call prices as stated above. However, at this time, it is sufficient for the reader to understand that there is an arbitrage process that is quite widely practiced that will, in fact, make true the foregoing relationships between puts and calls. Put Option Buying The purchase of a put option provides leverage in the case of a downward move by the underlying stock. In this manner, it is an alternative to the short sale of stock, much as the purchase of a call option is a leveraged alternative to the purchase of stock. PUT BUYING VERSUS SHORT SALE In the simplest case, when an investor expects a stock to decline in price, he may either short the underlying stock or buy a put option on the stock. Suppose that XYZ is at 50 and that an XYZ July 50 put option is trading at 5. If the underlying stock declines substantially, the buyer of the put could make profits considerably in excess of his initial investment. However, if the underlying stock rises in price, the put buyer has limited risk; he can lose only the amount of money that he originally paid for the put option. In this example, the most that the put buyer could lose would be 5 points, which is equal to his entire initial investment. Table 16-1 and Figure 16-1 depict the results, at expiration, of this simple purchase of the put option. The put buyer has limited profit potential, since a stock can never drop in price below zero dollars per share. However, his potential profits can be huge, percent­ agewise. His loss, which normally would occur if the stock rises in price, is limited to the amount of his initial investment. The simplest use of a put purchase is for specu­ lative purposes when expecting a price decline in the underlying stock. These results for the profit or loss of the put option purchases can be compared to a similar short sale of XYZ at 50 in order to observe the benefits of leverage and limited risk that the put option buyer achieves. In order to sell short 100 XYZ at 50, assume that the trader would have to use $2,500 in margin. Several points can be ver- 256 Gopter 16: Put Option Buying TABLE 16-1. Results of put purchase at expiration. XYZ Price ot Put Price ot Expiration Expiration 20 30 40 45 48 50 60 70 FIGURE 16-1. Put option purchase. 30 20 10 5 2 0 0 0 Stock Price at Expiration 257 Put Option Profit +$2,500 + 1,500 + 500 0 300 500 500 500 ifled from Table 16-2 and Figure 16-1. If the stock drops in price sufficiently far, the percentage profits are much greater on the put option purchase than they are on the short sale of the underlying stock. This is the leveraging effect that an option pur- 258 Part Ill: Put Option Strategies chase can achieve. If the underlying stock remains relatively unchanged, the short seller would do better because he does not risk losing his entire investment in a lim­ ited amount of time if the underlying stock changes only slightly in price. However, if the underlying stock should rise dramatically, the short seller can actually lose more than his initial investment. The short sale of stock has theoretically unlimited risk. Such is not true of the put option purchase, whereby the risk is limited to the amount of the initial investment. One other point should be made when comparing the pur­ chase of a put and the short sale of stock: The short seller of stock is obligated to pay the dividends on the stock, but the put option holder has no such obligation. This is an additional advantage to the holder of the put. TABLE 16-2. Results of selling short. XYZ Price at Put Option Expiration Short Sale Purchase 20 + $3,000 (+ 120%) +$2,500 (+ 500%) 30 + 2,000 (+ 80%) + 1,500 (+ 300%) 40 + 1,000 (+ 40%) + 500 (+ 100%) 45 + 500(+ 20%) 0( 0%) 48 + 200(+ 80%) 300 (- 60%) 50 0( 0%) 500 (- 100%) 60 - 1,000 (- 40%) 500 (- 100%) 75 - 2,500 (- 100%) 500 (- 100%) 100 - 5,000 (- 200%) 500 (- 100%) SELECTING WHICH PUT TO BUY Many of the same types of analyses that the call buyer goes through in deciding which call to buy can be used by the prospective put buyer as well. First, when approach­ ing put buying as a speculative strategy, one should not place more than 15% of his risk capital in the strategy. Some investors participate in put buying to add some amount of downside protection to their basically bullishly-oriented common stock portfolios. More is said in Chapter 17 about buying puts on stocks that one actually owns. The out-ofthe-nwney put offers both higher reward potentials and higher risk potentials than does the in-the-nwney put. If the underlying stock drops substantial- G,pter 16: Put Option Buying 259 ly, the percentage returns from having purchased a cheaper, out-of-the-money put will be greater. However, should the underlying stock decline only moderately in price, the in-the-rrwney put will often prove to be the better choice. In fact, since a put option tends to lose its time value premium quickly as it becomes an in-the­ money option, there is an even greater advantage to the purchase of the in-the­ money put. Example: XYZ is at 49 and the following prices exist: XYZ, 49; XYZ July 45 put, l; and XYZ July 50 put, 3. If the underlying stock were to drop to 40 by expiration, the July 45 put would be worth 5 points, a 400% profit. The July 50 put would be worth 10 points, a 233% profit over its initial purchase price of 3. Thus, in a substantial downward move, the out-of-the-money put purchase provides higher reward potential. However, if the underlying stock drops only moderately, say to t:15, the purchaser of the July 45 put would lose his entire investment, since the put would be worthless at expiration. The purchaser of the in-the-money July 50 put would have a 2-point profit with XYZ at 45 at expiration. The preceding analysis is based on holding the put until expiration. For the option buyer, this is generally an erroneous form of analysis, because the buyer generally tends to liquidate his option purchase in advance of expiration. When considering what happens to the put option in advance of expiration, it is helpful to remember that an in-the-money put tends to lose its time premium rather quickly. In the example above, the July 45 put is completely composed of time value pre­ mium. If the underlying stock begins to drop below 45, the price of the put will not increase as rapidly as would the price of a call that is going into-the-money. Example: If XYZ fell by 5 points to 44, definitely a move in the put buyer's favor, he may fmd that the July 45 put has increased in value only to 2 or 2½ points. This is somewhat disappointing because, with call options, one would expect to do signifi­ cantly better on a 5-point stock movement in his favor. Thus, when purchasing put options for speculation, it is generally best to concentrate on in-the-rrwney puts unless a very substantial decline in the price of the underlying stock is anticipated. Once the put option is in-the-money, the time value premium will decrease even in the longer-term series. Since this time premium is small in all series, the put 260 Part Ill: Put Option Strategies buyer can often purchase a longer-term option for very little extra money, thus gain­ ing more time to work with. Call option buyers are generally forced to avoid the longer-term series because the extra cost is not worth the risk involved, especially in a trading situation. However, the put buyer does not necessarily have this disadvan­ tage. If he can purchase the longer-term put for nearly the same price as the near­ term put, he should do so in case the underlying stock takes longer to drop than he had originally anticipated it would. It is not uncommon to see such prices as the following: XYZ common, 46: XYZ April 50 put, 4; XYZ July 50 put, 4½; and XYZ October 50 put, 5. None of these three puts have much time value premium in their prices. Thus, the buyer might be willing to spend the extra 1 point and buy the longest-term put. If the underlying stock should drop in price immediately, he will profit, but not as much as if he had bought one of the less expensive puts. However, should the underlying stock rise in price, he will own the longest-term put and will therefore suffer less of a loss, percentagewise. If the underlying stock rises in price, some amount of time value premium will come back into the various puts, and the longest-term put will have the largest amount of time premium. For example, if the stock rises back to 50, the fol­ lowing prices might exist: XYZ common, 50; XYZ April 50 put, l; XYZ July 50 put, 2½; and XYZ October 50 put, 3½. The purchase of the longer-term October 50 put would have suffered the least loss, percentagewise, in this event. Consequently, when one is purchasing an in-the­ money put, he may often want to consider buying the longest-term put if the time value premium is small when compared to the time premium in the nearer-term puts. In Chapter 3, the delta of an option was described as the amount by which one might expect the option will increase or decrease in price if the underlying stock moves by a fixed amount (generally considered to be one point, for simplicity). Thus, if XYZ is at 49 and a call option is priced at 3 with a delta of ½, one would expect the call to sell for 3½ with XYZ at 50 and to sell at 2¼ with XYZ at 48. In reality, the delta O.,ter 16: Put Option Buying 261 changes even on a fractional move in the underlying stock, but one generally assumes that it will hold true for a 1-point move. Obviously, put options have deltas as well. The delta of a put is a negative number, reflecting the fact that the put price and the stock price are inversely related. As an approximation, one could say that the delta of the ctill option minus the delta of the put option with the same terms is equal to 1. That is, Delta of put = Delta of call - 1. This is an approximation and is accurate unless the put is deeply in-the-money. It has already been pointed out that the time value premium behavior of puts and calls is different, so it is inaccurate to assume that this formula holds true exactly for all cases. The delta of a put ranges between O and minus 1. If a July 50 put has a delta of -½, and the underlying stock rises by 1 point, the put will lose ½ point. The delta of a deeply out-of-the-money put is close to zero. The put's delta would decrease slow­ ly at first as the stock declined in value, then would begin to decrease much more rapidly as the stock fell through the striking price, and would reach a value of minus 1 (the minimum) as the stock fell only moderately below the striking price. This is reflective of the fact that an out-of-the-money put tends to hold time premium quite well and an in-the-money put comes to parity rather quickly. RANKING PROSPECTIVE PUT PURCHASES In Chapter 3, a method of ranking prospective call purchases was developed that encompassed certain factors, such as the volatility of the underlying stock and the expected holding period of the purchased option. The same sort of analysis should be applied to put option purchases. The steps are summarized below. The reader may refer to the section titled "Advanced Selection Criteria" in Chapter 3 for a more detailed description of why this method of ranking is superior. 1. Assume that each underlying stock can decrease in price in accordance with its volatility over a fixed holding period (30, 60, or 90 days). 2. Estimate the put option prices after the decrease. 3. Rank all potential put purchases by the highest reward opportunity for aggressive purchases. 4. Estimate how much would be lost if the underlying stock instead rose in accor­ dance with its volatility, and rank all potential put purchases by best risk/reward ratio for a more conservative list of put purchases. 262 Part Ill: Put Option Strategies As was stated earlier, it is necessary to have a computer to make an accurate analysis of all listed options. The average customer is forced to obtain such data from a bro­ kerage firm or data service. He should be sure that the list he is using conforms to the above-mentioned criteria. If the data service is ranking option purchases by how well the puts would do if each underlying stock fell by a fixed percentage (such as 5% or 10%), the list should be rejected because it is not incorporating the volatility of the underlying stock into its analysis. Also, if the list is based on holding the put purchase until expiration, the list should be rejected as well, because this is not a realistic assumption. There are enough reliable and sophisticated data services that one should not have to work with inferior analyses in today's option market. For those readers who are more mathematically advanced and have the com­ puter capability to construct their own analyses, the details of implementing an analy­ sis similar to the one described above are presented in Chapter 28, Mathematical Applications. An application of put purchases, combined with fixed-income securi­ ties, is described in Chapter 26, Buying Options and Treasury Bills. FOLLOW-UP ACTION The put buyer can take advantage of strategies that are very similar to those the call buyer uses for follow-up action, either to lock in profits or to attempt to improve a losing situation. Before discussing these specific strategies, it should be stated again that it is rarely to the option buyer's benefit to exercise the option in order to liqui­ date. This precludes, of course, those situations in which the call buyer actually wants to own the stock or the put buyer actually wants to sell the stock. If, however, the option holder is merely looking to liquidate his position, the cost of stock commis­ sions makes exercising a prohibitive move. This is true even ifhe has to accept a price that is a slight discount from parity when he sells his option. LOCKING IN PROFITS The reader may recall that there were four strategies (perhaps "tactics" is a better word) for the call buyer with an unrealized profit. These same four tactics can be used with only slight variations by the put option buyer. Additionally, a fifth strategy can be employed when a stock has both listed puts and calls. After an underlying stock has moved down and the put buyer has a relatively substantial unrealized gain, he might consider taking one of the following actions: 1. Sell the put and liquidate the position for a profit. 2. Do nothing and continue to hold the put. O.,,er 16: Put Option Buying 263 3, Sell the in-the-money long put and use part of the proceeds to purchase out-of­ the-money puts. 4. Create a spread by selling an out-of-the-money put against the one he currently holds. These are the same four tactics that were discussed earlier with respect to call buy­ ing. In the fifth tactic, the holder of a listed put who has an unrealized profit might consider buying a listed call to protect his position. Example: A speculator originally purchased an XYZ October 50 put for 2 points when the stock was 52. If the stock has now fallen to 45, the put might be worth 6 points, representing an unrealized gain of 4 points and placing the put buyer in a position to implement one of these five tactics. After some time has passed, with the stock at 45, an at-the-money October 45 put might be selling for 2 points. Table 16-3 summarizes the situation. If the trader merely liquidates his position by selling out the October 50 put, he would realize a profit of 4 points. Since he is terminating the position, he can make neither more nor less than 4 points. This is the most conservative of the tactics, allowing no additional room for appreciation, but also eliminating any chance of los­ ing the accumulated profits. TABLE 16-3. Background table for profit alternatives. Original Trade Current Prices XYZ common: 52 XYZ common: 45 Bought XYZ October 50 put at 2 XYZ October 50 put: 6 XYZ October 45 put: 2 If the trader does nothing, merely continuing to hold the October 50 put, he is taking an aggressive action. If the stock should reverse and rise back above 50 by expiration, he would lose everything. However, if the stock continues to fall, he could build up substantially larger profits. This is the only tactic that could eventually result in a loss at expiration. These two simple strategies - liquidating or doing nothing are the easiest alternatives. The remaining strategies allow one to attempt to achieve a balance between retaining built-up profits and generating even more profits. The third tactic that the speculator could use would be to sell the put that he is currently holding and 264 Part Ill: Put Option Strategies use some of the proceeds to purchase the October 45 put. The general idea in this tactic is to pull one's initial investment out of the market and then to increase the number of option contracts held by buying the out-of-the-money option. Example: The trader would receive 6 points from the sale of the October 50 put. He should take 2 points of this amount and put it back into his pocket, thus covering his initial investment. Then he could buy 2 October 45 puts at 2 points each with the remaining portion of the proceeds from the sale. He has no risk at expiration with this strategy, since he has recovered his initial investment. Moreover, if the underlying stock should continue to fall rapidly, he could profit handsomely because he has increased the number of put contracts that he holds. The fourth choice that the put holder has is to create a spread by selling the October 45 put against the October 50 that he currently holds. This would create a bear spread, technically. This type of spread is described in more detail later. For the time being, it is sufficient to understand what happens to the trader's risks and rewards by creating this spread. The sale of the October 45 put brings in 2 points, which covers the initial 2-point purchase cost of the October 50 put. Thus, his "cost" for this spread is nothing; he has no risk, except for commissions. If the underlying stock should rise above 50 by expiration, all the puts would expire worthless. (A put expires worthless when the underlying stock is above the striking price at expiration.) This would represent the worst case; he would recover nothing from the spread. If the stock should be below 45 at expiration, he would realize the maximum potential of the spread, which is 5 points. That is, no matter how far XYZ is below 45 at expi­ ration, the October 50 put will be worth 5 points more than the October 45 put, and the spread could thus be liquidated for 5 points. His maximum profit potential in the spread situation is 5 points. This tactic would be the best one if the underlying stock stabilized near 45 until expiration. To analyze the fifth strategy that the put holder could use, it is necessary to introduce a call option into the picture. Example: With XYZ at 45, there is an October 45 call selling for 3 points. The put holder could buy this call in order to limit his risk and still retain the potential for large future profits. If the trader buys the call, he will have the following position: Long l October 50 put C b' d t 5 . t l O b 5 all - om me cos : porn s Long cto er 4 c The total combined cost of this put and call combination is 5 points - 2 points were originally paid for the put, and now 3 points have been paid for the call. No matter where the underlying stock is at expiration, this combination will be worth at least 5 Gapter 16: Put Option Buying 265 points. For example, if XYZ is at 46 at expiration, the put will be worth 4 and the call worth l; or if XYZ is at 48, the put will be worth 2 and the call worth 3. If the stock is above 50 or below 45 at expiration, the combination will be worth more than 5 points. Thus, the trader has no risk in this combination, since he has paid 5 points for it and will be able to sell it for at least 5 points at expiration. In fact, if the underly­ ing stock continues to drop, the put will become more valuable and he could build up substantial profits. Moreover, if the underlying stock should reverse direction and climb substantially, he could still profit, because the call will then become valuable. This tactic is the best one to use if the underlying stock does not stabilize near 45, but instead makes a relatively dramatic move either up or down by expiration. The strategy of simultaneously owning both a put and a call is discussed in much greater detail in Chapter 23. It is introduced here merely for the purposes of the put buyer wanting to obtain protection of his unrealized profits. Each of these five strategies may work out to be the best one under a different set of circumstances. The ultimate result of each tactic is dependent on the direction that XYZ moves in the future. As was the case with call options, the spread tactic never turns out to be the worst tactic, although it is the best one only if the underly­ ing stock stabilizes. Tables 16-4 and 16-5 summarize the results the speculator could expect from invoking each of these five tactics. The tactics are: 1. Liquidate - sell the long put for a profit and do not reinvest. 2. Do nothing - continue to hold the long put. 3. "Roll down" - sell the long put, pocket the initial investment, and invest the remaining proceeds in out-of-the-money puts at a lower strike. 4. "Spread" - create a spread by selling the out-of-the-money put against the put already held. 5. "Combine" create a combination by buying a call at a lower strike while con­ tinuing to hold the put. TABLE 16-4. Comparison of the five tactics. By expiration, if XYZ ... Continues to fall dramatically Falls moderately further Remains relatively unchanged Rises moderately Rises substantially the best strategy was ... "Roll down" Do nothing Spread Liquidate Combine and the worst strategy was ... Liquidate Combine Combine or "roll down" "Roll down" or do nothing Do nothing 266 Part Ill: Put Option Strategies TABLE 16-5. Results of adopting each of the five tactics. XYZ Price at "Roll Down" Do-Nothing Spread Liquidate Combine Expiration Profit Profit Profit Profit Profit 30 + $3,000 (8) +$1,800 +$500 +$400 (W) +$1,500 35 + 2,000 (8) + 1,300 + 500 + 400 (W) + 1,000 41 + 800 (8) + 700 + 500 + 400 (W) + 400 42 + 600 (8) + 600 (8) + 500 + 400 + 300 (W) 43 + 400 + 500 (8) + 500 (8) + 400 + 200 (W) 45 0(W) + 300 + 500 (8) + 400 0(W) 46 0(W) + 200 + 400 (8) + 400 (8) O(W) 48 0(W) 0(W) + 200 + 400 (8) 0(W) 50 0 200 (W) 0 + 400 (8) 0 54 0 200 (W) 0 + 400 (8) + 400 (8) 60 0 200 (W) 0 + 400 + 1,000 (8) Note that each tactic is the best one under one of the scenarios, but that the spread tactic is never the worst of the five. The actual results of each tactic, using the figures from the example above, are depicted in Table 16-5, where B denotes best tactic and W denotes worst one. All the strategies are profitable if the underlying stock continues to fall dramat­ ically, although the "roll down," "do nothing," and combinations work out best, because they continue to accrue profits if the stock continues to fall. If the underly­ ing stock rises instead, only the combination outdistances the simplest tactic of all, liquidation. If the underlying stock stabilizes, the "do-nothing" and "spread" tactics work out best. It would generally appear that the combination tactic or the "roll-down" tactic would be the most attractive, since neither one has any risk and both could generate large profits if the stock moved substantially. The advantage for the spread was sub­ stantial in call options, but in the case of puts, the premium received for the out-of­ the-money put is not as large, and therefore the spread strategy loses some of its attractiveness. Finally, any of these tactics could be applied partially; for example, one could sell out half of a profitable long position in order to take some profits, and con­ tinue to hold the remainder. Cl,opter 16:PutOptionBuying LOSS-LIMITING ACTIONS 267 The foregoing discussion concentrated on how the put holder could retain or increase his profit. However, it is often the case in option buying that the holder of the option is faced with an unrealized loss. The put holder may also have several choices of action to take in this case. His first, and simplest, course of action would be to sell the put and take his loss. Although this is advisable in certain cases, espe­ cially when the underlying stock seems to have assumed a distinctly bullish stance, it is not always the wisest thing to do. The put holder who has a loss may also consider either "rolling up" to create a bearish spread or entering into a calendar spread. Either of these actions could help him recover part or all of his loss. THE "ROLLING-UP" STRATEGY The reader may recall that a similar action to "rolling up," termed "rolling down," was available for call options held at a loss and was described in Chapter 3. The put buyer who owns a put at a loss may be able to create a spread that allows him to break even at a more favorable price at expiration. Such action will inevitably limit his profit potential, but is generally useful in recovering something from a put that might oth­ erwise expire totally worthless. Example: An investor initially purchases an XYZ October 45 put for 3 points when the underlying stock is at 45. However, the stock rises to 48 at a later date and the put that was originally bought for 3 points is now selling for 1 ¼ points. It is not unusual, by the way, for a put to retain this much of its value even though the stock has moved up and some amount of time has passed, since out-of-the-money puts tend to hold time value premium rather well. With XYZ at 48, an October 50 put might be selling for 3 points. The put holder could create a position designed to per­ mit recovery of some of his losses by selling two of the puts that he is long - October 45's - and simultaneously buying one October 50 put. The net cost for this transac­ tion would be only commissions, since he receives $300 from selling two puts at 1 ¼ each, which completely covers the $300 cost of buying the October 50 put. The transactions are summarized in Table 16-6. By selling 2 of the October 45 puts, the investor is now short an October 45 put. Since he also purchased an October 50 put, he has a spread ( technically, a bear spread). He has spent no additional money, except commissions, to set up this spread, since the sale of the October 45's covered the purchase of the October 50 put. This strategy is most attractive when the debit involved to create the spread is small. In this example, the debit is zero. 268 TABLE 16-6. Summary of rolling-up transactions. Original trade: Later: Net position: Buy 1 October 45 put for 3 with XYZ at 45 With XYZ at 48, sell 2 October 45's for 11/2 each and buy l October 50 put for 3 Long 1 October 50 put Short 1 October 45 put Part Ill: Put Option Strategies $300 debit $300 credit $300 debit $300 debit The effect of creating this spread is that the investor has not increased his risk at all, but has raised the break-even point for his position. That is, if XYZ merely falls a small distance, he will be able to get out even. Without the effect of creating the spread, the put holder would need XYZ to fall back to 42 at expiration in order for him to break even, since he originally paid 3 points for the October 45 put. His orig­ inal risk was $300. IfXYZ continues to rise in price and the puts in the spread expire worthless, the net loss will still be only $300 plus additional commissions. Admittedly, the commissions for the spread will increase the loss slightly, but they are small in comparison to the debit of the position ($300). On the other hand, if the stock should fall back only slightly, to 47 by expiration, the spread will break even. At expiration, with XYZ at 47, the in-the-money October 50 put will be worth 3 points and the out­ of-the-money October 45 put will expire worthless. Thus, the investor will recover his $300 cost, except for commissions, with XYZ at 47 at expiration. His break-even point is raised from 42 to 47, a substantial improvement of his chances for recovery. The implementation of this spread strategy reduces the profit potential of the position, however. The maximum potential of the spread is 2 points. If XYZ is any­ where below 45 at expiration, the spread will be worth 5 points, since the October 50 put will sell for 5 points more than the October 45 put. The investor has limited his potential profit to 2 points - the 5-point maximum width of the spread, less the 3 points that he paid to get into the position. He can no longer gain substantially on a large drop in price by the underlying stock. This is normally of little concern to the put holder faced with an unrealized loss and the potential for a total loss. He gener­ ally would be appreciative of getting out even or of making a small profit. The cre­ ation of the spread accomplishes this objective for him. It should also be pointed out that he does not incur the maximum loss of his entire debit plus commissions, unless XYZ closes above 50 at expiration. If XYZ is O,apter 16: Put Option Buying 269 anywhere below 50, the October 50 will have some value and the investor will be able to recover something from the position. This is distinctly different from the original put holding of the October 45, whereby the maximum loss would be incurred unless the stock were below 45 at expiration. Thus, the introduction of the spread also reduces the chances of having to realize the maximum loss. In summary, the put holder faced with an unrealized loss may be able to create a spread by selling twice the number of puts that he is currently long and simultane­ ously buying the put at the next higher strike. This action should be used only if the spread can be transacted at a small debit or, preferably, at even money (zero debit). The spread position offers a much better chance of breaking even and also reduces the possibility of having to realize the maximum loss in the position. However, the introduction of these loss-limiting measures reduces the maximum potential of the position if the underlying stock should subsequently decline in price by a significant amount. Using this spread strategy for puts would require a margin account, just as calls do. THE CALENDAR SPREAD STRATEGY Another strategy is sometimes available to the put holder who has an unrealized loss. If the put that he is holding has an intermediate-term or long-term expiration date, he might be able to create a calendar spread by selling the near-term put against the put that he currently holds. Example: An investor bought an XYZ October 45 put for 3 points when the stock was at 45. The stock rises to 48, moving in the wrong direction for the put buyer, and his put falls in value to 1 ½. He might, at that time, consider selling the near-term July 45 put for 1 point. The ideal situation would be for the July 45 put to expire worth­ less, reducing the cost of his long put by 1 point. Then, if the underlying stock declined below 45, he could profit after July expiration. The major drawback to this strategy is that little or no profit will be made - in fact, a loss is quite possible - if the underlying stock falls back to 45 or below before the near-term July option expires. Puts display different qualities in their time value premiums than calls do, as has been noted before. With the stock at 45, the differ­ ential between the July 45 put and the October 45 put might not widen much at all. This would mean that the spread has not gained anything, and the spreader has a loss equal to his commissions plus the initial unrealized loss. In the example above, ifXYZ dropped quickly back to 45, the July 45 might be worth 1 ½ and the October worth 2½. At this point, the spreader would have a loss on both sides of his spread: He sold the July 45 put for 1 and it is now 1 ½; he bought the October 45 for 3 and it is now 270 Part Ill: Put Option Strategies 2½; plus he has spent two commissions to date and would have to spend two more to liquidate the position. At this point, the strategist may decide to do nothing and take his chances that the stock will subsequently rally so that the July 45 put will expire worthless. However, if the stock continues to decline below 45, the spread will most certainly become more of a loss as both puts come closer to parity. This type of spread strategy is not as attractive as the "rolling-up" strategy. In the "rolling-up" strategy, one is not subjected to a loss if the stock declines after the spread is established, although he does limit his profits. The fact that the calendar spread strategy can lead to a loss even if the stock declines makes it a less desirable alternative. EQUIVALENT POSITIONS Before considering other put-oriented strategies, the reader should understand the definition of an equivalent position. Two strategies, or positions, are equivalent when they have the same profit potential. They may have different collateral or investment requirements, but they have similar profit potentials. Many of the call-oriented strategies that were discussed in Part II of the book have an equivalent put strategy. One such case has already been described: The "protected short sale," or shorting the common stock and buying a call, is equivalent to the purchase of a put. That is, both have a limited risk above the striking price of the option and relatively large profit potential to the downside. An easy way to tell if two strategies are equivalent is to see if their profit graphs have the same shape. The put purchase and the "protected short sale" have profit graphs with exactly the same shape (Figures 16-1 and 4-1, respec­ tively). As more put strategies are discussed, it will always be mentioned if the put strategy is equivalent to a previously described call strategy. This may help to clarify the put strategies, which understandably may seem complex to the reader who is not familiar with put options. Put Buying in Conjunction with Com.m.on Stock Ownership Another useful feature of put options, in addition to their speculative leverage in a downward move by the underlying stock, is that the put purchase can be used to limit downside loss in a stock that is owned. When one simultaneously owns both the com­ mon stock and a put on that same stock, he has a position with limited downside risk during the life of the put. This position is also called a synthetic long call, because the profit graph is the same shape as a long call's. Example: An investor owns XYZ stock, which is at 52, and purchases an XYZ October 50 put for 2. The put gives him the right to sell XYZ at 50, so the most that the stock­ holder can lose on his stock is 2 points. Since he pays 2 points for the put protection, his maximum potential loss until October expiration is 4 points, no matter how far XYZ might decline up until that time. If, on the other hand, the price of the stock should move up by October, the investor would realize any gain in the stock, less the 2 points that he paid for the put protection. The put functions much like an insurance policy with a finite life. Table 17-1 and Figure 17-1 depict the results at October expiration for this position: buying the October 50 put for 2 points to protect a holding in XYZ common stock, which is selling at 52. The dashed line on the graph represents the profit poten­ tial of the common stock ownership by itself. Notice that if the stock were below 48 in October, the common stock owner would have been better off buying the put. However, with XYZ above 48 at expiration, the put purchase was a burden that cost a small por­ tion of potential profits. This strategy, however, is not necessarily geared to maximizing 211 272 Part Ill: Put Option Strategies TABLE 17-1. Results at expiration on a protected stock holding. XYZ Price at Stock Put Expiration Profit Profit 30 -$2,200 +$1,800 40 - 1,200 + 800 50 200 200 54 + 200 200 60 + 800 200 70 + 1,800 200 80 + 2,800 200 FIGURE 17-1. long common stock and long put. C: 0 e ·5. X w 1i'i $0 Cf) Cf) 0 ..J c5 e 0. -$400 , , , , Long ,' Stock ,, ,, ,, , , , 48 50 ,'52 , ,, , ,, , , , ,, , , , ,, Stock Price at Expiration ,, ,, ,, ,, , , Total Profit -$ 400 400 400 0 + 600 + 1,600 + 2,600 one's profit potential on the common stock, but rather provides the stock owner with protection, eliminating the possibility of any devastating loss on the stock holding during the life of the put. In all the put buying strategies discussed in this chapter and Chapter 18, the put must be paid for in full. That is the only increase in investment. Although any common stockholder may use this strategy, two general classes of stock owners find it particularly attractive: First, the long-term holder of the stock who is not considering selling the stock may utilize the put protection to limit losses over a short-term horizon. Second, the buyer of common stock who wants some "insurance" in case he is wrong may also find the put protection attractive. Cl,apter 17: Put Buying in Conjunction with Common Stock Ownership 273 The long-term holder who strongly feels that his stock will drop should proba­ bly sell that stock. However, his cost basis may make the capital gains tax on the sale prohibitive. He also may not be entirely sure that the stock will decline - and may want to continue to hold the stock in case it does go up. In either case, the purchase of a put will limit the stockholder's downside risk while still allowing room for upside appreciation. A large number of individual and institutional investors have holdings that they might find difficult to sell for one reason or another. The purchase of a low­ cost put can often reduce the negative effects of a bear market on their holdings. The second general class of put buyers for protection includes the investor who is establishing a position in the stock. He might want to buy a put at the same time that he buys the stock, thereby creating a position with profitability as depicted in the previous profit graph. He immediately starts out with a position that has limited downside risk with large potential profits if the stock moves up. In this way, he can feel free to hold the stock during the life of the put without worrying about when to sell it if it should experience a temporary setback. Some fairly aggressive stock traders use this technique because it eliminates the necessity of having to place a stop loss order on the stock. It is often frustrating to see a stock fall and touch off one's stop loss limit order, only to subsequently rise in price.' The stock owner who has a put for protection need not overreact to a downward move. He can afford to sit back and wait during the life of the put, since he has built-in protection. WHICH PUT TO BUY The selection of which put the stock owner purchases will determine how much of his profit potential he is giving up and how much risk he is limiting. An out-of-the­ money put will cost very little. Therefore, it will be less of a hindrance on profit potential if the underlying stock rises in price. Unfortunately, the put's protective fea­ ture is small until the stock falls to the striking price of the put. Therefore, the pur­ chase of the out-ofthe-rrwney put will not provide as much downside protection as an at- or in-the-money put would. The purchase of a deeply out-of-the-money put as protection is more like "disaster insurance": It will prevent a stock owner from expe­ riencing a disaster in terms of a downside loss during the life of the put, but will not provide much protection in the case of a limited stock decline. Example: XYZ is at 40 and the October 35 put is selling for ½. The purchase of this put as protection for the common stock would not reduce upside potential much at all, only by ½ point. However, the stock owner could lose 5½ points if XYZ fell to 35 or below. That is his maximum possible loss, for if XYZ were below 35 at October expi­ ration, he could exercise his put to sell the stock at 35, losing 5 points on the stock, and he would have paid ½ point for the put, bringing his total loss to 5½ points. 274 Part Ill: Put Option Strategies At the opposite end of the spectrum, the stock owner might buy an in-the­ money put as protection. This would quite severely limit his profit potential, since the underlying stock would have to rise above the strike and more for him to make a profit. However, the in-the-money put provides vast quantities of downside protec­ tion, limiting his loss to a very small amount. Example: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock owner who purchases the October 45 put would have a maximum risk of½ point, for he could always exercise the put to sell stock at 45, giving him a 5-point gain on the stock, but he paid 5½ points for the put, thereby giving him an overall maximum loss of ½ point. He would have difficulty making any profit during the life of the put, however. XYZ would have to rise by more than 5½ points (the cost of the put) for him to make any total profit on the position by October expiration. The deep in-the-money put purchase is overly conservative and is usually not a good strategy. On the other hand, it is not wise to purchase a put that is too deeply out-of-the-money as protection. Generally, one should purchase a slightly out-ofthe­ money put as protection. This helps to achieve a balance between the positive feature of protection for the common stock and the negative feature of limiting profits. The reader may find it interesting to know that he has actually gone through this analysis, back in Chapter 3. Glance again at the profit graph for this strategy of using the put purchase to protect a common stock holding (Figure 17-1). It has exactly the same shape as the profit graph of a simple call purchase. Therefore, the call purchase and the long put/long stock strategies are equivalent. Again, by equivalent it is meant that they have similar profit potentials. Obviously, the ownership of a call differs sub­ stantially from the ownership of common stock and a put. The stock owner continues to maintain his position for an indefinite period of time, while the call holder does not. Also, the stockholder is forced to pay substantially more for his position than is the call holder, and he also receives dividends whereas the call holder does not. Therefore, "equivalent" does not mean exactly the same when comparing call-oriented and put­ oriented strategies, but rather denotes that they have similar profit potentials. In Chapter 3, it was determined that the slightly in-the-money call often offers the best ratio between risk and reward. When the call is slightly in-the-money, the stock is above the striking price. Similarly, the slightly out-of-the-money put often offers the best ratio between risk and reward for the common stockholder who is buy­ ing the put for protection. Again, the stock is slightly above the striking price. Actually, since the two positions are equivalent, the same conclusions should be arrived at; that is why it was stated that the reader has been through this analysis previously. G,pter 17: Put Buying in Conjunction with Common Stock Ownership TAX CONSIDERATIONS 275 Although tax considerations are covered in detail in a later chapter, an important tax law concerning the purchase of puts against a common stock holding should be men­ tioned at this time. If the stock owner is already a long-term holder of the stock at the time that he buys the put, the put purchase has no effect on his tax status. Similarly, if the stock buyer buys the stock at the time that he buys the put and identifies the position as a hedge, there is no effect on the tax status of his stock. However, if one Is currently a short-tenn holder of the common stock at the time that he buys a put, he eliminates any accrued holding period on his common stock. Moreover, the hold­ ing period for that stock does not begin again until the put is sold. Example: Assume the long-term holding period is 6 months. That is, a stock owner must own the stock for 6 months before it can be considered a long-term capital gain. An investor who bought the stock and held it for 5 months and then purchased a put would wipe out his entire holding period of 5 months. Suppose he then held the put and the stock simultaneously for 6 months, liquidating the put at the end of 6 months. His holding period would start all over again for that common stock. Even though he has owned the stock for 11 months - 5 months prior to the put purchase and 6 months more while he simultaneously owned the put - his holding period for tax pur­ poses is considered to be zero! This law could have important tax ramifications, and one should consult a tax advisor if he is in doubt as to the effect that a put purchase might have on the taxability of his common stock holdings. PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER Since put purchases afford protection to the owner of common stock, some investors naturally feel that the same protective feature could be used to limit their downside risk in the covered call writing strategy. Recall that the covered call writing strategy involves the purchase of stock and the sale of a call option against that stock. The cov­ ered write has limited upside profit potential and offers protection to the downside in the amount of the call premium. The covered writer will make money if the stock falls a little, remains unchanged, or rises by expiration. The covered writer can actually lose money only if the stock falls by more than the call premium received. He has poten­ tially large downside losses. This strategy is known as a protective collar or, more sim­ ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.) 274 Part Ill: Put Option Strategies At the opposite end of the spectrum, the stock owner might buy an in-the­ money put as protection. This would quite severely limit his profit potential, since the underlying stock would have to rise above the stiike and more for him to make a profit. However, the in-the-money put provides vast quantities of downside protec­ tion, limiting his loss to a very small amount. Example: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock owner who purchases the October 45 put would have a maximum risk of½ point, for he could always exercise the put to sell stock at 45, giving him a 5-point gain on the stock, but he paid 5½ points for the put, thereby giving him an overall maximum loss of ½ point. He would have difficulty making any profit during the life of the put, however. XYZ would have to rise by more than 5½ points (the cost of the put) for him to make any total profit on the position by October expiration. The deep in-the-money put purchase is overly conservative and is usually not a good strategy. On the other hand, it is not wise to purchase a put that is too deeply out-of-the-money as protection. Generally, one should purchase a slightly out-ofthe­ nwney put as protection. This helps to achieve a balance between the positive feature of protection for the common stock and the negative feature of limiting profits. The reader may find it interesting to know that he has actually gone through this analysis, back in Chapter 3. Glance again at the profit graph for this strategy of using the put purchase to protect a common stock holding (Figure 17-1). It has exactly the same shape as the profit graph of a simple call purchase. Therefore, the call purchase and the long put/long stock strategies are equivalent. Again, by equivalent it is meant that they have similar profit potentials. Obviously, the ovvnership of a call differs sub­ stantially from the ownership of common stock and a put. The stock owner continues to maintain his position for an indefinite period of time, while the call holder does not. Also, the stockholder is forced to pay substantially more for his position than is the call holder, and he also receives dividends whereas the call holder does not. Therefore, "equivalent" does not mean exactly the same when comparing call-oriented and put­ oriented strategies, but rather denotes that they have similar profit potentials. In Chapter 3, it was determined that the slightly in-the-money call often offers the best ratio between 1isk and reward. When the call is slightly in-the-money, the stock is above the striking price. Similarly, the slightly out-of-the-money put often offers the best ratio between risk and reward for the common stockholder who is buy­ ing the put for protection. Again, the stock is slightly above the striking price. Actually, since the two positions are equivalent, the same conclusions should be arrived at; that is why it was stated that the reader has been through this analysis previously. 0.,,,,, I 7: Put Buying in Conjundion with Common Stock Ownership JAX CONSIDERATIONS 275 Although tax considerations are covered in detail in a later chapter, an important tax law concerning the purchase of puts against a common stock holding should be men­ tioned at this time. If the stock owner is already a long-term holder of the stock at the time that he buys the put, the put purchase has no effect on his tax status. Similarly, if the stock buyer buys the stock at the time that he buys the put and identifies the position as a hedge, there is no effect on the tax status of his stock. However, if one is currently a short-term holder of the comrrwn stock at the time that he buys a put, he eliminates any accrued holding period on his comrrwn stock. Moreover, the hold­ ing period for that stock does not begin again until the put is sold. Example: Assume the long-term holding period is 6 months. That is, a stock owner must own the stock for 6 months before it can be considered a long-term capital gain. An investor who bought the stock and held it for 5 months and then purchased a put would wipe out his entire holding period of 5 months. Suppose he then held the put and the stock simultaneously for 6 months, liquidating the put at the end of 6 months. His holding period would start all over again for that common stock. Even though he has owned the stock for 11 months - 5 months prior to the put purchase and 6 months more while he simultaneously owned the put - his holding period for tax pur­ poses is considered to be zero! This law could have important tax ramifications, and one should consult a tax advisor if he is in doubt as to the effect that a put purchase might have on the taxability of his common stock holdings. PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER Since put purchases afford protection to the owner of common stock, some investors naturally feel that the same protective feature could be used to limit their downside risk in the covered call writing strategy. Recall that the covered call writing strategy involves the purchase of stock and the sale of a call option against that stock. The cov­ ered write has limited upside profit potential and offers protection to the downside in the amount of the call premium. The covered writer will make money if the stock falls a little, remains unchanged, or rises by expiration. The covered writer can actually lose money only if the stock falls by more than the call premium received. He has poten­ tially large downside losses. This strategy is known as a protective collar or, more sim­ ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.) 276 Part Ill: Put Option Strategies The purchase of an out-of the-money put option can eliminate the risk of large potential losses for the covered write, although the money spent for the put purchase will reduce the overall return from the covered write. One must therefore include the put cost in his initial calculations to determine if it is worthwhile to buy the put. Example: X'YZ is at 39 and there is an XYZ October 40 call selling for 3 points and an XYZ October 35 put selling for ½ point. A covered write could be established by buy­ ing the common at 39 and selling the October 40 call for 3. This covered write would have a maximum profit potential of 4 points if XYZ were anywhere above 40 at expi­ ration. The write would lose money if XYZ were anywhere below 36, the break-even point, at October expiration. By also purchasing the October 35 put at the time the covered write is initiated, the covered writer will limit his profit potential slightly, but will also greatly reduce his risk potential. If the put purchase is added to the covered write, the maximum profit potential is reduced to 3½ points at October expiration. The break-even point moves up to 36½, and the writer will experience some loss if XYZ is below 36½ at expiration. However, the most that the writer could lose would be 1 ¼ points if XYZ were below 35 at expiration. The purchase of the put option produces this loss-limiting effect. Table 17-2 and Figure 17-2 depict the profitability of both the regular covered write and the covered write that is protected by the put purchase. Commissions should be carefully included in the covered writer's return calcula­ tions, as well as the cost of the put. It was demonstrated in Chapter 2 that the covered writer must include all commissions and margin interest expenses as well as all divi­ dends received in order to produce an accurate "total return" picture of the covered write. Figure 17-2 shows that the break-even point is raised slightly and the overall prof­ it potential is reduced by the purchase of the put. However, the maximum risk is quite small and the writer need never be forced to roll down in a disadvantageous situation. Recall that the covered writer who does not have the protective put in place is forced to roll down in order to gain increased downside protection. Rolling down merely means that he buys back the call that is currently written and writes another call, with a lower striking price, in its place. This rolling-down action can be helpful if the stock stabilizes after falling; but if the stock reverses and climbs upward in price again, the covered writer who rolled down would have limited his gains. In fact, he may even have "locked in" a loss. The writer who has the protective put need not be bothered with such things. He never has to roll down, for he has a limited maximum loss. Therefore, he should never get into a "locked-in" loss situation. This can be a great advantage, especially from an emotional viewpoint, because the writer is never forced to make a decision as to the future price of the stock in the middle of the stock's decline. With the put in place, he can feel free to take no action at all, since his overall loss is limited. If the stock should rally upward later, he will still be in a position to make his maximum profit. Chapter 17: Put Buying in Conjundion with Common Stock Ownership TABLE 17·2. Comparison of regular and protected covered writes. XYZ Price at Stock October 40 October 35 Expiration Profit Call Profit Put Profit 25 -$1,400 +$300 +$950 30 900 + 300 + 450 35 400 + 300 - 50 36.50 250 + 300 - 50 38 100 + 300 - 50 40 + 100 + 300 - 50 45 + 600 - 200 - 50 50 + 1,100 - 700 - 50 FIGURE 17-2. Covered call write protected by a put purchase. C 0 e ·5. X LU co $0 CJ) CJ) 0 .J 0 ~ -$150 a.. ,, },.,,' ; ,, Regular Covered ,,' Write/ 36 / , , ; ,,' +$400 ,----------➔ ,,,' _____ ...,.. , +$350 ,,,' 40 Stock Price at Expiration 277 Total Profit -$150 - 150 - 150 0 + 150 + 350 + 350 + 350 The longer-term effects of buying puts in combination with covered writes are not easily definable, but it would appear that the writer reduces his overall rate of return slightly by buying the puts. This is because he gives something away if the stock falls slightly, remains unchanged, or rises in price. He only "gains" something if the stock falls heavily. Since the odds of a stock falling heavily are small in compari­ son to the other events (falling slightly, remaining unchanged, or rising), the writer will be gaining something in only a small percentage of cases. However, the put buy­ ing strategy may still prove useful in that it removes the emotional uncertainty of 278 Part Ill: Put Option Strategies large losses. The covered writer who buys puts may often find it easier to operate in a more rational manner when he has the protective put in place. This strategy is equivalent to one that has been described before, the bull spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull spread profit graph (Figure 7-1). This means that the two strategies are equivalent. In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con­ sidered a "substitute" for covered writing. Actually, the bull spread is more akin to this strategy - the covered write protected by a put purchase. There are, of course, differences between the strategies. They are equivalent in profit and loss potential, but the covered writer could never lose all his investment in a short period of time, although the spreader could. In order to actually use bull spreads as substitutes for covered writes, one would invest only a small portion of his available funds in the spread and would place the remainder of his funds in fixed-income securities. That strategy was discussed in more depth in Chapter 7. NO-COST COLLARS The "collar" strategy is often arrived at in another manner: a stockholder begins to worry about the downside potential of the stock market and decides to buy puts on his stock as protection. However, he is dismayed by the cost of the puts and so he also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi­ ble that he might be able to sell an out-of-the-money call whose proceeds complete­ ly cover the cost of the put. Thus, he has established a protective collar at no cost - at least no debit. His "cost" is the fact that he has forsaken the upside profit poten­ tial on his stock, above the striking price of the written call. In fact, certain large institutional traders are able to transact collars through large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. They might even give the broker instructions such as this: "I own XYZ and I want to buy a put 10 percent out of the money that expires in a year. What would the strik­ ing price of a one-year call have to be in order to create a no-cost collar?" The bro­ ker might then tell him that such a call would have to be struck 30 percent out of the money. The actual strike price of the call would depend on the volatility estimate for the underlying stock, as well as interest rates and dividends. These types of transac­ tions occur with a fair amount of frequency. Some very interesting situations can be created with long-term options. One of the most interesting occurred in 1999, when a company that owned 5 million shares of Cisco ( CSCO) decided it would like to hedge them by creating a no-cost collar over the next three years. At the time, CSCO was trading at about 130, and its volatil­ ity was about 50%. It turns out that a three-year put struck at 130 sells for about the 278 Part Ill: Put Option Strategies large losses. The covered writer who buys puts may often find it easier to operate in a more rational manner when he has the protective put in place. This strategy is equivalent to one that has been described before, the bull spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull spread profit graph (Figure 7-1). This means that the two strategies are equivalent. In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con­ sidered a "substitute" for covered writing. Actually, the bull spread is more akin to this strategy- the covered write protected by a put purchase. There are, of course, differences between the strategies. They are equivalent in profit and loss potential, but the covered writer could never lose all his investment in a short period of time, although the spreader could. In order to actually use bull spreads as substitutes for covered writes, one would invest only a small portion of his available funds in the spread and would place the remainder of his funds in fixed-income securities. That strategy was discussed in more depth in Chapter 7. NO-COST COLLARS The "collar" strategy is often arrived at in another manner: a stockholder begins to worry about the downside potential of the stock market and decides to buy puts on his stock as protection. However, he is dismayed by the cost of the puts and so he also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi­ ble that he might be able to sell an out-of-the-money call whose proceeds complete­ ly cover the cost of the put. Thus, he has established a protective collar at no cost - at least no debit. His "cost" is the fact that he has forsaken the upside profit poten­ tial on his stock, above the striking price of the written call. In fact, certain large institutional traders are able to transact collars through large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. They might even give the broker instructions such as this: "I own XYZ and I want to buy a put 10 percent out of the money that e.:\.J)ires in a year. What would the strik­ ing price of a one-year call have to be in order to create a no-cost collar?" The bro­ ker might then tell him that such a call would have to be struck 30 percent out of the money. The actual strike price of the call would depend on the volatility estimate for the underlying stock, as well as interest rates and dividends. These types of transac­ tions occur with a fair amount of frequency. Some very interesting situations can be created with long-term options. One of the most interesting occurred in 1999, when a company that owned 5 million shares of Cisco (CSCO) decided it would like to hedge them by creating a no-cost collar over the next three years. At the time, CSCO was trading at about 130, and its volatil­ ity was about 50%. It turns out that a three-year put struck at 130 sells for about the 278 Part Ill: Put Option Strategies large losses. The covered writer who buys puts may often find it easier to operate in a more rational manner when he has the protective put in place. This strategy is equivalent to one that has been described before, the bull spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull spread profit graph (Figure 7-1). This means that the two strategies are equivalent. In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con­ sidered a "substitute" for covered writing. Actually, the bull spread is more akin to this strategy - the covered write protected by a put purchase. There are, of course, differences between the strategies. They are equivalent in profit and loss potential, but the covered writer could never lose all his investment in a short period of time, although the spreader could. In order to actually use bull spreads as substitutes for covered ,vrites, one would invest only a small portion of his available funds in the spread and would place the remainder of his funds in fixed-income securities. That strategy was discussed in more depth in Chapter 7. NO-COST COLLARS The "collar" strategy is often arrived at in another manner: a stockholder begins to worry about the downside potential of the stock market and decides to buy puts on his stock as protection. However, he is dismayed by the cost of the puts and so he also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi­ ble that he might be able to sell an out-of-the-money call whose proceeds complete­ ly cover the cost of the put. Thus, he has established a protective collar at no cost - at least no debit. His "cost" is the fact that he has forsaken the upside profit poten­ tial on his stock, above the striking price of the written call. In fact, certain large institutional traders are able to transact collars through large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. They might even give the broker instructions such as this: "I own XYZ and I want to buy a put 10 percent out of the money that expires in a year. What would the strik­ ing p1ice of a one-year call have to be in order to create a no-cost collar?" The bro­ ker might then tell him that such a call would have to be struck 30 percent out of the money. The actual strike price of the call would depend on the volatility estimate for the underlying stock, as well as interest rates and dividends. These types of transac­ tions occur with a fair amount of frequency. Some very interesting situations can be created with long-term options. One of the most interesting occurred in 1999, when a company that owned 5 million shares of Cisco ( CSCO) decided it would like to hedge them by creating a no-cost collar over the next three years. At the time, CSCO was trading at about 130, and its volatil­ ity was about 50%. It turns out that a three-year put struck at 130 sells for about the Cltapter 17: Put Buying in Conjunction with Common Stock Ownership TABLE 17-3. Highest Call Strike That Pays for an At-the-Money Put (Assuming 2.5 years to expiration) Volatility Coll Strike 30% 40% 50% 70% 100% of Underlying 30% out of money 35% out of money 40% out of money 50% out of money 70% out of money 279 same price as a three-year call struck at 200! That may seem illogical, but the figures can be checked out with the aid of an option-pricing model. Thus, this company was able to hedge all of its CSCO stock, with no downside risk ( the striking price of the puts was the same as the current stock price) and still had profit potential of over 50% to the upside over the next three years. Thus, one should consider using LEAPS options when he establishes a collar - even ifhe is not an institutional trader - because the striking price of the calls can be quite high in comparison to that of the put' s strike or in comparison to the price of the underlying stock. Table 17-3 shows how far out-of-the-money a written call could be that still covers the cost of buying an at-the-money put. The time to expiration in this table is 2.5 years - the longest term listed option that currently exists as a LEAPS option. USING LOWER STRIKES AS A PARTIAL COVERED WRITE It should also be pointed out that one does not necessarily have to forsake all of the profit potential from his stock. He might buy the puts, as usual, and then sell calls with a somewhat lower strike than needed for a low-cost collar, but the quantity of calls sold would be less than that of stock owned. In that way, there would be unlim­ ited profit potential on some of the shares of the underlying stock. Example: Suppose that the following prices exist: XYZ:61 Apr 55 put: 1 Apr 65 call: 2 Furthermore, suppose that one owns 1000 shares of XYZ. Thus, the purchase of 10 Apr 55 puts at 1 point apiece would protect the downside. In order to cover the cost of those puts ($1000), one need only sell five of the Apr 65 calls at 2 points 280 Part Ill: Put Option Strategies apiece. Thus, the protection would have cost nothing and there would still be unlim­ ited profit potential on 500 of the shares of XYZ, since only five calls were sold against the 1000 shares that are owned. In this manner, one could get quite creative in constructing collars - deciding what call strike to use in order to strike a balance between paying for the puts and allowing upside profit potential. The lower the strike he uses for the written calls, the fewer calls he will have to write; the higher the strike of the written calls, the more calls will be necessary to cover the cost of the purchased puts. The tradeoff is that a lower call strike allows for more eventual upside profit potential, but it limits what has been written against to a lower price. Using the above example once again, these facts can be demonstrated: Example (continued): As before, the same prices exist, but now one more call will be brought into the picture: XYZ: 61 Apr55 put: l Apr 65 call: 2 Apr 70 call: l As before one could sell five of the Apr 65 calls to cover the cost of ten puts, or as an alternative he could sell ten of the Apr 70 calls. If he sells the five, he has unlim­ ited profit potential on 500 shares, but the other 500 shares will be called away at 65. In the alternative strategy, he has limited upside profit potential, but nothing will be called away until the stock reaches 70. Which is "better?" It's not easy to say. In the former strategy, if the stock climbs all the way to 75, it results in the same profit as if the stock is called away at 70 in the latter strategy. This is true because 500 shares would be worth 75, but the other 500 would have been called away at 65 - making for an average of 70. Hence, the former strategy only outperforms the latter if the stock actually climbs above 75 - a rather unlikely event, one would have to surmise. Still, many investors prefer the former strategy because it gives them protection with­ out asking them to surrender all of their upside profit potential. In summary, one can often be quite creative with the "collar" strategy. One thing to keep in mind: if one sells options against stock that he has no intention of selling, he is actually writing naked calls in his ovm mind. That is, if one owns stock that "can't" be sold - perhaps the capital gains would be devastating or the stock has been "in the family" for a long time - then he should not sell covered calls against it, because he will be forced into treating the calls as naked (if he refuses to sell the stock). This can cause quite a bit of consternation if the underlying stock rises significantly in price, that could have easily been avoided by not writing calls against the stock in the first place. CHAPCIJER 18 Buying Puts in Conjunction with Call Purchases There are several ways in which the purchases of both puts and calls can be used to the speculator's advantage. One simple method is actually a follow-up strategy for the call buyer. If the stock has advanced and the call buyer has a profit, he might con­ sider buying a put as a means of locking in his call profits while still allowing for more potential upside appreciation. In Chapter 3, four basic alternatives were listed for the call buyer who had a profit: He could liquidate the call and take his profit; he could do nothing; he could "roll up" by selling the call for a profit and using part of the pro­ ceeds to purchase more out-of-the-money calls; or he could create a bull spread by selling the out-of-the-money call against the profitable call that he holds. If the underlying stock has listed puts, he has another alternative: He could buy a put. This put purchase would serve to lock in some of the profits on the call and would still allow room for further appreciation if the stock should continue to rise in price. Example: An investor initially purchased an XYZ October 50 call for 3 points when the stock was at 48. Sometime later, after the stock had risen to 58, the call would be worth about 9 points. If there was an October 60 put, it might be selling for 4 points, and the call holder could buy this put to lock in some of his profits. His position, after purchasing the put, would be: Long l October 50 call at 3 points N t t 7 • t - e cos: pom s Long l October 60 put at 4 points He would own a "strangle" - any position consisting of both a put and a call with dif­ fering terms - that is always worth at least 10 points. The combination will be worth exactly 10 points at expiration if XYZ is anywhere between 50 and 60. For example, 281 282 Part Ill: Put Option Strategies if xyz is at 52 at expiration, the call will be worth 2 points and the put will be wort Ii 8 points. Alternatively, if the stock is at 58 at expiration, the put will be worth 2 points and the call worth 8 points. Should xyz be above 60 at expiration, the combination's value will be equal to the call's value, since the put will expire worthless with XYZ above 60. The call would have to be worth more than 10 points in that case, since it has a striking price of 50. Similarly, if xyz were below 50 at expiration, the combi­ nation would be worth more than 10 points, since the put would be more than 10 points in-the-money and the call would be worthless. The speculator has thus created a position in which he cannot lose money, because he paid only 7 points for the combination (3 points for the call and 4 points for the put). No matter what happens, the combination will be worth at least 10 points at e:x-piration, and a 3-point profit is thus locked in. If xyz should continue to climb in price, the speculator could make more than 3 points of profit whenever xyz is above 60 at expiration. Moreover, if xyz should suddenly collapse in price, the speculator could make more than 3 points of profit if the stock was below 50 by expi­ ration. The reader must realize that such a position can never be created as an initial position. This desirable situation arose only because the call had built up a substan­ tial profit before the put was purchased. The similar strategy for the put buyer who might buy a call to protect his unrealized put profits was described in Chapter 16. STRADDLE BUYING A straddle purchase consists of buying both a put and a call with the same terms - sarne underlying stock, striking price, and expiration date. The straddle purchase allows the buyer to make large potential profits if the stock moves far enough in either direction. The buyer has a predetermined maximum loss, equal to the amount of his initial investment. Example: The following prices exist: xyz common, 50; XYZ July 50 call, 3; and XYZ July 50 put, 2. If one purchased both the July 50 call and the July 50 put, he would be buying a straddle. This would cost 5 points plus commissions. The investment required to purchase a straddle is the net debit. If the underlying stock is exactly at 50 at expi­ ration, the buyer would lose all his investment, since both the put and the call would expire worthless. If the stock were above .55 at expiration, the call portion of the 18: Buying Puts in Conjundion with Call Purchases 283 dle would be worth more than 5 points and the straddle buyer would make y, even though his put expired worthless. To the downside, a similar situation Mists. If XYZ were below 45 at expiration, the put would be worth more than 5 points and he would have a profit despite the fact that the call expired worthless. Table 18-1 and Figure 18-1 depict the results of this example straddle purchase at expiration. The straddle buyer can immediately determine his break-even points at expiration - 45 and 55 in this example. He will lose money if the underlying stock is between those break-even points at expiration. He has potentially large profits if XYZ should move a great distance away from 50 by expiration. One would normally purchase a straddle on a relatively volatile stock that has the potential to move far enough to make the straddle profitable in the allotted time. This strategy is particularly attractive when option premiums are low, since low pre­ miums will mean a cheaper straddle cost. Although losses may occur in a relatively large percentage of cases that are held all the way until their expiration date, there is actually only a minute probability of losing one's entire investment. Even if XYZ should be at 50 at expiration, there would still be the opportunity to sell the straddle for a small amount on the final day of trading. TABLE 18-1. Results of straddle purchase at expiration. XYZ Price at Total Straddle Expiration Coll Profit Put Profit Profit 30 -$ 300 +$1,800 + $1,500 40 300 + 800 + 500 45 300 + 300 0 50 300 200 500 55 + 200 200 0 60 + 700 200 + 500 70 + 1,700 200 + 1,500 EQUIVALENCES Straddle buying is equivalent to the reverse hedge, a strategy described in Chapter 4 in which one sells the underlying stock short and purchases two calls on the under­ lying stock. Both strategies have similar profit characteristics: a limited loss that would occur at the striking price of the options involved, and potentially large prof­ its if the underlying stock should rise or fall far enough in price. The straddle pur- 284 FIGURE 18-1. Straddle purchase. C: .Q I!! ·a. X w ro $0 en en 0 ..J 0 -e a.. -$500 Part Ill: Put Option Strategies Stock Price at Expiration chase is superior to the reverse hedge, however, and where listed puts exist on a stock, the reverse hedge strategy becomes obsolete. The reasons that the straddle purchase is superior are that dividends are not paid by the holder and that commission costs are much smaller in the straddle situation. REVERSE HEDGE WITH PUTS A third strategy is equivalent to both the straddle purchase and the reverse hedge. It consists of buying the underlying stock and buying two put options. If the stock rises substantially in price, large profits will accrue, for the stock profit will more than offset the fixed loss on the purchase of two put options. If the stock declines in price by a large amount, profits will also be generated. In a decline, the profits gen­ erated by 2 long puts will more than offset the loss on 100 shares of long stock. This form of the straddle purchase has limited risk as well. The worst case would occur if the stock were exactly at the striking price of the puts at their expiration date - the puts would both expire worthless. The risk is limited, percentagevvise and dollar­ wise, since the cost of two put options would normally be a relatively small per­ centage of the total cost of buying the stock. Furthermore, the investor may receive some dividends if the underlying stock is a dividend-paying stock. Buying stock and buying two puts is superior to the reverse hedge strategy, but is still inferior to the straddle purchase. ter 18: Buying Puts in Conjunction with Call Purchases IILECTING A STRADDLE BUY 285 In theory, one could find the best straddle purchases by applying the analyses for best call purchases and best put purchases simultaneously. Then, if both the puts and calls on a particular stock showed attractive opportunity, the straddle could be bought. The straddle should be viewed as an entire position. A similar sort of analysis to that proposed for either put or call purchases could be used for straddles as well. First, one would assume the stock would move up or down in accordance with its volatili­ ty within a fixed time period, such as 60 or 90 days. Then, the prices of both the put and the call could be predicted for this stock movement. The straddles that off er the best reward opportunity under this analysis would be the most attractive ones to buy. To demonstrate this sort of analysis, the previous example can be utilized again. Example: XYZ is at 50 and the July 50 call is selling for 3 while the July 50 put is sell­ ing for 2 points. If the strategist is able to determine that XYZ has a 25% chance of being above 54 in 90 days and also has a 25% chance of being below 46 in 90 days, he can then predict the option prices. A rigorous method for determining what per­ centage chance a stock has of making a predetermined price movement is presented in Chapter 28 on mathematical applications. For now, a general procedure of analy­ sis is more important than its actual implementation. If XYZ were at 54 in 90 days, it might be reasonable to assume that the call would be worth 5½ and the put would be worth 1 point. The straddle would therefore be worth 6½ points. Similarly, if the stock were at 46 in 90 days, the put might be worth 4½ points, and the call worth 1 point, making the entire straddle worth 5½ points. It is fairly common for the strad­ dle to be higher-priced when it is a fixed distance in-the-money on the call side (such as 4 points) than when it is in-the-money on the put side by that same distance. In this example, the strategist has now determined that there is a 25% chance that the straddle will be worth 6½ points in 90 days on an upside movement, and there is a 25% chance that the straddle will be worth 5½ points on a downside movement. The average price of these two expectations is 6 points. Since the straddle is currently sell­ ing for 5 points, this would represent a 20% profit. If all potential straddles are ranked in the same manner - allowing for a 25% chance of upside and downside movement by each underlying stock - the straddle buyer will have a common basis for comparing various straddle opportunities. FOLLOW-UP ACTION It has been mentioned frequently that there is a good chance that a stock will remain relatively unchanged over a short time period. This does not mean that the stock will 286 Part Ill: Put Option Strategies never move much one way or the other, but that its net movement over the time peri­ od will generally be small. Example: If XYZ is currently at 50, one might say that its chances of being over .5.5 at the end of 90 days are fairly small, perhaps 30%. This may even be supported by mathematical analysis based on the volatility of the underlying stock. This does not imply, however, that the stock has only a 30% chance of ever reaching 55 during the 90-day period. Rather, it implies that it has only a 30% chance of being over 55 at the end of the 90-day period. These are two distinctly different events, with different probabilities of occurrence. Even though the probability of being over 55 at the end of 90 days might be only 30%, the probability of ever being over 55 during the 90- day period could be amazingly high, perhaps as high as 80%. It is important for the straddle buyer to understand the differences between these events occurring, for he might often be able to take follow-up action to improve his position. Many times, after a straddle is bought, the underlying stock will begin to move strongly, making it appear that the straddle is immediately going to become prof­ itable. However, just as things are going well, the stock reverses and begins to change direction, perhaps so quickly that it would now appear that the straddle will become profitable on the other side. These volatile stock movements often result in little net change, however, and at expiration the straddle buyer may have a loss. One might think that he would take profits on the call side when they became available in a quick upward movement, and then hope for a downward reversal so that he could take profits on the put side as well. Taking small profits, however, is a poor strategy. Straddle buying has limited losses and potentially unlimited profits. One might have to suffer through a substantial number of small losses before hitting a big winner, but the magnitude of the gain on that one large stock movement can offset many small losses. By taking small profits, the straddle buyer is immediately cutting off his chances for a substantial gain; that is why it is a poor strategy to limit the profits. This is one of those statements that sounds easier in theory than it is in practice. It is emotionally distressing to watch the straddle gain 2 or 3 points in a short time period, only to lose that and more when the stock fails to follow through. By using a different example, it is possible to demonstrate the types of follow-up action that the straddle buyer might take. Example: One had initially bought an XYZ January 40 straddle for 6 points when the stock was 40. After a fairly short time, the stock jumps up to 45 and the following prices exist: Cl,apter 18: Buying Puts in Conjunction with Call Purchases XYZ common, 45: XYZ January 40 call, 7; XYZ January 40 put, l; and XYZ January 45 put, 3. 287 The straddle itself is now worth 8 points. The January 45 put price is included because it will be part of one of the follow-up strategies. What could the straddle buyer do at this time? First, he might do nothing, preferring to let the straddle run its course, at least for three months or so. Assuming that he is not content to sit tight, however, he might sell the call, taking his profit, and hope for the stock to then drop in price. This is an inferior course of action, since he would be cutting off potential large profits to the upside. In the older, over-the-counter option market, one might have tried a technique known as trading against the straddle. Since there was no secondary market for over-the-counter options, straddle buyers often traded the stock itself against the straddle that they owned. This type of follow-up action dictated that, if the stock rose enough to make the straddle profitable to the upside, one would sell short the underlying stock. This involved no extra risk, since if the stock continued up, the straddle holder could always exercise his call to cover the short sale for a profit. Conversely, if the underlying stock fell at the outset, making the straddle profitable to the downside, one would buy the underlying stock. Again, this involved no extra risk if the stock continued down, since the put could always be exercised to sell the stock at a profit. The idea was to be able to capitalize on large stock price reversals with the addition of the stock position to the straddle. This strategy worked best for the brokers, who made numerous commissions as the trader tried to gauge the whipsaws in the market. In the listed options market, the same strategic effect can be realized ( without as large a commission expense) by merely selling out the long call on an upward move, and using part of the proceeds to buy a second put similar to the one already held. On a downside move, one could sell out the long put for a profit and buy a second call similar to the one he already owns. In the example above, the call would be sold for 7 points and a second January 40 put purchased for 1 point. This would allow the straddle buyer to recover his initial 6-point cost and would allow for large downside profit potential. This strategy is not recommended, however, since the straddle buyer is limiting his profit in the direction that the stock is moving. Once the stock has moved from 40 to 45, as in this example, it would be more reasonable to expect that it could continue up rather than experience a drop of more than 5 points. 288 Part Ill: Put Option Strategies A rrwre desirable sort off allow-up action would be one whereby the straddle buyer could retain much of the profit already built up without limiting further poten­ tial profits if the stock continues to run. In the example above, the straddle buyer could use the January 45 put - the one at the higher price - for this purpose. Example: Suppose that when the stock got to 45, he sold the put that he owned, the January 40, for 1 point, and simultaneously bought the January 45 put for 3 points. This transaction would cost 2 points, and would leave him in the following position: Long 1 January 40 call C b· d t 8 . t - om me cos : porn s Long 1 January 45 put He now owns a combination at a cost of 8 points. However, no matter where the underlying stock is at expiration, this combination will be worth at least 5 points, since the put has a striking price 5 points higher than the call's striking price. In fact, if the stock is above 45 at expiration or is below 40 at expiration, the straddle will be worth more than 5 points. This follow-up action has not limited the potential profits. If the stock continues to rise in price, the call will become more and more valuable. On the other hand, if the stock reverses and falls dramatically, the put will become quite valuable. In either case, the opportunity for large potential profits remains. Moreover, the investor has improved his risk exposure. The most that the new posi­ tion can lose at expiration is 3 points, since the combination cost 8 points originally, and can be sold for 5 points at worst. To summarize, if the underlying stock moves up to the ne:t"t strike, the straddle buyer should consider rolling his put up, selling the one that he is long and buying the one at the next higher striking price. Conversely, if the stock starts out with a downward move, he should consider rolling the call down, selling the one that he is long and buying the one at the next lower strike. In either case, he reduces his risk exposure without limiting his profit potential - exactly the type of follow-up result that the straddle buyer should be aiming for. BUYING A STRANGLE A strangle is a position that consists of both a put and a call, which generally have the same expiration date, but different striking prices. The fallowing example depicts a strangle. Example: One might buy a strangle consisting of an XYZ January 45 put and an XYZ January 50 call. Buying such a strangle is quite similar to buying a straddle, although O.,,ter 18: Buying Puts in Conjunction with Call Purchases 289 there are some differences, as the following discussion will demonstrate. Suppose the following prices exist: XYZ common, 47; XYZ January 45 put, 2; and XYZ January 50 call, 2. In this example, both options are out-of-the-money when purchased. This, again, is the most normal application of the strangle purchase. If XYZ is still between 45 and 50 at January expiration, both options will expire worthless and the strangle buyer will lose his entire investment. This investment - $400 in the example - is generally smaller than that required to buy a straddle on XYZ. If XYZ moves in either direc­ tion, rising above 50 or falling below 45, the strangle will have some value at expira­ tion. In this example, ifXYZ is above 54 at expiration, the call will be worth more than 4 points (the put will expire worthless) and the buyer will make a profit. In a similar manner, if XYZ is below 41 at expiration, the put will have a value greater than 4 points and the buyer would make a profit in that case as well. The potential profits are quite large if the underlying stock should nwve a great deal before the options expire. Table 18-2 and Figure 18-2 depict the potential profits or losses from this position at January expiration. The maximum loss is possible over a much wider range than that of a straddle. The straddle achieves its maximum loss only if the stock is exactly at the striking price of the options at expiration. However, the strangle has its maximum loss anywhere between the two strikes at expiration. The actual amount of the loss is smaller for the strangle, and that is a compensating factor. The potential profits are large for both strategies. The example above is one in which both options are out-of-the money. It is also possible to construct a very similar position by utilizing in-the-money options. Example: With XYZ at 47 as before, the in-the-money options might have the fol­ lowing prices: XYZ January 45 call, 4; and XYZ January 50 put, 4. If one purchased this in-the-rrwney strangle, he would pay a total cost of 8 points. However, the value of this strangle will always be at least 5 points, since the striking price of the put is 5 points higher than that of the call. The reader has seen this sort of position before, when protective follow-up strategies for straddle buying and for call or put buying were described. Because the strangle will always be worth at least 5 points, the most that the in-the-money strangle buyer can lose is 3 points in this example. His poten­ tial profits are still unlimited should the underlying stock move a large distance. Thus, even though it requires a larger initial investment, the in-the-rrwney strangle may often be a superior strategy to the out-of the-rrwney strangle, from a buyer's 290 TABLE 18-2. Results at expiration of a strangle purchase. XYZ Price at Expiration 25 35 41 43 45 47 50 54 60 70 FIGURE 18-2. Strangle purchase. C: 0 ~ ·c. X w 1ii (/) $0 (/) 0 ..J 6 il= -$400 e a. Put Call Profit Profit +$1,800 -$ 200 + 800 200 + 200 200 0 200 200 200 200 200 200 200 200 + 200 200 + 800 200 + 1,800 Stock Price at Expiration Part Ill: Put Option Strategies Total Profit +$1,600 + 600 0 200 400 400 400 0 + 600 + 1,600 viewpoint. The in-the-money strangle purchase certainly involves less percentage risk: The buyer can never lose all his investment, since he can always get back 5 points, even in the worst case (when XYZ is behveen 45 and 50 at expiration). His percentage profits are lower with the in-the-money strangle purchase, since he paid more for the strangle to begin with. These observations should come as no surprise, \O.,ter 18: Buying Puts in Conjunction with Call Purchases 291 since when the outright purchase of a call was discussed, it was shown that the purchase of an in-the-money call was more conservative than the purchase of an out­ of-the-money call, in general. The same was true for the outright purchase of puts, perhaps even more so, because of the smaller time value of an in-the-money put. Therefore, the strangle created by the two an in-the-money call and an in-the­ money put - should be more conservative than the out-of-the-money strangle. If the underlying stock moves quickly in either direction, the strangle buyer may sometimes be able to take action to protect some of his profits. He would do so in a manner similar to that described for the straddle buyer. For example, if the stock moved up quickly, he could sell the put that he originally bought and buy the put at the next higher striking price in its place. If he had started from an out-of-the-money strangle position, this would then place him in a straddle. The strategist should not blindly take this sort of follow-up action, however. It may be overly expensive to "roll up" the put in such a manner, depending on the amount of time that has passed and the actual option prices involved. Therefore, it is best to analyze each situation on a case-by-case basis to see whether it is logical to take any follow-up action at all. As a final point, the out-of-the-money strangles may appear deceptively cheap, both options selling for fractions of a point as expiration nears. However, the proba­ bility of realizing the maximum loss equal to one's initial investment is fairly large with strangles. This is distinctly different from straddle purchases, whereby the prob­ ability of losing the entire investment is small. The aggressive speculator should not place a large portion of his funds in out-of-the-money strangle purchases. The per­ centage risk is smaller with the in-the-money strangle, being equal to the amount of time value premium paid for the options initially, but commission costs will be some­ what larger. In either case, the underlying stock still needs to move by a relatively large amount in order for the buyer to profit. CH.APTER 19 The Sale of a Put The buyer of a put stands to profit if the underlying stock drops in price. As might then be expected, the seller of a put will make money if the underlying stock increas­ es in price. The uncovered sale of a put is a more common strategy than the covered sale of a put, and is therefore described first. It is a bullishly-oriented strategy. THE UNCOVERED PUT SALE Since the buyer of a put has a right to sell stock at the striking price, the writer of a put is obligating himself to buy that stock at the striking price. For assuming this obli­ gation, he receives the put option premium. If the underlying stock advances and the put expires worthless, the put writer will not be assigned and he could make a maxi­ mum profit equal to the premium received. He has large downside risk, since the stock could fall substantially, thereby increasing the value of the written put and caus­ ing large losses to occur. An example will aid in explaining these general statements about risk and reward. Example: XYZ is at 50 and a 6-month put is selling for 4 points. The naked put writer has a fixed potential profit to the upside - $400 in this example and a large poten­ tial loss to the downside (Table 19-1 and Figure 19-1). This downside loss is limited only by the fact that a stock cannot go below zero. The collateral requirement for writing naked puts is the same as that for writ­ ing naked calls. The requirement is equal to 20% of the current stock price plus the put premium minus any out-of-the-money amount. Example: If XYZ is at 50, the collateral requirement for writing a 4-point put with a striking price of 50 would be $1,000 (20% of 5,000) plus $400 for the put premium 292 Cl,opter 19: The Sale of a Put TABLE 19-1. Results from the sale of an uncovered put. XYZ Price at Put Price at Expiration Expiration (Parity) 30 20 40 10 46 4 50 0 60 0 70 0 f IGURE 19-1. Uncovered sale of a put. $400 C 0 ~ ·5. X w 'lii (/l $0 (/l .3 50 0 ~ a. Stock Price at Expiration 293 Put Sale Profit -$1,600 600 0 + 400 + 400 + 400 for a total of $1,400. If the stock were above the striking price, the striking price dif­ forential would be subtracted from the requirement. The minimum requirement is I 0% of the put' s striking price, plus the put premium, even if the computation above yields a smaller result. The uncovered put writing strategy is similar in many ways to the covered call writing strategy. Note that the profit graphs have the same shape; this means that the two strategies are equivalent. It may be helpful to the reader to describe the aspects of naked put writing by comparing them to similar aspects of covered call writing. 294 Part Ill: Put Option Strategies In either strategy, one needs to be somewhat bullish, or at least neutral, on the underlying stock. If the underlying stock moves upward, the uncovered put writer will make a profit, possibly the entire amount of the premium received. If the under­ lying stock should be unchanged at expiration - a neutral situation - the put writer will profit by the amount of the time value premium received when he initially wrote the put. This could represent the maximum profit if the put was out-of-the-money initially, since that would mean that the entire put premium was composed of time value premium. For an in-the-money put, however, the time value premium would represent something less than the entire value of the option. These are similar qual­ ities to those inherent in covered call writing. If the stock moves up, the covered call writer can make his maximum profit. However, if the stock is unchanged at expira­ tion, he will make his maximum profit only if the stock is above the call's striking price. So, in either strategy, if the position is established with the stock above the striking price, there is a greater probability of achieving the maximum profit. This represents the less aggressive application: writing an out-of-the-money put initially, which is equivalent to the covered write of an in-the-money call. The more aggressive application of naked put writing is to write an in-the­ money put initially. The writer will receive a larger amount of premium dollars for the in-the-money put and, if the underlying stock advances far enough, he will thus make a large profit. By increasing his profit potential in this manner, he assumes more risk. If the underlying stock should fall, the in-the-money put writer will lose money more quickly than one who initially wrote an out-of-the-money put. Again, these facts were demonstrated much earlier with covered call writing. An in-the­ money covered call write affords more downside protection but less profit potential than does an out-of-the-money covered call write. It is fairly easy to summarize all of this by noting that in either the naked put writing strategy or the covered call writing strategy, a less aggressive position is estab­ lished when the stock is higher than the striking price of the written option. If the stock is below the striking price initially, a more aggressive position is created. There are, of course, some basic differences between covered call writing and naked put writing. First, the naked put write will generally require a smaller invest­ ment, since one is only collateralizing 20% of the stock price plus the put premium, as opposed to 50% for the covered call write on margin. Also, the naked put writer is not actually investing cash; collateral is used, so he may finance his naked put writing through the value of his present portfolio, whether it be stocks, bonds, or government securities. However, any losses would create a debit and might therefore cause him to disturb a portion of this portfolio. It should be pointed out that one can, ifhe wish­ es, write naked puts in a cash account by depositing cash or cash equivalents equal to the striking price of the put. This is called "cash-based put writing." The covered call O.,,ter 19: The Sale of a Put 295 writer receives the dividends on the underlying stock, but the naked put writer does not. In certain cases, this may be a substantial amount, but it should also be pointed out that the puts on a high-yielding stock will have more value and the naked put writer will thus be taking in a higher premium initially. From strictly a rate of return viewpoint, naked put writing is superior to covered call writing. Basically, there is a different psychology involved in writing naked puts than that required for covered call writing. The covered call write is a comfortable strategy for most investors, since it involves common stock ownership. Writing naked options, however, is a more foreign concept to the average investor, even if the strategies are equivalent. Therefore, it is relatively unlikely that the same investor would be a participant in both strategies. FOLLOW-UP ACTION The naked put writer would take protective follow-up action if the underlying stock drops in price. His simplest form of follow-up action is to close the position at a small loss if the stock drops. Since in-the-money puts tend to lose time value premium rap­ idly, he may find that his loss is often quite small if the stock goes against him. In the example above, XYZ was at 50 with the put at 4. If the stock falls to 45, the writer may be able to quite easily repurchase the put for 5½ or 6 points, thereby incurring a fairly small loss. In the covered call writing strategy, it was recommended that the strategist roll down wherever possible. One reason for doing so, rather than closing the covered call position, is that stock commissions are quite large and one cannot generally afford to be moving in and out of stocks all the time. It is more advantageous to try to preserve the stock position and roll the calls down. This commission disadvantage does not exist with naked put writing. When one closes the naked put position, he merely buys in the put. Therefore, rolling down is not as advantageous for the naked put writer. For example, in the paragraph above, the put writer buys in the put for 5½ or 6 points. He could roll down by selling a put with striking price 45 at that time. However, there may be better put writing situations in other stocks, and there should be no reason for him to continue to preserve a position in XYZ stock In fact, this same reasoning can be applied to any sort of rolling action for the naked put writer. It is extremely advantageous for the covered call writer to roll for­ ward; that is, to buy back the call when it has little or no time value premium remain­ ing in it and sell a longer-term call at the same striking price. By doing so, he takes in additional premium without having to disturb his stock position at all. However, the naked put writer has little advantage in rolling forward. He can also take in addition­ al premium, but when he closes the initial uncovered put, he should then evaluate 296 Part Ill: Put Option Strategies other available put writing positions before deciding to write another put on the sam<' underlying stock. His commission costs are the same if he remains in XYZ stock or if he goes on to a put writing position in a different stock. EVALUATING A NAKED PUT WRITE The computation of potential returns from a naked put write is not as straightforward as were the computations for covered call writing. The reason for this is that the col­ lateral requirement changes as the stock moves up or down, since any naked option position is marked to the market. The most conservative approach is to allow enough collateral in the position in case the underlying stock should fall, thus increasing the requirement. In this way, the naked put writer would not be forced to prematurely close a position because he cannot maintain the margin required. Example: XYZ is at 50 and the October 50 put is selling for 4 points. The initial col­ lateral requirement is 20% of 50 plus $400, or $1,400. There is no additional require­ ment, since the stock is exactly at the striking price of the put. Furthermore, let us assume that the writer is going to close the position should the underlying stock fall to 43. To maintain his put write, he should therefore allow enough margin to collat­ eralize the position if the stock were at 43. The requirement at that stock price would be $1,560 (20% of 43 plus at least 7 points for the in-the-money amount). Thus, the put writer who is establishing this position should allow $1,560 of collateral value for each put written. Of course, this collateral requirement can be reduced by the amount of the proceeds received from the put sale, $400 per put less commissions in this example. If we assume that the writer sells 5 puts, his gross premium inflow would be $2,000 and his commission expense would be about $75, for a net premi­ um of $1,925. Once this information has been determined, it is a simple matter to determine the maximum potential return and also the downside break-even point. To achieve the maximum potential return, the put would expire worthless with the underlying stock above the striking price. Therefore, the maximum potential profit is equal to the net premium received. The return is merely that profit divided by the collateral used. In the example above, the maximum potential profit is $1,925. The collateral required is $1,560 per put (allowing for the stock to drop to 43) or $7,800 for 5 puts, reduced by the $1,925 premium received, for a total requirement of $5,875. The potential return is then $1,925 divided by $5,875, or 32.8%. Table 19-2 summarizes these calculations. t,r 19: The Sale of a Put ILE 19-2. 297 lculation of the potential return of uncovered put writing. 50 4 less commissions Potential maximum profit (premium received) Striking price Less premium per put ($1,925/5) Break-even stock price Collateral required (allowing for stock to drop to 43): 20% of 43 Plus put premium Requirement for 5 puts Less premium received Net collateral Potential return: Premium divided by net collateral $2,000 75 $1,925 $50.00 3.85 46.15 $ 860 + 700 $1,560 X 5 $7,800 - 1,925 $5,875 $1,925/$5,875 = 32.8% There are differences of opinion on how to compute the potential returns from naked put writing. The method presented above is a more conservative one in that it takes into consideration a larger collateral requirement than the initial requirement. Of course, since one is not really investing cash, but is merely using the collateral value of his present portfolio, it may even be correct to claim that one has no invest­ ment at all in such a position. This may be true, but it would be impossible to com­ pare various put writing opportunities without having a return computation available. One other important feature of return computations is the return if unchanged. If the put is initially out-of-the-money, the return if unchanged is the same as the maximum potential return. However, if the put is initially in-the-money, the compu­ tation must take into consideration what the writer would have to pay to buy back the put when it expires. 298 Part Ill: Put Option Strategies Example: XYZ is 48 and the XYZ January 50 put is selling for 5 points. The profit that could be made if the stock were unchanged at expiration would be only 3 points, less commissions, since the put would have to be repurchased for 2 points with XYZ at 48 at expiration. Commissions for the buy-back should be included as well, to make the computation as accurate as possible. As was the case with covered call writing, one can create several rankings of naked put writes. One list might be the highest potential returns. Another list could be the put writes that provide the rrwst downside protection; that is, the ones that have the least chance of losing money. Both lists need some screening applied to them, however. When considering the maximum potential returns, one should take care to ensure at least some room for downside movement. Example: If XYZ were at 50, the XYZ January 100 put would be selling at 50 also and would most assuredly have a tremendously large maximum potential return. However, there is no room for downside movement at all, and one would surely not write such a put. One simple way of allowing for such cases would be to reject any put that did not offer at least 5% downside protection. Alternatively, one could also reject situations in which the return if unchanged is below 5%. The other list, involving maximum downside protection, also must have some screens applied to it. Example: With XYZ at 70, the XYZ January 50 put would be selling for½ at most. Thus, it is extremely unlikely that one would lose money in this situation; the stock would have to fall 20 points for a loss to occur. However, there is practically nothing to be made from this position, and one would most likely not ever write such a deeply out-of-the-money put. A minimum acceptable level of return must accompany the items on this list of put writes. For example, one might decide that the return would have to be at least 12% on an annualized basis in order for the put write to be on the list of positions offering the most downside protection. Such a requirement would preclude an extreme situation like that shown above. Once these screens have been applied, the lists can then be ranked in a normal manner. The put writes offering the highest returns would be at the top of the more aggressive list, and those offering the high­ est percentage of downside protection would be at the top of the more conservative list. In the strictest sense, a more advanced technique to incorporate the volatility of the underlying stock should rightfully be employed. As mentioned previously, that technique is presented in Chapter 28 on mathematical applications. 19: The Sale of a Put 299 YING STOCK BELOW ITS MARKET PRICE addition to viewing naked put writing as a strategy unto itself, as was the case in previous discussion, some investors who actually want to acquire stock will often te naked puts as well. bmple: XYZ is a $60 stock and an investor feels it would be a good buy at 55. He places an open buy order with a limit of 55. Three months later, XYZ has drifted down to 57 but no lower. It then turns and rises heavily, but the buy limit was never reached, and the investor misses out on the advance. This hypothetical investor could have used a naked put to his advantage. Suppose that when XYZ was originally at 60, this investor wrote a naked three-month put for 5 points instead of placing an open buy limit order. Then, if XYZ is anywhere below 60 at expiration, he will have stock put to him at 60. That is, he will have to buy stock at 60. However, since he received 5 points for the put sale, his net cost for the stock is 55. Thus, even ifXYZ is at 57 at expiration and has never been any lower, the investor can still buy XYZ for a net cost of 55. Of course, if XYZ rose right away and was above 60 at expiration, the put would not be assigned and the investor would not own XYZ. However, he would still have made $500 from selling the put, which is now worthless. The put writer thus assumes a more active role in his investments by acting rather than waiting. He receives at least some compensation for his efforts, even though he did not get to buy the stock. If, instead of rising, XYZ fell considerably, say to 40 by expiration, the investor would be forced to purchase stock at a net cost of 55, thereby giving himself an immediate paper loss. He was, however, going to buy stock at 55 in any case, so the put writer and the investor using a buy limit have the same result in this case. Critics may point out that any buy order for common stock may be canceled if one's opinion changes about purchasing the stock. The put writer, of course, may do the same thing by closing out his obligation through a closing purchase of the put. This technique is useful to many types of investors who are oriented toward eventually owning the stock. Large portfolio managers as well as individual investors may find the sale of puts useful for this purpose. It is a method of attempting to accu­ mulate a stock position at prices lower than today's market price. If the stock rises and the stock is not bought, the investor will at least have received the put premium as compensation for his efforts. SOME CAUTION IS REQUIRED Despite the seemingly benign nature of naked put writing, it can be a highly dan­ gerous strategy for two reasons: (1) Large losses are possible if the underlying stock 300 Part Ill: Put Option Strategies takes a nasty fall, and (2) collateral requirements are small, so it is possible to utilize a great deal of leverage. It may seem like a good idea to write out-of-the-money puts on "quality" stocks that you "wouldn't mind owning." However, any stock is subject to a crushing decline. In almost any year there are serious declines in one or more of the largest stocks in America (IBM in 1991, Procter and Gamble in 1999, and Xerox in 1999, just to name a few). If one happens to be short puts on such stocks - and worse yet, ifhe happens to have overextended himself because he had the initial mar­ gin required to sell a great deal of puts - then he could actually be wiped out on such a decline. Therefore, do not leverage your account heavily in the naked put strategy, regardless of the "quality" of the underlying stock. THE COVERED PUT SALE By definition, a put sale is covered only if the investor also owns a corresponding put with striking price equal to or greater than the strike of the written put. This is a spread. However,formargin purposes, one is covered ifhe sells a put and is also short the underlying stock. The margin required is strictly that for the short sale of the stock; there is none required for the short put. This creates a position with limited profit potential that is obtained if the underlying stock is anywhere below the strik­ ing price of the put at expiration. There is unlimited upside risk, since if the under­ lying stock rises, the short sale of stock will accrue losses, while the profit from the put sale is limited. This is really a position equivalent to a naked call write, except that the covered put writer must pay out the dividend on the underlying stock, if one exists. The naked sale of a call also has an advantage over this strategy in that com­ mission costs are considerably smaller. In addition, the time value premium of a call is generally higher than that of a put, so that the naked call writer is taking in more time premium. The covered put sale is a little-used strategy that appears to be infe­ rior to naked call writing. As a result, the strategy is not described more fully. RATIO PUT WRITING A ratio put write involves the short sale of the underlying stock plus the sale of 2 puts for each 100 shares sold short. This strategy has a profit graph exactly like that of a ratio call write, achieving its maximum profit at the striking price of the written options, and having large potential losses if the underlying stock should move too far in either direction. The ratio call write is a highly superior strategy, however, for the reasons just outlined. The ratio call writer receives dividends while the ratio put Qapter 19: The Sale ol a Put 301 writer would have to pay them out. In addition, the ratio call writer will generally be taking in larger amounts of time value premium, because calls have more time pre­ mium than puts do. Therefore, the ratio put writing strategy is not a viable one. CHAPTER 20 The Sale of a Straddle Selling a straddle involves selling both a put and a call with the same terms. As with any type of option sale, the straddle sale may be either covered or uncovered. Both uses are fairly common. The covered sale of a straddle is very similar to the covered call writing strategy and would generally appeal to the same type of investor. The uncovered straddle write is more similar to ratio call writing, and is attractive to the more aggressive strategist who is interested in selling large amounts of time premi­ um in hopes of collecting larger profits if the underlying stock remains fairly stable. THE COVERED STRADDLE WRITE In this strategy, one owns the underlying stock and simultaneously writes a straddle on that stock. This may be particularly appealing to investors who are already involved in covered call writing. In reality, this position is not totally covered - only the sale of the call is covered by the ownership of the stock. The sale of the put is uncovered. However, the name "covered straddle" is generally used for this type of position in order to distinguish it from the uncovered straddle write. Example: XYZ is at 51 and an XYZ January 50 call is selling for 5 points while an XYZ January 50 put is selling for 4 points. A covered straddle write would be established by buying 100 shares of the underlying stock and simultaneously selling one put and one call. The similarity between this position and a covered call writer's position should be obvious. The covered straddle write is actually a covered write - long 100 shares of XYZ plus short one call - coupled with a naked put write. Since the naked put write has already been shown to be equivalent to a covered call write, this posi­ tion is quite similar to a 200-share covered call write. In fact, all the profit and loss 302 er 20: The Sale of a Straddle 303 aracteristics of a covered call write are the same for the covered straddle write. There is limited upside profit potential and potentially large downside risk. Readers will remember that the sale of a naked put is equivalent to a covered call write. Hence, a covered straddle write can be thought of either as the equivalent of a 200-share covered call write, or as the sale of two uncovered puts. In fact, there •• some merit to the strategy of selling two puts instead of establishing a covered straddle write. Commission costs would be smaller in that case, and so would the ini­ tial investment required (although the introduction of leverage is not always a good tlting). The maximum profit is attained if XYZ is anywhere above the striking price of 50 at expiration. The amount of maximum profit in this example is $800: the premi­ um received from selling the straddle, less the 1-point loss on the stock if it is called 11way at 50. In fact, the maximum profit potential of a covered straddle write is quick­ ly computed using the following formula: Maximum profit = Straddle premium + Striking price - Initial stock price The break-even point in this example is 46. Note that the covered writing por­ tion of this example buying stock at 51 and selling a call for 5 points - has a break­ even point of 46. The naked put portion of the position has a break-even point of 46 as well, since the January 50 put was sold for 4 points. Therefore, the combined posi­ tion - the covered straddle write - must have a break-even point of 46. Again, this observation is easily defined by an equation: B ak . Stock price + Strike price - Straddle premium re -even pnce = 2 Table 20-1 and Figure 20-1 compare the covered straddle write to a 100-share cov­ ered call write of the XYZ January 50 at expiration. The attraction for the covered call writer to become a covered straddle writer is that he may be able to increase his return without substantially altering the parame­ ters of his covered call writing position. Using the prices in Table 20-1, if one had decided to establish a covered write by buying XYZ at 51 and selling the January 50 call at 5 points, he would have a position with its maximum potential return anywhere above 50 and with a break-even point of 46. By adding the naked put to his covered call position, he does not change the price parameters of his position; he still makes his maximum profit anywhere above 50 and he still has a break-even point of 46. Therefore, he does not have to change his outlook on the underlying stock in order to become a covered straddle writer. The investment is increased by the addition of the naked put, as are the poten­ tial dollars of profit if the stock is above 50 and the potential dollars of loss if the stock 304 Part Ill: Put Option Strategies TABLE 20-1. Results at expiration of covered straddle write. Stock (A) 100-Shore (8) Put Price Covered Write Write 35 40 46 50 60 FIGURE 20-1. -$1, 100 600 0 + 400 + 400 Covered straddle write. +$800 § +$400 e ·5. ~ al en $0 en 0 ...J c5 e a. ~, ,,' ,, ,, ,, ,, ,, ,, ,, -$1, 100 600 0 + 400 + 400 100-Share Covered Call Write ~-----------------► , 46 50 Stock Price at Expiration Covered Straddle Write (A+ 8) -$2,200 - 1,200 0 + 800 + 800 is below 46 at expiration. The covered straddle writer loses money twice as fast on the downside, since his position is similar to a 200-share covered write. Because the commissions are smaller for the naked put write than for the covered call write, the covered call writer who adds a naked put to his position will generally increase his return somewhat. Follow-up action can be implemented in much the same way it would be for a covered call write. Whenever one would normally roll his call in a covered situation, t,r 20: The Sale ol a Straddle 305 now rolls the entire straddle - rolling down for protection, rolling up for an ease in profit potential, and rolling forward when the time value premium of the die dissipates. Rolling up or down would probably involve debits, unless one led to a longer maturity. Some writers might prefer to make a slight adjustment to the covered straddle ting strategy. Instead of selling the put and call at the same price, they prefer to ell an out-of-the-money put against the covered call write. That is, if one is buying XYZ at 50 and selling the call, he might then also sell a put at 45. This would increase his upside profit potential and would allow for the possibility of both options expir­ ing worthless if XYZ were anywhere between 45 and 50 at expiration. Such action would, of course, increase the potential dollars of risk if XYZ fell below 45 by expira­ tion, but the writer could always roll the call down to obtain additional downside pro­ tection. One final point should be made with regard to this strategy. The covered call writer who is writing on margin and is fully utilizing his borrowing power for call writ­ ing will have to add additional collateral in order to write covered straddles. This is because the put write is uncovered. However, the covered call writer who is operat­ ing on a cash basis can switch to the covered straddle writing strategy without put­ ting up additional funds. He merely needs to move his stock to a margin account and use the collateral value of the stock he already owns in order to sell the puts neces­ sary to implement the covered straddle writes. THE UNCOVERED STRADDLE WRITE In an uncovered straddle write, one sells the straddle without owning the underlying stock. In broad terms, this is a neutral strategy with limited profit potential and large risk potential. However, the probability of making a profit is generally quite large, and methods can be implemented to reduce the risks of the strategy. Since one is selling both a put and a call in this strategy, he is initially taking in large amounts of time value premium. If the underlying stock is relatively unchanged at expiration, the straddle writer will be able to buy the straddle back for its intrinsic value, which would normally leave him with a profit. Example: The following prices exist: XYZ common, 45; XYZ January 45 call, 4; and XYZ January 45 put, 3. 306 Part Ill: Put Option Strategies A straddle could be sold for 7 points. If the stock were above 38 and below 52 at expi­ ration, the straddle writer would profit, since the in-the-money option could ht· bought back for less than 7 points in that case, while the out-of-the-money option expires worthless (Table 20-2). TABLE 20-2. The naked straddle write. XYZ Price at Call Put Total Expiration Profit Profit Profit 30 +$ 400 -$1,200 -$800 35 + 400 700 - 300 38 + 400 400 0 40 + 400 200 + 200 45 + 400 + 300 + 700 50 100 + 300 + 200 52 300 + 300 0 55 600 + 300 - 300 60 - 1,100 + 300 - 800 Notice that Figure 20-2 has a shape like a roof. The maximum potential profit point is at the striking price at expiration, and large potential losses exist in either direction if the underlying stock should move too far. The reader may recall that the ratio call writing strategy - buying 100 shares of the underlying stock and selling two calls - has the same profit graph. These two strategies, the naked straddle write and the ratio call write, are equivalent. The two strategies do have some differences, of course, as do all equivalent strategies; but they are similar in that both are highly probabilistic strategies that can be somewhat complex. In addition, both have large potential risks under adverse market conditions or if follow-up strategies are not applied. The investment required for a naked straddle is the greater of the requirement on the call or the put. In general, this means that the margin requirement is equal to the requirement for the in-the-money option in a simple naked write. This require­ ment is 20% of the stock price plus the in-the-money option premium. The straddle writer should allow enough collateral so that he can take whatever follow-up actions he deems necessary without having to incur a margin call. If he is intending to close out the straddle if the stock should reach the upside break-even point - 52 in the example above - then he should allow enough collateral to finance the position with ler 20: The Sale of a Straddle GURE 20-2. ked straddle sale. 307 Stock Price at Expiration the stock at 52. If, however, he is planning to take other action that might involve staying with the position if the stock goes to 55 or 56, he should allow enough collat­ eral to be able to finance that action. If the stock never gets that high, he will have excess collateral while the position is in place. SELECTING A STRADDLE WRITE Ideally, one would like to receive a premium for the straddle write that produces a profit range that is wide in relation to the volatility of the underlying stock. In the example above, the profit range is 38 to 52. This may or may not be extraordinarily wide, depending on the volatility of XYZ. This is a somewhat subjective measure­ ment, although one could construct a simple straddle writer's index that ranked strad­ dles based on the following simple formula: I d Straddle time value premium n ex= _______ ..._ ___ _ Stock price x Volatility Refinements would have to be made to such a ranking, such as eliminating cases in which either the put or the call sells for less than ¼ point ( or even 1 point, if a more restrictive requirement is desired) or cases in which the in-the-money time premium is small. Furthermore, the index would have to be annualized to be able to compare straddles for different expiration months. More advanced selection criteria, in the 308 Part Ill: Put Option Strategies form of an expected return analysis, will be presented in Chapter 28 on mathemati­ cal applications. More screens can be added to produce a more conservative list of straddl<' writes. For example, one might want to ignore any straddles that are not worth at least a fixed percentage, say 10%, of the underlying stock price. Also, straddles that are too short-term, such as ones with less than 30 days of life remaining, might b<' thrown out as well. The remaining list of straddle writing candidates should be ones that will provide reasonable returns under favorable conditions, and also should be readily adaptable to some of the follow-up strategies discussed later. Finally, one would generally like to have some amount of technical support at or above the lower break-even price and some technical resistance at or below the upper break-even point. Thus, once the computer has generated a list of straddles ranked by an index such as the one listed above, the straddle writer can further pare down the list by looking at the technical pictures of the underlying stocks. FOLLOW-UP ACTION The risks involved in straddle writing can be quite large. When market conditions are favorable, one can make considerable profits, even with restrictive selection require­ ments, and even by allowing considerable extra collateral for adverse stock move­ ments. However, in an extremely volatile market, especially a bullish one, losses can occur rapidly and follow-up action must be taken. Since the time premium of a put tends to shrink when it goes into-the-money, there is actually slightly less risk to the downside than there is to the upside. In an extremely bullish market, the time value premiums of call options will not shrink much at all and might even expand. This may force the straddle writer to pay excessive amounts of time value premium to buy back the written straddle, especially if the movement occurs well in advance of expiration. The simplest form of follow-up action is to buy the straddle back when and if the underlying stock reaches a break-even point. The idea behind doing so is to limit the losses to a small amount, because the straddle should be selling for only slightly more than its original value when the stock has reached a break-even point. In practice, there are several flaws in this theory. If the underlying stock arrives at a break-even point well in advance of expiration, the amount of time value premium remaining in the straddle may be extremely large and the writer will be losing a fairly large amount by repurchasing the straddle. Thus, a break-even point at expiration is probably a loss point prior to expiration. Example: After the straddle is established with the stock at 45, there is a sudden rally in the stock and it climbs quickly to 52. The call might be selling for 9 points, even 20: The Sale of a Straddle 309 gh it is 7 points in-the-money. This is not unusual in a bullish situation. ver, the put might be worth 1 ½points.This is also not unusual, as out-of-the­ y puts with a large amount of time remaining tend to hold time value premium well. Thus, the straddle writer would have to pay 10½ points to buy back this dle, even though it is at the break-even point, 7 points in-the-money on the call This example is included merely to demonstrate that it is a misconception to ieve that one can always buy the straddle back at the break-even point and hold losses to mere fractions of a point by doing so. This type of buy-back strategy ks best when there is little time remaining in the straddle. In that case, the options will indeed be close to parity and the straddle will be able to be bought back for close to its initial value when the stock reaches the break-even point. Another follow-up strategy that can be employed, similar to the previous one but with certain improvements, is to buy back only the in-the-money option when it reaches a price equal to that of the initial straddle price. ~mple: Again using the same situation, suppose that when XYZ began to climb heavily, the call was worth 7 points when the stock reached 50. The in-the-money option the call - is now worth an amount equal to the initial straddle value. It could then be bought back, leaving the out-of-the-money put naked. As long as the stock then remained above 45, the put would expire worthless. In practice, the put could be bought back for a small fraction after enough time had passed or if the underly­ Ing stock continued to climb in price. This type of follow-up action does not depend on taking action at a fixed stock price, but rather is triggered by the option price itself. It is therefore a dynamic sort of follow-up action, one in which the same action could be applied at various stock prices, depending on the amount of time remaining until expiration. One of the prob­ lems with closing the straddle at the break-even points is that the break-even point is C)nly a valid break-even point at expiration. A long time before expiration, this stock price will not represent much of a break-even point, as was pointed out in the last example. Thus, buying back only the in-the-money option at a fixed price may often be a superior strategy. The drawback is that one does not release much collateral by buying back the in-the-money option, and he is therefore stuck in a position with little potential profit for what could amount to a considerable length of time. The collateral released amounts to the in-the-money amount; the writer still needs to C.'Ollateralize 20% of the stock price. One could adjust this follow-up method to attempt to retain some profit. For example, he might decide to buy the in-the-money option when it has reached a 310 Part Ill: Put Option Strategies value that is 1 point less than the total straddle value initially taken in. This would then allow him the chance to make a I-point profit overall, if the other option expired worthless. In any case, there is always the risk that the stock would suddenly revers(' direction and cause a loss on the remaining option as well. This method of follow-up action is akin to the ratio writing follow-up strategy of using buy and sell stops on th<' underlying stock. Before describing other types of follow-up action that are designed to combat the problems described above, it might be worthwhile to address the method used in ratio writing - rolling up or rolling down. In straddle writing, there is often little to be gained from rolling up or rolling down. This is a much more viable strategy in ratio writing; one does not want to be constantly moving in and out of stock positions, because of the commissions involved. Howeve1~ with straddle writing, once one posi­ tion is closed, there is no need to pursue a similar straddle in that same stock. It may be more desirable to look elsewhere for a new straddle position. There are two other very simple forms of follow-up action that one might con­ sider using, although neither one is for most strategists. First, one might consider doing nothing at all, even if the underlying stock moves by a great deal, figuring that the advantage lies in the probability that the stock will be back near the striking price by the time the options expire. This action should be used only by the most diversi­ fied and well-heeled investors, for in extreme market periods, almost all stocks may move in unison, generating tremendous losses for anyone who does not take some sort of action. A more aggressive type off allow-up action would be to attempt to "leg out" of the straddle, by buying in the profitable side and then hoping for a stock price reversal in order to buy back the remaining side. In the example above, when XYZ ran up to 52, an aggressive trader would buy in the put at 1 ½, taking his profit, and then hope for the stock to fall back in order to buy the call in cheaper. This is a very aggressive type of follow-up action, because the stock could easily continue to rise in price, thereby generating larger losses. This is a trader's sort of action, not that of a disciplined strategist, and it should be avoided. In essence, follow-up action should be designed to do two things: First, to limit the risk in the position, and second, to still allow room for a potential profit to be made. None of the above types of follow-up action accomplish both of these purpos­ es. There is, however, a follow-up strategy that does allow the straddle writer to limit his losses while still allowing for a potential profit. Example: After the straddle was originally sold for 7 points when the stock was at 45, the stock experiences a rally and the following prices exist: XYZ common, 50; XYZ January 45 call, 7; Cl,opter 20: The Sale of a Straddle XYZ January 45 put, l; and XYZ January 50 call, 3. 311 The January 50 call price is included because it will be part of the follow-up strategy. Notice that this straddle has a considerable amount of time value premium remain­ Ing in it, and thus would be rather expensive to buy back at the current time. Suppose, however, that the straddle writer does not touch the January 45 straddle tliat he is short, but instead buys the January 50 call for protection to the upside. Since this call costs 3 points, he will now have a position with a total credit of 4 points. (The straddle was originally sold for 7 points credit and he is now spending 3 points for the call at 50.) This action of buying a call at a higher strike than the striking price of the straddle has limited the potential loss to the upside, no matter how far the stock might run up. If XYZ is anywhere above 50 at expiration, the put will expire worthless and the writer will have to pay 5 points to close the call spread short January 45, long January 50. This means that his maximum potential loss is 1 point plus commissions if XYZ is anywhere above 50 at expiration. In addition to being able to limit the upside loss, this type of follow-up action still allows room for potential profits. If XYZ is anywhere between 41 and 49 at expi­ ration - that is, less than 4 points away from the striking price of 45 - the writer will he able to buy the straddle back for less than 4 points, thereby making a profit. Thus, the straddle writer has both limited his potential losses to the upside and also allowed room for profit potential should the underlying stock fall back in price toward the original striking price of 45. Only severe price reversal, with the stock falling back below 40, would cause a large loss to be taken. In fact, by the time the stock could reverse its current strong upward momentum and fall all the way back to 40, a significant amount of time should have passed, thereby allowing the writer to purchase the straddle back with only a relatively small amount of time premium left in it. This follow-up strategy has an effect on the margin requirement of the position. When the calls are bought as protection to the upside, the writer has, for margin purposes, a bearish spread in the calls and an uncovered put. The margin for this position would normally be less than that required for the straddle that is 5 points in-the-money. A secondary move is available in this strategy. Example: The stock continues to climb over the short term and the out-of-the­ money put drops to a price of less than ½ point. The straddle writer might now consider buying back the put, thereby leaving himself with a bear spread in the calls. His net credit left in the position, after buying back the put at ½, would be 312 Part Ill: Put Optian Strategies 3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the striking price - that is, anywhere below 48½ - at expiration, the position will pro­ duce a profit. In fact, if XYZ should be below 45 at expiration, the entire bear spread will expire worthless and the strategist will have made a 3½-point profit. Finally, this repurchase of the put releases the margin requirement for the naked put, and will generally free up excess funds so that a new straddle position can be established in another stock while the low-requirement bear spread remains in place. In summary, this type of follow-up action is broader in purpose than any of the simpler buy-back strategies described earlier. It will limit the writer's loss, but not prevent him from making a profit. Moreover, he may be able to release enough mar­ gin to be able to establish a new position in another stock by buying in the uncov­ ered puts at a fractional price. This would prevent him from tying up his money completely while waiting for the original straddle to reach its expiration date. The same type of strategy also works in a downward market. If the stock falls after the straddle is written, one can buy the put at the next lower strike to limit the down­ side risk, while still allowing for profit potential if the stock rises back to the striking price. EQUIVALENT STOCK POSITION FOLLOW-UP Since there are so many follow-up strategies that can be used with the short straddle, the one method that summarizes the situation best is again the equivalent stock posi­ tion (ESP). Recall that the ESP of an option position is the multiple of the quantity times the delta times the shares per option. The quantity is a negative number if it is referring to a short position. Using the above scenario, an example of the ESP method follows: Example: As before, assume that the straddle was originally sold for 7 points, but the stock rallied. The following prices and deltas exist: XYZ common, 50; XYZ Jan 45 call, 7; delta, .90; XYZ Jan 45 put, l; delta, - .10; and XYZ Jan 50 call, 3; delta, .60. Assume that 8 straddles were sold initially and that each option is for 100 shares of XYZ. The ESP of these 8 short straddles can then be computed: Chapter 20: The Sale of a Straddle Option Jan 45 call Jan 45 put Total ESP Position short 8 short 8 Delta 0.90 -0.10 313 ESP short 720 (-8 x . 9 x 1 00) long 80 (-8 x -. 1 x 100) short 640 shares Obviously, the position is quite short. Unless the trader were extremely bearish on XYZ, he should make an adjustment. The simplest adjustment would be to buy 600 shares of XYZ. Another possibility would be to buy back 7 of the short January 45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9 x 100). This would leave the position essentially neutral. As pointed out in the previ­ ous example, however, the strategist may not want to buy that option. If, instead, he decided to try to buy the January 50 call to hedge the short straddle, he would have to buy 10 of those to make the position neutral. He would buy that many because the delta of that January 50 is 0.60; a purchase of 10 would add a delta long of 600 shares to the position. Even though the purchase of 10 is theoretically correct, since one is only short 8 straddles, he would probably buy only 8 January 50 calls as a practical matter. STARTING OUT WITH THE PROTECTION IN PLACE In certain cases, the straddle writer may be able to initially establish a position that has no risk in one direction: He can buy an out-of-the-money put or call at the same time the straddle is written. This accomplishes the same purposes as the follow-up action described in the last few paragraphs, but the protective option will cost less since it is out-of-the-money when it is purchased. There are, of course, both positive and negative aspects involved in adding an out-of-the-money long option to the strad­ dle write at the outset. Example: Given the following prices: XYZ, 45; XYZ January 45 straddle, 7; and XYZ January 50 call, 1 ½, the upside risk will be limited. If one writes the January 45 straddle for 7 points and buys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no upside risk in this position, for if XYZ should rise and be over 50 at expiration, he will be able to close the position by buying back the call spread for 5 points. The put will expire worthless. The out-of-the-money call has eliminated any risk above 50 on the 312 Part Ill: Put Option Strategies 3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the striking price - that is, anywhere below 48½ - at expiration, the position will pro­ duce a profit. In fact, if XYZ should be below 45 at expiration, the entire bear spread will expire worthless and the strategist will have made a 3½-point profit. Finally, this repurchase of the put releases the margin requirement for the naked put, and will generally free up excess funds so that a new straddle position can be established in another stock while the low-requirement bear spread remains in place. In summary, this type of follow-up action is broader in purpose than any of the simpler buy-back strategies described earlier. It will limit the writer's loss, but not prevent him from making a profit. Moreover, he may be able to release enough mar­ gin to be able to establish a new position in another stock by buying in the uncov­ ered puts at a fractional price. This would prevent him from tying up his money completely while waiting for the original straddle to reach its expiration date. The same type of strategy also works in a downward market. If the stock falls after the straddle is written, one can buy the put at the next lower strike to limit the down­ side risk, while still allowing for profit potential if the stock rises back to the striking price. EQUIVALENT STOCK POSITION FOLLOW-UP Since there are so many follow-up strategies that can be used with the short straddle, the one method that summarizes the situation best is again the equivalent stock posi­ tion (ESP). Recall that the ESP of an option position is the multiple of the quantity times the delta times the shares per option. The quantity is a negative number if it is referring to a short position. Using the above scenario, an example of the ESP method follows: Example: As before, assume that the straddle was originally sold for 7 points, but the stock rallied. The following prices and deltas exist: XYZ common, 50; XYZ Jan 45 call, 7; delta, .90; XYZ Jan 45 put, l; delta, - .10; and XYZ Jan 50 call, 3; delta, .60. Assume that 8 straddles were sold initially and that each option is for 100 shares of XYZ. The ESP of these 8 short straddles can then be computed: Chapter 20: The Sale of a Straddle Option Jan 45 call Jan 45 put Total ESP Position short 8 short 8 Delta 0.90 -0.10 313 ESP short 720 (-8 x .9 x 100) long 80 (-8 x -. 1 x 1 00) short 640 shares Obviously, the position is quite short. Unless the trader were extremely bearish on XYZ, he should make an adjustment. The simplest adjustment would be to buy 600 shares of XYZ. Another possibility would be to buy back 7 of the short January 45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9 x 100). This would leave the position essentially neutral. As pointed out in the previ­ ous example, however, the strategist may not want to buy that option. If, instead, he decided to try to buy the January 50 call to hedge the short straddle, he would have to buy 10 of those to make the position neutral. He would buy that many because the delta of that January 50 is 0.60; a purchase of 10 would add a delta long of 600 shares to the position. Even though the purchase of 10 is theoretically correct, since one is only short 8 straddles, he would probably buy only 8 January 50 calls as a practical matter. STARTING OUT WITH THE PROTECTION IN PLACE In certain cases, the straddle writer may be able to initially establish a position that has no risk in one direction: He can buy an out-of-the-money put or call at the same time the straddle is written. This accomplishes the same purposes as the follow-up action described in the last few paragraphs, but the protective option will cost less since it is out-of-the-money when it is purchased. There are, of course, both positive and negative aspects involved in adding an out-of-the-money long option to the strad­ dle write at the outset. Example: Given the following prices: XYZ, 45; XYZ January 45 straddle, 7; and XYZ January 50 call, 1 ½, the upside risk will be limited. If one writes the January 45 straddle for 7 points and buys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no upside risk in this position, for if XYZ should rise and be over 50 at expiration, he will be able to close the position by buying back the call spread for 5 points. The put will expire worthless. The out-of-the-money call has eliminated any risk above 50 on the 314 Part Ill: Put Option Strategies position. Another advantage of buying the protection initially is that one is protected if the stock should experience a gap opening or a trading halt. Ifhe already owns the protection, such stock price movement in the direction of the protection is of little consequence. However, if he was planning to buy the protection as a follow-up action, the sudden surge in the stock price may ruin his strategy. The overall profit potential of this position is smaller than that of the normal straddle write, since the premium paid for the long call will be lost if the stock is below 50 at expiration. However, the automatic risk-limiting feature of the long call may prove to be worth more than the decrease in profit potential. The strategist has peace of mind in a rally and does not have to worry about unlimited losses accruing to the upside. Downside protection for a straddle writer can be achieved in a similar manner by buying an out-of-the-money put at the outset. Example: With XYZ at 45, one might write the January 45 straddle for 7 and buy a January 40 put for I point if he is concerned about the stock dropping in price. It should now be fairly easy to see that the straddle writer could limit risk in either direction by initially buying both an out-of-the-money call and an out-of-the­ money put at the same time that the straddle is written. The major benefit in doing this is that risk is limited in either direction. Moreover, the margin requirements are significantly reduced, since the whole position consists of a call spread and a put spread. There are no longer any naked options. The detriment of buying protection on both sides initially is that commission costs increase and the overall profit poten­ tial of the straddle write is reduced, perhaps significantly, by the cost of two long options. Therefore, one must evaluate whether the cost of the protection is too large in comparison to what is received for the straddle write. This completely protected strategy can be very attractive when available, and it is described again in Chapter 23, Spreads Combining Calls and Puts. In summary, any strategy in which the straddle writer also decides to buy pro­ tection presents both advantages and disadvantages. Obviously, the risk-limiting fea­ ture of the purchased options is an advantage. However, the seller of options does not like to purchase pure time value premium as protection at any time. He would gen­ erally prefer to buy intrinsic value. The reader will note that, in each of the protec­ tive buying strategies discussed above, the purchased option has a large amount of time value premium left in it. Therefore, the writer must often try to strike a delicate balance between trying to limit his risk on one hand and trying to hold down the expenses of buying long options on the other hand. In the final analysis, however, the risk must be limited regardless of the cost. 314 Part Ill: Put Option Strategies position. Another advantage of buying the protection initially is that one is protected if the stock should experience a gap opening or a trading halt. If he already owns the protection, such stock price movement in the direction of the protection is of little consequence. However, if he was planning to buy the protection as a follow-up action, the sudden surge in the stock price may ruin his strategy. The overall profit potential of this position is smaller than that of the normal straddle write, since the premium paid for the long call will be lost if the stock is below 50 at expiration. However, the automatic risk-limiting feature of the long call may prove to be worth more than the decrease in profit potential. The strategist has peace of mind in a rally and does not have to worry about unlimited losses accruing to the upside. Downside protection for a straddle writer can be achieved in a similar manner by buying an out-of-the-money put at the outset. Example: With XYZ at 45, one might write the January 45 straddle for 7 and buy a January 40 put for l point if he is concerned about the stock dropping in price. It should now be fairly easy to see that the straddle writer could limit risk in either direction by initially buying both an out-of-the-money call and an out-of-the­ money put at the same time that the straddle is written. The major benefit in doing this is that risk is limited in either direction. Moreover, the margin requirements are significantly reduced, since the whole position consists of a call spread and a put spread. There are no longer any naked options. The detriment of buying protection on both sides initially is that commission costs increase and the overall profit poten­ tial of the straddle write is reduced, perhaps significantly, by the cost of two long options. Therefore, one must evaluate whether the cost of the protection is too large in comparison to what is received for the straddle write. This completely protected strategy can be very attractive when available, and it is described again in Chapter 23, Spreads Combining Calls and Puts. In summary, any strategy in which the straddle writer also decides to buy pro­ tection presents both advantages and disadvantages. Obviously, the risk-limiting fea­ ture of the purchased options is an advantage. However, the seller of options does not like to purchase pure time value premium as protection at any time. He would gen­ erally prefer to buy intrinsic value. The reader will note that, in each of the protec­ tive buying strategies discussed above, the purchased option has a large amount of time value premium left in it. Therefore, the ·writer must often try to strike a delicate balance between trying to limit his risk on one hand and trying to hold down the expenses of buying long options on the other hand. In the final analysis, however, the risk must be limited regardless of the cost. 314 Part Ill: Put Option Strategies position. Another advantage of buying the protection initially is that one is protected if the stock should expe1ience a gap opening or a trading halt. If he already owns the protection, such stock price movement in the direction of the protection is of little consequence. However, if he was planning to buy the protection as a follow-up action, the sudden surge in the stock price may ruin his strategy. The overall profit potential of this position is smaller than that of the normal straddle write, since the premium paid for the long call will be lost if the stock is below 50 at ex-piration. However, the automatic risk-limiting feature of the long call may prove to be worth more than the decrease in profit potential. The strategist has peace of mind in a rally and does not have to worry about unlimited losses accruing to the upside. Downside protection for a straddle writer can be achieved in a similar manner by buying an out-of-the-money put at the outset. Example: With XYZ at 45, one might write the January 45 straddle for 7 and buy a January 40 put for l point if he is concerned about the stock dropping in price. It should now be fairly easy to see that the straddle writer could limit risk in either direction by initially buying both an out-of-the-money call and an out-of-the­ money put at the same time that the straddle is written. The major benefit in doing this is that risk is limited in either direction. Moreover, the margin requirements are significantly reduced, since the whole position consists of a call spread and a put spread. There are no longer any naked options. The detriment of buying protection on both sides initially is that commission costs increase and the overall profit poten­ tial of the straddle write is reduced, perhaps significantly, by the cost of two long options. Therefore, one must evaluate whether the cost of the protection is too large in comparison to what is received for the straddle write. This completely protected strategy can be very attractive when available, and it is described again in Chapter 23, Spreads Combining Calls and Puts. In summary, any strategy in which the straddle writer also decides to buy pro­ tection presents both advantages and disadvantages. Obviously, the risk-limiting fea­ ture of the purchased options is an advantage. However, the seller of options does not like to purchase pure time value premium as protection at any time. He would gen­ erally prefer to buy intrinsic value. The reader will note that, in each of the protec­ tive buying strategies discussed above, the purchased option has a large amount of time value premium left in it. Therefore, the writer must often try to strike a delicate balance between trying to limit his risk on one hand and trying to hold down the expenses of buying long options on the other hand. In the final analysis, however, the risk must be limited regardless of the cost. Chapter 20: The Sale of a Straddle 315 STRANGLE (COMBINATION) WRITING Recall that a strangle is any position involving both puts and calls, when there is some difference in the terms of the options. Commonly, the puts and calls will have the same expiration date but differing striking prices. A strangle write is usually estab­ lished by selling both an out-of-the-money put and an out-of-the-money call with the stock approximately centered between the two striking prices. In this way, the naked option writer can remain neutral on the outlook for the underlying stock, even when the stock is not near a striking price. This strategy is quite similar to straddle writing, except that the strangle writer makes his maximum profit over a much wider range than the straddle writer does. In this or any other naked writing strategy, the most money that the strategist can make is the amount of the premium received. The straddle writer has only a minute chance of making a profit of the entire straddle premium, since the stock would have to be exactly at the striking price at expiration in order for both the written put and call to expire worthless. The strangle writer will make his maximum profit potential if the stock is anywhere between the two strikes at expi­ ration, because both options will expire worthless in that case. This strategy is equivalent to the variable ratio write described previously in Chapter 6 on ratio call writing. Example: Given the following prices: XYZ common, 65; XYZ January 70 call, 4; and XYZ January 60 put, 3, a strangle write would be established by selling the January 70 call and the January 60 put. IfXYZ is anywhere between 60 and 70 at January expiration, both options will expire worthless and the strangle writer will make a profit of 7 points, the amount of the original credit taken in. If XYZ is above 70 at expiration, the strategist will have to pay something to buy back the call. For example, if XYZ is at 77 at expiration, the January 70 call will have to be bought back for 7 points, thereby creating a break-even situation. To the downside, if XYZ were at 53 at expiration, the January 60 put would have to be bought back for 7 points, thereby defining that as the downside break­ even point. Table 20-3 and Figure 20-3 outline the potential results of this strangle write. The profit range in this example is quite wide, extending from 53 on the down­ side to 77 on the upside. With the stock presently at 65, this is a relatively neutral position. 316 TABLE 20-3. Results of a combination write. Stock Price at Coll Expiration Profit 40 +$ 400 50 + 400 53 + 400 57 + 400 60 + 400 65 + 400 70 + 400 73 + 100 77 300 80 600 90 - 1,600 FIGURE 20-3. Sale of a combination. C: ~ +$700 ·5. X UJ rn en en 0 ....I ci e a.. $0 Put Profit $1,700 700 400 0 + 300 + 300 + 300 + 300 + 300 + 300 + 300 Stock Price at Expiration Part Ill: Put Option Strategies Total Profit -$1,300 300 0 + 400 + 700 + 700 + 700 + 400 0 300 - 1,300 At first glance, this may seem to be a more conservative strategy than straddle writing, because the profit range is wider and the stock needs to move a great deal to reach the break-even points. In the absence of follow-up action, this is a true obser­ vation. However, if the stock begins to rise quickly or to drop dramatically, the stran­ gle writer often has little recourse but to buy back the in-the-money option in order Chapter 20: The Sale of a Straddle 317 to limit his losses. This can, as has been shown previously, entail a purchase price involving excess amounts of time value premium, thereby generating a significant loss. The only other alternative that is available to the strangle writer ( outside of attempting to trade out of the position) is to convert the position into a straddle if the stock reaches either break-even point. Example: IfXYZ rose to 70 or 71 in the previous example, the January 70 put would be sold. Depending on the amount of collateral available, the January 60 put may or may not be bought back when the January 70 put is sold. This action of converting the strangle write into a straddle write will work out well if the stock stabilizes. It will also lessen the pain if the stock continues to rise. However, if the stock revers­ es direction, the January 70 put write will prove to be unprofitable. Technical analy­ sis of the underlying stock may prove to be of some help in deciding whether or not to convert the strangle write into a straddle. If there appears to be a relatively large chance that the stock could fall back in price, it is probably not worthwhile to roll the put up. This example of a strangle write is one in which the writer received a large amount of premium for selling the put and the call. Many times, however, an aggres­ sive strangle writer is tempted to sell two out-of-the-money options that have only a short life remaining. These options would generally be sold at fractional prices. This can be an extremely aggressive strategy at times, for if the underlying stock should move quickly in either direction through a striking price, there is little the strangle writer can do. He must buy in the options to limit his loss. Nevertheless, this type of strangle writing - selling short-term, fractionally priced, out-of-the-money options - appeals to many writers. This is a similar philosophy to that of the naked call writer described in Chapter 5, who writes calls that are nearly restricted, figuring there will be a large probability that the option will expire worthless. It also has the same risk: A large price change or gap opening can cause such devastating losses that many profitable trades are wiped away. Selling fractionally priced combinations is a poor strategy and should be avoided. Before leaving the topic of strangle writing, it may be useful to determine how the margin requirements apply to a strangle write. Recall that the margin require­ ment for writing a straddle is 20% of the stock price plus the price of either the put or the call, whichever is in-the-money. In a strangle write, however, both options may be out-of-the-money, as in the example above. When this is the case, the straddle writer is allowed to deduct the smaller out-of-the-money amount from his require­ ment. Thus, if XYZ were at 68 and the January 60 put and the January 70 call had been written, the collateral requirement would be 20% of the stock price, plus the 318 Part Ill: Put Option Strategies call premium, less $200 - the lesser out-of-the-money amount. The call is 2 points out-of-the-money and the put is 8 points out-of-the-money. Actually, the true collat­ eral requirement for any write involving both puts and calls - straddle write or stran­ gle write - is the greater of the requirement on the put or the call, plus the amount by which the other option is in-the-nwney. The last phrase, the amount by which the other option is in-the-money, applies to a situation in which a strangle had been con­ structed by selling two in-the-money options. This is a less popular strategy, since the writer generally receives less time value premium by writing two in-the-money options. An example of an in-the-money strangle is to sell the January 60 call and the January 70 put with the stock at 65. FURTHER COMMENTS ON UNCOVERED STRADDLE AND STRANGLE WRITING When ratio writing was discussed, it was noted that it was a strategy with a high prob­ ability of making a limited profit. Since the straddle write is equivalent to the ratio write and the strangle write is equivalent to the variable ratio write, the same state­ ment applies to these strategies. The practitioner of straddle and strangle writing must realize, however, that protective follow-up action is mandatory in limiting loss­ es in a very volatile market. There are other techniques that the straddle writer can sometimes use to help reduce his risk. It has often been mentioned that puts lose their time value premium more quickly when they become in-the-money options than calls do. One can often con­ struct a neutral position by writing an extra put or two. That is, if one sells 5 or 6 puts and 4 calls 'Ai.th the same terms, he may often have created a more neutral position than a straddle write. If the stock moves up and the call picks up time premium in a bullish market, the extra puts 'Aill help to offset the negative effect of the calls. On the other hand, if the stock drops, the 5 or 6 puts will not hold as much time premi­ um as the 4 calls are losing - again a neutral, standoff position. If the stock begins to drop too much, the writer can always balance out the position by selling another call or two. The advantage of writing an extra put or two is that it counterbalances the straddle writer's most severe enemy: a quick, extremely bullish rise by the underly­ ing stock. USING THE DELTAS This analysis, that adding an extra short put creates a neutral position, can be sub­ stantiated more rigorously. Recall that a ratio writer or ratio spreader can use the Chapter 20: The Sale of a Straddle 319 deltas of the options involved in his position to determine a neutral ratio. The strad­ dle writer can do the same thing, of course. It was stated that the difference between a call's delta and a put' s delta is approximately one. Using the same prices as in the previous straddle writing example, and assuming the call's delta to be .60, a neutral ratio can be determined. Prices XYZ common: XYZ January 45 call: XYZ January 45 put: 45 4 3 Deltas .60 -.40 (.60 - 1) The put has a negative delta, to indicate that the put and the underlying stock are inversely related. A neutral ratio is determined by dividing the call's delta by the put's delta and ignoring the minus sign. The resultant ratio - 1.5:1 (.60/.40) in this case - is the ratio of puts to sell for each call that is sold. Thus, one should sell 3 puts and sell 2 calls to establish a neutral position. The reader may wonder if the assumption that an at-the-money call has a delta of .60 is a fair one. It generally is, although very long-term calls will have higher at-the-money deltas, and very short-term calls will have deltas near .50. Consequently, a 3:2 ratio is often a neutral one. When neutral ratios were discussed with respect to ratio writing, it was mentioned that selling 5 calls and buying 300 shares of stock often results in neutral ratio. The reader should note that a straddle constructed by selling 3 puts and 2 calls is equivalent to the ratio write in which one sells 5 calls and buys 300 shares of stock. If a straddle writer is going to use the deltas to determine his neutral ratio, he should compute each one at the time of his initial investment, of course, rather than relying on a generality such as that 3 puts and 2 calls often result in a neutral posi­ tion. The deltas can be used as a follow-up action, by adjusting the ratio to remain neutral after a move by the underlying stock. AVOID EXCESS TRADING In any of the straddle and strangle writing strategies described above, too much fol­ low-up action can be detrimental because of the commission costs involved. Thus, although it is important to take protective action, the straddle writer should plan in advance to make the minimum number of strategic moves to protect himself. That is why buying protection is often useful; not only does it limit the risk in the direction that the stock is moving, but it also involves only one additional option commission. In fact, if it is feasible, buying protection at the outset is often a better strategy than protecting as a secondary action. 320 Part Ill: Put Option Strategies An extension of this concept of trying to avoid too much follow-up action is that the strategist should not attempt to anticipate movement in an underlying stock. For example, if the straddle writer has planned to take defensive action should the stock reach 50, he should not anticipate by taking action with the stock at 48 or 49. It is possible that the stock could retreat back down; then the writer would have taken a defensive action that not only cost him commissions, but reduced his profit potential. Of course, there is a little trader in everyone, and the temptation to anticipate (or to wait too long) is always there. Unless there are very strong technical reasons for doing so, the strategist should resist the temptation to trade, and should operate his strate­ gy according to his original plan. The ratio writer may actually have an advantage in this respect, because he can use buy and sell stops on the underlying stock to remove the emotion from his follow-up strategy. This technique was described in Chapter 6 on ratio call writing. Unfortunately, no such emotionless technique exists for the straddle or strangle writer. USING THE CREDITS In previous chapters, it was mentioned that the sale of uncovered options does not require any cash investment on the pait of the strategist. He may use the collateral value of his present portfolio to finance the sale of naked options. Moreover, once he sells the uncovered options, he can take the premium dollars that he has brought in from the sales to buy fixed-income securities, such as Treasury bills. The same state­ ments naturally apply to the straddle writing and strangle writing strategies. However, the strategist should not be overly obsessed with continuing to maintain a credit bal­ ance in his positions, nor should he strive to hold onto the Treasury bills at all costs. If one's follow-up actions dictate that he must take a debit to avoid losses or that he should sell out his Treasury bills to keep a credit, he should by all means do so. Synthetic Stock Positions Created by Puts and Calls It is possible for a strategist to establish a position that is essentially the same as a stock position, and he can do this using only options. The option position generally requires a smaller margin investment and may have other residual benefits over sim­ ply buying stock or selling stock short. In brief, the strategies are summarized by: 1. Buy call and sell put instead of buying stock. 2. Buy put and sell call instead of selling stock short. SYNTHETIC LONG STOCK When one buys a call and sells a put at the same strike, he sets up a position that is equivalent to owning the stock. His position is sometimes called "synthetic" long stock. Example: To verify that this option position acts much like a long stock position would, suppose that the following prices exist: XYZ common, 50; XYZ January 50 call, 5; and XYZ January 50 put, 4. If one were bullish on XYZ and wanted to buy stock at 50, he might consider the alternative strategy of buying the January 50 call and selling (uncovered) the January 321 322 Part Ill: Put Option Strategies 50 put. By using the option strategy, the investor has nearly the same profit and loss potential as the stock buyer, as shown in Table 21-1. The two right-hand columns of the table compare the results of the option strategy with the results that would be obtained by merely owning the stock at .50. The table shows that the result of the option strategy is exactly $100 less than the stock results for any price at expiration. Thus, the "synthetic" long stock and the actual long stock have nearly the same profit and loss potentials. The reason there is a difference in the results of the two equivalent positions lies in the fact that the option strategist had to pay 1 point of time premium in order to set up his position. This time premium represents the $100 by which the "synthetic" position underper­ forms the actual stock position at expiration. Note that, with XYZ at 50, both the put and the call are completely composed of time value premium initially. The synthetic position consists of paying out 5 points of time premium for the call and receiving in 4 points of time premium for the put. The net time premium is thus a 1-point pay­ out. The reason one would consider using the synthetic long stock position rather than the stock position itself is that the synthetic position may require a much small­ er investment than buying the stock would require. The purchase of the stock requires $5,000 in a cash account or $2,500 in a margin account (if the margin rate is 50%). However, the synthetic position requires only a $100 debit plus a collateral requirement - 20% of the stock price, plus the put premium, minus the difference between the striking price and the stock price. The balance, invested in short-term funds, would earn enough money, theoretically, to offset the $100 paid for the syn­ thetic position. In this example, the collateral requirement would be 20% of $5,000, or $1,000, plus the $400 put premium, plus the $100 debit incurred by paying 5 for the call and only receiving 4 for the put. This is a total of $1,500 initially. There is no TABLE 21·1. Synthetic long stock position. XYZ Price at January 50 January 50 Total Option Long Stock Expiration Call Result Put Result Result Result 40 -$500 -$600 -$1, 100 -$1,000 45 - 500 - 100 600 500 50 - 500 + 400 100 0 55 0 + 400 + 400 + 500 60 + 500 + 400 + 900 + 1,000 Chapter 21: Synthetic Stock Positions Created by Puts and Calls 323 initial difference between the stock price and the striking price. Of course, this col­ lateral requirement would increase if the stock fell in price, and would decrease if the stock rose in price, since there is a naked put. Also notice that buying stock creates a $5,000 debit in the account, whereas the option strategy's debit is $100; the rest is a collateral requirement, not a cash requirement. The effect of this reduction in margin required is that some leverage is obtained in the position. If XYZ rose to 60, the stock position profit would be $1,000 for a return of 40% on margin ($1,000/$2,500). With the option strategy, the percentage return would be higher. The profit would be $900 and the return thus 60% ($900/$1,500). Of course, leverage works to the downside as well, so that the percent risk is also greater in the option strategy. The synthetic stock strategy is generally not applied merely as an alternative to buying stock. Besides possibly having a smaller profit potential, the option strategist does not collect dividends, whereas the stock owner does. However, the strategist is able to earn interest on the funds that he did not spend for stock ownership. It is important for the strategist to understand that a long call plus a short put is equiva­ lent to long stock. It thus may be possible for the strategist to substitute the synthet­ ic option position in certain option strategies that normally call for the purchase of stock SYNTHETIC SHORT SALE A position that is equivalent to the short sale of the underlying stock can be estab­ lished by selling a call and simultaneously buying a put. This alternative option strat­ egy, in general, offers significant benefits when compared with selling the stock short. Using the prices above - XYZ at 50, January 50 call at 5, and January 50 put at 4 - Table 21-2 depicts the potential profits and losses at January expiration. Both the option position and the short stock position have similar results: large potential profits if the stock declines and unlimited losses if the underlying stock rises in price. However, the option strategy does better than the stock position, because the option strategist is getting the benefit of the time value premium. Again, this is because the call has more time value premium than the put, which works to the option strategist's advantage in this case, when he is selling the call and buying the put. Two important factors make the option strategy preferable to the short sale of stock: (1) There is no need to borrow stock, and (2) there is no need for an uptick. When one sells stock short, he must first borrow the stock from someone who owns it. This procedure is handled by one's brokerage firm's stock loan department. If, for 324 Part Ill: Put Option Strategies TABLE 21-2. Synthetic short sale position. XYZ Price at January 50 January 50 Total Option Short Stock Expiration Coll Result Put Result Result Result 40 +$500 +$600 +$1, 100 +$1,000 45 + 500 + 100 + 600 + 500 50 + 500 - 400 + 100 0 55 0 - 400 400 500 60 - 500 - 400 900 - 1,000 some reason, no one who owns the stock wants to loan it out, then a short sale can­ not be executed. In addition, both the NYSE and NASDAQ require that a stock being sold short must be sold on an uptick. That is, the price of the short sale must be higher than the previous sale. This rule was introduced (for the NYSE) years ago in order to prevent traders from slamming the market down in a "bear raid." With the option "synthetic short sale" strategy, however, one does not have to worry about either of these factors. First, calls can be sold short at will; there is no need to borrow anything. Also, calls can be sold short (and puts bought) even though the underlying stock might be trading on a minus tick (a downtick). Many profes­ sional traders use the "synthetic short sale" strategy because it allows them to get equivalently short the stock in a very timely manner. If one wants to short stock, and if he has not previously arranged to borrow it, then some time is wasted while one's broker checks with the stock loan department in order to make sure that the stock can indeed be borrowed. There is a caveat, however. If one sells calls on a stock that cannot be borrowed, then he must be sure to avoid assignment. For if one is assigned a call, then he too will be short the stock. If the stock cannot be borrowed, the broker will buy him in. Thus, in situations in which the stock might be difficult to borrow, one should use a striking price such that the call is out-of-the-money when sold initially. This will decrease, but not eliminate, the possibility of early assignment. Leverage is a factor in this strategy also. The short seller would need $2,500 to collateralize this position, assuming that the margin rate is 50%. The option strategist initially only needs 20% of the stock price, plus the call price, less the credit received, for a $1,400 requirement. Moreover, one of the major disadvantages that was men­ tioned with the synthetic long stock position is not a disadvantage in the synthetic short sale strategy: The option trader does not have to pay out dividends on the options, but the short seller of stock must. Chapter 21: Synthetic Stock Positions Created by Puts and Calls 325 Because of the advantages of the option position in not having to pay out the dividend and also having a slightly larger profit potential from the excess time value premium, it may often be feasible for the trader who is looking to sell stock short to instead sell a call and buy a put. It is also important for the strategist to understand the equivalence between the short stock position and the option position. He might be able to substitute the option position in certain cases when the short sale of stock is normally called for. SPLITTING THE STRIKES The strategist may be able to use a slight variation of the synthetic strategy to set up an aggressive, but attractive, position. Rather than using the same striking price for the put and call, he can use a lower striking price for the put and a higher striking price for the call. This action of splitting apart the striking prices gives him some room for error, while still retaining the potential for large profits. BULLISHLY ORIENTED If an out-of-the-money put is sold naked, and an out-of-the-money call is simultane­ ously purchased, an aggressive bullish position is established - often for a credit. If the underlying stock rises far enough, profits can be generated on both the long call and the short put. If the stock remains relatively unchanged, the call purchase will be a loss, but the put sale will be a profit. The risk occurs if the underlying stock drops in price, producing losses on both the short put and the long call. Example: The following prices exist: XYZ is at 53, a January 50 put is selling for 2, and a January 60 call is selling for 1. An investor who is bullish on XYZ sells the January 50 put naked and simultaneously buys the January 60 call. This position brings in a credit of 1 point, less commissions. There is a collateral requirement necessary for the naked put. If XYZ is anywhere between 50 and 60 at January expiration, both options would expire worthless, and the investor would make a small profit equal to the amount of the initial credit received. If XYZ rallies above 60 by expiration, however, his potential profits are unlimited, since he owns the call at 60. His losses could be very large if XYZ should decline well below 50 before expiration, since he has written the naked put at 50. Table 21-3 and Figure 21-1 depict the results at expiration of this strategy. Essentially, the investor who uses this strategy is bullish on the underlying stock and is attempting to buy an out-of-the-money call for free. If he is moderately wrong 326 TABLE 21-3. Bullishly split strikes. XYZ Price al January 50 Expirafion 40 45 50 55 60 65 70 FIGURE 21-1. Bullishly split strikes. Pu! Profil -$800 - 300 + 200 + 200 + 200 + 200 + 200 Part Ill: Put Option Strategies January 60 Tolal Call Profil Profif -$100 -$ 900 - 100 400 - 100 + 100 - 100 + 100 - 100 + 100 + 400 + 600 + 900 + 1,100 Stock Price at Expiration and the underlying stock rallies only slightly or even declines slightly, he can still make a small profit. If he is correct, of course, large profits could be generated in a rally. He may lose heavily if he is very wrong and the stock falls by a large amount instead of rising. This strategy is often useful when options are overpriced. Suppose that one has a bullish opinion on the underlying stock, yet is dismayed to find that the calls are quite expensive. If he buys one of these expensive calls, he can mitigate the expen­ siveness somewhat by also selling an out-of-the-money put, which is presumably Chapter 21: Synthetic Stock Positions Created by Puts and Calls 327 somewhat expensive also. Thus, if he is right about the bullish attitude on the stock, he owns a call that is more "fairly priced" because its cost was reduced by the amount of the put sale. BEARISHLY ORIENTED There is a companion strategy for the investor who is bearish on a stock. He could attempt to buy an out-of-the-money put, giving himself the opportunity for substan­ tial profits in a stock price decline, and could "finance" the purchase of the put by writing an out-of-the-money call naked. The sale of the call would provide profits if the stock stayed below the striking price of the call, but could cost him heavily if the underlying stock rallies too far. Example: With XYZ at 65, the bearish investor buys a February 60 put for 2 points, and simultaneously sells a February 70 call for 3 points. These trades bring in a cred­ it of 1 point, less commissions. The investor must collateralize the sale of the call. If XYZ should decline substantially by February expiration, large profits are possible because the February 60 put is owned. Even if XYZ does not perform as expected, but still ends up anywhere between 60 and 70 at expiration, the profit will be equal to the initial credit because both options will expire worthless. However, if the stock rallies above 70, unlimited losses are possible because there is a naked call at 70. Table 21-4 and Figure 21-2 show the results of this strategy at expiration. This is clearly an aggressively bearish strategy. The investor would like to own an out-of-the-money put for downside potential. In addition, he sells an out-of-the­ money call, normally for a price greater than that of the purchased put. The call sale TABLE 21-4. Bearishly split strikes. XYZ Price at February 60 February 70 Total Expiration Put Profit Call Profit Profit 50 +$800 +$300 +$1, 100 55 + 300 + 300 + 600 60 - 200 + 300 + 100 65 - 200 + 300 + 100 70 - 200 + 300 + 100 75 - 200 - 200 400 80 - 200 - 700 900 328 FIGURE 21-2. Bearishly split strikes. C 0 e ·15. X w Part Ill: Put Option Strategies 1u +$100 w $0 I-----------'------ ................. ----- ~ 60 ....J 0 ~ a. Stock Price at Expiration essentially lets him own the put for free. In fact, he can still make profits even if the underlying stock rises slightly or only falls slightly. His risk is realized if the stock rises above the striking price of the written call. This strategy of splitting the strikes in a bearish manner is used very frequently in conjunction with the ownership of common stock. That is, a stock owner who is looking to protect his stock will buy an out-of-the-money put and sell an out-of-the­ money call to finance the put purchase. This strategy is called a "protective collar" and was discussed in more detail in the chapter on Put Buying in Conjunction with Common Stock Ownership. A strategy that is similar to these, but modifies the risk, is presented in Chapter 23, Spreads Combining Calls and Puts. SUMMARY In either of these aggressive strategies, the investor must have a definite opinion about the future price movement of the underlying stock. He buys an out-of-the­ money option to provide profit potential for that stock movement. However, an investor can lose the entire purchase proceeds of an out-of-the-money option if the stock does not perform as expected. An aggressive investor, who has sufficient collat­ eral, might attempt to counteract this effect by also writing an out-of-the-money option to cover the cost of the option that he bought. Then, he will not only make money if the stock performs as expected, but he will also make money if the stock remains relatively unchanged. He will lose quite heavily, however, if the underlying stock goes in the opposite direction from his original anticipation. That is why he must have a definite opinion on the stock and also be fairly certain of his timing. Basic Put Spreads Put spreading strategies do not differ substantially in theory from their accompany- ;,,..,,. ,...,,1] v-n..-a<>rl vl-..-al-arriac Rol-h h11llich nnrl hP<>rich nocitionc r>!'.ln hP r>onctn1r>tPrl with .l.J..1.5 V(A,,1.1. .;Jt'.l.'\,.,U'L.L J\...l 1.Vf,A.VoJ• .Jl.,l''\Jl,....t..1. J.J\..1..1..1..1.V.a...._ f.4.1..1..._... ,._,...,_,'-4Ji.A.V..._.,._ ,t'"-"._,..._ ... ...__..._..._...,, .._,.__...,,._ -....,..., _.._,,.._.,....,,...,._ .....,._,_....,,_ , , ,,..._.,._""- put spreads, as was also the case with call spreads. However, because puts are more oriented toward downward stock movement than calls are, some bearish put spread strategies are superior to their equivalent bearish call spread strategies. The three simplest forms of option spreads· are: 1. the bull spread, 2. the bear spread, and 3. the calendar spread. The same types of spreads that were constructed with calls can be established with puts, but there are some differences. BEAR SPREAD In a call bear spread, a call with a lower striking price was sold while a call at a high­ er striking price was bought. Similarly, a put bear spread is established by selling a put at a lower strike while buying a put at a higher strike. The put bear spread is a debit spread. This is true because a put with a higher striking price will sell for more than a put with a lower striking price. Thus, on a stock with both puts and calls trad­ ing, one could set up a bear spread for a credit ( using calls) or alternatively set one up for a debit (using puts): 329 330 Put Bear Spread Buy XYZ January 60 put Sell XYZ January 50 put (debit spread) Part Ill: Put Option Strategies Call Bear Spread Buy XYZ January 60 call Sell XYZ January 50 call (credit spread) The put bear spread has the same sort of profit potential as the call bear spread. There is a limited maximum potential profit, and this profit would be realized if XYZ were below the lower striking price at expiration. The put spread would widen, in this case, to equal the difference between the striking prices. The maximum risk is also limited, and would be realized if XYZ were anywhere above the higher striking price at expiration. Example: The following prices exist: XYZ common, 55; XYZ January 50 put, 2; and XYZ January 60 put, 7. Buying the January 60 put and selling the January 50 would establish a bear spread for a 5-point debit. Table 22-1 will help verify that this is indeed a bearish position. The reader will note that Figure 22-1 has the same shape as the call bear spread's graph (Figure 8-1). The investment required for this spread is the net debit, and it must be paid in full. Notice that the maximum profit potential is realized any­ where below 50 at expiration, and the maximum risk potential is realized anywhere above 60 at expiration. The maximum risk is always equal to the initial debit required to establish the spread plus commissions. The break-even point is 55 in this example. The following formulae allow one to quickly compute the meaningful statistics regarding a put bear spread. Maximum risk = Initial debit Maximum profit = Difference between strikes - Initial debit Break-even price = Higher striking price - Initial debit Put bear spreads have an advantage over call bear spreads. With puts, one is selling an out-of-the-money option when setting up the spread. Thus, one is not risk­ ing early exercise of his written option before the spread becomes profitable. For the written put to be in-the-money, and thus in danger of being exercised, the spread would have to be profitable, because the stock would have to be below the lower striking price. Such is not the case with call bear spreads. In the call spread, one sells an in-the-money call as part of the bear spread, and thus could be at risk of early exer­ cise before the spread has a chance to become profitable. Chapter 22: Basic Put Spreads 331 TABLE 22-1. Put bear spread. XYZ Price at January 50 January 60 Total Expiration Put Profit Put Profit Profit 40 -$800 +$1,300 +$500 45 - 300 + 800 + 500 50 + 200 + 300 + 500 55 + 200 200 0 60 + 200 700 - 500 70 + 200 700 - 500 80 + 200 700 - 500 FIGURE 22-1. Put bear spread. Stock Price at Expiration Beside this difference in the probability of early exercise, the put bear spread holds another advantage over the call bear spread. In the put spread, if the underly­ ing stock drops quickly, thereby making both options in-the-rrwney, the spread will normally widen quickly as well. This is because, as has been mentioned previously, put options tend to lose time value premium rather quickly when they go into-the­ money. In the example above, if XYZ rapidly dropped to 48, the January 60 put would be near 12, retaining very little time premium. However, the January 50 put that is short would also not retain much time value premium, perhaps selling at 4 points or 332 Part Ill: Put Option Strategies so. Thus, the spread would have widened to 8 points. Call bear spreads often do not produce a similar result on a short-term downward movement. Since the call spread involves being short a call with a lower striking price, this call may actually pick up time value premium as the stock falls close to the lower strike. Thus, even though the call spread might have a similar profit at expiration, it often will not perform as well on a quick downward movement. For these two reasons - less chance of early exercise and better profits on a short-term movement - the put bear spread is superior to the call bear spread. Some investors still prefer to use the call spread, since it is established for a credit and thus does not require a cash investment. This is a rather weak reason to avoid the superi­ or put spread and should not be an overriding consideration. Note that the margin requirement for a call bear spread will result in a reduction of one's buying power by an amount approximately equal to the debit required for a similar put bear spread. (The margin required for a call bear spread is the difference between the striking prices less the credit received from the spread.) Thus, the only accounts that gain any substantial advantage from a credit spread are those that are near the minimum equi­ ty requirement to begin with. For most brokerage firms, the minimum equity requirement for spreads is $2,000. BULL SPREAD A bull spread can be established with put options by buying a put at a lower striking price and simultaneously selling a put with a higher striking price. This, again, is the same way a bull spread was constructed with calls: selling the higher strike and buy­ ing the lower strike. Example: The same prices can be used: XYZ common, 55; XYZ January 50 put, 2; and XYZ January 60 put, 7. The bull spread is constructed by buying the January 50 put and selling the January 60 put. This is a credit spread. The credit is 5 points in this example. If the underly­ ing stock advances by January expiration and is anywhere above 60 at that time, the maximum profit potential of the spread will be realized. In that case, with XYZ any­ where above 60, both puts would expire worthless and the spreader would make a profit of the entire credit - 5 points in this example. Thus, the maximum profit poten­ tial is limited, and the maximum profit occurs if the underlying stock rises in price Chapter 22: Basic Put Spreads 333 above the higher strike. These are the same qualities that were displayed by a call bull spread (Chapter 7). The name "bull spread" is derived from the fact that this is a bull­ ish position: The strategist wants the underlying stock to rise in price. The risk is limited in this spread. If the underlying stock should decline by expi­ ration, the maximum loss will be realized with XYZ anywhere below 50 at that time. The risk is 5 points in this example. To see this, note that if XYZ were anywhere below 50 at expiration, the differential between the two puts would widen to 10 points, since that is the difference between their striking prices. Thus, the spreader would have to pay 10 points to buy the spread back, or to close out the position. Since he initially took in a 5-point credit, this means his loss is equal to 5 points - the 10-point cost of closing out less the 5 points he received initially. The investment required for a bullish put spread is actually a collateral require­ ment, since the spread is a credit spread. The amount of collateral required is equal -1-r.. f-ha rliffa:rannci, hahuaan tho cfr-il;nrr r\rint::u.:- lace th.-:;). not nrorlit ror-A-iuorl fnr thA \..V l,,J...111._, Ul.J..J..V.lV.l.l.\..,V LIV\..VVVVJ..l '-- J.'L, oJ\..l..l.J.'-l.J.J..o .t'.l.J..\,.,VoJ J.VoJ,J I..J.J.'-' J..1.V\.. \,.,.l.V"-AJ.l.- .LVV'-'..l.Y'-'"'--4 .J..'-.-".I. .__...._.._ ....... spread. In this example, the collateral requirement is $500- the $1,000, or 10-point, differential in the striking prices less the $500 credit received from the spread. Note that the maximum possible loss is always equal to the collateral requirement in a bull­ ish put spread. It is not difficult to calculate the break-even point in a bullish spread. ·In this example, the break-even point before commissions is 55 at expiration. With XYZ at 55 in January, the January 50 put would expire worthless and the January 60 put would have to be bought back for 5 points. It would be 5 points in-the-money with XYZ at 55. Thus, the spreader would break even, since he originally received 5 points credit for the spread and would then pay out 5 points to close the spread. The fol­ lowing formulae allow one to quickly compute the details of a bullish put spread: Maximum potential risk = Initial collateral requirement = Difference in striking prices - Net credit received Maximum potential profit= Net credit Break-even price = Higher striking price - Net credit CALENDAR SPREAD In a calendar spread, a near-term option is sold and a longer-term option is bought, both with the same striking price. This definition applies to either a put or a call cal­ endar spread. In Chapter 9, it was shown that there were two philosophies available for call calendar spreads, either neutral or bullish. Similarly, there are two philoso­ phies available for put calendar spreads: neutral or bearish. 334 Part Ill: Put Option Strategies In a neutral calendar spread, one sets up the spread with the idea of closing the spread when the near-term call or put expires. In this type of spread, the maximum profit will be realized if the stock is exactly at the striking price at expiration. The spreader is merely attempting to capitalize on the fact that the time value premium disappears more rapidly from a near-term option than it does from a longer-term one. Example: XYZ is at 50 and a January 50 put is selling for 2 points while an April 50 put is selling for 3 points. A neutral calendar spread can be established for a 1-point debit by selling the January 50 put and buying the April 50 put. The investment required for this position is the amount of the net debit, and it must be paid for in full. If XYZ is exactly at 50 at January expiration, the January 50 put will expire worth­ less and the April 50 put will be worth about 2 points, assuming other factors are the same. The neutral spreader would then sell the April 50 put for 2 points and take his profit. The spreader's profit in this case would be one point before commissions, because he originally paid a 1-point debit to set up the spread and then liquidates the position by selling the April 50 put for 2 points. Since commission costs can cut into available profits substantially, spreads should be established in a large enough quan­ tity to minimize the percentage cost of commissions. This means that at least 10 spreads should be set up initially. In any type of calendar spread, the risk is limited to the amount of the net debit. This maximum loss would be realized if the underlying stock moved substantially far away from the striking price by the time the near-term option expired. If this hap­ pened, both options would trade at nearly the same price and the differential would shrink to practically nothing, the worst case for the calendar spreader. For example, if the underlying stock drops substantially, say to 20, both the near-term and the long­ term put would trade at nearly 30 points. On the other hand, if the underlying stock rose substantially, say to 80, both puts would trade at a very low price, say 1/15 or 1/s, and again the spread would shrink to nearly zero. Neutral call calendar spreads are generally superior to neutral put calendar spreads. Since the amount of time value premium is usually greater in a call option (unless the underlying stock pays a large dividend), the spreader who is interested in selling time value would be better off utilizing call options. The second philosophy of calendar spreading is a more aggressive one. With put options, a bearish strategy can be constructed using a calendar spread. In this case, one would establish the spread with out-of-the-money puts. Example: With XYZ at 55, one would sell the January 50 put for 1 point and buy the April 50 put for 1 ½ points. He would then like the underlying stock to remain above the striking price until the near-term January put expires. If this happens, he would Chapter 22: Basic Put Spreads 335 make the I-point profit from the sale of that put, reducing his net cost for the April 50 put to ½ point. Then, he would become bearish, hoping for the underlying stock to decline in price substantially before April expiration in order that he might be able to generate large profits on the April 50 put he holds. Just as the bullish calendar spread with calls can be a relatively attractive strat­ egy, so can the bearish calendar spread with puts. Granted, two criteria have to be fulfilled in order for the position to work to the optimum: The near-term put must expire worthless, and then the underlying stock must drop in order to generate prof­ its on the long side. Although these conditions may not occur frequently, one prof­ itable situation can more than make up for several losing ones. This is true because the initial debit for a bearish calendar spread is small, ½ point in the example above. Thus, the losses will be small and the potential profits could be very large if things work out right. The aggressive spreader must be careful not to "leg out" of his spread, since he could generate a large loss by doing so. The object of the strategy is to accept a rather large number of small losses, with the idea that the infrequent large profits will more than offset the sum of the losses. If one generates a large loss somewhere along the way, this may ruin the overall strategy. Also, if the underlying stock should fall to the striking price before the near-term put expires, the spread will normally have widened enough to produce a small profit; that profit should be taken by closing the spread at that time. Spreads Cotnbining Calls and Puts Certain types of spreads can be constructed that utilize both puts and calls. One of these strategies has been discussed before: the butterfly spread. However, other strategies exist that off er potentially large profits to the spreader. These other strate­ gies are all variations of calendar spreads and/or straddles that involve both put and call options. THE BUTTERFLY SPREAD This strategy has been described previously, although its usage in Chapter 10 was restricted to constructing the spread with calls. Recall that the butterfly spread is a neutral position that has limited risk as well as limited profits. The position involves three striking prices, utilizing a bull spread between the lower two strikes and a bear spread between the higher two strikes. The maximum profit is realized at the middle strike at expiration, and the maximum loss is realized if the stock is above the higher strike or below the lower strike at expiration. Since either a bull spread or a bear spread can be constructed with puts or calls, it should be obvious that a butterfly spread ( consisting of both a bull spread and a bear spread) can be constructed in a number of ways. In fact, there are four ways in which the spread can be established. If option prices are fairly balanced - that is, the arbitrageurs are keeping prices in line - any of the four ways will have the same potential profits and losses at expiration of the options. However, because of the ways in which puts and calls behave prior to their expiration, certain advantages or disad- 336 Chapter 23: Spreads Combining Calls and Puts 331 vantages are connected with some of the methods of establishing the butterfly spread. Example: The following prices exist: Strike: Call: Put: XYZ common: 60 50 12 60 6 5 70 2 1 1 The method using only the calls indicates that one would buy the 50 call, sell two 60 calls, and buy the 70 call. Thus, there would be a bull spread in the calls between the 50 and 60 strikes, and a bear spread in the calls between the 60 and 70 strikes. In a similar manner, one could establish a butterfly spread by combining either type of bull spread between the 50 and 60 strikes with any type of bear spread between the 60 and 70 strikes. Some of these spreads would be credit spreads, while others would be debit spreads. In fact, one's personal choice between two rather equivalent makeups of the butterfly spread might be decided by whether there were a credit or a debit involved. Table 23-1 summarizes the four ways in which the butterfly spread might be constructed. In order to verify the debits and credits listed, the reader should recall that a bull spread consists of buying a lower strike and selling a higher strike, whether puts or calls are used. Similarly, bear spreads with either puts or calls consist of buy­ ing a higher strike and selling a lower strike. Note that the third choice - bull spread with puts and bear spread with calls - is a short straddle protected by buying the out­ of-the-money put and call. In each of the four spreads, the maximum potential profit at expiration is 8 points if the underlying stock is exactly at 60 at that time. The maximum possible loss in any of the four spreads is 2 points, if the stock is at or above 70 at expiration or is at or below 50 at expiration. For example, either the top line in the table, where the spread is set up only with calls; or the bottom line, where the spread is set up only with puts, has a risk equal to the debit involved - 2 points. The large-debit spread (second line of table) will be able to be liquidated for a minimum of 10 points at expi­ ration no matter where the stock is, so the risk is also 2 points. (It cost 12 points to begin with.) Finally, the credit combination (third line) has a maximum buy-back of 10 points, so it also has risk of 2 points. In addition, since the striking prices are 10 points apart, the maximum potential profit is 8 points (maximum profit = striking price differential minus maximum risk) in all the cases. 338 TABLE 23-1. Butterfly spread. Bull Spread (Buy Option at 50, ... plus ... Sell at 60) Calls (6 debit) Calls (6 debit) Puts (4 credit) Puts (4 credit) Bear Spread (Buy Option at 70, Sell at 60) Calls (4 credit) Puts (6 debit) Calls (4 credit) Puts (6 debit) Part Ill: Put Option Strategies Total Money 2 debit 12 debit 8 credit 2 debit The factor that causes all these combinations to be equal in risk and reward is the arbitrageur. If put and call prices get too far out of line, the arbitrageur can take riskless action to force them back. This particular form of arbitrage, known as the box spread, is described later, in Chapter 27, Arbitrage. Even though all four ways of constructing the butterfly spread are equal at expiration, some are superior to others for certain price movements prior to expira­ tion. Recall that it was previously stated that bull spreads are best constructed with calls, and bear spreads are best constructed with puts. Since the butterfly spread is merely the combination of a bull spread and a bear spread, the best way to set up the butterfly spread is to use calls for the bull spread and puts for the bear spread. This combination is the one listed on the second line of Table 23-1. This strategy involves the largest debit of the four combinations and, as a result, many investors shun this approach. However, all the other combinations involve selling an in-the-money put or call at the outset, a situation that could lead to early exercise. The reader may also recall that the credit combination, listed on the third line of Table 23-1, was previ­ ously described as a protected straddle position. That is, one sells a straddle and simultaneously buys both an out-of-the-money put and an out-of-the-money call with the same expiration month, as protection for the straddle. Thus, a butterfly spread is actually the equivalent of a completely protected straddle wiite. A butterfly spread is not an overly attractive strategy, although it may be useful from time to time. The commissions required are extremely high, and there is no chance of making a large profit on the position. The limited risk feature is good to have in a position, but it alone cannot compensate for the less attractive features of the strategy. Essentially, the strategist is looking for the stock to remain in a neutral pattern until the options expire. If the potential profit is at least three times the max­ imum 1isk (and preferably four times) and the underlying stock appears to be in trad­ ing range, the strategy is feasible. Othe:nvise, it is not. Chapter 23: Spreads Combining Calls and Puts 339 COMBINING AN OPTION PURCHASE AND A SPREAD It is possible to combine the purchase of a call and a credit put spread to produce a position that behaves much like a call buy, although it has less risk over much of the profit range. This strategy is often used when one has a quite bullish opinion regard­ ing the underlying security, yet the call one wishes to purchase is "overpriced." In a similar manner, if one is bearish on the underlying, he can sometimes combine the purchase of a put with the sale of a call credit spread. Both approaches are described in this section. THE BULLISH SCENARIO It sometimes happens that one arrives at a bullish opinion regarding a stock, only to find that the options are very expensive. In fact, they may be so expensive as to pre­ clude thoughts of making an outright call purchase. This might happen, for example, if the stock has suddenly plummeted in price (perhaps during an ongoing, rapid bear­ ish move by the overall stock market). To buy calls at this time would be overly risky. If the underlying began to rally, it would often be the case that the implied volatility of the calls would shrink, thus harming one's long call position. As a counter to this, it might make sense to buy the call, but at the same time to sell a put credit spread. Recall that a put credit spread is a bullish strategy. Moreover, since it is presumed that the options are expensive on this particular stock, the puts being used in the spread would be expensive as well. Thus, the credit received from the spread would be slightly larger than "normal" because the options are expensive. Example: XYZ is selling at 100. One wishes to purchase the December 100 call as an outright bullish speculation. That call is selling for 10. However, one determines that the December 100 call is overpriced at these levels. (In order to make this determi­ nation, one would use an option model whose techniques are described in Chapter 28 on mathematical applications.) Hence, he decides to use the following put spread in addition to buying the December 100 call: Sell December 90 put, 6 Buy December 80 put, 3 The sale of the put spread brings in a 3-point credit. Thus, his total expenditure for the entire position is 7 points ( 10 for the December 100 call, less 3 credit from the sale of the put spread). If one is correct about his bullish outlook for the stock (i.e., the stock goes up), he can in some sense consider that he paid 7 for the call. Another way 340 Part Ill: Put Option Strategies to look at it is this: The sale of the put spread reduces the call price down to a more moderate level, one that might be in line with its "theoretical value." In other words, the call would not be considered expensive if it were priced at 7 instead of 10. The sale of the put spread can be considered a way to reduce the overall cost of the call. Of course, the sale of the put spread brings some extra risk into the position because, if the stock were to fall dramatically, the put spread could lose 7 points ( the width of the strikes in the spread, 10 points, less the initial credit received, 3 points). This, added to the call's cost of 10 points, means that the entire risk here is 17 points. In fact, that is the margin required for this spread as well. Thus, the overall spread still has limited risk, because both the call purchase and the put credit spread are lim­ ited-risk strategies. However, the total risk of the two combined is larger than for either one separately. Remember that one must be bullish on the underlying in order to employ this strategy. So, if his analysis is correct, the upside is what he wants to maximize. If he is wrong on his outlook for the stock, then he needs to employ some sort of stop-loss measures before the maximum risk of the position is realized. The resulting position is shown in Figure 23-1, along with two other plots. The straight line marked "Spread at expiration" shows how the profitability of the call pur­ chase combined with a bull spread would look at December expiration. In addition, there is a plot with straight lines of the purchase of the December 100 call for 10 points. That plot can be compared with the three-way spread to see where extra risk and reward occur. Note that the three-way spread does better than the outright pur­ chase of the December 100 call as long as the stock is higher than 87 at expiration. Since the stock is initially at 100 and,since one is initially bullish on the stock, one would have to surmise that the odds of it falling to 87 are fairly small. Thus, the three­ way spread outperforms the outright purchase of the call over a large range of stock prices. The final plot in Figure 23-1 is that of the three-way spread's profit and losses halfway to the expiration date. You can see that it looks much like the profitability of merely owning a call: The curve has the same shape as the call pricing curve shown in Chapter 1. Hence, this three-way strategy can often be more attractive and more profitable than merely owning a call option. Remember, though, that it does increase risk and require a larger collateral deposit than the outright purchase of the at-the-money call would. One can experiment with this strategy, too, in that he might consider buying an out-of-the-money call and selling a put spread that brings in enough credit to com­ pletely pay for the call. In that way, he would have no risk as long as the stock remained above the higher striking price used in the put credit spread. Chapter 23: Spreads Combining Calls and Puts FIGURE 23-1. Call buy and put credit (bull) spread. +$2,000 +$1,000 (/J (/J 0 ..J 0 $0 -e a. -$1,000 -$2,000 70 80 .... ,, -----,, -=-----' THE BEARISH SCENARIO ~ Spread at Expiration Call Buy Only, at Expiration 341 Stock In a similar manner, one can construct a position to take advantage of a bearish opin­ ion on a stock. Again, this would be most useful when the options were overpriced and one felt that an at-the-money put was too expensive to purchase by itself. Example: XYZ is trading at 80, and one has a definite bearish opinion on the stock. However, the December 80 put, which is selling for 8, is expensive according to an option analysis. Therefore, one might consider selling a call credit spread (out-of-the­ money) to help reduce the cost of the put. The entire position would thus be: Buy 1 December 80 put: Sell l December 90 call: Buy 1 December 100 call: Total cost: 8 debit 4 credit 2 debit 6 debit ($600) The profitability of this position is shown in Figure 23-2. The straight line on that graph shows how the position would behave at expiration. The introduction of the call credit spread has increased the risk to $1,600 if the stock should rally to 100 or higher by expiration. Note that the risk is limited since both the put purchase and the call credit spread are limited-risk strategies. The margin required would be this max­ imum risk, or $1,600. 342 Part Ill: Put Option Strategies FIGURE 23-2. Put buy and call credit (bear) spread. +$1,000 Halfway to Expiration / Stock 0 60 110 -e a. -$1,000 At Expiration -$2,000 The curved line on Figure 23-2 shows how the three-way spread would behave if one looked at it halfway to its expiration date. In that case, it has a curved appear­ ance much like the outright purchase of a put option. Thus, this strategy could be appealing to bearishly-oriented traders, especially when the options are expensive. It might have certain advantages over an outright put purchase in that case, but it does require a larger margin investment and has theo­ retically larger risk. A SIMPLE FOLLOW-UP ACTION FOR BULL OR BEAR SPREADS Another way of combining puts and calls in a spread can sometimes be used when one has a bull or bear spread already in place. Suppose that one owns a call bull spread and the underlying stock has advanced nicely. In fact, it is above both of the strikes used in the spread. However, as is often the case, the bull spread may not have widened out to its maximum profit potential. One can use the puts for two purposes at this point: (1) to determine whether the call spread is trading at a "reasonable" value, and (2) to try to lock in some profits. First, let's look at an example of the "rea­ sonable value" verification. Chapter 23: Spreads Combining Calls and Puts 343 Example: A trader buys an XYZ call bull spread for 5 points. The spread uses the January 70 calls and the January 80 calls. Later, XYZ advances to a price of 88, but there is still a good deal of time remaining in the options. Perhaps the spread has widened out only to 7 points at that time. The trader finds it somewhat disappoint­ ing that the spread has not widened out to its maximum profit potential of 10 points. However, this is a fairly common occurrence with bull and bear spreads, and is one of the factors that may make them less attractive than outright call or put purchases. In any case, suppose the following prices exist: January 80 put, 5 January 70 put, 2 We can use these put prices to verify that the call spread is "in line." Notice that the put spread is 3 points and the call spread is 7 points (both are the January 70-January 80 spread). Thus, they add up to 10 points the width of the strikes. When that occurs, we can conclude that the spreads are "in line" and are trading at theoretical­ ly correct prices. Knowing this information doesn't help one make any more profits, but it does provide some verification of the prices. Many times, one feels frustrated when he sees that a call bull spread has not widened out as he expected it to. Using the put spread as verification can help keep the strategist "on track" so that he makes ration­ al, not emotional, decisions. Now let's look at a similar example, in which perhaps the puts can be used to lock in profits on a call bull spread. Example: Using the same bull spread as in the previous example, suppose that one owns an XYZ call bull spread, having bought the January 70 call and sold the January 80 call for a debit of 5 points. Now assume it is approaching expiration, and the stock is once again at 88. At this time, the spread is theoretically nearing its maximum price of 10. However, since both calls are fairly deeply in-the-money, the market-makers are making very wide spreads in the calls. Perhaps these are the markets, with the stock at 88 and only a week or two remaining until expiration: Coll January 70 call January 80 call Bid Price 17.50 8.80 Asked Price 18.50 8.20 If one were to remove this spread at market prices, he would sell his long January 70 call for 17.50 and would buy his short January 80 call back for 8.20, a cred- 344 Part Ill: Put Option Strategies it of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents, quite a bit for just such a short time remaining. However, suppose that one looks at the puts and finds these prices: Put January 80 put January 70 put Bid Price 0.20 none Asked Price 0.40 0.10 One could "lock in" his call spread profits by buying the January 80 put for 40 cents. Ignoring commissions for a moment, if he bought that put and then held it along with the call spread until expiration, he would unwind the call spread for a 10 credit at expiration. He paid 40 cents for the put, so his net credit to exit the spread would be 9.60 - considerably better than the 9.30 he could have gotten above for the call spread alone. This put strategy has one big advantage: If the underlying stock should sudden­ ly collapse and tumble beneath 70 - admittedly, a remote possibility - large profits could accrue. The purchase of the January 80 put has protected the bull spread's profits at all prices. But below 70, the put starts to make extra money, and the spread­ er could profit handsomely. Such a drop in price would only occur if some material­ ly damaging news surfaced regarding X'iZ Company, but it does occasionally happen. If one utilizes this strategy, he needs to carefully consider his commission costs and the possibility of early assignment. For a professional trader, these are irrelevant, and so the professional trader should endeavor to exit bull spreads in this manner whenever it makes sense. However, if the public customer allows stock to be assigned at 80 and exercises to buy stock at 70, he will have two stock commissions plus one put option commission. That should be compared to the cost of two in-the-money call option commissions to remove the call spread directly. Furthermore, if the pub­ lic customer receives an early assignment notice on the short January 80 calls, he may need to provide day-trade margin as he exercises his January 70 calls the next day. Without going into as much detail, a bear spread's profits can be locked in via a similar strategy. Suppose that one owns a January 60 put and has sold a January 50 put to create a bear spread. Later, with the stock at 45, the spreader wants to remove the spread, but again finds that the markets for the in-the-money puts are so wide that he cannot realize anywhere near the 10 points that the spread is theoretically worth. He should then see what the January 50 call is selling for. If it is fractionally priced, as it most likely will be if expiration is drawing nigh, then it can be purchased to lock in the profits from the put spread. Again, commission costs should be con­ sidered by the public customer before finalizing his strategy. Chapter 23: Spreads Combining Calls and Puts 345 THREE USEFUL BUT COMPLEX STRATEGIES The three strategies presented in this section are all designed to limit risk while allowing for large potential profits if correct market conditions develop. Each is a combination strategy - that is, it involves both puts and calls and each is a calendar strategy, in which near-term options are sold and longer-term options are bought. (A fourth strategy that is similar in nature to those about to be discussed is presented in the next chapter.) Although all of these are somewhat complex and are for the most advanced strategist, they do provide attractive risk/reward opportunities. In addition, the strategies can be employed by the public customer; they are not designed strict­ ly for professionals. All three strategies are described conceptually in this section; specific selection criteria are presented in the next section. A TWO-PRONGED ATTACK {THE CALENDAR COMBINATION} A bullish calendar spread was shown to be a rather attractive strategy. A bullish call calendar spread is established with out-of-the-money calls for a relatively small debit. If the near-term call expires worthless and the stock then rises substantially before the longer-term call expires, the profits could potentially be large. In any case, the risk is limited to the small debit required to establish the spread. In a similar man­ ner, the bearish calendar spread that uses put options can be an attractive strategy as well. In this strategy, one would set up the spread with out-of-the-money puts. He would then want the near-term put to expire worthless, followed by a substantial drop in the stock price in order to profit on the longer-term put. Since both strategies are attractive by themselves, the combination of the two should be attractive as well. That is, with a stock midway between two striking prices, one might set up a bullish out-of-the-money call calendar spread and simultaneously establish a bearish out-of-the-money put calendar spread. If the stock remains rela­ tively stable, both near-term options would expire worthless. Then a substantial stock price movement in either direction could produce large profits. With this strategy, the spreader does not care which direction the stock moves after the near options expire worthless; he only hopes that the stock becomes volatile and moves a large dis­ tance in either direction. Example: Suppose that the following prices exist three months before the January options expire: January 70 call: 3 April 70 call: 5 XYZ common: 65 January 60 put: 2 April 60 put: 3 346 Part Ill: Put Option Strategies The bullish portion of this combination of calendar spreads would be set up by sell­ ing the shorter-term January 70 call for 3 points and simultaneously buying the longer-term April 70 call for 5 points. This portion of the spread requires a 2-point debit. The bearish portion of the spread would be constructed using the puts. The near-term January 60 put would be sold for 2 points, while the longer-term April 60 put would be bought for 3. Thus, the put portion of the spread is a I-point debit. Overall, then, the combination of the calendar spreads requires a 3-point debit, plus commissions. This debit is the required investment; no additional collateral is required. Since there are four options involved, the commission cost will be large. Again, establishing the spreads in quantity can reduce the percentage cost of com­ missions. Note that all the options involved in this position are initially out-of-the-money. The stock is below the striking price of the calls and is above the striking price of the puts. One has sold a near-term put and call combination and purchased a longer-term combination. For nomenclature purposes, this strategy is called a "calendar combi­ nation." There are a variety of possible outcomes from this position. First, it should be understood that the risk is limited to the amount of the initial debit, 3 points in this example. If the underlying stock should rise dramatically or fall dramatically before the near-term options expire, both the call spread and the put spread will shrink to nearly nothing. This would be the least desirable result. In actual practice, the spread would probably have a small positive differential left even after a premature move by the underlying stock, so that the probability of a loss of the entire debit would be small. If the near-term options both expire worthless, a profit will generally exist at that time. Example: IfXYZ were still at 65 at January expiration in the prior example, the posi­ tion should be profitable at that time. The January call and put would expire worth­ less with XYZ at 65, and the April options might be worth a total of 5 points. The spread could thus be closed for a profit with XYZ at 65 in January, since the April options could be sold for 5 points and the initial "cost" of the spread was only 3 points. Although commissions would substantially reduce this 2-point gross profit, there would still be a good percentage profit on the overall position. If the strategist decides to take his profit at this time, he would be operating in a conservative manner. However, the strategist may want to be more aggressive and hold onto the April combination in hopes that the stock might experience a substantial movement before those options expire. Should this occur, the potential profits could be quite large. Chapter 23: Spreads Combining Calls and Puts 347 Example: If the stock were to undergo a very bullish move and rise to 100 before April expiration, the April 70 call could be sold for 30 points. (The April 60 put would expire worthless in that case.) Alternatively, if the stock plunged to 30 by April expi­ ration, the put at 60 could be sold for 30 points while the call expired worthless. In either case, the strategist would have made a substantial profit on his initial 3-point investment. It may be somewhat difficult for the strategist to decide what he wants to do after the near-term options expire worthless. He may be torn between taking the lim­ ited profit that is at hand or holding onto the combination that he owns in hopes of larger profits. A reasonable approach for the strategist to take is to do nothing imme­ diately after the near-term options expire worthless. He can hold the longer-term options for some time before they will decay enough to produce a loss in the posi­ tion. Referring again to the previous example, when the January options expire worthless, the strategist then owns the April combination, which is worth 5 points at that time. He can continue to hold the April options for perhaps 6 or 8 weeks before they decay to a value of 3 points, even if the stock remains close to 65. At this point, the position could be closed for a net loss of the .commission costs involved in the var­ ious transactions. As a general rule, one should be willing to hold the combination, even if this means that he lets a small profit decay into a loss. The reason for this is that one should give himself the maximum opportunity to realize large profits. He will proba­ bly sustain a number of small losses by doing this, but by giving himself the oppor­ tunity for large profits, he has a reasonable chance of having the profits outdistance the losses. There is a time to take small profits in this strategy. This would be when either the puts or the calls were slightly in-the-money as the near-term options expire. Example: IfXYZ moved to 71 just as the January options were expiring, the call por­ tion of the spread should be closed. The January 70 call could be bought back for 1 point and the April 70 call would probably be worth about 5 points. Thus, the call portion of the spread could be "sold" for 4 points, enough to cover the entire cost of the position. The April 60 put would not have much value with the stock at 71, but it should be held just in case the stock should experience a large price decline. Similar results would occur on the put side of the spread if the underlying stock were slight­ ly in-the-money, say at 58 or 59, at January expiration. At no time does the strategist want to risk being assigned on an option that he is short, so he must always close the portion of the position that is in-the-money at near-term expiration. This is only nec­ essary, of course, if the stock has risen above the striking price of the calls or has fall­ en below the striking price of the puts. 348 Part Ill: Put Option Strategies In summary, this is a reasonable strategy if one operates it over a period of time long enough to encompass several market cycles. The strategist must be careful not to place a large portion of his trading capital in the strategy, however, since even though the losses are limited, they still represent his entire net investment. A varia­ tion of this strategy, whereby one sells more options than he buys, is described in the next chapter. THE CALENDAR STRADDLE Another strategy that combines calendar spreads on both put and call options can be constructed by selling a near-term straddle and simultaneously purchasing a longer­ term straddle. Since the time value premium of the near-term straddle will decrease more rapidly than that of the longer-term straddle, one could make profits on a lim­ ited investment. This strategy is somewhat inferior to the one described in the pre­ vious section, but it is interesting enough to examine. Example: Suppose that three months before January expiration, the following prices exist: XYZ common: 40 January 40 straddle: 5 April 40 straddle: 7 A calendar spread of the straddles could be established by selling the January 40 straddle and simultaneously buying the April 40 straddle. This would involve a cost of 2 points, or the debit of the transaction, plus commissions. The risk is limited to the amount of this debit up until {he time the near-term straddle expires. That is, even if XYZ moves up in price by a substantial amount or declines in price by a substantial amount, the worst that can happen is that the dif­ ference between the straddle prices shrinks to zero. This could cause one to lose an amount equal to his original debit, plus commissions. This limit on the risk applies only until the near-term options expire. If the strategist decides to buy back the near­ term straddle and continue to hold the longer-term one, his risk then increases by the cost of buying back the near-term straddle. Example: XYZ is at 43 when the January options expire. The January 40 call can now be bought back for 3 points. The put expires worthless; so the whole straddle was closed out for 3 points. The April 40 straddle might be selling for 6 points at that time. If the strategist wants to hold on to the April straddle, in hopes that the stock might experience a large price swing, he is free to do so after buying back the January Chapter 23: Spreads Combining Calls and Puts 349 40 straddle. However, he has now invested a total of 5 points in the position: the orig­ inal 2-point debit plus the 3 points that he paid to buy back the January 40 straddle. Hence, his risk has increased to 5 points. If XYZ were to be at exactly 40 at April expi­ ration, he would lose the entire 5 points. While the probability of losing the entire 5 points must be considered small, there is a substantial chance that he might lose more than 2 points his original debit. Thus, he has increased his risk by buying back the near-term straddle and continuing to hold the longer-term one. This is actually a neutral strategy. Recall that when calendar spreads were dis­ cussed previously, it was pointed out that one establishes a neutral calendar spread with the stock near the striking price. This is true for either a call calendar spread or a put calendar spread. This strategy - a calendar spread with straddles is merely the combination of a neutral call calendar spread and a neutral put calendar spread. Moreover, recall that the neutral calendar spreader generally establishes the position with the intention of closing it out once the near-term option expires. He is mainly interested in selling time in an attempt to capitalize on the fact that a near-term option loses time value premium more rapidly than a longer-term option does. The straddle calendar spread should be treated in the same manner. It is generally best to close it out at near-term expiration. If the stock is near the striking price at that time, a profit will generally result. To verify this, refer again to the prices in the pre­ ceding paragraph, with XYZ at 43 at January expiration. The January 40 straddle can be bought back for 3 points and the April 40 straddle can be sold for 6. Thus, the dif­ ferential between the two straddles has widened to 3 points. Since the original dif­ ferential was 2 points, this represents a profit to the strategist. The maximum profit would be realized if XYZ were exactly at the striking price at near-term expiration. In this case, the January 40 straddle could be bought back for a very small fraction and the April 40 straddle might be worth about 5 points. The differential would have widened from the original 2 points to nearly 5 points in this case. This strategy is inferior to the one described in the previous section (the "calen­ dar combination"). In order to have a chance for unlimited profits, the investor must increase his net debit by the cost of buying back the near-term straddle. Consequently, this strategy should be used only in cases when the near-term straddle appears to be extremely overpriced. Furthermore, the position should be closed at near-term expiration unless the stock is so close to the striking price at that time that the near-term straddle can be bought back for a fractional price. This fractional buy­ back would then give the strategist the opportunity to make large potential profits with only a small increase in his risk. This situation of being able to buy back the near­ term straddle at a fractional price will occur very infrequently, much more infre- 350 Part Ill: Put Option Strategies quently than the case in which both the out-of-the-money put and call expire worth­ less in the previous strategy. Thus, the "calendar combination" strategy will afford the spreader more opportunities for large profits, and will also never force him to increase his risk. OWNING A ✓,,FREE" COMBINATION (THE ""DIAGONAL BUTTERFLY SPREAD") The strategies described in the previous sections are established for debits. This means that even if the near-term options expire worthless, the strategist still has risk. The long options he then holds could proceed to expire worthless as well, thereby leaving him with an overall loss equal to his original debit. There is another strategy involving both put and call options that gives the strategist the opportunity to own a "free" combination. That is, the profits from the near-term options could equal or exceed the entire cost of his long-term options. This strategy consists of selling a near-term straddle and simultaneously pur­ chasing both a longer-term, out-of the-money call and a longer-term, out-of the­ money put. This differs from the protected straddle write previously described in that the long options have a more distant maturity than do the short options. Example: XYZ common: 40 April 35 put: January 40 straddle: April 45 call: If one were to sell the short-term January 40 straddle for 7 points and simultaneous­ ly purchase the out-of-the-money put and call combination -April 35 put and April 45 call - he would establish a credit spread. The credit for the position is 3 points less commissions, since 7 points are brought in from the straddle sale and 4 points are paid for the out-of-the-money combination. Note that the position technically con­ sists of a bearish spread in the calls - buy the higher strike and sell the lower strike - coupled with a bullish spread in the puts - buy the lower strike and sell the higher strike. The investment required is in the form of collateral since both spreads are credit spreads, and is equal to the differential in the striking prices, less the net cred­ it received. In this example, then, the investment would be 10 points for the striking price differential (5 points for the calls and 5 points for the puts) less the 3-point credit received, for a total collateral requirement of $700, plus commissions. Chapter 23: Spreads Combining Calls and Puts 351 The potential results from this position may vary widely. However, the risk is limited before near-tenn expiration. If the underlying stock should advance substan­ tially before January expiration, the puts would be nearly worthless and the calls would both be trading near parity. With the calls at parity, the strategist would have to pay, at most, 5 points to close the call spread, since the striking prices of the calls are 5 points apart. In a similar manner, if the underlying stock had declined substan­ tially before the near-term January options expired, the calls would be nearly worth­ less and the puts would be at parity. Again, it would cost a maximum of 5 points to close the put spread, since the difference in the striking prices of the puts is also 5 points. The worst result would be a 2-point loss in this example - 3 points of credit were initially received, and the most that the strategist would have to pay to close the position is 5 points. This is the theoretical risk. In actual practice, it is very unlikely that the calls would trade as much as 5 points apart, even if the underlying stock advanced by a large amount, because the longer-term call should retain some small time value premium even if it is deeply in-the-money. A similar analysis might apply to the puts. The risk can always be quickly computed as being equal to the difference between two contiguous striking prices ( two strikes next to each other), less the net credit received. The strategist's objective with this position is to be able to buy back the near­ tenn straddle for a price less than the original credit received. If he can do this, he will own the longer-term combination for free. Example: Near January expiration, the strategist is able to repurchase the January 40 straddle for 2 points. Since he initially received a 3-point credit and is then able to buy back the written straddle for 2 points, he is left with an overall credit in the posi­ tion of 1 point, less commissions. Once he has done this, the strategist retains the long options, the April 35 put and April 45 call. If the underlying stock should then advance substantially or decline substantially, he could make very large profits. However, even if the long combination expires worthless, the strategist still makes a profit, since he was able to buy the straddle back for less than the amount of the orig­ inal credit. In this example, the strategist's objective is to buy back the January 40 straddle for less than 3 points, since that is the amount of the initial credit. At expiration, this would mean that the stock would have to be between 37 and 43 for the buy-back to be made for 3 points or less. Although it is possible, certainly, that the stock will be in this fairly narrow range at near-term expiration, it is not probable. However, the strategist who is willing to add to his risk slightly can often achieve the same result by "legging out" of the January 40 straddle. It has repeatedly been stated that one should 352 Part Ill: Put Option Strategies not attempt to leg out of a spread, but this is an exception to that rule, since one owns a long combination and therefore is protected; he is not subjecting himself to large risks by attempting to "leg out" of the straddle he has written. Example: XYZ rallies before January expiration and the January 40 put drops to a price of ½ during the rally. Even though there is time remaining until expiration, the strategist might decide to buy back the put at ½. This could potentially increase his overall risk by ½ point if the stock continues to rise. However, if the stock then reversed itself and fell, he could attempt to buy the call back at 2½ points or less. In this manner, he would still achieve his objective of buying the short-term straddle back for 3 points or less. In fact, he might be able to close both sides of the straddle well before near-term expiration if the underlying stock first moves quickly in one direction and then reverses direction by a large amount. The maximum risk and the optimum potential objectives have been described, but interim results might also be considered in this strategy. Example: XYZ is at 44 at January expiration. The January 40 straddle must be bought back for 4 points. This means that the long combination will not be owned free, but will have a cost of I point plus commissions. The strategist must decide at this time if he wants to hold on to the April options or if he wants to sell them, possibly pro­ ducing a small overall profit on the entire position. There is no ironclad rule in this type of situation. If the decision is made to hold on to the longer-term options, the strategist realizes that he has assumed additional risk by doing so. Nevertheless, he may decide that it is worth owning the long combination at a relatively low cost. The cost in this example would be I point plus commissions, since he paid 4 points to buy back the straddle after only taking in a 3-point credit initially. The more ex.pensive the buy-back of the near-term straddle is, the more the strategist should be readily will­ ing to sell his long options at the same time. For example, if XYZ were at 48 at January expiration and the January 40 straddle had to be bought back for 8 points, there should be no question that he should simultaneously sell his April options as well. The most difficult decisions come when the stock is just outside the optimum buy-back area at near-term expiration. In this example, the strategist would have a fairly difficult decision if XYZ were in the 44 to 45 area or in the 35 to 36 area at January expiration. The reader may recall that, in Chapter 14 on diagonalizing a spread, it was men­ tioned that one is sometimes able to own a call free by entering into a diagonal cred­ it spread. A diagonal bear spread was given as an example. The same thing happens to be true of a diagonal bullish put spread, since that is a credit spread as well. The Chapter 23: Spreads Combining Calls and Puts 3S3 strategy discussed in this section is merely a combination of a diagonal bearish call spread and a diagonal bullish put spread and is known as a "diagonal butterfly spread." The same concept that was described in Chapter 14 - being able to make more on the short-term call than one originally paid for the long-term call - applies here as well. One enters into a credit position with the hope of being able to buy back the near-term written options for a profit greater than the cost of the long options. If he is able to do this, he will own options for free and could make large profits if the underlying stock moves substantially in either direction. Even if the stock does not move after the buy-back, he still has no risk. The risk occurs prior to the expiration of the near-term options, but this risk is limited. As a result, this is an attractive strat­ egy that, when operated over a period of market cycles, should produce some large profits. Ideally, these profits would offset any small losses that had to be taken. Since large commission costs are involved in this strategy, the strategist is reminded that establishing the spreads in quantity can help to reduce the percentage effect of the commissions. SELECTING THE SPREADS Now that the concepts of these three strategies have been laid out, let us define selection criteria for them. The "calendar combination" is the easiest of these strate­ gies to spot. One would like to have the stock nearly halfway between two striking prices. The most attractive positions can normally be found when the striking prices are at least 10 points apart and the underlying stock is relatively volatile. The opti­ mum time to establish the "calendar combination" is two or three months before the near-term options expire. Additionally, one would like the sum of the prices of the near-term options to be equal to at least one-half of the cost of the longer-term options. In the example given in the previous section on the "calendar combination," the near-term combination was sold for 5 points, and the longer-term combination was bought for 8 points. Thus, the near-term combination was worth more than one­ half of the cost of the longer-term combination. These five criteria can be summa­ rized as follows: 1. Relatively volatile stock. 2. Stock price nearly midway between two strikes. 3. Striking prices at least 10 points apart. 4. Two or three months remaining until near-term expiration. 5. Price of near-term combination greater than one-half the price of the longer­ term combination. 354 Part Ill: Put Option Strategies Even though five criteria have been stated, it is relatively easy to find a position that satisfies all five conditions. The strategist may also be able to rely upon technical input. If the stock seems to be in a near-term trading range, the position may be more attractive, for that would indicate that the chances of the near-term combination expiring worthless are enhanced. The "calendar straddle" is a strategy that looks deceptively attractive. As the reader should know by now, options do not decay in a linear fashion. Instead, options tend to hold time value premium until they get quite close to expiration, when the time value premium disappears at a fast rate. Consequently, the sale of a near-term straddle and the simultaneous purchase of a longer-term straddle often appear to be attractive because the debit seems small. Again, certain criteria can be set forth that will aid in selecting a reasonably attractive position. The stock should be at or very near the striking price when the position is established. Since this is basically a neu­ tral strategy, one that offers the largest potential profits at near-term expiration, one should want to sell the most time premium possible. This is why the stock must be near the striking price initially. The underlying stock does not have to be a volatile one, although volatile stocks will most easily satisfy the next two criteria. The near­ term credit should be at least two-thirds of the longer-term debit. In the example used to explain this strategy, the near-term straddle was sold for 5, while the longer­ term straddle was bought for 7 points. Thus, the near-term straddle was worth more than two-thirds of the longer-term straddle's price. Finally, the position should be established with two to four months remaining until near-term expiration. If positions with a longer time remaining are used, there is a significant probability that the underlying stock will have moved some distance away from the striking price by the time the near-term options expire. Summarizing, the three criteria for a "calendar straddle" are: 1. Stock near striking price initially. 2. Two to four months remaining until near-term expiration. 3. Near-term straddle price at least two-thirds of longer-term straddle price. The "diagonal butterfly" is the most difficult of these three types of positions to locate. Again, one would like the stock to be near the middle striking price when the position is established. Also, one would like the underlying stock to be somewhat volatile, since there is the possibility that long-term options will be owned for free. If this comes to pass, the strategist wants the stock to be capable of a large move in order to have a chance of generating large profits. The most restrictive criterion -:­ one that will eliminate all but a few possibilities on a daily basis - is that the near­ term straddle price should be at least one and one-half times that of the longer-term, Chapter 23: Spreads Combining Calls and Puts 355 out-of-the-money combination. By adhering to this criterion, one gives himself area­ sonable chance of being able to buy the near-term straddle back for a price low enough to result in owning the longer-term options for free. In the example used to describe this strategy, the near-term straddle was sold for 7 while the out-of-the­ money, longer-term combination cost 4 points. This satisfies the criterion. Finally, one should limit his possible risk before near-term expiration. Recall that the risk is equal to the difference between any two contiguous striking prices, less the net cred­ it received. In the example, the risk would be 5 minus 3, or 2 points. The risk should always be less than the credit taken in. This precludes selling a near-term straddle at 80 for 4 points and buying the put at 60 and the call at 100 for a combined cost of 1 point. Although the credit is substantially more than one and one-half times the cost of the long combination, the risk would be ridiculously high. The risk, in fact, is 20 points ( the difference between two contiguous striking prices) less the 3 points cred­ it, or 17 points - much too high. The criteria can be summarized as follows: 1. Stock near middle striking price initially. 2. Three to four months to near-term expiration. 3. Price of written straddle at least one and one-half times that of the cost of the longer-term, out-of-the-money combination. 4. Risk before near-term expiration less than the net credit received. One way in which the strategist may notice this type of position is when he sees a rel­ atively short-term straddle selling at what seems to be an outrageously high price. Professionals, who often have a good feel for a stock's short-term potential, will some­ times bid up straddles when the stock is about to make a volatile move. This will cause the near-term straddles to be very overpriced. When a straddle seller notices that a particular straddle looks too attractive as a sale, he should consider establish­ ing a diagonal butterfly spread instead. He still sells the overpriced straddle, but also buys a longer-term, out-of-the-money combination as a hedge against a large loss. Both factions can be right. Perhaps the stock will experience a very short-term volatile movement, proving that the professionals were correct. However, this will not worry the strategist holding a diagonal butterfly, for he has limited risk. Once the short-term move is over, the stock may drift back toward the original strike, allowing the near-term straddle to be bought back at a low price - the eventual objective of the strategist utilizing the diagonal butterfly spread. These are admittedly three quite complex strategies and thus are not to be attempted by a novice investor. If one wants to gain experience in how he would operate such a strategy, it would be far better to operate a "paper strategy" for a 356 Part Ill: Put Option Strategies while. That is, one would not actually make investments, but would instead follow prices in the newspaper and make day-to-day decisions without actual risk. This will allow the inexperienced strategist to gain a feel for how these complex strategies per­ form over a particular time period. The astute investor can, of course, obtain price history information and track a number of market cycles in this same way. SUMMARY Puts and call can be combined to make some very attractive positions. The addition of a call or put credit spread to the outright purchase of a put or call can enhance the overall profitability of the position, especially if the options are expensive. In addi­ tion, three advanced strategies were presented that combined puts and calls at vari­ ous expiration dates. These three various types of strategies that involve calendar combinations of puts and calls may all be attractive. One should be especially alert for these types of positions when near-term calls are overpriced. Typically, this would be during, or just after, a bullish period in the stock market. For nomenclature pur­ poses, these three strategies are called the "calendar combination," the "calendar straddle," and the "diagonal butterfly." All three strategies offer the possibility of large potential profits if the underly­ ing stock remains relatively stable until the near-term options expire. In addition, all three strategies have limited risk, even if the underlying stock should move explo­ sively in either direction prior to near-term expiration. If an intermediate result occurs - for example, the stock moves a moderate distance in either direction before near-term expiration - it is still possible to realize a limited profit in any of the strate­ gies, because of the fact that the time premiums decay much more rapidly in the near-term options than they do in the longer-term options. The three strategies have many things in common, but each has its own advan­ tages and disadvantages. The "diagonal butterfly" is the only one of the three strate­ gies whereby the strategist has a possibility of owning free options. Admittedly, the probability of actually being able to own the options completely for free is small. However, there is a relatively large probability that one can substantially reduce the cost of the long options. The "calendar combination," the first of the three strategies discussed, offers the largest probability of capturing the entire near-term premium. This is because both near-term options are out-of-the-money to begin with. The "cal­ endar straddle" offers the largest potential profits at near-term expiration. That is, if the stock is relatively unchanged from the time the position was established until the time the near-term options expire, the "calendar straddle" will show the best profit of the three strategies at that time. Chapter 23: Spreads Combining Calls and l'uts 357 Looking at the negative side, the "calendar straddle" is the least attractive of the three strategies, primarily because one is forced to increase his risk after near-term expiration, if he wants to continue to hold the longer-term options. It is often diffi­ cult to find a "diagonal butterfly" that offers enough credit to make the position attractive. Finally, the "calendar combination" has the largest probability oflosing the entire debit eventually, because one may find that the longer-term options expire worthless also. (They are out-of-the-money to begin with, just as the near-term options were.) The strategist will not normally be able to find a large number of these positions available at attractive price levels at any particular time in the market. However, since they are attractive strategies with little or no margin collateral requirements, the strategist should constantly be looking for these types of positions. A certain amount of cash or collateral should be reserved for the specific purpose of utilizing it for these types of positions - perhaps 15 to 20% of one's dollars. Ratio Spreads Using Puts The put option spreader may want to sell more puts than he owns. This creates a ratio spread. Basically, two types of put ratio spreads may prove to be attractive: the stan­ dard ratio put spread and the ratio calendar spread using puts. Both strategies are designed for the more aggressive investor; when operated properly, both can present attractive reward opportunities. THE RATIO PUT SPREAD This strategy is designed for a neutral to slightly bearish outlook on the underlying stock. In a ratio put spread, one buys a number of puts at a higher strike and sells more puts at a lower strike. This position involves naked puts, since one is short more puts than he is long. There is limited upside risk in the position, but the downside risk can be very large. The maximum profit can be obtained if the stock is exactly at the striking price of the written puts at expiration. Example: Given the following: XYZ common, 50; XYZ January 45 put, 2; and XYZ January 50 put, 4. A ratio put spread might be established by buying one January 50 put and simulta­ neously selling two January 45 puts. Since one would be paying $400 for the pur­ chased put and would be collecting $400 from the sale of the two out-of-the-money puts, the spread could be done for even money. There is no upside risk in this posi­ tion. If XYZ should rally and be above 50 at January expiration, all the puts would 358 Cl,apter 24: Ratio Spreads Using Puts 359 expire worthless and the result would be a loss of commissions. However, there is downside risk. If XYZ should fall by a great deal, one would have to pay much more to buy back the two short puts than he would receive from selling out the one long put. The maximum profit would be realized if XYZ were at 45 at expiration, since the short puts would expire worthless, but the long January 50 put would be worth 5 points and could be sold at that price. Table 24-1 and Figure 24-1 summarize the position. Note that there is a range within which the position is profitable - 40 to 50 in this example. If XYZ is above 40 and below 50 at January expiration, there will be some profit, before commissions, from the spread. Below 40 at expiration, losses will be generated and, although these losses are limited by the fact that a stock cannot decline in price below zero, these losses could become very large. There is no upside risk, however, as was pointed out earlier. The following formulae summarize the sit­ uation for any put ratio spread: Maximum upside risk Maximum profit potential = Net debit of spread (no upside risk if done for a credit) = Striking price differential x Number of long puts - Net debit (or plus net credit) Downside break-even price = Lower strike price - Maximum profit potential + Number of naked puts The investment required for the put ratio spread consists of the collateral requirement necessary for a naked put, plus or minus the credit or debit of the entire position. Since the collateral requirement for a naked option is 20% of the stock TABLE 24-1. Ratio put spread. XYZ Price at Long January 50 Short 2 January 45 Total Expiration Put Profit Put Profit Profit 20 +$2,600 -$4,600 -$2,000 30 + 1,600 - 2,600 - 1,000 40 + 600 600 0 42 + 400 200 + 200 45 + 100 + 400 + 500 48 200 + 400 + 200 50 400 + 400 0 60 400 + 400 0 360 FIGURE 24-1. Ratio put spread. +$500 C: 0 ~ ·5. X w iil (/) $0 (/) 0 ....I 0 e a. Part Ill: Put Option Strategies Stock Price at Expiration price, plus the premium, minus the amount by which the option is out-of-the-money, the actual dollar requirement in this example would be $700 (20% of $5,000, plus the $200 premium, minus the $500 by which the January 45 put is out-of-the-money). As with all types of naked writing positions, the strategist should allow enough collater­ al for an adverse stock move to occur. This will allow enough room for stock move­ ment without forcing early liquidation of the position due to a margin call. If, in this example, the strategist felt that he might stay with the position until the stock declined to 39, he should allow $1,380 in collateral (20% of $3,900 plus the $600 in­ the-money amount). The ratio put spread is generally most attractive when the underlying stock is initially between the two striking prices. That is, if XYZ were somewhere between 45 and 50, one might find the ratio put spread used in the example attractive. If the stock is initially below the lower striking price, a ratio put spread is not as attractive, since the stock is already too close to the downside risk point. Alternatively, if the stock is too far above the striking price of the written calls, one would normally have to pay a large debit to establish the position. Although one could eliminate the debit by writing four or five short options to each put bought, large ratios have extraordi­ narily large downside risk and are therefore very aggressive. Follow-up action is rather simple in the ratio put spread. There is very little that one need do, except for closing the position if the stock breaks below the downside break-even point. Since put options tend to lose time value premium rather quickly after they become in-the-money options, there is not normally an opportunity to roll Chapter 24: Ratio Spreads Using Puts 361 down. Rather, one should be able to close the position with the puts close to parity if the stock breaks below the downside break-even point. The spreader may want to buy in additional long puts, as was described for call spreads in Chapter 11, but this is not as advantageous in the put spread because of the time value premium shrinkage. This strategy may prove psychologically pleasing to the less experienced investor because he will not lose money on an upward move by the underlying stock. Many of the ratio strategies that involve call options have upside risk, and a large number of investors do not like to lose money when stocks move up. Thus, although these investors might be attracted to ratio strategies because of the possibility of col­ lecting the profits on the sale of multiple out-of-the-money options, they may often prefer ratio put spreads to ratio call spreads because of the small upside risk in the put strategy. USING DELTAS The "delta spread" concept can also be used for establishing and adjusting neutral ratio put spreads. The delta spread was first described in Chapter 11. A neutral put spread can be constructed by using the deltas of the two put options involved in the spread. The neutral ratio is determined by dividing the delta of the put at the higher strike by the delta of the put at the lower strike. Referring to the previous example, suppose the delta of the January 45 put is -.30 and the delta of the January 50 put is -.50. Then a neutral ratio would be 1.67 (-.50 divided by -.30). That is, 1.67 puts would be sold for each put bought. One might thus sell 5 January 45 puts and buy 3 January 50 puts. This type of spread would not change much in price for small fluctuations in the underlying stock price. However, as time passes, the preponderance of time value premium sold via the January 45 puts would begin to tum a profit. As the underlying stock moves up or down by more than a small distance, the neutral ratio between the two puts will change. The spreader can adjust his position back into a neutral one by selling more January 45's or buying more January 50's. THE RATIO PUT CALENDAR SPREAD The ratio put calendar spread consists of buying a longer-term put and selling a larg­ er quantity of shorter-term puts, all with the same striking price. The position is gen­ erally established with out-of-the-money puts that is, the stock is above the striking price - so that there is a greater probability that the near-term puts will expire worth- 362 Part Ill: Put Option Strategies less. Also, the position should be established for a credit, such that the money brought in from the sale of the near-term puts more than covers the cost of the longer-term put. If this is done and the near-term puts expire worthless, the strate­ gist will then own the longer-term put free, and large profits could result if the stock subsequently experiences a sizable downward movement. Example: If XYZ were at 55, and the January 50 put was at 1 ½ with the April 50 at 2, one could establish a ratio put calendar spread by buying the April 50 and selling two January 50 puts. This is a credit position, because the sale of the two January 50 puts would bring in $300 while the cost of the April 50 put is only $200. If the stock remains above 50 until January expiration, the January 50 puts will expire worthless and the April 50 put will be owned for free. In fact, even if the April 50 put should then expire worthless, the strategist will make a small profit on the overall position in the amount of his original credit - $100 - less commissions. However, after the Januarys have expired worthless, if XYZ should drop dramatically to 25 or 20, a very large profit would accrue on the April 50 put that is still owned. The risk in the position could be very large if the stock should drop well below 50 before the January puts expire. For example, if XYZ fell to 30 prior to January expiration, one would have to pay $4,000 to buy back the January 50 puts and would receive only $2,000 from selling out his long April 50 put. This would represent a rather large loss. Of course, this type of tragedy can be avoided by taking appropri­ ate follow-up action. Nomwlly, one would close the position if the stock fell rrwre than 8 to 10% below the striking price before the near-term puts expire. As with any type of ratio position, naked options are involved. This increases the collateral requirement for the position and also means that the strategist should allow enough collateral in order for the follow-up action point to be reached. In this exam­ ple, the initial requirement would be $750 (20% of $5,500, plus the $150 January premium, less the $500 by which the naked January 50 put is out-of-the-money). However, if the strategist decides that he will hold the position until XYZ falls to 46, he should allow $1,320 in collateral (20% of $4,600 plus the $400 in-the-money amount). Of course, the $100 credit, less commissions, generated by the initial posi­ tion can be applied against these collateral requirements. This strategy is a sensible one for the investor who is willing to accept the risk of writing a naked put. Since the position should be established with the stock above the striking price of the put options, there is a reasonable chance that the near-term puts will expire worthless. This means that some profit will be generated, and that the profit could be large if the stock should then experience a large downward move before the longer-term puts expire. One should take care, however, to limit his losses Chapter 24: Ratio Spreads Using Puts 363 before near-term expiration, since the eventual large profits will be able to overcome a series of small losses, but could not overcome a preponderance oflarge losses. RATIO PUt CALENDARS Using the deltas of the puts in the spread, the strategist can construct a neutral posi­ tion. If the puts are initially out-of-the-money, then the neutral spread generally involves selling more puts than one buys. Another type of ratioed put calendar can be constructed with in-the-money puts. As with the companion in-the-money spread with calls, one would buy more puts than he sells in order to create a neutral ratio. In either case, the delta of the put to be purchased is divided by the delta of the put to be sold. The result is the neutral ratio, which is used to determine how many puts to sell for each one purchased. Example: Consider the out-of-the-money case. XYZ is trading at 59. The January 50 put has a delta of 0.10 and the April 50 put has a delta of -0.17. If a calendar spread is to be established, one would be buying the April 50 and selling the January 50. Thus, the neutral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts would be sold for every 10 purchased. This spread has naked puts and therefore has large risk if the underlying stock declines too far. However, follow-up action could be taken if the stock dropped in an orderly manner. Such action would be designed to limit the downside risk. Conversely, the calendar spread using in-the-money puts would normally have one buying more options than he is selling. An example using deltas will demonstrate this fact: Example: XYZ is at 59. The January 60 put has a delta of -0.45 and the April 60 put has a delta of -0.40. It is normal for shorter-term, in-the-money options to have a delta that is larger (in absolute terms) than longer-term, in-the-money options. The neutral ratio for this spread would be 0.889 (-0.40/-0.45). That is, one would sell only 0.889 puts for each one he bought. Alternatively stated, he would sell 8 and buy 9. A spread of this type has no naked puts and therefore does have large downside profit potential. If the stock should rise too far, the loss is limited to the initial debit of the spread. The optimum result would occur if the stock were at the strike at expi­ ration because, even though the excess long put would lose money in that case, the spreads involving the other puts would overcome that small loss. Another risk of the in-the-money put spread is that one might be assigned rather quickly if the stock should drop. In fact, one must be careful not to establish 364 Part Ill: Put Option Strategies the spread with puts that are too deeply in-the-money, for this reason. While being put will not necessarily change the profitability of the spread, it will mean increased commission costs and margin charges for the customer, who must buy the stock upon assignment. A LOGICAL EXTENSION (THE RATIO CALENDAR COMBINATION) The previous section demonstrated that ratio put calendar spreads can be attractive. The ratio call calendar spread was described earlier as a reasonably attractive strate­ gy for the bullish investor. A logical combination of these two types of ratio calendar spreads (put and call) would be the ratio combination - buying a longer-term out-of­ the-money combination and selling several near-term out-of-the-money combina­ tions. Example: The following prices exist: XYZ common: 55 XYZ January 50 put: XYZ January 60 call: XYZ April 50 put: 2 XYZ April 60 call: 5 One could sell the near-term January combination (January 50 put and January 60 call) for 5 points. It would cost 7 points to buy the longer-term April combination (April 50 put and April 60 call). By selling more January combinations than April com­ binations bought, a ratio calendar combination could be established. For example, suppose that a strategist sold two of the near-term January combinations, bringing in 10 points, and simultaneously bought one April combination for 7 points. This would be a credit position, a credit of 3 points in this example. If the near-term, out-of-the­ money combination expires worthless, a guaranteed profit of 3 points will exist, even if the longer-term options proceed to expire totally worthless. If the near-term com­ bination expires worthless, the longer-term combination is owned for free, and a large profit could result on a substantial stock price movement in either direction. Although this is a superbly attractive strategy if the near-term options do, in fact, expire worthless, it must also be monitored closely so that large losses do not occur. These large losses would be possible if the stock broke out in either direction too quickly, before the near-term options expire. In the absence of a technical opin­ ion on the underlying stock, one can generally compute a stock price at which it might be reasonable to take follow-up action. This is a similar analysis to the one Chapter 24: Ratio Spreads Using Puts 365 described for ratio call calendar spreads in Chapter 12. Suppose the stock in this example began to rally. There would be a point at which the strategist would have to pay 3 points of debit to close the call side of the combination. That would be his break-even point. Example: With XYZ at 65 at January expiration (5 points above the higher strike of the original combination), the near-term January 60 call would be worth 5 points and the longer-term April 60 call might be worth 7 points. If one closed the call side of the combination, he would have to pay 10 points to buy back two January 60 calls, and would receive 7 points from selling out his April 60. This closing transaction would be a 3-point debit. This represents a break-even situation up to this point in time, except for commissions, since a 3-point credit was initially taken in. The strate­ gist would continue to hold the April 50 put (the January 50 put would expire worth­ less) just in case the improbable occurs and the underlying stock plunges below 50 before April expiration. A similar analysis could be performed for the put side of the spread in case of an early downside breakout by the underlying stock. It might be determined that the downside break-even point at January expiration is 46, for exam­ ple. Thus, the strategist has two parameters to work with in attempting to limit loss­ es in case the stock moves by a great deal before near-term expiration: 65 on the upside and 46 on the downside. In practice, if the stock should reach these levels before, rather than at, January expiration, the strategist would incur a small loss by closing the in-the-money side of the combination. This action should still be taken, however, as the objective of risk management of this strategy is to take small losses, if necessary. Eventually, large profits may be generated that could more than compen­ sate for any small losses that were incurred. The foregoing follow-up action was designed to handle a volatile move by the underlying stock prior to near-term expiration. Another, perhaps more common, time when follow-up action is necessary is when the underlying stock is relatively unchanged at near-term expiration. If XYZ in the example above were near 55 at January expiration, a relatively large profit would exist at that time: The near-term combination would expire worthless for a gain of 10 points on that sale, and the longer-term combination would probably still be worth about 5 points, so that the unrealized loss on the April combination would be only 2 points. This represents a total (realized and unrealized) gain of 8 points. In fact, as long as the near-term com­ bination can be bought back for less than the original 3-point credit of the position, the position will show a total unrealized gain at near-term expiration. Should the gain be taken, or should the longer-term combination be held in hopes of a volatile move by the underlying stock? Although the strategist will normally handle each position 366 Part Ill: Put Option Strategies on a case-by-case basis, the general philosophy should be to hold on to the April com­ bination. A profit is already guaranteed at this time - the worst that can happen is a 3-point profit (the original credit). Consequently, the strategist should allow himself the opportunity to make large profits. The strategist may want to attempt to trade out of his long combination, since he will not risk making the position a losing one by doing so. Technical analysis may be able to provide him with buy or sell zones on the stock, and he would then consider selling out his long options in accordance with these technical levels. In summary, this strategy is very attractive and should be utilized by strategists who have the expertise to trade in positions with naked options. As long as risk man­ agement principles of taking small losses are adhered to, there will be a large proba­ bility of overall profit from this strategy. PUT OPTION SUMMARY This concludes the section on put option strategies. The put option is useful in a vari­ ety of situations. First, it represents a more attractive way to take advantage of a bear­ ish attitude with options. Second, the use of the put options opens up a new set of strategies - straddles and combinations - that can present reasonably high levels of profit potential. Many of the strategies that were described in Part II for call options have been discussed again in this part. Some of these strategies were described more fully in terms of philosophy, selection procedures, and follow-up action when they were first discussed. The second description the one involving put options - was often shortened to a more mechanical description of how puts fit into the strategy. This format is intentional. The reader who is planning to employ a certain strategy that can be established with either puts or calls (a bear spread, for example) should familiarize himself with both applications by a simultaneous review of the call chap­ ter and its analogous put chapter. The combination strategies generally introduced new concepts to the reader. The combination allows the construction of positions that are attractive with either puts or calls (out-of-the-money calendar spreads, for example) to be combined into one position. The four combination strategies that involve selling short-term options and simultaneously buying longer-term options are complex, but are most attractive in that they have the desirable features of limited risk and large potential profits. CHAPTER 25 LEAPS In an attempt to provide customers with a broader range of derivative products, the options exchanges introduced LEAPS. This chapter does a fair amount of reviewing basic option facts in order to explain the concepts behind LEAPS. The reader who has a knowledge of the preceding chapters and therefore does not need the review will be able to quickly skim through this chapter and pick out the strategically impor­ tant points. However, if one encounters concepts here that don't seem familiar, he should review the earlier chapter that discusses the pertinent strategy. The term LEAPS is a name for "long-term option." A LEAPS is nothing more than a listed call or put option that is issued with two or more years of time remain­ ing. It is a longer-term option than we are used to dealing with. Other than that, there is no material difference between LEAPS and the other calls and puts that have been discussed in the previous chapters. LEAPS options were first introduced by the CBOE in October 1990, and were offered on a handful of blue-chip stocks. Their attractiveness spurred listings on many underlying stocks on all option exchanges as well as on several indices. (Index options are covered in a later section of the book.) Strategies involving long-term options are not substantially different from those involving shorter-term options. However, the fact that the option has so much time remaining seems to favor the buyer and be a detriment to the seller. This is one rea­ son why LEAPS have been popular. As a strategist, one knows that the length of time remaining has little to do with whether a certain strategy makes sense or not. Rather, it is the relative value of the option that dictates strategy. If an option is overpriced, it is a viable candidate for selling, whether it has two years of life remaining or two months. Obviously, follow-up action may become much more of a necessity during the life of a two-year option; that matter is discussed later in this chapter. 361 368 Part Ill: Put Option Strategies THE BASICS Certain facets of LEAPS are the same as for other listed equity options, while others involve slight differences. The amount of standardization is considerably less, which makes the simple process of quoting LEAPS a bit more tedious. LEAPS are listed options that can be traded in a secondary market or can be exercised before expira­ tion. As with other listed equity options, they do not receive the dividend paid by the underlying common stock. Recall that four specifications uniquely describe any option contract: 1. the type (put or call), 2. the underlying stock name (and symbol), 3. the expiration date, and 4. the striking price. Type. LEAPS are puts or calls. The LEAPS owner has the right to buy the stock at the striking price (LEAPS call) or sell it there (LEAPS put). This is exactly the same for LEAPS and for regular equity options. Underlying Stock and Quote Symbol. The underlying stocks are the same for LEAPS as they are for equity options. The base symbol in an option quote is the part that designates the underlying stock. For equity options, the base symbol is the same as the stock symbol. However, until the Option Price Reporting Authority ( OPRA) changes the way that all options are quoted, the base symbols for LEAPS are not the same as the stock symbols. For example, LEAPS options on stock XYZ might trade under the base symbol WXY; so it is possible that one stock might have listed options trading with different base symbols even though all the symbols refer to the same underlying stock. Check with your broker to determine the LEAPS symbol if you need to know it. Expiration Date. LEAPS expire on the Saturday following the third Friday of the expiration month, just as equity options do. One must look in the newspaper, ask his broker, or check the Internet (www.cboe.com) to determine what the expiration months are, however, since they are also not completely standardized. When LEAPS were first listed, there were differing expiration months through December 1993. At the current time, LEAPS are issued to expire in January of each year, so some attempt is being made at standardization. However, there is no guarantee that vary­ ing expiration months won't reappear at some future time. Chapter 25: LEAPS 369 Striking Price. There is no standardized striking price interval for LEAPS as there is for equity options. If XYZ is a 95-dollar stock, there might be LEAPS with striking prices of 80, 95, and 105. Again, one must look in the newspaper, ask his bro­ ker, or check the Internet (www.cboe.com) to determine the actual LEAPS striking prices for any specific underlying stock. New striking prices can be introduced when the underlying stock rises or falls too far. For example, if the lowest strike for XYZ were 80 and the stock fell to 80, a new LEAPS strike of 70 might be introduced. Other Basic Factors. LEAPS may be exercised at any time during their life, just as is the case with equity options. Note that this statement regarding exercise is not necessarily true for Index LEAPS or Index Options. See Part V of this book for discussions of index products. Standard LEAPS contracts are for 100 shares of the underlying stock, just as equity options are. The number of shares would be adjusted for stock splits and stock dividends (leading to even more arcane LEAPS symbol problems). LEAPS are quot­ ed on a per-share basis, as are other listed options. There are position and exercise limits for LEAPS just as there are for other list­ ed options. One must add his LEAPS position and his regular equity option position together in order to determine his entire position quantity. Exemptions may be obtained for bona fide hedgers of common stock. As time passes, LEAPS eventually have less than 9 months remaining until expi­ ration. When such a time is reached, the LEAPS are "renamed" and become ordi­ nary equity options on the underlying security. Example: Assume LEAPS on stock XYZ were initially issued to expire two years hence. Assume that one of these LEAPS is the XYZ January 90; that is, it has a strik­ ing price of 90 and expires in January, two years from now. Its symbol is WXYAR (WXY being the LEAPS base symbol assigned by the exchange where XYZ is traded, A for January, and R for 90). Fifteen months later, the January LEAPS only have 9 months of life remaining. The LEAPS symbol would be changed from WXYAR to XYZAR (a regular equity option), and the quotes would be listed in the regular equity option section of the newspaper instead of in the LEAPS section. PRICING LEAPS Terms such as in-the-money, out-of-the-money, intrinsic value, time value premium, and parity all apply and have the same definitions. The factors influencing the prices of LEAPS are the same as those for any other option: 370 Part Ill: Put Option Strategies 1. underlying stock price, 2. striking price, 3. time remaining, 4. volatility, 5. risk-free interest rate, and 6. dividend rate. The relative influence of these factors may be a little more pronounced for LEAPS than it is for shorter-term equity options. Consequently, the trader may think that a LEAPS is overly expensive or cheap by inspection, when in reality it is not. One should be careful in his evaluation of LEAPS until he has acquired experience in observing how their prices relate to the shorter-tenn equity options with which he is experienced. It might prove useful to reexamine the option pricing curve with some LEAPS included. Please refer to Figure 25-1 for the pricing curves of several options. As always, the solid intrinsic value line is the bottom line; it is the same for any call option. The curves are all drawn with the same values for the pertinent variables: stock price, striking price, volatility, short-term interest rate, and dividends. Thus, they can be compared directly. The most obvious thing to notice about the curves in Figure 25-1 is that the curve depicting the 2-year LEAPS is quite flat. It has the general shape of the shorter-term curves, but there is so much time value at stock prices even 25% in­ or out-of-the-money, that the 2-year curve is much flatter than the others. Other observations can be made as well. Notice the at-the-money options: The 2-year LEAPS sells for a little more than four times the 3-month option. As we shall see, this can change with the effects of interest rates and dividends, but it confirms something that was demonstrated earlier: Time decay is not linear. Thus, the 2-year LEAPS, which has eight times the amount of time remaining as compared to the 3- month call, only sells for about four times as much. This LEAPS might appear cheap to the casual observer, but remember that these graphs depict the fair values for this set of input parameters. Do not be deluded into thinking that a LEAPS looks cheap merely by comparing its price to a nearer-term option; use a model to evaluate it, or at least use the output of someone else's model. The curves in Figure 25-1 depict the relationships between stock price, striking price, and time remaining. The most important remaining determinant of an option's price is the volatility of the underlying stock. Changes in volatility can greatly change the price of any option. This is especially true for LEAPS, since a long-term option's price will fluctuate greatly when volatility changes only a little. Some observations on the differing effects that volatility changes have on short- and long-term options are presented later. Chapter 25: LEAPS FIGURE 25-1. LEAPS call pricing curve. 45 40 35 Q) 30 .g o. 25 'lii U 20 15 10 5 , .... ,, Various Expiration Dates Strike= 80 2 Years (LEAP) , ' ' ,,,,' ,, ,, ,, ,, ,, "' ,, ,, ,, ,, ,,' ,, ,. ,, ,, 0 L----~==--..l.---..J£----1.---L----.I....-- 60 70 80 90 100 110 Stock Price 371 Before that discussion, however, it may be beneficial to examine the effects that interest rates and dividends can have on LEAPS. These effects are much, much greater than those on conventional equity options. Recall that it was stated that inter­ est rates and dividends are minor determinants in the price of an option, unless the dividends were large. That statement pertains mostly to short-term options. For longer-term options such as LEAPS, the cumulative effect of an interest rate or div­ idend over such a long period of time can have a magnified effect in terms of the absolute price of the option. Figure 25-2 presents the option pricing curve again, but the only option depict­ ed is a 2-year LEAPS. The striking price is 100, and the straight line at the right depicts the intrinsic value of the LEAPS. The three curves represent option prices for risk-free interest rates of 3%, 6%, and 9%. All other factors (time to expiration, volatility, and dividends) are fixed. The difference between option prices caused merely by a shift in rates of 3% is very large. The difference in LEAPS prices increases as the LEAPS becomes in-the­ money. Note that in this figure, the distance between the curves gets wider as one scans them from left to right. The price difference for out-of-the-money LEAPS is large enough- nearly a point even for options fairly far out-of-the-money (that is, the points on the left-hand side of the graph). A shift of 3% in rates causes a larger price difference of over 2 points in the at-the-money, 2-year LEAPS. The largest differen­ tial in option prices occurs in-the-rrwney ! This may seem somewhat illogical, but when LEAPS strategies are examined later, the reasons for this will become clear. 372 Part Ill: Put Option Strategies Suffice it to say that the in-the-money LEAPS are changed in price by over 4 points when rates change by 3%. That is a monstrous differential and should cause any trad­ er who is considering trading in-the-money LEAPS to consider what his outlook is for short-term interest rates. There is always a substantial probability that rates can change by 3% in two years. Thus, it is difficult to predict with any certainty what risk-free rate to use in the pricing of two-year LEAPS. Moreover, one should be very careful when deciding LEAPS are "cheap" or "expensive" because, conventionally, the short-term interest rate is not usually considered as a significant factor in making such an analysis. For LEAPS, however, Figure 25-2 is obvious proof that interest rate considerations are important for LEAPS traders. Now consider dividends. Figure 25-3 depicts the prices of two-year LEAPS calls. The three curves on the graph are for different dividend rates - the top line representing the current rate, the middle line representing prices if the dividend were raised by $1 annually, and the bottom line showing what prices would be if the dividend were raised by $2 annually. All other factors (volatility, time remain­ ing, and risk-free interest rates) are the same for each curve in this graph. The increase in dividends manifests itself by decreasing the LEAPS call price. The rea­ son that this is true, of course, is that the stock will be reduced in price more when it goes ex-dividend by the larger amounts of the increased dividends. FIGURE 25-2. 2-year LEAPS call pricing curve, interest rate comparison. 35 30 25 Q) (.) ~ 20 C: 0 a 15 0 10 5 Stock Price Chapter 25: LEAPS FIGURE 25-3. LEAPS call pricing curve as dividends increase. 30 25 (I) .g 20 0.. C: :g_ 15 0 10 5 0 70 80 90 100 Stock Price With Current Dividend 110 373 Dividend )> Increases $1 T Increases $2 120 The actual amount that the LEAPS calls lose in price increases slightly as the call is more in-the-money. That is, the curves are closer together on the left-hand (out-of-the-money) side than they are on the right-hand (in-the-money) side. For the in-the-money call, a $1 increase in dividends over two years can cause the LEAPS to be worth about 1 ½ points less in value. Figure 25-3 is to the same scale as Figure 25-2, so they can be compared direct­ ly in terms of magnitude. Notice that the effect of a $1 increase in dividends on the LEAPS call prices is much smaller than that of an increase in interest rates by 3%. Graphically speaking, one can observe this by noting that the spaces between the three curves in the previous figure are much wider than the spaces between the three curves in this figure. Finally, note that dividend increases have the opposite effect on puts. That is, an increase in the dividend payout of the underlying common will cause a put to increase in price. If the put is a long-term LEAPS put, then the effect of the increase will be even larger. Lest one think that LEAPS are too difficult to price objectively, note the follow­ ing. The prior figures of interest rate and dividend effects tend to magnify the effects on LEAPS prices for two reasons. First, they depict the effects on 2-year LEAPS. That is a large amount of life for LEAPS. Many LEAPS have less life remaining, so the effects would be diminished somewhat for LEAPS with 10 to 23 months of life left. 374 Part Ill: Put Option Strategies Second, the figures depict the change in rates or dividends as being instantaneous. This is not completely realistic. If rates change, they will change by a little bit at a time, usually¼% or½% at a time, perhaps as much as 1 %. If dividends are increased, that increase may be instantaneous, but it will not likely occur immediately after the LEAPS are purchased or sold. However, the point that these figures are meant to con­ vey is that interest rates and dividends have a much greater effect on LEAPS than on ordinary shorter-term equity options, and that is certainly a true statement. COMPARING LEAPS AND SHORT-TERM OPTIONS Table 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or with a model. All of the variables - stock price, volatility, interest rates, and dividends - are given in increments and the comparison is shown between 3-month equity options and 2-year LEAPS. There are three sets of comparisons: for options 20% out­ of-the-money, options at-the-money, and options 20% in-the-money. A few words are needed here to explain how volatility is shown in this table. Volatility is normally expressed as a percent. The volatility of the stock market is about 15%. The table shows what would happen if volatility changed by one per­ centage point, to 16%, for example. Of course, the table also shows what would hap­ pen if the other factors changed by a small amount. Most of the discrepancies between the 3-month and the 2-year options are large. For example, if volatility increases by one percentage point, the 3-month out­ of-the-money call will increase in price by only 3 cents (0.03 in the left-hand column) while the 2-year LEAPS call will increase by 43 cents. As another example, look at the bottom right-hand pair of numbers, which show the effect of a dividend increase on the options that are 20% in-the-money. The assumption is that the dividend will increase 25 cents this quarter (and will be 25 cents higher every quarter thereafter). This translates into a loss of 14 cents for the 3-month call, since there is only one ex­ dividend period that affects this call; but it translates into a loss of 1 ½ for the 2-year LEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call. TABLE 25-1. Comparing LEAPS and Short-Term Calls. Change in Price of the Options 20% out at 20% in Variable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr . Stock Pre. + 1 pt . 03 .41 .54 .70 .97 .89 Volatility + 1% .03 .43 .21 .48 .04 .33 Int. Rate + 1/2% .01 .27 .08 .55 .14 .72 Dividend + $.25/qtr 0 -.62 -.08 -1.18 -.14 -1.50 Chapter 25: LEAPS 375 The table also shows that only three of the discrepancies are not large. Two involve the stock price change. If the stock changes in price by 1 point, neither the at­ the-money nor the in-the-money options behave very differently, although the at-the­ money LEAPS do jump by 70 cents. The observant reader will notice that the top line of the table depicts the delta of the options in question; it shows the change in option price for a one-point change in stock price. The only other comparison that is not extremely divergent is that of volatility change for the at-the-money option. The 3- month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is still a factor of two-to-one, but is much less than the other comparisons in the table. Study the other comparisons in the table. The trader who is used to dealing with short-term options might ordinarily ignore the effect of a rise in interest rates of ½ of 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by a mere 1 %, or maybe even of the stock moving by one point (only if his option is out­ of-the-money). The LEAPS option trader will gain or suffer substantially and imme­ diately if any of these occur. In almost every case, his LEAPS call will gain or lose ½ point of value - a significant amount, to be sure. LEAPS STRATEGIES Many of the strategies involving LEAPS are not significantly different from their counterparts that involve short-term options. However, as shown earlier, the long­ term nature of the LEAPS can sometimes cause the strategist to experience a result different from that to which he has become accustomed. As a general rule, one would want to be a buyer of LEAPS when interest rates were low and when the volatilities being implied in the marketplace are low. If the opposite were true (high rates and high volatilities), he would lean toward strategies in which the sale of LEAPS is used. Of course, there are many other specific consid­ erations when it comes to operating a strategy, but since the long-term nature of LEAPS exposes one to interest rate and volatility movements for such a long time, one may as well attempt to position himself favorably with respect to those two ele­ ments when he enters a position. LEAPS AS STOCK SUBSTITUTE Any in-the-money option can be used as a substitute for the underlying stock. Stock owners may be able to substitute a long in-the-money call for their long stock. Short sellers of stock may be able to substitute a long put for their short stock. This is not a new idea; it was discussed briefly in Chapter 3 under reasons why people buy calls. It has been available as a strategy for some time with short-term options. Its attrac­ tiveness seems to have increased somewhat with the introduction of LEAPS, howev- 374 Part Ill: Put Option Strategies Second, the figures depict the change in rates or dividends as being instantaneous. This is not completely realistic. If rates change, they will change by a little bit at a time, usually¼% or ½% at a time, perhaps as much as 1 %. If dividends are increased, that increase may be instantaneous, but it will not likely occur immediately after the LEAPS are purchased or sold. However, the point that these figures are meant to con­ vey is that interest rates and dividends have a much greater effect on LEAPS than on ordinary shorter-term equity options, and that is certainly a true statement. COMPARING LEAPS AND SHORT-TERM OPTIONS Table 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or with a model. All of the variables - stock price, volatility, interest rates, and dividends - are given in increments and the comparison is shown between 3-month equity options and 2-year LEAPS. There are three sets of comparisons: for options 20% out­ of-the-money, options at-the-money, and options 20% in-the-money. A few words are needed here to explain how volatility is shown in this table. Volatility is normally expressed as a percent. The volatility of the stock market is about 15%. The table shows what would happen if volatility changed by one per­ centage point, to 16%, for example. Of course, the table also shows what would hap­ pen if the other factors changed by a small amount. Most of the discrepancies between the 3-month and the 2-year options are large. For example, if volatility increases by one percentage point, the 3-month out­ of-the-money call will increase in price by only 3 cents (0.03 in the left-hand column) while the 2-year LEAPS call will increase by 43 cents. As another example, look at the bottom right-hand pair of numbers, which show the effect of a dividend increase on the options that are 20% in-the-money. The assumption is that the dividend will increase 25 cents this quarter ( and will be 25 cents higher every quarter thereafter). This translates into a loss of 14 cents for the 3-month call, since there is only one ex­ dividend period that affects this call; but it translates into a loss of 1 ½ for the 2-year LEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call. TABLE 25-1. Comparing LEAPS and Short-Term Calls. Change in Price of the Options 20% out al 20% in Variable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr. Stock Pre. + 1 pt .03 .41 .54 .70 .97 .89 Volatility + 1% .03 .43 .21 .48 .04 .33 Int. Rate + 1/2% .01 .27 .08 .55 .14 .72 Dividend + $.25/qtr 0 -.62 -.08 - l.18 -.14 -1.50 Chapter 25: LEAPS 375 The table also shows that only three of the discrepancies are not large. Two involve the stock price change. If the stock changes in price by 1 point, neither the at­ the-money nor the in-the-money options behave very differently, although the at-the­ money LEAPS do jump by 70 cents. The observant reader will notice that the top line of the table depicts the delta of the options in question; it shows the change in option price for a one-point change in stock price. The only other comparison that is not extremely divergent is that of volatility change for the at-the-money option. The 3- month call changes by 21 cents while the LEAPS changes by nearly ½ point. This is still a factor of two-to-one, but is much less than the other comparisons in the table. Study the other comparisons in the table. The trader who is used to dealing with short-term options might ordinarily ignore the effect of a rise in interest rates of½ of 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by a mere 1 %; or maybe even of the stock moving by one point (only if his option is out­ of-the-money). The LEAPS option trader will gain or suffer substantially and imme­ diately if any of these occur. In almost every case, his LEAPS call will gain or lose ½ point of value - a significant amount, to be sure. LEAPS STRATEGIES Many of the strategies involving LEAPS are not significantly different from their counterparts that involve short-term options. However, as shown earlier, the long­ term nature of the LEAPS can sometimes cause the strategist to experience a result different from that to which he has become accustomed. As a general rule, one would want to be a buyer of LEAPS when interest rates were low and when the volatilities being implied in the marketplace are low. If the opposite were true (high rates and high volatilities), he would lean toward strategies in which the sale of LEAPS is used. Of course, there are many other specific consid­ erations when it comes to operating a strategy, but since the long-term nature of LEAPS exposes one to interest rate and volatility movements for such a long time, one may as well attempt to position himself favorably with respect to those two ele­ ments when he enters a position. LEAPS AS STOCK SUBSTITUTE Any in-the-money option can be used as a substitute for the underlying stock. Stock owners may be able to substitute a long in-the-money call for their long stock. Short sellers of stock may be able to substitute a long put for their short stock. This is not a new idea; it was discussed briefly in Chapter 3 under reasons why people buy calls. It has been available as a strategy for some time with short-term options. Its attrac­ tiveness seems to have increased somewhat with the introduction of LEAPS, howev- 376 Part Ill: Put Option Strategies er. More and more people are examining the potential of selling the stock they own and buying long-term calls (LEAPS) as a substitute, or buying LEAPS instead of making an initial purchase in a particular common stock. Substitution for Stock Currently Held Long. Simplistically, this strate­ gy involves this line of thinking: If one owns stock and sells it, an investor could rein­ vest a small portion of the proceeds in a call option, thereby providing continued upside profit potential if the stock rises in price, and invest the rest in a bank to earn interest. The interest earned would act as a substitute for the dividend, if any, to which the investor is no longer entitled. Moreover, he has less downside risk: If the stock should fall dramatically, his loss is limited to the initial cost of the call. In actual practice, one should carefully calculate what he is getting and what he is giving up. For example, is the loss of the dividend too great to be compensated for by the investment of the excess proceeds? How much of the potential gain will be wasted in the form of time value premium paid for the call? The costs to the stock owner who decides to switch into call options as a substitute are commissions, the time value premium of the call, and the loss of dividends. The benefits are the inter­ est that can be earned from freeing up a substantial portion of his funds, plus the fact that there is less downside risk in owning the call than in owning the stock. Example: XYZ is selling at 50. There are one-year LEAPS with a striking price of 40 that sell for $12. XYZ pays an annual dividend of $0.50 and short-term interest rates are 5%. What are the economics that an owner of 100 XYZ common stock must cal­ culate in order to determine whether it is viable to sell his stock and buy the one-year LEAPS as a substitute? The call has time value premium of 2 points (40 + 12 - 50). Moreover, if the stock is sold and the LEAPS purchased, a credit of $3,800 less commissions would be generated. First, calculate the net credit generated: Credit balance generated: Sale of 1 00 XYZ stock Less stock commission Net sale proceeds: Cost of one LEAPS call Plus option commission Net cost of call: Total credit balance: $5,000 25 $4,975 credit $3,760 credit $1,200 15 $1,215 debit Now the costs and benefits of making the switch can be computed: Chapter 25: LEAPS Costs of switching: Time value premium Loss of dividend Stock commissions Option commissions Total cost: Fixed benefit from switching: Interest earned on credit balance of $3,760 at 5% interest for one year= 0.05 x $3,760: Net cost of switching: 317 -$200 -$ 50 -$ 25 - .l__Ll_ -$290 + $188 - $102 The stock owner must now decide if it is worth just over $1 per share in order to have his downside risk limited to a price of 39½ over the next year. The price of 39½ as his downside risk is merely the amount of the net credit he received from doing the switch ($3,760) plus the interest earned ($188), expressed in per-share terms. That is, if XYZ falls dramatically over the next year and the LEAPS expires worthless, this investor will still have $3,948 in a bank account. That is equivalent to limiting his risk to about 39½ on the original 100 shares. If the investor decides to make the substitution, he should invest the proceeds from the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the current rate - the one used in his calculations - for the year. Second, he is not tempt­ ed to use the money for something else, an action that might negate the potential benefits of the substitution. The above calculations all assume that the LEAPS call or the stock would have been held for the full year. If that is known not to be the case, the appropriate costs or benefits must be recalculated. Caveats. This ($102) seems like a reasonably small price to pay to make the switch from common stock to call ownership. However, if the investor were planning to sell the stock before it fell to 39½ in any case, he might not feel the need to pay for this protection. (Be aware, however, that he could accomplish essentially the same thing, since he can sell his LEAPS call whenever he wants to.) Moreover, when the year is up, he will have to pay another stock commission to repurchase his XYZ common if he still wants to own it ( or he will have to pay two option commissions to roll his long call out to a later expiration date). One other detriment that might exist, although a relatively unlikely one, is that the underlying common might declare an increased dividend or, even worse, a special cash dividend. The LEAPS call owner would not be entitled to that dividend increase in whatever form, while, obviously, the common 378 Part Ill: Put Option Strategies stock owner would have been. If the company declared a stock dividend, it would have no effect on this strategy since the call owner is entitled to those. A change in interest rates is not a factor either, since the owner of the LEAPS should invest in a 1-year Treasury bill or a 1-year CD and therefore would not be subject to interim changes in short-term interest rates. There may be other mitigating circumstances. Mostly these would involve tax considerations. If the stock is currently a profitable investment, the sale would gen­ erate a capital gain, and taxes might be owed. If the stock is currently being held at a loss, the purchase of the call would constitute a wash sale and the loss could not be taken at this time. (See Chapter 41 on taxes for a broader discussion of the wash sale rule and option trading.) In tl1eory, the calculations above could produce an overall credit, in which case the stockholder W(?uld normally want to substitute with the call, unless he has overriding tax considerations or suspects that a cash dividend increase is going to be announced. Be very careful about switching if this situation should arise. Normally, arbitrageurs - per­ sons trading for exchange members and paying no commission - would take advantage of such a situation before the general public could. If they are letting the opportunity pass by, there must be a reason (probably the cash dividend), so be extremely certain of your economics and research before venturing into such a situation. In summary, holders of common stock on which there exist in-the-money LEAPS should evaluate the economics of substituting the LEAPS call for the com­ mon stock. Even if arithmetic calculations call for the substitution, the stockholder should consider his tax situation as well as his outlook for the cash dividends to be paid by the common before making the switch. BUYING LEAPS AS THE INITIAL PURCHASE INSTEAD OF BUYING A COMMON STOCK Logic similar to that used earlier to determine whether a stockholder might want to substitute a LEAPS call for his stock can be used by a prospective purchaser of com­ mon stock. In other words, this investor does not already own the common. He is going to buy it. This prospective purchaser might want to buy a LEAPS call and put the rest of the money he had planned to use in the bank, instead of actually buying the stock itself. His costs - real and opportunity - are calculated in a similar manner to those expressed earlier. The only real difference is that he has to spend the stock commis­ sion in this case, whereas he did not in the previous example (since he already owned the stock). Chapter 25: LEAPS 379 Example: As before, XYZ is selling at 50; there are 1-year LEAPS with a striking price of 40 that sell for $12; XYZ pays an annual dividend of $0.50, and short-term interest rates are 5%. The initial purchaser of common stock would have certain "opportunity" costs and savings if he decided instead to buy the LEAPS calls. First, calculate the differ­ ence in investment required for the stock versus the LEAPS: Costs: Prospective initial investment: Stock: $5,000 + $25 commission LEAPS: $1,200 + $15 commission Net difference: Now calculate the costs versus the savings: Time value premium Loss of dividend Savings: Interest on $3, 810 for one year at 5%: Net opportunity cost: $5,025 $1,215 $3,810 -$200 -$ 50 +$190 -$ 60 In this case, it seems even more likely that the prospective stock purchaser would instead buy the LEAPS call. His net "cost" of doing so, provided he puts the difference in initial investment in a 1-year CD or Treasury bill, is only $60. For this small amount, he has all the upside appreciation ( except $60 worth), but has risk only down to 40 (he will have $4,000 in his bank account at the end of one year even if the LEAPS expire worthless). This strategy of buying in-the-money LEAPS and putting the difference between the LEAPS cost and the stock cost in an interest-bearing instrument is an attractive one. It might seem it would be especially attractive if interest rates for the differential were high. Unfortunately, those high rates would present something of a catch-22 because, as was shown earlier, higher rates will cause the LEAPS to be more expensive. In this margin strategy, one has the risk of not participating in cash dividend increases or specials as the stockholder who substitutes does. But the other concerns of the stockholder, such as taxes, are not pertinent here. Again, these specific calcu­ lations only apply if the stock were to be held for the entire year. Adjustments would have to be made if the holding period envisioned is shorter. 380 Part Ill: Put Option Strategies Using Margin. The same prospective initial purchaser of common stock might have been contemplating the purchase of the stock on margin. If he used the LEAPS instead, he could save the margin interest. Of course, he wouldn't have as much money to put in the bank, but he should also compare his costs against those of buy­ ing the LEAPS call instead. Example: As before, XYZ is selling at 50; there are 1-year LEAPS with a striking price of 40 that sell for $12; XYZ pays an annual dividend of $0.50; and short-term interest rates are 5%. Furthermore, assume the margin rate is 8% on borrowed debit balances. First, calculate the difference in prospective investments: Cost of buying the stock: $5,000 + $25 commission: Amount borrowed (50%) Equity required Cost of buying LEAPS: $1,200 + $15 commission: Difference (available to be placed in bank account) $5,025 -2,512 $2,513 $1,215 $1,298 Now the costs and opportunities can be compared, if it is assumed that he buys the LEAPS: Costs: Time value premium Dividend loss Savings: Interest on $1,298 at 5% Margin interest on $2,512 debit balance at 8% for one year Net Savings: -$200 - 50 +$ 65 + 201 +$ 16 For the prospective margin buyer, there is a real savings in this example. The fact that he does not have to pay the margin interest on his debit balance makes the purchase of the LEAPS call a cost-saving alternative. Finally, it should be noted that current margin rules allow one to purchase a LEAPS option on margin. That can be accounted for in the above calculations as well; merely reduce the investment required and increase the margin charges on the debit balance. Chapter 25: LEAPS 381 In summary, a prospective purchaser of common stock may often find that if there is an in-the-money option available, the purchase of that option is more attrac­ tive than buying the common stock itself. If he were planning to buy on margin, it is even more likely that the LEAPS purchase will be attractive. The main drawback is that he will not participate if cash dividends are increased or a special dividend is declared. Read on, however, because the next strategy may be better than the one above. PROTECTING EXISTING STOCK HOLDINGS WITH LEAPS PUTS What was accomplished in the substitution strategy previously discussed? The stock owner paid some cost ($102 in the actual example) in order to limit the risk of his stock ownership to a price of 39½. What if he had bought a LEAPS put instead? Forgetting the price of the put for a moment, concentrate on what the strategy would accomplish. He would be protected from a large loss on the downside since he owns the put, and he could participate in upside appreciation since he still owns the stock. Isn't this what the substitution strategy was trying to accomplish? Yes, it is. In this strategy, only one commission is paid- that being on a fairly cheap out-of-the-money LEAPS put - and there is no risk of losing out on dividend increases or special divi­ dends. The comparison between substituting a call or buying a put is a relatively sim­ ple one. First, do the calculations as they were performed in the initial example above. That example showed that the stockholder's cost would be $102 to substitute the LEAPS call for the stock, and such a substitution would protect him at a price of 39½. In effect, he is paying $152 for a LEAPS put with a strike of 40- the $102 cost plus the difference between 40 and the 39½ protection price. Now, if an XYZ 1-year LEAPS put with strike 40 were available at 1 ½, he could accomplish everything he had initially wanted merely by buying the put. Moreover, he would save commissions and still be in a position to participate in increased cash dividends. These additional benefits should make the put worth even more to the stockholder, so that he might pay even slightly more than 1 ½ for the put. If the LEAPS put were available at this price, it would clearly be the bet­ ter choice and should be bought instead of substituting the LEAPS call for the com­ mon stock. Thus, any stockholder who is thinking of protecting his position can do it in one of two ways: Sell the stock and substitute a call, or continue to hold his stock and buy a put to protect it. LEAPS calls and puts are amenable to this strategy. Because of the LEAPS' long-term nature, one does not have to keep reestablishing his position and pay numerous commissions, as he would with short-term options. The stock­ holder should perform the simple calculations as shown above in order to decide 382 Part Ill: Put Option Strategies whether the move is feasible at all, and if it is, whether to use the call substitution strategy or the put protection strategy. LEAPS INSTEAD OF SHORT STOCK Just as in-the-money LEAPS calls may sometimes be a smarter purchase than the stock itself, in-the-money puts may sometimes be a better purchase than shorting the common stock. Recall that either the put purchase or the short sale of stock is a bear­ ish strategy, generally implemented by someone who expects the stock to decline in price. The strategist knows, however, that short stock is a component of many strate­ gies and might reflect other opinions than pure bearishness on the common. In any case, an in-the-money put may prove to be a viable substitute for shorting the stock itself. The two main advantages that the put owner has are that he has limited risk (whereas the short seller of stock has theoretically unlimited risk); and he does not have to pay out any dividends on the underlying stock as the short seller would. Also, the commissions for buying the put would normally be smaller than those required to sell the stock short. There is not much in the way of calculating that needs to be done in order to make the comparison between buying the in-the-money put and shorting the stock. If the time value premium spent is small in comparison \vith the dividend payout that is saved, then the put is probably the better choice. Professional arbitrageurs and other exchange members, as well as some large customers, receive interest on their short sales. For these traders, the put would have to be trading with virtually no time premium at all in order for the comparison to favor the put purchase over the stock short sale. However, the public customer who is going to be shorting stock should be aware of the potential for buying an in-the­ money put instead. SPECULATIVE OPTION BUYING WITH LEAPS Strategists know that buying calls and puts can have various applications; witness the stock substitution strntegies above. However, the most popular reason for buying options is for speculative gain. The leverage inherent in owning options and their lim­ ited risk feature make them attractive for this purpose as well. The risk, of course, can be 100% of the investment, and time decay works against the option owner as well. LEAPS calls and puts fit all of these descriptions; they simply have longer matu­ rities. Time decay is the major enemy of the speculative option holder. Purchasing LEAPS options instead of the shorter-term equity options generally exposes the Chapter 25: LEAPS 383 buyer to less risk of time decay on a daily basis. This is true because the extreme neg­ ative effects of time decay magnify as the option approaches its expiration. Recall that it was shown in Chapter 3 that time decay is not linear: An option decays more rap­ idly at the end of its life than at the beginning. Eventually, a LEAPS put or call will become a normal short-term equity option and time will begin to take a more rapid toll. But in the beginning of the life of LEAPS, there is so much time remaining that the short-term decay is not large in terms of price. Table 25-2 and Figure 25-4 depict the rate of decay of two options: one is at­ the-money (the lower curve) and the other is 20% out-of-the-money (the upper curve). The horizontal axis is months of life remaining until expiration. The vertical axis is the percent of the option price that is lost daily due to time decay. The options that qualify as LEAPS are ones with more than 9 months oflife remaining, and would thus be the ones on the lower right-hand part of the graph. The upward-sloping nature of both curves as time to expiration wanes shows that time decay increases more rapidly as expiration approaches. Notice how much more rapidly the out-of-the-money option decays, percentagewise, than the at-the­ money. LEAPS, however, do not decay much at all compared to normal equity options. Most LEAPS, even the out-of-the-money ones, lose less than¼ of one per­ cent of their value daily. This is a pittance when compared with a 6-month equity option that is 20% out-of-the-money- that option loses well over 1 % of its value daily and it still has 6 months of life remaining. From the accompanying table, observe that the out-of-the-money 2-month option loses over 4% of its value daily! Thus, LEAPS do not decay at a rapid rate. This gives the LEAPS holder a chance to have his opinion about the stock price work for him without having to worry as much about the passage of time as the average equity option holder would. An advantage of owning LEAPS, therefore, is that one's timing of the option pur­ chase does not have to be as exact as that for shorter-term option buying. This can be a great psychological advantage as well as a strategic advantage. The LEAPS option buyer who feels strongly that the stock will move in the desired direction has the lux­ ury of being able to wait calmly for the anticipated move to take place. If it does not, even in perhaps as long as 6 months' time, he may still be able to recoup a reason­ able portion of his initial purchase price because of the slow percentage rate of decay. Do not be deluded into believing that LEAPS don't decay at all. Although the rate of decay is slow (as shown previously), an option that is losing 0.15% of its value daily will still lose about 25% of its value in six months. Example: XYZ is at 60 and there are 18-month LEAPS calls selling for $8, with a striking price of 60. The daily decay of this call with respect to time will be minus- 384 TABLE 25-2. Daily percent time value decay. Months remaining At-the-money 24 .12 18 .14 12 .19 9 .22 6 .27 3 .60 2 .73 1.27 2 wks 3.33 FIGURE 25-4. Daily percent time value decay. 125 100 20% Out-of-the-Money 0 0 ~ ~ 75 - ~ 0 c @ 50 8: 25 0 3 At-the-Money 6 9 12 15 Part Ill: Put Option Strategies Percent Decay 20% Out-of-the-money .18 .27 .55 .76 1.18 3.57 4.43 LEAPS 18 21 24 Months Remaining cule; it will take about a week for even an eighth of a point to be lost due to time. However, if the option is held for six months and nothing else happens, the LEAPS call will be selling for about 6. Thus, it will have lost 25% of its value if the stock remains around 60 at the end of six months. Chapter 25: LEAPS 385 Those familiar with holding equity calls and puts are more accustomed to seeing an option lose 25% of its value in possibly as little as four or five weeks' time. Thus, the advantage of holding the LEAPS is obvious from the viewpoint of slower time decay. This observation leads to the obvious question: "When is the best time to sell my call and repurchase a longer-term one?" Referring again to the figure above may help answer the question. Note that for the at-the-money option, the curve begins to bend dramatically upward soon after the 6-month time barrier is passed. Thus, it seems log­ ical that to minimize the effects of time decay, all other things being equal, one would sell his long at-the-money call when it has about 6 months of life left and simultane­ ously buy a 2-year LEAPS call. This keeps his time decay exposure to a. minimum. The out-of-the-money call is more radical. Figure 25-4 shows that the call that is 20% out-of-the-money begins to decay much more rapidly (percentagewise) at sometime just before it reaches one year until expiration. The same logic would dic­ tate, then, that if one is trading out-of-the-money options, he would sell his option held long when it has about one year to go and reestablish his position by buying a 2- year LEAPS option at the same time. ADVANTAGES OF BUYING HCHEAP" It has been demonstrated that rising interest rates or rising volatility would make the price of a LEAPS call increase. Therefore, if one is attempting to participate in LEAPS speculative call buying strategies, he should be more aggressive when rates and volatilities are low. A few sample prices may help to demonstrate just how powerful the effects of rates and volatilities are, and how they can be a friend to the LEAPS call buyer. Suppose that one buys a 2-year LEAPS call at-the-money when the following situation exists: XYZ: 100 January 2-year LEAPS call with strike of 100: 14 Short-term interest rates: 3% Volatility: below average (historically) For the purposes of demonstration, suppose that the current volatility is low for XYZ (historically) and that 3% is a low level for rates as well. If the stock moves up, there is no problem, because the LEAPS call will increase in price. But what if the stock drops or stays unchanged? Is all hope of a profit lost? Actually, no. If interest rates increase or the volatility that the calls trade at increases, we know the LEAPS call will increase in value as well. Thus, even though the direction in which the stock is mov­ ing may be unfavorable, it might still be possible to salvage one's investment. Table 25-3 shows where volatility would have to be or where short-term rates would have 386 Part Ill: Put Option Strategies TABLE 25-3. Factors necessary for January 2-year LEAPS to be = 14. Stock price After l month 100 (unchanged) r = 3 .4% or V + 5% 95 90 r = 6% or V + 20% r = 8.5% or V + 45% After 6 months r = 6% or V + 20% r = 9.4% or V + 45% r = 12.6% or V + 70% to go in order to keep the value of the LEAPS call at 14 even after the indicated amount of time had expired. To demonstrate the use of this table, suppose the stock price were 100 (unchanged) after one month. If interest rates had 1isen to 3.4% from their original level of 3% during that time, the call would still be worth 14 even though one month had passed. Alternatively, if rates were the same, but volatility had increased by only 5% from its original level, then the call would also still be worth 14. Note that this means that volatility would have to increase only slightly (by ½oth) from its original level, not by 5 percentage points. Even if the stock were to drop to 90 and six months had passed, the LEAPS call holder would still be even if rates had iisen to 12.6% (highly unlikely) or volatility had risen by 70%. It is often possible for volatilities to fluctuate to that extent in six months, but not likely for interest rates. In fact, as interest rates go, only the top line of the table probably represents realistic interest rates; an increase of 0.4% in one month, or 3% in 6 months, is pos­ sible. The other lines, where the stock drops in price, probably require too large a jump in rates for rates alone to be able to salvage the call price. However, any increase in rates will be helpful. Volatility is another matter. It is often feasible for volatilities to change by as much as 50% from their previous level in a month, and certainly in six months. Hence, as has been stated before, the volatility factor is the more dominant one. This table shows the effect of rising interest rates and volatilities on LEAPS calls. It would be beneficial to the LEAPS call owner and, of course, detrimental to the LEAPS call seller. This is clear evidence that one should be aware of the gener­ al level of rates and volatility before using LEAPS options in a strategy. Chapter 25: LEAPS THE DELTA 387 The delta of an option is the amount by which the option price will change if the underlying stock changes in price by one point. In an earlier section of this chapter, comparing the differences between LEAPS and short-term calls, mention was made of delta. The subject is explored in more depth here because it is such an important concept, not only for option buyers, but for most strategic decisions as well. Figure 25-5 depicts the deltas of two different options: 2-year LEAPS and 3- month equity options. Their terms are the same except for their expiration dates; strik­ ing price is 100, and volatility and interest rate assumptions are equal. The horizontal axis displays the stock price while the vertical axis shows the delta of the options. Several relevant observations can be made. First, notice that the delta of the at­ the-money LEAPS is very large, nearly 0.70. This means that the LEAPS call will move much more in line with the common stock than a comparable short-term equi­ ty option would. Very short-term at-the-money options have deltas of about½, while slightly longer-term ones have deltas ranging up to the 0.55 to 0.60 area. What this implies is that the longer the life of an at-the-nwney option, the greater its delta. In addition, the figure shows that the deltas of the 3-month call and the 2-year LEAPS call are about equal when the options a~e approximately 5% in-the-money. If the options are more in-the-money than that, then the LEAPS call has a lower delta. This means that at- and out-of-the-money LEAPS will move more in line with the common stock than comparable short-term options will. Restated, the LEAPS calls will move faster than the ordinary short-term equity calls unless both options are more than 5% in-the-money. Note that the movement referred to is in absolute terms in change of price, not in percentage terms. The delta of the 2-year LEAPS does not change as dramatically when the stock moves as does the delta of the 3-month option (see Figure 25-5). Notice that the LEAPS curve is relatively flat on the chart, rising only slightly above horizon­ tal. In contrast, the delta of the 3-month call is very low out-of-the-money and very large in-the-money. What this means to the call buyer is that the amount by which he can expect the LEAPS call to increase or decrease in price is somewhat stable. This can affect his choice of whether to buy the in-the-money call or the out-of­ the-money call. With normal short-term options, he can expect the in-the-money call to much more closely mirror the movement in the stock, so he might be tempt­ ed to buy that call if he expects a small movement in the stock. With LEAPS, how­ ever, there is much less discrepancy in the amount of option price movement that will occur. 388 Part Ill: Put Option Strategies FIGURE 25·5. Call delta comparison, 2-year LEAPS versus 3-month equity options. 90 80 70 8 60 ,... X .l!l 50 Q) 0 40 30 t= 3 months 20 10 O 70 80 90 100 110 120 130 Stock Price Example: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and there are 2-year LEAPS calls at those strikes as well. The following table summarizes the available information: XYZ: 82 Date: January, 2002 Option Price Delta April ('02) 80 call 4 s/a April ('02) 90 call i/a January ('04) 80 LEAPS call 14 3/4 January ('04) 90 LEAPS call 7 1/2 Suppose the trader expects a 3-point move by the underlying common stock, from 82 to 85. If he were analyzing short-term calls, he would see his potential as a gain of 17/s in the April 80 call versus a gain of 3/s in the April 90 call. Each of these gains is pro­ jected by multiplying the call's delta times 3 (the expected stock move, in points). Thus, there is a large difference between the expected gains from these two options, particularly after commissions are considered. Now observe the LEAPS. The January 80 would increase by 2¼ while the January 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near­ ly as large a discrepancy as the short-term options had. Observe that the January 90 LEAPS sells for half the price of the January 80. These movements projected by the Chapter 25: LEAPS 389 delta indicate that the January 90 LEAPS will move by a larger percentage than the January 80 and therefore would be the better buy. PUT DELTAS Many of the previous observations regarding deltas of LEAPS calls can be applied to LEAPS puts as well. However, Figure 25-5 changes a little when the following for­ mula is applied. Recall that the relationship between put deltas and call deltas, except for deeply in-the-money puts, is: Put delta = Call delta - 1 This has the effect of inverting the relationships that have just been described. In other words, while the short-term calls didn't move as fast as the LEAPS, the short-term puts move Jaster than the LEAPS puts in most cases. Figure 25-6 shows the deltas of these options. The vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS puts and short-term equity puts don't behave very differently in terms of price change (bottom right-hand section of figure). In-the-money puts (when the stock is below the striking price) move faster if they are shorter-term. This fact is accentuated even more when the puts are more deeply in-the-money. The left-hand side of the figure depicts this fact. FIGURE 25-6. Put delta comparison, 2-year LEAPS versus 3-month equity options. 90 80 70 t= 3 months 0 60 0 1 50 X Jg 40 Q) 0 30 20 10 O 70 80 90 100 110 120 130 Stock Price 388 Part Ill: Put Option Strategies FIGURE 25-5. Call delta comparison, 2-year LEAPS versus 3-month equity options. 90 80 70 g 60 ; 50 ~ O 40 30 t= 3 months 20 10 O 70 80 90 100 110 120 130 Stock Price Example: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and there are 2-year LEAPS calls at those strikes as well. The following table summarizes the available information: XYZ: 82 Date: January, 2002 Option Price Delta April ('02) 80 call 4 s/a April ('02) 90 call 1 i/s January ('04) 80 LEAPS call 14 3/4 January ('04) 90 LEAPS call 7 1/2 Suppose the trader expects a 3-point move by the underlying common stock, from 82 to 85. Ifhe were analyzing short-term calls, he would see his potential as a gain of F/s in the April 80 call versus a gain of 3/s in the April 90 call. Each of these gains is pro­ jected by multiplying the call's delta times 3 (the expected stock move, in points). Thus, there is a large difference behveen the expected gains from these two options, particularly after commissions are considered. Now observe the LEAPS. The January 80 would increase by 2¼ while the January 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near­ ly as large a discrepancy as the short-term options had. Observe that the January 90 LEAPS sells for half the price of the January 80. These movements projected by the Chapter 25: LEAPS 389 delta indicate that the January 90 LEAPS will move by a larger percentage than the January 80 and therefore would be the better buy. PUT DELTAS Many of the previous observations regarding deltas of LEAPS calls can be applied to LEAPS puts as well. However, Figure 25-5 changes a little when the following for­ mula is applied. Recall that the relationship between put deltas and call deltas, except for deeply in-the-money puts, is: Put delta = Call delta - 1 This has the effect of inverting the relationships that have just been described. In other words, while the short-term calls didn't move as fast as the LEAPS, the short-term puts nwve fa,ster than the LEAPS puts in nwst cases. Figure 25-6 shows the deltas of these options. The vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS puts and short-term equity puts don't behave very differently in terms of price change (bottom right-hand section offigure). In-the-money puts (when the stock is below the striking price) move faster if they are shorter-term. This fact is accentuated even more when the puts are more deeply in-the-money. The left-hand side of the figure depicts this fact. FIGURE 25-6. Put delta comparison, 2-year LEAPS versus 3-month equity options. 90 80 70 t= 3 months 0 60 0 1 50 X Jg 40 Q) 0 30 20 10 O 70 80 90 100 110 120 130 Stock Price 390 Part Ill: Put Option Strategies The LEAPS put delta curve is flat, just as the call delta curve was. Moreover, the delta is not very large anywhere across the figure. For example, at-the-money 2- year LEAPS puts move only about 30 cents for a one-point move in the underlying stock. LEAPS put buyers who want to speculate on a stock's downward movement must realize that the leverage factor is not large; it takes approximately a 3-point move by the underlying common for an at-the-money LEAPS put to increase in value by one point. Long-term puts don't mirror stock movement nearly as well as shorter-term puts do. In summary, the option buyer who is considering buying LEAPS puts or calls as speculation should be aware of the different price action that LEAPS exhibit when compared to shorter-term options. Due to the large amount of time that LEAPS have remaining in their lives, the time decay of the LEAPS options is smaller. For this rea­ son, the LEAPS option buyer doesn't need to be as precise in his timing. In general, LEAPS calls move faster when the underlying stock moves, and LEAPS puts move more slowly. Other than that, the general reasons for speculative option buying apply to LEAPS as well: leverage and limited risk. SELLING LEAPS Strategies involving selling LEAPS options do not differ substantially from those involving shorter-term options. The discussions in this section concentrate on the two major differences that sellers of LEAPS will notice. First, the slow rate of time decay of LEAPS options means that option writers who are used to sitting back and watch­ ing their written options waste away will not experience the same effect with LEAPS. Second, follow-up action for writing strategies usually depends on being able to buy back the w1itten option when it has little or no time value premium remaining. Since LEAPS retain time value even when substantially in- or out-of-the-money, follow-up action involving LEAPS may involve the repurchase of substantial amounts of time value premium. COVERED WRITING LEAPS options can be sold against underlying stock just as short-term options can. No extra collateral or investment is required to do so. The resulting position is again one with limited profit potential, but enhanced profitability (as compared to stock ownership), if the underlying stock remains unchanged or falls. The maximum prof­ it potential of the covered write is reached whenever the underlying stock is at or above the striking price of the written option at expiration. The LEAPS covered writer takes in substantial premium, in terms of price, when he sells the long-term option. He should compare the return that he could Chapter 25: LEAPS 391 make from the LEAPS write with returns that can be made from repeatedly writing shorter-term calls. Of course, there is no guarantee that he will actually be able to repeat the short-term writes during the longer life of the LEAPS. As an aside, the strategist who is utilizing the incremental return concept of cov­ ered writing may find LEAPS call writing quite attractive. This is the strategy where­ in he has a higher target price at which he would be willing to sell his common stock, and he writes calls along the way to earn an incremental return (see Chapter 2 for details). Since this type of writer is only concerned with absolute levels of premiums being brought into the account and not with things like return if exercised, he should utilize LEAPS calls if available, since the premiums are the largest available. Moreover, if the incremental return writer is currently in a short-term call and is going to be called away, he might roll into a LEAPS call in order to retain his stock and take in more premium. The rest of this section discusses covered writing from the more normal view­ point of the investor who buys stock and sells a call against it in order to attain a par­ ticular return. Example: XYZ is selling at 50. The investor is considering a 500-share covered write and he is unsure whether to use the 6-month call or the 2-year LEAPS. The July 50 call sells for 4 and has 6 months of life remaining; the January 50 LEAPS call sells for 8½ and has 2 years of life. Further assume that XYZ pays a dividend of $0.25 per quarter. As was done in Chapter 2, the net required investment is calculated, then the return (if exercised) is computed, and finally the downside break-even point is deter­ mined. Stock cost (500 shares @ 50) Plus stock commission Less option premiums received Plus option commissions Net cash investment Net Investment Required July 50 call $25,000 + 300 2,000 + 50 $23,350 January 50 LEAPS $25,000 + 300 4,250 + 100 $21,150 Obviously, the LEAPS covered writer has a smaller cash investment, since he is sell­ ing a more expensive call in his covered write. Note that the option premium is being applied against the net investment in either case, as is the normal custom when doing covered writing. Now, using the net investment required, one can calculate the return (if exer­ cised). That return assumes the stock is above the striking price of the written option 392 Part Ill: Put Option Strategies at its expiration, and the stock is called away. The short-term writer would have col­ lected two dividends of the common stock, while the LEAPS writer would have col­ lected eight by expiration. Stock sale (500 @ 50) Less stock commission Plus dividends earned until expiration Less net investment Net profit if exercised Return if exercised (net profit/net investment) Return If Exercised + July 50 call $25,000 300 250 - 23,350 $ 1,600 6.9% January 50 LEAPS $25,000 300 + 1,000 - 21,150 $ 4,550 21.5% The LEAPS writer has a much higher net return if exercised, again because he wrote a more expensive option to begin with. However, in order to fairly compare the two writes, one must annualize the returns. That is, the July 50 covered write made 6.9% in six months, so it could make twice that in one year, if it can be duplicated six months from now. In a similar manner, the LEAPS covered writer can make 21.5% in two years if the stock is called away. However, on an annualized basis, he would make only half that amount. Return If Exercised, Annualized July 50 call January 50 LEAPS 13.8% 10.8% Thus, on an annualized basis, the short-term write seems better. The shorter-term call will generally have a higher rate of return, annualized, than the LEAPS call. The problems with annualizing are discussed in the following text. Finally, the downside break-even point can be computed for each write. Downside Break-Even Calculation Net investment Less dividends received Total stock cost to expiration Divided by shares held (500), equals break-even price: July 50 call $23,350 250 $23,100 46.2 January 50 LEAPS $21,150 1 000 $20,150 40.3 Chapter 25: LEAPS 393 The larger premium of the LEAPS call that was written produces this dramatically lower break-even price for the LEAPS covered write. Similar comparisons could be made for a covered write on margin if the investor is using a margin account. The steps above are the mechanical ones that a covered writer should go through in order to see how the short-term write compares to the longer-term LEAPS write. Analyzing them is often a less routine matter. It would seem that the short-term write is better if one uses the annualized rate of return. However, the annualized return is a somewhat subjective number that depends on several assumptions. The first assumption is that one will be able to generate an equivalent return six months from now when the July 50 call expires worthless or the stock is called away. If the stock were relatively unchanged, the covered writer would have to sell a 6- month call for 4 points again six months from now. Or, if the stock were called away, he would have to invest in an equivalent situation elsewhere. Moreover, in order to reach the 2-year horizon offered by the LEAPS write, the 6-month return would have to be regenerated three more times (six months from now, one year from now, and a year and a half from now). The covered writer cannot assume that such returns can be repeated with any certainty every six months. The second assumption that was made when the annualized returns were cal­ culated was that one-half the return if exercised on the LEAPS call would be made when one year had passed. But, as has been demonstrated repeatedly in this chapter, the time decay of an option is not linear. Therefore, one year from now, if XYZ were still at 50, the January 50 LEAPS call would not be selling for half its current price (½ x 8½ = 4¼). It would be selling for something more like 5.00, if all other factors remained unchanged. However, given the variability of LEAPS call premiums when interest rates, volatility, or dividend payouts change, it is extremely difficult to esti­ mate the call price one year from now. Consequently, to say that the 21.5% 2-year return if exercised would be 10.8% after one year may well be a false statement. Thus, the covered writer must make his decision based on what he knows. He knows that with the short-term July 50 write, if the stock is called away in six months, he will make 6.9%, period. If he opts for the longer term, he will make 21.5% if he is called away in two years. Which is better? The question can only be answered by each covered writer individually. One's attitude toward long-term investing will be a major factor in making the decision. If he thinks XYZ has good prospects for the long term, and he feels conservative returns will be below 10% for the next couple of years, then he would probably choose the LEAPS write. However, if he feels that there is a temporary expansion of option premium in the short-term XYZ calls that should be exploited, and he would not really want to be a long-term holder of the stock, then he would choose the short-term covered write. 394 Part Ill: Put Option Strategies Downside Protection. The actual downside break-even point might enter into one's thinking as well. A downside break-even point of 40.3 is available by using the LEAPS write, and that is a known quantity. No matter how far XYZ might fall, as long as it can recover to slightly over 40 by expiration two years from now, the investment will at least break even. A problem arises if XYZ falls to 40 quickly. If that happened, the LEAPS call would still have a significant amount of time value premium remain­ ing on it. Thus, if the investor attempted to sell his stock at that time and buy back his call, he would have a loss, not a break-even situation. The short-term write offers downside protection only to a stock price of 46.2. Of course, repeated writes of 6-month calls over the next 2 years would lower the break-even point below that level. The problem is that if XYZ declines and one is forced to keep selling 6-month calls every 6 months, he may be forced to use a lower striking price, thereby locking in a smaller profit ( or possibly even a loss) if premium levels shrink. The concepts of rolling down are described in detail in Chapter 2. A further word about rolling down may be in order here. Recall that rolling down means buying back the call that is currently written and selling another one with a lower striking price. Such action always reduces the profitability of the over­ all position, although it may be necessary to prevent further downside losses if the common stock keeps declining. Now that LEAPS are available, the short-term writer faced with rolling down may look to the LEAPS as a means of bringing in a healthy premium even though he is rolling down. It is true that a large premium could be brought into the account. But remember that by doing so, one is committing himself to sell the stock at a lower price than he had originally intended. This is why the rolling down reduces the original profit potential. If he rolls down into a LEAPS call, he is reducing his maximum profit potential for a longer period of time. Consequently, one should not always roll dm,vn into an option with a longer maturi­ ty. Instead, he should carefully analyze whether he wants to be committed for an even longer time to a position in which the underlying common stock is declining. To summarize, the large absolute premiums available in LEAPS calls may make a covered write of those calls seem unusually attractive. However, one should calcu­ late the returns available and decide whether a short-term write might not serve his purpose as well. Even though the large LEAPS premium might reduce the initial investment to a mere pittance, be aware that this creates a great amount of leverage, and leverage can be a dangerous thing. The large amount of downside protection offered by the LEAPS call is real, but if the stock falls quickly, there would definitely be a loss at the calculated downside break-even point. Finally, one cannot always roll down into a LEAPS call if trouble develops, because he will be committing himself for an even longer period of time to sell his stock at a lower price than he had originally intended. Chapter 25: LEAPS 39S ✓,,FREE" COVERED CALL WRITES In Chapter 2, a strategy of writing expensive LEAPS options was briefly described. In this section, a more detailed analysis is offered. A certain type of covered call write, one in which the call is quite expensive, sometimes attracts traders looking for a "free ride." To a certain extent, this strategy is something of a free ride. As you might imagine, though, there can be major problems. The investment required for a covered call write on margin is 50% of the stock price, less the proceeds received from selling the call. In theory, it is possible for an option to sell for more than 50% of the stock cost. This is a margin account, a cov­ ered write could be established for "free." Let's discuss this in terms of two types of calls: the in-the-money call write and the out-of-the-money call write. Out-of-the-Money Covered Call Write. This is the simplest way to approach the strategy. One may be able to find LEAPS options that are just slightly out-of-the­ money, which sell for 50% of the stock price. Understandably, such a stock would be quite volatile. Example: GOGO stock is selling for $38 per share. GOGO has listed options, and a 2-year LEAPS call with a striking price of 40 is selling for $19. The requirement for this covered write would be zero, although some commission costs would be involved. The debit balance would be 19 points per share, the amount the broker loans you on margin. Certain brokerage firms might require some sort of minimum margin deposit, but technically there is no further requirement for this position. Of course, the leverage is infinite. Suppose one decided to buy 10,000 shares of GOGO and sell 100 calls, covered. His risk is $190,000 if the stock falls to zero! That also happens to be the debit balance in his account. Thus, for a minimal investment, one could lose a for­ tune. In addition, if the stock begins to fall, one's broker is going to want maintenance margin. He probably wouldn't let the stock slip more than a couple of points before asking for margin. If one owns 10,000 shares and the broker wants two points main­ tenance margin, that means the margin call would be $20,000. The profits wouldn't be as big as they might at first seem. The maximum gross profit potential is $210,000 if the 10,000 shares are called away at 40. The covered write makes 21 points on each share - the $40 sale price less the original cost of $19. However, one will have had to pay interest on the debit balance of $190,000 for two years. At 10%, say, that's a total of $38,000. There would also be commissions on the purchase and the sale. 396 Part Ill: Put Option Strategies In summary, this is a position with tremendous, even dangerous, leverage. In-the-Money Covered Call Write. The situation is slightly different if the option is in-the-money to begin with. The above margin requirements actually don't quite accurately state the case for a margined covered call write. When a covered call is written against the stock, there is a catch: Only 50% of the stock price or the strike price, whichever is less, is available for "release." Thus, one will actually be required to put up more than 50% of the stock price to begin with. Example: XYZ is trading at 50, and there is a 2-year LEAPS call with a strike price of 30, selling for 25 points. One might think that the requirement for a covered call write would be zero, since the call sells for 50% of the stock price. But that's not the case with in-the-money covered calls. Margin requirement: Buy stock: 50 points Less option proceeds -25 Less margin release* -15* Net requirement: 10 points * 50% of the strike price or 50% of stock price, whichever is less. This position still has a lot ofleverage: One invests 10 points in hopes of making 5, if the stock is called away at 30. One also would have to pay interest on the 15-point debit balance, of course, for the two-year duration of the position. Furthermore, should the stock fall below the strike price, the broker would begin to require main­ tenance margin. Note that the above "formula" for the net requirement works equally well for the out-of-the-money covered call write, since 50% of the stock price is always less than 50% of the strike price in that case. To summarize this "free ride" strategy: If one should decide to use this strate­ gy, he must be extremely aware of the dangers of high leverage. One must not risk more money than he can afford to lose, regardless of how small the initial investment might be. Also, he must plan for some method of being able to make the margin pay­ ments along the way. Finally, the in-the-money alternative is probably better, because there is less probability that maintenance margin will be asked for. SELLING UNCOVERED LEAPS Uncovered option selling can be a viable strategy, especially if premiums are over­ priced. LEAPS options may be sold uncovered with the same margin requirements as short-term options. Of course, the particular characteristics of the long-term option may either help or hinder the uncovered writer, depending on his objective. Chapter 25: LEAPS 397 Uncovered Put Selling. Naked put selling is addressed first because, as a strat­ egy, it is equivalent to covered writing, and covered writing was just discussed. Two strategies are equivalent if they have the same profit picture at expiration. Naked put selling and covered call writing are equivalent because they have the profit picture depicted in Graph I, Appendix D. Both have limited upside profit potential and large loss exposure to the downside. In general, when two strategies are equivalent, one of the two has certain advantages over the other. In this case, naked put selling is normally the more advantageous of the two because of the way margin requirements are set. One need not actually invest cash in the sale of a naked put; the margin requirement that is asked for may be satisfied with collateral. This means the naked put writer may use stocks, bonds, T-bills, or money market funds as collateral. Moreover, the actual amount of collateral that is required is less than the cash or margin investment required to buy stock and sell a call. This means that one could operate his portfolio normally - buying stock, then selling it and putting the proceeds in a Treasury bill or perhaps buying another stock - without disturbing his naked put position, as long as he maintained the collateral requirement. Consequently, the strategist who is buying stock and selling calls should probably be selling naked puts instead. This does not apply to covered writers who are writing against existing stock or who are using the incremental return concept of covered writ­ ing, because stock ownership is part of their strategy. However, the strategist who is looking to take in premium to profit if the underlying stock remains relatively unchanged or rises, while having a modicum of downside protection ( which is the definition of both naked put writing and covered writing), should be selling naked puts. As an example of this, consider the LEAPS covered write discussed previously. Example: XYZ is selling at 50. The investor is debating between a 500-share covered write using 2-year LEAPS calls or selling five 2-year LEAPS puts. The January 50 LEAPS call sells for 8½ and has two years of life, while the January 50 LEAPS put sells for 3½. Further assume that XYZ pays a dividend of $0.25 per quarter. The net investment required for the covered write is calculated as it was before. Net Investment Required - Covered Write Stock cost (500 shares @ 50) Plus stock commission Less option premiums received Plus option commissions Net cash investment + $25,000 300 - 4,250 + 100 $21,150 398 Part Ill: Put Option Strategies The collateral requirement for the naked put write is the same as that for any naked equity option: 20% of the stock price, plus the option price, less any out-of­ the-money amount, with an absolute minimum requirement of 15% of the stock price. Collateral Requirement - Naked Put 20% of stock price (.20 x 500 x $50) Plus option premium Less out-of-the-money amount Total collateral requirement $5,000 1,750 0 $6,750 Note that the actual premium received by the naked put seller is $1,750 less com­ missions of $100, for example, or $1,650. This net premium could be used to reduce the total collateral requirement. Now one can compare the profitability of the two investments: Return If Stock Over 50 at Expiration Stock sale {500 @ 50) Less stock commission Plus dividends earned until expiration Less net investment Net profit if exercised Net put premium received Dividends received Net profit Covered Write $25,000 300 + 1,000 - 21,150 $ 4,55_0 Naked Put Sole $1,650 0 $1,650 Now the returns can be compared, if XYZ is over 50 at expiration of the LEAPS: Return if XYZ over 50 (net profit/net investment) Naked put sale: 24.4% Covered write: 21 .5% The naked put write has a better rate of return, even before the following fact is considered. The strategist who is using the naked put write does not have to spend the $6,750 collateral requirement in the form of cash. That money can be kept in a Chapter 25: LEAPS 399 Treasury bill and earn interest over the two years that the put write is in place. Even if the T-bill were earning only 4% per year, that would increase the overall two-year return for the naked put sale by 8%, to 32.4%. This should make it obvious that naked put selling is rrwre strategically advantageous than covered call writing. Even so, one might rightfully wonder if LEAPS put selling is better than selling shorter-term equity puts. As was the case with covered call writing, the answer depends on what the investor is trying to accomplish. Short-term puts will not bring as much premium into the account, so when they expire, one will be forced to find another suitable put sale to replace it. On the other hand, the LEAPS put sale brings in a larger premium and one does not have to find a replacement until the longer­ term LEAPS put expires. The negative aspect to selling the LEAPS puts is that time decay won't help much right away and, even if the stock moves higher (which is ostensibly good for the position), the put won't decline in price by a large amount, since the delta of the put is relatively small. One other factor might enter in the decision regarding whether to use short­ term puts or LEAPS puts. Some put writers are actually attempting to buy stock below the market price. That is, they would not mind being assigned on the put they sell, meaning that they would buy stock at a net cost of the striking price less the pre­ mium they received from the sale of the put. If they don't get assigned, they get to keep a profit equal to the premium they received when they first sold the put. Generally, a person would only sell puts in this manner on a stock that he had faith in, so that if he was assigned on the put, he would view that as a buying opportunity in the underlying stock. This strategy does not lend itself well to LEAPS. Since the LEAPS puts will carry a significant amount of time premium, there is little (if any) chance that the put writer will actually be assigned until the life of the put shortens substantially. This means that it is unlikely that the put writer will become a stock owner via assignment at any time in the near future. Consequently, if one is attempt­ ing to wTite puts in order to eventually buy the common stock when he is assigned, he would be better served to write shorter-term puts. UNCOVERED CALL SELLING There are very few differences between using LEAPS for naked call selling and using shorter-term calls, except for the ones that have been discussed already with regard to selling uncovered LEAPS: Time value decay occurs more slowly and, if the stock rallies and the naked calls have to be covered, the call writer will normally be paying more time premium than he is used to when he covers the call. Of course, the rea­ son that one is engaged in naked call writing might shed some more light on the use of LEAPS for that purpose. 400 Part Ill: Put Option Strategies The overriding reason that most strategists sell naked calls is to collect the time premium before the stock can rise above the striking price. These strategists gener­ ally have an opinion about the stock's direction, believing that it is perhaps trapped in a trading range or even headed lower over the short term. This strategy does not lend itself well to using LEAPS, since it would be difficult to project that the stock would remain below the strike for so long a period of time. Short LEAPS Instead of Short Stock. Another reason that naked calls are sold is as a strategy akin to shorting the common stock. In this case, in-the-money calls are sold. The advantages are threefold: l. The amount of collateral required to sell the call is less than that required to sell stock short. 2. One does not have to borrow an option in order to sell it short, although one must borrow common stock in order to sell it short. 3. An uptick is not required to sell the option, but one is required in order to sell stock short. For these reasons, one might opt to sell an in-the-money call instead of shorting stock. The profit potentials of the two strategies are different. The short seller of stock has a very large profit potential if the stock declines substantially, while the seller of an in-the-money call can collect only the call premium no matter how far the stock drops. Moreover, the call's price decline will slow as the stock nears the strike. Another way to express this is to say that the delta of the call shrinks from a number close to l (which means the call mirrors stock movements closely) to something more like 0.50 at the strike (which means that the call is only declining half as quickly as the stock). Another problem that may occur for the call seller is early assignment, a topic that is addressed shortly. One should not attempt this strategy if the underlying stock is not borrowable for ordinary short sales. If the underlying stock is not available for borrowing, it generally means that extraneous forces are at work; perhaps there is a tender offer or exchange offer going on, or some form of convertible arbitrage is tak­ ing place. In any case, if the underlying stock is not borrowable, one should not be deluded into thinking that he can sell an in-the-money call instead and have a worry­ free position. In these cases, the call will normally have little or no time premium and may be subject to early assignment. If such assignment does occur, the strategist will become short the stock and, since it is not borrowable, will have to cover the stock. At the least, he will cost himself some commissions by this unprofitable strategy; and at worst, he will have to pay a higher price to buy back the stock as well. Chapter 25: LEAPS 401 LEAPS calls may help to alleviate this problem. Since they are such long-term calls, they are likely to have some time value premium in them. In-the-money calls that have time value premium are not normally assigned. As an alternative to shorting a stock that is not borrowable, one might try to sell an in-the-money LEAPS call, but only if it has time value premium remaining. Just because the call has a long time remaining until expiration does not mean that it must have time value premium, as will be seen in the following discussion. Finally, if one does sell the LEAPS call, he must realize that if the stock drops, the LEAPS call will not follow it completely. As the stock nears the strike, the amount of time value premium will build up to an even greater level in the LEAPS. Still, the naked call seller would make some profit in that case, and it presents a better alternative than not being able to sell the stock short at all. Early Assignment. An American-style option is one that can be exercised at any time during its life. All listed equity options, LEAPS included, are of this variety. Thus, any in-the-money option that has been sold may become subject to early assignment. The clue to whether early assignment is imminent is whether there is time value premium in the option. If the option has no time value premium - in other words, it is trading at parity or at a discount then assignment may be close at hand. The option writer who does not want to be assigned would want to cover the option when it no longer carries time premium. LEAPS may be subject to early assignment as well. It is possible, albeit far less likely, that a long-term option would lose all of its time value premium and therefore be subject to early assignment. This would certainly happen if the underlying stock were being taken over and a tender off er were coming to fruition. However, it may also occur because of an impending dividend payment, or more specifically, because the stock is about to go ex-dividend. Recall that the call owner, LEAPS calls includ­ ed, is not entitled to any dividends paid by the underlying stock. So if the call owner wants the dividend, he exercises his call on the day before the stock goes ex-dividend. This makes him an owner of the common stock just in the nick of time to get the div­ idend. What economic factors motivate him to exercise the call? If there is any time value premium at all in the call, the call holder would be better off selling the call in the open market and then purchasing the stock in the open market as well. In this manner, he would still get the dividend, but he would get a better price for his call when he sold it. If, however, there is no time value premium in the call, he does not have to bother with two transactions in the open market; he merely exercises his call in order to buy stock. All well and good, but what makes the call sell at parity before expiration? It has to do with the arbitrage that is available for any call option. In this case, the arbitrage 402 Part Ill: Put Option Strategies is not the simple discount arbitrage that was discussed in Chapter l when this topic was covered. Rather, it is a more complicated form that is discussed in greater detail in Chapter 28. Suffice it to say that if the dividend is larger than the interest that can be earned from a credit balance equal to the striking price, then the time value pre­ mium will disappear from the call. Example: XYZ is a $30 stock and about to go ex-dividend 50 cents. The prevailing short-term interest rate is 5% and there are LEAPS with a striking price of 20. A 50-cent quarterly dividend on a striking price of 20 is an annual dividend rate (on the strike) of 10%. Since short-term rates are much lower than that, arbitrageurs economically cannot pay out 10% for dividends and earn 5% for their credit balances. In this situation, the LEAPS call would lose its time value premium and would be a candidate for early exercise when the stock goes ex-dividend. In actual practice, the situation is more complicated than this, because the price of the puts comes into play; but this example shows the general reasoning that the arbitrageur must go through. Certain arbitrageurs construct positions that allow them to earn interest on a credit balance equal to the striking price of the call. This position involves being short the underlying stock and being long the call. Thus, when the stock goes ex-dividend, the arbitrageur will owe the dividend. If, however, the amount of the dividend is more than he vvill earn in interest from his credit balance, he will merely exercise his call to cover his short stock. This action will prevent him from having to pay out the dividend. The arbitrageur's exercise of the call means that someone is going to be assigned. If you are a writer of the call, it could be you. It is not important to under­ stand the arbitrage completely; its effect will be reflected in the marketplace in the form of a call trading at parity or a discount. Thus, even a LEAPS call with a sub­ stantial anwunt of time rernaining may be assigned if it is trading at parity. STRADDLE SELLING Straddle selling is equivalent to ratio writing and is a strategy whereby one attempts to sell ( overpriced) options in order to produce a range of stock prices within which the option seller can profit. The strategy often involves follow-up action as the stock moves around, and the strategist feels that he must adjust his position in order to pre­ vent large losses. LEAPS puts and calls might be used for this strategy. However, their long-term nature is often not conducive to the aims of straddle selling. First, consider the effect of time decay. One might normally sell a three-month straddle. If the stock "behaves" and is relatively unchanged after two months have Chapter 25: LEAPS 403 passed, the straddle seller could reasonably expect to have a profit of about 40% of the original straddle price. However, if one had sold a 2-year LEAPS straddle, and the stock were relatively unchanged after two months, he would only have a profit of about 7% of the original sale price. This should not be surprising in light of what has been demonstrated about the decaying of long-term options. It should make the straddle seller somewhat leery of using LEAPS, however, unless he truly thinks the options are overpriced. Second, consider follow-up action. Recall that in Chapter 20, it was shown that the bane of the straddle seller was the whipsaw. A whipsaw occurs when one makes a follow-up protective action on one side (for instance, he does something bullish because the underlying stock is rising and the short calls are losing money), only to have the stock reverse and come crashing back down. Obviously, the more time left until expiration, the more likely it is that a whipsaw will occur after any follow-up action, and the more expensive it will be, since there will be a lot of time value pre­ mium left in the options that are being repurchased. This makes LEAPS straddle selling less than attractive. LEAPS straddles may look expensive because of their large absolute price, and therefore may appear to be attractive straddle sale candidates. However, the price is often justified, and the seller of LEAPS straddles will be fighting sudden stock move­ ments without getting much benefit from the passage of time. The best time to sell LEAPS straddles is when short-term rates are high and volatilities are high as well (i.e., the options are overpriced). At least, in those cases, the seller will derive some real benefit if rates or volatilities should drop. SPREADS USING LEAPS Any of the spread strategies previously discussed can be implemented with LEAPS as well, if one desires. The margin requirements are the same for LEAPS spreads as they are for ordinary equity option spreads. One general category of spread lends itself well to using LEAPS: that of buying a longer-term option and selling a short­ term one. Calendar spreads, as well as diagonal spreads, fall into that category. The combinations are myriad, but the reasoning is the same. One wants to own the option that is not so subject to time decay, while simultaneously selling the option that is quite subject to time decay. Of course, since LEAPS are long-term and therefore expensive, one is generally taking on a large debit in such a spread and may have substantial risk if the stock performs adversely. Other risks may be pres­ ent as well. As a means of demonstrating these facts, let us consider a simple bull spread using calls. 404 Part Ill: Put Option Strategies Example: The following prices exist in the month of January: XYZ: 105 April 100 call: 10 1/2 April 110 call: 5 1/2 January (2-year) 100 call: 26 January (2-year) 110 call: 21 1/2 An investor is considering a bull spread in XYZ and is unsure about whether to use the short-term calls, the LEAPS calls, or a mixture. These are his choices: Short-term bull spread: Diagonal bull spread: LEAPS bull spread: Buy April 100@ 101/2 Sell April 110@ 51/2 Net Debit: $500 Buy January LEAPS 100 @ 26 Sell April 110@ 51/2 Net Debit: $2,050 Buy January LEAPS 1 00 @ 26 Sell January LEAPS 110@ 21 1/2 Net Debit: $450 Notice that the debit paid for the LEAPS spread is slightly less than that of the short­ term bull spread. This means that they have approximately the same profit potential at their respective expiration dates. However, the strategist is more concerned with how these compare directly with each other. The obvious point in time to make this comparison is when the short-term options expire. Figure 25-7 shows the profitability of these three positions at April expiration. It was assumed that all of the following were the same in April as they had been in January: volatility, short-term rates, and dividend payout. Note that the short-term bull spread has the familiar profit graph from Chapter 7, making its maximum profit over 110 and taking its maximum loss below 100. (See Table 25-4.) The LEAPS spread doesn't generate much of either a profit or a loss in only three months' time. Even if XYZ rises to 120, the LEAPS bull spread will have only a $150 profit. Conversely, if XYZ falls to 80, the spread loses only about $200. This price action is very typical for long-term bull spreads when both options have a sig­ nificant amount of time premium remaining in them. Chapter 25: LEAPS FIGURE 25-7. Bull spread comparison at April expiration. Stock Price 405 The diagonal spread is different, however. Typically, the maximum profit poten­ tial of a bull spread is the difference in the strikes less the initial debit paid. For this diagonal spread, that would be $1,000 minus $2,050, a loss! Obviously, this simple formula is not applicable to diagonal spreads, because the purchased option still has time value premium when the written option expires. The profit graph shows that indeed the diagonal spread is the most bullish of the three. It makes its best profit at the strike of the written option - a standard procedure for any spread - and that prof­ it is greater than either of the other two spreads at April expiration ( under the sig- TABLE 25-4. Bull spread comparison at April expiration. Stock Price Short-Term Diagonal LEAPS 80 -500 -1, 100 -200 90 -500 - 600 -150 100 -500 50 - 25 110 500 750 50 120 500 550 150 140 500 150 250 160 500 50 350 180 500 - 350 450 406 Part Ill: Put Option Strategies nificant assumption that volatility and interest rates are unchanged). If XYZ trades higher than llO, the diagonal spread will lose some of its profit; in fact, if XYZ were to trade at a very high price, the diagonal spread would actually have a loss (see Table 25-4). Whenever the purchased LEAPS call loses its time value premium, the diag­ onal spread will not perform as well. If the common stock drops in price, the diagonal spread has the greatest risk in dollar terms but not in percentage terms, because it has the largest initial debit. If XYZ falls to 80 in three months, the spread will lose about $1,100, just over half the initial $2,050 debit. Obviously, the short-term spread would have lost 100% of its ini­ tial debit, which is only $500, at that same point in time. The diagonal spread presents an opportunity to earn more money if the under­ lying common is near the strike of the written option when the written option expires. However, if the common moves a great deal in either direction, the diagonal spread is the worst of the three. This means that the diagonal spread strategy is a neutral strategy: One wants the underlying common to remain near the written strike until the near-term option expires. This is a true statement even if the diagonal spread is under the guise of a bullish spread, as in the previous example. Many traders are fond of buying LEAPS and selling an out-of-the-money near­ term call as a hedge. Be careful about doing this. If the underlying common rises too fast and/or interest rates fall and/or volatility decreases, this could be a poor strategy. There is really nothing quite as psychologically damaging as being right about the stock, but being in the wrong option strategy and therefore losing money. Consider the above examples. Ostensibly, the spreader was bullish on XYZ; that's why he chose bull spreads. If XYZ became a wildly bullish stock and rose from 100 to 180 in three months, the diagonal spreader would have lost money. He couldn't have been happy - no one would be. This is something to keep in mind when diagonalizing a LEAPS spread. The deltas of the options involved in the spread will give one a good clue as to how it is going to perform. Recall that a short-term, in-the-money option acquires a rather high delta, especially as expiration draws nigh. However, an in-the-money LEAPS call will not have an extremely high delta, because of the vast amount of time remaining. Thus, one is short an option with a high delta and long an option with a smaller delta. These deltas indicate that one is going to lose money if the underlying stock rises in price. Consider the following situation: XYZ Stock, 120: Call Long 1 January LEAPS 100 call: Short 1 April 110 call: Position Delta 0.70 -0.90 Chapter 25: LEAPS 401 At this point, if XYZ rises in price by 1 point, the spread can be expected to lose 20 cents, since the delta of the short option is 0.20 greater than the delta of the long option. This phenomenon has ramifications for the diagonal spreader of LEAPS. If the two strike prices of the spread are too close together, it may actually be possible to construct a bull spread that loses money on the upside. That would be very difficult for most traders to accept. In the above example, as depicted in Table 25-4, that's what happens. One way around this is to widen the strike prices out so that there is at least some profit potential, even if the stock rises dramatically. That may be diffi­ cult to do and still be able to sell the short-term option for any meaningful amount of premium. Note that a diagonal spread could even be considered as a substitute for a cov­ ered write in some special cases. It was shown that a LEAPS call can sometimes be used as a substitute for the common stock, with the investor placing the difference between the cost of the LEAPS call and the cost of the stock in the bank (or in T­ bills). Suppose that an investor is a covered writer, buying stock and selling relative­ ly short-term calls against it. If that investor were to make a LEAPS call substitution for his stock, he would then have a diagonal bull spread. Such a diagonal spread would probably have less risk than the one described above, since the investor pre­ sumably chose the LEAPS substitution because it was "cheap." Still, the potential pitfalls of the diagonal bull spread would apply to this situation as well. Thus, if one is a covered writer, this does not necessarily mean that he can substitute LEAPS calls for the long stock without taking care. The resulting position may not resemble a cov­ ered write as much as he thought it would. The "bottom line" is that if one pays a debit greater than the difference in the strike prices, he may eventually lose money if the stock rises far enough to virtually eliminate the time value premium of both options. This comes into play also if one rolls his options down if the underlying stock declines. Eventually, by doing so, he may invert the strikes - i.e., the striking price of the written option is lower than the striking price of the option that is owned. In that case, he will have locked in a loss if the overall credit he has received is less than the difference in the strikes - a quite likely event. So, for those who think this strategy is akin to a guaranteed profit, think again. It most certainly is not. Backspreads. LEAPS may be applied to other popular forms of diagonal spreads, such as the one in which in-the-money, near-term options are sold, and a greater quan­ tity of longer-term (LEAPS) at- or out-of-the money calls are bought. (This was referred to as a diagonal backspread in Chapter 14.) This is an excellent strategy, and 408 Part Ill: Put Option Strategies a LEAPS may be used as the long option in the spread. Recall that the object of the spread is for the stock to be volatile, particularly to the upside if calls are used. If that doesn't happen, and the stock declines instead, at least the premium captured from the in-the-money sale will be a gain to offset against the loss suffered on the longer­ term calls that were purchased. The strategy can be established with puts as well, in which case the spreader would want the underlying stock to fall dramatically while the spread was in place. Without going into as much detail as in the examples above, the diagonal back­ spreader should realize that he is going to have a significant debit in the spread and could lose a significant portion of it should the underlying stock fall a great deal in price. To the upside, his LEAPS calls will retain some time value premium and will move quite closely with the underlying common stock. Thus, he does not have to buy as many LEAPS as he might think in order to have a neutral spread. Example: XYZ is at 105 and a spreader wants to establish a backspread. Recall that the quantity of options to use in a neutral strategy is determined by dividing the deltas of the two options. Assume the following prices and deltas exist: Option April 100 call July 110 call January (2-year) LEAPS 100 call XYZ: 105 in January Price 8 5 15 Delta 0.75 0.50 0.60 Two backspreads are available with these options. In the first, one would sell the April 100 calls and buy the July llO calls. He would be selling 3-month calls and buy­ ing 6-month calls. The neutral ratio is 0.75/0.50 or 3 to 2; that is, 3 calls are to be bought for every 2 sold. Thus, a neutral spread would be: Buy 6 July 110 calls Sell 4 April l 00 calls As a second alternative, he might use the LEAPS as the long side of the spread; he would still sell the April 100 calls as the short side of the spread. In this case, his neu­ tral ratio would be 0.75/0.60, or 5 to 4. The resulting neutral spread would be: Buy 5 January LEAPS 110 calls Sell 4 April 100 calls Chapter 25: LEAPS 409 Thus, a neutral backspread involving LEAPS requires buyingfewer calls than a neu­ tral backspread involving a 6-rnonth option on the long side. This is because the delta of the LEAPS call is larger. The significant point here is that, because of the time value retention of the LEAPS call, even when the stock moves higher, it is not nec­ essary to buy as many. If one does not use the deltas, but merely figures that 3 to 2 is a good ratio for any diagonal backspread, then he will be overly bullish if he uses LEAPS. That could cost him if the underlying stock declines. Calendar Spreads. LEAPS may also be used in calendar spreads - spreads in which the striking price of the longer-term option purchased and the shorter-term option sold are the same. The calendar spread is a neutral strategy, wherein the spreader wants the underlying stock to be as close as possible to the striking price when the near-term option expires. A calendar spread has risk if the stock moves too far away from the striking price (see Chapters 9 and 22). Purchasing a LEAPS call increases that risk in terms of dollars, not percentage, because of the larger debit that one must spend for the spread. Simplistically, calendar spreads are established with equal quantities of options bought and sold. This is often not a neutral strategy in the true sense. As was shown in Chapter 9 on call calendar spreads, one may want to use the deltas of the two options to establish a truly neutral calendar spread, particularly if the stock is not ini­ tially right at the striking price. Out-of-the-money, one would sell more calls than he is buying. Conversely, in-the-money, one would buy more calls than he is selling. Both strategies statistically have merit and are attractive. When using LEAPS deltas to construct the neutral spread, one need generally buy fewer calls than he might think, because of the higher delta of a LEAPS call. This is the same phenomenon described in the previous example of a diagonal backspread. SUMMARY LEAPS are nothing more than long-term options. They are usable in a wide variety of strategies in the same way that any option would be. Their margin and investment requirements are similar to those of the more familiar equity options. Both LEAPS puts and calls are traded, and there is a secondary market for them as well. There are certain differences between the prices of LEAPS and those of short­ er-term options, but the greatest is the relatively large effect that interest rates and dividends have on the price of LEAPS, because LEAPS are long-term options. Increases in interest rates will cause LEAPS to increase in price, while increases in dividend payout will cause LEAPS calls to decrease in price and LEAPS puts to 410 Part Ill: Put Option Strategies increase in price. As usual, volatility has a major effect on the price of an option, and LEAPS are no exception. Even small changes in the volatility of the underlying com­ mon stock can cause large price differences in a two-year option. The rate of decay due to time is much smaller for LEAPS, since they are long-term options. Finally, the deltas of LEAPS calls are larger than those of short-term calls; conversely, the deltas of LEAPS puts are smaller. Several common strategies lend themselves well to the usage of LEAPS. A LEAPS may be used as a stock substitute if the cash not invested in the stock is instead deposited in a CD or T-bill. LEAPS puts can be bought as protection for common stock. Speculative option buyers will appreciate the low rate of time decay of LEAPS. LEAPS calls can be written against common stock, thereby creating a covered write, although the sale of naked LEAPS puts is probably a better strategy in most cases. Spread strategies with LEAPS may be viable as well, but the spreader should carefully consider the ramifications of buying a long-term option and selling a shorter-term one against it. If the underlying stock moves a great distance quickly, the spread strategy may not perform as expected. Overall, LEAPS are not very different from the shorter-term options to which traders and investors have become accustomed. Once these investors become famil­ iar with the way these long-term options are affected by the various factors that determine the price of an option, they will consider the use of LEAPS as an integral part of a strategic arsenal. Additional Considerations Buying Options and Treasury Bills Numerous strategies have been described, ranging from the simple to the complex. Each one has advantages, but there are disadvantages as well. In fact, some of them may be too complex for the average investor to seriously consider implementing. The reader may feel that there should be an easier answer. Isn't there a strategy that might not require such a large investment or so much time spent in monitoring the position, but would still have a chance of returning a reasonable profit? In fact, there is a strategy that has not yet been described, a strategy considered by some experts in the field of mathematical analysis to be the best of them all. Simply stated, the strategy consists of putting 90% of one's money in risk-free investments (such as short-term Treasury bills) and buying options with the remaining 10% of one's funds. It has previously been pointed out that some of the more attractive strategies are those that involve small levels of risk with the potential for large profits. Usually, these types of strategies inherently have a rather large frequency of small losses, and a small probability of realizing large gains. Their advantage lies in the fact that one or two large profits can conceivably more than make up for numerous small losses. This Treasury bill/option strategy is another strategy of this type. HOW THE TREASURY BILL/OPTION STRATEGY OPERATES Although there are certain details involved in operating this strategy, it is basically a simple one to approach. First, the most that one can lose is 10%, less the interest earned on the fixed-income portion of his portfolio (the remaining 90% of his assets), during the life of the purchased options. It is a simple matter to space out one's com- 413 414 Part IV: Additional Considerations mitments to option purchases so that his overall risk in a one-year period can be kept down to nearly 10%. Example: An investor might decide to put 2½% of his money into three-month option purchases. Thus, in any one year, he would be 1isking 10%. At the same time he would be earning perhaps 6% from the overall interest generated on the fixed­ income securities that make up the remaining 90% of his assets. This would keep his overall risk down to approximately 4.6% per year. There are better ways to monitor this risk, and they are described shortly. The potential profits from this strategy are limited only by time. Since one is owning options - say call options - he could profit handsomely from a large upward move in the stock market. As with any strategy in which one has limited risk and the poten­ tial of large profits, a small number of large profits could offset a large number of small losses. In actual practice, of course, his profits will never be overwhelming, since only approximately 10% of the money is committed to option purchases. In total, this strategy has greatly reduced 1isk with the potential of making above-average profits. Since the 10% of the money that is invested in options gives great leverage, it might be possible for that portion to double or triple in a short time under favorable market conditions. This strategy is something like owning a convert­ ible bond. A convertible bond, since it is convertible into the common stock, moves up and down in price with the price of the underlying stock. However, if the stock should fall a great deal, the bond will not follow it all the way down, because eventu­ ally its yield will provide a "floor" for the price. A strategy that is not used very often is called the "synthetic convertible bond." One buys a debenture and a call option on the same stock. If the stock rises in price, the call does too, and so the combination of the debenture and the call acts much like a convertible bond would to the upside. If, on the other hand, the stock falls, the call will expire worthless; but the investor will retain most of his investment, because he will still have the debenture plus any interest that the bond has paid. The strategy of placing 90% of one's money into risk-free, interest-bearing cer­ tificates and buying options with the remainder is superior to the convertible bond or the "synthetic convertible bond," since there is no risk of price fluctuation in the largest portion of the investment. The Treasury bill/option strategy is fairly easy to operate, although one does have to do some work every time new options are purchased. Also, periodic adjust­ ments need to be made to keep the level of risk approximately the same at all times. As for which options to buy, the reader may recall that specifications were outlined in Chapters 3 and 16 on how to select the best option purchases. These criteria can be summarized briefly as follows: Chapter 26: Buying Options and Treasury Bills 415 1. Assume that each underlying stock can advance or decline in accordance with its volatility over a fixed time period (30, 60, or 90 days). 2. Estimate the call prices after the advance, or put prices after the decline. 3. Rank all potential purchases by the highest reward opportunity. The user of this strategy need only be interested in those option purchases that provide the highest reward opportunity under this ranking method. In the previous chapters on option buying, it was mentioned that one might want to look at the risk/reward ratios of his potential option purchases in order to have a more conser­ vative list. However, that is not necessary in the Treasury bill/option strategy, since the overall risk has already been limited. A ranking of option purchases via the fore­ going criteria will generally give a list of at- or slightly out-of-the-money options. These are not necessarily "underpriced" options; although if an option is truly under­ priced, it will have a better chance of ranking higher on the selection list than one that is "overpriced." A list of potential option purchases that is constructed with criteria similar to those outlined above is available from many data services and brokerage firms. The strategist who is willing to select his option purchases in this manner will find that he does not have to spend a great deal of time on the selection process. The reader should note that this type of option purchase ranking completely ignores the outlook for the underlying stock. If one would rather make his purchases based on an outlook for the underlying stock - preferably a technical outlook - he will be forced to spend more time on his selection process. Although this may be appealing to some investors, it will probably yield worse results in the long run than the previously described unbiased approach to option purchases, unless the strategist is extremely adept at stock selection. KEEPING THE RISK LEVEL EQUAL The second function that the strategist has to perform in this Treasury bill/option strategy is to keep his risk level approximately equal at all times. Example: An investor starts the strategy with $90,000 in Treasury bills (T-bills) and $10,000 in option purchases. After some time has passed, the option purchases may have worked out well and perhaps he now has $90,000 in T-bills plus $30,000 worth of options, plus interest from the T-bills. Obviously, he no longer has 90% of his money in fixed-income securities and 10% in option purchases. The ratio is now 75% in T-bills and 25% in option purchases. This is too risky a ratio, and the strategist must consequently sell some of his options and buy T-bills with the proceeds. Since his total assets are $120,000 currently, he must sell out $18,000 of options to bring his 416 Part IV: Additional Considerations option investment down from the current $30,000 figure to $12,000, or 10% of his total assets. If one fails to adhere to this readjustment of his funds after profits are made, he may eventually lose those profits. Since options can lose a great percentage of their worth in a short time pe1iod, the investor is always running the risk that the option portion of his investment may be nearly wiped out. If he has kept all his prof­ its in the option portion of his strategy, he is constantly risking nearly all of his accu­ mulated profits, and that is not wise. One must also adjust his ratio of T-bills to options after losses occur. Example: In the first year, the strategist loses all of the $10,000 he originally placed in options. This would leave him with total assets of $90,000 plus interest (possibly $6,000 of interest might be earned). He could readjust to a 90:10 ratio by selling out some of the T-bills and using the proceeds to buy options. If one follows this strate­ gy, he will be risking 10% of his funds each year. Thus, a series of loss years could depreciate the initial assets, although the net losses in one year would be smaller than 10% because of the interest earned on the T-bills. It is recommended that the strate­ gist pursue this method of readjusting his ratios in both up and down markets in order to constantly provide himself with essentially similar risk/reward opportunities at all times. The individual can blend the option selection process and the adjustment of the T-bill/option ratio to fit his individual portfolio. The larger portfolio can be diversi­ fied into options \vith differing holding periods, and the ratio adjustments can be made quite frequently, perhaps once a month. The smaller investor should concen­ trate on somewhat longer holding periods for his options, and would adjust the ratio less often. Some examples might help to illustrate the way in which both the large and small strategist might operate. It should be noted that this T-bill/option strategy is quite adaptable to fairly small sums of money, as long as the 10% that is going to be put into option purchases allows one to be able to participate in a reasonable man­ ner. A tactic for the extremely small investor is also described below. ANNUALIZED RISK Before getting into portfolio size, let us describe the concept of annualized risk. One might want to purchase options with the intent of holding some of them for 30 days, some for 90 days, and some for 180 days. Recall that he does not want his option purchases to represent more than 10% annual risk at any time. In actual practice, if one purchases an option that has 90 days of life, but he is planning to hold the option only 30 days, he will most likely not lose 100% of his investment in Chapter 26: Buying Options and Treasury Bills 417 the 30-day period. However, for purposes of computing annualized risk easily, the assumption that will be made is that the risk during any holding period is 100%, regardless of the length of time remaining in the life of the option. Thus, a 30-day option purchase represents an annualized risk of 1,200% (100% risk every 30 days times twelve 30-day periods in one year). Ninety-day purchases have 400% annual­ ized risk, and 180-day purchases have 200% annualized risk. There is a multitude of ways to combine purchases in these three holding periods so that the overall risk is 10% annualized. Example: An investor could put 2½% of his total money into 90-day purchases four times a year. That is, 2½% of his total assets are being subjected to a 400% annual­ ized risk; 400% times 2½% equals 10% annualized risk on the total assets. Of course, the remainder of the assets would be placed in risk-free, income-bearing securities. Another of the many combinations might be to place 1 % of the total assets in 90-day purchases and also place 3% of the total assets in 180-day purchases. Thus, 1 % of one's total money would be subjected to a 400% annual risk and 3% would be sub­ jected to a 200% annual risk (.01 times 400 plus .03 times 200 equals 10% annualized risk on the entire assets). If one prefers a formula, annualized risk can be computed as: A al. d • k • r 1. Percent of total 360 nnu 1ze ns on entire portro 10 = d x assets investe Holding period If one is able to diversify into several holding periods, the annualized risk is merely the sum of the risks for each holding period. With this information in mind, the strategist can utilize option purchases of 1 month, 3 months, and 6 months, preferably each generated by a separate computer analysis similar to the one described earlier. He will know how much of his total assets he can place into purchases of each holding period, because he will know his annualized risk. Example: Suppose that a very large investor, or pool of investors, has $1 million com­ mitted to this T-bill/option strategy. Further, suppose ½ of 1 % of the money is to be committed to 30-day option purchases with the idea of reinvesting every 30 days. Similarly, ½ of 1 % is to be placed in 90-day purchases and 1 % in 180-day purchases. The annualized risk is 10%: Total annualized risk = ½% x 360 + ½% x 360 + 1 % x 360 30 90 180 = .06 + .02 + .02 = 10% 418 Part IV: Additional Considerations With asset.s of $1 million, this means that $.5,000 would be committed to 30-day pur­ chases; $.5,000 to 90-day purchases; and $10,000 to 180-day purchases. This money would be reinvested in similar quantities at the end of each holding period. RISK ADJUSTMENT The subject of adjusting the ratio to constantly reflect 10% risk must be addressed at the end of each holding period. Although it is correct for the investor to keep his per­ centage commitments constant, he must not be deluded into automatically reinvest­ ing the same amount of dollars each time. Example: At the end of 30 days, the value of the entire portfolio, including potential option profits and losses, and interest earned, was down to $990,000. Then only ½ of 1 % of that amount should be invested in the next 30-day purchase ($4,9.50). By operating in this manner - first computing the annualized risk and balanc­ ing it through predetermined percentage commitments to holding periods of various lengths; and second, readjusting the actual dollar commitment at the end of each holding period - the overall risk/reward ratios v,ill be kept close to the levels described in the earlier, simple desciiption of this strategy. This may require a rela­ tively large amount of work on the part of the strategist, but large portfolios usually do require work. The smaller investor does not have the luxury of such complete diversification, but he also does not have to adjust his total position as often. Example: An investor decided to commit $.50,000 to this strategy. Since there is a 1,200% annualized risk in 30-day purchases, it does not make much sense to even consider purchases that are so short-term for assets of this size. Rather, he might decide to commit 1 % of his assets to a 90-day purchase and 3% to a 180-day pur­ chase. In dollar amounts, this would be $.500 in a 90-day option and $1,.500 in 180- day options. Admittedly, this does not leave much room for diversification, but to risk more in the short-term purchases would expose the investor to too much risk. In actual practice, this investor would probably just invest .5% of his assets in 180-day purchases, also a 10% annualized risk. This would mean that he could operate with only one option buyer's analysis (the 180-day one) and could place $2,.500 into selec­ tions from that list. His adjustments of the assets committed to option purchases could not be done as frequently as the large investor, because of the commissions involved. He certain­ ly would have to adjust every 180 days, but might prefer to do so more frequently - perhaps every 90 days - to be able to space his 180-day commitments over different Chapter 26: Buying Options and Treasury Bills 419 option expiration cycles. It should also be pointed out that T-bills can be bought and sold only in amounts of at least $10,000 and in increments of $5,000 thereafter. That is, one could buy or sell $10,000 or $15,000 or $20,000 or $25,000, and so on, but could not buy or sell $5,000 or $8,000 or $23,000 in T-bills. This is of little concern to the investor with $1 million, since it takes only a fraction of a percentage of his assets to be able to round up to the next $5,000 increment for a T-bill sale or pur­ chase. However, the medium-sized investor with a $50,000 portfolio might run into problems. While short-term T-bills do represent the best risk-free investment, the medium-sized investor might want to utilize one of the no-load, money market funds for at least part of his income-bearing assets. Such funds have only slightly more risk than T-bills and offer the ability to deposit and withdraw in any amount. The truly small investor might be feeling somewhat left out. Could it be possi­ ble to operate this strategy with a very small amount of money, such as $5,000? Yes it could, but there are several disadvantages. Example: It would be extremely difficult to keep the risk level down to 10% annual­ ly with only $5,000. For example, 5% of the money invested every 180 days is only $250 in each investment period. Since the option selection process that is described will tend to select at- or slightly out-of-the-money calls, many of these will cost more than 2½ points for one option. The small investor might decide to raise his risk level slightly, although the risk level should never exceed 20% annually, no matter how small the actual dollar investment. To exceed this risk level would be to completely defeat the purpose of the fixed-income/option purchase strategy. Obviously, this small investor cannot buy T-bills, for his total investable assets are below the mini­ mum $10,000 purchase level. He might consider utilizing one of the money market funds. Clearly, an investor of this small magnitude is operating at a double disadvan­ tage: His small dollar commitment to option purchases may preclude him from buy­ ing some of the more attractive items; and his fixed-income portion will be earning a smaller percentage interest rate than that of the larger investor who is in T-bills or some other form of relatively risk-free, income-bearing security. Consequently, the small investor should carefully consider his financial capability and willingness to adhere strictly to the criteria of this strategy before actually committing his dollars. It may appear to the reader that the actual dollars being placed at risk in each option purchase are quite small in these examples. In fact, they are rather small, but they have been shown to represent 10% annualized risk. An assumption was made in these examples that the risk in each option purchase was 100% for the holding peri­ od. This is a fairly restrictive assumption and, if it were lessened, would allow for a larger dollar commitment in each holding period. It is difficult and dangerous, how- 420 Part IV: Additional Considerations ever, to assume that the risk in holding a call option is less than 100% in a holding period as short as 30 days. The strategist may feel that he is disciplined enough to sell out when losses occur and thereby hold the risk to less than 100%. Alternatively, mathematical analysis will generally show that the expected loss in a fixed time peri­ od is less than 100%. One can also mitigate the probability oflosing all of his money in an option purchase by buying in-the-money options. While they are more expen­ sive, of course, they do have a larger probability of having some residual worth even if the underlying stock doesn't rise to the trader's expectations. Adhering to any of these criteria can lead one to become too aggressive and therefore be too heavily committed to option purchases. It is far safer to stick to the simpler, more restrictive assumption that one is risking all his money, even over a fairly short holding period, when he buys an option. AVOIDING EXCESSIVE RISK One final word of caution must be inserted. The investor should not attempt to become 'Janey" with the income-bearing portion of his assets. T-bills may appear to be too "tame" to some investors, and they consider using GNMA's (Government National Mortgage Association certificates), corporate bonds, convertible bonds, or municipal bonds for the fixed-income portion. Although the latter securities may yield a slightly higher return than do T-bills, they may also prove to be less liquid and they quite clearly involve more risk than a short-term T-bill does. Moreover, some investors might even consider placing the balance of their funds in other places, such as high-yield stock or covered call writing. While high-yield stock purchases and cov­ ered call writing are conservative investments, as most investments go, they would have to be considered very speculative in comparison to the purchase of a 90-day T­ hill. In this strategy, the profit potential is represented by the option purchases. The yield on short-term T-bills will quite adequately offset the risks. One should take great care not to attempt to generate much higher yields on the fixed-income portion of his investment, for he may find that he has assumed risk with the portion of his money that was not intended to have any risk at all. A fair amount of rigorous mathematical work has been done on the evaluation of this strategy. The theoretical papers are quite favorable. Scholars have generally considered only the purchase of call options as the risk portion of the strategy. Obviously, the strategist is quite free to purchase put options without harming the overall intent of the strategy. When only call options are purchased, both static and down markets harm the performance. If some puts are included in the option pur­ chases, only static markets could produce the worst results. Chapter 26: Buying Options and Treasury Bills 421 There are trade-offs involved as well. If, after purchasing the options, the mar­ ket experiences a substantial rally, that portion of the option purchase money that is devoted to put option purchases will be lost. Thus, the combination of both put and call purchases would do better in a down market than a strategy of buying only calls, but would do worse in an up market. In a broad sense, it makes sense to include some put purchases if one has the funds to diversify, since the frequency of market rallies is smaller than the combined frequency of market rallies and declines. The investor who owns both puts and calls will be able to profit from substantial moves in either direction, because the profitable options will be able to overcome the limited losses on the unprofitable ones. SUMMARY In summary, the T-bill/option strategy is attractive from several viewpoints. Its true advantage lies in the fact that it has predefined risk and does not have a limit on potential profits. Some theorists claim it is the best strategy available, if the options are "underpriced" when they are purchased. The strategy is also relatively simple to operate. It is not necessary to have a margin account or to compute collateral require­ ments for uncovered options; the strategy can be operated completely from a cash account. There are no spreads involved, nor is it necessary to worry about details such as early assignment (because there are no short options in this strategy). The investor who is going to employ this strategy, however, must not be delud­ ed into thinking that it is so simple that it does not take any work at all. The concepts and application of annualized risk management are very important to the strategy. So are the mechanics of option buying - particularly a disciplined, rational approach to the selection of which calls and/or puts to buy. Consequently, this strategy is suitable only for the investor who has both the time and the discipline to operate it correctly. Arbitrage Arbitrage in the securities market often connotes that one is buying something in one marketplace and selling it in another marketplace, for a small profit with little or no risk. For example, one might buy XYZ at 55 in New York and sell it at 55¼ in Chicago. Arbitrage, especially option arbitrage, involves a far wider range of tactics than this simple example. Many of the option arbitrage tactics involve buying one side of an equivalent position and simultaneously selling the other side. Since there is a large number of equivalent strategies, many of which have been pointed out in earlier chapters, a full-time option arbitrageur is able to construct a rather large number of positions, most of which have little or no risk. The public customer can­ not generally operate arbitrage-like strategies because of the commission costs involved. Arbitrageurs are firm traders or floor traders who are trading through a seat on the appropriate securities exchange, and therefore have only minimal trans­ action costs. The public customer can benefit from understanding arbitrage techniques, even ifhe does not personally employ them. The arbitrageurs perform a useful function in the option marketplace, often making markets where a market might not otherwise exist (deeply in-the-money options, for example). This chapter is directed at the strategist who is actually going to be participating in arbitrage. This should not be confusing to the public customer, for he will better understand the arbitrage strate­ gies if he temporarily places himself in the arbitrageur's shoes. It is virtually impossible to perform pure arbitrage on dually listed options; that is, to buy an option on the CBOE and sell it on the American exchange in New York for a profit. Such discrepancies occur so infrequently and in such small size that an option arbitrageur could never hope to be fully employed in this type of simple arbi­ trage. Rather, the more complex forms of arbitrage described here are the ones on which he would normally concentrate. 422 Chapter 27: Arbitrage 423 BASIC PUT AND CALL ARBITRAGE ("DISCOUNTING") The basic call and the basic put arbitrages are two of the simpler forms of option arbi­ trage. In these situations, the arbitrageur attempts to buy the option at a discount while simultaneously taking an opposite position in the underlying stock. He can then exercise his option immediately and make a profit equal to the amount of the discount. The basic call arbitrage is described first. This was also outlined in Chapter 1, under the section on anticipating exercise. Example: XYZ is trading at 58 and the XYZ July 50 call is trading at 7¾. The call is actually at a discount from parity of ¼ point. Discount options generally either are quite deeply in-the-money or have only a short time remaining until expiration, or both. The call arbitrage would be constructed by: 1. buying the call at 7¾; 2. selling the stock at 58; 3. exercising the call to buy the stock at 50. The arbitrageur would make 8 points of profit from the stock, having sold it at 58 and bought it back at 50 via the option exercise. He loses the 7¾ points that he paid for the call option, but this still leaves him with an overall profit of¼ point. Since he is a member of the exchange, or is trading the seat of an exchange member, the arbi­ trageur pays only a small charge to transact the trades. In reality, the stock is not sold short per se, even though it is sold before it is bought. Rather, the position is designated, at the time of its inception, as an "irrevo­ cable exercise." The arbitrageur is promising to exercise the call. As a result, no uptick is required to sell the stock. The main goal in the call arbitrage is to be able to buy the call at a discount from the price at which the stock is sold. The differential is the profit potential of the arbi­ trage. The basic put arbitrage is quite similar to the call arbitrage. Again, the arbi­ trageur is looking to buy the put option at a discount from parity. The put arbitrage is completed with a stock purchase and option exercise. Example: XYZ is at 58 and the XYZ July 70 put is at 11 ¾. With the put at ¼ discount from parity, the arbitrageur might take the following action: 1. Buy put at 11 ¾. 2. Buy stock at 58. 3. Exercise put to sell stock at 70. 424 Part IV: Additional Considerations The stock transaction is a 12-point profit, since the stock was bought at 58 and is sold at 70 via the put exercise. The cost of the put - 11 ¾ points - is lost, but the arbi­ trageur still makes ¼-point profit. Again, this profit is equal to the arrwunt of the dis­ count in the option when the position was established. Generally, the arbitrageur would exercise his put option immediately, because he would not want to tie up his capital to carry the long stock. An exception to this would be if the stock were about to go ex-dividend. Dividend arbitrage is discussed in the next section. The basic call and put arbitrages may exist at any time, although they will be more frequent when there is an abundance of deeply in-the-money options or when there is a very short time remaining until expiration. After market rallies, the call arbitrage may be easier to establish; after market declines, the put arbitrage will be easier to find. As an expiration date draws near, an option that is even slightly in-the­ money on the last day or two of trading could be a candidate for discount arbitrage. The reason that this is true is that public buying interest in the option will normally wane. The only public buyers would be those who are short and want to cover. Many covered writers will elect to let the stock be called away, so that will reduce even fur­ ther the buying potential of the public. This leaves it to the arbitrageurs to supply the buying interest. The arbitrageur obviously wants to establish these positions in as large a size as possible, since there is no risk in the position if it is established at a discount. Usually, there will be a larger market for the stock than there will be for the options, so the arbitrageur spends more of his time on the option position. However, there may be occasions when the option markets are larger than the corresponding stock quotes. When this happens, the arbitrageur has an alternative available to him: He might sell an in-the-money option at parity rather than take a stock position. Example: XYZ is at 58 and the XYZ July 50 call is at 7¾. These are the same figures as in the previous example. Furthermore, suppose that the trader is able to buy more options at 7¾ than he is able to sell stock at 58. If there were another in-the-money call that could be sold at parity, it could be used in place of the stock sale. For exam­ ple, if the XYZ July 40 call could be sold at 18 (parity), the arbitrage could still be established. Ifhe is assigned on the July 40 that he is short, he will then be short stock at a net price of 58 - the striking price of 40, plus the 18 points that were brought in from the sale of the July 40 call. Thus, the sale of the in-the-money call at parity is equivalent to shorting the stock for the arbitrage purpose. In a similar manner, an in-the-money put can be used in the basic put arbitrage. Example: With XYZ at 58 and the July 70 put at 11¾, the arbitrage could be estab­ lished. However, if the trader is having trouble buying enough stock at 58, he might Chapter 27: Arbitrage 425 be able to use another in-the-money put. Suppose the XYZ July 80 put could be sold at 22. This would be the same as buying the stock at 58, because if the put were assigned, the arbitrageur would be forced to buy stock at 80 - the striking price - but his net cost would be 80 minus the 22 points he received from the sale of the put, for a net cost of 58. Again, the arbitrageur is able to use the sale of a deeply in-the-money option as a substitute for the stock trade. The examples above assumed that the arbitrageur sold a deeper in-the-money option at parity. In actual practice, if an in-the-money option is at a discount, an even deeper in-the-money option will generally be at a discount as well. The arbitrageur would normally try to sell, at parity, an option that was less deeply in-the-money than the one he is discounting. In a broader sense, this technique is applicable to any arbitrage that involves a stock trade as part of the arbitrage, except when the dividend in the stock itself is important. Thus, if the arbitrageur is having trouble buying or selling stock as part of his arbitrage, he can always check whether there is an in-the-money option that could be sold to produce a position equivalent to the stock position. DIVIDEND ARBITRAGE Dividend arbitrage is actually quite similar to the basic put arbitrage. The trader can lock in profits by buying both the stock and the put, then waiting to collect the divi­ dend on the underlying stock before exercising his put. In theory, on the day before a stock goes ex-dividend, all puts should have a time value premium at least as large as the dividend amount. This is true even for deeply in-the-money puts. Example: XYZ closes at 45 and is going to go ex-dividend by $1 tomorrow. Then a put with striking price of 50 should sell for at least 6 points ( the in-the-money amount plus the amount of the dividend), because the stock will go ex-dividend and is expect­ ed to open at 44, six points in-the-money. If, however, the put' s time value premium should be less than the amount of the dividend, the arbitrageur can take a riskless position. Suppose the XYZ July 50 put is selling for 5¾, with the stock at 45 and about to go ex-dividend by $1. The arbi­ trageur can take the following steps: 1. Buy the put at 5¼. 2. Buy the stock at 45. 3. Hold the put and stock until the stock goes ex-dividend (1 point in this case). 4. Exercise the put to sell the stock at 50. 426 Part IV: Additional Considerations The trader makes 5 points from the stock trade, buying it at 45 and selling it at 50 via the put exercise, and also collects the I-point dividend, for a total inflow of 6 points. Since he loses the 5¾ points he paid for the put, his net profit is ¼ point. Far in advance of the ex-dividend date, a deeply in-the-money put may trade very close to parity. Thus, it would seem that the arbitrageur could "load up" on these types of positions and merely sit back and wait for the stock to go ex-dividend. There is a flaw in this line of thinking, however, because the arbitrageur has a carrying cost for the rrwney that he must tie up in the long stock. This carrying cost fluctuates with short-term interest rates. Example: If the current rate of carrying charges were 6% annually, this would be equivalent to 1 % every 2 months. If the arbitrageur were to establish this example position 2 months prior to expiration, he would have a carrying cost of .5075 point. (His total outlay is 50¾ points, 45 for the stock and 5¾ for the options, and he would pay 1 % to carry that stock and option for the two months until the ex-dividend date.) This is more than ½ point in costs - clearly more than the ¼-point potential profit. Consequently, the arbitrageur must be aware of his carrying costs if he attempts to establish a dividend arbitrage well in advance of the ex-dividend date. Of course, if the ex-dividend date is only a short time away, the carrying cost has little effect, and the arbitrageur can gauge the profitability of his position mostly by the amount of the dividend and the time value premium in the put option. The arbitrageur should note that this strategy of buying the put and buying the stock to pick up the dividend might have a residual, rather profitable side effect. If the underlying stock should rally up to or above the striking price of the put, there could be rather large profits in this position. Although it is not likely that such a rally could occur, it would be an added benefit if it did. Even a rather small rally might cause the put to pick up some time premium, allowing the arbitrageur to trade out his position for a profit larger than he could have made by the arbitrage discount. This form of arbitrage occasionally lends itself to a limited form of risk arbi­ trage. Risk arbitrage is a strategy that is designed to lock in a profit if a certain event occurs. If that event does not occur, there could be a loss (usually quite limited); hence, the position has risk. This risk element differentiates a risk arbitrage from a standard, no-risk arbitrage. Risk arbitrage is described more fully in a later section, but the following example concerning a special dividend is one form of risk arbitrage. Example: XYZ has been known to declare extra, or special, dividends with a fair amount of regularity. There are several stocks that do so - Eastman Kodak and General Motors, for example. In this case, assume that a hypothetical stock, XYZ, has Chapter 27: Arbitrage 427 generally declared a special dividend in the fourth quarter of each year, but that its normal quarterly rate is $1.00 per share. Suppose the special dividend in the fourth quarter has ranged from an extra $1.00 to $3.00 over the past five years. If the arbi­ trageur were willing to speculate on the size of the upcoming dividend, he might be able to make a nice profit. Even if he overestimates the size of the special dividend, he has a limited loss. Suppose XYZ is trading at 55 about two weeks before the com­ pany is going to announce the dividend for the fourth quarter. There is no guarantee that there will, in fact, be a special dividend, but assume that XYZ is having a rela­ tively good year profitwise, and that some special dividend seems forthcoming. Furthermore, suppose the January 60 put is trading at 7½. This put has 2½ points of time value premium. If the arbitrageur buys XYZ at 55 and also buys the January 60 put at 7½, he is setting up a risk arbitrage. He will profit regardless of how far the stock falls or how much time value premium the put loses, if the special dividend is larger than $1.50. A special dividend of $1.50 plus the regular dividend of $1.00 would add up to $2.50, or 2½ points, thus covering his risk in the position. Note that $1.50 is in the low end of the $1.00 to $3.00 recent historical range for the special dividends, so the arbitrageur might be tempted to speculate a little by establishing this dividend risk arbitrage. Even if the company unexpectedly decided to declare no special dividend at all, it would most likely still pay out the $1.00 regular dividend. Thus, the most that the arbitrageur would lose would be 1 ½ points (his 2½-point ini­ tial time value premium cost, less the 1-point dividend). In actual practice, the stock would probably not change in price by a great deal over the next two weeks (it is a high-yield stock), and therefore the January 60 put would probably have some time value premium left in it after the stock goes ex-dividend. Thus, the practical risk is even less than 1 ½ points. While these types of dividend risk arbitrage are not frequently available, the arbitrageur who is willing to do some homework and also take some risk may find that he is able to put on a position with a small risk and a profitability quite a bit larger than the normal discount dividend arbitrage. There is really not a direct form of dividend arbitrage involving call options. If a relatively high-yield stock is about to go ex-dividend, holders of the calls will attempt to sell. They do so because the stock will drop in price, thereby generally forcing the call to drop in price as well, because of the dividend. However, the hold­ er of a call does not receive cash dividends and therefore is not willing to hold the call if the stock is going to drop by a relatively large amount (perhaps ¾ point or more). The effect of these call holders attempting to sell their calls may often pro­ duce a discount option, and therefore a basic call arbitrage may be possible. The arbi­ trageur should be careful, however, if he is attempting to arbitrage a stock that is 428 Part IV: Additional Considerations going ex-dividend on the following day. Since he must sell the stock to set up the arbi­ trage, he cannot afford to wind up the day being short any stock, for he will then have to pay out the dividend the following day (the ex-dividend date). Furthermore, his records must be accurate, so that he exercises all his long options on the day before the ex-dividend date. If the arbitrageur is careless and is still short some stock on the ex-date, he may find that the dividend he has to pay out wipes out a large portion of the discount profits he has established. CONVERSIONS AND REVERSALS In the introductory material on puts, it was shown that put and call prices are relat­ ed through a process known as conversion. This is an arbitrage process whereby a trader may sometimes be able to lock in a profit at absolutely no risk. A conversion consists of buying the underlying stock, and also buying a put option and selling a call option such that both options have the same terms. This position will have a locked-in profit if the total cost of the position is less than the striking price of the options. Example: The following prices exist: XYZ common, 55; XYZ January 50 call, 6½; and XYZ January 50 put, 1. The total cost of this conversion is 49½ - 55 for the stock, plus 1 for the put, less 6½ for the call. Since 49½ is less than the striking price of 50, there is a locked-in profit on this position. To see that such a profit exists, suppose the stock is somewhere above 50 at expiration. It makes no difference how far above 50 the stock might be; the result will be the same. With the stock above 50, the call will be assigned and the stock will be sold at a price of 50. The put will expire worthless. Thus, the profit is½ point, since the initial cost of the position was 49½ and it can eventually be liquidat­ ed for a price of 50 at expiration. A similar result occurs if XYZ is below 50 at expi­ ration. In this case, the trader would exercise his put to sell his stock at 50, and the call would expire worthless. Again, the position is liquidated for a price of 50 and, since it only cost 49½ to establish, the same ½-point profit can be made. No matter where the stock is at expiration, this position has a locked-in-profit of½ point. This example is rather simplistic because it does not include two very important factors: the possible dividend paid by the stock and the cost of carrying the position Chapter 27: Arbitrage 429 until expiration. The inclusion of these factors complicates things somewhat, and its discussion is deferred momentarily while the companion strategy, the reversal, is explained. A reversal (or reverse conversion, as it is sometimes called) is exactly the oppo­ site of a conversion. In a reversal, the trader sells stock short, sells a put, and buys a call. Again, the put and call have the same terms. A reversal will be profitable if the initial credit ( sale price) is greater than the striking price of the options. Example: A different set of prices will be used to describe a reversal: XYZ common, 55; XYZ January 60 call, 2; and XYZ January 60 put, 7½. The total credit of the reversal is 60½ - 55 from the stock sale, plus 7½ from the put sale, less the 2-point cost of the call. Since 60½ is greater than the striking price of the options, 60, there is a locked-in profit equal to the differential of½ point. To ver­ ify this, first assume that XYZ is anywhere below 60 at January expiration. The put will be assigned - stock is bought at 60 - and the call will expire worthless. Thus, the reversal position is liquidated for a cost of 60. A ½-point profit results since the orig­ inal sale value ( credit) of the position was 60½. On the other hand, if XYZ were above 60 at expiration, the trader would exercise his call, thus buying stock at 60, and the put would expire worthless. Again, he would liquidate the position at a cost of 60 and would make a ½-point profit. Dividends and carrying costs are important in reversals, too; these factors are addressed here. The conversion involves buying stock, and the trader will thus receive any dividends paid by the stock during the life of the arbitrage. However, the converter also has to pay out a rather large sum of money to set up his arbitrage, and must therefore deduct the cost of carrying the position from his potential profits. In the example above, the conversion position cost 49½ points to establish. If the trad­ er's cost of money were 6% annually, he would thus lose .06/12 x 49½, or .2475 point per month for each month that he holds the position. This is nearly ¼ of a point per month. Recall that the potential profit in the example is ½ point, so that if one held the position for more than two months, his carrying costs would wipe out his profit. It is extremely important that the arbitrageur compute his carrying costs accurately prior to establishing any conversion arbitrage. If one prefers formulae, the profit potentials of a conversion or a reversal can be stated as: 430 l'art IV: Additional Considerations Conversion profit = Striking price + Call price - Stock price - Put price + Dividends to be received - Carrying cost of position Reversal profit = Stock + Put - Strike - Call + Carrying cost - Dividends Note that during any one trading day, the only items in the formulae that can change are the prices of the securities involved. The other items, dividends and carrying cost, are fixed for the day. Thus, one could have a small computer program prepared that listed the fixed charges on a particular stock for all the strikes on that stock. Example: It is assumed that XYZ stock is going to pay a ½-point dividend during the life of the position, and that the position will have to be held for three months at a carrying cost of 6% per year. If the arbitrageur were interested in a conversion with a striking price of 50, his fixed cost would be: Conversion fixed cost = Carrying rate x Time held x Striking price - Dividend to be received = .06 X 3/12 X 50 - ½ = .75- ½ = .25, or¼ point The arbitrageur would know that if the profit potential, computed in the simplistic manner using only the prices of the securities involved, was greater than ¼ point, he could establish the conversion for an eventual profit, including all costs. Of course, the carrying costs would be different if the striking price were 40 or 60, so a com­ puter printout of all the possible striking prices on each stock would be useful in order for the trader to be able to refer quickly to a table of his fixed costs each day. MORE ON CARRYING COSTS The computation of carrying costs can be made more involved than the simple method used above. Simplistically, the carrying cost is computed by multiplying the debit of the position by the interest rate charged and the time that the position will be held. That is, it could be formulated as: Carrying cost = Strike x r x t where r is the interest rate and t is the time that the position will be held. Relating this formula for the carrying cost to the conversion profit formula given above, one would get: Conversion profit = Call - Stock - Put + Dividend + Strike - Carrying cost = Call - Stock - Put + Dividend + Strike ( 1 - rt) Chapter 27: Arbitrage 431 In an actuarial sense, the carrying cost could be expressed in a slightly more complex manner. The simple formula (strike x r x t) ignores two things: the compounding effect of interest rates and the "present value" concept ( the present value of a future amount). The absolutely correct formula to include both present value and the com­ pounding effect would necessitate replacing the factor strike (1- rt) in the profit for­ mula by the factor Strike (1 + r)f Is this effect large? No, not when rand tare small, as they would be for most option calculations. The interest rate per month would normally be less than 1 %, and the time would be less than 9 months. Thus, it is generally acceptable, and is the com­ mon practice among many arbitrageurs, to use the simple formula for carrying costs. In fact, this is often a matter of convenience for the arbitrageur if he is computing the carrying costs on a hand calculator that does not perform exponentiation. However, in periods of high interest rates when longer-term options are being ana­ lyzed, the arbitrageur who is using the simple formula should double-check his cal­ culations with the correct formula to assure that his error is not too large. For purposes of simplicity, the remaining examples use the simple formula for carrying-cost computations. The reader should remember, however, that it is only a convenient approximation that works best when the interest rate and the holding period are small. This discussion of the compounding effect of interest rates also rais­ es another interesting point: Any investor using margin should, in theory, calculate his potential interest charge using the compounding formula. However, as a matter of practicality, extremely few investors do. An example of this compounding effect on a covered call write is presented in Chapter 2. BACK TO CONVERSIONS AND REVERSALS Profit calculation similar to the conversion profit formula is necessary for the rever­ sal arbitrage. Since the reversal necessitates sho1ting stock, the trader must pay out any dividends on the stock during the time in which the position is held. However, he is now bringing in a credit when the position is established, and this money can be put to work to earn interest. In a reversal, then, the dividend is a cost and the interest earned is a profit. 432 Part IV: Additional Considerations Example: Use the same XYZ details described above: The stock is going to pay a ½­ point dividend, the position will be held for three months, and the money will earn interest at a rate of ½ of 1 % per month. If the trader were contemplating an arbi­ trage with a striking price of 30, the fixed cost would be: Reversal fixed cost = Dividend to be paid - Interest rate per month x Months held x Striking price = .50 - .005 X 3 X 30 = ½ - .045 = .005 point The fixed cost in this reversal is extremely small. In fact, the reader should be able to see that it is often possible - even probable - that there will be a fixed credit, not a frxed cost, in a reversal arbitrage. To verify this, rework the example with a striking price of 50 or 60. As in a conversion, the frxed cost (or profit) in a reversal is a num­ ber that can be used for the entire trading day. It will not change. BORROWING STOCK TO SELL SHORT The above example assumes that the arbitrageur earns the full carrying rate on the short stock. Only certain arbitrageurs are actually able to earn that rate. When one sells stock short, he must actually borrow the stock from someone who owns it, and then the seller goes into the market to sell the stock. When customers of brokerage firms keep stock in a margin account, they agree to let the brokerage firm loan their stock out without the customer's specific approval. Thus, if an arbitrageur working for that brokerage firm wanted to establish a reversal, and if the stock to be sold short in the reversal were available in one of the margin accounts, the arbitrageur could bor­ row that stock and earn the full carrying rate on it. This is called "using box stock," since stock held in margin accounts is generally referred to as being in the "box." There are other times, however, when an arbitrageur wants to do a reversal but does not have access to "box" stock. He must then find someone else from whom to borrow the stock. Obviously, there are people who own stock and would loan it to arbitrageurs for a fee. There are people who specialize in matching up investors with stock to loan and arbitrageurs who want to borrow stock. These people are said to be in the "stock loan" business. Generally, the fee for borrowing stock in this manner is anywhere from 10 to 20% of the prevailing carrying cost rate. For example, if the cur­ rent carrying rate were 10% annually, then one would expect to pay 1 or 2% to the lender to borrow his stock. This reduces the profitability of the reversal slightly. Since small margins are being worked with, this cost to borrow the stock may make a sig­ nificant difference to the arbitrageur. These variations in the rates that an arbitrageur can earn on the credit balances in his account affect the marketplace. For example, a particular reversal might be Chapter 27: Arbitrage 433 available in the marketplace at a net profit of ½ point, or 50 cents. Such a reversal may not be equally attractive to all arbitrageurs. Those who have "box" stock may be willing to do the reversal for 50 cents; those who have to pay 1 % to borrow stock may want 0.55 for the reversal; and those who pay 2% to borrow stock may need 0.65 for the reversal. Thus, arbitrageurs who do conversions and reversals are in competition with each other not only in the marketplace, but in the stock loan arena as well. Reversals are generally easier positions for the arbitrageur to locate than are conversions. This is because the fixed cost of the conversion has a rather burdensome effect. Only if the stock pays a rather large dividend that outweighs the carrying cost could the fixed portion of the conversion formula ever be a profit as opposed to a cost. In practice, the interest rate paid to carry stock is probably higher than the interest earned from being short stock, but any reasonable computer program should be able to handle two different interest rates. The novice trader may find the term "conversion" somewhat illogical. In the over-the-counter option markets, the dealers create a position similar to the one shown here as a result of actually converting a put to a call. Example: When someone owns a conventional put on XYZ with a striking price of 60 and the stock falls to 50, there is often little chance of being able to sell the put profitably in the secondary market. The over-the-counter option dealer might offer to convert the put into a call. To do this, he would buy the put from the holder, then buy the stock itself, and then offer a call at the original striking price of 60 to the holder of the put. Thus, the dealer would be long the stock, long the put, and short the call - a conversion. The customer would then own a call on XYZ with a striking price of 60, due to expire on the same date that the put was destined to. The put that the customer owned has been converted into a call. To effect this conversion, the dealer pays out to the customer the difference between the current stock price, 50, and the striking price, 60. Thus, the customer receives $1,000 for this conver­ sion. Also, the dealer would charge the customer for costs to carry the stock, so that the dealer had no risk. If the stock rallied back above 60, the customer could make more money, because he owns the call. The dealer has no risk, as he has an arbitrage position to begin with. In a similar manner, the dealer can effect a reverse conver­ sion - converting a call to a put - but will charge the dividends to the customer for doing so. RISKS IN CONVERSIONS AND REVERSALS Conversions and reversals are generally considered to be riskless arbitrage. That is, the profit in the arbitrage is fixed from the start and the subsequent movement of the 434 Part IV: Additional Considerations underlying stock makes no difference in the eventual outcome. This is generally a true statement. However, there are some risks, and they are great enough that one can actually lose money in conversions and reversals if he does not take care. The risks are fourfold in reversal arbitrage: An extra dividend is declared, the interest rate falls while the reversal is in place, an early assignment is received, or the stock is exactly at the striking price at expiration. Converters have similar risks: a dividend cut, an increase in the interest rate, early assignment, or the stock closing at the strike at expiration. These risks are first explored from the viewpoint of the reversal trader. If the company declares an extra dividend, it is highly likely that the reversal will become unprofitable. This is so because most extra dividends are rather large - more than the profit of a reversal. There is little the arbitrageur can do to avoid being caught by the declaration of a truly extra dividend. However, some companies have a track record of declaring extras with annual regularity. The arbitrageur should be aware of which companies these are and of the timing of these extra dividends. A clue sometimes exists in the marketplace. If the reversal appears overly profitable when the arbi­ trageur is first examining it (before he actually establishes it), he should be somewhat skeptical. Perhaps there is a reason why the reversal looks so tempting. An extra div­ idend that is being factored into the opinion of the marketplace may be the answer. The second risk is that of variation in interest rates while the reversal is in progress. Obviously, rates can change over the life of a reversal, normally 3 to 6 months. There are two ways to compensate for this. The simplest way is to leave some room for rates to move. For example, if rates are currently at 12% annually, one might allow for a movement of 2 to 3% in rates, depending on the length of time the reversal is expected to be in place. In order to allow for a 2% move, the arbitrageur would calculate his initial profit based on a rate of 10%, 2% less than the currently prevailing 12%. He would not establish any reversal that did not at least break even with a 10% rate. The rate at which a reversal breaks even is often called the "effec­ tive rate" - 10% in this case. Obviously, if rates average higher than 10% during the life of the reversal, it will make money. Normally, when one has an entire portfolio of reversals in place, he should know the effective rate of each set of reversals expiring at the same time. Thus, he would have an effective rate for his 2-month reversals, his 3-month ones, and so forth. Allowing this room for rates to move does not necessarily mean that there will not be an adverse affect if rates do indeed fall. For example, rates could fall farther than the room allowed. Thus, a further measure is necessary in order to completely protect against a drop in rates: One should invest his credit balances generated by the reversals in interest-bearing paper that expires at approximately the same time the reversals do, and that bears interest at a rate that locks in a profit for the reversal Chapter 27: Arbitrage 435 account. For example, suppose that an arbitrageur has $5 million in 3-month rever­ sals at an effective rate of 10%. If he can buy $5 million worth of 3-month Certificates of Deposit with a rate of 11 ½%, then he would lock in a profit of 1 ½% on his $5 mil­ lion. This method of using paper to hedge rate fluctuations is not practiced by all arbitrageurs; some think it is not worth it. They believe that by leaving the credit bal­ ances to fluctuate at prevailing rates, they can make more if rates go up, and that will cushion the effect when rates decline. The third risk of reversal arbitrage is reception of an early assignment on the short puts. This forces the arbitrageur to buy stock and incur a debit. Thus, the posi­ tion does not earn as much interest as was originally assumed. If the assignment is received early enough in the life of the reversal (recall that in-the-money puts can be assigned very far in advance of expiration), the reversal could actually incur an overall loss. Such early assignments normally occur during bearish markets. The only advantage of this early assignment is that one is left with unhedged long calls; these calls are well out-of-the-money and normally quite low-priced (¼ or less). If the market should reverse and turn bullish before the expiration of the calls, the arbi­ trageur may make money on them. There is no way to hedge completely against a market decline, but it does help if the arbitrageur tries to establish reversals with the call in-the-money and the put out-of-the-money. That, plus demanding a better overall return for reversals near the strike, should help cushion the effects of the bear market. The final risk is the most common one, that of the stock closing exactly at the strike at expiration. This presents the arbitrageur with a decision to make regarding exercise of his long calls. Since the stock is exactly at the strike, he is not sure whether he will be assigned on his short puts at expiration. The outcome is that he may end up with an unhedged stock position on Monday morning after expiration. If the stock should open on a gap, he could have a substantial loss that wipes out the profits of many reversals. This risk of stock closing at the strike may seem minute, but it is not. In the absence of any real buying or selling in the stock on expiration day, the process of discounting will force a stock that is near the strike virtually right onto the strike. Once it is near the strike, this risk materializes. There are two basic scenarios that could occur to produce this unhedged stock position. First, suppose one decides that he will not get put and he exercises his calls. However, he was wrong and he does get put. He has bought double the amount of stock - once via call exercise and again via put assignment. Thus, he will be long on Monday morning. The other scenario produces the opposite effect. Suppose one decides that he will get put and he decides not to exercise his calls. If he is wrong in this case, he does not buy any stock - he didn't exercise nor did he get put. Consequently, he will be short stock on Monday morning. 436 Part IV: Additional Considerations If one is truly undecided about whether he will be assigned on his short puts, he might look at several clues. First, has any late news come out on Friday evening that might affect the market's opening or the stock's opening on Monday morning? If so, that should be factored into the decision regarding exercising the calls. Another clue arises from the price at which the stock was trading during the Friday expiration day, prior to the close. If the stock was below the strike for most of the day before closing at the strike, then there is a greater chance that the puts will be assigned. This is so because other arbitrageurs (discounters) have probably bought puts and bought stock during the day and will exercise to clean out their positions. If there is still doubt, it may be wisest to exercise only half of the calls, hoping for a partial assignment on the puts (always a possibility). This halfway measure will normally result in some sort of unhedged stock position on Monday morning, but it will be smaller than the maximum exposure by at least half. Another approach that the arbitrageur can take if the stock is near the strike of the reversal during the late trading of the options' life - during the last few days - is to roll the reversal to a later expiration or, failing that, to roll to another strike in the same expiration. First, let us consider rolling to another expiration. The arbitrageur knows the dollar price that equals his effective rate for a 3-month reversal. If the cur­ rent options can be closed out and new options opened at the next expiration for at least the effective rate, then the reversal should be rolled. This is not a likely event, mostly due to the fact that the spread between the bid and asked prices on four sep­ arate options makes it difficult to attain the desired price. Note: This entire four-way order can be entered as a spread order; it is not necessary to attempt to "leg" the spread. The second action - rolling to another strike in the same expiration month - may be more available. Suppose that one has the July 45 reversal in place (long July 45 call and short July 45 put). If the underlying stock is near 45, he might place an order to the exchange floor as a three-way spread: Sell the July 45 call (closing), buy the July 45 put (closing), and sell the July 40 call ( opening) for a net credit of 5 points. This action costs the arbitrageur nothing except a small transaction charge, since he is receiving a 5-point credit for moving the strike by 5 points. Once this is accom­ plished, he will have moved the strike approximately 5 points away and will thus have avoided the problem of the stock closing at the strike. Overall, these four risks are significant, and reversal arbitrageurs should take care that they do not fall prey to them. The careless arbitrageur uses effective rates too close to current market rates, establishes reversals with puts in-the-money, and routinely accepts the risk of acquiring an unhedged stock position on the morning after expiration. He will probably sustain a large loss at some time. Since many rever­ sal arbitrageurs work with small capital and/or have convinced their backers that it is Chapter 27: Arbitrage 437 a riskless strategy, such a loss may have the effect of putting them out of business. That is an unnecessary risk to take. There are countermeasures, as described above, that can reduce the effects of the four risks. Let us consider the risks for conversion traders more briefly. The risk of stock closing near the strike is just as bad for the conversion as it is for the reversal. The same techniques for handling those risks apply equally well to conversions as to reversals. The other risks are similar to reversal risks, but there are slight nuances. The conversion arbitrage suffers if there is a dividend cut. There is little the arbitrageur can do to predict this except to be aware of the fundamentals of the com­ pany before entering into the conversion. Alternatively, he might avoid conversions in which the dividend makes up a major part of the profit of the arbitrage. Another risk occurs if there is an early assignment on the calls before the ex-div­ idend date and the dividend is not received. Moreover, an early assignment leaves the arbitrageur with long puts, albeit fractional ones since they are surely deeply out-of­ the-money. Again, the policy of establishing conversions in which the dividend is not a major factor would help to ease the consequences of early assignment. The final risk is that interest rates increase during the time the conversion is in place. This makes the carrying costs larger than anticipated and might cause a loss. The best way to hedge this initially is to allow a margin for error. Thus, if the pre­ vailing interest rate is 12%, one might only establish reversals that would break even if rates rose to 14%. If rates do not rise that far on average, a profit will result. The arbitrageur can attempt to hedge this risk by shorting interest-bearing paper that matures at approximately the same time as the conversions. For example, if one has $5 million worth of 3-month conversions established at an effective rate of 14% and he shorts 3-month paper at 12½%, he locks in a profit of 1 ½%. This is not common practice for conversion arbitrageurs, but it does hedge the effect of rising interest rates. SUMMARY OF CONVERSION ARBITRAGE The practice of conversion and reversal arbitrage in the listed option markets helps to keep put and call prices in line. If arbitrageurs are active in a particular option, the prices of the put and call will relate to the stock price in line with the formulae given earlier. Note that this is also a valid reason why puts tend to sell at a lower price than calls do. The cost of money is the determining factor in the difference between put and call prices. In essence, the "cost" (although it may sometimes be a credit) is sub­ tracted from the theoretical put price. Refer again to the formula given above for the profit potential of a conversion. Assume that things are in perfect alignment. Then the formula would read: 438 Part IV: Additional Considerations Put price = Striking price + Call price - Stock price - Fixed cost Furthermore, if the stock is at the striking price, the formula reduces to: Put price = Call price - Fixed cost So, whenever the fixed cost, which is equal to the carrying charge less the dividends, is greater than zero (and it usually is), the put will sell for less than the call if a stock is at the striking price. Only in the case of a large-dividend-paying stock, when the fixed cost becomes negative (that is, it is not a cost, but a credit), does the reverse hold true. This is supportive evidence for statements made earlier that at-the-money calls sell for more than at-the-money puts, all other things being equal. The reader can see quite clearly that it has nothing to do with supply and demand for the puts and calls, a fallacy that is sometimes proffered. This same sort of analysis can be used to prove the broader statement that calls have a greater time value premium than puts do, except in the case of a large-dividend-paying stock. One final word of advice should be offered to the public customer. He may sometimes be able to find conversions or reversals, by using the simplistic formula, that appear to have profit potentials that exceed commission costs. Such positions do exist from time to time, but the rate of return to the public customer will almost assuredly be less than the short-term cost of money. If it were not, arbitrageurs would be onto the position very quickly. The public option trader may not actually be think­ ing in terms of comparing the profit potential of a position with what he could get by placing the money into a bank, but he must do so to convince himself that he cannot feasibly attempt conversion or reversal arbitrages. THE "INTEREST PLAY" In the preceding discussion of reversal arbitrage, it is apparent that a substantial por­ tion of the arbitrageur's profits may be due to the interest earned on the credit of the position. Another type of position is used by many arbitrageurs to take advantage of this interest earned. The arbitrageur sells the underlying stock short and simultane­ ously buys an in-the-money call that is trading slightly over parity. The actual amount over parity that the arbitrageur can afford to pay for the call is determined by the interest that he will earn from his short sale and the dividend payout before expira­ tion. He does not use a put in this type of position. In fact, this "interest play" strat­ egy is merely a reversal arbitrage without the short put. This slight variation has a residual benefit for the arbitrageur: If the underlying stock should drop dramatically in price, he could make large profits because he is short the underlying stock. In any case, he will make his interest credit less the amount of time value premium paid for the call less any dividends lost. Chapter 27: Arbitrage 439 Example 1: XYZ is sold short at 60, and a January 50 call is bought for 10¼ points. Assume that the prevailing interest rate is 1 % per month and that the position is established one month prior to expiration. XYZ pays no dividend. The total credit brought in from the trades is $4,975, so the arbitrageur will earn $49.75 in interest over the course of 1 month. If the stock is above 50 at expiration, he will exercise his call to buy stock at 50 and close the position. His loss on the security trades will be $25 the amount of time value premium paid for the call option. (He makes 10 points by selling stock at 60 and buying at 50, but loses 10¼ points on the exercised call.) His overall profit is thus $24.75. Example 2: A real-life example may point out the effect of interest rates even more dramatically. In early 1979, IBM April 240 calls with about six weeks of life remain­ ing were over 60 points in-the-money. IBM was not going to be ex-dividend in that time. Normally, such a deeply in-the-money option would be trading at parity or even a discount when the time remaining to expiration is so short. However, these calls were trading 3½ points over parity because of the prevailing high interest rates at the time. IBM was at 300, the April 240 calls were trading at 63½, and the prevailing interest rate was approximately 1 % per month. The credit from selling the stock and buying the call was $23,700, so the arbitrageur earned $365.50 in interest for 1 ½ months, and lost $350 - the 3½ points of time value premium that he paid for the call. This still left enough room for a profit. In Chapter 1, it was stated that interest rates affect option prices. The above examples of the "interest play" strategy quite clearly show why. As interest rates rise, the arbitrageur can afford to pay more for the long call in this strategy, thus causing the call price to increase in times of high interest rates. If call prices are higher, so will put prices be, as the relationships necessary for conversion and reversal arbitrage are preserved. Similarly, if interest rates decline, the arbitrageur will make lower bids, and call and put prices will be lower. They are active enough to give truth to the theory that option prices are directly related to interest rates. THE BOX SPREAD An arbitrage consists of simultaneously buying and selling the same security or equiv­ alent securities at different prices. For example, the reversal consists of selling a put and simultaneously shorting stock and buying a call. The reader will recall that the short stock/long call position was called a synthetic put. That is, shorting the stock and buying a call is equivalent to buying a put. The reversal arbitrage therefore con­ sists of selling a (listed) put and simultaneously buying a (synthetic) put. In a similar 440 Part IV: Additional Considerations manner, the conversion is merely the purchase of a (listed) put and the simultaneous sale of a (synthetic) put. Many equivalent strategies can be combined for arbitrage purposes. One of the more common ones is the box spread. Recall that it was shown that a bull spread or a bear spread could be construct­ ed with either puts or calls. Thus, if one were to simultaneously buy a (call) bull spread and buy a (put) bear spread, he could have an arbitrage. In essence, he is merely buying and selling equivalent spreads. If the price differentials work out cor­ rectly, a risk-free arbitrage may be possible. Example: The following prices exist: XYZ common, 55 XYZ January 50 call, 7 XYZ January 50 put, 1 XYZ January 60 call, 2 XYZ January 60 put, 5½ The arbitrageur could establish the box spread in this example by executing the following transactions: Buy a call bull spread: Buy XYZ January 50 call Sell XYZ January 60 call Net call cost Buy a put bear spread: Buy XYZ January 60 put Sell XYZ January 50 put Net put cost Total cost of position 7 debit 2 credit 51/2 debit 1 credit 5 debit No matter where XYZ is at January expiration, this position will be worth 10 points. The arbitrageur has locked in a risk-free profit of½ point, since he "bought" the box spread for 9½ points and will be able to "sell" it for 10 points at expiration. To verify this, evaluate the position at expiration, first with XYZ above 60, then with XYZ between 50 and 60, and finally with XYZ below 50. If XYZ is above 60 at expiration, the puts will expire worthless and the call bull spread will be at its maximum poten­ tial of 10 points, the difference between the striking prices. Thus, the position can be liquidated for 10 points if XYZ is above 60 at expiration. Now assume that XYZ is Chapter 27: Arbitrage 441 between 50 and 60 at expiration. In that case, the out-of-the-money, written options would expire worthless-the January 60 call and the January 50 put. This would leave a long, in-the-money combination consisting of a January 50 call and a January 60 put. These two options must have a total value of 10 points at expiration with XYZ between 50 and 60. (For example, the arbitrageur could exercise his call to buy stock at 50 and exercise his put to sell stock at 60.) Finally, assume that XYZ is below 50 at expiration. The calls would expire worthless if that were true, but the remaining put spread- actually a bear spread in the puts -would be at its maximum potential of 10 points. Again, the box spread could be liquidated for 10 points. The arbitrageur must pay a cost to carry the position, however. In the prior example, if interest rates were 6% and he had to hold the box for 3 months, it would cost him an additional 14 cents (.06 x 9½ x 3112). This still leaves room for a profit. In essence, a bull spread ( using calls) was purchased while a bear spread ( using puts) was bought. The box spread was described in these terms only to illustrate the fact that the arbitrageur is buying and selling equivalent positions. The arbitrageur who is utilizing the box spread should not think in terms of bull or bear spread, how­ ever. Rather, he should be concerned with "buying" the entire box spread at a cost of less than the differential between the two striking prices. By "buying" the box spread, it is meant that both the call spread portion and the put spread portion are debit spreads. Whenever the arbitrageur observes that a call spread and a put spread using the same strikes and that are both debit spreads can be bought for less than the dif­ ference in the strikes plus carrying costs, he should execute the arbitrage. Obviously, there is a companion strategy to the one just described. It might sometimes be possible for the arbitrageur to "sell" both spreads. That is, he would establish a credit call spread and a credit put spread, using the same strikes. If this credit were greater than the difference in the striking prices, a risk-free profit would be locked in. Example: Assume that a different set of prices exists: XYZ common, 75 XYZ April 70 call, 8½ XYZ April 70 put, 1 XYZ April 80 call, 3 XYZ April 80 put, 6 By executing the following transactions, the box spread could be "sold": 442 Sell a call (bear) spread: Buy April 80 call Sell April 70 call Net credit on calls Sell a put (bull) spread: Buy April 70 put Sell April 80 put Net credit on puts Total credit of position 3 debit 81/2 credit 1 debit 6 credit Part IV: Additional Considerations 5 credit 10 1/2 credit In this case, no matter where XYZ is at expiration, the position can be bought back for 10 points. This means that the arbitrageur has locked in risk-free profit of¼ point. To verify this statement, first assume that XYZ is above 80 at April expiration. The puts will expire worthless, and the call spread will have widened to 10 points - the cost to buy it back. Alternatively, if XYZ were between 70 and 80 at April expira­ tion, the long, out-of-the-money options would expire worthless and the in-the­ money combination would cost 10 points to buy back. (For example, the arbitrageur could let himself be put at 80, buying stock there, and called at 70, selling the stock there - a net "cost" to liquidate of 10 points.) Finally, if XYZ were below 70 at expi­ ration, the calls would expire worthless and the put spread would have widened to 10 points. It could then be closed out at a cost of 10 points. In each case, the arbitrageur is able to liquidate the box spread by buying it back at 10. In this sale of a box spread, he would earn interest on the credit received while he holds the position. There is an additional factor in the profitability of the box spread. Since the sale of a box generates a credit, the arbitrageur who sells a box will earn a small amount of money from that sale. Conversely, the purchaser of a box spread will have a charge for carrying cost. Since profit margins may be small in a box arbitrage, these carrying costs can have a definite effect. As a result, boxes may actually be sold for 5 points, even though the striking prices are 5 points apart, and the arbitrageur can still make money because of the interest earned. These box spreads are not easy to find. If one does appear, the act of doing the arbitrage will soon make the arbitrage impossible. In fact, this is true of any type of arbitrage; it cannot be executed indefinitely because the mere act of arbitraging will force the prices back into line. Occasionally, the arbitrageur will be able to find the option quotes to his liking, especially in volatile markets, and can establish a risk-free Chapter 27: Arbitrage 443 arbitrage with the box spread. It can be evaluated at a glance. Only two questions need to be answered: 1. If one were to establish a debit call spread and a debit put spread, using the same strikes, would the total cost be less than the difference in the striking prices plus carrying costs? If the answer is yes, an arbitrage exists. 2. Alternatively, if one were to sell both spreads - establishing a credit call spread and a credit put spread - would the total credit received plus interest earned be greater than the difference in the striking prices? If the answer is yes, an arbi­ trage exists. There are some risks to box arbitrage. Many of them are the same as those risks faced by the arbitrageur doing conversions or reversals. First, there is risk that the stock might close at either of the two strikes. This presents the arbitrageur with the same dilemma regarding whether or not to exercise his long options, since he is not sure whether he will be assigned. Additionally, early assignment may change the prof­ itability: Assignment of a short put will incur large carrying costs on the resulting long stock; assignment of a short call will inevitably come just before an ex-dividend date, costing the arbitrageur the amount of the dividend. There are not many opportunities to actually transact box arbitrage, but the fact that such arbitrage exists can help to keep markets in line. For example, if an under­ lying stock begins to move quickly and order flow increases dramatically, the special­ ist or market-markers in that stock's options may be so inundated with orders that they cannot be sure that their markets are correct. They can use the principles of box arbitrage to keep prices in line. The most active options would be the ones at strikes nearest to the current stock price. The specialist can quickly add up the markets of the call and put at the nearest strike above the stock price and add to that the mar­ kets of the options at the strike just below. The sum of the four should add up to a price that surrounds the difference in the strikes. If the strikes are 5 points apart, then the sum of the four markets should be something like 4½ bid, 5½ asked. If, instead, the four markets add up to a price that allows box arbitrage to be established, then the specialist will adjust his markets. VARIATIONS ON EQUIVALENCE ARBITRAGE Other variations of arbitrage on equivalent positions are possible, although they are relatively complicated and probably not worth the arbitrageur's time to analyze. For example, one could buy a butterfly spread with calls and simultaneously sell a but­ terfly spread using puts. A listed straddle could be sold and a synthetic straddle 444 Part IV: Additional Considerations could be bought - short stock and long 2 calls. Inversely, a listed straddle could be bought against a ratio write - long stock and short 2 calls. The only time the arbi­ trageur should even consider anything like this is when there are more sizable mar­ kets in certain of the puts and calls than there are in others. If this were the case, he might be able to take an ordinary box spread, conversion, or reversal and add to it, keeping the arbitrage intact by ensuring that he is, in fact, buying and selling equiv­ alent positions. THE EFFECTS OF ARBITRAGE The arbitrage process serves a useful purpose in the listed options market, because it may provide a secondary market where one might not otherwise exist. Normally, public interest in an in-the-money option dwindles as the option becomes deeply in­ the-money or when the time remaining until expiration is very short. There would be few public buyers of these options. In fact, public selling pressure might increase, because the public would rather liquidate in-the-money options held long than exer­ cise them. The few public buyers of such options might be writers who are closing out. However, if the writer is covered, especially where call options are concerned, he might decide to be assigned rather than close out his option. This means that the public seller is creating a rather larger supply that is not offset by a public demand. The market created by the arbitrageur, especially in the basic put or call arbitrage, essentially creates the demand. Without these arbitrageurs, there could conceivably be no buyers at all for those options that are short-lived and in-the-money, after pub­ lic writers have finished closing out their positions. Equivalence arbitrage - conversion, reversals, and box spreads - helps to keep the relative prices of puts and calls in line with each other and with the underlying stock price. This creates a more efficient and rational market for the public to oper­ ate in. The arbitrageur would help eliminate, for example, the case in which a public customer buys a call, sees the stock go up, but cannot find anyone to sell his call to at higher prices. If the call were too cheap, arbitrageurs would do reversals, which involve call purchases, and would therefore provide a market to sell into. Questions have been raised as to whether option trading affects stock prices, especially at or just before an expiration. If the amount of arbitrage in a certain issue becomes very large, it could appear to temporarily affect the price of the stock itself. For example, take the call arbitrage. This involves the sale of stock in the market. The corresponding stock purchase, via the call exercise, is not executed on the exchange. Thus, as far as the stock market is concerned, there may appear to be an inordinate amount of selling in the stock. If large numbers of basic call arbitrages are taking place, they might thus hold the price of the stock down until the calls expire. Chapter 27: Arbitrage 445 The put arbitrage has an opposite effect. This arbitrage involves buying stock in the market. The offsetting stock sale via the put exercise takes place off the exchange. If a large amount of put arbitrage is being done, there may appear to be an inordi­ nate amount of buying in the stock. Such action might temporarily hold the stock price up. In a vast majority of cases, however, the arbitrage has no visible effect on the underlying stock price, because the amount of arbitrage being done is very small in comparison to the total number of trades in a given stock. Even if the open interest in a particular option is large, allowing for plenty of option volume by the arbi­ trageurs, the actual act of doing the arbitrage will force the prices of the stock and option back into line, thus destroying the arbitrage. Rather elaborate studies, including doctoral theses, have been written that try to prove or disprove the theory that option trading affects stock prices. Nothing has been proven conclusively, and it may never be, because of the complexity of the task. Logic would seem to dictate that arbitrage could temporarily affect a stock's move­ ment if it has discount, in-the-money options shortly before expiration. However, one would have to reasonably conclude that the size of these arbitrages could almost never be large enough to overcome a directional trend in the underlying stock itself. Thus, in the absence of a definite direction in the stock, arbitrage might help to per­ petuate the inertia; but if there were truly a preponderance of investors wanting to buy or sell the stock, these investors would totally dominate any arbitrage that might be in progress. RISK ARBITRAGE USING OPTIONS Risk arbitrage is a strategy that is well described by its name. It is basically an arbi­ trage - the same or equivalent securities are bought and sold. However, there is gen­ erally risk because the arbitrage usually depends on a future event occurring in order for the arbitrage to be successful. One form of risk arbitrage was described earlier concerning the speculation on the size of a special dividend that an underly­ ing stock might pay. That arbitrage consisted of buying the stock and buying the put, when the put' s time value premium is less than the amount of the projected special dividend. The risk lies in the arbitrageur's speculation on the size of the anticipated special dividend. MERGERS Risk arbitrage is an age-old type of arbitrage in the stock market. Generally, it con­ cerns speculation on whether a proposed merger or acquisition will actually go through as proposed. 446 Part IV: Additional Considerations Example: XYZ, which is selling for $50 per share, offers to buy out LMN and is offer­ ing to swap one share of its (XYZ's) stock for every two shares of LMN. This would mean that LMN should be worth $25 per share if the acquisition goes through as pro­ posed. On the day the takeover is proposed, LMN stock would probably rise to about $22 per share. It would not trade all the way up to 25 until the takeover was approved by the shareholders of LMN stock. The arbitrageur who feels that this takeover will be approved can take action. He would sell short XYZ and, for every share that he is short, he would buy 2 shares of LMN stock. If the merger goes through, he will prof­ it. The reason that he shorts XYZ as well as buying LMN is to protect himself in case the market price of XYZ drops before the acquisition is approved. In essence, he has sold XYZ and also bought the equivalent of XYZ (two shares of LMN will be equal to one share of XYZ if the takeover goes through). This, then, is clearly an arbitrage. However, it is a risk arbitrage because, if the stockholders of LMN reject the offer, he will surely lose money. His profit potential is equal to the remaining differential between the current market price of LMN (22) and the takeover price (25). If the proposed acquisition goes through, the differential disappears, and the arbitrageur has his profit. The greatest risk in a merger is that it is canceled. If that happens, stock being acquired (LMN) will fall in price, returning to its pre-takeover levels. In addition, the acquiring stock (XYZ) will probably rise. Thus, the risk arbitrageur can lose money on both sides of his trade. If either or both of the stocks involved in the proposed takeover have options, the arbitrageur may be able to work options into his strategy. In merger situations, since large moves can occur in both stocks ( they move in concert), option purchases are the preferable option strategy. If the acquiring com­ pany (XYZ) has in-the-money puts, then the purchase of those puts may be used instead of selling XYZ short. The advantage is that if XYZ rallies dramatically during the time it takes for the merger to take effect, then the arbitrageur's profits will be increased. Example: As above, assume that XYZ is at 50 and is acquiring LMN in a 2-for-l stock deal. LMN is at 22. Suppose that XYZ rallies to 60 by the time the deal closes. This would pull LMN up to a price of 30. If one had been short 100 XYZ at 50 and long 200 LMN at 22, then his profit would be $600 - a $1,600 gain on the 200 long LMN minus a $1,000 loss on the XYZ short sale. Compare that result to a similar strategy substituting a long put for the short XYZ stock. Assume that he buys 200 LMN as before, but now buys an XYZ put. If one could buy an XYZ July 55 put with little time premium, say at 5½ points, then he would have nearly the same dollars of profit if the merger should go through with XYZ below 55. Chapter 27: Arbitrage 447 However, when XYZ rallies to 60, his profit increases. He would still make the $1,600 on LMN as it rose from 22 to 30, but now would only lose $550 on the XYZ put - a total profit of $1,050 as compared to $600 with an all-stock position. The disadvantage to substituting long puts for short stock is that the arbitrageur does not receive credit for the short sale and, therefore, does not earn money at the carrying rate. This might not be as large a disadvantage as it initially seems, however, since it is often the case that it is very expensive - even impossible - to borrow the acquiring stock in order to short it. If the stock borrow costs are very large or if no stock can be located for borrowing, the purchase of an in-the-money put is a viable alternative. The purchase of an in-the-money put is preferable to an at- or out-of-the­ money put, because the amount of time value premium paid for the latter would take too much of the profitability away from the arbitrage if XYZ stayed unchanged or declined. This strategy may also save money if the merger falls apart and XYZ rises. The loss on the long put may well be less than the loss would be on short XYZ stock. Note also that one could sell the XYZ July 55 call short as well as buy the put. This would, of course, be synthetic short stock and is a pure substitute for shorting the stock. The use of this synthetic short is recommended only when the arbitrageur cannot borrow the acquiring stock. If this is his purpose, he should use the in-the­ money put and out-of-the-money call, since if he were assigned on the call, he could not borrow the stock to deliver it as a short sale. The use of an out-of-the-money call lessens the chance of eventual assignment. The companion strategy is to buy an in-the-money call instead of buying the company being acquired (LMN). This has advantages if the stock falls too far, either because the merger falls apart or because the stocks in the merger decline too far. Additionally, the cost of carrying the long LMN stock is eliminated, although that is generally built into the cost of the long calls. The larger amount of time value pre­ mium in calls as compared to puts makes this strategy often less attractive than that of buying the puts as a substitute for the short sale. One might also consider selling options instead of buying them. Generally this is an inferior strategy, but in certain instances it makes sense. The reason that option sales are inferior is that they do not limit one's risk in the risk arbitrage, but they cut off the profit. For example, if one sells puts on the company being acquired (LMN), he has a bullish situation. However, if the company being acquired (XYZ) rallies too far, there will be a loss, because the short puts will stop making money as soon as LMN rises through the strike. This is especially disconcerting if a takeover bidding war should develop for LMN. The arbitrageur who is long LMN will participate nice­ ly as LMN rises heavily in price during the bidding war. However, the put seller will not participate to nearly the same extent. 448 Part IV: Additional Considerations The sale of in-the-money calls as a substitute for shorting the acquiring compa­ ny (XYZ) can be beneficial at certain times. It is necessary to have a plus tick in order to sell stock short. When many arbitrageurs are trying to sell a stock short at the same time, it may be difficult to sell such stock short. Morever, natural owners of XYZ may see the arbitrageurs holding the price down and decide to sell their long stock rather than suffer through a possible decline in the stock's price while the merger is in progress. Additionally, buyers of XYZ will become very timid, lowering their bids for the same reasons. All of this may add up to a situation in which it is very difficult to sell the stock short, even if it can be borrowed. The sale of an in-the-money call can overcome this difficulty. The call should be deeply in-the-money and not be too long­ term, for the arbitrageur does not want to see XYZ decline below the strike of the call. If that happened, he would no longer be hedged; the other side of the arbitrage - the long LMN stock - would continue to decline, but he would not have any remaining short against the long LMN. LIMITS ON THE MERGER There is another type of merger for stock that is more difficult to arbitrage, but options may prove useful. In some merger situations, the acquiring company (XYZ) promises to give the shareholders of the company being acquired (LMN) an amount of stock equal to a set dollar price. This amount of stock would be paid even if the acquiring company rose or fell moderately in price. If XYZ falls too far, however, it cannot pay out an extraordinarily increased number of shares to LMN shareholders, so XYZ puts a limit on the maximum number of shares that it will pay for each share of LMN stock. Thus, the shareholders ofXYZ are guaranteed that there will be some downside buffer in terms of dilution of their company in case XYZ declines, as is often the case for an acquiring company. However, ifXYZ declines too far, then LMN shareholders will receive less. In return for getting this downside guarantee, XYZ will usually also stipulate that there is a minimum amount of shares that they will pay to LMN shareholders, even if XYZ stock rises tremendously. Thus, if XYZ should rise tremendously in price, then LMN shareholders will do even better than they had anticipated. An example will demonstrate this type of merger accord. Example: Assume that XYZ is at 50 and it intends to acquire LMN for a stated price of $25 per share, as in the previous example. However, instead of merely saying that it will exchange two shares of LMN for one share of XYZ, the company says that it wants the offer to be worth $25 per share to LMN shareholders as long as XYZ is between 45 and 55. Given this information, we can determine the maximum and minimum number of shares that LMN shareholders will receive: The maximum is Chapter 27: Arbitrage 449 the stated price, 25, divided by the lower limit, 45, or 0.556 shares; the minimum is 25 divided by the higher limit, 55, or 0.455. This type of merger is usually stated in terms of how many shares of XYZ will be issued, rather than in terms of the price range that XYZ will be able to move in. In either case, one can be derived from the other, so that the manner in which the merger deal is stated is merely a convention. In this case, for example, the merger might be stated as being worth $25 per share, with each share of LMN being worth at least 0.455 shares of XYZ and at most 0.556 shares of XYZ. Note that these ratios make the deal worth 25 as long as XYZ is between 45 and 55: 45 times 0.556 equals 25, as does 0.455 times 55. If the acquiring stock, XYZ, is between 45 and 55 at the time the merger is com­ pleted, then the number of shares of XYZ that each LMN shareholder will receive is determined in a preset manner. Usually, at the time the merger is announced, XYZ will say that its price on the closing date of the merger will be used to establish the proper ratio. As a slight alternative, sometimes the acquiring company will state that the price to be used in determining the final ratio is to be an average of the closing prices of the stock over a stated period of time. This stated period of time might be something like the 10 days prior to the closing of the merger. Example: Suppose that the closing price of XYZ on the day that the merger closes is to be the price used in the ratio. Furthermore, suppose that XYZ closes at 51 on that day. It is within the prestated range, so a calculation must be done in order to deter­ mine how many shares of XYZ each LMN shareholder will get. This ratio is deter­ mined by dividing the stated price, 25, by the price in question, 51. This would give a final ratio of 0.490196. The final ratio is usually computed to a rather large number of decimal points in order to assure that LMN shareholders get as close to $25 per share as possible. The above two examples explain how this type of merger works. A merger of this type is said to have "hooks" - the prices at which the ratio steadies. This makes it difficult to arbitrage. As long as XYZ roams around in the 45 to 55 range, the arbi­ trageur does not want to short XYZ as part of his arbitrage, because the price of XYZ does not affect the price he will eventually receive for LMN 25. Rather, he would buy LMN and wait until the deal is near closing before actually shorting XYZ. By waiting, he will know approximately how many shares of XYZ to short for each share of LMN that he owns. The reason that he must short XYZ at the end of the merger is that there is usually a period of time before the physical stock is reorganized from LMN into XYZ. During that time, if he were long LMN, he would be at risk if he did not short XYZ against it. 450 Part IV: Additional Considerations Problems arise if XYZ begins to fall below 45 well before the closing of the merger, the lower "hook" in the merger. If it should remain below 45, then one should set up the arbitrage as being short 0.556 shares ofXYZ for each share of LMN that is held long. As long as XYZ remains below 45 until the merger closes, this is the proper ratio. However, if, after establishing that ratio, XYZ rallies back above 45, the arbitrageur can suffer damaging losses. XYZ may continue to rise in price, creating a loss on the short side. However, LMN will not follow it, because the merger is struc­ tured so that LMN is worth 25 unless XYZ rises too far. Thus, the long side stops fol­ lowing as the short side moves higher. On the other hand, no such problem exists if XYZ rises too far from its original price of 50, going above the upper "hook" of 55. In that case, the arbitrageur would already be long the LMN and would not yet have shorted XYZ, since the merger was not yet closing. LMN would merely follow XYZ higher after the latter had crossed 55. This is not an uncommon dilemma. Recall that it was shown that the acquiring stock will often fall in price immediately after a merger is announced. Thus, XYZ may fall close to, or below, the lower "hook." Some arbitrageurs attempt to hedge them­ selves by shorting a little XYZ as it begins to fall near 45 and then completing the short if it drops well below 45. The problem with handling the situation in this way is that one ends up with an inexact ratio. Essentially, he is forcing himself to predict the movements of XYZ. If the acquiring stock drops below the lower "hook," there may be an opportu­ nity to establish a hedge without these risks if that stock has listed options. The idea is to buy puts on the acquiring company, and for those puts to have a striking price nearly equal to the price of the lower "hook." The proper amount of the company being acquired (LMN) is then purchased to complete the arbitrage. If the acquiring company subsequently rallies back into the stated price range, the puts will not lose money past the striking price and the problems described in the preceding paragraph will have been overcome. Example: A merger is announced as described in the preceding example: XYZ is to acquire LMN at a stated value of $25 per share, with the stipulation that each share of LMN will be worth at least 0.455 shares of XYZ and at most 0.556 shares. These share ratios equate to prices of 45 and 55 on XYZ. Suppose that XYZ drops immediately in price after the merger is announced, and it falls to 40. Furthermore, suppose that the merger is expected to close some­ time during July and that there are XYZ August 45 puts trading at 5½. This repre­ sents only ½ point time value premium. The arbitrageur could then set up the arbi­ trage by buying 10,000 LMN and buying 56 of those puts. Smaller investors might buy 1,000 LMN and buy 6 puts. Either of these is in approximately the proper ratio of 1 LMN to 0.556 XYZ. Chapter 27: Arbitrage TENDER OFFERS 451 Another type of corporate takeover that falls under the broad category of risk arbi­ trage is the tender offer. In a tender offer, the acquiring company normally offers to exchange cash for shares of the company to be acquired. Sometimes the off er is for all of the shares of the company being acquired; sometimes it is for a fractional por­ tion of shares. In the latter case, it is important to know what is intended to be done with the remaining shares. These might be exchanged for shares of the acquiring company, or they might be exchanged for other securities (bonds, most likely), or perhaps there is no plan for exchanging them at all. In some cases, a company ten­ ders for part of its own stock, so that it is in effect both the acquirer and the acquiree. Thus, tender offers can be complicated to arbitrage properly. The use of options can lessen the risks. In the case in which the acquiring company is making a cash tender for all the shares (called an "any and all" offer), the main use of options is the purchase of puts as protection. One would buy puts on the company being acquired at the same time that he bought shares of that company. If the deal fell apart for some reason, the puts could prevent a disastrous loss as the acquiring stock dropped. The arbitrageur must be judicious in buying these puts. If they are too expensive or too far out-of-the­ money, or if the acquiring company might not really drop very far if the deal falls apart, then the purchase of puts is a waste. However, if there is substantial downside risk, the put purchase may be useful. Selling options in an "any and all" deal often seems like easy money, but there may be risks. If the deal is completed, the company being acquired will disappear and its options would be delisted. Therefore, it may often seem reasonable to sell out-of­ the-money puts on the acquiring company. If the deal is completed, these expire worthless at the closing of the merger. However, if the deal falls through, these puts will soar in price and cause a large loss. On the other hand, it may also seem like easy money to sell naked calls with a striking price higher than the price being offered for the stock. Again, if the deal goes through, these will be delisted and expire worthless. The risk in this situation is that another company bids a higher price for the compa­ ny on which the calls were written. If this happens, there might suddenly be a large upward jump in price, and the written calls could suffer a large loss. Options can play a more meaningful role in the tender off er that is for only part of the stock, especially when it is expected that the remaining stock might fall sub­ stantially in price after the partial tender offer is completed. An example of a partial tender offer might help to establish the scenario. Example: XYZ proposes to buy back part of its own stock It has offered to pay $70 per share for half the company. There are no plans to do anything further. Based on 452 Part IV: Additional Considerations the fundamentals of the company, it is expected that the remaining stock will sell for approximately $40 per share. Thus, the average share of XYZ is worth 55 if the ten­ der offer is completed ( one-half can be sold at 70, and the other half will be worth 40). XYZ stock might sell for $52 or $53 per share until the tender is completed. On the day after the tender offer expires, XYZ stock will drop immediately to the $40 per share level. There are two ways to make money in this situation. One is to buy XYZ at the current price, say 52, and tender it. The remaining portion would be sold at the lower price, say 40, when XYZ reopened after the tender expired. This method would yield a profit of $3 per share if exactly 50% of the shares are accepted at 70 in the tender offer. In reality, a slightly higher percentage of shares is usually accepted, because a few people make mistakes and don't tender. Thus, one's average net price tnight be $56 per share, for a $4 profit from this method. The risk in this situation is that XYZ opens substantially below 40 after the tender at 70 is completed. Theoretically, the other way to trade this tender off er might be to sell XYZ short at 52 and cover it at 40 when it reopens after the tender offer expires. Unfortunately, this method cannot be effected because there will not be any XYZ stock to borrow in order to sell it short. All owners will tender the stock rather than loan it to arbi­ trageurs. Arbitrageurs understand this, and they also understand the risk they take if they try to short stock at the last minute: They might be forced to buy back the stock for cash, or they may be forced to give the equivalent of $70 per share for half the stock to the person who bought the stock from them. For some reason, many indi­ vidual investors believe that they can "get away" with this strategy. They short stock, figuring that their brokerage firm will find some way to borrow it for them. Unfortunately, this usually costs the customer a lot of money. The use of calls does not provide a more viable way of attempting to capitalize on the drop of XYZ from 52 to 40. In-the-money call options on XYZ will normally be selling at parity just before the tender offer expires. If one sells the call as a sub­ stitute for the short sale, he will probably receive an assignment notice on the day after the tender offer expires, and therefore find himself with the same problems the short seller has. The only safe way to play for this drop is to buy puts on XYZ. These puts will be very expensive. In fact, with XY"L at 52 before the tender offer expires, if the con­ sensus opinion is that XYZ will trade at 40 after the offer expires, then puts with a 50 strike will sell for at least $10. This large price reflects the expected drop in price of XYZ. Thus, it is not beneficial to buy these puts as downside speculation unless one expects the stock to drop farther than to the $40 level. There is, however, an oppor­ tunity for arbitrage by buying XYZ stock and also buying the expensive puts. Chapter 27: Arbitrage 453 Before giving an example of that arbitrage, a word about short tendering is in order. Short tendering is against the law. It comes about when one tenders stock into a tender offer when he does not really own that stock. There are complex definitions regarding what constitutes ownership of stock during a tender offer. One must be net long all the stock that he tenders on the day the tender offer expires. Thus, he can­ not tender the stock on the day before the offer expires, and then short the stock on the next day ( even if he could borrow the stock). In addition, one must subtract the number of shares covered by certain calls written against his position: Any calls with a strike price less than the tender off er price must be subtracted. Thus, if he is long 1,000 shares and has written 10 in-the-money calls, he cannot tender any shares. The novice and experienced investor alike must be aware of these definitions and should not violate the short tender rules. Let us now look at an arbitrage consisting of buying stock and buying the expen­ sive puts. Example: XYZ is at 52. As before, there is a tender offer for half the stock at 70, with no plans for the remainder. The July 55 puts sell for 15, and the July 50 puts sell for 10. It is common that both puts would be predicting the same price in the after-mar­ ket: 40. If one buys 200 shares ofXYZ at 52 and buys one July 50 put at 10, he has a locked­ in profit as long as the tender offer is completed. He only buys one put because he is assuming that 100 shares will be accepted by the company and only 100 shares will be returned to him. Once the 100 shares have been returned, he can exercise the put to close out his position. The following table summarizes these results: Initial purchase Buy 200 XYZ at 52 Buy 1 July 50 put at 10 Total Cost Closing sale Sell 1 00 XYZ at 70 via tender Sell 1 00 XYZ at 50 via put exercise Total proceeds Total profit: $600 $10,400 debit 1,000 debit $11 ,400 debit 7,000 credit 5,000 credit $12,000 credit This strategy eliminates the risk ofloss ifXYZ opens substantially below 40 after the tender offer. The downside price is locked in by the puts. 454 Part IV: Additional Considerations If more than 50% of XYZ should be accepted in the tender offer, then a larger profit will result. Also, if XYZ should subsequently trade at a high enough price so that the July 50 put has some time value premium, then a larger profit would result as well. (The arbitrageur would not exercise the put, but would sell the stock and the put separately in that case.) Partial tender offers can be quite varied. The type described in the above exam­ ple is called a "two-tier" offer because the tender offer price is substantially different from the remaining price. In some partial tenders, the remainder of the stock is slat­ ed for purchase at substantially the same price, perhaps through a cash merger. The above strategy would not be applicable in that case, since such an offer would more closely resemble the "any and all" offer. In other types of partial tenders, debt secu­ rities of the acquiring company may be issued after the partial cash tender. The net price of these debt securities may be different from the tender offer price. If they are, the above strategy might work. In summary, then, one should look at tender offers carefully. One should be careful not to take extraordinary option risk in an "any and all" tender. Conversely, one should look to take advantage of any "two-tier" situation in a partial tender offer by buying stock and buying puts. PROFITABILITY Since the potential profits in risk arbitrage situations may be quite large, perhaps 3 or 4 points per 100 shares, the public can participate in this strategy. Commission charges will make the risk arbitrage less profitable for a public customer than it would be for an arbitrageur. The profit potential is often large enough, however, to make this type of risk arbitrage viable even for the public customer. In summary, the risk arbitrageur may be able to use options in his strategy, either as a replacement for the actual stock position or as protection for the stock position. Although the public cannot normally participate in arbitrage strategies because of the small profit potential, risk arbitrages may often offer exceptions. The profit potential can be large enough to overcome the commission burden for the public customer. PAIRS TRADING A stock trading strategy that has gained some adherents in recent years is pairs trad­ ing. Simplistically, this strategy involves trading pairs of stocks - one held long, the other short. Thus, it is a hedged strategy. The two stocks' price movements are relat­ ed historically. The pairs trader would establish the position when one stock was Chapter 27: Arbitrage 455 expensive with respect to the other one, historically. Then, when the stocks return to their historical relationship, a profit would result. In reality, some fairly complicated computer programs search out the appropriate pairs. The interest on the short sale offsets the cost of carry of the stock purchased. Therefore, the pairs trader doesn't have any expense except the possible differential in dividend payout. The bane of pairs trading is a possible escalation of the stock sold short without any corresponding rise in price of the stock held long. A takeover attempt might cause this to happen. Of course, pairs traders will attempt to research the situation to ensure that they don't often sell short stocks that are perceived to be takeover can­ didates. Pairs traders can use options to potentially reduce their risk if there are in-the­ money options on both stocks. One would buy an in-the-money put instead of selling one stock short, and would buy an in-the-money call on the other stock instead of buying the stock itself. In this option combination, traders are paying very little time value premium, so their profit potential is approximately the same as with the pairs trading strategy using stocks. ( One would, however, have a debit, since both options are purchased; so there would be a cost of carry in the option strategy.) If the stocks return to their historical relationship, the option strategy will reflect the same profit as the stock strategy, less any loss of time value premium. One added advantage of the option strategy, however, is that if a takeover occurs, the put has limited liability, and the trader's loss would be less. Another advantage of the option strategy is that if both stocks should experience large moves, it could make money even if the pair doesn't return to historical norms. This would happen, for example, if both stocks dropped a great deal: The call has lim­ ited loss, while the put' s profits would continue to accrue. Similarly, to the upside, a large move by both stocks would make the put worthless, but the call would keep making money. In both cases, the option strategy could profit even if the pair of stocks didn't perform as predicted. This type of strategy- buying in-the-money options as substitutes for both sides of a spread or hedge strategy - is discussed in more detail in Chapter 31 on index spreading and Chapter 35 on futures spreads. FACILITATION (BLOCK POSITIONING) Facilitation is the process whereby a trader seeks to aid in making markets for the purchase or sale of large blocks of stock. This is not really an arbitrage, and its description is thus deferred to Chapter 28. CHAPTER 28 Mathetnatical Applications In previous chapters, many references have been made to the possibility of applying mathematical techniques to option strategies. Those techniques are developed in this chapter. Although the average investor - public, institutional, or floor trader - nor­ mally has a limited grasp of advanced mathematics, the information in this chapter should still prove useful. It will allow the investor to see what sorts of strategy deci­ sions could be aided by the use of mathematics. It will allow the investor to evaluate techniques of an information service. Additionally, if the investor is contemplating hiring someone knowledgeable in mathematics to do work for him, the information to be presented may be useful as a focal point for the work. The investor who does have a knowledge of mathematics and also has access to a computer will be able to directly use the techniques in this chapter. THE BLACK-SCHOLES MODEL Since an option's price is the function of stock price, striking price, volatility, time to expiration, and short-term interest rates, it is logical that a formula could be drawn up to calculate option prices from these variables. Many models have been conceived since listed options began trading in 1973. Many of these have been attempts to improve on one of the first models introduced, the Black-Scholes model. This model was introduced in early 1973, very near the time when listed options began trading. It was made public at that time and, as a result, gained a rather large number of adherents. The formula is rather easy to use in that the equations are short and the number of variables is small. The actual formula is: 456 Chapter 28: Mathematical Applications Theoretical option price= pN(d 1) se-rtN(d2) p v2 ln(8 )+ (r +2 )t where d1 = _ r. V-4 t d2 = d1 - v--ft The variables are: p = stock price s = striking price t = time remaining until expiration, expressed as a percent of a year r = current risk-free interest rate v = volatility measured by annual standard deviation ln = natural logarithm N(x) = cumulative normal density function 457 An important by-product of the model is the exact calculation of the delta - that is, the amount by which the option price can be expected to change for a small change in the stock price. The delta was described in Chapter 3 on call buying, and is more formally known as the hedge ratio. Delta= N(d1) The formula is so simple to use that it can fit quite easily on most programmable cal­ culators. In fact, some of these calculators can be observed on the exchange floors as the more theoretical floor traders attempt to monitor the present value of option pre­ miums. Of course, a computer can handle the calculations easily and with great speed. A large number of Black-Scholes computations can be performed in a very short period of time. The cumulative normal distribution function can be found in tabular form in most statistical books. However, for computation purposes, it would be wasteful to repeatedly look up values in a table. Since the normal curve is a smooth curve (it is the "bell-shaped" curve used most commonly to describe population distributions), the cumulative distribution can be approximated by a formula: x = l-z(l.330274y 5 - l.821256y 4 + l.781478y 3 - .356538y 2 + .3193815y) where y 1 and z = .3989423e- 0 or N(cr) = 1- x if cr < 0 458 Part IV: Additional Considerations This approximation is quite accurate for option pricing purposes, since one is not really interested in thousandths of a point where option prices are concerned. Example: Suppose that XYZ is trading at 45 and we are interested in evaluating the July 50 call, which has 60 days remaining until expiration. Furthermore, assume that the volatility of XYZ is 30% and that the risk-free interest rate is currently 10%. The theoretical value calculation is shown in detail, in order that those readers who wish to program the model will have something to compare their calculations against. page: Initially, determine t, d1, and d2, by referring to the formulae on the previous t = 60/365 = .16438 years d _ In (45/50) + (.1 + .3 x .3/2) x .16438 1- .3 X ✓.16438 = -.10536 + (.145 X .16438) = __ 67025 .3 X .40544 d2 = -.67025 - .3 ✓.16438 = -.67025 - (.3 x .40544) = -.79189 Now calculate the cumulative normal distribution function for d1 and d2 by referring to the above formulae: dl = -.67025 l 1 y = l + (.2316419 I -.67025 I) = 1.15526 = ·86561 z = .3989423e--(-.67025 X -.67025)/2 = .3989423e-0·22462 = .31868 There are too many calculations involved in the computation of the fifth-order polynomial to display them here. Only the result is given: X = .74865 Since we are determining the cumulative normal distribution of a negative number, the distribution is determined by subtracting x from l. N(d1) = N(-.67O25) = l -x = l - .74865 = .25134 In a similar manner, which requires computing new values for x, y, and z, N(d2) = N(-.79179) = 1- .78579 = .21421 Chapter 28: Mathematical Applications 459 Now, returning to the formula for theoretical option price, we can complete the calculation of the July 50 call's theoretical value, called value here for short: value = 45 x N(d1) - 50 x e-·1 x ·16438 x N(d2) = 45 X .25134 - 50 X .9837 X .21421 = .7746 Thus, the theoretical value of the July 50 call is just slightly over¼ of a point. Note that the delta of the call was calculated along the way as N(d1) and is equal to just over .25. That is, the July 50 call will change price about¼ as fast as the stock for a small price change by the stock. This example should answer many of the questions that readers of the first edi­ tion have posed. The reader interested in a more in-depth description of the model, possibly including the actual derivation, should refer to the article "Fact and Fantasy in the Use of Options." 1 One of the less obvious relationships in the model is that call option prices will increase (and put option prices will decrease) as the risk-free inter­ est rate increases. It may also be observed that the model correctly preserves rela­ tionships such as increased volatility, higher stock prices, or more time to expiration, which all imply higher option prices. CHARACTERISTICS Of THE MODEL Several aspects of this model are worth further discussion. First, the reader will notice that the model does not include dividends paid by the common stock. As has been demonstrated, dividends act as a negative effect on call prices. Thus, direct application of the model will tend to give inflated call prices, especially on stocks that pay relatively large dividends. There are ways of handling this. Fisher Black, one of the coauthors of the model, suggested the following method: Adjust the stock price to be used in the formula by subtracting, from the current stock price, the present worth of the dividends likely to be paid before maturity. Then calculate the option. price. Second, assume that the option expires just prior to the last ex-dividend date preceding actual option expiration. Again adjust the stock price and calculate the option price. Use the higher of the two option prices calculated as the theoretical price. Another, less exact, method is to apply a weighting factor to call prices. The weighting factor would be based on the dividend payment, with a heavier weight being applied to call options on high-yielding stock. It should be pointed out that, in 1Fisher Black, Financial Analysts Journal, July-August 1975, pp. 36-70. 460 Part IV: Additional Considerations many of the applications that are going to be prescribed, it is not necessary to know the exact theoretical price of the call. Therefore, the dividend "correction" might not have to be applied for certain strategy decisions. The model is based on a lognormal distribution of stock prices. Even though the normal distribution is part of the model, the inclusion of the exponential functions makes the distribution lognormal. For those less familiar with statistics, a normal dis­ tribution has a bell-shaped curve. This is the most familiar mathematical distribution. The problem with using a normal distribution is that it allows for negative stock prices, an impossible occurrence. Therefore, the lognormal distribution is generally used for stock prices, because it implies that the stock price can have a range only between zero and infinity. Furthermore, the upward (bullish) bias of the lognormal distribution appears to be logically correct, since a stock can drop only 100% but can rise in price by more than 100%. Many option pricing models that antedate the Black-Scholes model have attempted to use empirical distributions. An empirical distribution has a different shape than either the normal or the lognormal distribu­ tion. Reasonable empirical distributions for stock prices do not differ tremendously from the lognormal distribution, although they often assume that a stock has a greater probability of remaining stable than does the lognormal distribution. Critics of the Black-Scholes model claim that, largely because it uses the lognormal distri­ bution, the model tends to overprice in-the-money calls and underprice out-of-the­ money calls. This criticism is true in some cases, but does not materially subtract from many applications of the model in strategy decisions. True, if one is going to buy or sell calls solely on the basis of their computed value, this would create a large prob­ lem. However, if strategy decisions are to be made based on other factors that out­ weigh the overpriced/underpriced criteria, small differentials will not matter. The computation of volatility is always a difficult problem for mathematical application. In the Black-Scholes model, volatility is defined as the annual standard deviation of the stock price. This is the regular statistical definition of standard devi­ ation: where P = average stock price of all P/s Pi = daily stock price n ~ (Pi -P)2 cr2 = _1=_1 __ _ n-1 v = a!P Chapter 28: Mathematical Applications 461 n = number of days observed v = volatility When volatility is computed using past stock prices, it is called a historical volatility. The volatilities of stocks tend to change over time. Certain predictable fac­ tors, such as a large stock split increasing the float of the stock, can reduce the volatil­ ity. The entry of a company into a more speculative area of business may increase the volatility. Other, less well-defined factors can alter the volatility as well. Since the volatility is a very crucial element of the pricing model, it is important that the mod­ eler use a reasonable estimate of the current volatility. It has become apparent that an annual standard deviation is not accurate, because it encompasses too long a peri­ od of time. Recent efforts by many modelers have suggested that one should perhaps weight the recent stock price action more heavily than older price action in arriving at a current volatility. This is a possible approach, but the computation of such fac­ tors may introduce as much error as using the annual standard deviation does. The problem of accurately computing the volatility is critical, because the model is so sen­ sitive to it. Computing Lognormal Historical Volatility. The above calculation does not give the proper input for the Black-Scholes model because the model assumes that the logarithms of changes in price are normally distributed, not the prices them­ selves. That is, the term Pi in the above formula should be changed. Example: XYZ closed at 51 today and at 50 yesterday. Thus, its percentage change for the day is 51/50 = 1.02. The natural logarithm of 1.02 is then based on the volatil­ ity formula: ln(51/50) = ln(l.02) = 0.0198 This is similar to saying that arithmetically the stock was up 2% today, but on a lognormal basis, it was only up 1.98% If the stock is down, this method will yield a negative number. Suppose that on the following day, XYZ declined from 51 back to 50. The number to use in the volatil­ ity formula would then be: ln(50/51) = ln(0.9804) = -0.0198 462 Part IV: Additional Considerations A new equation can now be formulated using this concept. It will yield volatili­ ties that are consistent with the Black-Scholes model: V= n I where Xi = ln(P /Pi _1); Pi = closing price on day i and X = the average of the X/s over the desired number of days. So to compute a IO-day historical volatility, one would need 11 observations. In the following example, do not be concerned with the complete details if you do not plan to compute the volatilities yourself; they are provided for the mathematician or programmer who needs to check his work: Day XYZ Stock P./P. 1 I I- X-=ln(P./P. 1) I I I- (X.-X)2 I 1 153.875 2 153.625 .9984 -.0016 .000020 3 151 .9829 -.0172 .000405 4 146 .9669 -.0337 .001336 5 144.125 .9872 -.0129 .000250 6 147.25 1.0217 .0215 .000345 7 146.25 .9932 -.0068 .000094 8 149.5 1.0222 .0220 .000365 9 152.5 1.0201 .0199 .000289 10 158.625 1.0402 .0394 .001332 1 1 158.375 0.9984 -.0016 .000020 AVG: 0.0028825 :l;: 0.004455 The average of the Ins (4th column) over the 10 days is 0.00288. The difference of each In from the mean, squared, is then summed (5th col­ umn). For example, for day 1 the term is (- .0016- .00288)2 = .00002. This is the top number in the far right-hand column. This process can be computed for each num­ ber in the "In" column. The sum of all these terms is 0.004455. Nowv = ✓(.004455/9) = 0.022249 This is a IO-day volatility. To convert it into an annual volatility, we need to mul­ tiply by the square root of the number of trading days in a year. Since there are approximately 260 trading days in a year, the final volatility would be: V = 0.022249 X ✓(260) = 0.3587 Thus, one could say that the volatility of XYZ is 36% on an annualized basis. Chapter 28: Mathematical Applications 463 This is then the proper way to calculate historical volatility. Obviously, the strategist can calculate 10-, 20-, and 50-day and annual volatilities if he wishes - or any other number for that matter. In certain cases, one can discern valuable infor­ mation about a stock or future and its options by seeing how the various volatilities compare with one another. There is, in fact, a way in which the strategist can let the market compute the volatility for him. This is called using the implied volatility; that is, the volatility that the market itself is implying. This concept makes the assumption that, for options with striking prices close to the current stock price and for options with relatively large trading volume, the market is fairly priced. This is something like an efficient market hypothesis. If there is enough trading interest in an option that is close to the money, that option will generally be fairly priced. Once this assumption has been made, a corollary arises: If the actual price of an option is the fair price, it can be fixed in the Black-Scholes equation while letting volatility be the unknown variable. The volatility can be determined by iteration. In fact, this process of iterating to compute the volatility can be done for each option on a particular underlying stock This might result in several different volatilities for the stock If one weights these various results by volume of trading and by distance in- or out-of-the-money, a single volatility can be derived for the underlying stock This volatility is based on the closing price of all the options on the underlying stock for that given day. Example: XYZ is at 33 and the closing prices are given in Table 28-1. Each option has a different implied volatility, as computed by determining what volatility in the Black-Scholes model would result in the closing price for each option: That is, if .34 were used as the volatility, the model would give 4¼ as the price of the January 30 call. In order to rationally combine these volatilities, weighting factors must be applied before a volatility for XYZ stock itself can be arrived at. The weighting factors for volume are easy to compute. The factor for each option is merely that option's daily volume divided by the total option volume on all XYZ options (Table 28-2). The weighting functions for distance from the striking price should probably not be linear. For example, if one option is 2 points out-of-the­ money and another is 4 points out-of-the-money, the former option should not nec­ essarily get twice as much weight as the latter. Once an option is too far in- or out-of­ the-money, it should not be given much or any weight at all, regardless of its trading volume. Any parabolic function of the following form should suffice: { (x - a)2 if xis less than a Weighting factor = -;;,r- = 0 if x is greater than a 464 Part IV: Additional Considerations TABLE 28-1. Implied volatilities, closing price, and volume. Option Option Price Volume January 30 41/2 January 35 11/2 April 35 21/2 April 40 11/2 TABLE 28-2. Volume weighting factors. Option January 30 January 35 April 35 April 40 Volume 50 90 55 5 50 90 55 ~ 200 Implied Volatility .34 .28 .30 .38 Volume Weighting Factor .25 (50/200) .45 (90/200) .275 (55/200) .025 ( 5/200) where x is the percentage distance between stock price and strike price and a is the maximum percentage distance at which the modeler wants to give any weight at all to the option's implied volatility. Example: An investor decides that he wants to discard options from the weighting criterion that have striking prices more than 25% from the current stock price. The variable, a, would then be equal to .25. The weighting factors, with XYZ at 33, could thus be computed as shown in Table 28-3. To combine the weighting factors for both volume and distance from strike, the two factors are multiplied by the implied volatil­ ity for that option. These products are summed up for all the options in question. This sum is then divided by the products of the weighting factors, summed over all the options in question. As a formula, this would read: Implied _ I,(Volume factor x Distance factor x Implied volatility) volatility - I,(Volume factor x Distance factor) In our example, this would give an implied volatility for XYZ stock of 29.8% (Table 28-4). Note that the implied volatility, .298, is not equal to any of the individ- Chapter 28: Mathematical Applications TABLE 28-3. Distance weighting factors. 465 Option Distonce from Stock Price Distance Weighting Factor January 30 January 35 April 35 April 40 TABLE 28-4. Option's implied volatility. .091 (3/33) .061 (2/33) .061 (2/33) .212 (7 /33) .41 .57 .57 .02 Volume Distance Option's Implied Option Factor Factor Volotility January 30 .25 .41 .34 January 35 .45 .57 .28 April 35 .275 .57 .30 April40 .025 .02 .38 Implied = .25 x .41 x .34 + .45 x .57 x .28 + .275 x .57 x .30 + .025 x .02 x .38 volatility. .25 x .41 + .45 x .57 + .275 x .57 + .025 x .02 = .298 ual option's implied volatilities. Rather, it is a composite figure that gives the most weight to the heavily traded, near-the-money options, and very little weight to the lightly-traded (5 contracts), deeply out-of-the-money April 40 call. This implied volatility is still a form of standard deviation, and can thus be used whenever a stan­ dard deviation volatility is called for. This method of computing volatility is quite accurate and proves to be sensitive to changes in the volatility of a stock. For example, as markets become bullish or bearish (generating large rallies or declines), most stocks will react in a volatile man­ ner as well. Option premiums expand rather quickly, and this method of implied volatility is able to pick up the change quickly. One last bit of fine-tuning needs to be done before the final volatility of the stock is arrived at. On a day-to-day basis, the implied volatility for a stock - especially one whose options are not too active may fluctuate more than the strategist would like. A smoothing effect can be obtained by 466 Part IV: Additional Considerations taking a moving average of the last 20 or 30 days' implied volatilities. An alternative that does not require the saving of many previous days' worth of data is to use a momentum calculation on the implied volatility. For example, today's final volatility might be computed by adding 5% of today's implied volatility to 95% of yesterday's final volatility. This method requires saving only one previous piece of data - yester­ day's final volatility - and still preserves a "smoothing" effect. Once this implied volatility has been computed, it can then be used in the Black-Scholes model ( or any other model) as the volatility variable. Thus one could compute the theoretical value of each option according to the Black-Scholes formu­ la, utilizing the implied volatility for the stock. Since the implied volatility for the stock will most likely be somewhat different from the implied volatility of this par­ ticular option, there will be a discrepancy between the option's actual closing price and the theoretical price as computed by the model. This differential represents the amount by which the option is theoretically overpriced or underpriced, compared to other options on that same stock. EXPECTED RETURN Certain investors will enter positions only when the historical percentages are on their side. When one enters into a transaction, he normally has a belief as to the pos­ sibility of making a profit. For example, when he buys stock he may think that there is a "good chance" that there will be a rally or that earnings will increase. The investor may consciously or unconsciously evaluate the probabilities, but invariably, an invest­ ment is made based on a positive expectation of profit. Since options have fixed terms, they lend themselves to a more rigorous computation of expected profit than the aforementioned intuitive appraisal. This more rigorous approach consists of com­ puting the expected return. The expected retum is nothing more than the retum that the position should yield over a large number of cases. A simple example may help to explain the concept. The crucial variable in com­ puting expected return is to outline what the chances are of the stock being at a cer­ tain price at some future time. Example: XYZ is selling at 33, and an investor is interested in determining where XYZ will be in 6 months. Assume that there is a 20% chance of XYZ being below 30 in 6 months, and that there is a 40% chance that XYZ will be above 35 in 6 months. Finally, assume that XYZ has an equal 10% chance of being at 31, 32, 33, or 34 in 6 months. All other prices are ignored for simplification. Table 28-5 summarizes these assumptions. Chapter 28: Mathematical Applications TABLE 28-5. Calculation of expected returns. Price of XYZ in 6 Months Below 30 31 32 33 34 Above 35 467 Chance of XYZ Being at That Price · 20% 10% 10% 10% 10% 40% 100% Since the percentages total 100%, all the outcomes have theoretically been allowed for. Now suppose a February 30 call is trading at 4 and a February 35 call is trading at 2 points. A bull spread could be established by buying the February 30 and selling the February 35. This position would cost 2 points - that is, it is a 2-point debit. The spreader could make 3 points if XYZ were above 35 at expiration for a return of 150%, or he could lose 100% if XYZ were below 30 at expiration. The expected return for this spread can be computed by multiplying the outcome at expi­ ration for each price by the probability of being at that price, and then summing the results. For example, if XYZ is below 30 at expiration, the spreader loses $200. It was assumed that there is a 20% chance of XYZ being below 30 at expiration, so the expected loss is 20% times $200, or $40. Table 28-6 shows the computation of the expected results at all the prices. The total expected profit is $100. This means that the expected return (profit divided by investment) is 50% ($100/$200). This appears to be an attractive spread, because the spreader could "expect" to make 50% of his money, less commissions. What has really been calculated in this example is merely the return that one would expect to make in the long run if he invested in the same position many times throughout history. Saying that a particular position has an expected return of 8 or 9% is no different from saying that common stocks return 8 or 9% in the long run. Of course, in bull markets stock would do much better, and in bear markets much worse. In a similar manner, this example bull spread with an expected return of 50% may do as well as the maximum profit or as poorly as losing 100% in any one case. It is the total return on many cases that has the expected return of 50%. Mathematical theory holds that, if one constantly invests in positions with positive expected returns, he should have a better chance of making rrwney. 468 Part IV: Additional Considerations TABLE 28-6. Computation of expected profit. Chance of Being Profit at Expected XYZ Price at at That Price That Price Profit: Expiration (A) (B) (A) x (8) Below 30 20% -$200 -$ 40 31 10% - 100 - 10 32 10% 0 0 33 10% + 100 + 10 34 10% + 200 + 20 Above 35 40% + 300 + 120 Total expected profit $100 As is readily observable, the selection of what percentages to assign to the pos­ sible outcomes in the stock price is a crucial choice. In the example above, if one altered his assumption slightly so that XYZ had a 30% chance of being below 30 and a 30% chance of being above 35 at expiration, the expected return would drop con­ siderably, to 25%. Thus, it is important to have a reasonably accurate and consistent method of assigning these percentages. Furthermore, the example above was too sim­ plistic, in that it did not allow for the stock to close at any fractional prices, such as 32½. A correct expected return computation must take into account all possible out­ comes for the stock. Fortunately, there is a straightforward method of computing the expected per­ centage chance of a given stock being at a certain price at a certain point in time. This computation involves using the distribution of stock prices. As mentioned earlier, the Black-Scholes model assumes a lognormal distribution for stock prices, although many modelers today use nonstandard (empirical or heuristic) distributions. No mat­ ter what the distribution, the area under the distribution curve between any two points gives the probability of being between those two points. Figure 28-1 is a graph of a typical lognormal distribution. The peak always lies at the "mean," or average, of the distribution. For stock price distributions, under the random walk assumption, the "mean" is generally considered to be the current stock price. The graph allows one to visualize the probability of being at any given price. Note that there is a fairly great chance that the stock will be relatively unchanged; there is no chance that the stock will be below zero; and there is a bullish bias to the graph - the stock could rise infinitely, although the chances of it doing so are extremely small. Chapter 28: Mathematical Applications FIGURE 28-1. Typical lognormal distribution. 60% 0 A Mean (current price) Stock Price at End of Time Period 469 The chance that XYZ will be below the meah at the end of the time period is 50% in a random walk distribution. This also means that 50% of the area under the graph lies to the left of the mean and 50% lies to the right of the mean. Note point A on the graph. Forty percent of the area under the distribution curve lies to the left of point A and 60% lies to the right of it. This means that there is a 40% chance that the stock will be below price A at the end of the time period and a 60% chance that the stock will be above price A. Consequently, the distribution curve can be used to determine the probabilities necessary for the expected return computation. The reader should take note of the fact that these probabilities apply to the end of the time period. They say nothing about the chances that XYZ might dip below price A at some time during the time period. To compute that percentage, an involved compu­ tation is necessary. The height and width of the distribution graph are determined by the volatility of the underlying stock, when volatility is expressed as a standard deviation. This is consistent with the method of computing volatility described earlier in this chapter. Implied volatility can, of course, be used. Since the option modeler is generally inter­ ested in time periods other than one year, the annual volatility must be converted into a volatility for the time period in question. This is easily accomplished by the follow­ ing formula: 470 where v = annual volatility t = time, in years vt = volatility for time, t. Part IV: Additional Considerations As an example, a 3-month volatility would be equal to one-half of the annual volatility. In this case, t would equal .25 (one fourth of a year), so v_25 = v65 = .5v. The necessary groundwork has been laid for the computation of the probabili­ ty necessary in the expected return calculation. The following formula gives the prob­ ability of a stock that is currently at price p being below some other price, q, at the end of the time period. The lognormal distribution is assumed. Probability of stock being below price q at end of time period t: P (below) = N (In~)) where N = cumulative normal distribution p = current price of the stock q = price in question In = natural logarithm for the time period in question. If one is interested in computing the probability of the stock being above the given price, the formula is P (above)= 1- P (below) With this formula, the computation of expected return is quickly accomplished with a computer. One merely has to start at some price - the lower strike in a bull spread, for example - and work his way up to a higher price - the high strike for a bull spread. At each price point in between, the outcome of the spread is multiplied by the probability of being at that price, and a running sum is kept. Simplistically, the following iterative equation would be used. P ( of being at price x) = P (below x) - P (below y) where y is close to but less than x in price. As an example: P (of being at 32.4) = P (below 32.4) - P (below 32.3) Chapter 28: Mathematical Applications 471 Thus, once the low starting point is chosen and the probability of being below that price is determined, one can compute the probability of being at prices that are suc­ cessively higher merely by iterating with the preceding formula. In reality, one is using this information to integrate the distribution curve. Any method of approxi­ mating the integral that is used in basic calculus, such as the Trapezoidal Rule or Simpson's Rule, would be applicable here for more accurate results, if they are desired. A partial example of an expected return calculation follows. Example: XYZ is currently at 33 and has an annual volatility of 25%. The previous bull spread is being established- buy the February 30 and sell the February 35 for a 2-point debit - and these are 6-month options. Table 28-7 gives the necessary com­ ponents for computing the expected return. Column (A), the probability of being below price q, is computed according to the previously given formula, where p = 33 and vt = .177 (t = .25-V ½). The first stock price that needs to be looked at is 30, since all results for the bull spread are equal below that price - a 100% loss on the spread. The calculations would be performed for each eighth (or tenth) of a point up through a price of 35. The expected return is computer example, if one index sells for twice the price of the other, and if both indices have similar volatilities, then a one-to-one spread gives too much weight to the higher-priced index. A two-to-one ratio would be better, for that would give equal weighting to the spread between the indices. Example: UVX is an index of stock prices that is currently priced at 100.00. ZYX, another index, is priced at 200.00. The two indices have some similarities and, there­ fore, a spreader might want to trade one against the other. They also display similar volatilities. If one were to buy one UVX future and sell one ZYX future, his spread would be too heavily oriented to ZYX price movement. The following table displays that, showing that if both indices have similar percentage movements, the profit of the one-by-one spread is dominated by the profit or loss in the ZYX future. Assume both fi1tures are worth $500 per point. Market ZYX ZYX uvx uvx Total Direction Price Profit Price Profit Profit up 20% 240 -$20,000 120 +$10,000 -$10,000 up 10% 220 - 10,000 110 + 5,000 - 5,000 down 10% 180 + 10,000 90 - 5,000 + 5,000 down 20% 160 + 20,000 80 - 10,000 + 10,000 This is not much of a hedge. If one wanted a position that reflected the movement of the ZYX index, he could merely trade the ZYX futures and not bother with a spread. If, however, one had used the ratio of the indices to decide how many futures to buy and sell, he would have a more neutral position. In this example, he would buy two UVX futures and sell one ZYX future. Proponents of using the ratio of indices are attempting strictly to capture any performance difference between the two indices. They are not trying to predict the overall direction of the stock market. Technically, the proper ratio should also include the volatility of the two indices, because that is also a factor in determining how fast they move in relationship to each other. 582 Part V: Index Options and Futures where p1 and p2 are the prices of the indices v 1 and v 2 are the respective volatilities and u1 and u2 are the units of trading ($500 per point, for example). Including the volatility ensures that one is spreading essentially equal "volatili­ ty dollars" of each index. Moreover, if the two futures don't have the same unit of trading, that should be factored in as well. Example: The ZYX Index is not very volatile, having a volatility of 15%. A trader is interested in spreading it against the ABX Index, which is volatile, having a historical volatility of 25%. The following data sum up the situation: Unit of Price Volatility Trading ZYX Futures 175.00 15% $250/pt ABX Futures 225.00 25% $500/pt R . .25 225.00 500 abo=-X--X- .15 175.00 250 = 4.286 In round numbers, one would probably trade four ZYX futures against one ABX future. INDEX CHARACTERISTICS Before discussing specific spreads, it might be constructive to describe how the makeup of the various indices that have listed options affects their price movements. The Value Line Index is composed of 1,600 stocks, some of which are traded over the counter. The Value Line Index movement is much more closely related to how small stocks perform, while the S&P 500 Index reflects more heavily the performance of the large-capitalization stocks. In fact, it has been said that a chart of the Value Line Index looks almost like the advance-decline line ( the running daily total of advances minus declines). The S&P 500, on the other hand, looks much more like the Dow­ Jones 30 Industrials because of the heavy weighting given the large-capitalization stocks. The S&P 100 (OEX) contains 100 stocks, but is capitalization-weighted and the stocks are generally the largest ones with listed options trading on the CBOE. Thus, its performance is much more like the S&P 500 and NYSE indices. The OEX is Chapter 31: Index Spreading 583 slightly more volatile than these two larger indices, and also has more technology and less basic industry such as steel and chemicals. The OEX movement definitely has good correlation to the S&P 500. The S&P 500 Index (SPX) currently trades at about twice the "speed" of the OEX Index. This has been true since OEX split 2-for-l in November 1997. A one-point move in SPX is approximately equal to a move of 7.5 points in the Dow-Jones Industrial Average, while a one-point move in OEX is approximately equal to 15 Dow points. In general, it is easier to spread the indices by using futures rather than options, although only the S&P 500 Index has liquid futures markets. (There is a mini-Value Line futures market, as well as Dow-Jones futures - both of which are fairly illiq­ uid - but no futures trade on OEX.) One reason for this is liquidity - the index futures markets have large open interest. Another reason is tightness of markets. Futures markets are normally 5 or 10 cents wide, while option markets are 10 cents wide or more. Moreover, an option position that is a full synthetic requires both a put and a call. Thus, the spread in the option quotes comes into play twice. The Japanese stock market can be spread against the U.S. markets by spread­ ing a U.S. index against Nikkei futures or futures options, traded on the Chicago Mere, or against JPN options, traded on the AMEX. INTER-INDEX SPREADS USING OPTIONS As mentioned before, it may not be as efficient to try to use options in lieu of the actual futures spreads since the futures are more liquid. However, there are still many applications of the inter-index strategy using options. OEX versus S&P 500. The OEX cash-based index options are the most liquid option contracts. Thus, any inter-index spread involving the OEX and other indices must include the OEX options. The S&P 100 was first introduced in 1982 by the CBOE. It was originally intended to be an S&P 500 look-alike whose characteristics would allow investors who did not want to trade futures ( S&P 500 futures) the opportunity to be able to trade a broad index by offering options on the OEX. Initially, the index was known as the CBOE 100, but later the CBOE and Standard and Poor's Corp. reached an agreement whereby the index would be added to S&P's array of indices. It was then renamed the S&P 100. Initially, the two indices traded at about the same price. The OEX was the more expensive of the two for a while in the early 1980s. As the bull market of the 1980s matured, the S&P 500 ground its way higher, eventually reaching a price nearly 30 points higher than OEX. As one can see, there is ample room for movement in the spread between the cash indices. 584 Part V: Index Options and Futures The S&P 500 has more stocks, and while both indices are capitalization-weight­ ed, 500 stocks include many smaller stocks than the 100-stock index. Also, the OEX is more heavily weighted by technology issues and is therefore slightly more volatile. Finally, the OEX does not contain several stocks that are heavily weighted in the S&P 500 because those stocks do not have options listed on the CBOE: Procter and Gamble, Philip Morris, and Royal Dutch, to name a few. There are two ways to approach this spread - either from the perspective of the derivative products differ­ ential or by attempting to predict the cash spread. In actual practice, most market-makers in the OEX use the S&P 500 futures to hedge with. Therefore, if the futures have a larger premium - are overpriced - then the OEX calls will be expensive and the puts will be cheap. Thus, there is not as much of an opportunity to establish an inter-index spread in which the derivative products (futures and options in this case) spread differs significantly from the cash spread. That is, the derivative products spread will generally follow the cash spread very closely, because of the number of people trading the spread for hedging purposes. Nevertheless, the application does arise, albeit infrequently, to spread the premium of the derivative products in two indices on strictly a hedged basis with­ out trying to predict the direction of movement of the cash indices. In order to establish such a spread, one would take a position in futures and an opposite posi­ tion in both the puts and calls on OEX. Due to the way that options must be exe­ cuted, one cannot expect the same speed of execution that he can with the futures, unless he is trading from the OEX pit itself. Therefore, there is more of an execu­ tion risk with this spread. Consequently, most of this type of inter-index spreading is done by the market-makers themselves. It is much more difficult for upstairs traders and customers. USING OPTIONS IN INDEX SPREADS Whenever both indices have options, as most do, the strategist may find that he can use the options to his advantage. This does not mean merely that he can use a syn­ thetic option position as a substitute for the futures position (long call, short put at the same strike instead of long futures, for example). There are at least two other alternatives with options. First, he could use an in-the-money option as a substitute for the future. Second, he could use the options' delta to construct a more leveraged spread. These alternatives are best used when one is interested in trading the spread between the cash indices - they are not really amenable to the short-term strategy of spreading the premiums between the futures. Using in-the-money options as a substitute for futures gives one an additional advantage: If the cash indices move far enough in either direction, the spreader could O,apter 31: Index Spreading 585 still make money, even if he was wrong in his prediction of the relationship of the cash indices. Example: The following prices exist: ZYX: 175.00 UVX: 150.00 ZYX Dec 185 put: 10½ UVX Dec 140 call: 11 Suppose that one wants to buy the UVX index and sell the ZYX index. He expects the spread between the two - currently at 25 points - to narrow. He could buy the UVX futures and sell the ZYX futures. However, suppose that instead he buys the ZYX put and buys the UVX call. The time value of the Dec 185 put is 1/2 point and that of the Dec 140 call is 1 point. This is a relatively small amount of time value premium. Therefore, the com­ bination would have results very nearly the same as the futures spread, as long as both options remain in-the-money; the only difference would be that the futures spread would outperform by the amount of the time premium paid. Even though he pays some time value premium for this long option combina­ tion, the investor has the opportunity to make larger profits than he would with the futures spread. In fact, he could even make a profit if the cash spread widens, if the indices are volatile. To see this, suppose that after a large upward move by the over­ all market, the following prices exist: ZYX: 200.00 UVX: 170.00 ZYX Dec 185 put: 0 ( virtually worthless) UVX Dec 140 call: 30 The combination that was originally purchased for 21 ½ points is now worth 30, so the spread has made money. But observe what has happened to the cash spread: It has widened to 30 points, from the original price of 25. This is a movement in the opposite direction from what was desired, yet the option position still made money. The reason that the option combination in the example was able to make money, even though the cash spread moved unfavorably, is because both indices rose so much in price. The puts that were owned eventually became worthless, but the long call continued to make money as the market rose. This is a situation that is very similar to owning a long strangle (long put and call with different strikes), except that 586 Part V: Index Options and Futures the put and call are based on different underlying indices. This concept is discussed in more detail in Chapter 35 on futures spreads. The second way to use options in index spreading is to use options that are less deeply in-the-money. In such a case, one must use the deltas of the options in order to accurately compute the proper hedge. He would calculate the number of options to buy and sell by using the formula given previously for the ratio of the indices, which incorporates both price and volatility, and then multiplying by a factor to include delta. where vi is the volatility of index i Pi is the price of index i ui is the unit of trading and di is the delta of the selected option on index i Example: The following data is known: ZYX: 175.00, volatility= 20% UVX: 150.00, volatility = 15% ZYX Dec 175 put: 7, delta= - .45, worth $500/pt. UVX Dec 150 call: 5, delta= .52, worth $100/pt Suppose one decides that he wants to set up a position that will profit if the spread between the two cash indices shrinks. Rather than use the deeply in-the­ money options, he now decides to use the at-the-money options. He would use the option ratio formula to determine how many puts and calls to buy. (Ignore the put's negative delta for the purposes of this formula.) .20 175.00 500 .45 Option Ratio= -x ---x - x - = 6 731 .15 150.00 100 .52 . He would buy nearly 7 UVX calls for every ZYX put purchased. In the previous example, using in-the-money options, one had a very small expense for time value premium and could profit if the indices were volatile, even if the cash spread did not shrink. This position has a great deal of time value premium e:x--pense, but could make profits on smaller moves by the indices. Of course, either one could profit if the cash indices moved favorably. Cl,apter 31: Index Spreading 587 Volatility Differential. A theoretical "edge" that sometimes appears is that of volatility differential. If two indices are supposed to have essentially the same volatil­ ity, or at least a relationship in their volatilities, then one might be able to establish an option spread if that relationship gets out ofline. In such a case, the options might actually show up as fair-valued on both indices, so that the disparity is in the volatili­ ty differential, and not in the pricing of the options. OEX and SPX options trade with essentially the same implied volatility. Thus, if one index's options are trading with a higher implied volatility than the other's, a potential spread might exist. Normally, one would want the differential in implied volatilities to be at least 2% apart before establishing the spread for volatility reasons. In any case, whether establishing the spread because one thinks the cash index relationship is going to change, or because the options on one index are expensive with respect to the options on the other index, or because of the disparity in volatili­ ties, the spreader must use the deltas of the options and the price ratio and volatili­ ties of the indices in setting up the spread. Striking Price Differential. The index relationships can also be used by the option trader in another way. When an option spread is being established with options whose strikes are not near the current index prices - that is, they are rela­ tively deeply in- or out-of-the-money- one can use the ratio between the indices to determine which strikes are equivalent. Example: ZYX is trading at 250 and the ZYX July 270 call is overpriced. An option strategist might want to sell that call and hedge it with a call on another index. Suppose he notices that calls on the UVX Index are trading at approximately fair value with the UVX Index at 175. What UVX strike should he buy to be equivalent to the ZYX 270 strike? One can multiply the ZYX strike, 270, by the ratio of the indices to arrive at the UVX strike to use: UVX strike= 270 x (175/250) = 189.00 So he would buy the UVX July 190 calls to hedge. The exact number of calls to buy would be determined by the formula given previously for option ratio. 588 SUMMARY Part V: Index Options and Futures This concludes the discussion of index spreading. The above examples are intended to be an overview of the most usable strategies in the complex universe of index spreading. The multitude of strategies involving inter-index and intra-index spreads cannot all be fully described. In fact, one's imagination can be put to good use in designing and implementing new strategies as market conditions change and as the emotion in the marketplace drives the premium on the futures contracts. Often one can discern a usable strategy by observation. Watch how two popu­ lar indices trade with respect to each other and observe how the options on the two indices are related. If, at a later time, one notices that the relationship is changing, perhaps a spread between the indices is warranted. One could use the NASDAQ­ based indices, such as the NASDAQ-100 (NDX) or smaller indices based on it (QQQ or MNX). Sector indices can be used as well. This brings into play a fairly large num­ ber of indices with listed options (few, if any, of which have futures), such as the Semiconductor Index (SOX), the Oil & Gas Index (XOI), the Gold and Silver Index (XAU), etc. The key point to remember is that the index option and futures world is more diverse than that of stock options. Stock option strategies, once learned or observed, apply equally well to all stocks. Such is not the case with index spreading strategies. The diversification means that there are more profit opportunities that are recognized by fewer people than is the case with stock options. The reader is thus challenged to build upon the concepts described in this part of the book. Structured Products The popularity of derivative instruments and the kinds of risk-reducing, volatility­ reducing effects that they can have on portfolios led to a new type of product in the 1990s. This new product, termed a structured product, has more appeal for investors than for traders. In essence, enterprising designers at the major institutional broker­ age firms have constructed a single security that behaves like a portfolio hedged by options. These designers structure the combination of derivatives and stocks so that the resulting product behaves in a manner that is attractive to many investors, whether institutional or private. In this chapter, these structured products are exam­ ined in detail, to give the reader the background so that in the future, he may ana­ lyze similar products for himself. Would you like to own an index fund that had no risk? Or, how about owning a popular stock and getting a dividend payment that is much, much larger than the stock itself pays? I think everyone would like to do those things. With structured products, one can own similar investments, but they come with a cost. The two ques­ tions asked previously might then be better restated as follows: Would you like to own an index fund that had no risk, but that perhaps did not fully participate in all of the upside movement of the market? It still has downside protection, and unlimited profit potential on the upside. This is akin to owning the stock or the index and hav­ ing protected it by buying a put option. Or, would you like to own that popular stock and receive that huge dividend, but know that your profit potential is limited to a fixed amount on the upside? This is akin to a covered call write. These two questions describe the majority of the listed structured products in existence today. They are attractive investments in their own right, but one must carefully assess the products before buying them. This chapter is divided into two main parts to discuss the two types of products: First, we'll discuss the "protected" stock or index. Later, the discussion will tum to "covered write" products. 589 590 Part V: Index Options and Futures The discussion in this chapter concentrates on the structured products that are listed and traded on the major stock exchanges. A broader array of products - typically called exotic options - is traded over-the-counter. These can be very com­ plicated, especially with respect to currency and bond options. It is not our intent to discuss exotic options, although the approaches to valuing the structured products that are presented in this chapter can easily be applied to the overall valuation of many types of exotic products. Also, the comments at the end of the chapter regard­ ing where to find information about these products may prove useful for those seek­ ing further information about either listed structured products or exotic options. Part I: "Riskless" Ownership of a Stock or Index THE "STRUCTURE" OF A STRUCTURED PRODUCT At many of the major institutional banks and brokerages, people are employed who design structured products. They are often called financial engineers because they take existing financial products and build something new with them. The result is packaged as a fund of sorts (or a unit trust, perhaps), and shares are sold to the pub­ lic. Not only that, but the shares are then listed on the American or New York Stock Exchanges and can be traded just like any other stock. These attributes make the structured product a very desirable investment. An example will show how a generic index structured product might look. Example: Let's look at the structured index product to see how it might be designed and then how it might be sold to the public. Suppose that the designers believe there is demand for an index product that has these characteristics: 1. This "index product" will be issued at a low price - say, $10 per share. 2. The product will have a maturity date - say, seven years hence. 3. The owner of these shares can redeem them at their maturity date for the greater of either a) $10 per share orb) the percentage appreciation of the S&P 500 index over that seven-year time period. That is, if the S&P doubles over the seven years, then the shares can be redeemed for double their issue price, or $20. Thus, this product has no price risk! The holder gets his $10 back in the worst case (except for credit risk, which will be addressed in a minute). Moreover, these shares will trade in the open market during the seven years, so that if the holder wants to exit at any time, he can do so. Perhaps the S&P has rallied O,apter 32: Structured Products 591 dramatically, or perhaps he needs cash for something else - both might be reasons that the holder of the shares would want to sell before maturity. Such a product has appeal to many investors. In fact, if one thought that the stock market was a "long-term" buy, this would be a much safer way to approach it than buying a portfolio of stocks that might conceivably be much lower in value seven years hence. The risk of the structured product is that the underwriter might not be able to pay the $10 obligation at maturity. That is, if the major institutional bank or brokerage firm who underwrote these products were to go out of business over the course of the next seven years, one might not be able to redeem them. In essence, then, structured products are really forms of debt (senior debt) of the brokerage firm that underwrote them. Fortunately, most structured products are underwritten by the largest and best-capitalized institutions, so the chances of a failure to pay at matu­ rity would have to be considered relatively tiny. How does the bank create these items? It might seem that the bank buys stock and buys a put and sells units on the combined package. In reality, the product is not normally structured that way. Actually, it is not a difficult concept to grasp. This example shows how the structure looks from the viewpoint of the bank: Example: Suppose that the bank wants to raise a pool of $1,000,000 from investors to create a structured product based on the appreciation of the S&P 500 index over the next seven years. The bank will use a part of that pool of money to buy U.S. zero­ coupon bonds and will use the rest to buy call options on the S&P 500 index. Suppose that the U.S. government zero-coupon bonds are trading at 60 cents on the dollar. Such bonds would mature in seven years and pay the holder $1.00. Thus, the bank could take $600,000 and buy these bonds, knowing that in seven years, they would mature at a value of $1,000,000. The other $400,000 is spent to buy call options on the S&P 500 index. Thus, the investors would be made whole at the end of seven years even if the options that were bought expired worthless. This is why the bank can "guarantee" that investors will get their initial money back. Meanwhile, if the stock market advances, the $400,000 worth of call options will gain value and that money will be returned to the holders of the structured product as well. In reality, the investment bank uses its own money ($1,000,000) to buy the secu­ rities necessary to structure this product. Then they make the product into a legal entity (often a unit trust) and sell the shares (units) to the public, marking them up slightly as they would do with any new stock brought to market. At the time of the initial offering, the calls are bought at-the-money, meaning the striking price of the calls is equal to the closing price of the S&P 500 index on the 592 Part V: Index Options and Futures day the products were sold to the public. Thus, the structured product itself has a "strike price" equal to that of the calls. It is this price that is used at maturity to deter­ mine whether the S&P has appreciated over the seven-year period - an event that would result in the holders receiving back more than just their initial purchase price. After the initial offering, the shares are then listed on the AMEX or the NYSE and they will begin to rise and fall as the value of the S&P 500 index fluctuates. So, the structured product is not an index fund protected by a put option, but rather it is a combination of zero-coupon government bonds and a call option on an index. These two structures are equivalent, just as the combination of owning stock protected by a put option is equivalent to being long a call option. Structured products of this type are not limited to indices. One could do the same thing with an individual stock, or perhaps a group of stocks, or even create a simulated bull spread. There are many possibilities, and the major ones will be dis­ cussed in the following sections. In theory, one could construct products like this for himself, but the mechanics would be too difficult. For example, where is one going to buy a seven-year option in small quantity? Thus, it is often worthwhile to avail one­ self of the product that is packaged (structured) by the investment banker. In actuality, many of the brokerage firms and investment banks that undetwrite these products give them names - usually acronyms, such as MITTS, TARGETS, BRIDGES, LINKS, DINKS, ELKS, and so on. If one looks at the listing, he may see that they are called notes rather than stocks or index funds. Nevertheless, when the terms are described, they will often match the examples given in this chapter. INCOME TAX CONSEQUENCES There is one point that should be made now: There is "phantom interest" on a struc­ tured product. Phantom interest is what one owes the government when a bond is bought at a discount to maturity. The IRS technically calls the initial purchase price an Original Issue Discount (OID) and requires you to pay taxes annually on a pro­ portionate amount of that OID. For example, if one buys a zero-coupon U.S. gov­ ernment bond at 60 cents on the dollar, and later lets it mature for $1.00, the IRS does not treat the 40-cent profit as capital gains. Rather, the 40 cents is interest income. Moreover, says the IRS, you are collecting that income each year, since you bought the bonds at a discount. (In reality, of course, you aren't collecting a thing; your investment is simply worth a little more each year because the discount decreas­ es as the bonds approach maturity.) However, you must pay income tax on the "phan- Chapter 32: Structured Products 593 tom interest" you supposedly received each year. Those are the rules, and there isn't anything you can do about them. Since some structured products involve the purchase of zero-coupon bonds, the IRS has ruled that owners of this type of structured product must pay phantom inter­ est each year. Thus, structured products should be bought in a tax-free retirement account (IRA, SEP, etc.) if at all possible, in order to avoid having to declare phan­ tom interest on your tax return for each year you hold the product. The phantom interest tax applies only to this type of structured product - one on which you are guaranteed to get back a fixed amount at maturity - because this is the only type that requires buying a zero-coupon bond in order to ensure that you'll get your money back if the stock market goes down. The phantom interest concept does not apply to the type of structured product to be discussed in the second part of this chapter. To be certain, one should get the necessary information from his broker or should read the prospectus of the structured product. Of course, any tax strategies should also be discussed with a qualified tax professional. CASH VALUE The cash value of the structured product is what it will be worth at maturity. It is usu­ ally stated in terms similar to those in the preceding example, and a formula is often given. This example will clarify the typical nature of this formula: Example: A structured product is issued at $10 per share. The terms stipulate that the holder will receive back, at maturity, either $10 or 100% of the appreciation of the S&P 500 index above a value of 1,245.27. (One would assume that the S&P 500 cash index closed at 1,245.27 on the day the structured product was issued.) The prospectus will usually provide a formula for the cash surrender value, and it will be stated something like this: At maturity, the cash value will be equal to the greater of: (a) $10 or (b) $10 + 10 x (Final Index Value - 1,245.27) / 1,245.27 where Final Index Value is, say, the closing value of the S&P 500 index on the maturity date. The formula given is merely the arithmetic equivalent of the statement that one will receive 100% of the appreciation of the S&P 500 Index above the strike price of 1,245.27. For those more adept at math, the formula can be reduced to common terms, in which case it reads: 594 Part V: Index Options and Futures Cash Surrender Value = $10 x Final Value/ 1,245.27 This shortened version of the formula only works, though, when the participa­ tion rate is 100% of the increase in the Final Index Value above the striking price. Otherwise, the longer formula should be used. Not all structured products of this type offer the holder 100% of the appreci­ ation of the index over the initial striking price. In some cases, the percentage is smaller ( although in the early days of issuance, some products offered a percentage appreciation that was actually greater than 100%). After 1996, options in general became more expensive as the volatility of the stock market increased tremendous­ ly. Thus, structured products issued after 1997 or 1998 tend to include an "annual adjustment factor." Adjustment factors are discussed later in the chapter. Therefore, a more general formula for Cash Surrender Value - one that applies when the participation rate is a fixed percentage of the striking price - is: Cash Surrender Value = Guarantee + Guarantee x Participation Rate x (Final Index Value/ Striking Price - I) THE COST OF THE IMBEDDED CALL OPTION Few structured products pay dividends. 1 Thus, the "cost" of owning one of these products is the interest lost by not having your money in the bank ( or money market fund), but rather having it tied up in holding the structured product. Continuing with the preceding example, suppose that you had put the $10 in the bank instead of buying a structured product with it. Let's further assume that the money in the bank earns 5% interest, compounded continuously. At the end of seven years, compounded continuously, the $10 would be worth: Money in the bank = Guarantee Price x ert = $10 x e 0-05 x 7 = 14.191, in this case This calculation usually raises some eyebrows. Even compounded annually, the amount is 14.07. You would make roughly 40% (without considering taxes) just by 1Some do pay dividends, though. A structured product existed on a contrived index, called the Dow-Jones Top 10 Yield index (symbol: $XMT). This is a sort of "dogs of the Dow" index. Since part of the reason for owning a "dogs of the Dow" product is that dividends are part of the performance, the creators of the structured product (Merrill Lynch) stated that the minimum price one would receive at maturity would be 12.40, not the 10 that was the initial offering price. Thus, this particular structured product had a "dividend" built into it in the form of an ele­ vated minimum price at maturity. Chapter 32: Structured Products 595 having your money in the bank. Forgetting structured products for a moment, this means that stocks in general would have to increase in value by over 40% during the seven-year period just for your performance to beat that of a bank account. In this sense, the cost of the imbedded call option in the structured product is this lost interest - 4.19 or so. That seems like a fairly expensive option, but if you con­ sider that it's a seven-year option, it doesn't seem quite so expensive. In fact, one could calculate the implied volatility of such a call and compare it to the current options on the index in question. In this case, with the stock at 10, the strike at 10, no dividends, a 5% interest rate, and seven years until expiration, the implied volatility of a call that costs $4.19 is 28.1 %. Call options on the S&P 500 index are rarely that expensive. So you can see that you are paying "something" for this call option, even if it is in the form of lost interest rather than an up-front cost. As an aside, it is also unlikely that the underwriter of the structured product actually paid that high an implied volatility for the call that was purchased; but he is asking you to pay that amount. This is where his underwriting profit comes from. The above example assumed that the holder of the structured product is par­ ticipating in 100% of the upside gain of the underlying index over its striking price. If that is not the case, then an adjustment has to be made when computing the price of the imbedded option. In fact, one must compute what value of the index, at matu­ rity, would result in the cash value being equal to the "money in the bank" calcula­ tion above. Then calculate the imbedded call price, using that value of the index. In that way, the true value of the imbedded call can be found. You might ask, "Why not just divide the 'money in the bank' formula by the par­ ticipation rate?" That would be okay if the participation were always stated as a per­ centage of the striking price, but sometimes it is not, as we will see when we look at the more complicated examples. Further examples of structured products in this chapter demonstrate this method of computing the cost of the imbedded call. PRICE BEHAVIOR PRIOR TO MATURITY The structured product cannot normally be "exercised" by the holder until it matures. That is, the cash surrender value is only applicable at maturity. At any other time during the life of the product, one can compute the cash surrender value, but he cannot actually attain it. What you can attain, prior to maturity, is the market price, since structured products trade freely on the exchange where they are listed. In actu­ al fact, the products generally trade at a slight discount to their theoretical cash sur­ render value. This is akin to a closed-end mutual fund selling at a discount to net 596 Part V: Index Options and Futures asset value. Eventually, upon maturity, the actual price will be the cash surrender value price; so if you bought the product at a discount, you would benefit, providing you held all the way to maturity. Example: Assume that two years ago, a structured product was issued with an initial offering price of $10 and a strike price of 1,245.27, based upon the S&P 500 index. Since issuance, the S&P 500 index has risen to 1,522.00. That is an increase of 22.22% for the S&P 500, so the structured product has a theoretical cash surrender value of 12.22. I say "theoretical" because that value cannot actually be realized, since the structured product is not exercisable at the current time - five years prior to maturity. In the real marketplace, this particular structured product might be trading at a price of 11. 75 or so. That is, it is trading at a discount to its theoretical cash sur­ render value. This is a fairly common occurrence, both for structured products and for closed-end mutual funds. If the discount were large enough, it should serve to attract buyers, for if they were to hold to maturity, they would make an extra 4 7 cents (the amount of this discount) from their purchase. That's 4% (0.47 divided by 11.75 = 4%) over five years, which is nothing great, but it's something. Why does the product trade at a discount? Because of supply and demand. It is free to trade at any price - premium or discount - because there is nothing to keep it fixed at the theoretical cash surrender value. If there is excess demand or supply in the open market, then the price of the structured product will fluctuate to reflect that excess. Eventually, of course, the discount will disappear, but five years prior to maturity, one will often find that the product differs from its theoretical value by somewhat significant amounts. If the discount is large enough, it will attract buyers; alternatively, if there should be a large premium, that should attract sellers. SIS One of the first structured products of this type that came to my attention was one that traded on the AMEX, entitled "Stock Index return Security" or SIS. It also trad­ ed under the symbol SIS. The product was issued in 1993 and matured in 2000, so we have a complete history of its movements. The terms were as follows: The under­ lying index was the S&P Midcap 400 index (symbol: $MID). Issued in June 1993, the original issue price was $10, and $MID was trading at 166.10 on the day of issuance, so that was the striking price. Moreover, buyers were entitled to 115% of the appre­ ciation of $MID above the strike price. Thus, the cash value formula was: Gopter 32: Structured Products 597 Cash value of SIS $10 + $10 x 1.15 x ($MID - 166.10) / 166.10 where Guarantee price = $10 Underlying index: S&P Midcap 400 ($MID) Striking price: 166.10 Participation rate: 115% of the increase of $MID above 166.10 SIS matured seven years later, on June 2, 2000. At the time of issuance, seven-year interest rates were about 5.5%, so the "money in the bank" formula shows that one could have made about 4.7 points on a $10 investment, just by utilizing risk-free gov­ ernment securities: Money in the bank= 10 x e0-055 x 7 = 14.70 We can't simply say that the cost of the imbedded call was 4. 7 points, though, because the participation rate is not 100% - it's greater. So we need to find out the Final Value of $MID that results in the cash value being equal to the "money in the bank" result. Using the cash value formula and inserting all the terms except the final value of $MID, we have the following equation. Note: $MIDMIB stands for the value of $MID that results in the "money in the bank" cash value, as computed above. 14.70 = 10 + 10 X 1.15 X ($MIDMIB 166.10) I 166.10 Solving for $MIDMIB' we get a value of 233.98. Now, convert this to a percent gain of the striking price: Imbedded call price = 233.98 I 166.10 - 1 = 0.4087 Hence, the imbedded call costs 40.87% of the guarantee price. In this example, where the guarantee price was $10, that means the imbedded call cost $4.087. Thus, a more generalized formula for the value of the imbedded call can be construed from this example. This formula only works, though, where the participa­ tion rate is a fixed percentage of the strike price. Imbedded call value= Guarantee price x (Final Index ValueMIB / Striking Price - 1) Final Index ValueMIB is the final index price that results in the cash value being equal to the "money in the bank" calculation, where Money in the bank = Guarantee Price x ert r = risk-free interest rate t = time to maturity Thus, the calculated value of the imbedded call was approximately 4.087 points, which is an implied volatility of just over 26%. At the time, listed short-term options 598 Part V: Index Options and Futures on $MID were trading with an implied volatility of about 14%, so this was an expen­ sive call in terms of its initial cost. However, one should remember that owning SIS gave one more than full par­ ticipation in the $MID for seven years, with virtually no risk. That has to be worth something. As it turned out, $MID was strong during this seven-year period, and SIS wound up being worth just over $30 per share. So, in the end, the owner of SIS tripled his money in seven years and had no risk to begin with. Not a bad scenario. SIS TRACK RECORD What SIS also imparts to us, though, is a track record of how it traded during its life. Figure 32-1 shows the discount at which SIS traded during its lifetime. It is the lower line on the chart. The upper line is the corresponding cash value on the same dates. Note that the upper line has the exact same shape as the S&P Midcap 400 ($MID) would, since it is merely $MID multiplied by some arithmetic constant. The graph of the discount is rather "choppy" because it uses last sales of SIS to compute the dis­ count. In reality, since SIS was a somewhat low-volume security, the last sale was not always representative of the closing bid-asked market in SIS. Nevertheless, the graph shows that the discount was greater than 2 points at the left side of the graph (1995) and gradually decreased until it reached zero near maturity (2000). The graph in Figure 32-1 is useful because it encompasses cases where $MID traded both above and below the striking price of 166.10. No matter whether SIS was in-the-money ($MID above 166.1) or out-of-the-money, SIS traded at a discount. As mentioned previously, this is akin to a closed-end mutual fund trading at a discount to net asset value. At a minimum, this discount allows the buyer of SIS to add an additional com­ ponent of overall return to his investment. Also, in some cases - when $MID was trading below the striking price - the buyer of SIS actually has a guaranteed return, as one might have with a bond paying interest or a stock paying a dividend. The examples in the next section examine those situations. SIS TRADING AT A DISCOUNT TO CASH VALUE When SIS is trading at a discount to cash value, the buyer of SIS actually has some downside protection. Example: In late 1996, $MID closed at 238.54 one day, and SIS closed at 13. The cash value of SIS for that price of $MID is: Cash Value = 10 + 10 x 1.15 x (238.54/166.10 - 1) = 15.02 Cbapter 32: Strudured Products FIGURE 32-1. SIS trading at a discount. Cash Value and SIS Discount 30 20 10 0 -1 -2 1997 Date· 599 Therefore, SIS is trading at almost exactly a 2-point discount to cash value. That is a fairly large discount of 15.4% (2/13 = .154). One way to look at this would be to say that an investor is making an "extra" 15.4% on his investment. That is, if $MID were at exactly the same price at expira­ tion, the cash value would be the settlement price - 15.02. In other words, the "stock market" as measured by $MID was exactly unchanged. However, the investor would make a return of 15.4% because he bought SIS at a discount. In fact, no matter where $MID is at maturity, the investor feels the positive effect of having bought at a discount. Thus, the discount can and should be perceived as adding to the overall return of owning the structured product. These discounts to net asset value are commonplace with structured products. However, there is another way to view it: as downside pro­ tection. Example: Using the same prices, $MID is at 238.54 and SIS is at 13 - a 15.4% dis­ count to the cash value of 15.02. Another way to view what this discount means is to view it as downside protection. In other words, $MID could decline in price by matu­ rity and this investor could still break even. The exact amount of the downside pro­ tection can be calculated. Essentially, one wants to know, at what price for $MID would the cash value be 13? 600 Part V: Index Options and Futures Solving the following equation for $MID would give the desired answer: Cash Value = 13 = 10 + 11.5 x ($MID/166.l - 1) 3 = 11.5 x $MID/ 166.1 - 11.5 14.5 x 166.1 / 11.5 = $MID 209.43 = $MID So, if $MID were at 209.43, the cash value would be 13 - the price the investor is currently paying for SIS. This is protection of 12.2% down from the current price of 238.54. That is, $MID could decline 12.2% at maturity, from the current price of 238.54 to a price of 209.43, and the investor who bought SIS would break even because it would still have a cash value of 13. Of course, this discount could have been computed using the SIS prices of 13 and 15.02 as well, but many investors prefer to view it in terms of the underlying index - especially if the underlying is a popular and often-cited index such as the S&P 500 or Dow-Jones Industrials. From Figure 32-1, it is evident that the discount persisted throughout the entire life of the product, shrinking more or less linearly until expiration. SIS TRADING AT A DISCOUNT TO THE GUARANTEE PRICE In the previous example, the investor could have bought SIS at a discount to its cash value computation, but if the stock market had declined considerably, he would still have had exposure from his SIS purchase price of 13 down to the guarantee price of 10. The discount would have mitigated his percentage loss when compared to the $MID index itself, but it would be a loss nevertheless. However, there are sometimes occasions when the structured product is trad­ ing at a discount not only to cash value, but also to the guarantee price. This situation occurred frequently in the early trading life of SIS. From Figure 32-1, you can see that in 1995 the cash value was near 11, but SIS was trading at a discount of more than 2 points. In other words, SIS was trading below its guarantee price, while the cash value was actually above the guarantee price. It is a "double bonus" for an investor when such a situation occurs. Example: In February 1995, the following prices existed: $MID: 177.59 SIS: 8.75 For a moment, set aside considerations of the cash value. If one were to buy SIS at 8. 75 and hold it for the 5.5 years remaining until maturity, he would make 1.25 points on his 8.75 investment- a return of 14.3% for the 5.5-year holding period. As a compounded rate of interest, this is an annual compound return of 2.43%. Cl,apter 32: Structured Produds 601 Now, a rate of return of 2.43% is rather paltry considering that the risk-free T•bill rate was more than twice that amount. However, in this case, you own a call option on the stock market and get to earn 2.43% per year while you own the call. In other words, "they" are paying you to own a call option! That's a situation that doesn't arise too often in the world of listed options. If we introduce cash value into this computation, the discrepancy is even larg­ er. Using the $MID price of 177.59, the cash value can be computed as: Cash Value = 10 + 11.5 x (177.59/166.10 - 1) = 10.80 Thus, with SIS trading at 8. 75 at that time, it was actually trading at a whopping 19% discount to its cash value of 10.80. Even if the stock market declined, the guar­ antee price of 10 was still there to provide a minimal return. In actual practice, a structured product will not normally trade at a discount to its guarantee price while the cash value is higher than the guarantee price. There's only a narrow window in which that occurs. There have been times when the stock market has declined rather substantial­ ly while these products existed. We can observe the discounts at which they then traded to see just how they might actually behave on the downside if the stock mar­ ket declined after the initial offering date. Consider this rather typical example: Example: In 1997, Merrill Lynch offered a structured product whose underlying index was Japan's Nikkei index. At the time, the Nikkei was trading at 20,351, so that was the striking price. The participation rate was 140% of the increase of the Nikkei above 20,351 - a very favorable participation rate. This structured product, trading under the symbol JEM, was designed to mature in five years, on June 14, 2002. As it turned out, that was about the peak of the Japanese market. By October of 1998, when markets worldwide were having difficulty dealing with the Russian debt crisis and the fallout from a major hedge fund in the U.S. going broke, the Nikkei had plummeted to 13,300. Thus, the Nikkei would have had to increase in price by just over 50% merely to get back to the striking price. Hence, it would not appear that JEM was ever going to be worth much more than its guarantee price of 10. Since we have actual price histories of JEM, we can review how the market­ place viewed the situation. In October 1998, JEM was actually trading at 8.75 - only 1.25 points below its guarantee price. That discount equates to an annual com­ pounded rate of 3.64%. In other words, if one were to buy JEM at 8.75 and it matured at 10 about 40 months later, his return would have been 3.64% compound­ ed annually. That by itself is a rather paltry rate of return, but one must keep in mind that he also would own a call option on the Nikkei index, and that option has a 140% participation rate on the upside. 602 Part V: Index Options and Futures COMPUTING THE VALUE OF THE IMBEDDED CALL WHEN THE UNDERLYING IS TRADING AT A DISCOUNT Can we compute the value of the imbedded call when the structured product itself is trading at a discount to its guarantee price? Yes, the formulae presented earlier can always be used to compute the value of the imbedded call. Example: Again using the example of JEM, the structured product on the Nikkei index, recall that it was trading at 8. 75 with a guaranteed price of 10, with maturity 40 months hence. Assume that the risk-free interest rate at the time was 5.5%. Assuming continuous compounding, $8.75 invested today would be worth $10.51 in 40 months. Money in the bank = 8. 75 x ert where r = 0.05 and t = 3.33 years (40 months) Money in the bank= 8.75 x e0-055 x 3-333 = 10.51 Since the structured product will be worth 10 at maturity, the value of the call is 0.51. There is another, nearly equivalent way to determine the value of the call. It involves determining where the structured product would be trading if it were com­ pletely a zero-coupon debt of the underwriting brokerage. The difference between that value and the actual trading price of the structured product is the value of the imbedded call. The credit rating of the underwriter of the structured product is an important factor in how large a discount occurs. Recall that the guarantee price is only as good as the creditworthiness of the underwriter. The underwriter is the one who will pay the cash settlement value at maturity - not the exchange where the product is listed nor any sort of clearinghouse or corporation. THE ADJUSTMENT FACTOR In recent years, some of the structured products have been issued with an adjustment factor. The adjustment factor is generally a negative thing for investors, although the underwriters try to couch it in language that makes it difficult to discern what is going on. Simply put, the adjustment factor is a multiplier (less than 100%) applied to the underlying index value before calculating the Final Cash Value. Adjustment factors seemed to come into being at about the time that index option implied volatility began to trade at much higher levels than it ever had (1997 onward). Cl,opter 32: Structured Products 603 Example: A structured product is issued at an initial price of $10. It ostensibly allows one to participate in the appreciation of the S&P 500 index over a price of 1,100.00. However, upon closer inspection, what the product really offers is the opportunity for one to participate in the appreciation of the S&P 500 index ($SPX) over an adjusted value, which is a percentage of the $SPX price - not the actual price itself. The cash value settlement formula is stated as: Cash settlement value = 10 + 10 x (Adjusted $SPX - 1,100.00) / 1,100.00 The formula looks similar to the "normal" cash settlement value formulae shown earlier in the chapter, but the term "adjusted $SPX" has yet to be defined. In fact, it is defined as a percentage of the final $SPX Price - 91.25% in this case. In real­ ity, the prospectus says something to the effect that the final price of $SPX will be adjusted downward by an annual adjustment factor of 1.25%. Thus, at the end of the seven-year maturity period, the total adjustment factor would be seven times 1.25%, or 8.75%. The adjusted value is then equal to 100% - 8.75%, or 91.25%. The adjustment factor is an onerous burden for the investor. It means that the final value of $SPX will be reduced by the adjustment factor before it is determined how far, or if at all, $SPX is above the striking price of 1,100.00. Example: Suppose that $SPX exactly doubles in price during the life of the example structured product. That is, it finishes at 2,200.00 - exactly twice the amount of the striking price. Before the cash settlement value can be determined, $SPX must be adjusted: $SPX adjusted value = 0.9125 x 2,200.00 = 2,007.50 So the final cash settlement value is based on the adjusted value of $SPX: Cash settlement value = 10 + 10 x (2,007.50 - l,100.00)/1,100.00 = 18.25 Hence, instead of doubling your money, as you might expect to do since the $SPX Index doubled in price, you "only" make 82.5%. Another way to view it: If the index doubles, then the structured product "should" be worth double the initial price, or 20. But instead, it's worth 91.25% of 20, or 18.25. Carrying the example a little further, suppose that $SPX had tripled in price by the maturity date, and was thus at 3,300. In this case, the cash settlement value would be: $SPX adjusted value = 0.9125 x 3,300.00 = 3,011.25 Cash settlement value = 10 + 10 x (3,011.25 - l,100.00)/1,100.00 = 27.375 604 Part V: Index Options and Futures Or, thinking in the alternative, if the index triples, then the structured produc1 (before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25o/c == 27.375. This example begins to demonstrate just how onerous the adjustment factor is. Notice that if the underlying doubles, you don't make "double" less 8.75% (the adjustment factor). No, you make "double" times the adjustment factor - 17.5% - less than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than triple (i.e., the structured product is worth 27.375, not 30, so the percentage increase was 173. 75%, not 200% - a difference of 26.25%, stated in terms of the initial invest­ ment). How can that be? It is a result of the adjustment factor being applied to the $SPX price before your profit (cash settlement value) is computed. THE BREAK-EVEN FINAL INDEX VALUE Before discussing the adjustment factor in more detail, one more point should be made: The owner of the structured product doesn't get back anything more than the base value unless the underlying has increased by at least a fixed amount at maturi­ ty. In others words, the underlying must appreciate to a price large enough that the final price times the adjustment factor is greater than the striking price of the struc­ tured product. We'll call this price the break-even final index value. An example will demonstrate this concept. Example: As in the preceding example, suppose tl1at the striking price of the struc­ tured product is 1,100 and the adjustment factor is 8.75%. At what price would the final cash settlement value be something greater than the base value of 10? That price can be solved for with the following simple equation: Break-even final index value== Striking price/ (1- Adjustment factor) = 1,100 / (0.9125) == 1,205.48. Generally speaking, the underlying index must increase in value by a specific amount just to break even. In this case that amount is: 1 / (1 -Adjustment factor) = 1 / 0.9175 = 1.0959 In other words, the underlying index must increase in value by more than 9.5% by maturity just to overcome the weight of the adjustment factor. If the index increas­ es by a lesser amount, then the structured product holder will merely receive back his base value ( 10) at maturity. The previous examples all show that the adjustment factor is not a trivial thing. At first glance, one might not realize just how burdensome it is. After all, one might 605 himself, what does 1.25% per year really matter? However, you can see that it matter. In fact, our above examples did not even factor in the other cost that any Investor has when his money is at risk - the cost of carry, or what he could have made had he just put the money in the bank. MEASURING THE COST OF THE ADJUSTMENT FACTOR The magnitude of the adjustment increases as the price of the underlying increases. lt is an unusual concept. We know that the structured product initially had an imbedded call option. Earlier in this chapter, we endeavored to price that option. However, with the introduction of the concept of an adjustment factor, it turns out that the call option's cost is not a fixed amount. It varies, depending on the final value of the underlying index. In fact, the cost of the option is a percentage of the final value of the index. Thus, we can't really price it at the beginning, because we don't know what the final value of the index will be. In fact, we have to cease thinking of this option's cost as a fixed number. Rather, it is a geometric cost, if you will, for it increases as the underlying does. Perhaps another way to think of this is to visualize what the cost will be in per­ centage terms. Figure 32-2 compares how much of the percent increase in the index is captured by the structured product in the preceding example. The x-axis on the graph is the percent increase by the index. The y-axis is the percent realized by the structured product. The terms are the same as used in the previous examples: The strike price is 1,100, the total adjustment factor is 8. 75%, and the guarantee price of the structured product is 10. The dashed line illustrates the first example that was shown, when a doubling of the index value (an increase of 100%) to 2,200 resulted in a gain of 83.5% in the price of the structured. Thus, the point (100%, 83.5%) is on the line on the chart where the dashed lines meet. Figure 32-2 points out just how little of the percent increase one captures if the underlying index increases only modestly during the life of the structured product. We already know that the index has to increase by 9.59% just to get to the break-even final price. That point is where the curved line meets the x-axis in Figure 32-2. The curved line in Figure 32-2 increases rapidly above the break-even price, and then begins to flatten out as the index appreciation reaches 100% or so. This depicts the fact that, for small percentage increases in the index, the 8.75% adjust­ ment factor - which is a flat-out downward adjustment in the index price - robs one of most of the percentage gain. It is only when the index has doubled in price or so that the curve stops rising so quickly. In other words, the index has increased enough in value that the structured product, while not capturing all of the percentage gain by any means, is now capturing a great deal of it. 604 Part V: Index Options and Futures Or, thinking in the alternative, if the index triples, then the structured product (before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25% = 27.375. This example begins to demonstrate just how onerous the adjustment factor is. Notice that if the underlying doubles, you don't make "double" less 8.75% (the adjustment factor). No, you make "double" times the adjustment factor - 17.5% - less than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than triple (i.e., the structured product is worth 27.375, not 30, so the percentage increase was 173. 75%, not 200% - a difference of 26.25%, stated in terms of the initial invest­ ment). How can that be? It is a result of the adjustment factor being applied to the $SPX price before your profit (cash settlement value) is computed. THE BREAK-EVEN FINAL INDEX VALUE Before discussing the adjustment factor in more detail, one more point should be made: The owner of the structured product doesn't get back anything more than the base value unless the underlying has increased by at least a fixed amount at maturi­ ty. In others words, the underlying must appreciate to a price large enough that the final price times the adjustment factor is greater than the striking price of the struc­ tured product. We'll call this price the break-even final index value. An example will demonstrate this concept. Example: As in the preceding example, suppose that the striking price of the struc­ tured product is 1,100 and the adjustment factor is 8.75%. At what price would the final cash settlement value be something greater than the base value of 10? That price can be solved for with the following simple equation: Break-even final index value = Striking price/ (1- Adjustment factor) = 1,100 / (0.9125) = 1,205.48. Generally speaking, the underlying index must increase in value by a specific amount just to break even. In this case that amount is: 1 / (1 - Adjustment factor) = 1 / 0.9175 = 1.0959 In other words, the underlying index must increase in value by more than 9.5% by maturity just to overcome the weight of the adjustment factor. If the index increas­ es by a lesser amount, then the structured product holder will merely receive back his base value (10) at maturity. The previous examples all show that the adjustment factor is not a trivial thing. At first glance, one might not realize just how burdensome it is. After all, one might 605 himself, what does 1.25% per year really matter? However, you can see that it matter. In fact, our above examples did not even factor in the other cost that any htvt?stor has when his money is at risk - the cost of carry, or what he could have made he just put the money in the bank. MIASURING THE COST OF THE ADJUSTMENT FACTOR The magnitude of the adjustment increases as the price of the underlying increases. It is an unusual concept. We know that the structured product initially had an hnbedded call option. Earlier in this chapter, we endeavored to price that option. However, with the introduction of the concept of an adjustment factor, it turns out that the call option's cost is not a fixed amount. It varies, depending on the final value of the underlying index. In fact, the cost of the option is a percentage of the final value of the index. Thus, we can't really price it at the beginning, because we don't know what the final value of the index will be. In fact, we have to cease thinking of this option's cost as a fixed number. Rather, it is a geometric cost, if you will, for it increases as the underlying does. Perhaps another way to think of this is t.o visualize what the cost will be in per­ centage terms. Figure 32-2 compares how much of the percent increase in the index is captured by the structured product in the preceding example. The x-axis on the graph is the percent increase by the index. The y-axis is the percent realized by the structured product. The terms are the same as used in the previous examples: The strike price is 1,100, the total adjustment factor is 8.75%, and the guarantee price of the structured product is 10. The dashed line illustrates the first example that was shown, when a doubling of the index value (an increase of 100%) to 2,200 resulted in a gain of 83.5% in the price of the structured. Thus, the point (100%, 83.5%) is on the line on the chart where the dashed lines meet. Figure 32-2 points out just how little of the percent increase one captures if the underlying index increases only modestly during the life of the structured product. We already know that the index has to increase by 9.59% just to get to the break-even final price. That point is where the curved line meets the x-axis in Figure 32-2. The curved line in Figure 32-2 increases rapidly above the break-even price, and then begins to flatten out as the index appreciation reaches 100% or so. This depicts the fact that, for small percentage increases in the index, the 8.75% adjust­ ment factor -which is a flat-out downward adjustment in the index price - robs one of most of the percentage gain. It is only when the index has doubled in price or so that the curve stops rising so quickly. In other words, the index has increased enough in value that the structured product, while not capturing all of the percentage gain by any means, is now capturing a great deal of it. 606 Part V: Index Options and Futu FIGURE 32-2. Percent of increase captured by structured product. 90 80 70 60 "O I!: 50 ::, 0.. ttl (.) 40 :£ 0 30 Break-even: 9.59% Increase 20 10 0 100 200 300 400 500 % Increase by Index After that, the curve in Figure 32-2 flattens dramatically. It eventually flattens out completely at 91.25%. That is, if the index increases enough in value (about 3,000% or morel), then the structured product final cash value will reflect the full 91.25% percent of appreciation of the index itself. That kind of increase in seven years is virtually unattainable. In reality, the index - if it increases at all - will proba­ bly be more in line with the values shown on the x-axis in Figure 32-2. In those cases, especially for increases of 100% or less, the oppressive weight of the adjustment fac­ tor significantly harms the return from the structured product. One could visualize the graph in Figure 32-2 another way, if it would help. Replace the values on the x-axis with the actual index values: 2,200, 3,300, 4,400, 5,500, and 6,600 would replace the figures shown as 100, 200, 300, 400, and 500. Thus, the x-axis could then represent the final value of the index (before adjustment). That might help to relate just how far the index would have to rise in order to over­ come the downward adjustment. Figure 32-3 shows a more conventional look at the comparison between the index value at maturity and the cash value of the structured product. For example, the dashed line shows that, with the final value (unadjusted) of the index at 3,300, the structured product's final cash value would be 27.375, as shown in a prior example. The line on Figure 32-3 looks like that of owning a call - limited risk, with large 32: Structured Products PIGURE 32-3. Cash value of structured product at maturity. Q) ::, 50 40 ~ 30 .c l{5 (.) 20 10----r 0 1100 Break-even: 1205.48 2200 3300 4400 5500 Index Final Price (Unadjusted) 607 6600 upside profit potential. It is much more difficult to tell that the adjustment factor is weighing down the value of the structured product so dramatically from this chart. Both Figures 32-2 and 32-3 are mathematically correct. However, only Figure 32-2 depicts the real cost of owning a structured product with an adjustment factor. The final graph on this topic, Figure 32-4, shows the cash value of the adjusted structured product ( the same line as was shown in Figure 32-3), compared with an unadjusted line. For example, the unadjusted line shows a true doubling of the price of the structured product if the underlying index has doubled. The difference between the two lines (the shaded area) can be thought of as the cost of the imbedded call- or at least as the cost of the adjustment factor. You can see from Figure 32-4 how the call's "cost" increases as the value of the underlying index increases. OTHER CONSTRUCTS The financial engineers who create structured products have come up with a num­ ber of different constructs over time. Some resemble spreads, and some have two or three different products bundled into one. In fact, just about anything is possible. All that is required is that the underwriter thinks there is enough interest somewhere for him to be able to create the product, mark it up, and sell it to whomever has inter- 608 Part V: Index Options and Future; FIGURE 32-4. Comparison of adiusted and unadiusted cash values at maturity. 50 40 20 0 1100 2200 3300 Cost of the Call Option 4400 5500 Index Final Price (Unadjusted) 6600 est. In this section, a couple of different constructs, ones that have been brought to the public marketplace in the past, are discussed. THE BUI.I. SPREAD Several structured products have represented a bull spread, in effect. In some cases, the structured product terms are stated just like those of a call spread in that the final cash value is defined with both a minimum and a maximum value. For example, it might be described something like this: "The final cash value of the (structured) product is equal to a minimum of a base price of 10, plus any appreciation of the underlying index above the striking price, subject to a maximum price of 20" (where the striking price is stated elsewhere). It's fairly simple to see how this resembles a bull spread: The worst you can do is to get back your $10, which is presumably the initial offering price, just as in any of the structured products described previously in this chapter. Then, above that, you'd get some appreciation of the index price above the stated striking price - again 609 the products discussed earlier. However, in this case, there is a maximum that the c,1.,;h value can be worth: 20. In other words, there is a ceiling on the value of this 1tructured product at maturity. It is exactly like a bull spread with two striking prices, one at 10 and one at 20. In reality, this structured product would have to be evaluat- using both striking prices. We'll get to that in a minute. There is another way that the underwriter sometimes states the terms of the structured product, but it is also a bull spread in effect. The prospectus might say something to the effect that the structured product is defined pretty much in the standard way, but that it is callable at a certain (higher) price on a certain date. In uther words, someone else can call your structured product away on that date. In effect, you have sold a call with a higher striking price against your structured prod­ Ut1:. Thus, you own an imbedded call via the usual purchase of the structured prod­ uct and you have written a call with a higher strike. That, again, is the definition of a bull spread. When analyzing a product such as this, one must be mindful that there are two calls to price, not only in determining the final value, but more importantly in deter­ mining where you might expect the structured product to trade during its life, prior to maturity. An option strategist knows that a bull spread doesn't widen out to its max­ imum profit potential when there is still a lot of time remaining before expiration, unless the underlying rises by a substantial amount in excess of the higher striking price of the spread. Thus, one would expect this type of structured product to behave in a similar manner. The example that will be used in the rest of this section is based on actual "bull spread" structured products of this type that trade in the open marketplace. Example: Suppose that a structured product is linked to the Internet index. The strike price, based on index values, is 150. If the Internet index is below 150 at matu­ rity, seven years hence, then the structured product will be worth a base value of 10. There is no adjustment factor, nor is there a participation rate factor. So far, this is just the same sort of definition that we've seen in the simpler examples presented previously. The final cash value formula would be simply stated as: Final cash value = 10 x (Final Internet index value/150) However, the prospectus also states that this structured product is callable at a price of 25 during the last month of its life. This call feature means that there is, in effect, a cap on the price of the under­ lying. In actual practice, the call feature may be for a longer or shorter period of time, and may be callable well in advance of maturity. Those factors merely determine the expiration date of the imbedded call that has been "written." 610 Part V: Index Options and Futures The first thing one should do is to convert the striking price into an equivalent price for the underlying index, so that he can see where the higher striking price is in relation to the index price. In this example, the higher striking price when stated in terms of the structured product is 2.5 times the base price. So the higher striking price, in index terms, would be 2.5 times the striking price, or 375: Index call price = ( Call price / Base price) x Striking price = (25 I 10) X 150 = 375 Hence, if the Internet index rose above 375, the call feature would be "in effect" (i.e., the written call would be in-the-money). The value at which we can expect the structured product to trade, at maturity, would be equal to the base price plus the value of the bull spread with strikes of 10 and 25. Valuing the Bull Spread. Just as the single-strike structured products have an imbedded call option in them, whose cost can be inferred, so do double-strike structured products. The same line of analysis leads to the following: "Theoretical" cash value = 10 + Value of bull spread - Cost of carry Cost of carry refers to the cost of carry of the base price (10 in this example). By using an option model and employing knowledge of bull spreads, one can calculate a theoretical value for the structured product at any time during its life. Moreover, one can decide whether it is cheap or expensive - factors that would lead to a decision as to whether or not to buy. Example: Suppose that the Internet index is trading at a price of 210. What price can we expect the structured product to be trading at? The answer depends on how much time has passed. Let's assume that two years have passed since the inception of the structured product (so there are still five years of life remaining in the option). With the Internet index at 210, it is 40% above the structured product's lower striking price of 150. Thus, the equivalent price for the structured product would be 14. Another way to compute this would be to use the cash value formula: Cash value= 10 x (210 / 150) = 14 Now, we could use the Black-Scholes (or some other) model to evaluate the two calls - one with a striking price of 10 and the other with a striking price of 25. Using a volatility estimate of 50%, and assuming the underlying is at 14, the two calls are roughly valued as follows: Underlying price: 14 Cl,opter 32: Structured Products Option 5-year call, strike = 10 5-year call, strike = 25 Theoretical Price 7.30 3.70 611 Thus, the value of the bull spread would be approximately 3.60 (7.30 minus 3.70). The structured product would then be worth 13.60- the base price of 10, plus the value of the spread: "Theoretical" cash value= 10 + 3.60 - Cost of carry= 13.60 - Cost of carry It may seem strange to say that the value of the structured product is actually less than the cash value, but that is what the call feature does: It reduces the worth of the structured product to values below what the cash value formula would indi­ cate. Given this information, we can predict where the structured product would trade at any price or at any time prior to maturity. Let's look at a more extreme example, then, one in which the Internet index has a tremendously big run to the upside. Example: Suppose that the Internet index has risen to 525 with four years of life remaining until maturity of the structured product. This is well above the index­ equivalent call price of 375. Again, it is first necessary to translate the index price back to an equivalent price of the structured product, using either percentage gains or the cash value formula: Cash value = 10 x (525/ 150) = 35 Again, using the Black-Scholes model, we can determine the following theo­ retical values: Underlying price: 35 Option 3-year c~strike = 10 3-year call, strike = 25 Theoretical Price 25.50 14.70 Now, the value of the bull spread is 10.80 (25.50 minus 14.70). The deepest in­ the-money option is trading near parity, but the (written) option is only 10 points in­ the-money and thus has quite a bit of time value premium remaining, since there are three years of life left: "Theoretical" cash value = 10 + 10.80 = 20.80 - Cost of carry 612 Part V: Index Options and Futures Hence, even though the Internet index is at 525 - far above the equivalent cal price of 375 - the structured product is expected to be trading at a price well belo\\ its maximum price of 25. Figure 32-5 shows the values over a broad spectrum of prices and for various expiration dates. One can clearly see that the structured product will not trade"near its maximum price of 25 until time shrinks to nearly the maturity date, or until the underlying index rises to very high prices. In particular, note where the theoretical values for the bull spread product lie when the index is at the higher striking price of 375 (there is a vertical line on the chart to aid in identifying those values). The struc­ tured product is not worth 20 in any of the cases, and for longer times to maturity, it isn't even worth 15. Thus, the call feature tends to dampen the upside profit poten­ tial of this product in a dramatic manner. The curves in Figure 32-5 were drawn with the assumption that volatility is 50%. Should volatility change materially during the life of the structured product, then the values would change as well. A lower volatility would push the curves up toward the "at maturity" line, while an increase in volatility would push the curves down even further. FIGURE 32-5. Value of bull spread structured product. At Maturity 25 1 Year Left 20 3Years Left 15 5 100 150 200 250 300 350 400 450 500 550 600 Price of Index Gtpter 32: Structured Products MULTIPLE EXPIRATION DATES 613 In some cases, more than one expiration date is involved when the structured prod­ uct is issued. These products are very similar to the simple ones first discussed in this chapter. However, rather than maturing on a specific date, the final index value - which is used to determine the final cash value of the structured product - is the average of the underlying index price on two or three different dates. For example, one such listed product was issued in 1996 and used the S&P 500 index ($SPX) as the underlying index. The strike price was the price of $SPX on the day of issuance, as usual. However, there were three maturity dates: one each in April 2001, August 2002, and December 2003. The final index value used to determine the cash settlement value was specified as the average of the $SPX closings on the three maturity dates. In effect, this structured product was really the sum of three separate struc­ tured products, each maturing on a different date. Hence, the values of the imbed­ ded calls could each be calculated separately, using the methods presented earlier. Then those three values could be averaged to determine the overall value of the imbedded call in this structured product. OPTION STRATEGIES INVOLVING STRUCTURED PRODUCTS Since the structured products described previously are similar to well-known option strategies (long call, bull spread, etc.), it is possible to use listed options in conjunc­ tion with the structured products to produce other strategies. These strategies are actually quite simple and would follow the same lines as adjustment strategies dis­ cussed in the earlier chapters of this book. Example: Assume that an investor purchased 15,000 shares of a structured product some time ago. It is essentially a call option on the S&P 500 index ($SPX). The prod­ uct was issued at a price of 10, and that is the guarantee price as well. The striking price is 700, which is where $SPX was trading at the time. However, now $SPX is trading at 1,200, well above the striking price. The cash value of the product is: )ox (1,2001100) = 11.14 Furthermore, assume that there are still two years remaining until maturity of the structured product, and the investor is getting a little nervous about the market. He is thinking of selling or hedging his holding in the structured product. However, the structured product itself is trading at 16.50, a discount of 64 cents from its theo- 614 Part V: Index Options and Futurei retical cash value. He is not too eager to sell at such a discount, but he realizes tha he has a lot of exposure between the current price and the guarantee price of 10. He might consider writing a listed call against his position. That would conver it into the equivalent of a bull spread, since he already holds the equivalent of a lonf call via ownership of the structured product. Suppose that he quotes the $SP) options that trade on the CBOE and finds the following prices for 6-month options expiring in December: $SPX: 1,200 Option December 1,200 call December 1,250 call December 1,300 call Price 85 62 43 Suppose that he likes the sale of the December 1,250 call for 62 points. How many should he sell against his position in order to have a proper hedge? First, one must compute a multiplier that indicates how many shares of the structured product are equivalent to one "share" of the $SPX. That is done in the simple case by dividing the striking price by the guarantee price: Multiplier = Striking price/ Base price = 700 / 10 = 70 This means that buying 70 shares of the structured product is equivalent to being long one share of $SPX. To verify this, suppose that one had bought 70 shares of the structured product initially at a price of 10, when $SPX was at 700. Later, assume that $SPX doubles to 1,400. With the simple structure of this product, which has a 100% participation rate and no adjustment factor, it should also double to 20. So 70 shares bought at 10 and sold at 20 would produce a profit of $700. As for $SPX, one "share" bought at 700 and later sold at 1,400 would also yield a profit of $700. This verifies that the 70-to-l ratio is the correct multiplier. This multiplier can then be used to figure out the current equivalent structured product position in terms of $SPX. Recall that the investor had bought 15,000 shares initially. Since the multiplier is 70-to-l, these 15,000 shares are equivalent to: $SPX equivalent shares = Shares of structured product held/ Multiplier = 15,000 / 70 = 214.29 That is, owning this structured product is the equivalent of owning 214+ shares of $SPX at current prices. Since an $SPX call option is an option on 100 "shares" of $SPX, one would write 2 calls (rounding off) against his structured profit position. Since the SPX December 1,250 calls are selling for 62, that would bring in $12,400 less commissions. 615 Note that the sale of these calls effectively puts a cap on the profit potential of investor's overall position until the December expiration of the listed calls. If $SPX were to rise substantially above 1,250, his profits would be "capped" because the two were sold. Thus, he has effectively taken his synthetic long call position and con­ verted it into a bull spread (or a collared index fund, if you prefer that description). In reality, any calls written against the structured product would have to be margined as naked calls. In a virtual sense, the 15,000 shares of the structured prod­ Ut't "cover" the sale of 2 $SPX calls, but margin rules don't allow for that distinction. In essence, the sale of two calls would create a bull spread. Alternatively, if one thinks uf the structured product as a long index fully protected by a put (which is another way to consider it), then the sale of the $SPX listed call produces a "collar." Of course, one could write more than two $SPX calls, if he had the required margin in his account. This would create the equivalent of a call ratio spread, and would have the properties of that strategy: greatest profit potential at the striking price of the written calls, limited downside profit potential, and theoretically unlim­ ited upside risk if $SPX should rise quickly and by a large amount. In any of these option writing strategies, one might want to write out-of-the­ money, short-term calls against his structured product periodically or continuously. Such a strategy would produce good results if the underlying index does not advance quickly while the written calls are in place. However, if the index should rise through the striking price of the written calls, such a strategy would detract from the overall return of the structured product. Changing the Striking Price. Another strategy that the investor could use if he so desired is to establish a vertical call spread in order to effectively change the striking price of the (imbedded) call. For example, if the market had advanced by a great deal since the product was bought, the imbedded call would theoreti­ cally have a nice profit. If one could sell it and buy another, similar call at a high­ er strike, he would effectively ~olling his call up. This would raise the striking price and would reduce downside risk greatly (at the cost of slightly reducing upside profit potential). Example: Using the same product as in the previous example, suppose that the investor who owns the structured product considers another alternative. In the pre­ vious example, he evaluated the possibility of selling a slightly out-of-the-money list­ ed call to effectively produce a collared position, or a bull spread. The problem with that is that it limits upside profit potential. If the market were to continue to rise, he would only participate up to the higher strike (plus the premium received). 616 Part V: Index Options and Futu, A better alternative might be to roll his imbedded call up, thereby taking s01 money out of the position but still retaining upside profit potential. Recall that t structured product had these terms: Guarantee price: 10 Underlying index: S&P 500 index ($SPX) Striking price: 700 As in the earlier example, the investor owns 15,000 shares of the structun product. Furthermore, assume that there are about two years remaining until mat rity of the structured product, and that the current prices are the same as in the pr vious example: Current price of structured product: 16.50 Current price of $SPX: 1,200 For purposes of simplicity, let's assume that there are listed two-year LEAP options available for the S&P index, whose prices are: S&P 2-year LEAPS, striking price 700: 550 S&P 2-year LEAPS, striking price 1,200: 210 In reality, S&P LEAPS options are normally reduced-value options, meanin. that they are for one-tenth the value of the index and thus sell for one-tenth the pricE However, for the purposes of this theoretical example, we will assume that the full value LEAPS shown here exist. It was shown in the previous example that the investor would trade two of thest calls as an equivalent amount to the quantity of calls imbedded in his structurec product. So, this investor could buy two of the 1,200 calls and sell two of the 700 calli and thereby roll his striking price up from 700 to 1,200. This roll would bring in 34( points, two times; or $68,000 less commissions. Since the difference in the striking prices is 500 points, you can see that he is leaving something "on the table" by receiving only 340 points for the roll-up. This is common when rolling up: One loses the time value premium of the vertical spread. However, when viewed from the perspective of what has been accomplished, the investor might still find this roll worthwhile. He has now raised the striking price of his call to 1,200, based on the S&P index, and has taken in $68,000 in doing so. Since he owns 15,000 shares of the structured product, that means he has taken in 4.53 p~r share (68,000 / 15,000). Now, for example, if the S&P crashes during the next two years and plummets below 700 at the maturity date, he will receive $10 as the guar­ antee price plus the $4.53 he got from the roll - a total "guarantee" of $14.53. Thus, he has protected his downside. Otpt,r 32: Structured Products 617 Note that his downside risk is not completely eliminated, though. The current prke of the structured product is 16.50 and the cash value at the current S&P price 11117.14 (see the previous example for this calculation), so he has risk from these lev­ down to a price of $14.53. His upside is still unlimited, because he is net long two calls - the S&P 2-year 1,,EAPS calls, struck at 1,200. The two LEAPS calls that he sold, struck at 700, effec­ tively offsets the call imbedded in the structured product, which is also struck at 700. This example showed how one could effectively roll the striking price of his structured product up to a higher price after the underlying had advanced. The indi­ vidual investor would have to decide if the extra downside protection acquired is worth the profit potential sacrificed. That depends heavily, of course, on the prices of the listed S&P options, which in turn depend on things such as volatility and time remaining until expiration. Of course, one other alternative exists for a holder of a structured product who has built up a good profit, as in the previous two examples: He could sell the prod­ uct he owns and buy another one with a striking price closer to the current market value of the underlying index. This is not always possible, of course, but as long as these products continue to be brought to market every few months or so by the underwriters, there will be a wide variety of striking prices to choose from. A possi­ ble drawback to rolling to another structured product is that one might have to extend his holding's maturity date, but that is not necessarily a bad thing. A different scenario exists when the underlying index drops after the structured product is bought. In that case, one would own a synthetic call option that might be quite far out-of the-rrwney. A listed call spread could be used to theoretically lower the call's striking price, so that upside movement might more readily produce prof­ its. In such a case, one would sell a listed call option with a striking price equal to the striking price of the structured product and would buy a listed call option with a lower striking price - one more in line with current market values. In other words, he would buy a listed call bull spread to go along with his structured product. Whatever debit he pays for this call bull spread will increase his downside risk, of course. However, in return he ~s the ability to make profits more quickly if the underlying index rises above the new, lower striking price. Many other strategies involving listed options and the structured product could be constructed, of course. However, the ones presented here are the primary strate­ gies that an investor should consider. All that is required to analyze any strategy is to remember that this type of structured product is merely a synthetic long call. Once that concept is in mind, then any ensuing strategies involving listed options can easily be analyzed. For example, the purchase of a listed put with a striking price essential- 618 Part V: Index Options and Future ly equal to that of the structured product would produce a position similar to a 101 straddle. The reader is left to interpret and analyze other such strategies on his OWI LISTS OF STRUCTURED PRODUCTS The descriptions provided so far encompass the great majority of listed structure products. There are many similar ones involving individual stocks instead ofJndice (often called equity-linked notes). The concepts are the same; merely substitute stock price for an index price in the previous discussions in this chapter. Some large insurance companies offer similar products in the form of annuities They behave in exactly the same way as the products described above, except tha there is no continuous market for them. However, they still afford one the opportu­ nity to own an index fund with no risk Many of the insurance company products, in fact, pay interest to the annuity holder - something that most of the products listed on the stock exchanges do not. Both the CBOE and American Exchange Web sites (www.cboe.com and www.amex.com) contain details of the structured products listed on their respective exchanges. A sampling at the time of this writing showed the following breakdowns of listed structured products: Underlying Index Percent of Listed Products Broad-based index (S&P 500, e.g.) 23% Sector index Stocks 43% 34% If you browse those lists, an investor may find indices or stocks that are of particular interest to him. In addition, it may be possible to find ones trading at a substantial discount to cash settlement value, something a strategist might find attractive. PERCS Part II: Products Designed to Provide /,/Income" At the beginning of this chapter, it was stated that most listed structured products~ fall into one of two categories. The first category was the type of structured prod­ uct that resembled the ownership of a call option. The second portion, to be dis- 0.,t,r 32: Structured Products 619 t'Ussed in the remainder of this chapter, resembles the covered write of a call option. These often have names involving the term preferreds. Some are called Trust Preferreds; another popular term for them is Preferred Equity Redemption Cumulative Stock (PERCS). We will use the term PERCS in the following exam­ ples, but the reader should understand that it is being used in a generic sense - that any of the similar types of products could be substituted wherever the term PERCS is used. A PERCS is a structured product, issued with a maturity date and tied to an individual stock. At the time of issuance, the PERCS and the common stock are usu­ ally about the same price. The PERCS pays a higher dividend than the common stock, which may pay no dividend at all. If the underlying common should decline in price, the PERCS should decline by a lesser amount because the higher dividend payout will provide a yield floor, as any preferred stock does. There is a limited life span with PERCS that is spelled out in the prospectus at the time it is issued. Typically, that life span is about three years. At the end of that time, the PERCS becomes ordinary common stock. A PERC S may be called at any time by the issuing corporation if the company's common stock exceeds a predetermined call price. In other words, this PERCS stock is callable. The call price is normally higher than the price at which the common is trading when the PERCS is issued. What one has then, if he owns a PERCS, is a position that will eventually become common stock unless it is called away. In order to compensate him for the fact that it might he called away, the owner receives a higher dividend. What if one substitutes the word "premium" for "higher dividend"? Then the last statement reads: In order to compensate him for the fact that it might be called away, the owner receives a premium. This is exactly the definition of a covered call option write. Moreover, it is an out-of-the-money covered write of a long-term call option, since the call price of the PERCS is akin to a striking price and is higher than the initial stock price. Example: XYZ is selling at $35 per share. XYZ common stock pays $1 a year in div­ idends. The company decides to issue a PERCS. The PERCS will have a three~ life and will be callable at $39. Moreover, the PERCS will pay an annual dividend of $2.50. The PERCS annual dividend rate is 7% as compared to 2.8% for the common stock. If XYZ were to rise to 39 in exactly three years, the PERCS would be called. The total return that the PERCS holder would have made over that time would be: 620 Stock price appreciation 139 - 35): Dividends over 3 years: Total gain Total return: Annualized return: Part V: Index Options and Future. 4 7.50 11.50 11.50/35 = 32.9% 32.9%/3 = 11% If the PERCS were called at an earlier time, the annualized return might be ever higher. · CALL FEATURE The company will most likely call the PER CS if the common is above the call price for even a short period of time. The prospectus for the PERCS will describe any requirements regarding the call. A typical one might be that the common must close above the call price for five consecutive trading days. If it does, then the company may call the PERCS, although it does not have to. The decision to call or not is strict­ ly the company's. The PERCS holder has no choice in the matter of when or if his shares are called. This is the same situation in which the writer of a covered call finds himself: He cannot control when the exercise will occur, although there are often clues, including the disappearance of time value premium in the written listed call option. The PERCS holder is more in the dark, because he cannot actually see the separate price of the imbedded call within the PERCS. Still, as will be shown later, he may be able to use several clues to determine whether a call is imminent. Most PERCS may be called for either cash or common stock. This does not change the profitability from the strategist's standpoint. He either receives cash in the amount of the call price, or the same dollar amount of common stock. The only difference between the two is that, in order to completely close his position, he would have to sell out any common stock received via the call feature. If he had received cash instead, he wouldn't have to bother with this final stock transaction. In the case of most PERCS, the call feature is more complicated than that pre­ sented in the preceding example. Recall that the company that issued the PERCS can call it at any time during the three years, as long as the common is above the call price. The holder of the XYZ PERCS in the example would not be pleased to find that the PER CS was called before he had received any of the higher dividends that the PERCS pays. Therefore, in order to give a PERCS holder essentially the same return no matter when the PERCS is called, there is a "sliding scale" of call prices. - At issuance, the call price will be the highest. Then it will drop to a slightly lower level after some of the dividends have been paid (perhaps after the first year). 621 This lowering of the call price continues as more dividends are paid, until it finally reaches the final call price at maturity. The PERCS holder should not be confused this sliding scale of call prices. The sliding call feature is designed to ensure that PERC S holder is compensated for not receiving all his "promised" dividends if the PERCS should be called prior to maturity. Example: As before, XYZ issues a PERCS when the common is at 35. The PERCS pays an annual dividend of $2.50 per share as compared to $1 per share on the com­ mon stock. The PERCS has a final call price of 39 dollars per share in three years. If XYZ stock should undergo a sudden price advance and rise dramatically in a very short period of time, it is possible that the PERCS could be called before any dividends are paid at all. In order to compensate the PERCS holder for such an c>ecurrence, the initial call price would be set at 43.50 per share. That is, the PERCS can't be called unless XYZ trades to a price over 43.50 dollars per share. Notice that the difference between the eventual call price of 39 and the initial call price of 43.50 is 4.50 points, which is also the amount of additional dividends that the PERCS would pay over the three-year period. The PER CS pays $2.50 per year and the com­ mon $1 per year, so the difference is $1.50 per year, or $4.50 over three years. Once the PERCS dividends begin to be paid, the call price will be reduced to reflect that fact. For example, after one year, the call price would be 42, reflecting the fact that if the PERCS were not called until a year had passed, the PERCS hold­ er would be losing $3 of additional dividends as compared to the common stock ($1.50 per year for the remaining two years). Thus, the call price after one year is set at the eventual call price, 39, plus the $3 of potential dividend loss, for a total call price of 42. This example shows how the company uses the sliding call price to compensate the PERCS holder for potential dividend loss if the PERCS is called before the three-year time to maturity has elapsed. Thus, the PER CS holder will make the same dollars of profit - dividends and price appreciation combined - no matter when the PERCS is called. In the case of the XYZ PERCS in the example, that total dollar profit is $11.50 (see the prior example). Notice that the investor's annualized rate of return would be much higher if he were called prior to the eventual maturity date. One final point: The call price §lides on a scale as set forth in the prospectus for the PERCS. It may be every time a dividend is paid, but more likely it will be daily! That is, the present worth of the remaining dividends is added to the final call price to calculate the sliding call price daily. Do not be overwhelmed by this feature. Remember that it is just a means of giving the PERCS holder his entire "dividend premium" if the PERCS is called before maturity. 622 Part V: Index Options and Futures For the remainder of this chapter, the call price of the PERCS will be referrea to as the redemption price. Since much of the rest of this chapter will be concemec with discussing the fact that a PERCS is related to a call option, there could be somE confusion when the word call is used. In some cases, call could refer to the price at which the PER CS can be called; in other cases, it could refer to a call option - either a listed one or one that is imbedded within the PERCS. Hence, the word redemp­ tion will be used to refer to the action and price at which the issuing compa:J)ly may call the PERCS. A PERCS IS A COVERED CALL WRITE It was stated earlier that a PER CS is like a covered write. However, that has not yet been proven. It is known that any two strategies are equivalent if they have the same profit potential. Thus, if one can show that the profitability of owning a PER CS is the same as that of having established a covered call write, then one can conclude that they are equivalent. Example: For the purposes of this example, suppose that there is a three-year listed call option with striking price 39 available to be sold on XYZ common stock. Also, assume that there is a PERCS on XYZ that has a redemption price of 39 in three years. The following prices exist: XYZ common: 35 XYZ PERCS: 35 3-year call on XYZ common with striking price of 39: 4.50 First, examine the XYZ covered call write's profitability from buying 100 XY2 and selling one call. It was initially established at a debit of 30.50 (35 less the 4.50 received from the call sale). The common pays $1 per year in dividends, for a total of $3 over the life of the position. XYZ Price Price of a Profit/loss on Total Profit/loss in 3 Years 3-Year Call Securities Incl. Dividend 25 0 -$550 -$250 30 0 -50 +250 35 0 +450 +750 39 0 +850 + 1,150 45 6 +850 + 1,150 50 11 +850 + 1,150 O.,,ter 32: Structured Products 623 TI1is is the typical picture of the total return from a covered write - potential losses on the downside with profit potential limited above the striking price of the written call. Now look at the profitability of buying the PER CS at 35 and holding it for three (Assume that it is not called prior to maturity.) The PER CS holder will earn a total of $750 in dividends over that time period. XYZ Price Profit/Loss on Total Profit/Loss in 3 Years PERCS Incl. Dividend 25 -$1,000 -$250 30 -500 +250 35 0 +750 >=39 +400 + 1, 150 This is exactly the same profitability as the covered call write. Therefore, it can be concluded with certainty that a PERCS is equivalent to a covered call write. Note that the PER CS potential early redemption feature does not change the truth of this statement. The early redemption possibility merely allows the PERCS holder to receive the same total dollars at an earlier point in time if the PERCS is demanded prior to maturity. The covered call writer could theoretically be facing a similar situ­ ation if the written call option were assigned before expiration: He would make the same total profit, but he would realize it in a shorter period of time. The PERCS is like a covered write of a call option with striking price equal to the redemption price of the PERCS, except that the holder does not receive a call option premium, but rather receives additional dividends. In essence, the PERCS has a call option imbedded within it. The value of the imbedded call is really the value of the additional dividends to be paid between the current date and maturity. The buyer of a PERCS is, in effect, selling a call option and buying common stock. He should have some idea of whether or not he is selling the option at a rea­ sonably fair price. The next section of this chapter addresses the problem of valuing the call option that is imbedded in the PERCS. PRICE BEHAVIOR The way that a PERCS price is often discussed is in relationship to the common stock. One may hear that the PERCS is trading at the same price as the common or at a premium or discount to the common. As an option strategist who understands covered call writing, it should be a simple matter to picture how the PERCS price will relate to the common price. 624 Part V: Index Options and Futures FIGURE 32-6. PERCS price estimate versus common stock. 44 (I) iii 39 6 Months E ~ w (I) u ct 34 Cf) (.) a: w a. 29 0 1-.J. ____ ,__ ___ ...._ ___ _._ ___ __._ ___ _.__ 25 30 35 40 Stock Price 45 50 First, consider the out-of-the-money situation. If the underlying common declines in price, the PERCS will not decline as fast because the additional dividends will provide yield support. The PER CS will therefore trade at a higher price than the common. Howeve1~ as the maturity date nears and the remaining number of addi­ tional dividends dwindles to a small amount, then the PER CS price and the common price will converge. The opposite effect occurs if the underlying common moves higher. The PERCS will trade at a lower price than the common when the common trades above the issue price. In fact, since there is a redemption price on the PERCS, it will not trade higher than the redemption price. The common, however, has no such restric­ tion, so it could continue to trade at prices significantly higher than the PERCS does. These points are illustrated in Figure 32-6, which contains the price curves of two PER CS: one at issuance, thus having three years remaining, and the other with just six months remaining until the maturity of the PERCS. For purposes of comparison, it was assumed that there is no sliding redemption feature involved. Several significant points can be made from the figure. First, notice that the PERCS and the common._ tend to sell at approximately the same price at the point labeled "I." This would be the price at which the PER CS are issued. This issue price must be below the redemption price of the PERCS. More will be said later about how this price is determined. Oapter 32: Structured Products 625 Another observation that can be made from the figure is that the PERCS pric­ ing curves level off at the redemption price. They cannot sell for more than that price. Now look on the left-hand side of the figure. Notice that the more time remain­ Ing until maturity, the higher the PERCS will trade above the common stock. This is because of the extra dividends that the PER CS pay. Obviously, the PERCS with three years until maturity has the potential to pay more dividends than the one with three months remaining, so the three-year PERCS will sell for more than the six-month PERCS when the common is below the issue price. Since either PERCS pays more dividends than the common, they both trade for higher prices than the common. When the common trades above the issue price (point 'T'), the opposite is true. The six-month PERCS trades for a slightly higher price than the three-year PERCS, but both sell for significantly less than the common, which has no limit on its poten­ tial price. One other observation can be made regarding the situation in which the com­ mon trades well below the issue price: After the last additional dividend has been paid by the PERCS, it will trade for approximately the same price as the common in that situation. · Viewed strictly as a security, a PERCS may not appear all that attractive to some investors. It has much, but not all, of the downside risk of the common stock, and not nearly the upside potential. It does provide a better dividend, however, so if the com­ mon is relatively unchanged from the issue price when the PERCS matures, the PERCS holder will have come out ahead. If this description of the PER CS does not appeal to you, then neither should covered call writing, for it is the same strategy; a call option premium is merely substituted for the higher dividend payout. PERCS STRATEGIES Since the PERCS is equivalent to a covered write, strategies that have covered writes as part of their makeup are amenable to having PERCS as part of their makeup as well. Covered writing is part of ratio writing. Other modifications to the covered writ­ ing strategy itself, such as the protected covered write, can also be applied to the PERCS. PROTECTING THE PERCS WITH LISTED OPTIONS ~ The safest way to protect the PERC S holding with listed options is to buy an out-of the-nwney put. The resultant position - long PERCS and long put - is a protected covered write, or a "collar." The long put prevents large losses on the downside, but it costs the PERCS holder something. He won't make as much from his extra divi­ dend payout, because he is spending money for the listed put. Still, he may want the downside comfort. 626 Part V: Index Options and Futures Once one realizes that a PERCS is equivalent to a covered write, he can easily extend that equivalence to other positions as well. For example, it is known that a covered call write is equivalent to the sale of a naked put. Thus, owning a PERCS is equivalent to the sale of a naked put. Obviously, the easiest way to hedge a naked put is to buy another put, preferably out-of-the-money, as protection. Do not be deluded into thinking that selling a listed call against the PERCS is a safe way of hedging. Such a call option sale does add a modicum of downside pro­ tection, but it exposes the upside to large losses and therefore introduces a potential risk into the position. It is really a ratio write. The subject is covered later in this chapter. REMOVING THE REDEMPTION FEATURE At issuance, the imbedded call is a three-year call, so it is not possible to exactly duplicate the PERCS strategy in the listed market. However, as the PERCS nears maturity, there will be listed calls that closely approximate the call that is imbedded in the PERCS. Consequently, one may be able to use the listed call or the underly­ ing stock to his advantage. If one were to buy a listed call with features similar to the imbedded call in a PERCS that he owned, he would essentially be creating long common stock. Not that one would necessarily need to go to all that trouble to create long common stock, but it might provide opportunities for arbitrageurs. In addition, it might appeal to the PERCS holder if the common stock has declined and the imbedded call is now inexpensive. If one covers the equivalent of the imbedded call in the listed market, he would be able to more fully participate in upside participation if the common were to rally later. This is not always a profitable strategy, however. It may be better to just sell out the PERCS and buy the common if one expects a large rally. Example: XYZ issued a PERCS some time ago. It has a redemption price of 39; the common pays a dividend of $1 per year, while the PER CS pays $2.50 per year. XYZ has fallen to a price of 30 and the PERCS holder thinks a rally may be imminent. He knows that the imbedded call in the PERCS must be relatively inex­ pensive, since it is 9 points out-of-the-money (the PERCS is redeemable at 39, while the common is currently 30). Ifhe could buy back this call, he could participate more fully in the upward potential of the stock. Suppose that there is a one-year LEAPS call on XYZ with a striking price of 40. If one were to buy that call, he would essentially be removing the redemption fea-­ ture from his PERCS. Assume the following prices exist: Gapter 32: Structured Products XYZ Common: 30 XYZ PERCS: 31 XYZ January 40 LEAPS call: 2 627 If one buys this LEAPS call and holds it until maturity of the PERCS one year from now, the profit picture of the long PERCS plus long call position will be the fol­ lowing: Total Value XYZ Price in PERCS January 40 of long PERCS January Next Year Price LEAPS + long LEAPS 25 25 0 25 30 30 0 30 35 35 0 35 40 39 0 39 45 39 5 44 50 39 10 49 Thus, the PE RCS + long call position is worth almost exactly what the common stock is after one year. The PERCS holder has regained his upside profit potential. What did it cost the investor to reacquire his upside? He paid out 2 points for the call, thereby more than negating his $1.50 dividend advantage over the course of the year (the common pays a $1 dividend;'the PERCS $2.50). Thus, it may not actu­ ally be worth the bother. In fact, notice that if the PERCS holder really wanted to reacquire his upside profit potential, he would have been better off selling his PERCS at 31 and buying the common at 30. If he had done this, he would have taken in 1 point from the sale and purchase, which is slightly smaller than the $1.50 divi­ dend he is forsaking. In either case, he must relinquish his dividend advantage and then some in order to reacquire his upside profit potential. This seems fair, however, for there must be some cost involved with reacquiring the upside. Remember that an arbitrageur might be able to find a trade involving these sit­ uations. He could buy a PERCS, sell the common short, and buy a listed call. If there were price discrepancies, he could profit. It is actions such as these that are required to keep prices in their proper relationship. 1 CHANGING THE REDEMPTION PRICE OF THE PERCS When covered writing was discussed as a strategy, it was shown that the writer may want to buy back the call that was written and sell another one at a different strike. 628 Part V: Index Options and Futu, If the action results in a lower strike, it is known as rolling down; if it results in a hi§ er strike, it is rolling up. This rolling action changes the profit potential of the position. If one rolls dov; he gets more downside protection, but his upside is even more limited than it prei ously was. Still, if he is worried about the stock falling lower, this may be a prop action to take. Conversely, if the common is rallying, and the covered writer is mo bullish on the stock, he can roll up in order to increase his upside profit potenti~( course, by rolling up, he creates more downside risk if the common stock should sue denly reverse direction and fall. The PERCS holder can achieve the same results as the covered writer. He ca effectively roll his redemption price down or up if he so chooses. His reasons fc doing so would be substantially the same as the covered writer's. For example, if th common were dropping in price, the PERCS holder might become worried that hi extra dividend income would not be enough to protect him in the case of furthe decline. Therefore, he would want to take in even more premium in exchange fo allowing himself to be called away at a lower price. Example: XYZ issued PERCS when both were trading at 35. Now, XYZ has fallen t< 30 with only a year remaining until maturity, and the PERCS holder is nervous abou further declines. He could, of course, merely sell his stock; but suppose that ht: prefers to keep it and attempt to modify his position to more accurately reflect hb attitude about future price movements. Assume the following prices exist: XYZ Common: 30 XYZ PERCS: 31 XYZ January 40 call: 2 XYZ January 35 call: 4 Ifhe buys the January 40 call and sells the January 35 call, he will have accomplished his purpose. This is the same as selling a call bear spread. As shown in the previous example, buying the January 40 call is essentially the same as removing the redemp­ tion feature from the PERCS. Then, selling the January 35 call will reinstate a redemption feature at 35. Thus, the PERCS holder has taken in a premium of 2 points and has lowered the redemption price. If XYZ is below 35 when the options expire, he will have an extra $200 profit from the option trades. If XYZ rallies and is above 35 at expiration, he will be effec­ tively called away at 37 (the striking price of 35 plus the two points from the rollr, instead of at the original demand price of 39. In actual practice, if the January 35 call 629 were assigned, the trader could then be simultaneously long the PERCS and short common stock, with a long January 40 call in addition. He would have to unwind pieces separately, an action that might include exercising the January 40 call (if It were in-the-money at expiration) to cover the short common stock. The conclusion that can be drawn is that in order to roll down the redemption fiature of a PERCS, one must sell a vertical call spread. In a similar manner, if he wanted to roll the strike up, he would buy a vertical call spread. Using the same example, one would still buy the January 40 call ( this effectively removes the redemp­ tion feature of the PERCS) and would then sell a January 45 call in order to raise the redemption price. Thus, buying a vertical call spread raises the effective redemption price of a PERCS. There is nothing magic about this strategy. Covered writers use it all the time. It merely evolves from thinking of a PERCS as a covered write. SELLING A CALL AGAINST A LONG PERCS IS A RATIO WRITE It is obvious to the strategist that if one owns a PERCS and also sells a call against it, he does not have a covered write. The PERCS is already a covered write. What he has when he sells another call is a ratio write. His equivalent position is long the com­ mon and short two calls. There is nothing inherently wrong with this, as long as the PERCS holder understands that he has exposed himself to potentially large upside losses by selling the extra call. If the common stock were to rally heavily, the PERCS would stop ris­ ing when it reached its redemption price. However, the additional call that was sold would continue to rise in price, possibly inflicting large losses if no defensive action were taken. The same strategies that apply to ratio writing or straddle writing would have to be used by someone who owns a PERCS and sells a call against it. He could buy com­ mon stock if the position were in danger on the upside, or he could roll the call(s) up. A difference between ordinary ratio writing and selling a listed call option against a PERCS is that the imbedded call in the PERCS may be a very long-term call (up to three years). The listed call probably wouldn't be of that duration. So the ratio writer in this case has two different expiration dates for his options. This does not change the overall strategy, but it does mean that the imbedded long-term call will not diminish much in price due to thepssage of time, until the PERCS is near­ er maturity. Neutrality is normally an important consideration for a ratio writer. If one is long a PERCS and short a listed call, he is by definition a ratio writer, so he should 630 Part V: Index Options and Futures be interested in neutrality. The key to determining one's neutrality, of course, is tc use the delta of the option. In the case of the PERCS stock, one would have to usE the delta of the imbedded call. Example: An investor is long 1,000 shares ofXYZ PERCS maturing in two years. He thinks XYZ is stuck in a trading range and does not expect much volatility in the near future. Thus, a ratio write appeals to him. How many calls should he sell in order to create a neutral position against his 1,000 shares? First, he needs to compute the delta of the imbedded option in the PER CS, and therefore the delta of the PERCS itself. The delta of a PERCS is not 1.00, as is the delta of common stock. Assume the XYZ PERCS matures in two years. It is redeemable at 39 at that time. XYZ common is currently trading at 33. The delta of a two-year call with strik­ ing price 39 and common stock at 33 can be calculated (the dividends, short-term interest rate, and volatility all play a part). Suppose that the delta of such an option is 0.30. Then the delta of the PER CS can be computed: PERCS delta= 1.00- Delta of imbedded call = 1.00 - 0.30 = 0.70 in this example Assume the following data is known: Security XYZ Common XYZ PERCS XYZ October 40 call Price 33 34 2 Delta 1.00 0.70(!) 0.35 Being long 1,000 PER CS shares is the equivalent of being long 700 shares of common (ESP= 1,000 x 0.70 = 700). In order to properly hedge that ESP with the October 40 call, one would need to sell 20 October 40 calls. Quantity to sell = ESP of PER CS/ESP of October 40 call = 700/(100 shares per option x 0.35) = 700/35 = 20 Thus, the position - long 1,000 PER CS, short 20 October 40 calls - is a neutral one and it is a ratio write. One may not want to have such a steep ratio, since the result of this example is the equivalent of being long 1,000 common and short 30 calls in total (10 are imbed­ ded in the long PERCS). Consequently, he could look at other options - perhaps writing in-the-money October calls - that have higher deltas and won't require so many to be sold in order to produce a neutral position. Cl,apter 32: Structured Produds 631 To remain neutral, one would have to keep computing the deltas of the options, both listed and imbedded, as time passes, because stock movements or the passage of time could change the deltas and therefore affect the neutrality of the position. HEDGING PERCS WITH COMMON STOCK Some traders may want to use the common stock to hedge the purchase of PERCS. These would normally be market-makers or block traders who acquire the PERCS in order to provide liquid markets or because they think they are slightly mispriced. The simplest way for these traders to hedge their long PERCS would be with common stock. This strategy might also apply to an individual who holds PERCS, if he wants to hedge them from a potential price decline but does not actually want to sell them (for tax reasons, perhaps). In either case, it is not correct to sell 100 shares of common against each 100 shares of PERCS owned. That is not a true hedge. In fact, what one accomplishes by doing that is to create a naked call option. A PERCS is a covered write; if one sells 100 shares of common stock from a covered write, he is left with a naked call. This could cause large losses if the common rallies. Rather, the proper way to hedge the PERCS with common stock is to calculate the equivalent stock position of the PERC S and hedge with the calculated amount of common stock. The example showed how to calculate the ESP of the PERCS: One must calculate the delta of the imbedded call option, which may be a long-term one. Then the delta of the PERCS can be computed, and the equivalent stock position can be determined. Example: V sing the same prices from the previous example, one can see how much stock he would have to sell in order to properly hedge his PERCS holding of 1,000 shares. Assume XYZ is trading at 33, and the PE RCS has two years until maturity. If the PERCS is redeemable at 39 at maturity, one can determine that the delta of the imbedded option is 0.30 (see previous example). Then: Delta of PE RCS = 1 - Delta of imbedded call = 1- 0.30 = 0.70 Hence, the equivalent stock position of 1,000 PERCS is 700 shares (1,000 x 0.10). 1 Consequently, one would sell short 700 shares of XYZ common in order to hedge this long holding of 1,000 PERCS. 632 Part V: Index Options and Futures This is not a static situation. If XYZ changes in price, the delta of the imbedded option will change as well, so that the proper amount of stock to sell as a hedge will change. The deltas will change with the passage of time as well. A change in volatili­ ty of the common stock can affect the deltas, too. Consequently, one must constant­ ly recalculate the amount of stock needed to hedge the PERCS. What one has actually created by selling some common stock against his long PERCS holding is another ratio write. Consider the fact that being long 1,000 PE RCS shares is the equivalent of being long 1,000 common and short 10 imbedded, long-term calls. If one sells 700 common, he will be left with an equivalent position of long 300 common and short 10 imbedded calls - a ratio write. The person who chooses to hedge his PER CS holding with a partial sale of com­ mon stock, as in the example, would do well to visualize the resulting hedged posi­ tion as a neutral ratio write. Doing so will help him to realize that there is both upside and downside risk if the underlying common stock should become very volatile (ratio writes have risk on both the upside and the downside). If the common remains fair­ ly stable, the value of the imbedded call will decrease and he will profit. However, if it is a long-term imbedded call (that is, if there is a long time until maturity of the PER CS), the rate of time decay will be quite small; the hedger should realize that fact as well. In summary, the sale of some common against a long holding of PERCS is a viable way to hedge the position. When one hedges in this manner, he must contin­ ue to monitor the position and would be best served by viewing it as a ratio write at all times. SELLING PERCS SHORT Can it make sense to sell PER CS short? The payout of the large dividend seems to be a deterrent against such a short sale. However, if one views it as the opposite of a long-term, out-of-the-money covered write, it may make some sense. A covered write is long stock, short call; it is also equivalent to being long a PERCS. The opposite of that is short stock, long call - a synthetic put. Therefore, a long put is the equivalent of being short a PERCS. Profit graph Hin Appendix D shows the profit potential of being short stock and long a call. There is large down­ side profit potential, but the upside risk is limited by the presence of the long call. The amount of premium paid for the long call is a wasting asset. If the stock does not decline in price, the long call premium may be lost, causing an overall loss. Shorting a PERCS would result in a position with those same qualities. The upside risk is limited by the redemption feature of the PERCS. The downside prof­ it potential is large, because the PER CS will trade down in price if the common stoek Chapter 32: Structured Products 633 does. The problem for the short seller of the PER CS is that he has to pay a lot for the imbedded call that affords him the protection from upside risk. The actual price that he has to pay is the dividends that he, as a short seller, must pay out. But this can also be thought of as having purchased a long-term call out-of-the-money as protec­ tion for a short sale of common stock. The long-term call is bound to be expensive, since it has a great deal of time premium remaining; moreover, the fact that it is out­ of-the-money means that one is also assuming the price risk from the current com­ mon price up to the strike of the call. Hence, this out-of-the-money amount plus the time value premium of the imbedded call can add up to a substantial amount. This discussion mainly pertains to shorting a PERCS near its issuance price and date. However, one is free to short PERCS at any time if they can be borrowed. They may be a more attractive short when they have less time remaining until the maturi­ ty date, or when the underlying common is closer to the redemption price. Overall, one would not normally expect the short sale of a PERCS to be vastly superior to a synthetic put constructed with listed options. Arbitrageurs would be expected to eliminate such a price discrepancy if one exists. However, if such a situ­ ation does present itself, the short seller of the PERCS should realize he has a posi­ tion that is the equivalent of owning a put, and plan his strategy accordingly. DETERMINING THE ISSUE PRICE An investor might wonder how it is always possible for the PERCS and the common to be at the same price at the issue date. In fact, the issuing company has two vari­ ables to work with to ensure that the common price and the PERCS issue price are the same. One variable is the amount of the additional dividend that the PERCS will pay. The other is the redemption price of the PER CS. By altering these two items, the value of the covered write (i.e., the PERCS) can be made to be the same as the common on the issue date. Figure 32-7 shows the values that are significant in determining the issue price of the PE RCS. The line marked Final Value is the shape of the profit graph of a cov­ ered write at expiration. This is the PERCS's final value at its maturity. The curved line is the value of the covered write at the current time, well before expiration. Of course, these two are linked together. The line marked Common Stock is merely the profit or loss of owning stock. The curved line (present PERCS value) crosses the Common Stock line at the issue price. At the time of issuance, the difference between the current stock price and the eventual maturity value of the PER CS is the present value of all the additional divi­ dends to be paid. That amount is marked a1/11e vertical line on the graph. Therefore, 634 Part V: Index Options and Futures FIGURE 32-7. 3-year PERCS issue price. i a. Stock Price anywhere out-of-the-money, the difference between the Final Value line and the Common Stock line, is the present worth of the additional dividends to be paid between now and maturity of the PERCS. Thus, on the day the PERCS is to be issued (or shortly before), the issuing cor­ poration can alter the PERCS dividend or demand price in order to "move" the curved line (present PERCS value) so that it intersects the Common Stock line at today's stock price. The terms of the PER CS would then be set to those parameters. PRICING PERCS The crucial factor in detennining whether a PERC S is fairly priced lies in valuing the imbedded call option within the PERCS. This may be a somewhat subjective task, especially if the PER CS has a long time until maturity. Recall that it was shown that small changes in the assumptions for LEAPS calls can seriously alter their theoreti­ cal values. The same holds true for valuing the call within the PERCS. If one trader is using a volatility assumption of 25%, say, for the common stock and another is using 28%, then they are going to arrive at different values for a three-year call. In such a case, one trader may think the PERCS is expensive at its current price and another may think it is cheap. G,pter 32: Strudured Products 635 Such discrepancies will be most notable when there is not a listed option that has terms near the terms of the PERCS's imbedded call. If there is such a listed option, then arbitrageurs should be able to use it and the common stock to bring the PERCS into line. However, if there is not any such listed option available, there may be opportunities for theoretical value traders. Models used for pricing call options, such as the Black-Scholes model, are dis­ cussed in Chapter 28 on mathematical applications. These models can be used to value the imbedded call in the PERCS as well. If the strategist determines the implied value of the imbedded call is out of line, he may be able to make a profitable trade. It is a fairly simple matter to determine the implied value of the imbedded call. The formula to be used is: Imbedded call implied value = Current stock price + Present value of dividends - Current PERCS price The validity of this formula can be seen by referring again to Figure 32-7. The difference between the Final Value (that is, the profit of the covered write at expira­ tion) and the Issue Value or current value of the PERCS is the imbedded call price. That is, the difference between the curved line and the line at expiration is merely the present time value of the imbedded call. Since this formula is describing an out­ of-the-money situation, then the time value of the imbedded call is its entire price. It is also known that the Final Value line differs from the current stock price by the present value of all the additional dividends to be paid by the PERCS until maturity. Thus, the four variables are related by the simple formula given above. Example: XYZ has fallen to 32 after the PERCS was issued. The PERCS is current­ ly trading at 34 and, as in previous examples, the PERCS pays an additional $1.50 per year in dividends. If there are two years remaining until maturity of the PERCS, what is the value of the imbedded call option? First, calculate the present value of the additional dividends. One should calcu­ late the present value of each dividend. Since they are paid quarterly, there will be eight of them between now and maturity. Assume the short-term interest rate is 6%. Each additional quarterly dividend is $0.375 ($1.50 divided by 4). Thus, the present value of the dividend to be paid in three months is: pw = 0.375/(1 + .06)114 = $0.3696 The present value of the dividend to be paid two years from now is: pw = 0.375/(1 + .06)2 = $0.338 i 636 Part V: Index Options and Futures Adding up all eight of these, it is determined that the present worth of all the remaining additional dividends is $2.81. Note that this is less than the actual amount that will eventually be paid over the two years, which is $3.00. Now, using the simple formula given earlier, the value of the imbedded call can be determined: XYZ: 32 PERCS: 34 Present worth of additional dividends: 2.81 Imbedded call = Stock price + pw divs - PERCS price = 32 + 2.81 - 34 = 0.81 Once this call value is determined, the strategist can use a model to see if this call appears to be cheap or expensive. In this case, the call looks cheap for a two-year call option that is 7 points out-of-the-money. Of course, one would need to know how volatile XYZ stock is, in order to draw a definitive conclusion regarding whether the imbedded call is undervalued or not. A basic relationship can be drawn between the PER CS price and the calculated value of the imbedded call: If the imbedded call is undervalued, then the PERCS is too expensive; if the imbedded call is overpriced, then the PERCS is cheap. In this exam­ ple, the value of the imbedded call was only 81 cents. If XYZ is a stock with average or above average volatility, then the call is certainly cheap. Therefore, the PERCS, trading at 34, is too expensive. Once this determination has been made, the strategist must decide how to use the information. A buyer of PER CS will need to know this information to determine if he is paying too much for the PER CS; alternatively stated, he needs to know if he is selling the imbedded call too cheaply. A hedger might establish a true hedge by buying common and selling the PERCS, using the proper hedge ratio. It is possible for a PER CS to remain expensive for quite some time, if investors are buying it for the additional dividend yield alone and are not giving proper consideration to the limited profit potential. Nevertheless, both the outright buyer and the strategist should calculate the correct value of the PER CS in order to make rational decisions. PERCS SUMMARY A PERCS is a preferred stock with a higher dividend yield than the common, and it is demandable at a predetermined series of prices. The decision to demand is strict­ ly at the discretion of the issuing company; the PER CS holder has no say in the deci- Cl,opter 32: Structured Products 637 :don. The PERCS is equivalent to a covered write of a long-term call option, which is imbedded in the PERCS value. Although there are not many PERCS trading at the current time, that number may grow substantially in the future. Any strategies that pertain to covered call writing will pertain to PER CS as well. Conventional listed options can be used to protect the PERCS from downside risk, to remove the limited upside profit potential, or to effectively change the price at which the PERCS is redeemable. Ratio writes can be constructed by selling a listed call. Shorting PERCS creates a security that is similar to a long put, which might be quite expensive if there is a significant amount of time remaining until maturity of the PERCS. Neutral traders and hedgers should be aware that a PERCS has a delta of its own, which is equal to one minus the delta of the imbedded call option. Thus, hedg­ ing PERCS with common stock requires one to calculate the PERCS delta. Finally, the implied value of the call option that is imbedded with the PERCS can be calculated quite easily. That information is used to determine whether the PERCS is fairly priced or not. The serious outright buyer as well as the option strate­ gist should make this calculation, since a PERCS is a security that is option-related. Either of these investors needs to know if he is making an attractive investment, and calculating the valuation of the imbedded call is the only way to do so. OTHER STRUCTURED PRODUCTS EXCHANGE-TRADED FUNDS Other listed products exist that are simpler in nature than those already discussed, but that the exchanges sometimes refer to as structured products. They often take the form of unit trusts and mutual funds. The general term for these products is Exchange-Traded Funds (ETFs). In a unit trust, an underwriter (Merrill Lynch, for example) packages together 10 to 12 stocks that have similar characteristics; perhaps they are in the same industry group or sector. The underwriter forms a unit trust with these stocks. That is, the shares are held in trust and the resulting entity - the unit trust - can actually be traded as shares of its own. The units are listed on an exchange and trade just like stocks. Example: One of the better-known and popular unit trusts is called the Standard & Poor's Depository Receipt{SPDR). It is a unit trust that exactly matches the S&P 500 index, divided by 10. Th&-SPDR unit trust is affectionately called Spiders (or Spyders). It trades on the AMEX under the symbol SPY. If the S&P 500 index itself is at 1,400, for example, then SPY will be trading near 140. Unit trusts are very active, mostly because they allow any investor to buy an index fund, and to move in and out of it at will. The bid-asked spread differential is very tight, due to the liquidity of the 638 Part V: Index Options and Futures product. When a customer trades the SPY, he pays a commission, just as he would with any listed stock. Exchange-traded funds are attractive to all investors who like to trade or invest in index funds, preferring the diversity provided by an index (passive management of stocks) to an active role in managing individual stocks. Exchange-traded funds can be sold short as long as the shares can be borrowed. Some of them don't even require an uptick when executing the short sale. Two other large and well-known unit trusts are similar to SPY. One is the NAS­ DAQ-100 tracking stock, whose symbol is QQQ. QQQ is 1140th of the value of the NASDAQ-100 index ($NDX), although it should be noted that $NDX has split two­ for-one in the past, as has QQQ, so the relationship could change by a factor of two. The other large, popular unit trust is linked to the Dow-Jones 30 Industrials; it is called Diamonds and trades under the symbol DIA. Both QQQ and DIA trade on the AMEX. Since this concept has proved to be popular, sector SPDRs were created on a large number of S&P index sectors - technology, oil, semiconductors, etc. These have proven to be less popular. There are even ETFs that are equal to one-tenth of the $OEX index, although they have not proven to be liquid. ETFs are "created" by institutions in blocks of shares known as Creation Units. A creation requires a deposit with the trustee of a specified number of shares of a portfolio of stocks closely approximating the composition of a specific index, and cash equal to accumulated dividends in return for specific index shares. Similarly, block­ sized units of ETFs can be redeemed in return for a portfolio of stocks approximat­ ing the index and a specified amount of cash. Very large blocks of shares - 50,000 or more - are required to create SPY, QQQ, DIA, and so forth. Slightly smaller blocks of shares are required to create the sector funds. If one is interested in knowing exactly what funds are listed at any time, he should consult the Web site of the exchange where the ETF is listed. The AMEX generally has extensive information about the nature of these products on its site at www.amex.com. A very large segment of ETFs, called iShares, was created by Barclays Global Investors to track all kinds of index funds. Many of these are not well known to the public, such as the Russell 2000 Value Fund and the Russell 2000 Growth Fund, but most of them are understandable upon inspection. There are iShares on funds that track foreign industries, plus a broad spectrum of funds that track small-cap stocks, value stocks, growth stocks, or individual sectors such as health care, the Internet, or real estate. A Web site, www.ishares.com, shows all of the currently available iShares. The iShares are all traded on major stock exchanges. Chapter 32: Structured Products 639 Another major segment of ETFs are called Holding Company Depository Receipts (HOLDRS). They were created by Merrill Lynch and are listed on the AMEX. Options on ETFs. Options are listed on many ETFs. QQQ options, for example, are listed on all of the option exchanges and are some of the most liquid contracts in existence. Things can always change, of course: Witness OEX, which at one time traded a million contracts a day and now barely trades one-thirtieth of that on most days. The options on ETFs can be used as substitutes for many expensive indices. This brings index option trading more into the realm of reasonable cost for the small individual investor. Example: The PHLX Semiconductor index ($SOX) has been a popular index since its inception, especially during the time that tech stocks were roaring. The index, whose options are expensive because of its high statistical volatility, traded at prices between 500 and 1,300 for several years. During that time, both implied and histor­ ical volatility was near 70%. So, for example, if $SOX were at 1,000 and one wanted to buy a three-month at-the-money call, it would cost approximately 135 points. That's $13,500 for one call option. For many investors, that's out of the realm of fea­ sibility. However, there are HOLDRS known as Semiconductor HOLDRS (symbol: SMH). The Semiconductor HOLD RS are composed of 20 stocks (in differing quan­ tities, since it is a capitalization-weighted unit trust) that behave in aggregate in much the same manner as the Semiconductor index ($SOX) does. However, SMH has trad­ ed at prices between 40 and 100 over the same period of time that $SOX was trad­ ing between 500 and 1,300. The implied volatility of SMH options is 70% - just like $SOX options - because the same stocks are involved in both indices. However, a three-month at-the-money call on the $100 SMH, say, would cost only 13.50 points ($1,350) - a much more feasible option cost for most investors and traders. Thus, a strategy that most option traders should keep in mind is one in which ETFs are substituted when one has a trading signal or opinion on a high-priced index. Similarities exist among many of them. For example, the Morgan Stanley High-Tech index ($MSH) is well known for the7eliability of its put-call ratio sentiment signals. However, the index is high-priced and volatile, much like $SOX. Upon examination, though, one can discover that QQQ trades almost exactly like $MSH. So QQQ options and "stock" can be used as a substitute when one wants to trade $MSH. 640 Part V: Index Options and Futures STRUCTURED PRODUCT SUMMARY Structured products whether of the simple style of the Exchange-Traded Fund or the more complicated nature of the PERCS, bull spreads, or protected index funds - can and should be utilized by investors looking for unique ways to protect long­ term holdings in indices or individual stocks. The number of these products is constantly evolving and changing. Thus, anyone interested in trading these items should check the Web sites of the exchanges where the shares are listed. Analytical tools are available on the Web as well. For example, the site www.derivativesmodels.com has over 40 different models especially designed for evaluating options and structured products. They range from the simple Black-Scholes model to models that are designed to evaluate extremely complicated exotic options. All of these products have a place, but the most conservative seem to be the structured products that provide upside market potential while limiting downside risk- the products discussed at the beginning of the chapter. As long as the credit­ worthiness of the underwriter is not suspect, such products can be useful longer­ term investments for nearly everyone who bothers to learn about and understand them. CHAPTER 33 Mathetnatical Considerations for Index Products In this chapter, we look at some riskless arbitrage techniques as they apply to index options. Then a summary of mathematical techniques, especially modeling, is pre­ sented. ARBITRAGE Most of the normal arbitrage strategies have been described previously. We will review them here, concentrating on specific techniques not described in previous chapters on hedging (market baskets) and index spreading. DISCOUNTING We saw that discounting in cash-based options is done with in-the-money options as it is with stock options. However, since the discounter cannot exactly hedge the cash­ based options, he will normally do his discounting near the close of the day so that there is as little time as possible between the time the option is bought and the close of the market. This reduces the risk that the underlying index can move too far before the close of trading. Example: OEX is trading at 673.53 7nd an arbitrageur can buy the June 690 puts for 16. That is a discount of 0.47 since,parity is 16.47. Is this enough of a discount? That is, can the discounter buy this put, hold it unhedged until the close of trading, and 641 642 Part V: Index Options and Futures exercise it; or is there too great a chance that OEX will rally and wipe out his dis­ count? If he buys this put when there is very little time left in the trading day, it might be enough of a discount. Recall that a one-point move in OEX is roughly equivalent to 15 points on the Dow (while a one-point move in SPX is about 7.5 Dow points). Thus, this O EX discount of 0.4 7 is about equal to 7 Dow points. Obviously, this is not a lot of cushion, because the Dow can easily move that far in a short period of time, so it would be sufficient only if there are just a few minutes of trading left and there were not previous indications oflarge orders to buy "market on close." However, if this situation were presented to the discounter at an earlier time in the trading day, he might defer because he would have to hedge his position and that might not be worth the trouble. If there were several hours left in the trading day, even a discount of a full point would not be enough to allow him to remain unhedged (one full OEX point is about 15 Dow points). Rather, he would, for example, buy futures, buy OEX calls, or sell puts on another index. At the end of the day, he could exercise the puts he bought at a discount and reverse the hedge in the open market. CONVERSIONS AND REVERSALS Conversions and reversals in cash-based options are really the market basket hedges (index arbitrage) described in Chapter 30. That is, the underlying security is actually all the stocks in the index. However, the more standard conversions and reversals can be executed with futures and futures options. Since there is no credit to one's account for selling a future and no debit for buy­ ing one, most futures conversions and reversals trade very nearly at a net price equal to the strike. That is, the value of the out-of-the-money futures option is equal to the time premium of the in-the-money option that is its counterpart in the conversion or reversal. Example: An index future is trading at 179.00. If the December 180 call is trading for 5.00, then the December 180 put should be priced near 6.00. The time value pre­ mium of the in-the-money put is 5.00 (6.00 + 179.00 - 180.00), which is equal to the price of the out-of-the-money call at the same strike. If one were to attempt to do a conversion or reversal with these options, he would have a position with no risk of loss but no possibility of gain: A reversal would be established, for example, at a "net price" of 180. Sell the future at 179, add the premium of the put, 6.00, and subtract the cost of the call, 5.00: 179 + 6.00 - 5.00 = 180.00. As we know from Chapter 27 on arbitrage, one unwinds a conversion or reversal for a "net price" equal to the strike. Hence, there would be no gain or loss from this futures reversal. Chapter 33: Mathematical Considerations for Index Products 643 For index futures options, there is no risk when the underlying closes near the strike, since they settle for cash. One is not forced to make a choice as to whether to exercise his calls. (See Chapter 27 on arbitrage for a description of risks at expiration when trading reversals or conversions.) In actual practice, floor traders may attempt to establish conversions in futures options for small increments - perhaps 5 or 10 cents in S&P futures, for example. The arbitrageur should note that futures options do actually create a credit or debit in the account. That is, they are like stock options in that respect, even though the underlying instrument is not. This means that if one is using a deep in-the-money option in the conversion, there will actually be some carrying cost involved. Example: An index future is trading at 179.00 and one is going to price the December 190 conversion, assuming that December expiration is 50 days away. Assume that the current carrying cost of money is 10% annually. Finally, assume that the December 190 call is selling for 1.00, and the December 190 put is selling for 11.85. Note that the put has a time value premium of only 85 cents, less than the pre­ mium of the call. The reason for this is that one would have to pay a carrying cost to do the December 190 conversion. If one established the 190 conversion, he would buy the futures (no credit or debit to the account), buy the put (a debit of 11.85), and sell the call (a credit of 1.00). Thus, the account actually incurs a debit of 10.85 from the options. The carrying cost for 10.85 at 10% for 50 days is 10.85 x 10% x 50/365 = 0.15. This indicates that the converter is willing to pay 15 cents less time premium for the put (or conversely that the reversal trader is willing to sell the put for 15 cents less time premium). Instead of the put trading with a time value premium equal to the call price, the put will trade with a premium of 15 cents less. Thus, the time premium of the put is 85 cents, rather than being equal to the price of the call, 1.00. BOX SPREADS Recall that a "box" consists of a bullish vertical spread involving two striking prices, and a bearish vertical spread using the same two strikes. One spread is constructed with puts and the other with calls. The profitability of the box is the same regardless of the price of the underlying security at expiration. Box arbitrage with equity options involves trying to buy the box for less than the difference in the striking prices, for ~ple, trying to buy a box in which the strikes are 5 points apart for 4. 75. Selling the box for more than 5 points would represent arbitrage as well. In fact, even selling the box at exactly 5 points would produce a profit for the arbitrageur, since he earns interest on the credit from the sale. 644 Part V: Index Options and Futures These same strategies apply to options on futures. However, boxes on cash­ based options involve another consideration. It is often the case with cash-based options that the box sells for more than the difference in the strikes. For example, a box in which the strikes are 10 points apart might sell for 10.50, a substantial premi­ um over the striking price differential. The reason that this happens is because of the possibility of early assignment. The seller of the box assumes that risk and, as a result, demands a higher price for the box. If he sells the box for half a point more than the striking price differential, then he has a built-in cushion of .50 point of index movement if he were to be assigned early. In general, box strategies are not particularly attractive. However, if the pre­ mium being paid for the box is excessively high, then one should consider selling the box. Since there are four commissions involved, this is not normally a retail strategy. MATHEMATICAL APPLICATIONS The following material is intended to be a companion to Chapter 28 on mathemati­ cal applications. Index options have a few unique properties that must be taken into account when trying to predict their value via a model. The Black-Scholes model is still the model of choice for options, even for index options. Other models have been designed, but the Black-Scholes model seems to give accurate results without the extreme complications of most of the other models. FUTURES Modeling the fair value of most futures contracts is a difficult task. The Black-Scholes model is not usable for that task. Recall that we saw earlier that the fair value of a future contract on an index could be calculated by computing the pres­ ent value of the dividend and also knowing the savings in carrying cost of the futures contract versus buying the actual stocks in the index. CASH-BASED INDEX OPTIONS The futures fair value model for a capitalization-weighted index requires knowing the exact dividend, dividend payment date, and capitalization of each stock in the index (for price-weighted indices, the capitalization is unnecessary). This is the only way of getting the accurate dividend for use in the model. The same dividend calculation must be done for any other index before the Black-Scholes formula can be applied. In the actual model, the dividend for cash-based index options is used in much the same way that dividends are used for stock options: The present value of the div- Chapter 33: Mathematical Considerations for Index Products 64S idend is subtracted from the index price and the model is evaluated using that adjust­ ed stock price. With stock options, there was a second alternative - shortening the time to expiration to be equal to the ex-date - but that is not viable with index options since there are numerous ex-dates. Let's look at an example using the same fictional dividend information and index that were used in Chapter 30 on stock index hedging strategies. Example: Assume that we have a capitalization-weighted index composed of three stocks: AAA, BBB, and CCC. The following table gives the pertinent information regarding the dividends and floats of these three stocks: Dividend Days until Stock Amount Dividend Float AAA 1.00 35 50,000,000 BBB 0.25 60 35,000,000 CCC 0.60 8 120,000,000 Divisor: 150,000,000 One first computes the present worth of each stock's dividend, multiplies that amount by the float, and then divides by the index divisor. The sum of these compu­ tations for each stock gives the total dividend for the index. The present worth of the dividend for this index is $0.8667. Assume that the index is currently trading at 175.63 and that we want to evalu­ ate the theoretical value of the July 175 call. Then, using the Black-Scholes model, we would perform the following calculations: 1. Subtract the present worth of the dividend, 0.8667, from the current index price of 175.63, giving an adjusted index price of 174.7633. 2. Evaluate the call's fair value using 17 4. 7633 as the stock price. All other variables are as they are for stocks, including the risk-free interest rate at its actual value (10%, for example). The theoretical value for puts is computed in the same way as for equity options, by using the arbitrage model. This is sufficient for cash-based index options because it is possible - albeit difficult to hedge these options by buying or selling the entire index. Thus, the options should reflect the potential for such arbitrage. The put value should, of course, reflect the potential for dividend arbitrage with the index. The arbitrage valuation model p"resented in Chapter 28 on modeling called for the dividend to be used. For these index puts, one would use the present worth of 646 Part V: Index Options and Futures the dividend on the index - the same one that was used for the call valuation, as in the last example. THE IMPLIED DIVIDEND If one does not have access to all of the dividend information necessary to make the "present worth of the dividends" calculation (i.e., if he is a private individual or pub­ lic customer who does not subscribe to a computer-based dividend "service"), there is still a way to estimate the present worth of the dividend. All one need do is make the assumption that the market- makers know what the present worth of the dividend is, and are thus pricing the options accordingly. The individual public customer can use this information to deduce what the dividend is. Example: OEX is trading at 700, the June options have 30 days of life remaining, the short-term interest rate is 10%, and the following prices exist: June 700 call: 18.00 June 700 put: 14.50 One can use iterations of the Black-Scholes model to determine what the OEX "dividend" is. In this case, it turns out to be something on the order of $2.10. Briefly, these are the steps that one would need to follow in order to determine this dividend: 1. Assume the dividend is $0.00. 2. Using the assumed dividend, use the Black-Scholes model to determine the implied volatility of the call option, whose price is known (18.00 in the above example). 3. Using the implied volatility determined from step 2 and the assumed dividend, is the arbitrage put value as derived from the Black-Scholes calculations at the end of step 2 roughly equal to the market value of the put (14.50 in the above example)? If yes, you are done. If not, increase the assumed dividend by some nominal amount, say $0.10, and return to step 2. Thus, without having access to complete dividend information, one can use the information provided to him by the marketplace in order to imply the dividend of an index option. The only assumption one makes is that the market-makers know what the dividend is (they most assuredly do). Note that the implied volatility of the options is determined concurrently with the implied dividend (step 2 above). A veiy useful tool, this simple "implied dividend calculator" can be added to any software that employs the Black-Scholes model. O,apter 33: Mathematical Considerations for Index Products EUROPEAN EXERCISE 647 To account for European exercise, one basically ignores the fact that an in-the-money put option's minimum value is its intrinsic value. European exercise puts can trade at a discount to intrinsic value. Consider the situation from the viewpoint of a conver­ sion arbitrage. If one buys stock, buys puts, and sells calls, he has a conversion arbi­ trage. In the case of a European exercise option, he is forced to carry the position to expiration in order to remove it: He cannot exercise early, nor can he be called early. Therefore, his carrying costs will always be the maximum value to expiration. These carrying costs are the amount of the discount of the put value. For a deeply in-the-money put, the discount will be equal to the carrying charges required to carry the striking price to expiration: Carry = s Ji - 1 ] L (1+ r)t Less deeply in-the-money puts, that is, those with deltas less than - 1.00, would not require the full discounting factor. Rather, one could multiply the discounting factor by the absolute value of the put' s delta to arrive at the appropriate discounting factor. FUTURES OPTIONS A modified Black-Scholes model, called the Black Model, can be used to evaluate futures options. See Chapter 29 on futures for a futures discussion. Essentially, the adjustment is as follows: Use 0% as the risk-free rate in the Black-Scholes model and obtain a theoretical call value; then discount that result. Black model: Call value= e-rt x Black-Scholes call value [using r = 0%] where r is the risk-free interest rate and t is the time to expiration in years. The relationship between a futures call theoretical value and that of a put can also be discussed from the model: Call = Put + e-rf(J - s) where f is the futures price ands is the striking price. 648 Part V: Index Options and Futures Example: The following prices exist: ZYX Cash Index: 17 4.49 ZYX December future: 177.00 There are 80 days remaining until expiration, the volatility of ZYX is 15%, and the risk-free interest rate is 6%. In order to evaluate the theoretical value of a ZYX December 185 call, the fol­ lowing steps would be taken: l. Evaluate the regular Black-Scholes model using 185 as the strike, 177.00 as the stock price, 15% as the volatility, 0.22 as the time remaining (80/365), and 0% as the interest rate. Note that the futures price, not the index price, is input to the model as stock price. Suppose that this yields a result of 2.05. 2. Discount the result from step l: Black Model call value = e-(.0 6 x 0-22) x 2.05 = 2.02 In this case, the difference between the Black model and the Black-Scholes model is small (3 cents). However, the discounting factor can be large for longer-term or deeply in-the-money options. The other items of a mathematical nature that were discussed in Chapter 28 on mathematical applications are applicable, without change, to index options. Expected return and implied volatility have the same meaning. Implied volatility can be calcu­ lated by using the Black-Scholes formulas as specified above. Neutral positioning retains its meaning as well. Recall that any of the above the­ oretical value computations gives the delta of the option as a by-product. These deltas can be used for cash-based and futures options just as they are used for stock options to maintain a neutral position. This is done, of course, by calculating the equivalent stock position (or equivalent "index" or "futures" position, in these cases). FOLLOW-UP ACTION The various types of follow-up action that were applicable to stock options are avail­ able for index options as well. In fact, when one has spread options on the same underlying index, these actions are virtually the same. However, when one is doing inter-index spreads, there is another type of follow-up picture that is useful. The rea- Chapter 33: Mathematical Considerations for Index Products 649 son for this is that the spread will have different outcomes not only based on the price of one index, but also based on that index's relationship to the other index. It is possible, for example, that a mildly bullish strategy implemented as an inter-index spread might actually lose money even if one index rose. This could hap­ pen if the other index performed in a manner that was not desirable. If one could have his computer "draw" a picture of several different outcomes, he would have a better idea of the profit potential of his strategy. Example: Assume a put spread between the ZYX and the ABX indices was estab­ lished. An ABX June 180 put was bought at 3.00 and a ZYX June 175 put was sold at 3.00, when the ZYX was at 175.00 and the ABX Index was at 178.00. This spread will obviously have different outcomes if the prices of the ZYX and the ABX move in dra­ matically different patterns. On the surface, this would appear to be a bearish position - long a put at a high­ er strike and short a put at a lower strike. However, the position could make money even in a rising market if the indices move appropriately: If, at expiration, the ZYX and ABX are both at 179.00, for example, then the short option expires worthless and the long option is still worth 1.00. This would mean that a 1-point profit, or $500, was made in the spread ($1,500 profit on the short ZYX puts less a $1,000 loss on the one ABX put). Conversely, a downward movement doesn't guarantee profits either. If the ZYX falls to 170.00 while the ABX declines to 175.00, then both puts would be worth 5 at expiration and there would be no gain or loss in the spread. What the strategist needs in order to better understand his position is a "sliding scale" picture. That is, most follow-up pictures give the outcome (say, at expiration) of the position at various stock or index prices. That is still needed: One would want to see the outcome for ZYX prices of, say, 165 up to 185 in the example. However, in this spread something else is needed: The outcome should also take into account how the ZYX matches up with the ABX. Thus, one might need three (or more) tables of out­ comes, each of which depicts the results as ZYX ranges from 165 up to 185 at expi­ ration. One might first show how the results would look if ZYX were, say, 5 points below ABX; then another table would show ZYX and ABX unchanged from their original relationship (a 3-point differential); finally, another table would show the results if ZYX and ABX were equal at expiration. If the relationship between the two indices were at 3 points at expiration, such a table might look like this: 6S0 Part V: Index Options and Futures Price at Expiration ZYX 165 170 175 180 185 ABX 168 173 178 183 188 ZYX June 175P 10 5 0 0 0 ABX June 1 80P 12 7 2 0 0 Profit +$1,000 +$1,000 +$1,000 0 0 This picture indicates that the position is neutral to bearish, since it makes money even if the indices are unchanged. However, contrast this with the situation in which the ZYX falls to a level 5 points below the ABX by expiration. Price at Expiration ZYX 165 170 175 180 185 ABX 170 175 180 185 190 ZYX June 175P 10 5 0 0 0 ABX June l 80P 10 5 0 0 0 Profit 0 0 0 0 0 In this case, the spread has no potential for profit at all, even if the market col­ lapses. Thus, even a bearish spread like this might not prove profitable if there is an adverse movement in the relationship of the indices. Finally, observe what happens if the ZYX rallies so strongly that it catches up to the ABX. Price at Expiration ZYX 165 170 175 180 185 ABX 165 170 175 180 185 ZYX June 175P 10 5 0 0 0 ABX June 180P 15 10 5 0 0 Profit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 These tables can be called "sliding scale" tables, because what one is actually doing is showing a different set of results by sliding the ABX scale over slightly each time while keeping the ZYX scale fixed. Note that in the above two tables, the ZYX results are unchanged, but the ABX has been slid over slightly to show a different result. Tables like this are necessary for the strategist who is doing spreads in options with different underlying indices or is trading inter-index spreads. 650 Part V: Index Options and Futures Price at Expiration ZYX 165 170 175 180 185 ABX 168 173 178 183 188 ZYX June 175P 10 5 0 0 0 ABX June 180P 12 7 2 0 0 Profit +$1,000 +$1,000 +$1,000 0 0 This picture indicates that the position is neutral to bearish, since it makes money even if the indices are unchanged. However, contrast this with the situation in which the Z¥X falls to a level 5 points below the ABX by expiration. Price at Expiration ZYX 165 170 175 180 185 ABX 170 175 180 185 190 ZYX June 175P 10 5 0 0 0 ABX June 1 80P 10 5 0 0 0 Profit 0 0 0 0 0 In this case, the spread has no potential for profit at all, even if the market col­ lapses. Thus, even a bearish spread like this might not prove profitable if there is an adverse movement in the relationship of the indices. Finally, observe what happens if the ZYX rallies so strongly that it catches up to the ABX. Price at Expiration ZYX 165 170 175 180 185 ABX 165 170 175 180 185 ZYX June 175P 10 5 0 0 0 ABX June 1 80P 15 10 5 0 0 Profit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 These tables can be called "sliding scale" tables, because what one is actually doing is showing a different set of results by sliding the ABX scale over slightly each time while keeping the Z¥X scale fixed. Note that in the above two tables, the Z¥X results are unchanged, but the ABX has been slid over slightly to show a different result. Tables like this are necessary for the strategist who is doing spreads in options with different underlying indices or is trading inter-index spreads. 650 ZYX ABX ZYX June 175P ABX June 1 80P Profit 165 168 10 12 +$1,000 170 173 5 7 +$1,000 Part V: Index Options and Futures Price at Expiration 175 180 185 178 183 188 0 0 0 2 0 0 +$1,000 0 0 This picture indicates that the position is neutral to bearish, since it makes money even if the indices are unchanged. However, contrast this with the situation in which the ZYX falls to a level 5 points below the ABX by expiration. Price at Expiration ZYX 165 170 175 180 185 ABX 170 175 180 185 190 ZYX June 175P 10 5 0 0 0 ABX June 1 80P 10 5 0 0 0 Profit 0 0 0 0 0 In this case, the spread has no potential for profit at all, even if the market col­ lapses. Thus, even a bearish spread like this might not prove profitable if there is an adverse movement in the relationship of the indices. Finally, observe what happens if the ZYX rallies so strongly that it catches up to the ABX. Price at Expiration ZYX 165 170 175 180 185 ABX 165 170 175 180 185 ZYX June 175P 10 5 0 0 0 ABX June 1 80P 15 10 5 0 0 Profit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 These tables can be called "sliding scale" tables, because what one is actually doing is showing a different set of results by sliding the ABX scale over slightly each time while keeping the ZYX scale fixed. Note that in the above two tables, the ZYX results are unchanged, but the ABX has been slid over slightly to show a different result. Tables like this are necessary for the strategist who is doing spreads in options with different underlying indices or is trading inter-index spreads. Cl,apter 33: Mathematical Considerations for Index Products 651 The astute reader will notice that the above example can be generalized by drawing a three-dimensional graph. The X axis would be the price of ZYX; the Y axis would be the dollars of profit in the spread; and instead of "sliding scales," the Z axis would be the price of ABX. There is software that can draw 3-dimensional profit graphs, although they are somewhat difficult to read. The previous tables would then be horizontal planes of the three-dimensional graph. This concludes the chapter on riskless arbitrage and mathematical modeling. Recall that arbitrage in stock options can affect stock prices. The arbitrage techniques outlined here do not affect the indices themselves. That is done by the market basket hedges. It was also known that no new models are necessary for evaluation. For index options, one merely has to properly evaluate the dividend for usage in the standard Black-Scholes model. Future options can be evaluated by set­ ting the risk-free interest rate to 0% in the Black-Scholes model and discounting the result, which is the Black model. ) CHAPTER 34 Futures and Futures Options In the previous chapters on index trading, a particular type of futures option - the index option - was described in some detail. In this chapter, some background infor­ mation on futures themselves is spelled out, and then the broad category of futures options is investigated. In recent years, options have been listed on many types of futures as well as on some physical entities. These include options on things as diverse as gold futures and cattle futures, as well as options on currency and bond futures. Much of the information in this chapter is concerned with describing the ways that futures options are similar to, or different from, ordinary equity and index options. There are certain strategies that can be developed specifically for futures options as well. However, it should be noted that once one understands an option strategy, it is generally applicable no matter what the underlying instrument is. That is, a bull spread in gold options entails the same general risks and rewards as does a bull spread in any stock's options - limited downside risk and limited upside profit potential. The gold bull spread would make its maximum profit if gold futures were above the higher strike of the spread at expiration, just as an equity option bull spread would do if the stock were above the higher strike at expiration. Consequently, it would be a waste of time and space to go over the same strategies again, substituting soybeans or orange juice futures, say, for XYZ stock in all the examples that have been given in the previous chapters of this book. Rather, the concentration will be on areas where there is truly a new or different strategy that futures options provide. Before beginning, it should be pointed out that futures contracts and futures options have far less standardization than equity or index options do. Most futures trade in different units. Most options have different expiration months, expiration times, and striking price intervals. All the different contract specifications are not spelled out here. One should contact his broker or the exchange where the contracts 652 Cl,apter 34: Futures and Futures Options 6S3 are traded in order to receive complete details. However, whenever examples are used, full details of the contracts used in those examples are given. FUTURES CONTRACTS Before getting into options on futures, a few words about futures contracts them­ selves may prove beneficial. Recall that a futures contract is a standardized contract calling for the delivery of a specified quantity of a certain commodity at some future time. Future contracts are listed on a wide variety of commodities and financial instruments. In some cases, one must make or take delivery of a specific quantity of a physical commodity (50,000 bushels of soybeans, for example). These are known as futures on physicals. In others, the futures settle for cash as do the S&P 500 Index futures described in a previous chapter; there are other futures that have this same feature (Eurodollar time deposits, for example). These types of futures are cash­ based, or cash settlement, futures. In terms of total numbers of contracts listed on the various exchanges, the more common type of futures contract is one with a physical commodity underlying it. These are sometimes broken down into subcategories, such as agricultural futures (those on soybeans, oats, coffee, or orange juice) and financial futures (those on U.S. Treasury bonds, bills, and notes). Traders not familiar with futures sometimes get them confused with options. There really is very little resemblance between futures and options. Think of futures as stock with an expiration date. That is, futures contracts can rise dramatically in price and can fall all the way to nearly zero (theoretically), just as the price of a stock can. Thus, there is great potential for risk. Conversely, with ownership of an option, risk is limited. The only real similarity between futures and options is that both have an expiration date. In reality, futures behave much like stock, and the novice should understand that con­ cept before moving on. HEDGING The primary economic function of futures markets is hedging - taking a futures position to offset the risk of actually owning the physical commodity. The physical commodity or financial instrument is known as the "cash." For index futures, this hedging was designed to remove the risk from owning stocks (the "cash market" that underlies index futures). A portfolio manager who owned a large quantity of stocks could sell index futures against the stock to remove much of the price risk of that 654 Part V: Index Options and Futures stock ownership. Moreover, he is able to establish that hedge at a much smaller com­ mission cost and with much less work than would be required to sell thousands of shares of stock. Similar thinking applies to all the cash markets that underlie futures contracts. The ability to hedge is important for people who must deal in the "cash" market, because it gives them price protection as well as allowing them to be more efficient in their pricing and profitability. A general example may be useful to demon­ strate the hedging concept. Example: An international businessman based in the United States obtains a large contract to supply a Swiss manufacturer. The manufacturer wishes to pay in Swiss francs, but the payment is not due until the goods are delivered six months from now. The U.S. businessman is obviously delighted to have the contract, but perhaps is not so delighted to have the contract paid in francs six months from now. If the U.S. dol­ lar becomes stronger relative to the Swiss franc, the U.S. businessman will be receiv­ ing Swiss francs which will be worth fewer dollars for his contract than he originally thought he would. In fact, if he is working on a narrow profit margin, he might even suffer a loss if the Swiss franc becomes too weak with respect to the dollar. A futures contract on the Swiss franc may be appropriate for the U.S. business­ man. He is "long" Swiss francs via his contract (that is, he will get francs in six months, so he is exposed to their fluctuations during that time). He might sell short a Swiss franc futures contract that expires in six months in order to lock in his current profit margin. Once he sells the future, he locks in a profit no matter what happens. The future's profit and loss are measured in dollars since it trades on a U.S. exchange. If the Swiss franc becomes stronger over the six-month period, he will lose money on the futures sale, but will receive more dollars for the sale of his products. Conversely, if the franc becomes weak, he will receive fewer dollars from the Swiss businessman, but his futures contract sale will show a profit. 111 either case, the futures contract enables him to lock in a future price (hence the name "futures") that is profitable to him at today's level. The reader should note that there are certain specific factors that the hedger must take into consideration. Recall that the hedger of stocks faces possible problems when he sells futures to hedge his stock portfolio. First, there is the problem of sell­ ing futures below their fair value; changes in interest rates or dividend payouts can affect the hedge as well. The U.S. businessman who is attempting to hedge his Swiss francs may face similar problems. Certain items such as short-term interest rates, which affect the cost of carry, and other factors may cause the Swiss franc futures to trade at a premium or discount to the cash price. That is, there is not necessarily a complete one-to-one relationship between the futures price and the cash price. Chapter 34: Futures and Futures Options 655 However, the point is that the businessman is able to substantially reduce the cur­ rency risk, since in six months there could be a large change in the relationship between the U.S. dollar and the Swiss franc. While his hedge might not eliminate every bit of the risk, it will certainly get rid of a very large portion of it. SPECULATING While the hedgers provide the economic function of futures, speculators provide the liquidity. The attraction for speculators is leverage. One is able to trade futures with very little margin. Thus, large percentages of profits and losses are possible. Example: A futures contract on cotton is for 50,000 pounds of cotton. Assume the March cotton future is trading at 60 (that is, 60 cents per pound). Thus, one is con­ trolling $30,000 worth of cotton by owning this contract ($0.60 per pound x 50,000 pounds). However, assume the exchange minimum margin is $1,500. That is, one has to initially have only $1,500 to trade this contract. This means that one can trade cot­ ton on 5% margin ($1,500/$30,000 = 5%). What is the profit or risk potential here? A one-cent move in cotton, from 60 to 61, would generate a profit of $500. One can always determine what a one-cent move is worth as long as he knows the contract size. For cotton, the size is 50,000 pounds, so a one-cent move is 0.01 x 50,000 = $500. Consequently, if cotton were to fall three cents, from 60 to 57, this speculator would lose 3 x $500, or $1,500 - his entire initial investment. Alternatively, a 3-cent move to the upside would generate a profit of $1,500, a 100% profit. This example clearly demonstrates the large risks and rewards facing a specula­ tor in futures contracts. Certain brokerage firms may require the speculator to place more initial margin than the exchange minimum. Usually, the most active customers who have a sufficient net worth are allowed to trade at the exchange minimum mar­ gins; other customers may have to put up two or three times as much initial margin in order to trade. This still allows for a lot of leverage, but not as much as the specu­ lator has who is trading with exchange minimum margins. Initial margin require­ ments can be in the form of cash or Treasury bills. Obviously, if one uses Treasury bills to satisfy his initial margin requirements, he can be earning interest on that money while it serves as collateral for his initial margin requirements. If he uses cash for the initial requirement, he will not earn interest. (Note: Some large customers do earn credit on the cash used for margin requirements in their futures accounts, but most customers do not.) A speculator will also be required to keep his account current daily through the use of maintenance mar~is account is marked to market daily, so unrealized 656 Part V: Index Options and Futures gains and losses are taken into account as well as are realized ones. If his account loses money, he must add cash into the account or sell out some of his Treasury bills in order to cover the loss, on a daily basis. However, if he makes money, that unreal­ ized profit is available to be withdrawn or used for another investment. Example: The cotton speculator from the previous example sees the price of the March cotton futures contract he owns fall from 60.00 to 59.20 on the first day he owns it. This means there is a $400 unrealized loss in his account, since his holding went down in price by 0.80 cents and a one-cent move is worth $500. He must add $400 to his account, or sell out $400 worth of T-bills. The next day, rumors of a drought in the growing areas send cotton prices much higher. The March future closes at 60.90, up 1.70 from the previous day's close. That represents a gain of $850 on the day. The entire $850 could be withdrawn, or used as initial margin for another futures contract, or transferred to one's stock market account to be used to purchase another investment there. Without speculators, a futures contract would not be successful, for the specu­ lators provide liquidity. Volatility attracts speculators. If the contract is not trading and open interest is small, the contract may be delisted. The various futures exchanges can delist futures just as stocks can be delisted by the New York Stock Exchange. However, when stocks are delisted, they merely trade over-the-counter, since the corporation itself still exists. When futures are delisted, they disappear - there is no over-the-counter futures market. Futures exchanges are generally more aggressive in listing new products, and delisting them if necessary, than are stock exchanges. TERMS Futures contracts have certain standardized terms associated with them. However, trading in each separate commodity is like trading an entirely different product. The standardized terms for soybeans are completely different from those for cocoa, for example, as might well be expected. The size of the contract (50,000 pounds in the cotton example) is often based on the historical size of a commodity delivered to market; at other times it is merely a contrived number ($100,000 face amount of U.S. Treasury bonds, for example). Also, futures contracts have expiration dates. For some commodities (for exam­ ple, crude oil and its products, heating oil and unleaded gasoline), there is a futures contract for every month of the year. Other commodities may have expirations in only 5 or 6 calendar months of the year. These items are listed along with the quotes in a good financial newspaper, so they are not difficult to discover. Gapter 34: Futures and Futures Options 657 The number of expiration months listed at any one time varies from one mar­ ket to another. Eurodollars, for example, have futures contracts with expiration dates that extend up to ten years in the future. T-bond and 10-year note contracts have expiration dates for only about the next year or so. Soybean futures, on the other hand, have expirations going out about two years, as do S&P futures. The day of the expiration month on which trading ceases is different for each commodity as well. It is not standardized, as the third Friday is for stock and index options. Trading hours are different, even for different commodities listed on the same futures exchange. For example, U.S. Treasury bond futures, which are listed on the Chicago Board of Trade, have very long trading hours (currently 8:20 A.M. to 3 P.M. and also 7 P.M. to 10:30 P.M. every day, Eastern time). But, on the same exchange, soy­ bean futures trade a very short day (10:30 A.M. to 2:15 P.M., Eastern time). Some mar­ kets alter their trading hours occasionally, while others have been fixed for years. For example, as the foreign demand for U.S. Treasury bond futures increases, the trad­ ing hours might expand even further. However, the grain markets have been using these trading hours for decades, and there is little reason to expect them to change in the future. · Units of trading vary for different futures contracts as well. Grain futures trade in eighths of a point, 30-year bond futures trade in thirty-seconds of a point, while the S&P 500 futures trade in 10-cent increments (0.10). Again, it is the responsibili­ ty of the trader to familiarize himself with the units of trading in the futures market if he is going to be trading there. Each futures contract has its own margin requirements as well. These conform to the type of margin that was described with respect to the cotton example above: An initial margin may be advanced in the form of collateral, and then daily mark-to­ market price movements are paid for in cash or by selling some of the collateral. Recall that maintenance margin is the term for the daily mark to market. Finally, futures are subject to position limits. This is to prevent any one entity from attempting to comer the market in a particular delivery month of a commodi­ ty. Different futures have different position limits. This is normally only of interest to hedgers or very large speculators. The exchange where the futures trade establishes the position limit. TRADING LIMITS Most futures contracts have some limit on their maximum daily price change. For index futures, it was shown that the limits are designed to act like circuit breakers to prevent the stock market from crashing. Trading limits exist in many futures con- ( 658 Part V: Index Options and Futures tracts in order to help ensure that the market cannot be manipulated by someone forcing the price to move tremendously in one direction or the other. Another rea­ son for having trading limits is ostensibly to allow only a fixed move, approximately equal to or slightly less than the amount covered by the initial margin requirement, so that maintenance margin can be collected if need be. However, limits have been applied to all futures, some of which don't really seem to warrant a limit - U.S. Treasury bonds, for example. The bond issue is too large to manipulate, and there is a liquid "cash" bond market to hedge with. Regardless, limits are a fact of life in futures trading. Each individual commod­ ity has its own limits, and those limits may change depending on how the exchange views the volatility of that commodity. For example, when gold was trading wildly at a price of more than $700 per ounce, gold futures had a larger daily trading limit than they do at more stable levels of $300 to $400 an ounce (the current limit is a $15 move per day). If a commodity reaches its limit repeatedly for two or three days in a row, the exchange will usually increase the limit to allow for more price movement. The Chicago Board of Trade automatically increases limits by 50% if a futures con­ tract trades at the limit three days in a row. Whenever limits exist there is always the possibility that they can totally destroy the liquidity of a market. The actual commodity underlying the futures contract is called the "spot" and trades at the "spot price." The spot trades without a limit, of course. Thus, it is possible that the spot commodity can increase in price tremen­ dously while the futures contract can only advance the daily limit each day. This sce­ nario means that the futures could trade "up or down the limit" for a number of days in a row. As a consequence, no one would want to sell the futures if they were trad­ ing up the limit, since the spot was much higher. In those cases there is no trading in the futures - they are merely quoted as bid up the limit and no trades take place. This is disastrous for short sellers. They may be wiped out without ever naving the chance to close out their positions. This sometimes happens to orange juice futures when an unexpected severe freeze hits Florida. Options can help alleviate the illiquidity caused by limit moves. That topic is covered later in this chapter. DELIVERY Futures on physical commodities can be assigned, much like stock options can be assigned. When a futures contract is assigned, the buyer of the contract is called upon to receive the full contract. Delivery is at the seller's option, meaning that the owner of the contract is informed that he must take delivery. Thus, if a corn contract is assigned, one is forced to receive 5,000 bushels of corn. The old adage about this being dumped in your yard is untrue. One merely receives a warehouse receipt and Chapter 34: Futures and Futures Options 659 is charged for storage. His broker makes the actual arrangements. Futures contracts cannot be assigned at any time during their life, as options can. Rather, there is a short period of time before they expire during which one can take delivery. This is generally a 4- to 6-week period and is called the "notice period" - the time during which one can be notified to accept delivery. The first day upon which the futures contract may be assigned is called the "first notice day," for logical reasons. Speculators close out their positions before the first notice day, leaving the rest of the trading up to the hedgers. Such considerations are not necessary for cash-based futures contracts (the index futures), since there is no physical commodity involved. It is always possible to make a mistake, of course, and receive an assignment when you didn't intend to. Your broker will normally be able to reverse the trade for you, but it will cost you the warehouse fees and generally at least one commission. The terms of the futures contract specify exactly what quantity of the commod­ ity must be delivered, and also specify what form it must be in. Normally this is straightforward, as is the case with gold futures: That contract calls for delivery of 100 troy ounces of gold that is at least 0.995 fine, cast either in one bar or in three one­ kilogram bars. However, in some cases, the commodity necessary for delivery is more compli­ cated, as is the case with Treasury bond futures. The futures contract is stated in terms of a nominal 8% interest rate. However, at any time, it is likely that the pre­ vailing interest rate for long-term Treasury bonds will not be 8%. Therefore, the delivery terms of the futures contract allow for delivery of bonds with other interest rates. Notice that the delivery is at the seller's option. Thus, if one is short the futures and doesn't realize that first notice day has passed, he has no problem, for delivery is under his control. It is only those traders holding long futures who may receive a sur­ prise delivery notice. One must be familiar with the specific terms of the contract and its methods of delivery if he expects to deal in the physical commodity. Such details on each futures contract are readily available from both the exchange and one's broker. However, most futures traders never receive or deliver the physical commodity; they close out their futures contracts before the time at which they can be called upon to make delivery. PRICING OF FUTURES It is beyond the scope of this book to describe futures arbitrage versus the cash com­ modity. Suffice it to say that this arbitrage is done, more in some markets (U.S. Treasury bonds, for example) than others (soybeans). Therefore, futures can be over- 660 Part V: Index Options and Futures priced or underpriced as well. The arbitrage possibilities would be calculated in a manner similar to that described for index futures, the futures premium versus cash being the determining factor. OPTIONS ON FUTURES The reader is somewhat familiar with options on futures, having seen many examples of index futures options. The commercial use of the option is to lock in a worst-case price as opposed to a future price. The U.S. businessman from the earlier example sold Swiss franc futures to lock in a future price. However, he might decide instead to buy Swiss franc futures put options to hedge his downside risk, but still leave room for upside profits if the currency markets move in his favor. DESCRIPTION A futures option is an option on the futures contract, not on the cash commodity. Thus, if one exercises or assigns a futures option, he buys or sells the futures contract. The options are always for one contract of the underlying commodity. Splits and adjustments do not apply in the futures markets as they do for stock options. Futures options generally trade in the same denominations as the future itself ( there are a few exceptions to this rule, such as the T-bond options, which trade in sixty-fourths while the futures trade in thirty-seconds). Example: Soybean options will be used to illustrate the above features of futures options. Suppose that March soybeans are selling at 575. Soybean quotes are in cents. Thus, 575 is $5.75 - soybeans cost $5.75 per bushel. A soybean contract is for 5,000 bushels of soybeans, so a one-cent move is worth $50 (5,000 x .01). - Suppose the following option prices exist. The dollar cost of the options is also shown (one cent is worth $50). Option Price Dollar Cost March 525 put 5 $ 250 March 550 call 35 1/2 $1,775 March 600 call 81/4 $ 412.50 The actual dollar cost is not necessary for the option strategist to determine the profitability of a certain strategy. For example, if one buys the March 600 call, he Chapter 34: Futures and Futures Options 661 needs March soybean futures to be trading at 608.25 or higher at expiration in order to have a profit at that time. This is the normal way in which a call buyer views his break-even point at expiration: strike price plus cost of the call. It is not necessary to know that soybean options are worth $50 per point in order to know that 608.25 is the break-even price at expiration. If the future is a cash settlement future (Eurodollar, S&P 500, and other indices), then the options and futures generally expire simultaneously at the end of trading on the last trading day. (Actually, the S&P's expire on the next morning's opening.) However, options on physical futures will expire before the first notice day of the actual futures contract, in order to give traders time to close out their positions before receiving a delivery notice. The fact that the option expires in advance of the expiration of the underlying future has a slightly odd effect: The option often expires in the month preceding the month used to describe it. Example: Options on March soybean futures are referred to as "March options." They do not actually expire in March - however, the soybean futures do. The rather arcane definition of the last trading day for soybean options is "the last Friday preceding the last business day of the month prior to the contract month by at least 5 business days"! Thus, the March soybean options actually expire in February. Assume that the last Friday of February is the 23rd. If there is no holiday during the business week of February 19th to 23rd, then the soybean options will expire on Friday, February 16th, which is 5 business days before the last Friday of February. However, if President's Day happened to fall on Monday, February 19th, then there would only be four business days during the week of the 19th to the 23rd, so the options would have to expire one Friday earlier, on February 9th. Not too simple, right? The best thing to do is to have a futures and options expi­ ration calendar that one can refer to. Futures Magazine publishes a yearly calendar in its December issue, annually, as well as monthly calendars which are published each month of the year. Alternatively, your broker should be able to provide you with the information. In any case, the March soybean futures options expire in February, well in advance of the first notice day for March soybeans, which is the last business day of the month preceding the expiration month (February 28th in this case). The futures option trader must be careful not to assume that there is a long time between option expiration and first notice day of the futures contract. In certain commodities, the futures first notice day is the day after the options expire (live cattle futures, for example). \ 662 Part V: Index Options and Futures Thus, if one is long calls or short puts and, therefore, acquires a long futures contract via exercise or assignment, respectively, he should be aware of when the first notice day of the futures is; he could receive a delivery notice on his longfutures posi­ tion unexpectedly if he is not paying attention. OTHER TERMS Striking Price Intervals. Just as futures on differing physical commodities have differing terms, so do options on those futures. Striking price intervals are a prime example. Some options have striking prices 5 points apart, while others have strikes only 1 point apart, reflecting the volatility of the futures contract. Specifically, S&P 500 options have striking prices 5 points apart, while soybean options striking prices are 25 points (25 cents) apart, and gold options are 10 points ($10) apart. Moreover, as is often the case ,vith stocks, the striking price differential for a particular com­ modity may change if the price of the commodity itself is vastly different. Example: Gold is quoted in dollars per ounce. Depending on the price of the futures contract, the striking price interval may be changed. The current rules are: Striking Price Interval $10 $20 $50 Price of Futures below $500/oz. between $500 and $1,000/oz. above $1,000/oz. Thus, when gold futures are more expensive, the striking prices are further apart. Note that gold has never traded above $1,000/oz., but the option exchanges are all set if it does. This variability in the striking prices is common for many commodities. In fact, some commodities alter the striking price interval depending on how much time is remaining until expiration, possibly in addition to the actual prices of the futures themselves. Realizing that the striking price intervals may change - that is, that new strikes will be added when the contract nears maturity - may help to plan some strategies, as it will give more choices to the strategist as to which options he can use to hedge or adjust his position. Automatic Exercise. All futures options are subject to automatic exercise as are stock options. In general, a futures option will be exercised automatically, even if it is Chapter 34: Futures and Futures Options 663 one tick in the money. You can give instructions to not have a futures option auto­ matically exercised if you wish. SERIAL OPTIONS Serial options are futures options whose expiration month is not the same as the expi­ ration month of their corresponding underlying futures. Example: Gold futures expire in February, April, June, August, October, and December. There are options that expire in those months as well. Notice that these expirations are spaced two months apart. Thus, when one gold contract expires, there are two months remaining until the next one expires. Most option traders recognize that the heaviest activity in an option series is in the nearest-term option. If the nearest-term option has two months remaining until expiration, it will not draw the trading interest that a shorter-term option would. Recognizing this fact, the exchange has decided that in addition to the regular expiration, there will be an option contract that expires in the nearest non-cycle rrwnth, that is, in the nearest month that does not have an actual gold future expir­ ing. So, if it were currently January 1, there might be gold options expiring in February, March, April, etc. Thus, the March option would be a serial option. There is no actual March gold future. Rather, the March options would be exercisable into Arpl futures. Serial options are exercisable into the nearest actual futures contract that exists after the options' expiration date. The number of serial option expirations depends on the underlying commodity. For example, gold will always have at least one serial option trading, per the definition highlighted in the example above. Certain futures whose expirations are three months apart (S&P 500 and all currency options) have serial options for the nearest two months that are not represented by an actual futures contract. Sugar, on the other hand, has only one serial option expiration per year - in December - to span the gap that exists between the normal October and March sugar futures expirations. Strategists trading in options that may have serial expirations should be careful in how they evaluate their strategies. For example, June S&P 500 futures options strategies can be planned with respect to where the underlying S&P 500 Index of stocks will be at expiration, for the June options are exercisable into the June futures, which settle at the same price as the Index itself on the last day of trading. However, if one is trading April S&P 500 options, he must plan his strategy on where the June futures contract is going to be trading at April expiration. The April options are exer- 664 Part V: Index Options and Futures cisable into the June futures at April expiration. Since the June futures contract will still have some time premium in it in April, the strategist cannot plan his strategy with respect to where the actual S&P 500 Index will be in April. Example: The S&P 500 Stock Index (symbol SPX) is trading at 410.50. The follow­ ing prices exist: Cash (SPX): 410.50 June futures: 415.00 Options April 415 coll: 5.00 June 415 coll: 10.00 If one buys the June 415 call for 10.00, he knows that the SPX Index will have to rise to 425.00 in order for his call purchase to break even at June expiration. Since the SPX is currently at 410.50, a rise of 14.50 by the cash index itself will be neces­ sary for break-even at June expiration. However, a similar analysis will not work for calculating the break-even price for the April 415 call at April expiration. Since 5.00 points are being paid for the 415 call, the break-even at April expiration is 420. But exactly what needs to be at 420? The June future, since that is what the April calls are exercisable into. Currently, the June futures are trading at a premium of 4.50 to the cash index (415.00 - 410.50). However, by April expiration, the fair value of that premium will have shrunk. Suppose that fair .value is projected to be 3.50 premium at April expi­ ration. Then the SPX would have to be at 416.50 in order for the June futures to be fairly valued at 420.00 (416.50 + 3.50 = 420.00). Consequently, the SPX cash index would have to rise 6 points, from 410.50 to 416.50, in order for the June futures to trade at 420 at April expiration. If this hap­ pened, the April 415 call purchase would break even at expiration. Quote symbols for futures options have improved greatly over the years. Most vendors use the convenient method of stating the striking price as a numeric num­ ber. The only "code" that is required is that of the expiration month. The codes for futures and futures options expiration months are shown in Table 34-1. Thus, a March (2002) soybean 600 call would use a symbol that is something like SH2C600, where S is the symbol for soybeans, H is the symbol for March, 2 means 2002, C stands for call option, and 600 is the striking price. This is a lot simpler and more flex­ ible than stock options. There is no need for assigning striking prices to letters of the alphabet, as stocks do, to everyone's great consternation and confusion. Chapter 34: Futures and Futures Options TABLE 34-1. Month symbols for futures or futures options. Futures or Futures Options Expiration Month Month Symbol January F February G March H April J May K June M July N August Q September u October V November X December z 665 Bid-Offer Spread. The actual markets - bids and offers - for most futures options are not generally available from quote vendors ( options traded on the Chicago Mere are usually a pleasant exception). The same is true for futures con­ tracts themselves. One can always request a ~rket from the trading floor, but that is a time-consuming process and is impractic!al if one is attempting to analyze a large number of options. Strategists who are used to dealing in stock or index options will find this to be a major inconvenience. The situation has persisted for years and shows no sign of improving. Commissions. Futures traders generally pay a commission only on the closing side of a trade. If a speculator first buys gold futures, he pays no commission at that time. Later, when he sells what he is long - closes his position - he is charged a com­ mission. This is referred to as a "round-tum" commission, for obvious reasons. Many futures brokerage firms treat future options the same way - with a round-tum com­ mission. Stock option traders are used to paying a commission on every buy and sell, and there are still a few futures option brokers who treat futures options that way, too. This is an important difference. Consider the following example. Example: A futures option trader has been paying a commission of $15 per side - that is, he pays a commission of $15 per contract each time he buys and sells. His bro- 666 Part V: Index Options and Futures ker informs him one day that they are going to charge him $30 per round tum, payable up front, rather than $15 per side. That is the way most futures option bro­ kerage firms charge their commissions these days. Is this the same thing, $15 per side or $30 round turn, paid up front? No, it is not! What happens if you buy an option and it expires worthless? You have already paid the commission for a trade that, in effect, never took place. Nevertheless, there is little you can do about it, for it has become the industry standard to charge round-turn commission on futures options. In either case, commissions are negotiated to a flat rate by many traders. Discount futures commission merchants (i.e., brokerage houses) often attract business this way. In general, this method of paying commissions is to the customer's benefit. However, it does have a hidden effect that the option trader should pay attention to. This effect makes it potentially more profitable to trade options on some futures than on others. Example: A customer who buys com futures pays $30 per round turn in option com­ missions. Since corn options are worth $50 per one point (one cent), he is paying 0.60 of a point every time he trades a corn option (30/50 = 0.60). Now, consider the same customer trading options on the S&P 500 futures. The S&P 500 futures and options are worth $250 per point. So, he is paying only 0.12 of a point to trade S&P 500 options (30/250 = .12). He clearly stands a much better chance of making money in an S&P 500 option than he does in a corn option. He could buy an S&P option at 5.00 and sell it at 5.20 and make .08 points profit. However, with com options, if he buys an option at 5, he needs to sell it at 55/s to make money- a substantial difference between the two con­ tracts. In fact, if he is participating in spread strategies and trading many options, the differential is even more important. Position limits exist for futures options. While the limits for financial futures are generally large, other futures - especially agricultural ones - may have small limits. A large speculator who is doing spreads might inadvertently exceed a smaller limit. Therefore, one should check with his broker for exact limits in the various futures options before acquiring a large position. ) OPTION MARGINS Futures option margin requirements are generally more logical than equity or index option requirements. For example, if one has a conversion or reversal arbitrage in place, his requirement would be nearly zero for futures options, while it could be quite large for equity options. Moreover, futures exchanges have introduced a better way of margining futures and futures option portfolios. Chapter 34: Futures and Futures Options 667 SPAN Margin. The SPAN margin system (Standard Portfolio ANalysis of Risk) is used by nearly all of the exchanges. SPAN is designed to determine the entire risk of a portfolio, including all futures and options. It is a unique system in that it bases the option requirements on projected movements in the futures contracts as well as on potential changes in implied volatility of the options in one's portfolio. This cre­ ates a more realistic measure of the risk than the somewhat arbitrary requirements that were previously used (called the "customer margin" system) or than those used for stock and index options. Not all futures clearing firms automatically put their customers on SPAN mar­ gin. Some use the older customer margin system for most of their option accounts. As a strategist, it would be beneficial to be under SPAN margin. Thus, one should deal with a broker who will grant SPAN margin. The main advantages of SPAN margin to the strategist are twofold. First, naked option margin requirements are generally less; second, certain long option requirements are reduced as well. This second point may seem somewhat unusual - margin on long options? SPAN calculates the amount of a long option's value that is at risk for the current day. Obviously, if there is time remaining until expiration, a call option will still have some value even if the underlying futures trade down the limit. SPAN attempts to calculate this remaining value. If that value is less than the market price of the option, the excess can be applied toward any other requirement in the portfoliol Obviously, in-the-money options would have a greater excess value under this system. ~ How SPAN Works. Certain basic requirements are determined by the futures exchange, such as the amount of movement by the futures contract that must be mar­ gined (maintenance margin). Once that is known, the exchange's computers gener­ ate an array of potential gains and losses for the next day's trading, based on futures movement within a range of prices and based on volatility changes. These results are stored in a "risk array." There is a different risk array generated for each futures con­ tract and each option contract. The clearing member (your broker) or you do not have to do any calculations other than to see how the quantities of futures and options in your portfolio are affected under the gains or losses in the SPAN risk array. The exchange does all the mathematical calculations needed to project the potential gains or losses. The results of those calculations are presented in the risk array. There are 16 items in the risk array: For seven different futures prices, SPAN projects a gain or loss for both increased and decreased volatility; that makes 14 items. SPAN also projects a profit or loss for an "extreme" upward move and an "extreme" downward move. The futures exchange determines the exact definition of "extreme," and defines "increased" or "decreased" volatility. 668 Part V: Index Options and Futures SPAN "margin" applies to futures contracts as well, although volatility consid­ erations don't mean anything in terms of evaluating the actual futures risk As a first example, consider how SPAN would evaluate the risk of a futures contract. Example: The S&P 500 futures will be used for this example. Suppose that the Chicago Mercantile Exchange determines that the required maintenance margin for the futures is $10,000, which represents a 20-point move by the futures (recall that S&P futures are worth $500 per point). Moreover, the exchange determines that an "extreme" move is 14 points, or $7,000 of risk Scenario Futures unchanged; volatility up Futures unchanged; volatility down Futures up one-third of range; volatility up Futures up one-third of range; volatility down Futures down one-third of range; volatility up Futures down one-third of range; volatility down Futures up two-thirds of range; volatility up Futures up two-thirds of range; volatility down Futures down two-thirds of range; volatility up Futures down two-thirds of range; volatility down Futures up three-thirds of range; volatility up Futures up three-thirds of range; volatility down Futures down three-thirds of range; volatility up Futures down three-thirds of range; volatility down Futures up "extreme" move Futures down "extreme" move Long 1 Future Potential Pit/Loss 0 0 + 3,330 + 3,330 - 3,330 - 3,330 + 6,670 + 6,670 - 6,670 - 6,670 + 10,000 + l 0,000 -10,000 - 10,000 + 7,000 - 7,000 The 16 array items are always displayed in this order. Note that since this array is for a futures contract, the "volatility up" and "volatility down" scenarios are always the same, since the volatility that is referred to is the one that is used as the input to an option pricing model. Notice that the actual price of the futures contract is not needed in order to generate the risk array. The SPAN requirement is always the largest potential loss from the array. Thus, if one were long one S&P 500 futures contract, his SPAN mar­ gin requirement would be $10,000, which occurs under the "futures down three­ thirds" scenarios. This will always be the maintenance margin for a futures contract. Cl,apter 34: Futures and Futures Options 669 Now let us consider an option example. In this type of calculation, the exchange uses the same moves by the underlying futures contract and calculates the option theoretical values as they would exist on the next trading day. One calculation is per­ formed for volatility increasing and one for volatility decreasing. Example: Using the same S&P 500 futures contract, the following array might depict the risk array for a long December 410 call. One does not need to know the option or futures price in order to use the array; the exchange incorporates that information into the model used to generate the potential gains and losses. Scenario Futures unchanged; volatility up Futures unchanged; volatility down Futures up one-third of range; volatility up Futures up one-third of range; volatility down Futures down one-third of range; volatility up Futures down one-third of range; volatility down Futures up two-thirds of range; volatility up Futures up two-thirds of range; volatility down Futures down two-thirds of range; volatility ur Futures down two-thirds of range; volatility /o:n Futures up three-thirds of range; volatility up Futures up three-thirds of range; volatility down Futures down three-thirds of range; volatility up Futures down three-thirds of range; volatility down Futures up "extreme" move Futures down "extreme" move Long 1 Dec 410 call Potential Ph/Loss + 460 610 + 2,640 + 1,730 - 1,270 - 2,340 + 5,210 + 4,540 - 2,540 - 3,430 + 8,060 + 7,640 - 3,380 - 3,990 + 3,130 - 1,500 The items in the risk array are all quite logical: Upward futures movements pro­ duce profits and downward futures movements produce losses in the long call posi­ tion. Moreover, worse results are always obtained by using the lower volatility as opposed to the higher one. In this particular example, the SPAN requirement would be $3,990 ("futures down three-thirds; volatility down"). That is, the SPAN system predicts that you could lose $3,990 of your call value if futures fell by their entire range and volatility decreased - a worst-case scenario. Therefore, that is the amount of margin one is required to keep for this long option position. 670 Part V: Index Options and Futures While the exchange does not tell us how much of an increase or decrease it uses in terms of volatility, one can get something of a feel for the magnitude by looking at the first two lines of the table. The exchange is saying that if the futures are unchanged tomorrow, but volatility "increases," then the call will increase in value by $460 (92 cents); if it "decreases," however, the call will lose $610 (1.22 points) of value. These are large piice changes, so one can assume that the volatility assump­ tions are significant. The real ease of use of the SPAN iisk array is when it comes to evaluating the iisk of a more complicated position, or even a portfolio of options. All one needs to do is to combine the risk array factors for each option or future in the position in order to arrive at the total requirement. Example: Using the above two examples, one can see what the SPAN requirements would be for a covered wiite: long the S&P future and short the Dec 410 call. Short 1 Long Dec 410 call 1 S&P Potential Covered Scenario Future Pft/Loss Write Futures unchanged; vol. up 0 460 - 460 Futures unchanged; vol. down 0 + 610 + 610 Futures up 1 /3 of range; vol. up + 3,330 - 2,640 + 690 Futures up 1 /3 of range; vol. down + 3,330 - 1,730 + 1,600 Futures down 1 /3 of range; vol. up - 3,330 + 1,270 -2,060 Futures down 1 /3 of range; vol. down 3,330 + 2,340 - 990 Futures up 2/3 of range; vol. up + 6,670 - 5,210 + 1,460 Futures up 2/3 of range; vol. down + 6,670 - 4,540 +2, 130 Futures down 2/3 of range; vol. up 6,670 + 2,540 -4, 130 Futures down 2/3 of range; vol. down - 6,670 + 3,430 -3,240 Futures up 3/3 of range; vol. up + 10,000 - 8,060 + 1,940 Futures up 3/3 of range; vol. down + 10,000 - 7,640 +2,360 Futures down 3/3 of range; vol. up -10,000 + 3,380 -6,620 Futures down 3/3 of range; vol. down -10,000 + 3,990 -6,010 Futures up ,, extreme" move + 7,000 - 3,130 +3\870 Futures down "extreme" move - 7,000 + 1,500 -5,500 As might be expected, the worst-case projection for a covered wiite is for the stock to drop, but for the implied volatility to increase. The SPAN system projects that this covered wiiter would lose $6,620 if that happened. Thus, "futures down 3/3 of range; volatility up" is the SPAN requirement, $6,620. Chapter 34: Futures and Futures Options 671 As a means of comparison, under the older "customer margin" option require­ ments, the requirement for a covered write was the futures margin, plus the option premium, less one-half the out-of-the-money amount. In the above example, assume the futures were at 408 and the call was trading at 8. The customer covered write margin would then be more than twice the SPAN requirement: Futures margin Option premium 1/2 out-of-money amount $10,000 + 4,000 - 1,000 $13,000 Obviously, one can alter the quantities in the use of the risk array quite easily. For example, ifhe had a ratio write oflong 3 futures and short 5 December 410 calls, he could easily calculate the SPAN requirement by multiplying the projected futures gains and losses by 3, multiplying the projected option gains and losses by 5, and adding the two together to obtain the total requirement. Once he had completed this calculation, his SPAN requirement would be the worst expected loss as projected by SPAN for the next trading day. In actual practice, the SPAN calculations are even more sophisticated: They take into account a certain minimum option margin (for deeply out-of-the-money options); they account for spreads between futures contracts on the same commodi­ ty (different expiration months); they add a delivery month charge (if you are hold­ ing a position past the first notice day); ~ they even allow for slightly reduced requirements for related, but different, futures spreads (T-bills versus T-bonds, for example). If you are interested in calculating SPAN margin yourself, your broker may be able to provide you with the software to do so. More likely, though, he will provide the service of calculating the SPAN margin on a position prior to your establishing it. The details for obtaining the SPAN margin requirements should thus be requested from your broker. PHYSICAL CURRENCY OPTIONS Another group oflisted options on a physical is the currency options that trade on the Philadelphia Stock Exchange (PHLX). In addition, there is an even larger over-the­ counter market in foreign currency options. Since the physical commodity underly­ ing the option is currency, in some sense of the word, these are cash-based options as well. However, the cash that the options are based in is not dollars, but rather may be deutsche marks, Swiss francs, British pounds, Canadian dollars, French francs, or 672 Part V: Index Options and Futures Japanese yen. Futures trade in these same currencies on the Chicago Mercantile Exchange. Hence, many traders of the physical options use the Chicago-based futures as a hedge for their positions. Unlike stock options, currency options do not have standardized terms - the amount of currency underlying the option contract is not the same in each of the cases. The striking price intervals and units of trading are not the same either. However, since there are only the six different contracts and since their terms corre­ spond to the details of the futures contracts, these options have had much success. The foreign currency markets are some of the largest in the world, and that size is reflected in the liquidity of the futures on these currencies. The Swiss franc contract will be used to illustrate the workings of the foreign currency options. The other types of foreign currency options work in a similar man­ ner, although they are for differing amounts of foreign currency. The amount of for­ eign currency controlled by the foreign currency contract is the unit of trading, just as 100 shares of stock is the unit of trading for stock options. The unit of trading for the Swiss franc option on the PHLX is 62,500 Swiss francs. Normally, the currency itself is quoted in terms of U.S. dollars. For example, a Swiss franc quote of 0.50 would mean that one Swiss franc is worth 50 cents in U.S. currency. Note that when one takes a position in foreign currency options (or futures), he is simultaneously taking an opposite position in U.S. dollars. That is, if one owns a Swiss franc call, he is long the franc (at least delta long) and is by implication there­ fore short U.S. dollars. Striking prices in Swiss options are assigned in one-cent increments and are stated in cents, not dollars. That is, if the Swiss franc is trading at 50 cents, then there might be striking prices of 48, 49, 50, 51, and 52. Given the unit of trading and the striking price in U.S. dollars, one can compute the total dollars involved in a foreign currency exercise or assignment. Example: Suppose the Swiss franc is trading at 0.50 and there are striking prices of 48, 50, and 52, representing U.S. cents per Swiss franc. If one were to exercise a call with a strike of 48, then the dollars involved in the exercise would be 125,000 (the unit of trading) times 0.48 (the strike in U.S. dollars), or $60,000. Option premiums are stated in U.S. cents. That is, if a Swiss franc option is quoted at 0. 75, its cost is $.0075 times the unit of trading, 125,000, for a total of $937.50. Premiums are quoted in hundredths of a point. That is, the next "tick" from 0.75 would be 0.76. Thus, for the Swiss franc options, each tick or hundredth of a point is equal to $12.50 (.0001 x 125,000). Chapter 34: Futures and Futures Options 673 Actual delivery of the security to satisfy an assignment notice must occur with­ in the country of origin. That is, the seller of the currency must make arrangements to deliver the currency in its country of origin. On exercise or assignment, sellers of currency would be put holders who exercise or call writers who are assigned. Thus, if one were short Swiss franc calls and he were assigned, he would have to deliver Swiss francs into a bank in Switzerland. This essentially means that there have to be agreements between your firm or your broker and foreign banks if you expect to exercise or be assigned. The actual payment for the exercise or assignment takes place between the broker and the Options Clearing Corporation (OCC) in U.S. dol­ lars. The OCC then can receive or deliver the currency in its country of origin, since OCC has arrangements with banks in each country. EXERCISE AND ASSIGNMENT The currency options that trade on the PHLX (Philadelphia Exchange) have exercise privileges similar to those for all other options that we have studied: They can be exercised at any time during their life. Even though PHLX currency options are "cash" options in the most literal sense of the word, they do not expose the writer to the same risks of early assignment that cash-based index options do. Example: Suppose that a currency trader has established the following spread on the PHLX: long Swiss franc December 50 puts, short Swiss franc December 52 puts - a bullish spread. As in any one-to-one spread, there is limited risk. However, the dol­ lar rallies and the Swiss franc falls, pushing the exchange rate down to 48 cents (U.S.) per Swiss franc. Now the puts that were wri,tten - the December 52 contracts - are deeply in-the-money and might be subject to early assignment, as would any deeply in-the-money put if it were trading at a discount. Suppose the trader learns that he has indeed been assigned on his short puts. He still has a hedge, for he is long the December 50 puts and he is now long Swiss francs. This is still a hedged position, and he still has the same limited risk as he did when he started (plus possibly some costs involved in taking physical delivery of the francs). This situation is essentially the same as that of a spreader in stock or futures options, who would still be hedged after an assignment because he would have acquired the stock or future. Contrast this to the cash-based index option, in which there is no longer a hedge after an assignment. 674 Part V: Index Options and Futures FUTURES OPTION TRADING STRATEGIES The strategies described here are those that are unique to futures option trading. Although there may be some general relationships to stock and index option strate­ gies, for the most part these strategies apply only to futures options. It will also be shown - in the backspread and ratio spread examples - that one can compute the profitability of an option spread in the same manner, no matter what the underlying instrument is (stocks, futures, etc.) by breaking everything down into "points" and not "dollars." Before getting into specific strategies, it might prove useful to observe some relationships about futures options and their price relationships to each other and to the futures contract itself. Carrying cost and dividends are built into the price of stock and index options, because the underlying instrument pays dividends and one has to pay cash to buy or sell the stock. Such is not the case with futures. The "investment" required to buy a futures contract is not initially a cash outlay. Note that the cost of carry associated with futures generally refers to the carrying cost of owning the cash commodity itself. That carrying cost has no bearing on the price of a futures option other than to determine the futures price itself. Moreover, the future has no divi­ dends or similar payout. This is even true for something like U.S. Treasury bond options, because the interest rate payout of the cash bond is built into the futures price; thus, the option, which is based on the futures price and not directly on the cash price, does not have to allow for carry, since the future itself has no initial car­ rying costs associated with it. Simplistically, it can be stated that: Futures Call = Futures Put + Futures Price - Strike Price Example: April crude oil futures closed at 18.74 ($18.74 per barrel). The following prices exist: Strike April Call April Put Put + Futures Price Price Price - Strike 17 1.80 0.06 1.80 18 0.96 0.22 0.96 19 0.35 0.61 \ 0.35 20 0.10 1.36 0.10 Note that, at every strike, the above formula is true (Call = Put + Futures - Strike). These are not theoretical prices; they were taken from actual settlement prices on a particular trading day. Chapter 34: Futures and Futures Options 675 In reality, where deeply in-the-money or longer-term options are involved, this simple formula is not correct. However, for most options on a particular nearby futures contract, it will suffice quite well. Examine the quotes in today's newspaper to verify that this is a true statement. A subcase of this observation is that when the futures contract is exactly at the striking price, the call and put with that strike will both trade at the same price. Note that in the above formula, if one sets the futures price equal to the striking price, the last two terms cancel out and one is left with: Call price = Put price. One final observation before getting into strategies: For a put and a call with the same strike, Net change call - Net change put = Net change futures This is a true statement for stock and index options as well, and is a useful rule to remember. Since futures options bid and offer quotes are not always disseminat­ ed by quote vendors, one is forced to use last sales. If the last sales don't conform to the rule above, then at least one of the last sales is probably not representative of the true market in the options. Example: April crude oil is up 50 cents to 19.24. A trader punches up the following quotes on his machine and sees the following prices: Option April 19 call: April 19 put: Last Sale 0.55 0.31 These options conform to the abo~rule: Net change futures = Net change call - Net change put = +0.20 - (-0.30) = +0.50 Net Change + 0.20 - 0.30 The net changes of the call and put indicate the April future should be up 50 cents, which it is. Suppose that one also priced a less active option on his quote machine and saw the following: Option April 17 call: April 17 put: Last Sale 2.10 0.04 Net Change + 0.30 - 0.02 676 Part V: Index Options and Futures In this case, the formula yields an incorrect result: Net change futures= +0.30 - (-0.02) = +0.32 Since the futures are really up 50 cents, one can assume that one of the last sales is out of date. It is obviously the April 17 call, since that is the in-the-money option; if one were to ask for a quote from the trading floor, that option would probably be indicated up about 48 cents on the day. DELTA While we are on the subject of pricing, a word about delta may be in order as well. The delta of a futures option has the same meaning as the delta of a stock option: It is the amount by which the option is expected to increase in price for a one-point move in the underlying futures contract. As we also know, it is an instantaneous meas­ urement that is obtained by taking the first derivative of the option pricing model. In any case, the delta of an at-the-money stock or index option is greater than 0.50; the more time remaining to expiration, the higher the delta is. In a simplified sense, this has to do with the cost of carrying the value of the striking price until the option expires. But part of it is also due to the distribution of stock price movements - there is an upward bias, and with a long time remaining until expiration, that bias makes call movements more pronounced than put movements. Options on futures do not have the carrying cost feature to deal with, but they do have the positive bias in their price distribution. A futures contract, just like a stock, can increase by more than 100%, but cannot fall more than 100%. Consequently, deltas of at-the-money futures calls will be slightly larger than 0.50. The more time remaining until expiration of the futures option, the higher the at-the­ money call delta will be. Many traders erroneously believe that the delta of an at-the-money futures option is 0.50, since there is no carrying cost involved in the futures conversion or reversal arbitrage. That is not a true statement, since the distribution of futures prices affects the delta as well. As always, for futures options as well as for stock and index options, the delta of a put is related to the delta of a call with the same striking price and expiration date: Delta of put = 1 - Delta of call Finally, the concept of equivalent stock position applies to futures optin strate­ gies, except, of course, it is called the equivalent futures position (EFP). The EFP is calculated by the simple formula: EFP = Delta of option x Option quantity Chapter 34: Futures and Futures Options 677 Thus, if one is long 8 calls with a delta of 0. 75, then that position has an EFP of 6 (8 x 0.75). This means that being long those 8 calls is the same as being long 6 futures contracts. Note that in the case of stocks, the equivalent stock position formula has anoth­ er factor shares per option. That concept does not apply to futures options, since they are always options on one futures contract. MATHEMATICAL CONSIDERATIONS This brief section discusses modeling considerations for futures options and options on physicals. Futures Options. The Black model (see Chapter 33 on mathematical consider­ ations for index options) is used to price futures options. Recall that futures don't pay dividends, so there is no dividend adjustment necessary for the model. In addition, there is no carrying cost involved with futures, so the only adjustment that one needs to make is to use 0% as the interest rate input to the Black-Scholes model. This is an oversimplification, especially for deeply in-the-money options. One is tying up some money in order to buy an option. Hence, the Black model will discount the price from the Black-Scholes model price. Therefore, the actual pricing model to be used for theoretical evaluation of futures options is the Black model, which is merely the Black-Scholes model, using 0% as the interest rate, and then discounted: Call Theoretical Price = e-rt x Black-Scholes formula [r = O] Recall that it was stated above that: Futures call = Futures put + Future price - Strike price The actual relationship is: ~ Futures call= Futures put+ e-rt (Futures price - Strike price) where r = the short-term interest rate, t = the time to expiration in years, and e-rt = the discounting factor. The short-term interest rate has to be used here because when one pays a debit for an option, he is theoretically losing the interest that he could earn if he had that money in the bank instead, earning money at the short-term interest rate. The difference between these two formulae is so small for nearby options that are not deeply in-the-money that it is normally less than the bid-asked spread in the options, and the first equation can be used. 678 Part V: Index Options and Futures Example: The table below compares the theoretical values computed with the two formulae, where r = 6% and t = 0.25 (1/4 of a year). Furthermore, assume the futures price is 100. The strike price is given in the first column, and the put price is given in the second column. The predicted call prices according to each formula are then shown in the next two columns. Put Formula l Formula 2 Strike Price (Simple) ( Using e-rf) 70 0.25 30.25 29.80 80 1.00 21.00 20.70 90 3.25 13.25 13.10 95 5.35 10.35 10.28 100 7.50 7.50 7.50 105 10.70 5.70 5.77 110 13.90 3.90 4.05 120 21.80 1.80 2.10 For options that are 20 or 30 points in- or out-of-the-money, there is a notice­ able differential in these three-month options. However, for options closer to the strike, the differential is small. If the time remaining to expiration is shorter than that used in the example above, the differences are smaller; if the time is longer, the differences are magnified. Options on Physicals. Determining the fair value of options on physicals such as currencies is more complicated. The proper way to calculate the fair value of an option on a physical is quite similar to that used for stock options. Recall that in the case of stock options, one first subtracts the present worth of the dividend from the current stock price before calculating the option value. A similar process is used for determining the fair value of currency or any other options on physicals. In any of these cases, the underlying security bears interest continuously, instead of quarterly as stocks do. Therefore, all one needs to do is to subtract from the underlying price the amount of interest to be paid until option expiration and then add the amount of accrued interest to be paid. All other inputs into the Black-Scholes model would remain the same, including the risk-free interest rate being equal to the 90-day T-bill rate. Again, the practical option strategist has a shortcut available to him. If one assumes that the various factors necessary to price currencies have been assimilated into the futures markets in Chicago, then one can merely use the futures price as the price of the underlying for evaluating the physical delivery options in Philadelphia. Chapter 34: Futures and Futures Options 679 This will not work well near expiration, since the future expires one week prior to the PHLX option. In addition, it ignores the early exercise value of the PHLX options. However, except for these small differentials, the shortcut will give theoretical values that can be used in strategy-making decisions. Example: It is sometime in April and one desires to calculate the theoretical values of the June deutsche mark physical delivery options in Philadelphia. Assume that one knows four of the basic items necessary for input to the Black-Scholes formula: 60 days to expiration, strike price of 68, interest rate of 10%, and volatility of 18%. But what should be used as the price of the underlying deutsche mark? Merely use the price of the June deutsche mark futures contract in Chicago. STRATEGIES REGARDING TRADING LIMITS The fact that trading limits exist in most futures contracts could be detrimental to both option buyers and option writers. At other times, however, the trading limit may present a unique opportunity. The following section focuses on who might benefit from trading limits in futures and who would not.. Recall that a trading limit in a futures contract limits the absolute number of points that the contract can trade up or down from the previous close. Thus, if the trading limit in T-bonds is 3 points and they closed last night at 7 421132, then the high­ est they can trade on the next day is 7721132, regardless of what might be happening in the cash bond market. Trading limits exist in many futures contracts in order to help ensure that the market cannot be manipulated by someone forcing the price to move tremendously in one direction or the other. Another reason for having trading limits is ostensibly to allow only a fixed move, approximately equal to the amount cov­ ered by the initial margin, so that maintenance margin can be collected if need be. However, limits have been applied in case~which they are unnecessary. For exam­ ple, in T-bonds, there is too much liquidity for anyone to be able to manipulate the market. Moreover, it is relatively easy to arbitrage the T-bond futures contract against cash bonds. This also increases liquidity and would keep the future from trading at a price substantially different from its theoretical value. Sometimes the markets actually need to move far quickly and cannot because of the trading limit. Perhaps cash bonds have rallied 4 points, when the limit is 3 points. This makes no difference when a futures contract has risen as high as it can go for the day, it is bid there (a situation called "limit bid") and usually doesn't trade again as long as the underlying commodity moves higher. It is, of course, possible for a future to be limit bid, only to find that later in the day, the underlying commodity becomes weaker, and traders begin to sell the future, driving it down off the limit. 680 Part V: Index Options and Futures Similar situations can also occur on the downside, where, if the future has traded as low as it can go, it is said to be "limit offered." As was pointed out earlier, futures options sometimes have trading limits imposed on them as well. This limit is of the same magnitude as the futures limit. Most of these are on the Chicago Board of Trade (all grains, U.S. Treasury bonds, Municipal Bond Index, Nikkei stock index, and silver), although currency options on the Chicago Mere are included as well. In other markets, options are free to trade, even though futures have effectively halted because they are up or down the limit. However, even in the situations in which futures options themselves have a trading limit, there may be out-of-the-money options available for trading that have not reached their trading limit. When options are still trading, one can use them to imply the price at which the futures would be trading, were they not at their trading limit. Example: August soybeans have been inflated in price due to drought fears, having closed on Friday at 650 ($6.50 per bushel). However, over the weekend it rains heav­ ily in the Midwest, and it appears that the drought fears were overblown. Soybeans open down 30 cents, to 620, down the allowable 30-cent limit. Furthermore, there are no buyers at that level and the August bean contract is locked limit down. No fur­ ther trading ensues. One may be able to use the August soybean options as a price discovery mech­ anism to see where August soybeans would be trading if they were open. Suppose that the following prices exist, even though August soybeans are not trading because they are locked limit down: Lost Sole Net Change Option Price for the Day August 625 call 19 - 21 August 625 put 31 +16 An option strategist knows that synthetic long futures can be created by buying a call and selling a put, or vice versa for short futures. Knowing this, one can tell what price futures are projected to be trading at: Implied Futures Price = Strike Price + Call Price - Put Price = 625 + 19 - 31 = 613 With these options at the prices shown, one can create a synthetic futures posi­ tion at a price of 613. Therefore, the implied price for August soybean futures in this example is 613. Chapter 34: Futures and Futures Options 681 Note that this formula is merely another version of the one previously present­ ed in this chapter. In the example above, neither of the options in question had moved the 30- point limit, which applies to soybean options as well as to soybean futures. If they had, they would not be useable in the formula for implying the price of the future. Only options that are freely trading - not limit up or down - can be used in the above formula. A more complete look at soybean futures options on the day they opened and stayed down the limit would reveal that some of them are not tradeable either: Example: Continuing the above example, August soybeans are locked limit down 30 cents on the day. The following list shows a wider array of option prices. Any option that is either up or down 30 cents on the day has also reached its trading limit, and therefore could not be used in the process necessary to discover the implied price of the August futures contract. last Sale Net Change Option Price for the Day August 550 call 71 - 30 August 575 call 48 30 August 600 call 31 - 26 August 625 call 19 - 21 August 650 call 11 - 15 August 675 call 6 - 10 August 550 put 4 + 3 August 575 put 9 + 6 August 600 put 18 + 11 August 625 put -----------31 + 16 August 650 put 48 + 22 August 675 put 67 + 30 The deeply in-the-money calls, August 550's and August 575's, and the deeply in­ the-money August 675 puts are all at the trading limit. All other options are freely trad­ ing and could be used for the above computation of the August future's implied price. One may ask how the market-makers are able to create markets for the options when the future is not freely trading. They are pricing the options off cash quotes. Knowing the cash quote, they can imply the price of the future (613 in this case), and they can then make option markets as well. 682 Part V: Index Options and Futures The real value in being able to use the options when a future is locked limit up or limit down, of course, is to be able to hedge one's position. Simplistically, if a trad­ er came in long the August soybean futures and they were locked limit down as in the example above, he could use the puts and calls to effectively close out his posi­ tion. Example: As before, August soybeans are at 620, locked down the limit of 30 cents. A trader has come into this trading day long the futures and he is very worried. He cannot liquidate his long position, and if soybeans should open down the limit again tomorrow, his account will be wiped out. He can use the August options to close out his position. Recall that it has been shown that the following is true: Long put + Short call is equivalent to short stock. It is also equivalent to short futures, of course. So if this trader were to buy a put and short a call at the same strike, then he would have the equivalent of a short futures position to offset his long futures position. Using the following prices, which are the same as before, one can see how his risk is limited to the effective futures price of 613. That is, buying the put and selling the call is the same as selling his futures out at 613, down 37 cents on the trading day. Current prices: Option August 625 call August 625 put Position: Buy August 625 put for 19 Sell August 625 call for 31 August Futures at Option Expiration Put Price 575 50 600 25 613 12 625 0 650 0 Put P/L + $1,900 600 - 1,900 - 3,100 3,100 Last Sale Price 19 31 Call Price 0 0 0 0 25 Call P/L +$1,900 + 1,900 + 1,900 + 1,900 600 Net Change for the Day -21 +16 Net Profit or loss on Position +$3,800 + 1,300 0 - 1,200 - 3,700 Otapter 34: Futures and Futures Options 683 This profit table shows that selling the August 625 call at 19 and buying the August 625 put at 31 is equivalent to - that is, it has the same profit potential as - selling the August future at 613. So, if one buys the put and sells the call, he will effectively have sold his future at 613 and taken his loss. His resultant position after buying the put and selling the call would be a con­ version (long futures, long put, and short call). The margin required for a conversion or reversal is zero in the futures market. The margin rules recognize the riskless nature of such a strategy. Thus, any excess money that he has after paying for the unrealized loss in the futures will be freed up for new trades. The futures trader does not have to completely hedge off his position ifhe does not want to. He might decide to just buy a put to limit the downside risk. Unfortunately, to do so after the futures are already locked limit down may be too lit­ tle, too late. There are many kinds of partial hedges that he could establish - buy some puts, sell some calls, utilize different strikes, etc. The same or similar strategies could be used by a naked option seller who can­ not hedge his position because it is up the limit. He could also utilize options that are still in free trading to create a synthetic futures position. Futures options generally have enough out-of-the-money striking prices listed that some of them will still be free trading, even if the futures are up or down the limit. This fact is a boon to anyone who has a losing position that has moved the daily trading limit. Knowing how to use just this one option trading strategy should be a worthwhile benefit to many futures traders. COMMONPLACE MISPRICING STRATEGIES Futures options are sometimes prone to severe mispricing. Of course, any product's options may be subject to mispricing from time to time. However, it seems to appear in futures options more often than it does in stock options. The following discussion of strategies concentrates on a specific pattern of futures options mispricing that occurs with relative frequency. It generally m{inifests itself in that out-of-the-money puts are too cheap, and out-of-the-money calls are too expensive. The proper term for this phenomenon is "volatility skewing" and it is discussed further in Chapter 36 on advanced concepts. In this chapter, we concentrate on how to spot it and how to attempt to profit from it. Occasionally, stock options exhibit this trait to a certain extent. Generally, it occurs in stocks when speculators have it in their minds that a stock is going to expe­ rience a sudden, substantial rise in price. They then bid up the out-of-the-money calls, particularly the near-term ones, as they attempt to capitalize on their bullish expectations. When takeover rumors abound, stock options display this mispricing 684 Part V: Index Options and Futures pattern. Mispricing is, of course, a statistically related term; it does not infer anything about the possible validity of takeover rumors. A significant amount of discussion is going to be spent on this topic, because the futures option trader will have ample opportunities to see and capitalize on this mis­ pricing pattern; it is not something that just comes along rarely. He should therefore be prepared to make it work to his advantage. Example: January soybeans are trading at 583 ($5.83 per bushel). The following prices exist: Strike 525 550 575 600 625 650 675 January beans: 583 Call Price 191/2 11 51/4 31/2 21/4 Put Price Suppose one knows that, according to historic patterns, the "fair values" of these options are the prices listed in the following table. Strike 525 550 575 600 625 650 675 Call Price 191/2 11 53/4 31/2 21/4 Call Theo. Value 21.5 10.4 4.3 1.5 0.7 Put Put Theo. Price Value 1/2 1.6 31/4 5.4 12 13.7 28 27.6 Notice that the out-of-the-money puts are priced well below their theoretical value, while the out-of-the-money calls are priced above. The options at the 575 and 600 strikes are much closer in price to their theoretical values than are the out-of­ the-money options. Chapter 34: Futures and Futures Options 685 There is another way to look at this data, and that is to view the options' implied volatility. Implied volatility was discussed in Chapter 28 on mathematical applica­ tions. It is basically the volatility that one would have to plug into his option pricing model in order for the model's theoretical price to agree with the actual market price. Alternatively, it is the volatility that is being implied by the actual marketplace. The options in this example each have different implied volatilities, since their mispricing is so distorted. Table 34-2 gives those implied volatilities. The deltas of the options involved are shown as well, for they will be used in later examples. These implied volatilities tell the same story: The out-of-the-money puts have the lowest implied volatilities, and therefore are the cheapest options; the out-of-the­ money calls have the highest implied volatilities, and are therefore the most expen­ sive options. So, no matter which way one prefers to look at it - through comparison of the option price to theoretical price or by comparing implied volatilities - it is obvious that these soybean options are out of line with one another. This sort of pricing distortion is prevalent in many commodity options. Soybeans, sugar, coffee, gold, and silver are all subject to this distortion from time to time. The distortion is endemic to some - soybeans, for example - or may be pres­ ent only when the speculators tum extremely bullish. This precise mispricing pattern is so prevalent in futures options that strategists should constantly be looking for it. There are two major ways to attempt to profit from this pattern. Both are attractive strategies, since one is buying options that are relatively less expensive than the options that are being sold. Such strategies, if implemented when the options are mispriced, tilt the odds in the strategist's favor, creating a positive expected return for the position. TABLE 34-2. Volatility skewing of soybean options. Strike 525 550 575 600 625 650 675 Call Price 19 1/2 11 53/4 31/2 21/4 Put Price 1/2 31/4 ; 12 28 Implied Delta Volatility Call/Put 12% /-0.02 13% /-0.16 15% 0.59/-0.41 17% 0.37 /-0.63 19% 0.21 21% 0.13 23% 0.09 686 Part V: Index Options and Futures The two theoretically attractive strategies are: 1. Buy out-of-the-money puts and sell at-the-money puts; or 2. Buy at-the-money calls and sell out-of-the-money calls. One might just buy one cheap and sell one expensive option - a bear spread with the puts, or a bull spread with the calls. However, it is better to implement these spreads with a ratio between the number of options bought and the number sold. That is, the first strategy involving puts would be a backspread, while the second strategy involving calls would be a ratio spread. By doing the ratio, each strategy is a more neutral one. Each strategy is examined separately. BACKSPREAD/NG THE PUTS The backspread strategy works best when one expects a large degree of volatility. Implementing the strategy with puts means that a large drop in price by the under­ lying futures would be most profitable, although a limited profit could be made if futures rose. Note that a moderate drop in price by expiration would be the worst result for this spread. Example: Using prices from the above example, suppose that one decides to estab­ lish a backspread in the puts. Assume that a neutral ratio is obtained in the following spread: Buy 4 January bean 550 puts 31/4 Sell 1 January bean 600 put at 28 Net position: 13 DB 28 CR 15 Credit The deltas (see Table 34-2) of the options are used to compute this neutral ratio. Figure 34-1 shows the profit potential of this spread. It is the typical picture for a put backspread - limited upside potential with a great deal of profit potential for large downward moves. Note that the spread is initially established for a credit of 15 cents. If January soybeans have volatile movements in either direction, the position should profit. Obviously, the profit potential is larger to the downside, where there are extra long puts. However, if beans should rally instead, the spreader could still make up to 15 cents ($750), the initial credit of the position. Note that one can treat the prices of soybean options in the same manner as he would treat the prices of stock options in order to determine such things as break­ even points and maximum profit potential. The fact that soybean options are worth Chapter 34: Futures and Futures Options 687 FIGURE 34-1. January soybean, backspread. 60 50 40 30 ..... e 20 a.. 0 10 ~ r::: ~ 550 600 625 -20 -30 Futures Price $50 per point ( which is cents when referring to soybeans) and stock options are worth $100 per point do not alter these calculations for a put backspread. Maximum upside profit potential= Initial debit or credit of position = 15 points Maximum risk = Maximum upside Distance between strikes x Number of puts sold short = 15-50 X 1 = -35 points Downside break-even point = Lower strike - Points of risk/Number of excess puts = 550- 35/3 = 538.3 Thus, one is able to analyze a futures option p~tion or a stock option position in the same manner - by reducing everything to be in terms of points, not dollars. Obviously, one will eventually have to convert to dollars in order to calculate his prof­ its or losses. However, note that referring to everything in "points" works very well. 688 Part V: Index Options and Futures Later, one can use the dollars per point to obtain actual dollar cost. Dollars per point would be $50 for soybeans options, $100 for stock or index options, $400 for live cat­ tle options, $375 for coffee options, $1,120 for sugar options, etc. In this way, one does not have to get hung up in the nomenclature of the futures contract; he can approach everything in the same fashion for purposes of analyzing the position. He will, of course, have to use proper nomenclature to enter the order, but that comes after the analysis is done. RATIO SPREADING THE CALLS Returning to the subject at hand - spreads that capture this particular mispricing phenomenon of futures options - recall that the other strategy that is attractive in such situations is the ratio call spread. It is established with the maximum profit potential being somewhat above the current futures price, since the calls that are being sold are out-of-the-money. Example: Again using the January soybean options of the previous few examples, suppose that one establishes the following ratio call spread. Using the calls' deltas (see Table 34-2), the following ratio is approximately neutral to begin with: Buy 2 January bean 600 calls at 11 Sell 5 January bean 650 calls at 31/2 Net position: 22 DB 171/2 CR 41/2 Debit Figure 34-2 shows the profit potential of the ratio call spread. It looks fairly typ­ ical for a ratio spread: limited downside exposure, maximum profit potential at the strike of the written calls, and unlimited upside exposure. Since this spread is established with both options out-of-the-money, one needs some upward movement by January soybean futures in order to be profitable. However, too much movement would not be welcomed (although follow-up strate­ gies could be used to deal with that). Consequently, this is a moderately bullish strat­ egy; one should feel that the underlying futures have a chance to move somewhat higher before expiration. Again, the analyst should treat this position in terms of points, not dollars or cents of soybean movement, in order to calculate the significant profit and loss points. Refer to Chapter 11 on ratio call spreads for the original explanation of these formulae for ratio call spreads: Maximum downside loss = Initial debit or credit = -4½ (it is a debit) Chapter 34: Futures and Futures Options FIGURE 34-2. January soybean, ratio spread. 90 80 70 60 50 :!:: 40 0 ... a.. 30 0 20 .le C 10 ~ 0 -10 -20 -30 575 625 650 At Expiration Futures Price Points of maximum profit = Maximum downside loss + Difference in strikes x Number of calls owned =-4½ + 50 X 2 =95½ Upside break-even price = Higher striking price 700 + Maximum profit/Net number of naked calls = 650 + 95½/3 = 681.8 689 These are the significant points of profitability at expiration. One does not care what the unit of trading is (for example, cents for soybeans) or how many dollars are involved in one unit of trading ($50 for soybeans and soybean options). He can con­ duct his analysis strictly in terms of points, and he should do so. Before proceeding into the comparisons beleen the backspread and the ratio spread as they apply to mispriced futures options, it should be pointed out that the seri­ ous strategist should analyze how his position will perform over the short term as well as at expiration. These analyses are presented in Chapter 36 on advanced concepts. 690 Part V: Index Options and Futures WHICH STRATEGY TO USE The profit potential of the put backspread is obviously far different from that of the call ratio spread. They are similar in that they both offer the strategist the opportu­ nity to benefit from spreading mispriced options. Choosing which one to implement (assuming liquidity in both the puts and calls) may be helped by examining the tech­ nical picture ( chart) of the futures contract. Recall that futures traders are often more technically oriented than stock traders, so it pays to be aware of basic chart patterns, because others are watching them as well. If enough people see the same thing and act on it, the chart pattern will be correct, if only from a "self-fulfilling prophecy" viewpoint if nothing else. Consequently, if the futures are locked in a (smooth) downtrend, the put strat­ egy is the strategy of choice because it offers the best downside profit. Conversely, if the futures are in a smooth uptrend, the call strategy is best. The worst result will be achieved if the strategist has established the call ratio spread, and the futures have an explosive rally. In certain cases, very bullish rumors - weather predictions such as drought or El Nifio, foreign labor unrest in the fields or mines, Russian buying of grain - will produce this mispricing phenomenon. The strategist should be leery of using the call ratio spread strategy in such situations, even though the out-of-the-money calls look and are ridiculously expensive. If the rumors prove true, or if there are too many shorts being squeezed, the futures can move too far, too fast and seriously hurt the spreader who has the ratio call spread in place. His margin requirements will escalate quickly as tl1e futures price moves high­ er. The option premiums will remain high or possibly even expand if the futures rally quickly, thereby overriding the potential benefit of time decay. Moreover, if the fun­ damentals change immediately - it rains; the strike is settled; no grain credits are offered to the Russians - or rumors prove false, the futures can come crashing back down in a hurry. Consequently, if rumors of fundamentals have introduced volatility in the futures rnarket, implement the strategy with the put backspread. The put backspread is geared to taking advantage of volatility, and this fundamental situation as described is certainly volatile. It may seem that because the market is exploding to the upside, it is a waste of time to establish the put spread. Still, it is the wisest choice in a volatile market, and there is always the chance that an explosive advance can turn into a quick decline, especially when the advance is based on rumors or fundamentals that could change overnight. There are a few "don'ts" associated with the ratio call spread. Do not be tempt­ ed to use the ratio spread strategy in volatile situations such as those just described; it works best in a slowly rising market. Also, do not implement the ratio spread with Chapter 34: Futures and Futures Options 691 ridiculously far out-of-the-money options, as one is wasting his theoretical advantage if the futures do not have a realistic chance to climb to the striking price of the writ­ ten options. Finally, do not attempt to use overly large ratios in order to gain the most theoretical advantage. This is an important concept, and the next example illustrates it well. Example: Assume the same pricing pattern for January soybean options that has been the basis for this discussion. January beans are trading at 583. The (novice) strategist sees that the slightly in-the-money January 575 call is the cheapest and the deeply out-of-the-money January 675 call is the most expensive. This can be verified from either of two previous tables: the one showing the actual price as compared to the "theoretical" price, or Table 34-2 showing the implied volatilities. Again, one would use the deltas (see Table 34-2) to create a neutral spread. A neutral ratio of these two would involve selling approximately six calls for each one purchased. Buy 1 January bean 575 call at 191/z Sell 6 January bean 675 calls at 21/4 Net position: 191/z DB 131/z CR 6 Debit Figure 34-3 shows the possible detrimental effects of using this large ratio. While one could make 94 points of profit if beans were at 675 at January expiration, he could lose that profit quickly if beans shot on through the upside break-even point, which is only 693.8. The previous formulae can be used to verify these maxi­ mum profit and upside break-even point calculations. The upside break-even point is too close to the striking price to allow for reasonable follow-up action. Therefore, this would not be an attractive position from a practical viewpoint, even though at first glance it looks attractive theoretically. It would seem that neutral spreading could get one into trouble if it "recom­ mends" positions like the 6-to-l ratio spread. In reality, it is the strategist who is get­ ting into trouble if he doesn't look at the whole picture. The statistics are just an aid - a tool. The strategist must use the tools to his advantage. It should be pointed out as well that there is a tool missing from the toolkit at this point. There are statistics that will clearly show the risk of this type of high-rati<,Yspread. In this case, that tool is the gamma of the option. Chapter 40 covers the -Lise of gamma and other more advanced statistical tools. This same example is expanded in that chapter to include the gamma concept. 692 Part V: Index Options and Futures FIGURE 34-3. January soybean, heavily ratioed spread. 90 60 30 - 0 e 575 625 650 675 725 a. -30 0 .1!l -60 C ~ -90 -120 At Expiration -150 -180 Futures Price FOLLOW-UP ACTION The same follow-up strategies apply to these futures options as did for stock options. They will not be rehashed in detail here; refer to earlier chapters for broader expla­ nations. This is a summary of the normal follow-up strategies: Ratio call spread: Follow-up action in strategies with naked options, such as this, generally involves taking or limiting losses. A rising market will produce a negative EFP. Neutralize a negative EFP by: Buying futures Buying some calls Limit upside losses by placing buy stop orders for futures at or near the upside break-even point. Put backspread: Follow-up action in strategies with an excess of long options generally involves taking or protecting profits. A falling market will produce a negative EFP. Neutralize a negative EFP by: Buying futures Selling some puts Chapter 34: Futures and Futures Options 693 The reader has seen these follow-up strategies earlier in the book. However, there is one new concept that is important: The mispricing continues to propagate itself no matter what the price of the underlying futures contract. The at-the-money options will always be about fairly priced; they will have the average implied volatility. Example: In the previous examples, January soybeans were trading at 583 and the implied volatility of the options with striking price 575 was 15%, while those with a 600 strike were 17%. One could, therefore, conclude that the at-the-money January soybean options would exhibit an implied volatility of about 16%. This would still be true if beans were at 525 or 675. The mispricing of the other options would extend out from what is now the at-the-money strike. Table 34-3 shows what one might expect to see if January soybeans rose 75 cents in price, from 583 to 658. Nate that the same mispricing properties exist in both the old and new situa­ tions: The puts that are 58 points out-of-the-money have an implied volatility of only 12%, while the calls that are 92 points out-of-the-money have an implied volatility of 23%. TABLE 34-3. Propagation of volatility skewing. Original Situation January beans: 583 Implied Strike Volatility 525 12% 550 13% 575 15% 600 17% 625 19% 650 21% 675 23% New Situation January beans: 658 Strike 600 625 650 675 700 725 750 This example is not meant to infer that the volatility of an at-the-money soybean futures option will always be 16%. It could be anything, depending on the historical and implied volatility of the futures contract itself. However, the volatility skewing will still persist even if the futures rally or decline. This fact will affect how these strategies behave as the(linderlying futures con­ tract moves. It is a benefit to both strategies. First, look at the put backspread when the stock falls to the striking price of the purchased puts. 694 Part V: Index Options and Futures Example: The put backspread was established under the following conditions: Strike 550 600 Put Price Theoretical Put Price 5.4 27.6 Implied Volatility 13% 17% If January soybean futures should fall to 550, one would expect the implied volatility of the January 550 puts that are owned to be about 16% or 17%, since they would be at-the-money at that time. This makes the assumption that the at-the­ money puts will have about a 17% implied volatility, which is what they had when the position was established. Since the strategy involves being long a large quantity of January 550 puts, this increase in implied volatility as the futures drop in price will be of benefit to the spread. Note that the implied volatility of the January 600 puts would increase as well, which would be a small negative aspect for the spread. However, since there is only one put short and it is quite deeply in the money with the futures at 550, this nega­ tive cannot outweigh the positive effect of the expansion of volatility on the long January 550 puts. In a similar manner, the call spread would benefit. The implied volatility of the written options would actually drop as the futures rallied, since they would be less far out-of-the-money than they originally were when the spread was established. While the same can be said of the long options in the spread, the fact that there are extra, naked, options means the spread will benefit overall. In summary, the futures option strategist should be alert to mispricing situations like those described above. They occur frequently in a few commodities and occa­ sionally in others. The put backspread strategy has limited risk and might therefore be attractive to more individuals; it is best used in downtrending and/or volatile mar­ kets. However, if the futures are in a smooth uptrend, not a volatile one, a ratio call spread would be better. In either case, the strategist has established a spread that is statistically attractive because he has sold options that are expensive in relation to the ones that he has bought. Chapter 34: Futures and Futures Options 695 SUMMARY This chapter presented the basics of futures and futures options trading. The basic differences between futures options and stock or index options were laid out. In a certain sense, a futures option is easier to utilize than is a stock option because the effects of dividends, interest rates, stock splits, and so forth do not apply to futures options. However, the fact that each underlying physical commodity is completely different from most other ones means that the strategist is forced to familiarize him­ self with a vast array of details involving striking prices, trading units, expiration dates, first notice days, etc. More details mean there could be more opportunities for mistakes, most of which can be avoided by visualizing and analyzing all positions in terms of points and not in dollars. Futures options do not create new option strategies. However, they may afford one the opportunity to trade when the futures are locked limit up. Moreover, the volatility skewing that is present in futures options will offer opportunities for put backspreads and call ratio spreads that are not normally present in stock options. Chapter 35 discusses futures spreads and how one can use futures options with those spreads. Calendar spreads are discussed as well. Calendar spreads with futures options are different from calendar spreads using stock or index options. These are important concepts in the futures markets - distinctly different from an option spread - and are therefore significant for the futures option trader. Futures Option Strategies for Futures Spreads A spread with futures is not the same as a spread with options, except that one item is bought while another is simultaneously sold. In this manner, one side of the spread hedges the risk of the other. This chapter describes futures spreading and offers ways to use options as an adjunct to those spreads. The concept of calendar spreading with futures options is covered in this chap­ ter as well. This is the one strategy that is very different when using futures options, as opposed to using stock or index options. FUTURES SPREADS Before getting into option strategies, it is necessary to define futures spreads and to examine some common futures spreading strategies. FUTURES PRICING DIFFERENTIALS It has already been shown that, for any paiticular physical commodity, there are, at any one time, several futures that expire in different months. Oil futures have month­ ly expirations; sugar futures expire in only five months of any one calendar year. The frequency of expiration months depends on which futures contract one is discussing. Futures on the same underlying commodity will trade at different prices. The differential is due to several factors, not just time, as is the case with stock options. A major factor is carrying costs - how much one would spend to buy and hold the phys- 696 Chapter 35: Futures Option Strategies for Futures Spreads 697 ical commodity until futures expiration. However, other factors may enter in as well, including supply and demand considerations. In a normal carrying cost market, futures that expire later in time are more expensive than those that are nearer-term. Example: Gold is a commodity whose futures exhibit forward or normal carry. Suppose it is March 1st and spot gold is trading at 351. Then, the futures contracts on gold and their respective prices might be as follows: Expiration Month Price April 352.50 June 354.70 August 356.90 December 361.00 June 366.90 Notice that each successive contract is more expensive than the previous one. There is a 2.20 differential between each of the first three expirations, equal to 1.10 per month of additional expiration time. However, the differential is not quite that great for the December, which expires in 9 months, or for the June contract, which expires in 15 months. The reason for this might be that longer-term interest rates are slightly lower than the short-term rates, and so the cost of carry is slightly less. However, prices in all futures don't line up this nicely. In some cases, different months may actually represent different products, even though both are on the same underlying physical commodity. For example, wheat is not always wheat. There is a summer crop and a winter crop. While the two may be related in general, there could be a substantial difference between the July wheat futures contract and the December contract, for example, that has very little to do with what interest rates are. Sometimes short-term demand can dominate the interest rate effect, and a series of futures contracts can be aligned such that the short-term futures are more expensive. This is known as a reverse carrying charge market, or contango. INTRAMARKET FUTURES SPREADS Some futures traders attempt to predict the relationships between various expiration months on the same underlying physical commodity. That is, one might buy July soybean futures and sell September soybean futures. When one both buys and sells differing futures contracts, he has a spread. When both contracts are on the same underlying physical commodity, he has an intramarket spread. ~ 698 Part V: Index Options and Futures The spreader is not attempting to predict the overall direction of prices. Rather, he is trying to predict the differential in prices between the July and September con­ tracts. He doesn't care if beans go up or down, as long as the spread between July and September goes his way. Example: A spread trader notices that historic price charts show that if September soybeans get too expensive with respect to July soybeans, the differential usually dis­ appears in a month or two. The opportunity for establishing this trade usually occurs early in the year - February or March. Assume it is February 1st, and the following prices exist: July soybean futures: 600 ($6.00/bushel) September soybean futures: 606 The price differential is 6 cents. It rarely gets worse than 12 cents, and often revers­ es to the point that July futures are more expensive than soybean futures - some years as much as 100 cents more expensive. If one were to trade this spread from a historical perspective, he would thus be risking approximately 6 cents, with possibilities of making over 100 cents. That is certainly a good risk/reward ratio, if historic price patterns hold up in the current environment. Suppose that one establishes the spread: Buy one July future @ 600 Sell one September future @ 606 At some later date, the following prices and, hence, profits and losses, exist. Futures Price July: 650 September: 630 Total Profit: Profit/Loss +50 cents -24 cents 26 cents ($1,300) The spread has inverted, going from an initial state in which September was 6 cents more expensive than July, to a situation in which July is 20 cents more expen­ sive. The spreader would thus make 26 cents, or $1,300, since 1 cent in beans is worth $50. Chapter 35: Futures Option Strategies for Futures Spreads 699 Notice that the same profit would have been made at any of the following pairs of prices, because the price differential between July and September is 20 cents in all cases (with July being the more expensive of the two). July Futures September Futures July Profit September Profit 420 400 -180 +206 470 450 -130 +156 550 530 -50 +76 600 580 0 +26 650 630 +50 -24 700 680 +100 -74 800 780 +200 -174 Therefore, the same 26-cent profit can be made whether soybeans are in a severe bear market, in a rousing bull market, or even somewhat unchanged. The spreader is only concerned with whether the spread widens from a 6-cent differen­ tial or not. Charts, some going back years, are kept of the various relationships between one expiration month and another. Spread traders often use these historical charts to determine when to enter and exit intramarket spreads. These charts display the sea­ sonal tendencies that make the relationships between various contracts widen or shrink. Analysis of the fundamentals that cause the seasonal tendencies could also be motivation for establishing intramarket spreads. The margin required for intramarket spread trading (and some other types of futures spreads) is smaller than that required for speculative trading in the futures themselves. The reason for this is that spreads are considered less risky than outright positions in the futures. However, one can still make or lose a good deal of money in a spread - percentage-wise as well as in dollars - so it cannot be considered conser­ vative; it's just less risky than outright futures speculation. Example: Using the soybean spread from the example above, assume the speculative initial margin requirement is $1,700. Then, the spread margin requirement might be $500. That is considerably less than one would have to put up as initial margin if each side of the spread had to be margined separately, a situation that would require $3,400. In the previous example, it was shown that the soybean spread had the poten­ tial to widen as much as 100 points ($1.00), a move that would be worth $5,000 if it 700 Part V: Index Options and Futures occurred. While it is unlikely that the spread would actually widen to historic highs, it is certainly possible that it could widen 25 or 30 cents, a profit of $1,250 to $1,500. That is certainly high leverage on a $500 investment over a short time period, so one must classify spreading as a risk strategy. INTERMARKET FUTURES SPREADS Another type of futures spread is one in which one buys futures contracts in one mar­ ket and sells futures contracts in another, probably related, market. When the futures spread is transacted in two different markets, it is known as an intermarket spread. Intermarket spreads are just as popular as intramarket spreads. One type of intermarket spread involves directly related markets. Examples include spreads between currency futures on two different international currencies; between financial futures on two different bond, note, or bill contracts; or between a commodity and its products - oil, unleaded gasoline, and heating oil, for example. Example: Interest rates have been low in both the United States and Japan. As a result, both currencies are depressed with respect to the European currencies, where interest rates remain high. A trader believes that interest rates will become more uni­ form worldwide, causing the Japanese yen to appreciate with respect to the German mark. However, since he is not sure whether Japanese rates will move up or German rates will move down, he is reluctant to take an outright position in either currency. Rather, he decides to utilize an intermarket spread to implement his trading idea. Assume he establishes the spread at the following prices: Buy I June yen future: 77.00 Sell I June mark future: 60.00 This is an initial differential of 17.00 between the two currency futures. He is hoping for the differential to get larger. The dollar trading terms are the same for both futures: One point of movement (from 60.00 to 61.00, for example) is worth $1,250. His profit and loss potential would therefore be: Spread Differential al a Later Date Profit/Loss 14.00 $3,750 16.00 - $1,250 18.00 + 1,250 20.00 + 3,750 Chapter 35: Futures Option Strategies for Futures Spreads 701 In some cases, the exchanges recognize frequently traded intermarket spreads as being eligible for reduced margin requirements. That is, the exchange recognizes that the two futures are hedges against one another if one is sold and the other is bought. These spreads between currencies, called cross-currency spreads, are so heavi­ ly traded that there are other specific vehicles - both futures and warrants - that allow the speculator to trade them as a single entity. Regardless, they serve as a prime example of an intermarket spread when the two futures are used. In the example above, assume the outright speculative margin for a position in either currency future is $1,700 per contract. Then, the margin for this spread would probably be nearly $1,700 as well, equal to the speculative margin for one side of the spread. This position is thus recognized as a spread position for margin purposes. The margin treatment isn't as favorable as for the intramarket spread (see the earlier soy­ bean example), but the spread margin is still only one-half of what one would have to advance as initial margin if both sides of the spread had to be margined separately. Other intermarket spreads are also eligible for reduced margin requirements, although at first glance they might not seem to be as direct a hedge as the two cur­ rencies above were. Example: A common intermarket spread is the TED spread, which consists of Treasury bill futures on one side and Eurodollar futures on the other. Treasury bills represent the safest investment there is; they are guaranteed. Eurodollars, however, are not insured, and therefore represent a less safe investment. Consequently, Eurodollars yield more than Treasury bills. How much more is the key, because as the yield differential expands or shrinks, the spread between the prices of T-bill futures and Eurodollar futures expands or shrinks as well. In essence, the yield dif­ ferential is small when there is stability and confidence in the financial markets, because uninsured deposits and insured deposits are not that much different in times of financial certainty. However, in times of financial uncertainty and instability, the spread widens because the uninsured depositors require a comparatively higher yield for the higher risk they are taking. Assume the outright initial margin for either the T-bill future or the Eurodollar future is $800 per contract. The margin for the TED spread, however, is only $400. Thus, one is able to trade this spread for only one-fourth of the amount of margin that would be required to margin both sides separately. The reason that the margin is more favorable is that there is not a lot of volatil­ ity in this spread. Historically, it has ranged between about 0.30 and 1.70. In both futures contracts, one cent (0.01) of movement is worth $25. Thus, the entire 140- cent historic range of the spread only represents $3,500 (140 x $25). ( 702 Part V: Index Options and Futures More will be said later about the TED spread when the application of futures options to intermarket spreads is discussed. Since there is a liquid option market on both futures, it is sometimes more logical to establish the spread using options instead of futures. One other comment should be made regarding the TED spread: It has carry­ ing cost. That is, if one buys the spread and holds it, the spread will shrink as time passes, causing a small loss to the holder. When interest rates are low, the carrying cost is small (about 0.05 for 3 months). It would be larger if short-term rates rose. The prices in Table 35-1 show that the spread is more costly for longer-term con­ tracts. TABLE 35-1. Carrying costs of the TED spread. Month T-Bill Future March 96.27 June 96.15 September 95.90 Eurodollar Future 95.86 95.69 95.39 TED Spread 0.41 0.46 0.51 Many intermarket spreads have some sort of carrying cost built into them; the spreader should be aware of that fact, for it may figure into his profitability. One final, and more complex, example of an intermarket spread is the crack spread. There are two major areas in which a basic commodity is traded, as well as two of its products: crude oil, unleaded gasoline, and heating oil; or soybeans, soy­ bean oil, and soybean meal. A crack spread involves trading all three - the base com­ modity and both byproducts. Example: The crack spread in oil consists of buying two futures contracts for crude oil and selling one contract each for heating oil and unleaded gasoline. The units of trading are not the same for all three. The crude oil future is a con­ tract for 1,000 barrels of oil; it is traded in units of dollars per barrel, so a $1 increase in oil prices from $18.00 to $19.00, say - is worth $1,000 to the futures contract. Heating oil and unleaded gasoline futures contracts have similar terms, but they are different from crude oil. Each of these futures is for 42,000 gallons of the product, and they are traded in cents. So, a one-cent move - gasoline going from 60 cents a gallon to 61 cents a gallon - is worth $420. This information is summarized in Table 35-2 by showing how much a unit change in price is worth. Chapter 35: Futures Option Strategies for Futures Spreads TABLE 35-2. Terms of oil production contract. Contract Crude Oil Unleaded Gasoline Heating Oil Initial Price 18.00 .6000 .5500 Subsequent Price 19.00 .6100 .5600 The following formula is generally used for the oil crack spread: Crack= (Unleaded gasoline + Heating oil) x 42 - 2 x Crude 2 (.6000 + .5500) X 42 - 2 X 18.00 = 2 = (48.3 - 36)/2 = 6.15 703 Gain in Dollars $1,000 $ 420 $ 420 Some traders don't use the divisor of 2 and, therefore, would arrive at a value of 12.30 with the above data. In either case, the spreader can track the history of this spread and will attempt to buy oil and sell the other two, or vice versa, in order to attempt to make an over­ all profit as the three products move. Suppose a spreader felt that the products were too expensive with respect to crude oil prices. He would then implement the spread in the following manner: Buy 2 March crude oil futures @ 18.00 Sell 1 March heating oil future @ 0.5500 Sell l March unleaded gasoline future @ 0.6000 Thus, the crack spread was at 6.15 when he entered the position. Suppose that he was right, and the futures prices subsequently changed to the following: March crude oil futures: 18.50 March unleaded gas futures: .6075 March heating oil futures: .5575 The profit is shown in Table 35-3. 704 TABLE 35-3. Profit and loss of crack spread. Contract 2 March Crude 1 March Unleaded 1 March Heating Oil Net Profit (before commissions) Initial Price 18.00 .6000 .5500 Part V: Index Options and Futures Subsequent Price 18.50 .6075 .5575 Gain in Dollars + $1,000 - $ 315 - $ 315 + $ 370 One can calculate that the crack spread at the new prices has shrunk to 5.965. Thus, the spreader was correct in predicting that the spread would narrow, and he profited. Margin requirements are also favorable for this type of spread, generally being slightly less than the speculative requirement for two contracts of crude oil. The above examples demonstrate some of the various intermarket spreads that are heavily watched and traded by futures spreaders. They often provide some of the most reliable profit situations without requiring one to predict the actual direction of the market itself. Only the differential of the spread is important. One should not assume that all intermarket spreads receive favorable margin treatment. Only those that have traditional relationships do. USING FUTURES OPTIONS IN FUTURES SPREADS After viewing the above examples, one can see that futures spreads are not the same as what we typically know as option spreads. However, option contracts may be use­ ful in futures spreading strategies. They can often provide an additional measure of profit potential for very little additional risk. This is true for both intramarket and intermarket spreads. The futures option calendar spread is discussed first. The calendar spread with futures options is not the same as the calendar spread with stock or index options. In fact, it may best be viewed as an alternative to the intramarket futures spread rather than as an option spread strategy. CALENDAR SPREADS A calendar spread with futures options would still be constructed in the familiar manner - buy the May call, sell the March call with the same striking price. However, Chapter 35: Futures Option Strategies for Futures Spreads 705 there is a major difference between the futures option calendar spread and the stock option calendar spread. That difference is that a calendar spread using futures options involves two separate underlying instruments, while a calendar spread using stock options does not. When one buys the May soybean 600 call and sells the March soybean 600 call, he is buying a call on the May soybean futures contract and selling a call on the March soybean futures contract. Thus, the futures option calendar spread involves two separate, but related, underlying futures contracts. However, if one buys the IBM May 100 call and sells the IBM March 100 call, both calls are on the same underlying instrument, IBM. This is a major difference between the two strategies, although both are called "calendar spreads." To the stock option trader who is used to visualizing calendar spreads, the futures option variety may confound him at first. For example, a stock option trader may conclude that if he can buy a four-month call for 5 points and sell a two-month call for 2 points, he has a good calendar spread possibility. Such an analysis is mean­ ingless with futures options. If one can buy the May soybean 600 call for 5 and sell the March soybean 600 call for 3, is that a good spread or not? It's impossible to tell, unless you know the relationship between May and March soybean futures contracts. Thus, in order to analyze the futures option calendar spread, one must not only ana­ lyze the options' relationship, but the two futures contracts' relationship as well. Simply stated, when one establishes a futures option calendar spread, he is not only spreading time, as he does with stock options, he is also spreading the relationship between the underlying futures. Example: A trader notices that near-term options in soybeans are relatively more expensive than longer-term options. He thinks a calendar spread might make sense, as he can sell the overpriced near-term calls and buy the relatively cheaper longer­ term calls. This is a good situation, considering the theoretical value of the options involved. He establishes the spread at the following prices: Soybean Trading Contract Initial Price Position March 600 call 14 Sell 1 May 600 call 21 Buy 1 March future 594 none May future 598 none The May/March 600 call calendar spread is established for 7 points debit. March expiration is two months away. At the current time, the May futures are trad­ ing at a 4-point premium to March futures. The spreader figures that if March 706 Part V: Index Options and Futures futures are approximately unchanged at expiration of the March options, he should profit handsomely, because the March calls are slightly overpriced at the current time, plus they will decay at a faster rate than the May calls over the next two months. Suppose that he is correct and March futures are unchanged at expiration of the March options. This is still no guarantee of profit, because one must also determine where May futures are trading. If the spread between May and March futures behaves poorly (May declines with respect to March), then he might still lose money. Look at the following table to see how the futures spread between March and May futures affects the profitability of the calendar spread. The calendar spread cost 7 debit when the futures spread was +4 initially. Futures Calendar Futures Prices Spread May 600 Call Spread March/May Price Price Profit/Loss 594/570 -24 4 -3 cents 594/580 -14 61/2 _1/2 594/590 -4 10 +3 594/600 +6 141/2 +71/2 Thus, the calendar spread could lose money even with March futures unchanged, as in the top two lines of the table. It also could do better than expected if the futures spread widens, as in the bottom line of the table. The profitability of the calendar spread is heavily linked to the futures spread price. In the above example, it was possible to lose money even though the March futures contract was unchanged in price from the time the calendar spread was initially established. This would never happen with stock options. If one placed a calendar spread on IBM and the stock were unchanged at the expiration of the near­ term option, the spread would make money virtually all of the time ( unless implied volatility had shrunk dramatically). The futures option calendar spreader is therefore trading two spreads at once. The first one has to do with the relative pricing differentials (implied volatilities, for example) of the two options in question, as well as the passage of time. The second one is the relationship between the two underlying futures contracts. As a result, it is difficult to draw the ordinary profit picture. Rather, one must approach the problem in this manner: 1. Use the horizontal axis to represent the futures spread price at the expiration of the near-term option. Chapter 35: Futures Option Strategies for Futures Spreads 707 2. Draw several profit curves, one for each price of the near-term future at near­ term expiration. Example: Expanding on the above example, this method is demonstrated here. Figure 35-1 shows how to approach the problem. The horizontal axis depicts the spread between March and May soybean futures at the expiration of the March futures options. The vertical axis represents the profit and loss to be expected from the calendar spread, as it always does. The major difference between this profit graph and standard ones is that there are now several sets of profit curves. A separate one is drawn for each price of the March futures that one wants to consider in his analysis. The previous example showed the profitability for only one price of the March futures - unchanged at 594. However, one cannot rely on the March futures to remain unchanged, so he must view the profitability of the calendar spread at various March futures prices. The data that is plotted in the figure is summarized in Table 35-4. Several things are readily apparent. First, if the futures spread improves in price, the calendar spread will generally make money. These are the points on the far right of the figure and on the bottom line of Table 35-4. Second, if the futures spread behaves miser- FIGURE 35-1. Soybean futures calendar spreads, at March expiration. gj 20 16 12 .3 8 ::.: 0 ct 4 0 -8 March/May Spread March =604 March =594 March= 614 March =584 March= 574 708 Part V: Index Options and Futures ably, the calendar spread will almost certainly lose money (points on the left-hand side of the figure, or top line of the table). Third, if March futures rise in price too far, the calendar spread could do poor­ ly. In fact, if March futures rally and the futures spread worsens, one could lose more than his initial debit (bottom left-hand point on figure). This is partly due to the fact that one is buying the March options back at a loss if March futures rally, and may also be forced to sell his May options out at a loss if May futures have fallen at the same time. Fourth, as might be expected, the best results are obtained if March futures rally slightly or remain unchanged and the futures spread also remains relatively unchanged (points in the upper right-hand quadrant of the figure). In Table 35-4, the far right-hand column shows how a futures spreader would have fared if he had bought May and sold March at 4 points May over March, not using any options at all. TABLE 35-4. Profit and loss from soybean call calendar. All Prices at March Option Expiration Futures Future Spread Calendar Spread Profit Spread (May-March) March Future Price: 574 584 594 604 614 Profit -24 -5.5 - 4.5 -3 -4.5 -11.5 -28 -14 -4.5 3 -0.5 -1 -7 -18 -4 -2.5 0 +3 +3.5 -1 - 8 6 0 + 3 +7.5 +9 +5.5 + 2 16 +7 + 11 +17 +19 +13 +12 This example demonstrates just how powerful the influence of the futures spread is. The calendar spread profit is predominantly a function of the futures spread price. Thus, even though the calendar spread was attractive from the theo­ retical viewpoint of the option's prices, its result does not seem to reflect that theo­ retical advantage, due to the influence of the futures spread. Another important point for the calendar spreader used to dealing with stock options to remember is that one can lose more than his initial debit in a futures calendar spread if the spread between the underlying futures inverts. There is another way to view a calendar spread in futures options, however, and that is as a substitute or alternative to an intramarket spread in the futures contracts themselves. Look at Table 35-4 again and notice the far right-hand column. This is Chapter 35: Futures Option Strategies for Futures Spreads 709 the profit or loss that would be made by an intramarket soybean spreader who bought May and sold March at the initial prices of 598 and 594, respectively. The calendar spread generally outperforms the intramarket spread for the prices shown in this example. This is where the true theoretical advantage of the calendar spread comes in. So, if one is thinking of establishing an intrarnarket spread, he should check out the calendar spread in the futures options first. If the options have a theoretical pric­ ing advantage, the calendar spread may clearly outperform the standard intramarket spread. Study Table 35-4 for a moment. Note that the intramarket spread is only better when prices drop but the spread widens (lower left comer of table). In all other cases, the calendar spread strategy is better. One could not always expect this to be true, of course; the results in the example are partly due to the fact that the March options that were sold were relatively expensive when compared with the May options that were bought. In summary, the futures option calendar spread is more complicated when compared to the simpler stock or index option calendar spread. As a result, calendar spreading with futures options is a less popular strategy than its stock option coun­ terpart. However, this does not mean that the strategist should overlook this strate­ gy. As the strategist knows, he can often find the best opportunities in seemingly complex situations, because there may be pricing inefficiencies present. This strate­ gy's main application may be for the intramarket spreader who also understands the usage of options. LONG COMBINATIONS Another attractive use of options is as a substitute for two instruments that are being traded one against the other. Since intermarket and intramarket futures spreads involve two instruments being traded against each other, futures options may be able to work well in these types of spreads. You may recall that a similar idea was pre­ sented with respect to pairs trading, as well as certain risk arbitrage strategies and index futures spreading. In any type of futures spread, one might be able to substitute options for the actual futures. He might buy calls for the long side of the spread instead of actually buying futures. Likewise, he could sell calls or buy puts instead of selling futures for the other side of the spread. In using options, however, he wants to avoid two prob­ lems. First, he does not want to increase his risk. Second, he does not want to pay a lot of time value premium that could waste away, costing him the profits from his spread. 710 Part V: Index Options and Futures Let's spend a short time discussing these two points. First, he does not want to increase his risk. In general, selling options instead of utilizing futures increases one's risk. If he sells calls instead of selling futures, and sells puts instead of buying futures, he could be increasing his risk tremendously if the futures prices moved a lot. If the futures rose tremendously, the short calls would lose money, but the short puts would cease to make money once the futures rose through the striking price of the puts. Therefore, it is not a recommended strategy to sell options in place of the futures in an intramarket or intennarket spread. The next example will show why not. Example: A spreader wants to trade an intramarket spread in live cattle. The con­ tract is for 40,000 pounds, so a one-cent move is worth $400. He is going to sell April and buy June futures, hoping for the spread to narrow between the two contracts. The following prices exist for live cattle futures and options: April future: 78.00 June future: 74.00 April 78 call: 1.25 June 74 put: 2.00 He decides to use the options instead of futures to implement this spread. He sells the April 78 call as an alternative to selling the April future; he also sells the June 74 put as an alternative to buying the June future. Sometime later, the following prices exist: April future: 68.00 June future: 66.00 April 78 call: 0.00 June 74 put: 8.05 The futures spread has indeed narrowed as expected - from 4.00 points to 2.00. However, this spreader has no profit to show for it; in fact he has a loss. The call that he sold is now virtually worthless and has therefore earned a profit of 1.25 points; however, the put that was sold for 2.00 is now worth 8.05 - a loss of 6.05 points. Overall, the spreader has a net loss of 4.80 points since he used short options, instead of the 2.00-point gain he could have had if he had used futures instead. The second thing that the futures spreader wants to ensure is that he does not pay for a lot of time value premium that is wasted, costing him his potential profits. If he buys at- or out-of-the-money calls instead of buying futures, and if he buys at- Chapter 35: Futures Option Strategies for Futures Spreads 711 or out-of-the-money puts instead of selling futures, he could be exposing his spread profits to the ravages of time decay. Do not substitute at- or out-of-the-rrwney options for the futures in intramarket or intennarket spreads. The next example will show why not. Example: A futures spreader notices that a favorable situation exists in wheat. He wants to buy July and sell May. The following prices exist for the futures and options: May futures: 410 July futures: 390 May 410 put: 20 July 390 call: 25 This trader decides to buy the May 410 put instead of selling May futures; he also buys the July 390 call instead of buying July futures. Later, the following prices exist: May futures: 400 July futures: 400 May 410 put: 25 July 390 call: 30 The futures spread would have made 20 points, since they are now the same price. At least this time, he has made money in the option spread. He has made 5 points on each option for a total of 10 points overall - only half the money that could have been made with the futures themselves. Nate that these sample option prices still show a good deal of time value premium remaining. If more time had passed and these options were trading closer to parity, the result of the option spread would be worse. It might be pointed out that the option strategy in the above example would work better if futures prices were volatile and rallied or declined substantially. This is true to a certain extent. If the market had moved a lot, one option would be very deeply in-the-money and the other deeply out-of-the-money. Neither one would have much time value premium, and the trader would therefore have wasted all the money spent for the initial time premium. So, unless the futures moved so far as to outdistance that loss of time value premium, the futures strategy would still outrank the option strategy. However, this last point of volatile futures movement helping an option position is a valid one. It leads to the reason for the only favorable option strategy that is a sub- 712 Part V: Index Options and Futures stitute for futures spreads - that is, using in-the-money options. If one buys in-the­ rnoney calls instead of buying futures, and buys in-the-money puts instead of selling futures, he can often create a position that has an advantage over the intramarket or intermarket futures spread. In-the-money options avoid most of the problems described in the two previous examples. There is no increase of risk, since the options are being bought, not sold. In addition, the amount of money spent on time value premium is small, since both options are in-the-money. In fact, one could buy them so far in the money as to virtually eliminate any expense for time value premium. However, that is not recommended, for it would negate the possible advantage of using moderately in-the-money options: If the underlyingfutures behave in a volatile manner, it might be possible for the option spread to make money, even if the futures spread does not behave as expected. In order to illustrate these points, the TED spread, an intermarket spread, will be used. Recall that in order to buy the TED spread, one would buy T-bill futures and sell an equal quantity of Eurodollar futures. Options exist on both T-bill futures and Eurodollar futures. If T-bill calls were bought instead of T-bill futures, and if Eurodollar puts were bought instead of sell­ ing Eurodollar futures, a similar position could be created that might have some advantages over buying the TED spread using futures. The advantage is that if T-bills and/or Eurodollars change in price by a large enough amount, the option strategist can make money, even if the TED spread itself does not cooperate. One might not think that short-term rates could be volatile enough to make this a worthwhile strategy. However, they can move substantially in a short period of time, especially if the Federal Reserve is active in lowering or raising rates. For example, suppose the Fed continues to lower rates and both T-bills and Eurodollars substan­ tially rise in price. Eventually, the puts that were purchased on the Eurodollars will become worthless, but the T-bill calls that are owned will continue to grow in value. Thus, one could make money, even if the TED spread was unchanged or shrunk, as long as short-term rates dropped far enough. Similarly, if rates were to rise instead, the option spread could make money as the puts gained in value (rising rates mean T-bills and Eurodollars will fall in price) and the calls eventually became worthless. Example: The following prices for June T-bill and Eurodollar futures and options exist in January. All of these products trade in units of 0.01, which is worth $25. So a whole point is worth $2,500. June T-bill futures: 94.75 June Euro$ futures: 94.15 Chapter 35: Futures Option Strategies for Futures Spreads June T-bill 9450 calls: 0.32 June Euro$ 9450 puts: 0.40 713 The TED spread, basis June, is currently at 0.60 (the difference in price of the two futures). Both futures have in-the-money options with only a small amount of time value premium in them. The June T-bill calls with a striking price of 94.50 are 0.25 in the money and are selling for 0.32. Their time value premium is only 0.07 points. Similarly, the June Eurodollar puts with a striking price of 94.50 are 0.35 in the money and are selling for 0.40. Hence, their time value premium is 0.05. Since the total time value premium - 0.12 ($300) - is small, the strategist decides that the option spread may have an advantage over the futures intermarket spread, so he establishes the following position: Buy one June T-bill call @ 0.40 Buy one June Euro$ put @ 0.32 Total cost: Cost $1,000 $ 800 $1,800 Later, financial conditions in the world are very stable and the TED spread begins to shrink. However, at the same time, rates are being lowered in the United States, and T-bill and Eurodollar prices begin to rally substantially. In May, when the June T-bill options expire, the following prices exist: June T-bill futures: 95.50 June Euro$ futures: 95.10 June T-bill 9450 calls: 1.00 June Euro$ 9450 puts: 0.01 The TED spread has shrunk from 0.60 to only 0.40. Thus, any trader attempt­ ing to buy the TED spread using only futures would have lost $500 as the spread moved against him by 0.20. However, look at the option position. The options are now worth a combined value of 1.01 points ($2,525), and they were bought for 0.72 points ($1,800). Thus, the option strategy has turned a profit of $725, while the futures strategy would have lost money. Any traders who used this option strategy instead of using futures would have enjoyed profits, because as the Federal Reserve lowered rates time after time, the prices of both T-bills and Eurodollars rose far enough to make the option strategist's 714 Part V: Index Options and Futures calls more profitable than the loss in his puts. This is the advantage of using in-the­ money options instead of futures in futures spreading strategies. In fairness, it should be pointed out that if the futures prices had remained rel­ atively unchanged, the 0.12 points of time value premium ($300) could have been lost, while the futures spread may have been relatively unchanged. However, this does not alter the reasoning behind wanting to use this option strategy. Another consideration that might come into play is the margin required. Recall that the initial margin for implementing the TED spread was $400. However, if one uses the option strategy, he must pay for the options in full - $1,800 in the above example. This could conceivably be a deterrent to using the option strategy. Of course, if by investing $1,800, one can make money instead of losing money with the smaller investment, then the initial margin requirement is irrelevant. Therefore, the profit potential must be considered the more important factor. FOLLOW-UP CONSIDERATIONS When one uses long option combinations to implement a futures spread strategy, he may find that his position changes from a spread to more of an outright position. This would occur if the markets were volatile and one option became deeply in-the­ money, while the other one was nearly worthless. The TED spread example above showed how this could occur as the call wound up being worth 1.00, while the put was virtually worthless. As one side of the option spread goes out-of-the-money, the spread nature begins to disappear and a more outright position takes its place. One can use the deltas of the options in order to calculate just how much exposure he has at any one time. The following examples go through a series of analyses and trades that a strate­ gist might have to face. The first example concerns establishing an intermarket spread in oil products. Example: In late summer, a spreader decides to implement an intermarket spread. He projects that the coming winter may be severely cold; furthermore, he believes that gasoline prices are too high, being artificially buoyed by the summer tourist sea­ son, and the high prices are being carried into the future months by inefficient mar­ ket pricing. Therefore, he wants to buy heating oil futures or options and sell unleaded gasoline futures or options. He plans to be out of the trade, if possible, by early December, when the market should have discounted the facts about the winter. Therefore, he decides to look at January futures and options. The following prices exist: Chapter 35: Futures Option Strategies for Futures Spreads Future or Option January heating oil futures: January unleaded gasoline futures: January heating oil 60 call: January unleaded gas 62 put: Price .6550 .5850 6.40 4.25 715 Time Value Premium 0.90 0.75 The differential in futures prices is .07, or 7 cents per gallon. He thinks it could grow to 12 cents or so by early winter. However, he also thinks that oil and oil prod­ ucts have the potential to be very volatile, so he considers using the options. One cent is worth $420 for each of these items. The time value premium of the options is 1.65 for the put and call combined. If he pays this amount ($693) per combination, he can still make money if the futures widen by 5.00 points, as he expects. Moreover, the option spread gives him the potential for profits if oil products are volatile, even if he is wrong about the futures relationship. Therefore, he decides to buy five combinations: Position Buy 5 January heating oil 60 calls @ 6.40 Buy 5 January unleaded 62 puts @ 4.25 Total cost: Cost $13,440 8,925 $22,365 This initial cost is substantially larger than the initial margin requirement for five futures spreads, which would be about $7,000. Moreover, the option cost must be paid for in cash, while the futures requirement could be taken care of with Treasury bills, which continue to earn money for the spreader. Still, the strategist believes that the option position has more potential, so he establishes it. Notice that in this analysis, the strategist compared his time value premium cost to the profit potential he expected from the futures spread itself This is often a good way to evaluate whether or not to use options or futures. In this example, he thought that, even if futures prices remained relatively unchanged, thereby wasting away his time premium, he could still make money - as long as he was correct about heating oil outperforming unleaded gasoline. Some follow-up actions will now be examined. If the futures rally, the position becomes long. Some profit might have accrued, but the whole position is subject to losses if the futures fall in price. The strategist can calculate the extent to which his 716 Part V: Index Options and Futures position has become long by using the delta of the options in the strategy. He can then use futures or other options in order to make the position more neutral, if he wants to. Example: Suppose that both unleaded gasoline and heating oil have rallied some and that the futures spread has widened slightly. The following information is known: Future or Option January heating oil futures: January unleaded gasoline futures: January heating oil 60 call: January unleaded gas 62 put: Total profit: Price .7100 .6300 11.05 1.50 Net Change + .055 + .045 + 4.65 - 2.75 Profit/loss +$9,765 - 5,775 +$3,990 The futures spread has widened to 8 cents. If the strategist had established the spread with futures, he would now have a one-cent ( $420) profit on five contracts, or a $2,100 profit. The profit is larger in the option strategy. The futures have rallied as well. Heating oil is up 5½ cents from its initial price, while unleaded is up 4½ cents. This rally has been large enough to drive the puts out­ of-the-money. When one has established the intermarket spread with options, and the futures rally this much, the profit is usually greater from the option spread. Such is the case in this example, as the option spread is ahead by almost $4,000. This example shows the most desirable situation for the strategist who has implemented the option spread. The futures rally enough to force the puts out-of­ the-money, or alternatively fall far enough to force the calls to be out-of-the-money. If this happens in advance of option expiration, one option will generally have almost all of its time value premium disappear (the calls in the above example). The other option, however, will still have some time value ( the puts in the example). This represents an attractive situation. However, there is a potential negative, and that is that the position is too long now. It is not really a spread anymore. If futures should drop in price, the calls will lose value quickly. The puts will not gain much, though, because they are out-of-the-money and will not adequately protect the calls. At this juncture, the strategist has the choice of taking his profit - closing the position - or making an adjustment to make the spread more neutral once again. He could also do nothing, of course, but a strategist would normally want to protect a profit to some extent. Chapter 35: Futures Option Strategies for Futures Spreads 717 Example: The strategist decides that, since his goal was for the futures spread to widen to 12 cents, he will not remove the position when the spread is only 8 cents, as it is now. However, he wants to take some action to protect his current profit, while still retaining the possibility to have the profit expand. As a first step, the equivalent futures position (EFP) is calculated. The pertinent data is shown in Table 35-5. TABLE 35-5. EFP of long combination. Future or Option January heating oil futures: January unleaded gasoline futures: January heating oil 60 call: Long 5 January unleaded gas 62 put: Long 5 Price .7100 .6300 11.05 1.50 Delta 0.99 -0.40 EFP +4.95 -2.00 Total EFP: +2.95 Overall, the position is long the equivalent of about three futures contracts. The position's profitability is mostly related to whether the futures rise or fall in price, not to how the spread between heating oil futures and unleaded gas futures behaves. The strategist could easily neutralize the long delta by selling three contracts. This would leave room for more profits if prices continue to rise ( there are still two extra long calls). It would also provide downside protection if prices suddenly drop, since the 5 long puts plus the 3 short futures would offset any loss in the 5 in-the­ money calls. Which futures should the strategist short? That depends on how confident he is in his original analysis of the intermarket spread widening. If he still thinks it will widen further, then he should sell unleaded gasoline futures against the deeply in­ the-money heating oil calls. This would give him an additional profit or loss opportu­ nity based on the relationship of the two oil products. However, ifhe decides that the intermarket spread should have widened more than this by now, perhaps he will just sell 3 heating oil futures as a direct hedge against the heating oil calls. Once one finds himself in a profitable situation, as in the above example, the rrwst conservative course is to hedge the in-the-rrwney option with its own underly­ ing future. This action lessens the further dependency of the profits on the inter­ market spread. There is still profit potential remaining from futures price action. Furthermore, if the futures should fall so far that both options return to in-the­ money status, then the intermarket spread comes back into play. Thus, in the above 718 Part V: Index Options and Futures example, the conservative action would be to sell three heating oil futures against the heating oil calls. The more aggressive course is to hedge the in-the-money option with the future underlying the other side of the intermarket spread. In the above example, that would entail selling the unleaded gasoline futures against the heating oil calls. Suppose that the strategist in the previous example decides to take the conser­ vative action, and he therefore shorts three heating oil futures at .7100, the current price. This action preserves large profit potential in either direction. It is better than selling out-of-the-money options against his current position. He would consider removing the hedge if futures prices dropped, perhaps when the puts returned to an in-the-money status with a put delta of at least -0. 75 or so. At that point, the position would be at its original status, more or less, except for the fact that he would have taken a nice profit in the three futures that were sold and covered. Epilogue. The above examples are taken from actual price movements. In reality, the futures fell back, not only to their original price, but far below it. The funda­ mental reason for this reversal was that the weather was warm, hurting demand for heating oil, and gasoline supplies were low. By the option expiration in December, the following prices existed: January heating oil futures: .5200 January unleaded gas futures: .5200 Not only had the futures prices virtually crashed, but the intermarket spread had been decimated as well. The spread had fallen to zero! It had never reached any­ thing near the 12-cent potential that was envisioned. Any spreader who had estab­ lished this spread with futures would almost certainly have lost money; he probably would not have held it until it reached this lowly level, but there was never much opportunity to get out at a profit. The strategist who established the spread with options, however, most certain­ ly would have made money. One could safely assume that he covered the three futures sold in the previous example at a nice profit, possibly 7 points or so. One could also assume that as the puts became in-the-money options, he established a similar hedge and bought three unleaded gasoline futures when the EFP reached -3.00. This probably occurred with unleaded gasoline futures around .5700-5 cents in the money. Assuming that these were the trades, the following table shows the profits and losses. Chapter 35: Futures Option Strategies for Futures Spreads 719 Initial Final Net Profit/ Position Price Price Loss Bought 5 calls 6.40 0 -$13,440 Bought 5 puts 4.25 10.00 + 12,075 Sold 3 heating oil futures .7100 .6400 + 8,820 Bought 3 unleaded gas futures .5700 .5200 - 6,300 Total profit: +$ 1,155 In the final analysis, the fact that the intermarket spread collapsed to zero actu­ ally aided the option strategy, since the puts were the in-the-money option at expira­ tion. This was not planned, of course, but by being long the options, the strategist was able to make money when volatility appeared. INTRAMARKET SPREAD STRATEGY It should be obvious that the same strategy could be applied to an intramarket spread as well. If one is thinking of spreading two different soybean futures, for example, he could substitute in-the-money options for futures in the position. He would have the same attributes as shown for the intermarket spread: large potential profits if volatil­ ity occurs. Of course, he could still make money if the intramarket spread widens, but he would lose the time value premium paid for the options. SPREADING FUTURES AGAINST STOCK SECTOR INDICES This concept can be carried one step further. Many futures contracts are related to stocks - usually to a sector of stocks dealing in a particular commodity. For example, there are crude oil futures and there is an Oil & Gas Sector Index (XOI). There are gold futures and there is a Gold & Silver Index (XAU). If one charts the history of the commodity versus the price of the stock sector, he can often find tradeable pat­ terns in terms of the relationship between the two. That relationship can be traded via an intermarket spread using options. For example, if one thought crude oil was cheap with respect to the price of oil stocks in general, he could buy calls on crude oil futures and buy puts on the Oil & Gas (XOI) Index. One would have to be certain to determine the number of options to trade on each side of the spread, by using the ratio that was presented in Chapter 31 on inter-index spreading. (In fact, this formula should be used for futures inter­ market spreading if the two underlying futures don't have the same terms.) Only now, there is an extra component to add if options are used - the delta of the options: 720 Part V: Index Options and Futures where vi = volatility Pi = price of the underlying ui = unit of trading of the option Lli = delta of the option Example: Suppose that one indeed wants to buy crude oil calls and also buy puts on the XOI Index because he thinks that crude oil is cheap with respect to oil stocks. The following prices exist: July crude futures: 16.35 Crude July 1550 call: 1.10 Volatility: 25% Call delta: O. 7 4 $XOI: 256.50 June 265 put: 14½ Volatility: 17% Put delta: 0. 73 The unit of trading for XOI options is $100 per point, as it is with nearly all stock and index options. The unit of trading for crude oil futures and options is $1,000 per point. With all of this information, the ratio can be computed: Crude= 1,000 x 0.25 x 16.35 x 0.74 XOI = 100 x 0.17 x 256.50 x 0.73 Ratio = Crude/ XOI = 0.91 Therefore, one would buy 0.91 XOI put for every 1 crude oil call that he bought. For small accounts, this is essentially a 1-to-l ratio, but for large accounts, the exact ratio could be used (for example, buy 91 XOI puts and 100 crude oil calls). The resultant quantities encompass the various differences in these two markets - mainly the price and volatility of the underlyings, plus the large differential in their units of trading (100 vs. 1,000). SUMMARY Futures spreading is a very important and potentially profitable endeavor. Utilizing options in these spreads can often improve profitability to the point that an originally mistaken assumption can be overcome by volatility of price movement. Chapter 35: Futures Option Strategies for Futures Spreads 721 Futures spreads fall into two categories - intermarket and intramarket. They are important strategies because many futures exhibit historic and/or seasonal ten­ dencies that can be traded without regard to the overall movement of futures prices. Options can be used to enhance these futures spreading strategies. The futures calendar spread is closely related to the intramarket spread. It is distinctly different from the stock or index option calendar spread. Using in-the-money long option combinations in lieu of futures can be a very attractive strategy for either intermarket or intramarket spreads. The option strategy gives the spreader two ways to make money: ( 1) from the movement of the underly­ ing futures in the spread; or (2) if the futures prices experience a big move, from the fact that one option can continually increase in value while the other can drop only to zero. The option strategy also affords the strategist the opportunity for follow-up action based on the equivalent futures position that accumulates as prices rise or fall. The concepts introduced in this chapter apply not only to futures spreads, but to intermarket spreads between any two entities. An example was given of an inter­ market spread between futures and a stock sector index, but the concept can be gen­ eralized to apply to any two related markets of any sort. Traders who utilize futures spreads as part of their trading strategy should give serious consideration to substituting options when applicable. Such an alternative strategy will often improve the chances for profit. PART VI Measuring and vv, V V' VV ,MN' V V V . Trading Volatility 724 Part VI: Measuring and Trading Volatility Even though a myriad of strategies and concepts have been presented so far, a com­ mon thread among them is lacking. The one thing that ties all option strategies together and allows one to make comparative decisions is volatility. In fact, volatility is the most important concept in option trading. Oh, sure, if you're a great picker of stocks, then you might be able to get by without considering volatility. Even then, though, you'd be operating without full consideration of the main factor influencing option prices and strategy. For the rest of us, it is mandatory that we consider volatil­ ity carefully before deciding what strategy to use. In this section of the book, an extensive treatment of volatility and volatility trading is presented. The first part defines the terms and discusses some general concepts about how volatility can - and should - be used. Then, a number of the more popular strategies, described earlier in the book, are discussed from the vantage point of how they perform when implied volatilities change. After that, volatility trading strategies are discussed - and these are some of the most important concepts for option traders. A discussion is present­ ed of how stock prices actually behave, as opposed to how investors perceive them to behave, and then specific criteria and methodology for both buying and selling volatility are introduced. The information to be presented here is not overly theoretical. All of the con­ cepts should be understandable by most option traders. Whether or not one chooses to actually "trade volatility," it is nevertheless important for an option trader to under­ stand the concepts that underlie the basic principles of volatility trading. WHY TRADE 11 THE MARKET"? The "game" of stock market predicting holds appeal for many because one who can do it seems powerful and intelligent. Everyone has his favorite indicators, analysis techniques, or "black box" trading systems. But can the market really be predicted? And if it can't, what does that say about the time spent trying to predict it? The answers to these questions are not clear, and even if one were to prove that the mar­ ket can't be predicted, most traders would refuse to believe it anyway. In fact, there may be more than one way to "predict" the market, so in a certain sense one has to qualify exactly what he is talking about before it can be determined if the market can be predicted or not. The astute option trader knows that market prediction falls into two categories: (1) the prediction of the short-term movement of prices, and (2) the prediction of volatility of the underlying. These are not independent predictions. For example, anyone who is using a "target" is trying to predict both. That's pretty hard. Not only do you have to be right about the direction of prices, but you also have to be able to Part VI: Measuring and Trading Volatility 725 predict how volatile the underlying is going to be so that you can set a reasonable tar­ get. In certain cases, the first prediction can be made with some degree of accuracy, but the second one is extremely difficult. Nearly every trader uses something to aid him in determining what to buy and when to buy it. Many of these techniques, especially if they are refined to a trading system, seem worthwhile. In that sense, it appears that the market can be predicted. However, this type of predicting usually involves a lot of work, including not only the initial selection of the position, but money management in determining position size, risk management in placing and watching ( trailing) stops, and so on. Thus, it's not easy. To make matters even worse, most mathematical studies have shown that the market can't really be predicted. They tend to imply that anyone who is outperform­ ing an index fund is merely "hot" - has hit a stream of winners. Can this possibly be true? Consider this example. Have you ever gone to Las Vegas and had a winning day? How about a weekend? What about a week? You might be able to answer "yes" to all of those, even though you know for a certainty that the casino odds are mathe­ matically stacked against you. What if the question were extended to your lifetime: Are you ahead of the casinos for your entire life? This answer is most certainly "no" if you have played for any reasonably long period of time. Mathematicians have tended to believe that outperforming the broad stock market is just about the same as beating the casinos in Las Vegas - possible in the short term, but virtually impossible in the long term. Thus, when mathematicians say that the stock market can't be predicted, they are talking about consistently beating the "index" - say, the S&P 500 - over a long period of time. Those with an opposing viewpoint, however, say that the market can be beat. They say the "game" is more like poker - where a good player can be a consistent winner through money management techniques - than like casino gambling, where the odds are fixed. It would be impossible to get everyone to agree for sure on who is right. There's some credibility in both viewpoints, but just as it's very hard to be a good poker player, so it is difficult to beat the market consistently with directional strategies. Moreover, even the best directional traders know that there are large swings or drawdowns in one's net worth during the year. Thus, the consistency of returns is generally erratic for the directional trader. This inconsistency of returns, the amount of work required, and the necessity to have sufficient capital and to manage it well are all factors that can lead to the demise of a directional trader. As such, short-term directional trading probably is not really a "comfortable" trading strategy for most traders - and if one is trading a strat­ egy that he is not comfortable with, he is eventually going to lose money doing it. 726 Part VI: Measuring and Trading Volatility So, is there a better alternative? Or should one just pack it in, buy some index funds, and forget it? As an option strategist, one should most certainly believe that there's something better than buying the index fund. The alternative of volatility trad­ ing offers significant advantages in terms of the factors that make directional trading difficult. If one finds that he is able to handle the rigors of directional trading, then stick with that approach. You might want to add some volatility trading to your arsenal, though, just to be safe. However, if one finds that directional trading is just too time­ consuming, or you have trouble utilizing stops properly, or are constantly getting whipsawed, then it's time to concentrate more heavily on volatility trading, preferably in the form of straddle buying. CHAPTER 36 The Basics of Volatility Trading Volatility trading first attracted mathematically oriented traders who noticed that the market's prediction of forthcoming volatility - for example, implied volatility - was substantially out of line with what one might reasonably expect should happen. Moreover, many of these traders (market-makers, arbitrageurs, and others) had found great difficulties with keeping a "delta neutral" position neutral. Seeking a bet­ ter way to trade without having a market opinion on the underlying security, they turned to volatility trading. This is not to suggest that volatility trading eliminates all market risk, turning it all into volatility risk, for example. But it does suggest that a certain segment of the option trading population can handle the risk of volatility with more deference and aplomb than they can handle price risk Simply stated, it seems like a much easier task to predict volatility than to pre­ dict prices. That is said notwithstanding the great bull market of the 1990s, in which every investor who strongly participated certainly feels that he understands how to predict prices. Remember not to confuse brains with a bull market. Consider the chart in Figure 36-1. This seems as if it might be a good stock to trade: Buy it near the lows and sell it near the highs, perhaps even selling it short near the highs and covering when it later declines. It appears to have been in a trading range for a long time, so that after each purchase or sale, it returns at least to the midpoint of its trading range and sometimes even continues on to the other side of the range. There is no scale on the chart, but that doesn't change the fact that it appears to be a tradable entity. In fact, this is a chart of implied volatility of the options on a major U.S. corporation. It really doesn't matter which one (it's IBM), because the implied volatility chart of near­ ly every stock, index, or futures contract has a similar pattern - a trading range. The only time that implied volatility will totally break out of its "normal" range is if some­ thing material happens to change the fundamentals of the way the stock moves - a takeover bid, for example, or perhaps a major acquisition or other dilution of the stock 727 728 Part VI: Measuring and Trading Volatility FIGURE 36-1. A sample chart. Buy at these points. So, many traders observed this pattern and have become adherents of trying to predict volatility. Notice that if one is able to isolate volatility, he doesn't care where the stock price goes he is just concerned with buying volatility near the bottom of the range and selling it when it gets back to the middle or high end of the range, or vice versa. In real life, it is nearly impossible for a public customer to be able to iso­ late volatility so specifically. He will have to pay some attention to the stock price, but he still is able to establish positions in which the direction of the stock price is irrel­ evant to the outcome of the position. This quality is appealing to many investors, who have repeatedly found it difficult to predict stock prices. Moreover, an approach such as this should work in both bull and bear markets. Thus, volatility trading appeals to a great number of individuals. Just remember that, for you personally to operate a strategy properly, you must find that it appeals to your own philosophy of trading. Trying to use a strategy that you find uncomfortable will only lead to losses and frus­ tration. So, if this somewhat neutral approach to option trading sounds interesting to you, then read on. DEFINITIONS OF VOLATILITY Volatility is merely the term that is used to describe how fast a stock, future, or index changes in price. When one speaks of volatility in connection with options, there are two types of volatility that are important. The first is historical volatility, which is a measure of how fast the underlying instrument has been changing in price. The other is implied volatility, which is the option market's prediction of the volatility of the Chapter 36: The Basics of Volatility Trading 729 underlying over the life of the option. The computation and comparison of these two measures can aid immensely in predicting the forthcoming volatility of the underly­ ing instrument - a crucial matter in determining today's option prices. Historical volatility can be measured with a specific formula, as shown in the · chapter on mathematical applications. It is merely the formula for standard deviation as contained in most elementary books on statistics. The important point to under­ stand is that it is an exact calculation, and there is little debate over how to compute historical volatility. It is not important to know what the actual measurement means. That is, if one says that a certain stock has a historical volatility of 20%, that by itself is a relatively meaningless number to anyone but an ardent statistician. However, it can be used for comparative purposes. The standard deviation is expressed as a percent. One can determine that the historical volatility of the broad stock market has usually been in the range of 15% to 20%. A very volatile stock might have an historical volatility in excess of 100%. These numbers can be compared to each other, so that one might say that a stock with the latter historical volatility is five times more volatile that the "stock market." So, the historical volatility of one instrument can be compared with that of another instru­ ment in order to determine which one is more volatile. That in itself is a useful func­ tion of historical volatility, but its uses go much farther than that. Historical volatility can be measured over different time periods to give one a sense of how volatile the underlying has been over varying lengths of time. For exam­ ple, it is common to compute a 10-day historical volatility, as well as a 20-day, 50-day, and even 100-day. In each case, the results are annualized so that one can compare the figures directly. Consider the chart in Figure 36-2. It shows a stock (although it could be a futures contract or index, too) that was meandering in a rather tight range for quite some time. At the point marked "A" on the chart, it was probably at its least volatile. At that time, the 10-dayvolatility might have been something quite low, say 20%. The price movements directly preceding point A had been very small. However, prior to that time the stock had been more volatile, so longer-term measures of the historical volatility would shown higher numbers. The possible measures of historical volatility, then at point A, might have been something like: 10-day historical volatility: 20% 20-day historical volatility: 23% 50-day historical volatility: 35% 100-day historical volatility: 45% A pattern of historical volatilities of this sort describes a stock that has been slowing down lately. 730 FIGURE 36-2. Sample stock chart. :::::::::r;~.w· r I , .. ~ n I ll•• ~N IT Part VI: Measuring and Trading Volatllity : I I j j ~ JI • I' 'Vn ~- A Its price movements have been less extreme in the near term. Again referring to Figure 36-2, note that shortly after point A, the stock jumped much higher over a short period of time. Price action like this increases the implied volatility dramatically. And, at the far right edge of the chart, the stock had stopped rising but was swinging back and forth in far more rapid fashion than it had been at most other points on the chart. Violent action in a back-and-forth manner can often produce a higher historical volatility reading that straight-line move can; it's just the way the numbers work out. So, by the far right edge of the chart, the 10-day histori­ cal volatility would have increased rather dramatically, while the longer-term meas­ ures wouldn't be so high because they would still contain the price action that occurred prior to point A. At the far right edge of Figure 36-2, these figures might apply: l 0-day historical volatility: 80% 20-day historical volatility: 75% 50-day historical volatility: 60% l 00-day historical volatility: 55% With this alignment of historical volatilities, one can see that the stock has been more volatile recently than in the more distant past. In Chapter 38 on the distribu­ tion of stock prices, we will discuss in some detail just which one, if any, of these his­ torical volatilities one should use as "the" historical volatility input into option and Chapter 36: The Basics of Volatility Trading 731 probability models. We need to be able to make volatility estimates in order to deter­ mine whether or not a strategy might be successful, and to determine whether the current option price is a relatively cheap one or a relatively expensive one. For exam­ ple, one can't just say, "I think XYZ is going to rise at least 18 points by February expi­ ration." There needs to be some basis in fact for such a statement and, lacking inside information about what the company might announce between now and February, that basis should be statistics in the form of volatility projections. Historical volatility is, of course, useful as an input to the (Black-Scholes) option model. In fact, the volatility input to any model is crucial because the volatility com­ ponent is such a major factor in determining the price of an option. Furthermore, historical volatility is useful for more than just estimating option prices. It is neces­ sary for making stock price projections and calculating distributions, too, as will be shown when those topics are discussed later. Any time one asks the question, "What is the probability of the stock moving from here to there, or of exceeding a particu­ lar target price?" the answer is heavily dependent on the volatility of the underlying stock (or index or futures). It is obvious from the above example that historical volatility can change dra­ matically for any particular instrument. Even if one were to stick with just one measure of historical volatility ( the 20-day historical is commonly the most popular measure), it changes with great frequency. Thus, one can never be certain that bas­ ing option price predictions or stock price distributions on the current historical volatility will yield the "correct" results. Statistical volatility may change as time goes forward, in which case your projections would be incorrect. Thus, it is impor­ tant to make projections that are on the conservative side. ANOTHER APPROACH: GARCH GARCH stands for Generalized Autoregressive Conditional Heteroskedasticity, which is why it's shortened to GARCH. It is a technique for forecasting volatility that some analysts say produces better projections than using historical volatility alone or implied volatility alone. GARCH was created in the 1980s by specialists in the field of econometrics. It incorporates both historical and implied volatility, plus one can throw in a constant ("fudge factor"). In essence, though, the user of GARCH volatility mod­ els has to make some predictions or decisions about the weighting of the factors used for the estimate. By its very nature, then, it can be just as vague as the situations described in the previous section. The model can "learn," though, if applied correctly. That is, if one makes a volatility prediction for today (using GARCH, let's say), but it turns out that the actu- 732 Part VI: Measuring and Trading Volatility al volatility was lower, then when you make the volatility prediction for tomorrow, you'll probably want to adjust it downward, using the experience of the real world, where you see volatility declining. This also incorporates the common-sense notion that volatility tends to remain the same; that is, tomorrow's volatility is likely to be much like today's. Of course, that's a little bit like saying tomorrow's weather is likely to be the same as today's (which it is, two-thirds of the time, according to statistics). It's just that when a tornado hits, you have to realize that your forecast could be wrong. The same thing applies to GAR CH volatility projections. They can be wrong, too. So, GARCH does not do a perfect job of estimating and forecasting volatility. In fact, it might not even be superior, from a strategist's viewpoint, to using the simple minimum/maximum techniques outlined in the previous section. It is really best geared to predicting short-term volatility and is favored most heavily by dealers in currency options who must adjust their markets constantly. For longer-term volatility projections, which is what a position trader of volatility is interested in, GARCH may not be all that useful. However, it is considered state-of-the-art as far as volatility pre­ dicting goes, so it has a following among theoretically oriented traders and analysts. MOVING AVERAGES Some traders try to use moving averages of daily composite implied volatility read­ ings, or use a smoothing of recent past historical volatility readings to make volatility estimates. As mentioned in the chapter on mathematical applications, once the com­ posite daily implied volatility has been computed, it was recommended that a smoothing effect be obtained by taking a moving average of the 20 or 30 days' implied volatilities. In fact, an exponential moving average was recommended, because it does not require one to keep accessing the last 20 or 30 days' worth of data in order to compute the moving average. Rather, the most recent exponential mov­ ing average is all that's needed in order to compute the next one. IMPLIED VOLATILITY Implied volatility has been mentioned many times already, but we want to expand on its concept before getting deeper into its measure and uses later in this section. Implied volatility pertains only to options, although one can aggregate the implied volatilities of the various options trading on a particular underlying instrument to produce a single number, which is often referred to as the implied volatility of the underlying. 732 Part VI: Measuring and Trading Volatility al volatility was lower, then when you make the volatility prediction for tomorrow, you'll probably want to adjust it downward, using the experience of the real world, where you see volatility declining. This also incorporates the common-sense notion that volatility tends to remain the same; that is, tomorrow's volatility is likely to be much like today's. Of course, that's a little bit like saying tomorrow's weather is likely to be the same as today's (which it is, two-thirds of the time, according to statistics). It's just that when a tornado hits, you have to realize that your forecast could be wrong. The same thing applies to GARCH volatility projections. They can be wrong, too. So, GARCH does not do a perfect job of estimating and forecasting volatility. In fact, it might not even be superior, from a strategist's viewpoint, to using the simple minimum/maximum techniques outlined in the previous section. It is really best geared to predicting short-term volatility and is favored most heavily by dealers in currency options who must adjust their markets constantly. For longer-term volatility projections, which is what a position trader of volatility is interested in, GAR CH may not be all that useful. However, it is considered state-of-the-art as far as volatility pre­ dicting goes, so it has a following among theoretically oriented traders and analysts. MOVING AVERAGES Some traders try to use moving averages of daily composite implied volatility read­ ings, or use a smoothing of recent past historical volatility readings to make volatility estimates. As mentioned in the chapter on mathematical applications, once the com­ posite daily implied volatility has been computed, it was recommended that a smoothing effect be obtained by taking a moving average of the 20 or 30 days' implied volatilities. In fact, an exponential moving average was recommended, because it does not require one to keep accessing the last 20 or 30 days' worth of data in order to compute the moving average. Rather, the most recent exponential mov­ ing average is all that's needed in order to compute the next one. IMPLIED VOLATILITY Implied volatility has been mentioned many times already, but we want to expand on its concept before getting deeper into its measure and uses later in this section. Implied volatility pertains only to options, although one can aggregate the implied volatilities of the various options trading on a particular underlying instrument to produce a single number, which is often referred to as the implied volatility of the underlying. 732 Part VI: Measuring and Trading Volatility al volatility was lower, then when you make the volatility prediction for tomorrow, you'll probably want to adjust it downward, using the experience of the real world, where you see volatility declining. This also incorporates the common-sense notion that volatility tends to remain the same; that is, tomorrow's volatility is likely to be much like today's. Of course, that's a little bit like saying tomorrow's weather is likely to be the same as today's (which it is, two-thirds of the time, according to statistics). It's just that when a tornado hits, you have to realize that your forecast could be wrong. The same thing applies to GARCH volatility projections. They can be wrong, too. So, GAR CH does not do a perfect job of estimating and forecasting volatility. In fact, it might not even be superior, from a strategist's viewpoint, to using the simple minimum/maximum techniques outlined in the previous section. It is really best geared to predicting short-term volatility and is favored most heavily by dealers in currency options who must adjust their markets constantly. For longer-term volatility projections, which is what a position trader of volatility is interested in, GARCH may not be all that useful. However, it is considered state-of-the-art as far as volatility pre­ dicting goes, so it has a following among theoretically oriented traders and analysts. MOVING AVERAGES Some traders try to use moving averages of daily composite implied volatility read­ ings, or use a smoothing of recent past historical volatility readings to make volatility estimates. As mentioned in the chapter on mathematical applications, once the com­ posite daily implied volatility has been computed, it was recommended that a smoothing effect be obtained by taking a moving average of the 20 or 30 days' implied volatilities. In fact, an exponential moving average was recommended, because it does not require one to keep accessing the last 20 or 30 days' worth of data in order to compute the moving average. Rather, the most recent exponential mov­ ing average is all that's needed in order to compute the next one. IMPLIED VOLATILITY Implied volatility has been mentioned many times already, but we want to expand on its concept before getting deeper into its measure and uses later in this section. Implied volatility pertains only to options, although one can aggregate the implied volatilities of the various options trading on a particular underlying instrument to produce a single number, which is often referred to as the implied volatility of the underlying. Chapter 36: The Basics of Volatility Trading 733 At any one point in time, a trader knows for certain the following items that affect an option's price: stock price, strike price, time to expiration, interest rate, and dividends. The only remaining factor is volatility - in fact, implied volatility. It is the big "fudge factor" in option trading. If implied volatility is too high, options will be overpriced. That is, they will be relatively expensive. On the other hand, if implied volatility is too low, options will be cheap or underpriced. The terms "overpriced" and "underpriced" are not really used by theoretical option traders much anymore, because their usage implies that one knows what the option should be worth. In the modem vernacular, one would say that the options are trading with a "high implied volatility" or a "low implied volatility," meaning that one has some sense of where implied volatility has been in the past, and the current measure is thus high or low in comparison. Essentially, implied volatility is the option market's guess at the forthcoming sta­ tistical volatility of the underlying over the life of the option in question. If traders believe that the underlying will be volatile over the life of the option, then they will bid up the option, making it more highly priced. Conversely, if traders envision a non­ volatile period for the stock, they will not pay up for the option, preferring to bid lower; hence the option will be relatively low-priced. The important thing to note is that traders normally do not know the future. They have no way of knowing, for sure, how volatile the underlying is going to be during the life of the option. Having said that, it would be unrealistic to assume that inside information does not leak into the marketplace. That is, if certain people possess nonpublic knowledge about a company's earnings, new product announcement, takeover bid, and so on, they will aggressively buy or bid for the options and that will increase implied volatil­ ity. So, in certain cases, when one sees that implied volatility has shot up quickly, it is perhaps a signal that some traders do indeed know the future - at least with respect to a specific corporate announcement that is about to be made. However, most of the time there is not anyone trading with inside information. Yet, every option trader - market-maker and public alike - is forced to make a "guess" about volatility when he buys or sells an option. That is true because the price he pays is heavily influenced by his volatility estimate ( whether or not he realizes that he is, in fact, making such a volatility estimate). As you might imagine, most traders have no idea what volatility is going to be during the life of the option. They just pay prices that seem to make sense, perhaps based on historic volatility. Consequently, today's implied volatility may bear no resemblance to the actual statistical volatility that later unfolds during the life of the option. For those who desire a more mathematical definition of implied volatility, con­ sider this. 734 Part VI: Measuring and Trading Volatillty Opt price = f(Stock price, Strike price, Time, Risk-free rate, Volatility, Dividends) Furthermore, suppose that one knows the following information: XYZ price: 52 April 50 call price: 6 Time remaining to April expiration: 36 days Dividends: $0.00 Risk-free interest rate: 5% This information, which is available for every option at any time, simply from an option quote, gives us everything except the implied volatility. So what volatility would one have to plug in the Black-Scholes model ( or whatever model one is using) to make the model give the answer 6 (the current price of the option)? That is, what volatility is necessary to solve the equation? 6 = f(52, 50, 36 days, 5%, Volatility, $0.00) Whatever volatility is necessary to make the model yield the current market price (6) as its value, is the implied volatility for the XYZ April 50 call. In this case, if you're interested, the implied volatility is 75.4%. The actual process of determining implied volatility is an iterative one. There is no formula, per se. Rather, one keeps trying var­ ious volatility estimates in the model until the answer is close enough to the market value. THE VOLATILITY OF VOLATILITY In order to discuss the implied volatility of a particular entity - stock, index, or futures contract one generally refers to the implied volatility of individual options or perhaps the composite implied volatility of the entire option series. This is gener­ ally good enough for strategic comparisons. However, it turns out that there might be other ways to consider looking at implied volatility. In paiticular, one might want to consider how wide the range of implied volatility is - that is, how volatile the indi­ vidual implied volatility numbers are. It is often conventional to talk about the percentile of implied volatility. That is a way to rank the current implied volatility reading with past readings for the same underlying instrument. However, a fairly important ingredient is missing when percentiles are involved. One can't really tell if "cheap" options are cheap as a practical matter. That's because one doesn't know how tightly packed together the past implied volatility readings are. For example, if one were to discover that the entire past range of implied volatility for XYZ stretched only from 39% to 45%, then a current reading of 40%, while low, Chapter 36: The Basics of Volatility Trading 135 might not seem all that attractive. That is, if the first percentile of XYZ options were at an implied volatility reading of 39% and the 100th percentile were at 45%, then a reading of 40% is really quite mundane. There just wouldn't be much room for implied volatility to increase on an absolute basis. Even if it rose to the 100th per­ centile, an individual XYZ option wouldn't gain much value, because its implied volatility would only be increasing from about 40% to 45%. However, if the distribution of past implied volatility is wide, then one can truly say the options are cheap if they are currently in a low percentile. Suppose, rather than the tight range described above, that the range of past implied volatilities for XYZ instead stretched from 35% to 90% - that the first percentile for XYZ implied volatility was at 35% and the 100th percentile was at 90%. Now, if the current read­ ing is 40%, there is a large range above the current reading into which the options could trade, thereby potentially increasing the value of the options if implied volatil­ ity moved up to the higher percentiles. What this means, as a practical matter, is that one not only needs to know the current percentile of implied volatility, but he also needs to know the range of num­ bers over which that percentile was derived. If the range is wide, then an extreme percentile truly represents a cheap or expensive option. But if the range is tight, then one should probably not be overly concerned with the current percentile of implied volatility. Another facet of implied volatility that is often overlooked is how it ranges with respect to the time left in the option. This is particularly important for traders of LEAPS (long-term) options, for the range of implied volatility of a LEAPS option will not be as great as that of a short-term option. In order to demonstrate this, the implied volatilities of $OEX options, both regular and LEAPS, were charted over several years. The resulting scatter diagram is shown in Figure 36-3. Two curved lines are drawn on Figure 36-3. They contain most of the data points. One can see from these lines that the range of implied volatility for near-term options is greater than it is for longer-term options. For example, the implied volatil­ ity readings on the far left of the scatter diagram range from about 14% to nearly 40% (ignore the one outlying point). However, for longer-term options of 24 months or more, the range is about 17% to 32%. While $0EX options have their own idiosyn­ cracies, this scatter diagram is fairly typical of what we would see for any stock or index option. One conclusion that we can draw from this is that LEAPS option implied volatilities just don't change nearly as much as those of short-term options. That can be an important piece of information for a LEAPS option trader especially if he is comparing the LEAPS implied volatility with a composite implied volatility or with the historical volatility of the underlying. 736 Part VI: Measuring and Trading Volatility Once again, consider Figure 36-3. While it is difficult to discern from the graph alone, the 10th percentile of $OEX composite implied volatility, using all of the data points given, is 17%. The line that marks this level (the tenth percentile) is noted on the right side of the scatter diagram. It is quite easy to see that the LEAPS options rarely trade at that low volatility level. In Figure 36-3, the distance between the curved lines is much greater on the left side (i.e., for shorter-term options) than it is on the right side (for longer-term options). Thus, it's difficult for the longer-term options to register either an extreme­ ly high or extremely low implied volatility reading, when all of the options are con­ sidered. Consequently, LEAPS options will rarely appear "cheap" when one looks at their percentile of implied volatility, including all the short-term options, too: One might say that, if he were going to buy long-term options, he should look only at the size of the volatility range on the right side of the scatter diagram. Then, he could make his decision about whether the options are cheap or not by only com­ paring the current reading to past readings of long-term options. This line of think­ ing, though, is somewhat fallacious reasoning, for a couple of reasons: First, if one holds the option for any long period of time, the volatility range will widen out and there is a chance that implied volatility could drop substantially. Second, the long­ term volatility range might be so small that, even though the options are initially cheap, quick increase in implied volatility over several deciles might not translate into much of a gain in price in the short term. FIGURE 36-3. Implied volatilities of $OEX options over several years. 50 45 40 ~ 35 ~ 30 g 25 "O .91 20 C. E 15 -0th 10 5 0 0 10 20 30 40 Time to Expiration (months) Chapter 36: The Basics ol Volatility Trading 737 It's important for anyone using implied volatility in his trading decisions to understand that the range of past implied volatilities is important, and to realize that the volatility range expands as time shrinks. IS IMPLIED VOLATILITY A GOOD PREDICTOR OF ACTUAL VOLATILITY? The fact that one can calculate implied volatility does not mean that the calculation is a good estimate of forthcoming volatility. As stated above, the marketplace does not really know how volatile an instrument is going to be, any more than it knows the forthcoming price of the stock. There are clues, of course, and some general ways of estimating forthcoming volatility, but the fact remains that sometimes options trade with an implied volatility that is quite a bit out of line with past levels. Therefore, implied volatility may be considered to be an inaccurate estimate of what is really going to happen to the stock during the life of the option. Just remember that implied volatility is a forward-looking estimate, and since it is based on traders' suppositions, it can be wrong - just as any estimate of future events can be in error. The question posed above is one that should probably be asked more often than it is: "Is implied volatility a good predictor of actual volatility?" Somehow, it seems logical to assume that implied and historical (actual) volatility will converge. That's not really true, at least not in the short term. Moreover, even if they do converge, which one was right to begin with - implied or historical? That is, did implied volatil­ ity move to get more in line with actual movements of the underlying, or did the stock's movement speed up or slow down to get in line with implied volatility? To illustrate this concept, a few charts will be used that show the comparison between implied and historical volatility. Figure 36-4 shows information for the $0EX Index. In general, $0EX options are overpriced. See the discussion in Chapter 29. That is, implied volatility of $0EX options is almost always higher than what actual volatility turns out to be. Consider Figure 36-4. There are three lines in the figure: (a) implied volatility, (b) actual volatility, and (c) the difference between the two. There is an important distinction here, though, as to what comprises these curves: (a) The implied volatility curve depicts the 20-day moving average of daily compos­ ite implied volatility readings for $0EX. That is, each day one number is com­ puted as a composite implied volatility for $0EX for that day. These implied volatility figures are computed using the averaging formula shown in the chapter on mathematical applications, whereby each option's implied volatility is weight­ ed by trading volume and by distance in- or out-of-the-money, to arrive at a sin­ gle composite implied volatility reading for the trading day. To smooth out those daily readings, a 20-day simple moving average is used. This daily implied volatil- 738 Part VI: Measuring and Trading Volatility FIGURE 36-4. $OEX implied versus historical volatility. 10 Implied minus Actual 1999 Date ity of $OEX options encompasses all the $OEX options, so it is different from the Volatility Index ($VIX), which uses only the options closest to the money. By using all of the options, a slightly different volatility figure is arrived at, as com­ pared to $VIX, but a chart of the two would show similar patterns. That is, peaks in implied volatility computed using all of the $OEX options occur at the same points in time as peaks in $VIX. (b) The actual volatility on the graph is a little different from what one normally thinks of as historical volatility. It is the 20-day historical volatility, computed 20 days later than the date of the implied volatility calculation. Hence, points on the implied volatility curve are matched with a 20-day historical volatility calculation that was made 20 days later. Thus, the two curves more or less show the predic­ tion of volatility and what actually happened over the 20-day period. These actu­ al volatility readings are smoothed as well, with a 20-day moving average. (c) The difference between the two is quite simple, and is shown as the bottom curve on the graph. A "zero" line is drawn through the difference. When this "difference line" passes through the zero line, the projection of volatility and what actually occurred 20 days later were equal. If the difference line is above the zero line, then implied volatility was too high; the options were over­ priced. Conversely, if the difference line is below the zero line, then actual volatility turned out to be greater than implied volatility had anticipated. The options were underpriced in that case. Those latter areas are shaded in Figure 36-4. Simplistically, you would want to own options during the shaded periods on the chart, and would want to be a seller of options during the non-shaded areas. Chapter 36: The Basics of Volatility Trading 739 Note that Figure 36-4 indeed confirms the fact that $OEX options are consis­ tently overpriced. Very few charts are as one-dimensional as the $OEX chart, where the options were so consistently overpriced. Most stocks find the difference line oscillating back and forth about the zero mark. Consider Figures 36-5 and 36-6. Figure 36-5 shows a chart similar to Figure 36-4, comparing actual and implied volatility, and their difference, for a particular stock. Figure 36-6 shows the price graph of that same stock, overlaid on implied volatility, during the period up to and including the heavy shading. The volatility comparison chart (Figure 36-5) shows several shaded areas, dur­ ing which the stock was more volatile than the options had predicted. Owners of options profited during these times, provided they had a more or less neutral outlook on the stock. Figure 36-6 shows the stock's performance up to and including the March-April 1999 period - the largest shaded area on the chart. Note that implied volatility was quite low before the stock made the strong move from 10 to 30 in little more than a month. These graphs are taken from actual data and demonstrate just how badly out of line implied volatility can be. In February and early March 1999, implied volatility was at or near the lowest levels on these charts. Yet, by the end of March, a major price explosion had begun in the stock, one that tripled its value in just over a month. Clearly, implied volatility was a poor predictor of forthcoming actual volatility in this case. What about later in the year? In Figure 36-5, one can observe that implied and actual volatility oscillated back and forth quite a few times during the rest of 1999. It might appear that these oscillations are small and that implied volatility was actually doing a pretty good job of predicting actual volatility, at least until the final spike in December 1999. However, looking at the scale on the left-hand side of Figure 36-5, one can see that implied volatility was trying to remain in the 50% to 60% range, but actual volatility kept bolting higher rather frequently. One more example will be presented. Figures 36-7 and 36-8 depict another stock and its volatilities. On the left half of each graph, implied volatility was quite high. It was higher than actual volatility turned out to be, so the difference line in Figure 36-7 remains above the zero line for several months. Then, for some reason, the option market decided to make an adjustment, and implied volatility began to drop. Its lowest daily point is marked with a circle in Figure 36-8, and the same point in time is marked with a similar circle in Figure 36-7. At that time, options traders were "saying" that they expected the stock to be very tame over the ensuing weeks. Instead, the stock made two quick moves, one from 15 down to 11, and then anoth­ er back up to 17. That movement jerked actual volatility higher, but implied volatili­ ty remained rather low. After a period of trading between 13 and 15, during which time implied volatility remained low, the stock finally exploded to the upside, as evi­ denced by the spikes on the right-hand side of both Figures 36-7 and 36-8. Thus, 740 Part VI: Measuring and Trading Volatility FIGURE 36-5. Implied versus historical volatility of a stock. 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 oi--""""'""""',,,.....""' -10 -20 -30 "O -40 ct! -50 ~ -80 0. -701'-'-=CIJ+---+---+--+; -80 1999 FIGURE 36-6. Implied minus Actual The price graph of the stock. . . . •• , •••••••• ,. •••••••• .,. ••• + ••••••••••• ••••• -~······ •••••• ,. ••••••••••• ·t . ······ . . . ... [" ·· · ·· ·· ··· ·· · · · Stock Price · ·· · : ·· ·· I ~ !'"Y"d"'il~tilirrs::•of'T! ' ' .· ............ ; ·--·•·····! ............ · ................ : ............... : ...........•.. :. ············•·:••············•:•···········•;••·············(·········•: Implied Volatility 98 0 N D J F M A M 99 29.000 27.000 25.000 23.000 21.000 19.000 17.000 15.000 13.000 11.000 9.000 7.000 5.000 Date Chapter 36: The Basics of Volatility Trading FIGURE 36-7. Implied versus historical volatility of a stock. 120 110 100 90 80 70 60 50 40 30 20 10 01-----------~~r:cr:1--- -10 "O -20 ~ -30"5" F M A M J J A S O N D- Implied minus Actual 1999 FIGURE 36-8. The price graph of the stock • ... : ....... --: ......... : ·······.··········, ····-·-:· ....... : ........ ..; ... . ······: ---:·······•: J. ...... 1 ....... ) ....... --) .... ----1 .).. ! .). ······-·········-··· -.. ;..... : ...... ;.. . : ......... : .... . ...... .: ......... : .......... : .......... : ....... , ......... •. ..... ; ...... ) ....... .L.. ... .L .. Stock· Pri~e ..... ) ...... ) .. . ·······'• ...... _.: ____ .... •. ·······:---- .•.•••• j ' . J F M A M J J A S 0 N D J 1999 Date 27.000 25.000 23.000 21.000 19.000 17.000 15.000 13.000 11.000 9.000 7.000 5.000 741 742 Part VI: Measuring and Trading Volatility implied volatility was a poor predictor of actual volatility for most of the time on these graphs. Moreover, implied volatility remained low at the right-hand side of the charts (January 2000) even though the stock doubled in the course of a month. The important thing to note from these figures is that they clearly show that implied volatility is really not a very good predictor of the actual volatility that is to follow. If it were, the difference line would hover near zero most of the time. Instead, it swings back and forth wildly, with implied volatility over- or underestimating actu­ al volatility by quite wide levels. Thus, the current estimates of volatility by traders (i.e., implied volatility) can actually be quite wrong. Conversely, one could also say that historical volatility is not a great predictor of volatility that is to follow, either, especially in the short term. No one really makes any claims that it is a good predictor, for historical volatility is merely a reflection of what has happened in the past. All we can say for sure is that implied and historical volatil­ ity tend to trade within a range. One thing that does stand out on these charts is that implied volatility seems to fluctuate less than actual volatility. That seems to be a natural function of the volatil­ ity predictive process. For example, when the market collapses, implied volatilities of options rise only modestly. This can be observed by again referring to Figure 36-4, the $0EX option example. The only shaded area on the graph occurred when the market had a rather sharp sell-off during October 1999. In previous years, when there had been even more severe market declines (October 1997 or August-October 1998) $0EX actual volatility had briefly moved above implied volatility (this data for 1997 and 1998 is shown in Figure 36-9). In other words, option traders and market­ makers are predicting volatility when they price options, and one tends to make a FIGURE 36-9. $OEX implied versus historical volatility, 1997-1998. Actual 40 30 10 0 D J F M A -20 1997 1998 Chapter 36: The Basics of Volatility Trading 743 prediction that is somewhat "middle of the road," since an extreme prediction is more likely to be wrong. Of course, it turns out to be wrong anyway, since actual volatility jumps around quite rapidly. The few charts that have been presented here don't constitute a rigorous study upon which to draw the conclusion that implied volatility is a poor predictor of actu­ al volatility, but it is this author's firm opinion that that statement is true. A graduate student looking for a master's thesis topic could take it from here. VOLATILITY TRADING As a result of the fact that implied volatility can sometimes be at irrational extremes, options may sometimes trade with implied volatilities that are significantly out of line with what one would normally expect. For example, suppose a stock is in a relatively nonvolatile period, like the price of the stock in Figure 36-2, just before point A on the graph. During that time, option sellers would probably become more aggressive while option buyers, who probably have been seeing their previous purchases decay­ ing with time, become more timid. As a result, option prices drop. Alternatively stat­ ed, implied volatility drops. When implied volatilities are decreasing, option sellers are generally happy (and may often become more aggressive), while option buyers are losing money (and may often tend to become more timid). This is just a function of looking at the profit and loss statements in one's option account. But anyone who took a longer backward look at the volatility of the stock in Figure 36-2 would see that it had been much more volatile in the past. Consequently, he might decide that the implied volatility of the options had gotten too low and he would be a buyer of options. It is the volatility trader's objective to spot situations when implied volatility is possibly or probably erroneous and to take a position that would profit when the error is brought to light. Thus, the volatility trader's main objective is spotting situa­ tions when implied volatility is overvalued or undervalued, irrespective of his outlook for the underlying stock itself. In some ways, this is not so different from the funda­ mental stock analyst who is attempting to spot overvalued or undervalued stocks, based on earnings and other fundamentals. From another viewpoint, volatility trading is also a contrarian theory of invest­ ing. That is, when everyone else thinks the underlying is going to be nonvolatile, the volatility trader buys volatility. When everyone else is selling options and option buy­ ers are hard to find, the volatility trader steps up to buy options. Of course, some rig­ orous analysis must be done before the volatility trader can establish new positions, but when those situations come to light, it is most likely that he is taking positions opposite to what "the masses" are doing. He will be buying volatility when the major- 744 Part VI: Measuring and Trading Volatility ity has been selling it (or at least, when the majority is refusing to buy it), and he will be selling volatility when everyone else is panicking to buy options, making them quite expensive. WHY DOES VOLATILITY REACH EXTREMES? One can't just buy every option that he considers to be cheap. There must be some consideration given to what the probabilities of stock movement are. Even more important, one can't just sell every option that he values as expensive. There may be valid reasons why options become expensive, not the least of which is that someone may have inside information about some forthcoming corporate news (a takeover or an earnings surprise, for example). Since options off er a good deal of leverage, they are an attractive vehicle to any­ one who wants to make a quick trade, especially if that person believes he knows something that the general public doesn't know. Thus, if there is a leak of a takeover rumor - whether it be from corporate officers, investment bankers, printers, or accountants - whoever possesses that information may quite likely buy options aggressively, or at least bid for them. Whenever demand for an option outstrips sup­ ply - in this case, the major supplier is probably the market-maker - the options quickly get more expensive. That is, implied volatility increases. In fact, there are financial analysts and reporters who look for large increases in trading volume as a clue to which stocks might be ready to make a big move. Invariably, if the trading volume has increased and if implied volatility has increased as well, it is a good warning sign that someone with inside information is buying the options. In such a case, it might not be a good idea to sell volatility, even though the options are mathematically expensive. Sometimes, even more minor news items are known in advance by a small seg­ ment of the investing community. If those items will be enough to move the stock even a couple of points, those who possess the information may try to buy options in advance of the news. Such minor news items might include the resignation or firing of a high-ranking corporate officer, or perhaps some strategic alliance with another company, or even a new product announcement. The seller of volatility can watch for two things as warning signs that perhaps the options are "predicting" a corporate event (and hence should be avoided as a "volatility sale"). Those two things are a dramatic increase in option volume or a sud­ den jump in implied volatility of the options. One or both can be caused by traders with inside information trying to obtain a leveraged instrument in advance of the actual corporate news item being made public. Chapter 36: The Basics of Volatility Trading 745 A SUDDEN INCREASE IN OPTION VOLUME OR IMPLIED VOLATILITY The symptoms of insider trading, as evidenced by a large increase in option trading activity, can be recognized. Typically, the majority of the increased volume occurs in the near-term option series, particularly the at-the-money strike and perhaps the next strike out-of-the-money. The activity doesn't cease there, however. It propagates out to other option series as market-makers (who by the nature of their job function are short the near-term options that those with insider knowledge are buying) snap up everything on the books that they can find. In addition, the market-makers may try to entice others, perhaps institutions, to sell some expensive calls against a portion of their institutional stock holdings. Activity of this sort should be a warning sign to the volatility seller to stand aside in this situation. Of course, on any given day there are many stocks whose options are extraordi­ narily active, but the increase in activity doesn't have anything to do with insider trad­ ing. This might include a large covered call write or maybe a large put purchase established by an institution as a hedge against an existing stock position, or a rela­ tively large conversion or reversal arbitrage established by an arbitrageur, or even a large spread transaction initiated by a hedge fund. In any of these cases, option vol­ ume would jump dramatically, but it wouldn't mean that anyone had inside knowl­ edge about a forthcoming corporate event. Rather, the increases in option trading volume as described in this paragraph are merely functions of the normal workings of the marketplace. What distinguishes these arbitrage and hedging activities from the machina­ tions of insider trading is: (1) There is little propagation of option volume into other series in the "benign" case, and (2) the stock price itself may languish. However, when true insider activity is present, the market-makers react to the aggressive nature of the call buying. These market-makers know they need to hedge themselves, because they do not want to be short naked call options in case a takeover bid or some other news spurs the stock dramatically higher. As mentioned earlier, they try to buy up any other options offered in "the book," but there may not be many of those. So, as a last result, the way they reduce their negative position delta is to buy stock. Thus, if the options are active and expensive, and if the stock is rising too, you probably have a reasonably good indication that "someone knows something." However, if the options are expensive but none of the other factors are present, espe­ cially if the stock is declining in price - then one might feel more comfortable with a strategy of selling volatility in this case. However, there is a case in which options might be the object of pursuit by someone with insider knowledge, yet not be accompanied by heavy trading volume. This situation could occur with illiquid options. In this case, a floor broker holding 746 Part VI: Measuring and Trading Volatility the order of those with insider information might come into the pit to buy options, but the market-makers may not sell them many, preferring to raise their offering price rather than sell a large quantity. If this happens a few times in a row, the options will have gotten very expensive as the floor broker raises his bid price repeatedly, but only buys a few contracts each time. Meanwhile, the market-maker keeps raising his offering price. Eventually, the floor broker concludes that the options are too expensive to bother with and walks away. Perhaps his client then buys stock. In any case, what has happened is that the options have gotten very expensive as the bids and offers were repeatedly raised, but not much option volume was actually traded because of the illiquidity of the contracts. Hence the normal warning light associated with a sudden increase in option volume would not be present. In this case, though, a volatility sell­ er should still be careful, because he does not want to step in to sell calls right before some major corporate news item is released. The clue here is that implied volatility literally exploded in a short period of time (one day, or actually less time), and that alone should be enough warning to a volatility seller. The point that should be taken here is that when options suddenly become very expensive, especially if accompanied by strong stock price movement and strong stock volume, there may very well be a good reason why that is happening. That rea­ son will probably become public knowledge shortly in the form of a news event. In fact, a major market-maker once said he believed that rrwst increases in implied volatility were eventually justified - that is, some corporate news item was released that made the stock jump. Hence, a volatility seller should avoid situations such as these. Any sudden increase in implied volatility should probably be viewed as a potential news story in the making. These situations are not what a neutral volatility seller wants to get into. On the other hand, if options have become expensive as a result of corporate news, then the volatility seller can feel more comfortable making a trade. Perhaps the company has announced poor earnings and the stock has taken a beating while implied volatility rose. In this situation, one can assess the information and analyze it clearly; he is not dealing with some hidden facts known to only a few insider traders. With clear analysis, one might be able to develop a volatility selling strategy that is prudent and potentially profitable. Another situation in which options become expensive in the wake of market action is during a bear market in the underlying. This can be true for indices, stocks, and futures contracts. The Crash of '87 is an extreme example, but implied volatility shot through the roof during the crash. Other similar sharp market collapses - such as October 1989, October 1997, and August-September 1998 - caused implied volatility to jump dramatically. In these situations, the volatility seller knows why Chapter 31,: 1be Basics of Volatility Trading 747 implied volatility is high. Given that fact, he can then construct positions around a neutral strategy or around his view of the future. The time when the volatility seller must be careful is when the options are expensive and no one seems to know why. That's when insider trading may be present, and that's when the volatility seller should defer from selling options. CHEAP OPTIONS When options are cheap, there are usually far less discernible reasons why they have become cheap. An obvious one may be that the corporate structure of the company has changed; perhaps it is being taken over, or perhaps the company· has acquired another company nearly its size. In either case, it is possible that the combined enti­ ty's stock will be less volatile than the original company's stock was. As the takeover is in the process of being consummated, the implied volatility of the company's options will drop, giving the false impression that they are cheap. In a similar vein, a company may mature, perhaps issuing more shares of stock, or perhaps building such a.., good earnings stream that the stock is considered less volatile than it formerly was. Some of the Internet companies will be classic cases: In the beginning they were high-flying stocks with plenty of price movement, so the options traded with a relatively high degree of implied volatility. However, as the com­ pany matures, it buys other Internet companies and then perhaps even merges with a large, established company (America Online and Time-Warner Communications, for example). In these cases, actual (statistical) volatility will diminish as the company matures, and implied volatility will do the same. On the surface, a buyer of volatility may see the reduced volatility as an attractive buying situation, but upon further inspection he may find that it is justified. If the decrease in implied volatility seems justified, a buyer of volatility should ignore it and look for other opportunities. All volatility traders should be suspicious when volatility seems to be extreme - either too expensive or too cheap. The trader should investigate the possibilities as to why volatility is trading at such extreme levels. In some cases, the supply and demand of the public just pushes the options to extreme levels; there is nothing more involved than that. Those are the best volatility trading situations. However, if there is a hint that the volatility has gotten to an extreme reading because of some logical (but per­ haps nonpublic) reason, then the volatility trader should be suspicious and should probably avoid the trade. Typically this happens with expensive options. Buyers of volatility really have little to fear if they miscalculate and thus buy an option that appears inexpensive but turns out not to be, in reality. The volatility buyer might lose money if he does this, and overpaying for options constantly will lead to ruin, but an occasional mistake will probably not be fatal. 748 Part VI: Measuring and Trading Volatility Sellers of volatility, however, have to be a lot more careful. One mistake could be the last one. Selling naked calls that seem terrifically expensive by historic stan­ dards could be ruinous if a takeover bid subsequently emerges at a large premium to the stock's current price. Even put sellers must be careful, although a lot of traders think that selling naked puts is safe because it's the same as buying stock. But who ever said buying stock wasn't risky? If the stock literally collapses - falling from 80, say, to 15 or 20, as Oxford Health did, or from 30 to 2 as Sunrise Technology did - then a put seller will be buried. Since the risk of loss from naked option selling is large, one could be wiped out by a huge gap opening. That's why it's imperative to study why the options are expensive before one sells them. If it's known, for exam­ ple, that a small biotech company is awaiting FDA trial results in two weeks,~and all the options suddenly become expensive, the volatility seller should not attempt to be a hero. It's obvious that at least some traders believe that there is a chance for the stock to gap in price dramatically. It would be better to find some other situation in which to sell options. The seller of futures options or index options should be cautious too, although there can't be takeovers in those markets, nor can there be a huge earnings surprise or other corporate event that causes a big gap. The futures markets, though do have things like crop reports and government economic data to deal with, and those can create volatile situations, too. The bottom line is that volatility selling - even hedged volatility selling - can be taxing and aggravating if one has sold volatility in front of what turns out to be a news item that justifies the expensive volatility. SUMMARY Volatility trading is a predictable way to approach the market, because volatility almost invariably trades in a range and therefore its value can be estimated with a great deal more precision than can the actual prices of the underlyings. Even so, one must be careful in his approach to volatility trading, because diligent research is needed to determine if, in fact, volatility is "cheap" or "expensive." As with any sys­ tematic approach to the market, if one is sloppy about his research, he cannot expect to achieve superior results. In the next few chapters, a good deal of time will be spent to give the reader a good understanding of how volatility affects positions and how it can be used to construct trades with positive expected rates of return. · GHAR:f ER :8'7 . . - How Volatility Affects Popular Strategies The previous chapter addressed the calculation or interpretation of implied volatili­ ty, and how to relate it to historic volatility. Another, related topic that is important is how implied volatility affects a specific option strategy. Simplistically, one might think that the effect of a change in implied volatility on an option position would be a sim­ ple matter to discern; but in reality, most traders don't have a complete grasp of the ways that volatility affects option positions. In some cases, especially option spreads or more complex positions, one may not have an intuitive "picture" of how his posi­ tion is going to be affected by a change in implied volatility. In this chapter, we'll attempt a relatively thorough review of how implied volatility changes affect most of the popular option strategies. There are ways to use computer analysis to "draw" a picture of this volatiiity effect, of course, and that will be discussed momentarily. But an option strategist should have some idea of the general changes that a position will undergo if implied volatility changes. Before getting into the individual strategies, it is important that one understands some of the basics of the effect of volatility on an option's price. VEGA Technically speaking, the term that one uses to quantify the impact of volatility changes on the price of an option is called the vega of the option. In this chapter, the references will be to vega, but the emphasis here is on practicality, so the descriptions 749 750 Part VI: Measuring and Trading Volatility of how volatility affects option positions will be in plain English as well as in the more mathematical realm of vega. Having said that, let's define vega so that it is understood for later use in the chapter. Simply stated, vega is the amount by which an option's price changes when volatility changes by one percentage point. Example: XYZ is selling at 50, and the July 50 call is trading at 7.25. Assume that there is no dividend, that short-term interest rates are 5%, and that July expiration is exactly three months away. With this information, one can determine that the implied volatility of the July 50 call is 70%. That's a fairly high number, so one can surmise that XYZ is a volatile stock. What would the option price be if implied volatility were rise to 71 %? Using a model, one can determine that the July 50 call would theoreti­ cally be worth 7.35 if that happened. Hence, the vega of this option is 0.10 (to two decimal places). That is, the option price increased by 10 cents, from 7.25 to 7.35, when volatility rose by one percentage point. (Note that "percentage point" here means a full point increase in volatility, from 70% to 71 %.) What if implied volatility had decreased instead? Once again, one can use the model to determine the change in the option price. In this case, using an implied volatility of 69% and keeping everything else the same, the option would then theo­ retically be worth 7.15- again, a 0.10 change in price (this time, a decrease in price). This example points out an interesting and important aspect of how volatility affects a call option: If implied volatility increases, the price of the option will increase, and if implied volatility decreases, the price of the option will decrease. Thus, there is a direct relationship between an option's price and its implied volatili- ty. Mathematically speaking, vega is the partial derivative of the Black-Scholes model (or whatever model you're using to price options) with respect to volatility. In the above example, the vega of the July 50 call, with XYZ at 50, can be computed to be 0.098 - very near the value of 0.10 that one arrived at by inspection. Vega also has a direct relationship with the price of a put. That is, as implied volatility rises, the price of a put will rise as well. Example: Using the same criteria as in the last example, suppose that XYZ is trading at 50, that July is three months away, that short-term interest rates are 5%, and that there is no dividend. In that case, the following theoretical put and call prices would apply at the stated implied volatilities: Chapter 37: How Volatility Affects Popular Strategies 751 Stock Price July 50 call July 50 put Implied Volatility Put's Vega 50 7.15 6.54 69% 0.10 7.25 6.64 70% 0.10 7.35 6.74 71% 0.10 Thus, the put's vega is 0.10, too - the same as the call's vega was. In fact, it can be stated that a call and a put with the same terms have the same vega. To prove this, one need only refer to the arbitrage equation for a conversion. If the call increases in price and everything else remains equal - interest rates, stock price, and striking price - then the put price must increase by the same amount. A change in implied volatility will cause such a change in the call price, and a similar change in the put price. Hence, the vega of the put and the call must be the same. It is also important to know how the vega changes as other factors change, par­ ticularly as the stock price changes, or as time changes. The following examples con­ tain several tables that illustrate the behavior of vega in a typically fluctuating envi­ ronment. Example: In this case, let the stock price fluctuate while holding interest rate (5% ), implied volatility (70%), time (3 months), dividends (0), and the strike price (50) con­ stant. See Table 37-1. In these cases, vega drops when the stock price does, too, but it remains fairly constant if the stock rises. It is interesting to note, though, that in the real world, when the underlying drops in price especially if it does so quickly, in a panic mode - implied volatility can increase dramatically. Such an increase may be of great ben­ efit to a call holder, serving to mitigate his losses, perhaps. This concept will be dis­ cussed further later in this chapter. TABLE 37-1 Implied Volatility Theoretical Stock Price July 50 Call Price Coll Price Vega 30 70% 0.47 0.028 40 2.62 0.073 50 7.25 0.098 60 14.07 0.092 70 22.35 0.091 752 Part VI: Measuring and Trading Volatility The above example assumed that the stock was making instantaneous changes in price. In reality, of course, time would be passing as well, and that affects the vega too. Table 37-2 shows how the vega changes when time changes, all other factors being equal. Example: In this example, the following items are held fixed: stock price (50), strike price (50), implied volatility (70%), risk-free interest rate (5%), and dividend\(0). But now, we let time fluctuate. Table 37-2 clearly shows that the passage of time results not only in a decreas­ ing call price, but in a decreasing vega as well. This makes sense, of course, since one cannot expect an increase in implied volatility to have much of an effect on a very short-term option - certainly not to the extent that it would affect a LEAPS option. Some readers might be wondering how changes in implied volatility itself would affect the vega. This might be called the "vega of the vega," although I've never actu­ ally heard it referred to in that manner. The next table explores that concept. Example: Again, some factors will be kept constant - the stock price (50), the time to July expiration (3 months), the risk-free interest rate (5%), and the dividend (0). Table 37-3 allows implied volatility to fluctuate and shows what the theoretical price of a July 50 call would be, as well as its vega, at those volatilities. Thus, Table 37-3 shows that vega is surprisingly constant over a wide range of implied volatilities. That's the real reason why no one bothers with "vega of the vega." Vega begins to decline only if implied volatility gets exceedingly high, and implied volatilities of that magnitude are relatively rare. One can also compute the distance a stock would need to rise in order to over­ come a decrease in volatility. Consider Figure 37-1, which shows the theoretical price TABLE 37-2 Implied Time Theoretical Stock Price Volatility Remaining Call Price Vega 50 70% One year 14.60 0.182 Six months 10.32 0.135 Three months 7.25 0.098 Two months 5.87 0.080 One month 4.16 0.058 Two weeks 2.87 0.039 One week 1.96 0.028 One day 0.73 0.010 Chapter 37: How Volatility Affeds Popular Strategies TABLE 37-3 Implied Stock Price Volatility 50 10% 30% 50% 70% 100% 150% 200% Theoretical Coll Price 1.34 3.31 5.28 7.25 10.16 14.90 19.41 753 Vega 0.097 0.099 0.099 0.098 0.096 0.093 0.088 of a 6-month call option with differing implied volatilities. Suppose one buys an option that currently has implied volatility of 170% (the top curve on the graph). Later, investor perceptions of volatility diminish, and the option is trading with an implied volatility of 140%. That means that the option is now "residing" on the sec­ ond curve from the top of the list. Judging from the general distance between those two curves, the option has probably lost between 5 and 8 points of value due to the drop in implied volatility. Here's another way to think about it. Again, suppose one buys an at-the-money option (stock price = 100) when its implied volatility is 170%. That option value is marked as point A on the graph in Figure 37-1. Later, the option's implied volatility drops to 140%. How much does the stock have to rise in order to overcome the loss of implied volatility? The horizontal line from point A to point B shows that the option value is the same on each line. Then, dropping a vertical line from B down to point C, we see that point C is at a stock price of about 109. Thus, the stock would have to rise 9 points just to keep the option value constant, if implied volatility drops from 170% to 140%. IMPLIED VOLATILITY AND DELTA Figure 37-1 shows another rather unusual effect: When implied volatility gets very high, the delta of the option doesn't change much. Simplistically, the delta of an option measures how much the option changes in price when the stock moves one point. Mathematically, the delta is the first partial derivative of the option model with respect to stock price. Geometrically, that means that the delta of an option is the slope of a line drawn tangent to the curve in the preceding chart. 754 Part VI: Measuring and Trading Volatility FIGURE 37-1. Theoretical option prices at differing implied volatilities (6-month calls). 80 70 Q) 60 (.) ·;::: Cl.. 50 C: 0 ·a 40 0 30 20 10 Stock Price 60 80 100 C 120 140 _JY.._ 170% 140% 110% 80% 50% 20% The bottom line in Figure 37-1 (where implied volatility= 20%) has a distinct curvature to it when the stock price is between about 80 and 120. Thus the delta ranges from a fairly low number (when the stock is near 80) to a rather high number (when the stock is near 120). Now look at the top line on the chart, where implied volatility= 170%. It's almost a straight line from the lower left to the upper right! The slope of a straight line is constant. This tells us that the delta (which is the slope) barely changes for such an expensive option - whether the stock is trading at 60 or it's trading at 150! That fact alone is usually surprising to many. In addition, the value of this delta can be measured: It's 0. 70 or higher from a stock price of 80 all the way up to 150. Among other things, this means that an out~ of-the-money option that has extremely high implied volatility has a fairly high delta - and can be expected to mirror stock price movements more closely than one might think, were he not privy to the delta. Figure 37-2 follows through on this concept, showing how the delta of an option varies with implied volatility. From this chart, it is clear how much the delta of an option varies when the implied volatility is 20%, as compared to how little it varies when implied volatility is extremely high. That data is interesting enough by itself, but it becomes even more thought-pro­ voking when one considers that a change in the implied volatility of his option (vega) also can mean a significant change in the delta of the option. In one sense, it explains why, in the first chart (Figure 37-1), the stock could rise 9 points and yet the option holder made nothing, because implied volatility declined from 170% to 140%. Chapter 37: How Volatility Affects Popular Strategies EFFECTS ON NEUTRALITY 755 A popular concept that uses delta is the "delta-neutral" spread a spread whose prof­ itability is supposedly ambivalent to market movement, at least for short time frames and limited stock price changes. Anything that significantly affects the delta of an option can affect this neutrality, thus causing a delta-neutral position to become unbalanced ( or, more likely, causing one's intuition to be wrong regarding what con­ stitutes a delta-neutral spread in the first place). Let's use a familiar strategy, the straddle purchase, as an example. Simplistically, when one buys a straddle, he merely buys a put and a call with the same terms and doesn't get any fancier than that. However, it may be the case that, due to the deltas of the options involved, that approach is biased to the upside, and a neutral straddle position should be established instead. Example: Suppose that XYZ is trading at 100, that the options have an implied volatility of 40%, and that one is considering buying a six-month straddle with a strik­ ing price of 100. The following data summarize the situation, including the option prices and the deltas: XYZ Common: l 00; Implied Volatility: 40% Option XYZ October l 00 call XYZ October l 00 put FIGURE 37-2. Price 12.00 10.00 Delta 0.60 -0.40 Value of delta of a 6-month option at differing implied volatilities. 90 80 70 .!!l ai 60 Cl C: 50 ,g 8° 40 30 20 10 60 80 100 Stock Price 120 140 756 Part VI: Measuring and Trading Volatility Notice that the stock price is equal to the strike price (100). However, the deltas are not at all equal. In fact, the delta of the call is 1.5 times that of the put (in absolute value). One must buy three puts and two calls in order to have a delta-neutral posi­ tion. Most experienced option traders know that the delta of an at-the-money call is somewhat higher than that of an at-the-money put. Consequently, they often esti­ mate, without checking, that buying three puts and two calls produces a delta-neu­ tral "straddle buy." However, consider a similar situation, but with a much higher implied volatility- 110%, say. AAA Common: 100; Implied Volatility: 110% Option AAA October 100 call AAA October 1 00 put Price 31.00 28.00 Delta 0.67 -0.33 The delta-neutral ratio here is two-to-one (67 divided by 33), not three-to-two as in the earlier case - even though both stock prices are 100 and both sets of options have six months remaining. This is a big difference in the delta-neutral ratio, espe­ cially if one is trading a large quantity of options. This shows how different levels of implied volatility can alter one's perception of what is a neutral position. It also points out that one can't necessarily rely on his intuition; it is always best to check with a model. Carrying this thought a step further, one must be mindful of a change in implied volatility if he wants to keep his position delta-neutral. If the implied volatility of AAA options should drop significantly, the 2-to-l ratio will no longer be neutral, even if the stock is still trading at 100. Hence, a trader wishing to remain delta-neutral must monitor not only changes in stock price, but changes in implied volatility as well. For­ more complex strategies, one will also find the delta-neutral ratio changing due to a change in implied volatility. The preceding examples summarize the major variables that might affect the vega and also show how vega affects things other than itself, such as delta and, there­ fore, delta neutrality. By the way, the vega of the underlying is zero; an increase in implied volatility does not affect the price of the underlying instrument at all, in the­ ory. In reality, if options get very expensive (i.e., implied volatility spikes up), that usually brings traders into a stock and so the stock price will change. But that's not a mathematical relationship, just a market cause-and-effect relationship. Chapter 37: How Volatility Affects Popular Strategies POSITION VEGA 757 As can be done with delta or with any other of the partial derivatives of the model, one can compute a position vega - the vega of an entire position. The position vega is determined by multiplying the individual option vegas by the quantity of options bought or sold. The "position vega" is merely the quantity of options held, times the vega, times the shares per options ( which is normally 100). Example: Using a simple call spread as an example, assume the following prices exist: Security Position Vega Position Vego XYZ Stock No position XYZ July 50 call Long 3 calls 0.098 +0.294 XYZ July 70 call Short 5 calls 0.076 -0.380 Net Position Vega: -0.086 This concept is very important to a volatility trader, for it tells him if he has con­ structed a position that is going to behave in the manner he expects. For example, suppose that one identifies expensive options, and he figures that implied volatility will decrease, eventually becoming more in line with its historical norms. Then he would want to construct a position with a negative position vega. A negative position vega indicates that the position will profit if implied volatility decreases. Conversely, a buyer of volatility - one who identifies some underpriced situation - would want to construct a position with a positive position vega, for such a position will profit if implied volatility rises. In either case, other factors such as delta, time to expiration, and so forth will have an effect on the position's actual dollar profit, but the concept of position vega is still important to a volatility trader. It does no good to identify cheap options, for example, and then establish some strange spread with a negative position vega. Such a construct would be at odds with one's intended purpose - in this case, buying cheap options. OUTRIGHT OPTION PURCHASES AND SALES Let us now begin to investigate the affects of implied volatility on various strategies, beginning with the simplest strategy of all - the outright option purchase. It was already shown that implied volatility affects the price of an individual call or put in a 758 Part VI: Measuring and Trading Volatility direct manner. That is, an increase in implied volatility will cause the option price to rise, while a decrease in volatility will cause a decline in the option price. That piece of information is the most important one of all, for it imparts what an option trader needs to know: An explosion in implied volatility is a boon to an option owner, but can be a devastating detriment to an option seller, especially a naked option seller. A couple of examples might demonstrate more clearly just how powerful the effect of implied volatility is, even when there isn't much time remaining in the life of an option. One should understand the notion that an increase in implied volatility can overcome days, even weeks, of time decay. This first example attempts to quan­ tify that statement somewhat. Example: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3- month call with striking price of 100. Furthermore, suppose that implied volatility is currently at 20%. Given these assumptions, the Black-Scholes model tells us that the call would be trading at a price of 4.64. Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 3 months 20% 4.64 Now, suppose that a month passes. If implied volatility remained the same (20% ), the call would lose nearly a point of value due to time decay. However, how much would implied volatility have had to increase to completely counteract the effect of that time decay? That is, after a month has passed, what implied volatility will yield a call price of 4.64? lt turns out to be just under 26%. Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 2 months 25.9% 4.64 What would happen after another month passes? There is, of course, some implied volatility at which the call would still be worth 4.64, but is it so high as to be unreasonable? Actually, it turns out that if implied volatility increases to about 38%, the call will still be worth 4.64, even with only one month of life remaining: Chapter 37: How Volatility Affects Popular Strategies Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 1 month 38.1% 4.64 759 So, if implied volatility increases from 20% to 26% over the first month, then this call option would still be trading at the same price - 4.64. That's not an unusual increase in implied volatility; increases of that magnitude, 20% to 26%, happen all the time. For it to then increase from 26% to 38% over the next month is probably less likely, but it is certainly not out of the question. There have been many times in the past when just such an increase has been possible - during any of the August, September, or October bear markets or mini-crashes, for example. Also, such an increase in implied volatility might occur if there were takeover rumors in this stock, or if the entire market became more volatile, as was the case in the latter half of the 1990s. Perhaps this example was distorted by the fact that an implied volatility of 20% is a fairly low number to begin with. What would a similar example look like if one started out with a much higher implied volatility - say, 80%? Example: Making the same assumptions as in the previous example, but now setting the implied volatility to a much higher level of 80%, the Black-Scholes model now says that the call would be worth a price of 16.45: Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 3 months 80% 16.45 Again, one must ask the question: "If a month passes, what implied volatility would be necessary for the Black-Scholes model to yield a price of 16.45?" In this case, it turns out to be an implied volatility of just over 99%. Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 2 months 99.4% 16.45 758 Part VI: Measuring and Trading Volatility direct manner. That is, an increase in implied volatility will cause the option price to rise, while a decrease in volatility will cause a decline in the option price. That piece of information is the most important one of all, for it imparts what an option trader needs to know: An explosion in implied volatility is a boon to an option owner, but can be a devastating detriment to an option seller, especially a naked option seller. A couple of examples might demonstrate more clearly just how powerful the effect of implied volatility is, even when there isn't much time remaining in the life of an option. One should understand the notion that an increase in implied volatility can overcome days, even weeks, of time decay. This first example attempts to quan­ tify that statement somewhat. Example: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3- month call with striking price of 100. Furthermore, suppose that implied volatility is currently at 20%. Given these assumptions, the Black-Scholes model tells us that the call would be trading at a price of 4.64. Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 3 months 20% 4.64 Now, suppose that a month passes. If implied volatility remained the same (20% ), the call would lose nearly a point of value due to time decay. However, how much would implied volatility have had to increase to completely counteract the effect of that time decay? That is, after a month has passed, what implied volatility will yield a call price of 4.64? It turns out to be just under 26%. Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 2 months 25.9% 4.64 What would happen after another month passes? There is, of course, some implied volatility at which the call would still be worth 4.64, but is it so high as to be unreasonable? Actually, it turns out that if implied volatility increases to about 38%, the call will still be worth 4.64, even with only one month of life remaining: Chapter 37: How Volatility Affects Popular Strategies Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 1 month 38.1% 4.64 759 So, if implied volatility increases from 20% to 26% over the first month, then this call option would still be trading at the same price 4.64. That's not an unusual increase in implied volatility; increases of that magnitude, 20% to 26%, happen all the time. For it to then increase from 26% to 38% over the next month is probably less likely, but it is certainly not out of the question. There have been many times in the past when just such an increase has been possible - during any of the August, September, or October bear markets or mini-crashes, for example. Also, such an increase in implied volatility might occur if there were takeover rumors in this stock, or if the entire market became more volatile, as was the case in the latter half of the 1990s. Perhaps this example was distorted by the fact that an implied volatility of 20% is a fairly low number to begin with. What would a similar example look like if one started out with a much higher implied volatility say, 80%? Example: Making the same assumptions as in the previous example, but now setting the implied volatility to a much higher level of 80%, the Black-Scholes model now says that the call would be worth a price of 16.45: Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 3 months 80% 16.45 Again, one must ask the question: "If a month passes, what implied volatility would be necessary for the Black-Scholes model to yield a price of 16.45?" In this case, it turns out to be an implied volatility of just over 99%. Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 2 months 99.4% 16.45 760 Part VI: Measuring and Trading Volatility Finally, to be able to completely compare this example with the previous one, it is necessary to see what implied volatility would have to rise to in order to offset the effect of yet another month's time decay. It turns out to be over 140%: Stock Price: Strike Price: Time Remaining: Implied Volatility: Theoretical Call Value: 100 100 1 month 140.9% 16.45 Table 37-4 summarizes the results of these examples, showing the levels to which implied volatility would have to rise to maintain the call's value as time passes. Are the volatility increases in the latter example less likely to occur than the ones in the former example? Probably yes - certainly the last one, in which implied volatility would have to increase from 80% to nearly 141 % in order to maintain the call's value. However, in another sense, it may seem more reasonable: Note that the increase in volatility from 20% to 26% is a 30% increase. That is, 20% times 1.30 equals 26%. That's what's required to maintain the call's value for the lower volatility over the first month - an increase in the magnitude of implied volatility of 30%. At the higher volatility, though, an increase in magnitude of only about 25% is required (from 80% to 99%). Thus, in those terms, the two appear on more equal footing. What makes the top line of Table 37-4 appear more likely than the bottom line is merely the fact that an experienced option trader knows that many stocks have implied volatilities that can fluctuate in the 20% to 40% range quite easily. However, there are far fewer stocks that have implied volatilities in the higher range. In fact, until the Internet stocks got hot in the latter portion of the 1990s, the only ones with volatilities like those were very low-priced, extremely volatile stocks. Hence one's experience factor is lower with such high implied volatility stocks, but it doesn't mean that the volatility fluctuations appearing in Table 37-4 are impossible. If the reader has access to a software program containing the Black-Scholes model, he can experiment with other situations to see how powerful the effect of implied volatility is. For example, without going into as much detail, if one takes the case of a 12-month option whose initial implied volatility is 20%, all it takes to main- TABLE 37-4 Initial Implied Volatility 20% 80% Volatility Leveled Required to Maintain Call Value ... ... After One Month ... After Two Months 26% 99% 38% 141% Chapter 37: How Volatility Affects Popular Strategies 761 tain the call's value over a 6-month time period is an increase in implied volatility to 27%. Taken from the viewpoint of the option seller, this is perhaps most enlighten­ ing: If you sell a one-year (LEAPS) option and six months pass, during which time implied volatility increases from 20% to 27% - certainly quite possible -you will have made nothing! The call will still be selling for the same price, assuming the stock is still selling for the same price. Finally, it was mentioned earlier that implied volatility often explodes during a market crash. In fact, one could determine just how much of an increase in implied volatility would be necessary in a market crash in order to maintain the call's value. This is similar to the first example in this section, but now the stock price will be allowed to decrease as well. Table 37-5, then, shows what implied volatility would be required to maintain the call's initial value (a price of 4.64), when the stock price falls. The other factors remain the same: time remaining (3 months), striking price (100), and interest rate (5% ). Again, this table shows instantaneous price changes. In real life, a slightly higher implied volatility would be necessary, because each market crash could take a day or two. Thus, from Table 37-5, one could say that even if the underlying stock dropped 20 points (which is 20% in this case) in one day, yet implied volatility exploded from 20% to 67% at the same time, the call's value would be unchanged! Could such an outrageous thing happen? It has: In the Crash of '87, the market plummeted 22% in one day, while the Volatility Index ($VIX) theoretically rose from 36% to 150% in one day. In fact, call buyers of some $OEX options actually broke even or made a little money due to the explosion in implied volatility, despite the fact that the worst mar­ ket crash in history had occurred. If nothing else, these examples should impart to the reader how important it is to be aware of implied volatility at the time an option position is established. If you are buying options, and you buy them when implied volatility is "low," you stand to TABLE 37-5 Stock Price 100 95 90 85 80 75 70 Implied Volatility Necessary for Call to Maintain Value 20% (the initial parameters) 33% 44% 55% 67% 78% 89% 762 Part VI: Measuring and Trading Volatility benefit if implied volatility merely returns to "normal" levels while you hold the posi­ tion. Of course, having the underlying increase in price is also important. Conversely, an option seller should be keenly aware of implied volatility when the option is initially sold - perhaps even more so than the buyer of an option. This pertains equally well to naked option writers and to covered option writers. If implied volatility is "too low" when the option writing position is established, then an increase (or worse, an explosion) in implied volatility will be very detrimental to the position, completely overcoming the effects of time decay. Hence, an option writer should not just sell options because he thinks he is collecting time decay each day that passes. That may be true, but an increase in implied volatility can completely domin.ate what little time decay might exist, especially for a longer-term option. In a similar manner, a decrease in implied volatility can be just as important. Thus, if the call buyer purchases options that are "too costly," ones in which implied volatility is "too high," then he could lose money even if the underlying makes a mod­ est move in his favor. In the next chapters, the topic of just how an option buyer or seller should measure implied volatility to determine what is "too low" or "too high" will be dis­ cussed. For now, suffice it to grasp the general concept that a change in implied volatility can have substantial effects on an option's price far greater effects than the passage of time can have. In fact, all of this calls into question just exactly what time value premium is. That part of an option's value that is not intrinsic value is really affected much more by volatility than it is by time decay, yet it carries the term "time value premium." TIME VALUE PREMIUM IS A MISNOMER Many (perhaps novice) option traders seem to think of time as the main antagonist to an option buyer. However, when one really thinks about it, he should realize that the portion of an option that is not intrinsic value is really much more related to stock price movement and/or volatility than anything else, at least in the short term. For this reason, it might be beneficial to more closely analyze just what the "excess value" portion of an option represents and why a buyer should not primarily think of it as time value premium. An option's price is composed of two parts: (1) intrinsic value, which is the "real" part of the option's value - the distance by which the option is in-the-money, and (2) "excess value" - often called time value premium. There are actually five factors that affect the "excess value" portion of an option. Eventually, time will dominate them Chapter 37: How Volah'lity Affects Popular Strategies 763 all, but the longer the life of the option, the more the other factors influence the "excess value." The five factors influencing excess value are: 1. stock price movements, 2. changes in implied volatility, 3. the passage of time, 4. changes in the dividend (if any exist), and 5. changes in interest rates. Each is stated in terms of a movement or change; that is, these are not static things. In fact, to measure them one uses the "greeks": delta, vega, theta, (there is no "greek" for dividend change), and rho. Typically, the effect of a change in dividend or a change in interest rate is small (although a large dividend change or an interest rate change on a very long-term option can produce visible changes in the prices of options). If everything remains static, then time decay will eventually wipe out all of the excess value of an option. That's why it's called time value premium. But things don't ever remain static, and on a daily basis, time decay is small, so it is the remaining two factors that are most important. Example: XYZ is trading at 82 in late November. The January 80 call is trading at 8. Thus, the intrinsic value is 2 (82 minus 80) and the excess value is 6 (8 minus 2). If the stock is still at 82 at January expiration, the option will of course only be worth 2, and one will say that the 6 points of excess value that was lost was due to time decay. But on that day in late November, the other factors are much more dominant. On this particular day, the implied volatility of this option is just over 50%. One can determine that the call's greeks are: Delta: 0.60 Vega: 0.13 Theta: -0.06 This means, for example, that time decay is only 6 cents per day. It would increase as time went by, but even with a day or so to go, theta would not increase above about 20 cents unless volatility increased or the stock moved closer to the strike price. From the above figures, one can see - and this should be intuitively appealing that the biggest factor influencing the price of the option is stock price movement (delta). 764 Part VI: Measuring and Trading VolatiRty It's a little unfair to say that, because it's conceivable (although unlikely) that volatil­ ity could jump by a large enough margin to become a greater factor than delta for one day's move in the option. Furthermore, since this option is composed mostly of excess value, these more dominant forces influence the excess value more than time decay does. There is a direct relationship between vega and excess value. That is, if implied volatility increases, the excess value portion of the option will increase and, if implied volatility decreases, so will excess value. The relationship between delta and excess value is not so straightforward. The farther the stock moves away from the strike, the more this will have the effect of shrinking the excess value. If the call is in-the-money (as in the above example), then an increase in stock price will result in a decrease of excess value. That is, a deeply in­ the-money option is composed primarily of intrinsic value, while excess value is quite small. However, when the call is out-of-the-money, the effect is just the opposite: Then, an increase in call price will result in an increase in excess value, because the stock price increase is bringing the stock closer to the option's striking price. For some readers, the following may help to conceptualize this concept. The part of the delta that addresses excess value is this: Out-of-the-money call: 100% of the delta affects the excess value. In-the-money call: "1.00 minus delta" affects the excess value. (So, if a call is very deeply in-the-money and has a delta of 0.95, then the delta only has 1.00 - 0.95, or 0.05, room to increase. Hence it has little effect on what small amount of excess value remains in this deeply in-the-money call.) These relationships are not static, of course. Suppose, for example, that in the same situation of the stock trading at 82 and the January 80 call trading at 8, there is only week remaining until expiration! Then the implied volatility would be 155% (high, but not unheard of in volatile times). The greeks would bear a significantly dif­ ferent relationship to each other in this case, though: Delta: 0.59 Vega: 0.044 Theta: -0 .5 1 This very short-term option has about the same delta as its counterpart in the previ­ ous example (the delta of an at-the-money option is generally slightly above 0.50). Meanwhile, vega has shrunk. The effect of a change in volatility on such a short-term option is actually about a third of what it was in the previous example. However, time decay in this example is huge, amounting to half a point per day in this option. Chapter 37: How Volatility Affects Popular Strategies 765 So now one has the idea of how the excess value is affected by the "big three" of stock price movement, change in implied volatility, and passage of time. How can one use this to his advantage? First of all, one can see that an option's excess value may be due much more to the potential volatility of the underlying stock, and there­ fore to the option's implied volatility, than to time. As a result of the above information regarding excess value, one shouldn't think that he can easily go around selling what appear to be options with a lot of excess value and then expect time to bring in the profits for him. In fact, there may be a lot of volatility both actual and implied - keeping that excess value nearly intact for a fairly long period of time. In fact, in the coming chapters on volatility estimation, it will be shown that option buyers have a much better chance of success than conven­ tional wisdom has maintained. VOLATILITY AND THE PUT OPTION While it is obvious that an increase in implied volatility ½ill increase the price of a put option, much as was shown for a call option in. the preceding discussion, there are certain differences between a put and a call, so a little review of the put option itself may be useful. A put option tends to lose its premium fairly quickly as it becomes an in-the-money option. This is due to the realities of conversion arbitrage. In a con­ version arbitrage, an arbitrageur or market-maker buys stock and buys the put, while selling the call. If he carries the position to expiration, he will have to pay carrying costs on the debit incurred to establish the position. Furthermore, he would earn any dividends that might be paid while he holds the position. This information was pre­ sented in a slightly different form in the chapter on arbitrage, but it is recounted here: In a perfect world, all option prices would be so accurate that there would be no profit available from a conversion. That is, the following equation (1) would apply: (1) Call price+ Strike price - Stock price - Put price+ Dividend- Carrying cost= 0 where carrying cost = strike price/ (1 + r)t t = time to expiration r = interest rate Now, it is also known that the time value premium of a put is the amount by which its value exceeds intrinsic value. The intrinsic value of an in-the-money put option is merely the difference between the strike price and the stock price. Hence, one can write the following equation (2) for the time value premium (TVP) of an in-the­ money put option: 766 Part VI: Measuring and Trading Volatility (2) Put TVP = Put price - Strike price + Stock price The arbitrage equation, (1), can be rewritten as: (3) Put price - Strike price+ Stock price= Call price+ Dividends - Carrying cost and substituting equation (2) for the terms in equation (3), one arrives at: ( 4) Put TVP = Call price + Dividends - Carrying cost In other words, the time value premium of an in-the-money put is the same as the (out-of-the-money) call price, plus any dividends to be ea med until expiration, less any carrying costs over that same time period. Assuming that the dividend is small or zero (as it is for most stocks), one can see that an in-the-money put would lose its time value premium whenever carrying costs exceed the value of the out-of-the-money call. Since these carrying costs can be rel­ atively large ( the carrying cost is the interest being paid on the entire debit of the position - and that debit is approximately equal to the strike price), they can quickly dominate the price of an out-of-the-money call. Hence, the time value premium of an in-the-money put disappears rather quickly. This is important information for put option buyers, because they must under­ stand that a put won't appreciate in value as much as one might expect, even when the stock drops, since the put loses its time value premium quickly. It's even more important information for put sellers: A short put is at risk of assignment as soon as there is no time value premium left in the put. Thus, a put can be assigned well in advance of expiration even a LEAPS put! Now, returning to the main topic of how implied volatility affects a position, one can ask himself how an increase or decrease in implied volatility would affect equa­ tion ( 4) above. If implied volatility increases, the call price would increase, and if the increase were great enough, might impart some time value premium to the put. Hence, an increase in implied volatility also may increase the price of a put, but if the put is too far in-the-nwney, a modest increase in implied volatility still won't budge the put. That is, an increase in implied volatility would increase the value of the call, but until it increases enough to be greater than the carrying costs, an in-the-money put will remain at parity, and thus a short put would still remain at risk of assignment. STRADDLE OR STRANGLE BUYING AND SELLING Since owning a straddle involves owning both a put and a call with the same terms, it is fairly evident that an increase in implied volatility will be very beneficial for a straddle buyer. A sort of double benefit occurs if implied volatility rises, for it will Chapter 37: How Volatility Affects Popular Strategies 767 positively affect both the put and the call in a long straddle. Thus, if a straddle buyer is careful to buy straddles in situations in which implied volatility is "low," he can make money in one of two ways. Either (1) the underlying price makes a move great enough in magnitude to exceed the initial cost of the straddle, or (2) implied volatil­ ity increases quickly enough to overcome the deleterious effects of time decay. Conversely, a straddle seller risks just the opposite - potentially devastating loss­ es if implied volatility should increase dramatically. However, the straddle seller can register gains faster than just the rate of time decay would indicate if implied volatil­ ity decreases. Thus, it is very important when selling options - and this applies to cov­ ered options as well as to naked ones - to sell only when implied volatility is "high." A strangle is the same as a straddle, except that the call and put have different striking prices. Typically, the call strike price is higher than the put strike price. Naked option sellers often prefer selling strangles in which the options are well out­ of-the-money, so that there is less chance of them having any intrinsic value when they expire. Strangles behave much like straddles do with respect to changes in implied volatility. The concepts of straddle ownership will be discussed in much more detail in the following chapters. Moreover, the general concept of option buying versus option selling will receive a great deal of attention. CALL BULL SPREADS In this section, the bull spread strategy will be examined to see how it is affected by changes in implied volatility. Let's look at a call bull spread and see how implied volatility changes might affect the price of the spread if all else remains equal. Make the following assumptions: Assumption Set 1 : Stock Price: 1 00 Time to Expiration: 4 months Position: long Call Struck at 90 Short Call Struck at 110 Ask yourself this simple question: If the stock remains unchanged at 100, and implied volatility increases dramatically, will the price of the 90-110 call bull spread grow or shrink? Answer before reading on. The truth is that, if implied volatility increases, the price of the spread will shrink. I would suspect that this comes as something of a surprise to a good number of readers. Table 37-6 contains some examples, generated from a Black-Scholes 768 TABLE 37-6 Implied Volatility 20% 30% 40% 50% 60% 70% 80% Stock Price = I 00 Part VI: Measuring and Trading VolatHity 90-110 Call Bull Spread (Theoretical Value) 10.54 9.97 9.54 9.18 8.87 8.58 8.30 model, using the assumptions stated above, the most important of which is that the stock is at 100 in all cases in this table. One should be aware that it would probably be difficult to actually trade the spread at the theoretical value, due to the bid-asked spread in the options. Nevertheless, the impact of implied volatility is clear. One can quantify the amount by which an option position will change for each percentage point of increase in implied volatility. Recall that this measure is called the vega of the option or option position. In a call bull spread, one would subtract the vega of the call that is sold from that of the call that is bought in order to arrive at the position vega of the call bull spread. Table 37-7 is a reprint of Table 37-6, but now including the vega. Since these vegas are all negative, they indicate that the spread will shrink in value if implied volatility rises and that the spread will expand in value if implied TABLE 37-7 90-110 Call Implied Bull Spread Position Volatility (Theoretical Value) Vega 20% 10.54 -0.67 30% 9.97 -0.48 40% 9.54 -0.38 50% 9.18 -0.33 60% 8.87 -0.30 70% 8.58 -0.28 80% 8.30 -0.26 Chapter 37: How VolatHity Afleds Popular Strategies 769 volatility decreases. Again, these statements may seem contrary to what one would expect from a bullish call position. Of course, it's highly unlikely that implied volatility would change much in the course of just one day while the stock price remained unchanged. So, to get a bet­ ter handle on what to expect, one really to needs to look at what might happen at some future time (say a couple of weeks hence) at various stock prices. The graph in Figure 37-3 begins the investigation of these more complex scenarios. The profit curve shown in Figure 37-3 makes certain assumptions: (1) The bull spread assumes the details in Assumption Set 1, above; (2) the spread was bought with an implied volatility of 20% and remained at that level when the profit picture above was drawn; and (3) 30 days have passed since the spread was bought. Under these assumptions, the profit graph shows that the bull spread conforms quite well to what one would expect; that is, the shape of this curve is pretty much like that of a bull spread at expiration, although if you look closely you'll see that it doesn't widen out to nearly its maximum gain or loss potential until the stock is well above llO or below 90 the strike prices used in the spread. Now observe what happens if one keeps all the other assumptions the same, except one. In this case, assume implied volatility was 80% at purchase and remains at 80% one month later. The comparison is shown in Figure 37-4. The 80% curve is overlaid on top of the 20% curve shown earlier. The contrast is quite startling. Instead of looking like a bull spread, the profit curve that uses 80% implied volatili- FIGURE 37-3. Bull spread profit picture in 30 days, at 20% IV. 1000 500 -500 130 140 iv= 20% -1000 Stock ty is a rather flat thing, sloping only slightly upward - and exhibiting far less risk and reward potential than its lower implied volatility counterpart. This points out anoth­ er important fact: For volatile stocks, one cannot expect a 4-rrwnth bull spread to expand or contract much during the first rrwnth of life, even if the stock makes a sub­ stantial rrwve. Longer-term spreads have even less movement. As a corollary, note that if implied volatility shrinks while the stock rises, the profit outlook will improve. Graphically, using Figure 37-4, if one's profit picture moves from the 80% curve to the 20% curve on the right-hand side of the chart, that is a positive development. Of course, if the stock drops and the implied volatility drops too, then one's losses would be worse - witness the left-hand side of the graph in Figure 37-4. A graph could be drawn that would incorporate other implied volatilities, but that would be overkill. The profit graphs of the other spreads from Tables 37-6 or 37-7 would lie between the two curves shown in Figure 37-4. If this discussion had looked at bull spreads as put credit spreads instead of call debit spreads, perhaps these conclusions would not have seemed so unusual. Experienced option traders already understand much of what has been shown here, but less experienced traders may find this information to be different from what they expected. Some general facts can be drawn about the bull spread strategy. Perhaps the most important one is that, if used on a volatile stock, you won't get much expansion in the spread even if the stock makes a nice move upward in your favor. In fact, for Cbapter 37: How Volatility Affects Popular Strategies 771 high implied volatility situations, the bull spread won't expand out to its maximum price until expiration draws nigh. That can be frustrating and disappointing. Often, the bull spread is established because the option trader feels the options are "too expensive" and thus the spread strategy is a way to cut down on the total debit invested. However, the ultimate penalty paid is great. Consider the fact that, if the stock rose from 100 to 130 in 30 days, any reasonable four-month call pur­ chase (i.e., with a strike initially near the current stock price) would make a nice profit, while the bull spread barely ekes out a 5-point gain. To wit, the graph in Figure 37-5 compares the purchase of the at-the-money call with a striking price of 100 and the 90-110 call bull spread, both having implied volatility of 80%. Quite clearly, the call purchase dominates to a great extent on an upward move. Of course, the call purchase does worse on the downside, but since these are bullish strategies, one would have to assume that the trader had a positive outlook for the stock when the position was established. Hence, what happens on the downside is not primary in his thinking. The bull spread and the call purchase have opposite position vegas, too. That is, a rise in implied volatility will help the call purchase but will harm the bull spread ( and vice versa). Thus, the call purchase and the bull spread are not very similar posi­ tions at all. If one wants to use the bull spread to effectively reduce the cost of buying an expensive at-the-money option, then at least make sure the striking prices are quite FIGURE 37-5. Call buy versus bull spread in 30 days; IV = 80%. Cl) ~ 2500 2000 1500 1000 e 500 Cl. -500 -1000 Outright Call Buy Bull Spread --- 140 Stock 772 Part VI: Measuring and Trading Volatility wide apart. That will allow for a reasonable amount of price appreciation in the bull spread if the underlying rises in price. Also, one might want to consider establishing the bull spread with striking prices that are both out-of-the-money. Then, if the stock rallies strongly, a greater percentage gain can be had by the spreader. Still, though, the facts described above cannot be overcome; they can only possibly be mitigated by such actions. A FAMILIAR SCENARIO? Often, one may be deluded into thinking that the two positions are more similar than they are. For example, one does some sort of analysis - it does not matter if it's fun­ damental or technical - and comes to a conclusion that the stock ( or futures contract or index) is ready for a bullish move. Furthermore, he wants to use options to imple­ ment his strategy. But, upon inspecting the actual market prices, he finds that the options seem rather expensive. So, he thinks, "Why not use a bull spread instead? It costs less and it's bullish, too." Fairly quickly, the underlying moves higher - a good prediction by the trader, and a timely one as well. If the move is a violent one, especially in the futures mar­ ket, implied volatility might increase as well. If you had bought calls, you'd be a happy camper. But if you bought the bull spread, you are not only highly disappointed, but you are now facing the prospect of having to hold the spread for several more weeks (perhaps months) before your spread widens out to anything even approaching the maximum profit potential. Sound familiar? Every option trader has probably done himself in with this line of thinking at one time or another. At least, now you know the reason why: High or increasing implied volatility is not a friend of the bull spread, while it is a friendly ally of the outright call purchase. Somewhat surprisingly, many option traders don't real­ ize the difference between these two strategies, which they probably consider to be somewhat similar in nature. So, be careful when using bull spreads. If you really think a call option is too expensive and want to reduce its cost, ti:y this strategy: Buy the call and simultane­ ously sell a credit put spread (bull spread) using slightly out-of-the-money puts. This strategy reduces the call's net cost and maintains upside potential (although it increases downside risk, but at least it is still a fixed risk). Example: With XYZ at 100, a trader is bullish and wants to buy the July 100 calls, which expire in two months. However, upon inspection, he finds that they are trad­ ing at 10 - an implied volatility of 59%. He knows that, historically, the implied volatility of this stock's options range from approximately 40% to 60%, so these are Chapter 37: How Volatility Affects Popular Strategies 773 very expensive options. If he buys them now and implied volatility returns to its median range near 50%, he will suffer from the decrease in implied volatility. As a possible remedy, he considers selling an out-of-the-money put credit spread at the same time that he buys the calls. The credit from this spread will act as a means of reducing the net cost of the calls. If he's right and the stock goes up, all will be well. However, the introduction of the put spread into the mix has introduced some additional downside risk. Suppose the following prices exist: XYZ: 100 July 100 call: 10 (as stated above) July 90 put: 5 July 80 put: 2 The entire bullish position would now consist of the following: Buy 1 July 100 call at 1 0 Buy 1 July 80 put at 2 Sell 1 July 90 put at 5 Net expenditure: 7 point debit (plus commission) Figure 37-6 shows the profitability, at expiration, of both the outright call pur­ chase and the bullish position constructed above. FIGURE 37-6. Profitability at expiration. 2000 Bullish Spread // / 1000 "' "' 0 ...J 87 :!:: Outright Call Purchase e 0 C. 70 80 90 6cr 47 19 Total 516 132 Total number of stocks moving >=3cr: 648 [22% of the stocks studied! The largest move was registered by a stock that jumped from a price of 5 to nearly 12 in about six trading days. One of the bigger downside movers was a stock that fell from about 20 to 8 in a matter of a couple of weeks, with most of the damage occur­ ring in a two-day time period. Chapter 38: The Distribution of Stock Prices 187 Lest you think that this example was biased by the fact that it was taken during a strong run in the NASDAQ market, here's another example, conducted with a dif­ ferent set of data- using stock prices between June 1 and July 18, 1999 (also 30 trad­ ing days in length). At that time, there were fewer large moves; about 250 stocks out of 2,500 or so had moves of more than three standard deviations. However, that's still one out of ten - way more than you've been led to expect if you believe in the nor­ mal distribution. The results are shown in Table 38-3. TABLE 38-3. More stock price movements. Total Stocks: 2,447 Dates: 6/1 /99-7 /18/99 Upside Moves: Downside Moves: 3cr 104 54 4cr 28 19 Scr 13 7 >6cr 12 14 Total number of stocks moving >=3cr: 251 ( 10% of the stocks studied) Total 157 94 Finally, one more example was conducted, using the least volatile period that we had in our database - July of 1993. Those results are in Table 38-4. TABLE 38-4. Stock price movements during a nonvolatile period. Total Stocks: 588 Dates: 7 /1 /93-8/17 /93 3cr 4cr Scr >6cr Total Upside Moves: 14 5 1 1 21 Downside Moves: 28 5 3 4 40 Total number of stocks moving >=3cr: 61 ( 10% of the stocks studied) At first glance, it appears that the number of large stock moves diminished dra­ matically during this less volatile period in the market - until you realize that it still represents 10% of the stocks in the study. There were just a lot fewer stocks with list­ ed options in 1993 than there were in 1999, so the database is smaller (it tracks only stocks with listed options). Once again, this means that there is a far greater chance for large standard deviations moves - about one in ten - than the nearly zero percent chance that the lognormal distribution would indicate. VOLATILITY BUYER'S RULE! The point of the previous discussion is that stocks move a lot farther than you might expect. Moreover, when they make these moves, it tends to be with rapidity, gener- 788 Part VI: Measuring and Trading VolatiDty ally including gap moves. There are not always gap moves, though, over a study of this length. Sometimes, there will be a more gradual transition. Consider the fact that one of the stocks in the study moved 5.8 sigma in the 30 days. There weren't any huge gaps during that time, but anyone who was short calls while the stock made its run surely didn't think it was a gradual advance. So, what does this information mean to the average option trader? For one, you should certainly think twice about selling stock options in a potentially volatile market ( or any market, for that matter, since these large moves are not by any means limited to the volatile market periods). This statement encompasses naked option selling, but also includes many forms of option selling, because of the possibilities of large moves by the underlying stocks. For example, covered call writing is considered to be "conservative." However, when the stock has the potential to make these big moves, it will either cause one to give up large upside profits or to suffer large downside losses. ( Covered call writing has limited profit potential and relatively large downside risk, as does its equivalent strategy, naked put selling.) When these large stock moves occur on the upside, a cov­ ered writer is often disappointed that he gave up too much of the upside profit poten­ tial. Conversely, if the stock drops quickly, and one is assigned on his naked put, he often no longer has much appetite for acquiring the stock ( even though he said he "wouldn't mind" doing so when he sold the puts to begin with). Even spreading has problems along these lines. For example, a vertical spread limits profits so that one can't participate in these relatively frequent large stock moves when they occur. What can an option seller do? First, he must carefully analyze his position and allow for much larger stock movements than one would expect under the lognormal distribution. Also, he must be careful to sell options only when they are expensive in terms of implied volatility, so that any decrease in implied will work in his favor. Probably most judicious, though, is that an option seller should really concentrate on indices (or perhaps certain futures contracts), because they are statistically much less volatile than stocks. Hard as it is to believe, futures are less volatile than stocks (although the leverage available in futures can make them a riskier investment overall). Two 30-day studies, similar to those conducted on stocks, were run on option­ able indices, covering the same time periods: 10/22/99 to 12/7/99 for one study and 7/1/93 to 8/17/93 for the other. The results are shown in Tables 38-5 and 38-6. This may be a somewhat distorted picture, though, because many of these indices overlap (there are four Internet indices, for example). The largest mover was the Morgan Stanley High-Tech Index (5 standard deviations), but it should also be noted that something that is considered fairly tame, such as the Russell 2000 ($RUT), also had a 3-standard deviation move in one study. The first study showed that 37% of the Chapter 38: The Distribution of Stock Prices TABLE 38-5. Index price movements. Total Indices: 135 Upside Moves: Downside Moves: TABLE 38-6. 3cr 32 None 4cr 15 Scr 3 Index price movements, least volatile period. Total Indices: 66 Upside Moves: Downside Moves: 3cr l 3 4cr l 0 Scr 0 0 789 Dates: 10/22/99-12/7/99 >6cr 0 Total 50 Dates: 7/1/93-8/17/93 >6cr 0 0 Total 2 3 Total number of indices moving >=3cr: 5 (8% of the indices studied) indices made oversized moves - probably a bias because of the strong Internet stock market during that time period. The low-volatility period showed a more reasonable, but still somewhat eye-opening, 8% making moves of greater than three standard deviations. So, even selling index options isn't as safe as it's cracked up to be, when they can make moves of this size, defying the "normal" probabilities. Since that period in 1999 was rather volatile, and all on the upside, the same study was conducted, once again using the least volatile period of July 1993. In Table 38-6, the numbers are lower than they are for stocks, but still much greater than one might expect according to the lognormal distribution. These examples of stock price movement are interesting, but are not rigorous­ ly complete enough to be able to substantiate the broad conclusion that stock prices don't behave lognormally. Thus, a more complete study was conducted. The follow­ ing section presents the results of this research. THE DISTRIBUTION OF STOCK PRICES The earlier examples pointed out that, at least in those specific instances, stock price movements don't conform to the lognormal distribution, which is the distribution used in many mathematical models that are intended to describe the behavior of stock and option prices. This isn't new information to mathematicians; papers dating back to the mid-1960s have pointed out that the lognormal distribution is flawed. However, it isn't a terrible description of the way that stock prices behave, so many applications have continued to use the lognormal distribution. 790 Part VI: Measuring and Trading Volatility Since 1987, the huge volatility that stocks have exhibited - especially on certain explosive down days such as the Crash of '87 or the mini-crash of April 14, 2000 - has alerted more people to the fact that something is probably amiss in their usual assump­ tions about the way that stocks move. The lognonnal distribution "says" that a stock really can't move farther than three standard deviations (whether it's in a day, a week, or a year). Actual stock price movements make a mockery of these assumptions, as stocks routinely move 4, 5, or even 10 standard deviations in a day (not all stocks, mind you, but some - many more than the lognormal distribution would allow for). In order to further quantify these thoughts, computer programs were written to analyze our database of stock prices, going back over six years. As it turns out, that is a short period of time as far as the stock market is concerned. While it is certainly a long enough time to provide meaningful analysis (there are over 2.5 million individ­ ual stock "trading days" in the study), it is a biased period in that the market was ris­ ing for most of that time. THE "'BIG" PICTURE The first part of the analysis shows that the total distribution of stock prices conforms pretty much to what the expectations were for the study, and - not surprisingly - to what others have written about the "real" distribution of stock prices. That is, there is a much greater chance of a large standard deviation move than the lognormal dis­ tribution would indicate. The high probabilities on the ends of the distribution are called "fat tails" by most mathematicians and stock market practitioners alike. These "tails" are what get option writers in trouble - and perhaps even leveraged stock own­ ers - because margin buyers and naked writers figure that they will never occur. It is not intuitively obvious to them and to many other stock market participants that stock prices behave in this manner. The graphs in Figure 38-1 show this total distribution. The top graph is that of the lognormal distribution and the actual distribution, using the data from September 1993 to April 2000 overlaid upon each other. The actual distribution was drawn using 30- day moves (i.e., the number of standard deviations was computed by looking at the stock price on a certain day, and then where it was 30 calendar days later). The x-axis (bottom axis) shows the number of standard deviations moved. Note that the curves have the shape of a normal distribution rather than a lognormal distribution, because the x-axis denotes number of standard deviations moved rather than stock prices them­ selves. For this reason, the term "normal" will be used in the remainder of this section; it should be understood that it is the distribution of standard deviations that is "normal," while the distribution of the stock prices measured by those standard deviation moves is "lognormal." The y-axis (left axis) shows the "count" - the number of times out of the 2.5 million data points computed that each point on the x-axis actually occurred (in the Chapter 38: The Distribution of Stock Prices FIGURE 38-1. Stock price distribution is not ''normal." Normal Stock Price Distribution vs. Actual Stock Distribution (30-Day Moves) 0 £ C ::, 0 (.) 4000 3000 2000 1000 0 -1.0 0 +1.0 Sigmas 240 Includes All Moves 180 220 below-4.0 0 160 210 £ 140 200 C 120 0 180 ::, 0 100 £ 160 (.) 80 C 140 ::, 120 60 0 (.) 100 40 80 20 60 0 40 +3.0 20 0 -4.0 Sigmas 791 792 Part VI: Measuring and Trading Volatility case of the "actual" distribution) or could be expected to occur (in the case of the "nor­ mal" distribution). The notation on the y-axis shows the actual count divided by 10. So, for example, the highest point (0 standard deviations moved) for the "normal" distri­ bution shows that about 95,000 times out of 2.5 million, you could expect a stock to be unchanged at the end of 30 calendar days. At first glance, it appears that the two curves have almost identical shapes. Upon closer inspection, however, it is clear that they do not, and in fact some rather startling differences are evident. Fat Tails Figure 38-1 shows the fat tails quite clearly. Magnified views of the fat tails are pro­ vided to show you the stark differences between the theoretical ("normal") distribu­ tion and actual stock price movements. Consider the downside (the lower left circled graph in Figure 38-1). First, note that both the "actual" and "normal" graphs lift up at the end - the leftmost point. This is because the graph was terminated at -4.0 stan­ dard deviations, and all moves that were greater than that were accumulated and graphed as the leftmost data point. You can see that the "normal" distribution expects fewer than 200 moves out of 2.5 million to be of -4.0 standard deviations or more (yes, the "normal" distribution does allow for moves greater than 3 standard devia­ tions; they just aren't very probable). On the other hand, actual stock prices - even during the bull market that was occurring during the term of the data in this study - fell more than -4.0 standard deviations nearly 2,500 times out of 2.5 million. Thus, in reality, there was really more than 12 times the chance (2,500 vs. 200) that stocks could suffer a severely dramatic fall, when comparing actual to theoretical distribu­ tion. Also notice in that lower left circle that the actual distribution is greater than the normal distribution all along the graph. The upside fat tail shows much the same thing: Actual stock prices can rise far­ ther than the normal distribution would indicate. At the extreme - moves of +4.0 standard deviations or more - there were about 2,000 such moves in actual stock prices, compared with fewer than 100 expected by the normal distribution. Again, a very large discrepancy: twenty-to-one. Inflection Points If the actual distribution is higher at both ends, it must be lower than the normal distribution somewhere, because there are only a total of 2.5 million data points plotted. It turns out in this case that the normal distribution is higher (i.e., is expect­ ed to occur more often than it actually does) between -2.5 standard deviations and +0.5 standard deviations. Those are the points where the two curves cross over each other - the inflection points. Outside of that range, the actual distribution is more frequent than it was expected to be. Chapter 38: The Distribution of Stock Prices 793 It is probably the case that this data reflected an overly bullish period. That is, actual stock prices rose farther than they were expected to, not necessarily at the tails, but in the intermediate ranges, say between +0.5 and +1.5 standard deviations. This does not change the results of the study as far as the tails go, but one may not always be able to count on intermediate upside moves being more frequent than predicted. SIDE BENEFITS OF THIS STUDY In the course of doing these analyses, a lot of smaller distributions were calculated along the way. One of these is the distribution on any individual trading day that was involved in the study. Now, one must understand that one day's trading yields only about 3,000 data points (there were about 3,000 stocks in the database), so the result­ ing curve is not going to be as smooth as the ones shown in Figure 38-1. Nevertheless, some days could be interesting. For example, consider the day of the mini-crash, Friday, April 14, 2000. The Dow-Jones Industrials were down 617 that day; the S&P 500 index was down 83 points; and the NASDAQ-100 was down 346. Except for the Crash of 1987, these were the largest single-day declines in history. The distribution graph is shown in Figure 38-2. First of all, notice how heavily the distribution is skewed to the left; that agrees with one's intuition that the distribution should be on the left when there is such a seri­ ous down day as 4/14/2000. Also, notice that the leftmost data point- representing all moves of -4.0 standard deviations and lower, shows that about 750 out of the 2,984 stocks had moves of that size! That is unbelievable, and it really points out just how FIGURE 38-2. Stock price distribution for 4/14/2000 - 2,984 Stocks in Study. 110 100 90 80 0 70 ,.... ~ 60 C ::, 50 0 () 40 30 20 10 -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 _3.0 +4.0 Sigmas 794 Part VI: Measuring and Trading Volatility FIGURE 38-3. Stock price distribution, IBM, 7-year. 7 6 5 ~ 4 :;:, C: :::, 8 3 2 o----------------+---,.._,._""-¥-+- -4.o -3.o -2.0 -1.0 o.o +1.0 +2.0 +3.o +4.o Sigmas dangerous naked puts and long stock on margin can be on days like this. No proba­ bility calculator is going to give much likelihood to a day like this occurring, but it did occur and it benefited those holding long puts greatly, while it seriously hurt others. In addition to distributions for individual dates, distributions for individual stocks were created for the time period in question. The graph for IBM, using data from the same study as above (September 1993 to April 2000) is shown in Figure 38-3. In the next graph, Figure 38-4, a longer price history of IBM is used to draw the distribution: 1987 to 2000. Both graphs depict 30-day movements in IBM. FIGURE 38-4. Actual stock price distribution, IBM, 13-year. 13 12 11 10 9 o a ,- E 7 g 6 (.) 5 4 3 2 o -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 Sigmas Chapter 38: The Distribution of Stock Prices 795 Figure 38-3 perhaps shows even more starkly how the bull market has affected things over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily readings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar­ ently was able to move up quite easily throughout this time period. In fact, the worst move that occurred was one move of -2.5 standard deviations, while there were about ten moves of +4.0 standard deviations or more. For a longer-term look at how IBM behaves, consider the longer-term distribu­ tion of IBM prices, going back to March 1987, as shown in Figure 38-4. From Figure 38-4, it's clear that this longer-term distribution conforms more closely to the normal distribution in that it has a sort of symmetrical look, as opposed to Figure 38-3, which is clearly biased to the right (upside). These two graphs have implications for the big picture study shown in Figure 38-1. The database used for this study had data for most stocks only going back to 1993 (IBM is one of the exceptions); but if the broad study of all stocks were run using data all the way back to 1987, it is certain that the "actual" price distribution would be more evenly centered, as opposed to its justification to the right (upside). That's because there would be more bearish periods in the longer study (1987, 1989, and 1990 all had some rather nasty periods). Still, this doesn't detract from the basic premise that stocks can move farther than the normal distribution would indicate. WHAT THIS MEANS FOR OPTION TRADERS The most obvious thing that an option trader can learn from these distributions and studies is that buying options is probably a lot more feasible than conventional wisdom would have you believe. The old thinking that selling an option is "best" because it wastes away every day is false. In reality, when you have sold an option, you are exposed to adverse price movements and adverse movements in implied volatility all during the life of the option. The likelihood of those occurring is great, and they generally have more influence on the price of the aption in the short run than does time decay. You might ask, "But doesn't all the volatility in 1999 and 2000 just distort the figures, making the big moves more likely than they ever were, and possibly ever will be again?" The answer to that is a resounding, "Nol" The reason is that the current 20-day historical volatility was used on each day of the study in order to determine how many standard deviations each stock moved. So, in 1999 and 2000, that histori­ cal volatility was a high number and it therefore means that the stock would have had to move a very long way to move four standard deviations. In 1993, however, when the market was in the doldrums, historical volatility was low, and so a much smaller 794 Part VI: Measuring and Trading Volatility FIGURE 38-3. Stock price distribution, IBM, 7-year. 7 6 5 0 4 :g ::, 0 3 () 2 0f-<--,.Jil,,J:.~------+---+---+----+--____;_,=!!:¥+- -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 Sigmas dangerous naked puts and long stock on margin can be on days like this. No proba­ bility calculator is going to give much likelihood to a day like this occurring, but it did occur and it benefited those holding long puts greatly, while it seriously hurt others. In addition to distributions for individual dates, distributions for individual stocks were created for the time period in question. The graph for IBM, using data from the same study as above (September 1993 to April 2000) is shown in Figure 38-3. In the next graph, Figure 38-4, a longer price history of IBM is used to draw the distribution: 1987 to 2000. Both graphs depict 30-day movements in IBM. FIGURE 38-4. Actual stock price distribution, IBM, 13-year. 13 12 11 10 9 0 8 ,... E 7 5 6 () 5 4 3 2 1 o -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 Sigmas Chapter 38: The Distribution of Stock Prices 195 Figure 38-3 perhaps shows even more starkly how the bull market has affected things over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily readings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar­ ently was able to move up quite easily throughout this time period. In fact, the worst move that occurred was one move of -2.5 standard deviations, while there were about ten moves of +4.0 standard deviations or more. For a longer-term look at how IBM behaves, consider the longer-term distribu­ tion of IBM prices, going back to March 1987, as shown in Figure 38-4. From Figure 38-4, it's clear that this longer-term distribution conforms more closely to the normal distribution in that it has a sort of symmetrical look, as opposed to Figure 38-3, which is clearly biased to the right (upside). These two graphs have implications for the big picture study shown in Figure 38-1. The database used for this study had data for most stocks only going back to 1993 (IBM is one of the exceptions); but if the broad study of all stocks were run using data all the way back to 1987, it is certain that the "actual" price distribution would be more evenly centered, as opposed to its justification to the right (upside). That's because there would be more bearish periods in the longer study (1987, 1989, and 1990 all had some rather nasty periods). Still, this doesn't detract from the basic premise that stocks can move farther than the normal distribution would indicate. WHAT THIS MEANS FOR OPTION TRADERS The most obvious thing that an option trader can learn from these distributions and studies is that buying options is probably a lot more feasible than conventional wisdom would have you believe. The old thinking that selling an option is "best" because it wastes away every day is false. In reality, when you have sold an option, you are exposed to adverse price movements and adverse movements in implied volatility all during the life of the option. The likelihood of those occurring is great, and they generally have more influence on the price of the option in the short run than does time decay. You might ask, "But doesn't all the volatility in 1999 and 2000 just distort the figures, making the big moves more likely than they ever were, and possibly ever will be again?" The answer to that is a resounding, "Nol" The reason is that the current 20-day historical volatility was used on each day of the study in order to determine how many standard deviations each stock moved. So, in 1999 and 2000, that histori­ cal volatility was a high number and it therefore means that the stock would have had to move a very long way to move four standard deviations. In 1993, however, when the market was in the doldrums, historical volatility was low, and so a much smaller 796 Part VI: Measuring and Trading Volatility move was needed to register a 4-standard deviation move. To see a specific example of how this works in actual practice, look carefully at the chart of IBM in Figure 38- 4, the one that encompasses the crash of '87. Don't you think it's a little strange that the chart doesn't show any moves of greater than minus 4.0 standard deviations? The reason is that IBM's historical volatility had already increased so much in the days preceding the crash day itself, that when IBM fell on the day of the crash, its move was less than minus 4.0 standard deviations. (Actually, its one-day move was greater than -4 standard deviations, but the 30-day move - which is what the graphs in Figure 38-3 and 38-4 depict - was not.) STOCK PRICE DISTRIBUTION SUMMARY One can say with a great deal of certainty that stocks do not conform to the normal distribution. Actually, the normal distribution is a decent approximation of stock price movement rrwst of the time, but it's these "outlying" results that can hurt any­ one using it as a basis for a nonvolatility strategy. Scientists working on chaos theo:ry have been trying to get a better handle on this. An article in Scientific American magazine ("A Fractal Walk Down Wall Street," Februa:ry 1999 issue) met some criticism from followers of Elliot Wave theo:ry, in that they claim the article's author is purporting to have "invented" things that R. N. Elliott discovered years ago. I don't know about that, but I do know that the article addresses these same points in more detail. In the article, the author points out that chaos theo:ry was applied to the prediction of earthquakes. Essentially, it concluded that earthquakes can't be predicted. Is this therefore a useless analysis? No, says the author. It means that humans should concentrate on building stronger buildings that can withstand the earthquakes, for no one can predict when they may occur. Relating this to the option market, this means that one should concentrate on building strate­ gies that can withstand the chaotic movements that occasionally occur, since chaotic stock price behavior can't be predicted either. It is important that option traders, above all people, understand the risks of making too conservative an estimate of stock price movement. These risks are espe­ cially great for the writer of an option (and that includes covered writers and spread­ ers, who may be giving away too much upside by writing a call against long stock or long calls). By quantifying past stock price movements, as has been done in this chap­ ter, my aim is to convince you that "conventional" assumptions are not good enough for your analyses. This doesn't mean that it's okay to buy overpriced options just because stocks can make large moves with a greater frequency than most option Chapter 38: The Distribution of Stock Prices 797 models predict; but it certainly means that the buyer of underpriced options stands to benefit in a couple of ways. Conversely, an option seller must certainly concentrate his efforts where options are expensive, and even then should be acutely aware that he may experience larger-than-expected stock price movements while the option position is in place. So what does this mean for option strategies? On the surface, it means that if one uses the normal (or lognormal) distribution for estimating the probability of a strategy's success, he may get a big move in the stock that he didn't originally view as possible. If one were long straddles, that's great. However, if he is short naked options, then there could be a nasty surprise in store. That's one reason why extreme caution should be used regarding selling naked options on stocks; they can make moves of this sort too often. At least with indices, such moves are far less frequent, although the Dow drop of over 550 points in October 1997 was a move of seven stan­ dard deviations, and the crash of '87 was about a 16-standard deviation move - which Professor Mark Rubenstein of the University of California at Berkeley says was some­ thing that should occur about once in ten times the life of our current universe! That's according to lognormal distribution, of course, which we know understates things somewhat, but it's still a big number under any distribution. There are two approaches that one can take, then, regarding option strategies. One is to invent another method for estimating stock price distributions. Suffice it to say that that is not an easy task, or someone would have made it well-known already. There have been many attempts, including some in which a large history of stock price movements is observed and then a distribution is fitted to them. The problem with accounting for these occasional large price moves is that it is perhaps an even more grievous error to overestimate the probabilities of such moves than to underes­ timate them. The second approach is to continue to use the normal distribution, because it's fast and accessible in a lot of places. Then, either rely on option buying strategies ( straddles, for example) where implied volatility appears to be low - knowing that you have a chance at better results than the statistics might indicate - or adjust your cal­ culations mentally for these large potential movements if you are using option selling strategies. THE PRICING OF OPTIONS The extreme movements of the fat tail distribution should be figured into the pricing of an option, but they really are not, at least not by most models. The Black-Scholes 798 Part VI: Measuring and Trading Volatility model, for example, uses a lognormal distribution. Personally, this author believes that the Black-Scholes model is an excellent tool for analyzing options and option strategies, but one must understand that it may not be affording enough probability to large moves by the underlying. Does this mean that most options are underpriced, since traders and market­ makers are using the Black-Scholes model (or similar models) to price them? Without getting too technical, the answer is that yes, some options - particularly out­ of-the-money options - are probably underpriced. However, one must understand that it is still a relatively rare occurrence to experience one of these big moves - ifs just not as rare as the lognormal distribution would indicate. So, an out-of-the-money option might be slightly underpriced, but often not enough to make any real differ­ ence. In fact, futures options in grains, gold, oil, and other markets that often experi­ ence large and sudden rallies display a distinct volatility skew. That is, out-of-the-money call options trade at significantly higher implied volatilities than do at-the-money options. Ironically, there is far less chance of one of these hyper-standard-deviation moves occurring in commodities than there is in stocks, at least if history is a guide. So, the fact that some out-of-the-money futures options are expensive is probably an incor­ rect overadjustment for the possibility of large moves. THE PROBABILITY OF STOCK PRICE MOVEMENT The distribution information introduced in this chapter can be incorporated into somewhat rigorous methods of determining probabilities. That is, one can attempt to assess the chances of a stock, futures contract, or index moving by a given distance, and those chances can incorporate the fat tails or other non-lognormal behavior of prices. The software that calculates such probabilities is typically named a "probability calculator." There are many such software programs available in the marketplace. They range from free calculators to completely overpriced ones selling for more than $1,000. In reality, high-level probability calculation software can be created by some­ one with a good understanding of statistics, or a program can be purchased for a rather nominal fee - perhaps $100 or so. Before getting into these various methods of probability estimation, it should be noted that all of them require the trader to input a volatility estimate. There are only a few other inputs, usually the stock price, target price(s), and length of time of the study. The volatility one inputs is, of course, an estimate of future volatility - some- Chapter 38: The Distribution of Stock Prices 799 thing that cannot be predicted with certainty. Nevertheless, any probability calcula­ tor requires this input. So, one must understand that the results one obtains from any of these probability calculators is an estimate of what might happen. It should not be relied on as "gospel." Additionally, probability calculators make a second assumption: that the volatil­ ity one inputs will remain constant over the entire length of the study. We know this is incorrect, for volatility can change daily. However, there really isn't a good way of estimating how volatility might change in the course of the study, so we are pretty much forced to live with this incorrect assumption as well. There is no certain way to mitigate these volatility "problems" as far as the prob­ ability calculator is concerned, but one helpful technique is to bias the volatility pro­ jection against your objectives. That is, be overly conservative in your volatility pro­ jections. If things tum out to be better than you estimated, fine. However, at least you won't be overstating things initially. An example may help to demonstrate this technique. Example: Suppose that a trader is considering buying a straddle on XYZ. The five­ month straddle is selling for a price of 8, with the stock currently trading near 40. A probability calculator will help him to determine the chances that XYZ can rise to 48 or fall to 32 (the break-even points) prior to the options' expiration. However, the probability calculator's answer will depend heavily on the volatility estimate that the trader plugs into the probability calculator. Suppose that the following information is know about the historical volatility of XYZ: l 0-day historical volatility: 20-day historical volatility: 50-day historical volatility: l 00-day historical volatility 22% 20% 28% 33% Which volatility should the trader use? Should he choose the 100-day historical volatility since this is a five-month straddle, which encompasses just about 100 trad­ ing days until expiration? Should he use the 20-day historical volatility, since that is the "generally accepted" measure that most traders refer to? Should he calculate a historical volatility based exactly on the number of days until expiration and use that? To be most conservative, none of those answers is right, at least not for the right reasons. Since one is buying options in this strategy, he should use the lowest of the above historical volatility measures as his volatility estimate. By doing so, he is taking a conservative approach. If the straddle buy looks good under this conservative assumption, then he can feel fairly certain that he has not overstated the possibilities 800 Part VI: Measuring and Trading Volatility of success. If it turns out that volatility is higher during the life of the position, that will be an added benefit to this position consisting of long options. So, in this exam­ ple, he should use the 20-day historical volatility because it is the lowest of the four choices that he has. Similarly, if one is considering the sale of options or is taking a position with a negative vega ( one that will be harmed if volatility increases), then he should use the highest historical volatility when making his probability projections. By so doing, he is again being conservative. If the strategy in question still looks good, even under an assumption of high volatility, then he can figure that he won't be unpleasantly sur­ prised by a higher volatility during the life of the position. There have been times when a 100-day lookback period was not sufficient for determining historical volatility. That is, the underlying has been performing in an erratic or unusual manner for over 100 days. In reality, its true nature is not described by its movements over the past 100 days. Some might say that 100 days is not enough time to determine the historical volatility in any case, although most of the time the four volatility measures shown above will be a sufficient guide for volatility. When a longer lookback period is required, there is another method that can be used: Go back in a historical database of prices for the underlying and compute the 20-day, 50-day, and l 00-day historic volatilities for all the time periods in the data­ base, or at least during a fairly large segment of the past prices. Then use the medi­ an of those calculations for your volatility estimates. Example: XYZ has been behaving erratically for several months, due to overall mar­ ket volatility being high as well as to a series of chaotic news events that have been affecting XYZ. A trader wants to trade XYZ's options, but needs a good estimate of the "true" volatility potential of XYZ, for he thinks that the news events are out of the way now. At the current time, the historical volatility readings are: 20-day historical: 130% 50-day historical l 00% 100-day historical 80% However, when the trader looks farther back in XYZ's trading history, he sees that it is not normally this volatile. Since he suspects that XYZ's recent trading histo­ ry is not typical of its true long-term performance, what volatility should he use in either an option model or a probability calculator? Rather than just using the maximum or minimum of the above three numbers (depending on whether one is buying or selling options), the trader decides to look Chapter 38: The Distribution of Stock Prices 801 back over the last 1,000 trading days for XYZ. A 100-day historical volatility can be computed, using 100 consecutive trading days of data, for 901 of those days (begin­ ning with the 100th day and continuing through the l,000th day, which is presumably the current trading day). Admittedly, these are not completely unique time periods; there would only be ten non-overlapping (independent) consecutive 100-day periods in 1,000 days of data. However, let's assume that the 901 periods are used. One can then arrive at a distribution of 100-day historical volatilities. Suppose it looks some­ thing like this: Percentile 100-Day Historical oth 34% 10th 37% 20th 43% 30th 45% 40th 46% 50th 48% 60th 51% 70th 58% aoth 67% 90th 75% 1 ooth 81% In other words, the 901 historical volatilities (100 days in each) are sorted and then the percentiles are determined. The above table is just a snapshot of where the per­ centiles lie. The range of those 901 volatilities is from 34% on the low side to 81 % on the high side. Notice also that there is a very flat grouping from about the 20th per­ centile to the 60th percentile: The 100-day historical volatility was between 43% and 51 % over that entire range. The median of the above figures is 48% - the 100-day volatility at the 50th percentile. Referring to the early part of this example, the current 100-day historical is 80%, a very high reading in comparison to what the measures were over the past 1,000 days, and certainly much higher than the median of 48%. One could perform similar analyses on the 1,000 days of historical data to deter­ mine where the 10-day, 20-day, and 50-day historical volatilities were over that time. Those, too, could be sorted and arranged in percentile format, using the 50% per­ centile (median) as a good estimate of volatility. After such computations, the trader might then have this information: 802 Part VI: Measuring and Trading Volatility Using 1,000 days of data: Median 100-day historical volatility: 48% Median 50-day historical volatility: 49% Median 20-day historical volatility: 52% Median 10-day historical volatility: 49% If these were all the data that one had, then he would probably use a volatility esti­ mate of 48% or so in his option models or probability calculators. Of course, this is starkly different from the current levels of historical volatility (shown at the begin­ ning of this example). So, one must be careful in assessing whether he expects the stock to perform more in line with its longer-term (1,000 trading days) characteristics or if there is some reason to think that the stock's behavior patterns have changed and the higher, more recent volatilities should be used. The pertinent volatilities to consider, then, in a strategy analysis are the medi­ ans as well as the current figures. If the trader were going to be buying options in his strategy, should he use the minimum of the volatilities shown, 48%? Probably. However, if he's a seller of options, should he use the maximum, 130%? That might be a little too much of a penalty, but at least he would feel safe that if his volatility selling position had a positive expected return with that high a volatility projection, then it must truly be an attractive position. In an analysis like that shown in this example, there is nothing magical about using 1,000 trading days. Perhaps something like 600 trading days would be better. The idea is to use enough trading days to bring in some historic data to counterbal­ ance the recent, erratic behavior of the stock. Among other things, this example also shows that volatilities are unstable, no matter how much work and mathematics one puts into calculating them. Therefore, they are at best a fragile estimate of what might happen in the future. Still, it's the best guess that one can make. The trader should realize, though, that when volatili­ ties are this disparate when comparing recent and more distant activity, the results of any mathematical projections using those volatilities should not be relied upon too heavily. Those results will be just as tenuous as the volatility projections themselves. Of course, in any case, the actual volatility that occurs while the position is in place may be even more unfavorable than the one the trader used in his initial analysis. There is nothing that one can do about that. But if you choose what appears to be a somewhat unfavorable volatility, and the position still looks good under those assumptions, then it is likely that the trader will be pleasantly surprised more often than not - that actual volatility during the life of the position will tend to be more in his favor than not. Chapter 38: The Distribution of Stock Prices 803 In a recent chapter, the various methods of trying to predict volatility were out­ lined, using either historical volatility, implied volatility, a moving average of either of those, or even GARCH volatility. None of these will predict with certainty what is going to happen in the future. Hence, the prediction of volatility is necessarily vague at best. In addition to the vagaries of estimating volatility, the probability calculators will return an answer that represents the probability of something happening "in the long run." That is, if the same scenario were to arise many, many times, the answer is rel­ evant to how many times the stock would move to the indicated target price. This is small solace if one happens to be caught in the vortex of the Crash of '87, for exam­ ple. So, just remember that these probability calculators are tools that can help you in assessing the relative risks of similar positions ( evaluating various naked option sales, say), but the resulting stock movement in any one case can be quite different from what any probability calculator describes as the chances of that move actually happening. THE ENDPOINT CALCULATION The following paragraphs describe how the various probability calculation mecha­ nisms work. The simplest and most straightforward probability calculation has already been presented in Chapter 28 on mathematical applications. It was included in the section on "expected returns" in that chapter. The formula is presented here again, for completeness. The formula gives the probability of a stock, which is currently at price p, being below some other price, q, at the end of the time period. The lognormal distribution is assumed. Probability of stock being below price q at end of time period, t where N = cumulative normal distribution p = current price of the stock q = price in question ln = natural logarithm for the time period in question 804 Part VI: Measuring and Trading Volatility If one is interested in computing the probability of the stock being above the given price, the formula is P (above) = 1 - P (below) In the above formula, Vt = v✓t where t is time to expiration in years and v is annual volatility, as usual. This formula is quite elementary for predictive purposes, and it is used by many traders. This calculator can be found for free at the Web site www.option­ strategist.com. Its main problem is that it gives the probability of the stock being above or below the target price at the end of the time period, t. That's not a totally realistic way of approaching probability analysis. Most option traders are very con­ cerned with what happens to their positions during the life of the option, not just at expiration. Example: suppose a trader is a seller of naked put options. He sells $OEX October 550 puts naked, with $OEX currently trading at 600. He would not normally just walk away from this position until October expiration, because of the large risk involved with the sale of a naked option. There are essentially three scenarios that can occur: 1. $OEX might never fall to 550 by expiration. In this case, he would have a very comfortable trade that was never in jeopardy, and the options would expire worthless. 2. $OEX might fall below 550 and remain there until expiration. In this case, he would surely have a loss unless $OEX were just a tiny bit below 550. 3. $OEX might fall below 550 at some time between when the trade was estab­ lished and when expiration occurred, but then subsequently rally back above 550 by the time expiration arrived. An experienced option trader would almost certainly adjust if scenario 3 arose, in order to prevent large losses from occurring. He might roll his naked puts down and out to another strike, or he might just close them out altogether. However, it is unlikely that he would do nothing. The simple probability calculator formula shown above does not take into account the trader's third scenario. Since it is only concerned with where the stock is at expiration of the options, only scenarios 1 and 2 apply to it. Hence the usage of this simple calculator is not really descriptive of what might happen to a trade during its lifetime. Let's assign some numbers to the above trade, so that you might see the differ­ ence. Suppose that the volatility estimate is 25%, there are 30 days until expiration, and the prices are as stated in the previous example: $OEX is at 600, and the strik- Chapter 38: The Distribution of Stock Prices 805 ing price of the naked put being sold is 550. The resulting probabilities might be something like this: Scenario Actual Probability of Occurrence 1 . $OEX never falls below 550 2. $OEX falls below 550 and remains there 3. $OEX falls below 550 but rallies later 67% 19% 14% The probabilities stated above are the "real" probabilities of the three various scenarios occurring. However, if one were using the simple probability calculator presented above, he would only have the following information: Probability of $OEX being above 550 at expiration: 81 % Probability of $OEX being below 550 at expiration: 19% So, with the simple calculator, it looks like there's an 81 % chance of a worry-free trade. Just sit back and relax and let the option expire worthless. However, in real life - as shown by the previous set of probabilities, there's only a 67% chance of a worry-free trade. The difference - the other 14% - is the probability of the third scenario occurring ($OEX falls below 550, but rallies back above it by expiration). The simple probability calculator doesn't account for that scenario at all. Hence, most serious traders don't use the simple model. Does that mean it's not useful at all? No, it is certainly viable as a comparative tool; for example, to compare the chances of the $OEX put expiring worthless versus those of another put sale being considered, perhaps something in a stock option. However, better analyses can be undertaken. Before leaving the scenario of the simple probability calculator, one more point should be made. It has been mentioned earlier in this book that the delta of an option is actually a fairly good estimate of the probability of the option being in-the-money at its expiration date. Thus, the delta and the simple endpoint probability calculator shown above attempt to convey the same information to a trader. In reality, because of the fact that implied volatility might be different for various strikes (a volatility skew), especially in index options, the delta of the option might not agree exactly with the probability calculator. Even so, the delta is a quick and dirty way of estimating the probability of the stock being above the strike price (in the case of call options) or below the strike price (in the case of put options) at expiration. THE nEVER" CALCULATOR Having seen the frailties of the endpoint calculator, the next step is to try to design a calculator that can estimate the probability of the stock ever hitting the target price(s) 806 Part VI: Measuring and 1iading Vo/atillty at any time during the life of the probability study, usually the life of an option. It turns out that there are a couple of ways to approach this problem. One is with a Monte Carlo analysis, whereby one lets a computer run a large number of random­ ly-generated scenarios (say, 100,000 or so) and counts the number of times the tar­ get price is hit. A Monte Carlo analysis is a completely valid way of estimating the probability of an event, but it is a somewhat complicated approach. In reality, there is a way to create a single formula that can estimate the "ever" probability, although it is not any easy task either. In the following discussion, I am borrowing liberally from correspondence with Dr. Stewart Mayhew, Professor of Mathematics at the University of Georgia. For proprietary reasons, the exact formu­ la is not given here, but the following description should be sufficient for a mathe­ matics or statistics major to encode it. If one is not interested in implementing the actual formula, the calculation can be obtained through programs sold by McMillan Analysis Corp. at www.optionstrategist.com. This discussion is quite technical, so readers not interested in the description of the mathematics can skip the next paragraph and instead move ahead to the next sec­ tion on Monte Carlo studies. These are the steps necessary in determining the formula for the "ever" proba­ bility of a stock hitting an upside target at any time during its life. First, make the assumption that stock prices behave randomly, and perform at the risk-free rate, r. Mathematicians call random behavior "Brownian motion." There are a number of formulae available in statistics books regarding Brownian motion. If one is to esti­ mate the probability of reaching a maximum (upside target) point, what is needed is the known formula for the cumulative density function (CDP) for a running maxi­ mum of a Brownian motion. In that formula, it is necessary to use the lognormal function to describe the upside target. Thus, instead of using the actual target price in the CDF formula, one substitutes ln( qlp ), where q is the target price and p is the current stock price. The "ever" probability calculator provides much more useful information to a trader of options. Not only does a naked option seller have a much more realistic esti­ mate of the probability that he's going to have to make an adjustment during the life of an option, but the option buyer can find the information useful as well. For exam­ ple, if one is buying an option at a price of 10, say, then he could use the "ever" prob­ ability calculator to estimate the chances of the stock trading 10 points above the striking price at any time during the life of the option. That is, what are the chances that the option is going to at least break even? The option buyer can, cf course, deter­ mine other things too, such as the probability that the option doubles in price ( or reaches some other return on investment, such as he might deem appropriate for his analysis). Chapter 38: The Distribution of Stock Prices 807 THE MONTE CARLO PROBABILITY CALCULATOR Up to this point, the calculators we have discussed are subject to the limitations described earlier - mainly, that they rely heavily on one's volatility estimate, that they assume the volatility will remain constant over time, and that they assume a lognor­ mal distribution. The early part of this chapter was spent explaining that the lognor­ mal distribution is not the real distribution that stock prices adhere to. So, what we'd like to see in a probability calculator is one that could adjust for various volatility sce­ narios as time passed and one in which the assumed distribution of stock prices was not lognormal. When one starts to make these sorts of assumptions, I do not believe there is a single formula that can be derived for the probability calculations. Rather, what is known as a Monte Carlo simulation must be undertaken. Essentially, one "tells" the computer what he is trying to simulate. It could be any number of things in real life, perhaps the rocket engine components in a NASA space shuttle, or the operation of an internal combustion engine, or the movement of a stock. As long as the process can be described, it can be simulated by a computer. Then, the computer can run a large number of those simulations to determine the answers to such things as "What is the failure rate of the NASA engine components," or "How long can the internal combustion engine go without an oil change," or "What is the probability of the stock trading at a certain target price?" The Monte Carlo simulation technique can be thought of as letting the computer run through the simulation a lot of times and counting how many times a certain outcome occurs. If the number of trials (simula­ tions) is large enough and the model is good enough, then the resulting count divid­ ed by the number of trials undertaken is a good probability estimate of the said event occurring. The reason one runs a lot of trials is that over a large number of trials, the frequency with which an event occurs will approximate the actual probability of its occurrence for a single trial - the single trial being your trade, for example. The next three paragraphs describe the general process necessary for con­ structing a stock probability calculator using a Monte Carlo simulation. Again, this is fairly technical, so if the reader is not interested in the background behind the math­ ematics, then skip ahead three paragraphs. In the case of a stock probability calcula­ tor, the Monte Carlo simulation can be undertaken as follows. We know what the distribution of stock prices looks like. The fat tails can be built into the distribution if one wants to simulate real life. See Figure 38-1 for both the lognormal distribution and the actual distribution. It's a simple matter to tell the computer this information. For example, recall that 2.5 million points went into mak­ ing up Figure 38-1. In the actual distribution in Figure 38-1, about 92,000 (or 3.68%) 808 Part VI: Measuring and Trading Volatility of them resulted in the stock being unchanged. Also, only about 2,500 or them, or 1110th of one percent, resulted in a move of-4.0 standard deviations or more. Those percentages, along with all of the others, would be built into the computer, so that the total distribution accounts for 100% of all possible stock movements. Then, we tell the computer to allow a stock to move randomly in accordance with whatever volatility the user has input. So, there would be a fairly large proba­ bility that it wouldn't move very far on a given day, and a very small probability that it would move three or more standard deviations. Of course, with the fat tail distri­ bution, there would be a larger probability of a movement of three or more standard deviations than there would be with the regular lognormal distribution. The Monte Carlo simulation progresses through the given number of trading days, moving the stock cumulatively as time passes. If the stock hits the break-even price, that partic­ ular simulation can be terminated and the next one begun. At the end of all the tri­ als (100,000 perhaps), the number in which the upside target was touched is divided by the total number of trials to give the probability estimate. Is it really worth all this extra trouble to evaluate these more complicated prob­ ability distributions? It seems so. Consider the following example: Example: Suppose that a trader is considering selling naked puts on XYZ stock, which is currently trading at a price of 80. He wants to sell the November 60 puts, which expire in two months. Although XYZ is a fairly volatile stock, he feels that he wouldn't mind owning it if it were put to him. However, he would like to see the puts expire worthless. Suppose the following information is available to him via the vari­ ous probability calculators: Simple "end point" probability of XYZ < 60 at expiration: 10% Probability that XYZ ever trades < 60 (using the lognormal distribution) 20% Probability that XYZ ever trades < 60 (using the fat tail distribution): 22% If the chances of the put never needing attention were truly only 10%, this trader would probably sell the puts naked and feel quite comfortable that he had a trade that he wouldn't have to worry too much about later on. However, if the true proba­ bility that the put will need attention is 22%, then he might not take the trade. Many naked option sellers try to sell options that have only probabilities of 15% or less of potentially becoming troublesome. Hence, the choice of which probability calculation he uses can make a differ­ ence in whether or not a trade is established. Other strategies lend themselves quite well to probability analysis as well. Credit spreaders - sellers of out-of-the-money put spreads - usually attempt to quan­ tify the probability of having to take defensive action. Any action to adjust or remove Chapter 38: The Distribution of Stock Prices 809 a deeply out-of-the-money put credit spread usually destroys most or all of its prof­ itability, so an accurate initial assessment of the probabilities of having to make such an adjustment is important. Option buyers, too, would benefit from the use of a more accurate probability estimate. This is especially true for neutral strategies, such as straddle or strangle buying, when the trader is interested in the chances of the stock being able to move far enough to hit one or the other of the straddle's break-even points at some time during the life of the straddle. The Monte Carlo probability calculation can be expanded to include other sorts of distributions. In the world of statistics, there are many distributions that define ran­ dom patterns. The lognormal distribution is but one of them (although it is the one that most closely follows stock prices movements in general). Also, there is a school of thought that says that each stock's individual price distribution patterns should be ana­ lyzed when looking at strategies on that stock, as opposed to using a general stock price distribution accumulated over the entire market. There is much debate about that, because an individual stock's trading pattern can change abruptly just consider any of the Internet stocks in the late 1990s and early 2000s. Thus, a probability esti­ mate based on a single stock's behavior, even if that behavior extends back several years, might be too unreliable a statistic upon which to base a probability estimate. In summary, then, one should use a probability calculator before taking an option position, even an outright option buy. Perhaps straight stock traders should use a probability calcutor as well. In doing so, though, one should be aware of the limitations of the estimate: It is heavily biased by the volatility estimate that is input and by the assumption of what distribution the underlying instrument will adhere to during the life of the position. While neither of those limitations can be overcome completely, one can mitigate the problems by using a conservative volatility estimate. Also, he can look at the results of the probability calculation under several distribu­ tions (perhaps lognormal, fat tail, and the distribution using only the past price behavior of the underlying instrument in question) and see how they differ. In that case, he would at least have a feeling for what could happen during the life of the option position. EXPECTED RETURN The concept of expected return was described in the chapter on mathematical appli­ cations. In short, expected return is a position's expected profit divided by its invest­ ment ( or expected investment if the investment varies with stock price, as in a naked option position or a futures position). The crucial component, though, is expected profit. 810 Part VI: Measuring and Trading Volatility Expected profit is computed by calculating the profitability of a position at a certain stock price times the probability of the stock being at that price, and summing that multiple over all possible stock prices. When the concept was first introduced, the "probability of the stock being at that price" was given as what we now know is the "endpoint" probability. In reality, a much better measure of the expected profit of a position can be obtained by using one of the more advanced probability estima­ tion models presented above. In generalized expected return studies done using the fat tails Monte Carlo sim­ ulation, certain general conclusions can be drawn about some strategies. • A bull spread is an inferior strategy when the options are fairly priced, no matter which distribution is assumed. This more or less agrees with observations that have been made previously regarding the disappointments that traders often encounter when using vertical spreads. • While covered writing might seem superior to stock ownership under the log­ normal distribution, the two are about equal under a fat tail distribution. • Most startling, though, is the fact that option buying strategies fare much, much better under a fat tail distribution than a lognormal one. This most clearly demonstrates the "power" of the fat tail distribution: A limited-risk investment with unlimited profit potential can be expected to perform very well if the fat tails are allowed for. Using the lognormal distribution more or less represents the conventional wisdom regarding option strategies - the one that many brokers promote: "Don't buy options, don't mess with spreads, either buy stocks or do covered call writes." The fat tail dis­ tribution column stands much of that advice on its head. In real life (as demonstrat­ ed by the fat tail distribution), strategies with limited profit potential and unlimited or large risk potential are inferior strategies. One should be aware that the phrase "expected return" is used in many quasi­ sophisticated option analyses (and even in analyses not using options). Many investors accept these "returns" on blind faith, figuring that if they're generated by a computer, they must be correct. In reality, they may be not be representative, even for comparisons. SUMMARY This chapter has demonstrated that probability analysis is an inexact science, because markets behave in ways that are very difficult to describe mathematically. However, probability analysis is also necessary for the option strategist; without it he would be Chapter 38: The Distribution of Stock Prices 811 in the dark as to the likelihood of profitable outcomes for his strategy. Overall, in a diversified set of positions, the option strategist should use the fat tail distribution in a Monte Carlo simulation to estimate probabilities. However, if that is not available, he can use the normal or lognormal distribution with the proviso that he understands it is not "gospel." He should require ve:ry stringent criteria on any strategies that are antivolatility strategies, such as naked option writing of stock options, for there is a greater than normal chance of a large move by the underlying, especially if the underlying is stock. The sophisticated trader may want to view his probabilities in the light of more than one proposed distribution of prices. Of course, this type of analysis ( using sev­ eral distributions) puts the onus on the investor to choose the distribution that he wants to use in order to analyze his investment. However, such an approach should be extremely illustrative in that he can compare returns from different strategies and have a reasonable expectation as to which ones might perform the best under differ­ ent market conditions. CHAPTER 39 Volatility Trading Techniques The previous three chapters laid the foundation for volatility trading. In this chapter, the actual application of the technique will be described. It should be understood that volatility trading is both an art and a science. It's a science to the extent that one must be rigorous about determining historical volatility or implied volatility, calculat­ ing probabilities, and so forth. However, given the vagaries of those measurements that were described in some detail in the previous chapters, volatility trading is also something of an art. Just as two fundamental analysts with the same information regarding earnings, sales projection, and so on might have two different opinions about a stock's fortunes, so also can two volatility traders disagree about the potential for movement in a stock. However, volatility traders do agree on the approach. It is based on comparing today's implied volatility with what one expects volatility to do in the future. As noted previously, one's expectations for volatility might be based on volatility charts, pat­ terns of historical volatility and implied volatility, or something as complicated as a GAR CH forecasting model. None of them guarantees success. However, we do know that volatility tends to trade in a range in the long run. Therefore, the approach that traders agree upon is this: If implied volatility is "low," buy it. If it's "high," sell it with caution. So simple: Buy low, sell high (not necessarily in that order). The theory behind volatility trading is that it's easier to buy low and sell high (or at least to deter­ mine what's "low" and "high") when one is speaking about volatility, than it is to do the same thing when one is talking about stock prices. Most of the time, implied volatility will not be significantly high or low on any particular stock, futures contract, or index. Therefore, the volatility trader will have little interest in most stocks on any given day. This is especially true of the big-cap stocks, the ones whose options are most heavily traded. There are so many traders 812 Chapter 39: Volatility Trading Techniques 813 watching the situation for those stocks that they will rarely let volatility get to the extremes that one would consider "too high" or "too low." Yet, with the large num­ ber of optionable stocks, futures, and indices that exist, there are always some that are out of line, and that's where the independent volatility trader will concentrate his efforts. Once a volatility extreme has been uncovered, there are different methods of trading it. Some traders - market-makers and short-term traders - are just looking for very fleeting trades, and expect volatility to fall back into line quickly after an aberrant move. Others prefer more of a position traders' approach: attempting to determine volatility extremes that are so far out of line with accepted norms that it will probably take some time to move back into line. Obviously, the trader's own sit­ uation will dictate, to a certain extent, which strategy he pursues. Things such as commission rates, capital requirements, and risk tolerance will determine whether one is more of a short-term trader or a position trader. The techniques to be described in this chapter apply to both methods, although the emphasis will be on position trading. TWO WAYS VOLATILITY PREDICTIONS CAN BE WRONG When traders determine the implied volatility of the options on any particular under­ lying instrument, they may generally be correct in their predictions; that is, implied volatility will actually be a fairly good estimate of forthcoming volatility. However, when they're wrong, they can actually be wrong in two ways: either in the outright prediction of volatility or in the path of their volatility predictions. Let's discuss both. When they're wrong about the absolute level of volatility, that merely means that implied volatility is either "too low" or "too high." In retrospect, one could only make that assessment, of course, after having seen what actual volatility turned out to be over the life of the option. The second way they could be wrong is by making the implied volatility on some of the options on a particular underlying instrument much cheaper or more expensive than other options on that same underlying instrument. This is called a volatility skew and it is usually an incorrect prediction about the way the underlying will perform during the life of the options. The rest of this chapter will be divided into two main parts, then. The first part will deal with volatility from the viewpoint of the absolute level of implied volatility being "wrong" (which we'll call "trading the volatility prediction"), and the second part will deal with trading the volatility skew. 814 Part VI: Measuring and Trading Volatility TRADING THE VOLATILITY PREDICTION The volatility trader must have some way of determining when implied volatility is sufficiently out of line that it warrants a trade. Then he must decide what trade to establish. Furthermore, as with any strategy- especially option strategies - follow-up action is important too. We will not be introducing any new strategies, per se, in this chapter. Those strategies have already been laid out in the previous chapters of this book. However, we will briefly review important points about those strategies and their follow-up actions where it is appropriate. First, one must try to find situations in which implied volatility is out of line. That is not the end of the analysis, though. After that, one needs to do some proba­ bility work and needs to see how the underlying has behaved in the past. Other fine­ tuning measures are often useful, too. These will all be described in this chapter. DETERMINING WHEN VOLATILITY IS OUT OF LINE There is much disagreement among volatility traders regarding the best method to use for determining if implied volatility is "out ofline." Most favor comparing implied with historical volatility. However, it was shown two chapters ago that implied volatility is not necessarily a good predictor of historical volatility. Yet this approach cannot be dis­ carded; however it must be used judiciously. Another approach is to compare today's implied volatility with where it has been in the past. This concept relies heavily on the concept of the percentile of implied volatility. Finally, there is the approach of trying to "read" the charts of implied and historical volatility. This is actually something akin to what GARCH tries to do, but on a short-term horizon. So the approaches are: 1. Compare implied volatility to its own past levels (percentile approach). 2. Compare implied volatility to historical volatility. 3. Interpret the chart of volatility. In addition, we will examine two lesser-used methods: comparing current levels of historical volatility to past measures of historical volatility, and finally, using only a probability calculator and trading the situation that has the best probabilities of success. THE PERCENTILE APPROACH In this author's opinion, there is much merit in the percentile approach. When one says that volatility tends to trade in a range, which is the basic premise behind volatility trad- Chapter 39: Volatility Trading Techniques 815 ing, he is generally talking about implied volatility. Thus, it makes sense to know where implied volatility is within the range of the past readings of implied volatility. If volatil­ ity is low with respect to where it usually trades, then we can say the options are cheap. Conversely, if it's high with respect to those past values, then we can say the options are expensive. These conclusions do not draw on historical volatility. The percentile of implied volatility is generally used to describe just where the current implied volatility reading lies with respect to its past values. The "implied volatility" reading that is being used in this case is the composite reading - the one that takes into account all the options on an underlying instrument, weighting them by their distance in- or out-of-the-money (at-the-money gets more weight) and also weighting them by their trading volume. This technique has been referred to many times and was first described in Chapter 28 on mathematical applications. That com­ posite implied volatility reading can be stored in a database for each underlying instrument every day. Such databases are available for purchase from firms that spe­ cialize in option data. Also, snapshots of such data are available to members of www.optionstrategist.com. In general, most underlying instruments would have a composite implied volatility reading somewhere near the 50th percentile on any given day. However, it is not uncommon to see some underlyings with percentile readings near zero or 100% on a given day. These are the ones that would interest a volatility trader. Those with readings in the 10th percentile or less, say, would be considered "cheap"; those in the 90th percentile or higher would be considered expensive. In reality, the percentile of implied volatility is going to be affected by what the broad market is doing. For example, during a severe market slide, implied volatilities will increase across the board. Then, one may find a large number of stocks whose options are in the 90th percentile or higher. Conversely, there have been other times when overall implied volatility has declined substantially: 1993, for example, and the summer of 2001, for another. At those times, we often find a great number of stocks whose options reside in the 10th percentile of implied volatility or lower. The point is that the distribution of percentile readings is a dynamic thing, not something stat­ ic like a lognormal distribution. Yes, perhaps over a long period of time and taking into account a great number of cases, we might find that the percentiles of implied volatility are normally distributed, but not on any given day. The trader has some discretion over this percentile calculation. Foremost, he must decide how many days of past history he wants to use in determining the per­ centiles. There are about 255 trading days in a year. So, if he wanted a two-year his­ tory, he would record the percentile of today's composite implied volatility with respect to the 510 daily readings over the past two years. This author typically uses 816 Part VI: Measuring and Trading Volatility 600 days of implied volatility history for the purpose of determining percentiles, but a case could be made for other lengths of time. The purpose is to use enough implied volatility history to give one a good perspective. Then, a reading of the 10th per­ centile or the 90th percentile will truly be significant and would therefore be a good starting point in determining whether the options are cheap or expensive. In addition to the actual percentile, the trader should also be aware of the width of the implied volatility distribution. This was discussed in an earlier chapter, but essentially the concept is this: If the first percentile is an implied volatility of 40% and the 100th percentile is an implied volatility of 45%, then that entire range is so nar­ row as to be meaningless in terms of whether one could classify the options as cheap or expensive. The advantage of buying options in a low percentile of implied volatility is to give oneself two ways to make money: one, via movement in the underlying (if a straddle were owned, for example), and two, by an increase in implied volatility. That is, if the options were to return to the 50th percentile of implied volatility, the volatil­ ity trader who has bought "cheap" options should expect to make money from that movement as well. That can only happen if the 50th percentile and the 10th per­ centile are sufficiently far apart to allow for an increase in the price of the option to be meaningful. Perhaps a good rule of thumb is this: If the option rises from the cur­ rent (low) percentile reading to the 50th percentile in a month, will the increase in implied volatility be equal to or greater than the time decay over that period? Alternatively stated, with all other things being equal, will the option be trading at the same or a greater price in a month, if implied volatility rises to the 50th percentile at the end of that time? If so, then the width of the range of implied volatilities is great enough to produce the desired results. The attractiveness to this method for determining if implied volatility is out of line is that the trader is "forced" to buy options that are cheap ( or to sell options that are expensive), on a relative basis. Even though historical volatility has not been taken into consideration, it will be later on when the probability calculators are brought to bear. There is no guarantee, of course, that implied volatility will move toward the 50th percentile while the position is in place, but if it does, that will certainly be an aid to the position. In effect this method is measuring what the option trading public is "thinking" about volatility and comparing it with what they've thought in the past. Since the pub­ lic is wrong (about prices as well as volatility) at major turning points, it is valid to want to be long volatility when "everyone else" has pushed it down to depressed levels. The converse may not necessarily be true: that we would want to be short volatility when everyone else has pushed it up to extremely high levels. The caveat in that case is that Chapter 39: Volatility Trading Techniques 817 someone may have inside information that justifies expensive options. This is another reason why selling volatility can be difficult: You may be dealing with far less infor­ mation than those who are actually making the implied volatility high. COMPARING IMPLIED AND HISTORICAL VOLATILITY The most common way that traders determine which options are cheap or expensive is by comparing the current composite implied volatility with various historical volatility measures. However, just because this is the conventional wisdom does not necessarily mean that this method is the preferred one for determining which options are best for volatility trades. In this author's opinion, it is inferior to the percentile method (comparing implied to past measures of implied), but it does have its merits. The theory behind using this method is that it is a virtual certainty that implied and historical volatility will eventually converge with each other. So, if one establishes volatility trading positions when they are far apart, there is supposedly an advantage there. However, this argument has plenty of holes in it. First of all, there is no guar­ antee that the two will converge in a timely manner, for example, before the options in the trader's position can become profitable. Historical and implied volatility often remain fairly far apart for weeks at a time. Second, even if the convergence does occur, it doesn't necessarily mean one will make money. As an example, consider the case in which implied volatility is 40% and historical volatility is 60%. That's quite a difference, so you'd want to buy volatility. Furthermore, suppose the two do converge. Does that mean you'll make money? No, it does not. What if they converge and meet at 40%? Or, worse yet, at 30%? You'd most certainly lose in those cases as the stock slowed down while your options lost time value. Another problem with this method is that implied volatility is not necessarily low when it is bought, nor high when it is sold. Consider the example just cited. We merely knew that implied volatility was 40% and that historical volatility was 60%. We had no perspective on whether 40% was high, medium, or low. Thus, it is also nec­ essary to see what the percentile of implied volatility is. If it turns out that 40% is a relatively high reading for implied volatility, as determined by looking at where implied volatility has been over the past couple of years, then we would probably not want to buy volatility in this situation, even though implied and historical volatility have a large discrepancy between them. Many market-makers and floor traders use this approach. However, they are often looking for an option that is briefly mispriced, figuring that volatilities will 818 Part VI: Measuring and Trading Volatility quickly revert back to where they were. But for a position trader, the problems cited above can be troublesome. Having said that, if one looks to implement this method of trying to determine when options are out of line, something along the following lines should be imple­ mented. One should ensure that implied volatility is significantly different from all of the pertinent historical volatilities. For example, one might require that implied volatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili­ ty calculations. In addition, the current percentile of implied volatility should be noted so that one has some relative basis for determining if all of the volatilities, his­ torical and implied, are very high or very low. One would not want to buy options if they were all in a very high percentile, nor sell them if they were all in a very low per­ centile. Often, a volatility chart showing both the implied and certain historical volatili­ ties will be a useful aid in making these decisions. One can not only quickly tell if the options are in a high or low percentile, but he may also be able to see what happened at similar times in the past when implied and historical volatility deviated substan­ tially. Finally, one needs some measure to ensure that, if convergence between implied and historical volatility does occur, he will be able to make money. So, for example, if one is buying a straddle, he might require that if implied rises to meet his­ torical (say, the lowest of the historicals) in a month, he will actually make money. One could use a different time frame, but be careful not to make it something unrea­ sonable. For example, if implied volatility is currently 40% and historical is 60%, it is highly unlikely that implied would rise to 60% in a day or two. Using this criterion also ensures that the absolute difference between implied and historical volatility is wide enough to allow for profits to be made. That is, if implied is 10% and historical is 13%, that's a difference of 30% in the two - ostensibly a "wide" divergence between implied and historical. However, if implied rises to meet historical, it will mean only an absolute increase of 3 percentage points in implied volatility - proba­ bly not enough to produce a profit, after costs, if any length of time passes. If all of these criteria are satisfied, then one has successfully found "mispriced" options using the implied versus historical method, and he can proceed to the next step in the volatility analysis: using the probability calculator. READING THE VOLATILITY CHART Another technique that traders use in order to determine if options are mispriced is to actually try to analyze the chart of volatility - typically implied volatility, but it could be historical. This might seem to be a subjective approach, except that it is real- 818 Part VI: Measuring and Trading Volatility quickly revert back to where they were. But for a position trader, the problems cited above can be troublesome. Having said that, if one looks to implement this method of trying to determine when options are out of line, something along the following lines should be imple­ mented. One should ensure that implied volatility is significantly different from all of the pertinent historical volatilities. For example, one might require that implied volatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili­ ty calculations. In addition, the current percentile of implied volatility should be noted so that one has some relative basis for determining if all of the volatilities, his­ torical and implied, are very high or very low. One would not want to buy options if they were all in a very high percentile, nor sell them if they were all in a very low per­ centile. Often, a volatility chart showing both the implied and certain historical volatili­ ties will be a useful aid in making these decisions. One can not only quickly tell if the options are in a high or low percentile, but he may also be able to see what happened at similar times in the past when implied and historical volatility deviated substan­ tially. Finally, one needs some measure to ensure that, if convergence between implied and historical volatility does occur, he will be able to make money. So, for example, if one is buying a straddle, he might require that if implied rises to meet his­ torical (say, the lowest of the historicals) in a month, he will actually make money. One could use a different time frame, but be careful not to make it something unrea­ sonable. For example, if implied volatility is currently 40% and historical is 60%, it is highly unlikely that implied would rise to 60% in a day or two. Using this criterion also ensures that the absolute difference between implied and historical volatility is wide enough to allow for profits to be made. That is, if implied is 10% and historical is 13%, that's a difference of 30% in the two - ostensibly a "wide" divergence between implied and historical. However, if implied rises to meet historical, it will mean only an absolute increase of 3 percentage points in implied volatility - proba­ bly not enough to produce a profit, after costs, if any length of time passes. If all of these criteria are satisfied, then one has successfully found "mispriced" options using the implied versus historical method, and he can proceed to the next step in the volatility analysis: using the probability calculator. READING THE VOLATILITY CHART Another technique that traders use in order to determine if options are mispriced is to actually try to analyze the chart of volatility - typically implied volatility, but it could be historical. This might seem to be a subjective approach, except that it is real- 818 Part VI: Measuring and Trading Volatility quickly revert back to where they were. But for a position trader, the problems cited above can be troublesome. Having said that, if one looks to implement this method of trying to determine when options are out of line, something along the following lines should be imple­ mented. One should ensure that implied volatility is significantly different from all of the pertinent historical volatilities. For example, one might require that implied volatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili­ ty calculations. In addition, the current percentile of implied volatility should be noted so that one has some relative basis for determining if all of the volatilities, his­ torical and implied, are very high or very low. One would not want to buy options if they were all in a very high percentile, nor sell them if they were all in a very low per­ centile. Often, a volatility chart showing both the implied and certain historical volatili­ ties will be a useful aid in making these decisions. One can not only quickly tell if the options are in a high or low percentile, but he may also be able to see what happened at similar times in the past when implied and historical volatility deviated substan­ tially. Finally, one needs some measure to ensure that, if convergence between implied and historical volatility does occur, he will be able to make money. So, for example, if one is buying a straddle, he might require that if implied rises to meet his­ torical (say, the lowest of the historicals) in a month, he will actually make money. One could use a different time frame, but be careful not to make it something unrea­ sonable. For example, if implied volatility is currently 40% and historical is 60%, it is highly unlikely that implied would rise to 60% in a day or two. Using this criterion also ensures that the absolute difference between implied and historical volatility is wide enough to allow for profits to be made. That is, if implied is 10% and historical is 13%, that's a difference of 30% in the two - ostensibly a "wide" divergence between implied and historical. However, if implied rises to meet historical, it will mean only an absolute increase of 3 percentage points in implied volatility - proba­ bly not enough to produce a profit, after costs, if any length of time passes. If all of these criteria are satisfied, then one has successfully found "mispriced" options using the implied versus historical method, and he can proceed to the next step in the volatility analysis: using the probability calculator. READING THE VOLATILITY CHART Another technique that traders use in order to determine if options are mispriced is to actually try to analyze the chart of volatility - typically implied volatility, but it could be historical. This might seem to be a subjective approach, except that it is real- Chapter 39: Volatility Trading Techniques 819 ly not much different from the GARCH approach, which is considered to be highly advanced. When one views the volatility chart, he is not looking for chart patterns like technical analysts might do with stock charts: support, resistance, head-and-shoul­ ders, flags, pennants, and so on. Rather, he is merely looking for the trend of volatil­ ity to change. This is a valid approach in the use of many indicators, particularly sentiment indicators, that can go to extreme levels. By waiting for the trend to change, the user is not subjecting himself to buying into the midst of a downtrend in volatility, nor sell­ ing into the midst of a steep uptrend in volatility. Example: Suppose a volatility trader has determined that the current level of implied volatility for XYZ stock is in the 1st percentile of all past readings. Thus, the options are as cheap as they've ever been. Perhaps, though, the overall market is experienc­ ing a very dull period, or XYZ itself has been in a prolonged, tight trading range - either of which might cause implied volatility to decline steadily and substantially. Having found these cheap options, he wants to buy volatility. However, he has no guarantee that implied volatility won't continue to decline, even though it is already as cheap as it's ever been. If he follows the technique of waiting for a reversal in the trend of implied volatility, then he would keep an eye on XYZ's implied volatility daily until it had at least a modest increase, something to indicate that option buyers have become more interested in XYZ's options. The chart in Figure 39-1 shows how this situation might look. There are a number of items marked on the chart, so it will be described in detail. There are two graphs in Figure 39-1: The top line is the implied volatility graph, while on the bottom is the stock price chart. The implied volatility chart shows that, near the first ofJune, it made new all-time lows near 28% (i.e., it was in the 0th percentile of implied volatility). Hence, one might have bought volatility at that point. However, it is obvious that implied volatility was in a steep downtrend at that time, so the volatility trader who reads the charts might have decided to wait for a pop in volatility before buying. This turned out to be a judicious decision, because the stock went nowhere for nearly another month and a half, all the while volatility was dropping. At the right of the chart, implied volatility has dropped to nearly 20%. The solid lines on the two graphs indicate the data that is known about the implied volatility and price history of XYZ. The dotted lines indicate a scenario that might unfold. If implied volatility were to jump ( and the stock price might jump, too), then one might think that the trend of implied volatility was no longer down, and he would then buy volatility. 820 Part VI: Measuring and Trading VolatHity The reason that this approach has merit is that one never knows how low volatil­ ity can go, and more important, how high it can get. It was mentioned that the same sort of approach works well for other sentiment indicators, the put-call ratio, in par­ ticular. During the bull market of the 1990s, the equity-only put-call ratio generally ranged between about 30 and 55. Thus, some traders became accustomed to buying the market when the put-call ratio reached numbers exceeding 50 (high put-call ratio numbers are bullish predictors for the market in general). However, when the bull market ended, or at least faltered, the put-call ratios zoomed to heights near 70 or 75. Thus, those using a static approach (that is, "Buy at 50 or higher") were buried as they bought too early and had to suffer while the put-call ratios went to new all­ time highs. A trend reversal approach would have saved them. It is a more dynamic procedure, and thus one would have let the put-call ratio continue to rise until it peaked. Then the market could have been bought. This is exactly what reading the volatility chart is about. Rather than relying on past data to indicate where the absolute maxima and minima of movements might occur, one rather notes that the volatility data is at extreme levels ( 1st percentile or 100th percentile) and then watches it until it reverses direction. This is especially useful for options sellers, because it avoids stepping into the vortex of massive option FIGURE 39-1. Chart of the trend of implied volatility. XYZ ,J' ········································ · ························ ....................... ··················· 50. 0 ... · ····················· 40. 0 Implied Volatility I/vi A r ···-····························· .. •·•······•·········-·············································-··vw•···················)·•······ 30. 0 All-Time Volatility Low - , .... , ..... , .. ··················,·······~················ t :t·•····•····· ...•. ':·LJJSL5~?. --;---··········•·: o, b ::r F f1 h j ::r 34.000 32.000 30. 000 28. 000 26.000 24.000 22.000 20. 000 Chapter 39: VolatiDty Trading Techniques 821 buying, where the buyers perhaps have inside information about some forthcominf corporate event such as a takeover. True, the options might be very expensive ( 10ot percentile), but there is a reason they are, and those with the inside information know the reason, whereas the typical volatility trader might not. However, if the volatility trader merely waits for a downturn in implied volatility readings before selling these options, he will most likely avoid the majority of trouble because the options will probably not lose implied volatility until news comes out or until the buyers give up (perhaps figuring that the takeover rumor has died). Volatility buyers don't face the same problems with early entry that volatility sellers do, but still it makes sense to wait for the trend of volatility to increase (as in Figure 39-1) before trying to guess the bottom in volatility. Just as it is usually fool­ hardy to buy a stock that is in a severe downtrend, so it may be, too, with buying volatility. A less useful approach would be to apply the same techniques to historical volatility charts, for such charts say nothing about option prices. See the next section for expansion on these thoughts. COMPARING HISTORICAL VERSUS HISTORICAL The above paragraphs summarize the three major ways that traders attempt to find options that are out of line. Sometimes, another method is mentioned: comparing current levels of historical volatility with past levels of the same measure, historical volatility. This method will be described, but it is generally an inferior method because such a comparison doesn't tell us anything about the option prices. It would do little good, for example, to find that current historical volatility is in a very low per­ centile of historical volatilities, only to learn later that the options are expensive and that perhaps implied volatility is even higher than historical volatility. One would nor­ mally not want to buy options in that case, so the initial analysis of comparing histor­ ical to historical is a wasted effort. Comparing current levels of historical volatility with past measures of historical volatility is sort of a backward-looking approach, since historical volatility involves strictly the use of past stock prices. There is no consideration of implied volatility in this approach. Moreover, this method makes the tacit assumption that a stock's volatility characteristics do not change, that it will revert to some sort of "normal" past price behavior in terms of volatility. In reality, this is not true at all. Nearly every stock can be shown to have considerable changes in its historical volatility patterns over time. 822 Part VI: Measuring and Trading Volatility Consider the historical volatilities of one of the wilder stocks of the tech stock boom, Rambus (RMBS). Historical volatilities had ranged between 50% and ll0%, from the listing of RMBS stock, through February 2000. At that time, the stock aver­ aged a price of about $20 per share. Things changed mightily when RMBS stock began to rise at a tremendous rate in February 2000. At that time, the stock blasted to ll5, pulled back to 35, made a new high near 135, and then collapsed to a price near 20. Hence, the stock itself had completed a wild round-trip over the two-year period. See Figures 39-2 and 39-3 for the stock chart and the historical volatility chart of RMBS over the time period in question. As this happened, historical volatility skyrocketed. After February 2000, and well into 2001, historical volatility was well above 120%. Thus it is clear that the behavior patterns of Rambus changed greatly after February 2000. However, if one had been comparing historical volatilities at any time after that, he would have erro­ neously concluded that RMBS was about to slow down, that the historic volatilities were too high in comparison with where they'd been in the past. If this had led one to sell volatility on RMBS, it could have been a very expensive mistake. While RMBS may be an extreme example, it is certainly not alone. Many other stocks experienced similar changes in behavior. In this author's opinion, such behav­ ior debunks the usefulness of comparing historical volatility with past measures of historical volatility as a valid way of selecting volatility trades. FIGURE 39-2. Historical volatilities of RMBS. RMBS 19.000 17.250 18.875 20010410 ............ ······· 60.0 · ·················· 50.0 ...... ······· 40. 0 39 M i·h··-:; s ·~ s a ~--f:i--·5--r;;····~··h s·s- A s a N □ s--r·;; r Chapter 39: Volatility Trading Techniques 823 FIGURE 39-3. Stock chart of RMBS. 19. 000 17. 250 18. 875 20010410 30.000 22. 000 14. 000 ' ' : : ! : : : ; 1 : : 1 r : ! : : : : ; : : : : : i l : l : 6. ooo 99 M il M :i J ii s b N b J F M il M :i J il s b N b J F h 1 What this method may be best used for is to complement the other methods described previously, in order to give the volatility trader some perspective on how volatile he can expect the underlying instrument to be; but it obviously has to be taken only as a general guideline. CHECK THE FUNDAMENTALS Once these mispriced options have been found, it is always imperative to check the news to see if there is some fundamental reason behind it. For example, if the options are extremely cheap and one then checks the news stories and finds that the under­ lying stock has been the beneficiary of an all-cash tender offer, he would not buy those options. The stock is not going to go anywhere, and in fact will disappear if the deal goes through as planned. Similarly, if the options appear to be very expensive, and one checks the news and finds that the underlying has a product up for review before a governmental agency (FDA, for example), then the options should not be sold because the stock may be about to undergo a large gap move based on the outcome of FDA hearings. There could be any number of similar corporate events that would make the options very expensive. The seller of volatility should not try to intercede when such events or rumors are occurring. 824 Part VI: Measuring and Trading Volatllity However, if there is no news that would seem to explain why the options are so cheap or so expensive, then the volatility trader can continue on to the rest of his analyses. SELECTING THE STRATEGY TO USE In general, when one wants to trade volatility, a simple approach is best, especially if one is buying volatility. If there is a volatility skew involved, then there may be other strategies that are superior, and they are discussed in the latter part of this chapter. However, when one is interested in the straight trading of volatility because he thinks implied volatility is out of line, then only a few strategies apply. If volatility is too low, then either a straddle or a strangle should be purchased. One would normally choose a straddle if the underlying instrument is currently trad­ ing near an available striking price. However, if the underlying is currently trading between two ~riking prices, then a strangle might be the better choice. In either case, a position trader would want to buy a straddle with several months of life remaining, in order to improve his chances of making a profit. There is no "best" time length to use, so one should use a probability calculator to aid in that decision. The use of prob­ ability calculators will be discussed shortly. Example: XYZ is trading at 39.60 and a volatility trader has determined that he wants to buy volatility. With this information, he should attempt to buy a straddle with a striking of 40 for both the put and the call. Suppose that the current date is in December, and the available expiration months for XYZ are January, February, April, July, and October, plus LEAPS for January of the next year. Then he would analyze each straddle (January 40, February 40, April 40, etc.) to see which is the best one to buy. It generally seems to work out that the midrange straddles have the best probabilities of success, given the way that option prices are usually structured. Of course, the actual prices of each straddle would be considered when using the probability calculator. In this case, then, the July 40 or October 40 straddle would probably be the best choices from a statistical view­ point for a position trader. If XYZ had been trading at a price of 37.50, say, then the trader would proba­ bly want to consider buying a strangle: buying a call with a striking price of 40 and a put with a striking price of 35. From the viewpoint of buying strangles, it does not make sense to separate the strikes by more than one striking price unit - 5 points for stock options, for example. This just makes the position more neutral to begin with. Chapter 39: Volatility Trading Techniques 825 Speaking of neutrality, one can also use the deltas of the options in question to alter the ratio of puts to calls, making the position initially as neutral as possible. This is the suggested approach, since the volatility buyer does not care whether the stock goes up or down. He is merely interested in stock movement and/or an increase in implied volatility. Example: XYZ is again trading at 39.60, and the trader wants a neutral position. He should use the deltas of the options to construct a neutral position. Consider the October 40 straddle, for example. Assume the volatility used for the probability cal­ culations is 40%. Under those conditions (and the ones assumed in the previous example), the October 40 call has a delta of 0.60 and the October 40 put has a delta of -0.40. Thus a ratio of buying 2 calls and 3 puts is a neutral ratio. If the call is sell­ ing for 6 and the put is selling for 5, then the break-even points for a 2-by-3 position would be 53.5 on the upside and 31 on the downside. This information is summarized as follows: Delta of October 40 call: Delta of October 40 put: +0.60 -0.40 Delta-neutral ratio: buy 2 calls and 3 puts Price of October 40 coll: Price of October 40 put: Net cost of 2-by-3 position: 27 points Break-even points: 6.00 5.00 Upside = 40 + 27 /2 = 53.50 Downside = 40 - 27 /3 = 31 .00 So, the probability calculations would endeavor to determine what the chances are of the stock ever trading at either 53.50 or 31.00 at any time prior to expiration. In fact, since there are straddles available in several expiration months, the strategist would want to analyze each of them in a similar fashion. Table 39-1 shows how his choices might look. If one were considering buying a strangle, similar calculations could be made using the deltas of the put and the call, where the call strike is higher than the put strike. Another simple strategy that can be used when volatility is low is the calendar spread, because it has a positive vega. That is, it can be expected to expand if implied volatility increases. For most traders, though, the limited profit nature of the calen- 826 Part VI: Measuring and Trading Volatility TABLE 39-1 January February April July October January LEAP Call price 1.25 2.25 3.50 5.00 6.00 7.15 Put price 1.50 2.35 3.35 4.35 5.00 5.55 Call delta 0.48 0.52 0.55 0.58 0.60 0.62 Put delta -0.52 -0.48 -0.45 -0.42 -0.40 -0.38 Neutral ~ 1-to-1 ~l-to-1 ~ 1-to-1 ~2-to-3 2-to-3 ~2-to-3 Debit 2.75 4.60 6.85 23.05 27.00 30.95 Upside break-even 42.75 44.60 46.85 51.57 53.50 55.47 Downside break-even 37.25 35.40 33.15 32.30 31.00 29.68 dar spread is too much of a burden"° either psychologically or in terms of commis­ sions, and so this strategy is only modestly used by volatility traders. Some traders will use the calendar spread if they don't see immediate prospects for an increase in implied volatility. They perhaps buy a call calendar slightly out-of-the-money and also buy a put calendar with slightly out-of-the-money puts. Then, if not much happens over the short term, the options that were sold expire worthless, and the remaining long straddle or strangle is even more attractive than ever. Of course, this strategy has its drawback in that a quick move by the underlying may result in a loss, something that would not have happened had a simple straddle or strangle been purchased. SELLING VOLATILITY If one were selling volatility (i.e., volatility is too high), his choices are more complex. Virtually anyone who has ever sold volatility has had a bad experience or two with either exploding stock prices or exploding volatility. Some of the concerns regarding the sale of volatility will be discussed at length later in this chapter. For now, the sim­ pler strategies will be considered, in keeping with the discussion involving the cre­ ation of a volatility trading position. Simplistically, a volatility seller would generally have a choice between one of two strategies (although there is a more complicated strategy that can be introduced as well). The simplest strategy is just to sell both an out-of-the-money put and an out­ of-the-money call. The striking prices chosen should be far enough away from the current underlying price so that the probabilities of the position getting in trouble (i.e., the probabilities that the underlying actually trades at the striking prices of the naked options during the life of the position) are quite small. Just as the option buyer Chapter 39: Volatility Trading Techniques 827 above outlined several expiration months, then computed the break-even prices, so should a volatility seller. Generally he will probably want to sell short-term options, but all expiration months should be considered, at least initially. Also, he may want to try different strike prices in order to get a balance between a low probability of the stock reaching the striking price of the naked options and taking in enough premium to make the trade worthwhile. To this author, the sale of naked options at small frac­ tional prices does not appear attractive. Of course, merely selling such a put and a call means the options are naked, and that strategy is not suitable for all traders. The next best choice then, I suppose, is a credit spread. The problem with a credit spread is that one is both selling expensive options and also buying expensive options as protection. The ramifications of volatil­ ity changes on the credit spread strategy were detailed two chapters previously, so they won't be recounted here, except to say that if volatility decreases, the profits to be realized by a credit spreader are quite small (perhaps not even enough to over­ come the commission expense of removing the position), whereas a naked option seller would benefit to a greater and more obvious extent. The choice between naked writing and credit spreading should be made based largely on the philosophy and psychological makeup of the trader himself. If one feels uncomfortable with naked options, or if he doesn't have the ability to watch the mar­ ket pretty much all the time (or have someone watch it for him), or ifhe doesn't have the financial wherewithal to margin the positions and carry them until the stock hits the break-even point, then naked writing is not for that trader. Another factor that might affect the choice of strategy for the option seller is what type of underlying instrument is being considered. Index options are by far the best choices for naked option selling. Futures are next, and stocks are last. This is because of the ways those various instruments behave; stocks have by far the great­ est capability of making huge gap moves that are the bane of naked option selling. So, if one has found expensive stock or futures options, that might lend more credence to the credit spread strategy. There is one other strategy that can be employed, upon occasion, when options are expensive. It is called the volatility backspread, but its discussion will be deferred until later in the chapter. USING A PROBABILITY CALCULATOR No matter which method is used to find options that are out of line, and no matter which strategy is preferred by the trader, it is still necessary to use a probability cal­ culator to get a meaningful idea of whether or not the underlying has the ability to 828 Part VI: Measuring and Trading Volatility make the move to profitability (or not make the move into loss territory, if you're sell­ ing options). This is where historical volatility plays a big part, for it is the input into the probability calculator. In fact, no probability calculator will give reasonable pre­ dictions without a good estimate of volatility. Please refer to the previous chapter for a more in-depth discussion of probability calculators and stock price distributions. The use of probability analysis also mitigates some of the problems inherent in the method of selection that compares implied and historical volatilities. If the prob­ abilities are good for success, then we might not care so much whether the options are currently in a low percentile of implied volatility or not (although we still would not want to buy volatility when the options were in a high percentile of implied volatility and we would not want to sell options that are in a low percentile). In using the probability calculator, one first selects a strategy (straddle buying, for example, if options are cheap) and then calculates the break-even points as demonstrated in the previous section. Then the probability calculator is used to determine what the chances are of the underlying instrument ever trading at one or the other of those break-even prices at any time during the life of the option position. It was shown in the previous chapter that a Monte Carlo simulation using the fat tail distribution is best used for this process. An attractive volatility buying situation should have probabilities in excess of 80% of the underlying ever exceeding the break-even point, while an attractive volatility selling situation should have probabilities of less than 25% of ever trading at prices that would cause losses. The volatility seller can, of course, heavily influence those probabilities by choosing options that are well out-of-the-money. As noted above, the volatility seller should, in fact, calculate the probabilities on several dif­ ferent striking prices, striving to find a balance between high probability of success and the ability to take in enough premium to make the risk worthwhile. Example: The OEX Index is trading at 650. Suppose that one has determined that volatilities are too high and wants to analyze the sale of some naked options. Furthermore, suppose that the choices have been narrowed down to selling the September options, which expire in about five weeks. The main choices under con­ sideration are those in Table 39-2. The option prices in this example, being index options, reflect a volatility skew (to be discussed later) to make the example realistic. The two right-hand columns should be rejected because the probabilities of the stock hitting one or the other of the striking prices prior to expiration are too high well in excess of the 25% guideline mentioned earlier. That leaves the September 500-800 strangle or the September 550-750 strangle to consider. The probabilities are best for the farthest out-of-the-money options (September 500- 800 strangle), but the options are selling at such small prices that they will not pro- Chapter 39: Volatility Trading Techniques 829 TABLE 39-2 September September September September 800 call 750 call 730 call 700 call September September September September Naked sale: 500 put 550 put 570 put 600 put Call price 0.20 1.50 3.50 8.80 Put price 0.40 2.00 3.70 8.50 Probability of call strike 4% 17% 30% 44% Probability of put strike 1% 11% 20% 40% vide much of a return even if they expire worthless. Remember that one is required to establish the position with margin of at least 10% of the index price for naked index options, which would be $6,500 in this case. In fact, it has been recommended that one margin the position at the striking price itself (15% of 800, or $12,000 in this case). So, taking in only $60, less commissions, for the sale of the September 500-800 strangle doesn't seem to provide enough of a reward. Thus, the best choice seems to be the September 550-750 strangle. One would be making about $320 after commissions if the options expired worthless, and the recommended margin would be 15% of 750 (the higher strike), or $11,250 - a return of about 2.8% for one month. One cannot annualize these returns, for he has no idea if the same option pricing structure will exist in five weeks, when these options expire. Other probabilities can be calculated as well. For example, suppose one has decided to buy a straddle. He might want to know what the odds are not only of breaking even, but also of making at least a certain percentage return- say 20%. One could also calculate the probability of the stock moving 20% past the break-even points. That distance - 20% - is a reasonable figure to use because one would most likely be taking some partial profits or adjusting his position if the stock did indeed move that far. USING STOCK PRICE HISTORY All of the work done so far - determining which options are expensive, selecting a strategy, and calculating the probabilities of success - has been somewhat theoretical in that we haven't done any "back testing" with regard to the volatility of the under­ lying instruments. At this point, one should look at past prices to see if the stock has been able to make large moves (whether or not such a move is desired). 830 Part VI: Measuring and Trading Volatility Example: A trader is considering the purchase of the XYZ October 40 straddle for 11 points, with the stock at 39.60. The options are cheap and the probabilities of suc­ cess appear to be good, according to the probability calculator. The question that now needs to be asked and answered is this: "In the past, has this stock been able to move 11 points in 10 months (the time remaining in the straddle's life)?" Or, more impor­ tantly, since 11 divided by 39.60 is about 28%, "Has this stock been able to make moves of 28% over 10 months, in the past?" The answers to these questions can be readily obtained if stock price history data is available. One could even look at a chart of the stock and attempt to answer the questions himself without the aid of a com­ puter, but computer analysis of the price history is more rigorous and is therefore encouraged. The answers can be expressed in the form of probabilities, much as the results of the probability calculator are. Suppose one determines that the stock has been able to move 11 points in 10 months 77% of the time in the past. That's okay, but not great. However, when one looks at the price chart ofXYZ, he sees that it traded at much lower prices - near $10 a share - for a long time before rising to its current levels. It would be very hard to expect a $10 stock to move 11 points in 10 months. That's why the second figure, the one involving the 28% move, is the more significant one. In this case, one might find that XYZ has been able to move 28% in 10 months over 90% of the time in the past. Now one has what appears to be a decent-looking straddle buy. This analysis of past prices can be done in a more sophisticated manner. Rather than just asking whether or not the stock has moved the required distance in the past, one might want to see just how the stock's movements "look." That is, there are a couple of scenarios under which the past movements might look attractive, but upon closer examination, one would not be so sanguine. For example, what ifXYZ had repeatedly moved 28%, but never much more in most of the IO-month periods that comprise its stock history? Then, one would be less inclined to want to own this straddle. Another scenario of past movements might be that XYZ had made moves that one could not reasonably expect to be repeated. Perhaps there was a huge gap down on an earnings shortfall, or if it was an Internet stock around the tum of the millen­ nium, it had a huge move upward, followed by a huge move downward. That would be another nonrepeating type of move, because absent the Internet mania, the stock might have been a rather range-bound item both prior to and after the one huge, round-trip move. Chapter 39: Volatility Trading Techniques 831 FIGURE 39-4. Histogram of XYZ movements. {Testing 28% move in ten months.) 15% X xx XXX X XXX XX XXX 5% xxxxxxx xxxxxxx X XXXXXXXX XXX XXXXXXXX xxxxxxxxxxxxxxxx -3 -2 -1 0 Movement 1 X X X X X X XXX XX X XXXX xxxxxxxxxxxxxxxxxxx 2 3 These problems could be addressed by merely looking at the chart, but the naked eye can be deceiving in many cases. Rather, a more rigorous approach would be to construct a histogram of these past stock movements and analyze the histogram. Figure 39-4 shows such a histogram. The x-axis shows the magnitude of each 10-month move that is in the database of XYZ stock prices. A move to 'T' would mean that it moved the 28% and no further over the 10-month period. A move to "-2" indicates that it fell 56% (twice the required distance) during the 10-month period. The y-axis (left-hand scale) shows the percentage of times that the move occurred. The sample histogram shown in Figure 39-4 is actually a very favorable one. Notice that the stock was always able to move at least 28%. Furthermore, it FIGURE 39-5. Example of poor movement. 15% 10% 5% -3 -2 X xx xx xxxx X XXXX XXXX X X X xx xxxx,"lrx~x~x~x--...----=.:.;:r· 0 X X X XXX 2 3 832 Part VI: Measuring and Trading Volatility moved two or three times that far with great frequency. Finally, there is a continu­ ity to the points on the histogram: There are some y-axis data points at almost all points on the x-axis (between the minimum and maximum x-axis points). That is good, because it shows that there has not been a clustering of movements by XYZ that might have dominated past activity. As for what is not a "good" histogram, we would not be so enamored of a his­ togram that showed a huge cluster of points near and between the "-1" and 'T' points on the X-axis. We want the stock to have shown an ability to move farther than just the break-even distance, if possible. As an example, see Figure 39-5, which shows a stock whose movements rarely exceed the "-1" or "+l" points, and even when they do, they don't exceed it by much. Most of these would be losing trades because, even though the stock might have moved the required percentage, that was its maximum move during the 10-month period, and there is no way that a trader would know to take profits exactly at that time. The straddles described by the histogram in Figure 39-5 should not be bought, regardless of what the previous analyses might have shown. Nor would it be desirable for the histogram to show a large number of move­ ments above the "+3" level on the histogram, with virtually nothing below that. Such a histogram would most likely be reflective of the spiky, Internet-type stock activity that was referred to earlier as being unreasonable to expect that it might repeat itself. In a general sense, one doesn't want to see too many open spaces on the histogram's X-axis; continuity is desired. If the histogram is a favorable one, then the volatility analysis is complete. One would have found mispriced options, with a good theoretical probability of profit, whose past stock movements verify that such movements are feasible in the future. ANOTHER APPROACH? After having considered the descriptions of all of these analyses, one other approach comes to mind: Use the past movements exclusively and ignore the other analyses altogether. This sounds somewhat radical, but it is certainly a valid approach. It's more like giving some rigor to the person who "knows" IBM can move 18 points and who therefore wants to buy the straddle. If the histogram (study of past movements) tells us that IBM does, indeed, have a good chance of moving 18 points, what do we really care about the relationship of implied and historical volatility, or about the cur­ rent percentiles of either type of volatility, or what a theoretical probability calcula­ tor might say? In some sense, this is like comparing implied volatility (the price of the straddle) with historical volatility (the history of stock price movements) in a strictly practical sense, not using statistics. Chapter 39: Volatility Trading Techniques 833 In reality, one would have to be mindful of not buying overly expensive options ( or selling overly cheap ones), because implied volatility cannot be ignored. However, the price of the straddle itself, which is what determines the x-axis on the histogram, does reflect option prices, and therefore implied volatility, in a nontechnical sense. This author suspects that a list of volatility trading candidates generated only by using past movements would be a rather long list. Therefore, as a practical matter, it may not be useful. MORE THOUGHTS ON SELLING VOLATILITY Earlier, it was promised that another, more complex volatility selling strategy would be discussed. An option strategist is often faced with a difficult choice when it comes to selling (overpriced) options in a neutral manner - in other words, "selling volatili­ ty." Many traders don't like to sell naked options, especially naked equity options, yet many forms of spreads designed to limit risk seem to force the strategist into a direc­ tional (bullish or bearish) strategy that he doesn't really want. This section addresses the more daunting prospect of trying to sell volatility with protection in the equity and futures option markets. The quandary in trying to sell volatility is in trying to find a neutral strategy that allows one to benefit from the sale of expensive options without paying too much for a hedge - the offsetting purchase of equally expensive options. The simple strategy that most traders first attempt is the credit spread. Theoretically, if implied volatility were to fall during the time the credit spread position is in place, a profit might be realized. However, after commissions on four different options in and possibly out (assuming one sold both out-of-the-money put and call spreads), there probably wouldn't be any real profit left if the position were closed out early. In sum, there is nothing really wrong with the credit spread strategy, but it just doesn't seem like any­ thing to get too excited about. What other strategy can be used that has limited risk and would benefit from a decline in implied volatility? The highest-priced options are the longer-term ones. If implied volatility is high, then if one can sell options such as these and hedge them, that might be a good strategy. The simplest strategy that has the desired traits is selling a calendar spread that is, sell a longer-term option and hedge it by buying a short-term option at the same strike. True, both are expensive (and the near-term option might even have a slightly higher implied volatility than the longer-term one). But the longer-term one trades with a far greater absolute price, so if both become cheaper, the longer-term one can decline quite a bit farther in points than the near-term one. That is, the vega of the longer-term option is greater than the vega of the shorter-term one. When one sells a calendar spread, it is called a reverse calendar spread. The strategy was 834 Part VI: Measuring and Trading Volatility described in the chapter on reverse spreads. The reader might want to review that chapter, not only for the description of the strategy, but also for the description of the margin problems inherent in reverse spreads on stocks and indices. One of the problems that most traders have with the reverse calendar spread is that it doesn't produce very large profits. The spread can theoretically shrink to zero after it is sold, but in reality it will not do so, for the longer-term option will retain some amount of time value premium even if it is very deeply in- or out-of-the-money. Hence the spread ·will never really shrink to zero. Yet, there is another approach that can often provide larger profit potential and still retain the potential to make money if implied volatility decreases. In some sense it is a modification of the reverse calendar spread strategy that can create a poten­ tially even more desirable position. The strategy, known as a volatility backspread, involves selling a long-term at-the-money option (just as in the reverse calendar spread) and then buying a greater number of near-er term out-of-the-money options. The position is generally constructed to be delta-neutral and it has a negative vega, meaning that it will profit if implied volatility decreases. Example: XYZ is trading at 115 in early June. Its options are very expensive. A trad­ er would like to construct a volatility backspread using the following two options: Call Option July 130 call: October 120 call: Price 2.50 13 Delta 0.26 0.53 Vega 0.10 0.27 A delta-neutral position would be to buy 2 of the July 130 calls and sell one of the October 120 calls. This would bring in a credit of 8 points. Also, it would have a small negative position vega, since tvvo times the vega of the July calls minus one times the vega of the October call is -0.07. That is, for each one percentage point drop in implied volatility of XYZ options in general, this position would make $7 - not a large amount, but it is a small position. The profitability of the position is shown in Figure 39-6. This strategy has lim­ ited risk because it does not involve naked options. In fact, if XYZ were to rally by a good distance, one could make large profits because of the extra long call. Meanwhile, on the downside, if XYZ falls heavily, all the options would lose most of their value and one would have a profit approaching the amount of the initial credit received. Furthermore, a decrease in implied volatility produces a small profit as well, although time decay may not be in the trader's favor, depending on exactly which short-term options were bought. The biggest risk is that XYZ is exactly at 130 at July expiration, so any strategist employing this strategy should plan to close it out Chapter 39: Volatility Trading Techniques FIGURE 39-6. Volatility backspread neutral position. Underlying Price 835 in advance of the near-term expiration. It should not be allowed to deteriorate to the point of maximum loss. Modifications to the strategy can be considered. One is to sell even longer-term options and of course hedge them with the purchase of the near-term options. The longer-term the option is, the bigger its vega will be, so a decrease in implied volatil­ ity will cause the heftier-priced long-term option to decline more in price. This mod­ ification is somewhat tempered, though, by the fact that when options get really expensive, there is often a tendency for the near-term options to be skewed. That is, the near-term options will be trading with a much higher implied volatility than will the longer-term options. This is especially true for LEAPS options. For that reason, one should make sure that he is not entering into a situation in which the shorter­ term options could lose volatility while the longer-term ones more or less retain the same implied volatility, as LEAPS options often do. This concept of differing volatil­ ity between near- and long-term options was discussed in more detail in Chapter 36 on the basics of volatility trading. As a sort of general rule, if one finds that the longer­ term option has a much lower implied volatility than the one you were going to buy, this strategy is not recommended. As a corollary, then, it is unlikely that this strate­ gy will work well with LEAPS options. One other thing that you should analyze when looking for this type of trade is whether it might be better to use the puts than the calls. For one thing, you can estab­ lish a position in which the heavy profitability is on the downside (as opposed to the upside, as in the XYZ example above). Then, of course, having considered that, it might actually behoove one to establish both the call spread and the put spread. If 836 Part VI: Measuring and Trading Volatility you do both, though, you create a "good news, bad news" situation. The good news is that the maximum risk is reduced; for example, if XYZ goes exactly to 130 (the worst point for the call spread), the companion put spread's credit would reduce that risk a little. However, the bad news is that there is a much wider range over which there is not profit, since there are two spots where losses are more or less maximized (at the strike price of the long calls and again at the strike price of the long puts). Margin will be discussed only briefly, since it was addressed in the chapter on reverse spreads. For both index and stock options, this strategy is considered to have naked options - a preposterous assumption, since one can see from the profit graph that the position is fully hedged until the near-term options expire. This raises the capital requirement for nonmember traders. The margin anomaly is not a problem with futures options, however. For those options, one need only margin the differ­ ence in the strikes, less any credit received, because that is the true risk of the posi­ tion. In summary, the volatility trader who wants to sell volatility in equity and futures options markets needs to be hedged, because gaps are prevalent and potentially very costly. This strategy creates a more neutral, less price-dependent way to benefit if implied volatility decreases, especially when compared with simple credit spreads. SUMMARY: TRADING THE VOLATILITY PREDICTION Attempting to establish trades when implied volatility is out of line is a theoretically attractive strategy. The process outlined above consisted of a few steps, employing both statistical and theoretical analysis. In any case, though, probability calculators must "say" that a volatility trade has good probabilities of success. It's merely a mat­ ter of what criteria we apply to limit our choices before we run the probability analy­ sis. So, it might be more useful to view volatility trading analysis in this light: Step I: Use a selection criterion to limit the myriad of volatility trading choices. Any of these could be used as the first criterion, but not all of them at once: a. Require implied volatility to be at an extreme percentile. b. Require historical and implied volatility to have a large discrepancy between them. c. Interpret the chart of implied volatility to see if it has reversed trend. Step 2: Use a probability calculator to project whether the strategy can be expected to be a success. Step 3: Using past price histories, determine whether the underlying has been able to create profitable trades in the past. (For example, if one is considering Chapter 39: Volatility Trading Techniques 837 buying a straddle, ask the question, "Has this stock been able to move far enough, with great enough frequency, to make this straddle purchase prof­ itable?") Use histograms to ensure that the past distribution of stock prices is smooth, so that an aberrant, nonrepeatable move is not overly influenc­ ing the results. Each criterion from Step 1 would produce a different list of viable volatility trading candidates on any given day. If a particular candidate were to appear on more than one of the lists, it might be the best situation of all. TRADING THE VOLATILITY SKEW In the early part of this chapter, it was mentioned that there are two ways in which volatility predictions could be "wrong." The first was that implied volatility was out of line. The second is that individual options on the same underlying instrument have significantly different implied volatilities. This is called a volatility skew, and presents trading opportunities in its own right. DIFFERING IMPLIED VOLATILITIES ON THE SAME UNDERLYING SECURITY The implied volatility of an option is the volatility that one would have to use as input to the Black-Scholes model in order for the result of the model to be equal to the current market price of the option. Each option will thus have its own implied volatil­ ity. Generally, they will be fairly close to each other in value, although not exactly the same. However, in some cases, there will be large enough discrepancies between the individual implied volatilities to warrant the strategist's attention. It is this latter con­ dition of large discrepancies that will be addressed in this section. Example: XYZ is trading at 45. The following option prices exist, along with their implied volatilities: Actual Implied Option Price Volatility January 45 call 2.75 41% January 50 call 1.25 47% January 55 call 0.63 53% February 45 call 3.50 38% February 50 call 4.00 45% 838 Part VI: Measuring and Trading Volatility Note that the implied volatilities of the individual options range from a low of 38% to a high of 53%. This is a rather large discrepancy for options on the same underlying security, but it is useful for exemplary purposes. A neutral strategy could be established by buying options with lower implied volatilities and simultaneously selling ones with higher volatilities, such as buy 10 February 45 calls and sell 20 January 50 calls. Examples of neutral spreads will be expanded upon in the next chapter, when more exact measures for determining how many calls to buy and sell are discussed. Before jumping into such a position, the strategist should ask himself if there is a valid reason why the different options have such different implied volatilities. As a generalization, it might be fair to say that out-of-the-money options have slightly higher implieds than at-the-money ones, and that longer-term options have lower implieds than short-term ones. But there are many instances in which such is not the case, so one must be careful not to overgeneralize. Speculators often desire the lowest dollar-cost option available. Thus, in a takeover rumor situation, they would buy the out-of-the-moneys as opposed to the higher-priced at- or in-the-moneys. If the out-of-the-moneys are extremely expen­ sive because of a takeover rumor, then the strategist must be careful, because the neutral strategy concept may lead him into selling naked calls. This is not to say he should avoid the situation altogether; he may be able to structure a position with enough upside room to protect himself, or he may believe the rumors are false. Returning to the general topic of differing implied volatilities on the same underlying stock, the strategist might ask how he is to determine if the discrepancies between the individual options are significantly large to warrant attention. A mathe­ matical approach is presented at the end of the next chapter in a section on advanced mathematical concepts. Suffice it to say that there is a way that the differences in the various implieds can be reduced to a single number - a sort of "standard deviation of the implieds" that is easy for the strategist to use. A list of these numbers can be con­ structed, comparing which stocks or futures might be candidates for this type of neu­ tral spreading. On a given day, the list is usually quite short - perhaps 20 stocks and 10 futures contracts will qualify. The concept of the implied volatilities of various options on the same underly­ ing stock remaining out of line with each other is one that needs more discussion. In the following section, the idea of semipermanent distortion between the volatilities of different striking prices is discussed. Chapter 39: Volatility Trading Techniques VOLATILITY SKEWING 839 After the stock market crashed in 1987, index options experienced what has since proven to be a permanent distortion: Out-of-the-money puts have remained more expensive than out-of-the-money calls. Furthermore, out-of-the-money puts are more expensive than at-the-money puts; out-of-the-money calls are cheaper than at­ the-money calls. This distorted effect is due to several factors, but it is so deep-seat­ ed that it has remained through all kinds of up and down markets since then. Other markets, particularly futures markets, have also experienced a long-lasting distortion between the implied volatilities at various strikes. The proper name given to this phenomenon is volatility skewing: the long-last­ ing effect whereby options at different striking prices trade with differing implied volatilities. It should be noted that the calls and puts at the same strike must trade for the same implied volatility; otherwise, conversion or reversal arbitrage would eliminate the difference. However, there is no true arbitrage between different strik­ ing prices. Hence, arbitrage cannot eliminate volatility skewing. Example: Volatility skewing exists in OEX index options. Assume the average volatil­ ity of OEX and its options is 16%. With volatility skewing present, the implied volatil­ ities at the various striking prices might look like this: OEX: 580 Implied Volatility Strike of Both Puts and Calls 550 22% 560 19% 570 17% 580 16% 590 15% 600 14% 610 13% In this form of volatility skewing, the out-of-the-money puts are the most expensive options; the out-of-the-money calls are the cheapest. This pattern of implied volatilities is called a reverse volatility skew or, alternatively, a negative volatility skew. 840 Part VI: Measuring and Trading Volatility The causes of this effect stem from the stock market's penchant to crash occa­ sionally. Investors who want protection buy index puts; they don't sell index futures as much as they used to because of the failure of the portfolio insurance strategy dur­ ing the 1987 crash. In addition, margin requirements for selling naked index puts have increased, especially for market-makers, who are the main suppliers of naked puts. Consequently, demand for index puts is high and supply is low. Therefore, out­ of-the-money index puts are overly expensive. This does not entirely explain why index calls are so cheap. Part of the reason for that is that institutional traders can help finance the cost of those expensive index puts by selling some out-of-the-money index calls. Such sales would essentially be covered calls if the institution owned stocks, which it most certainly would. This strat­ egy is called a collar. This distortion in volatilities is not in accordance with the probability distribu­ tion of stock prices. These distorted implied volatilities define a different probability curve for stock movement. They seem to say that there is more chance of the market dropping than there is of it rising. This is not true; in fact, just the opposite is true. Refer to the reasons for using lognormal distribution to define stock price move­ ments. Consequently, there are opportunities to profit from volatility skewing, if one is able to hold the position until expiration. It was shown in previous examples that one would attempt to sell the options with higher implied volatilities and buy ones with lower implieds as a hedge. Hence, for OEX traders, three strategies seem relevant: 1. Buy a bear put spread in OEX. Example: Buy 10 OEX June 560 puts Sell IO OEX June 540 puts 2. Buy OEX puts and sell a larger number of out-of-the-money puts - a ratio write of put options. Example: Buy 10 OEX June 560 puts Sell 20 OEX June 550 puts 3. Sell OEX calls and buy a larger number of out-of-the-money calls - a backspread of call options. Example: Buy 20 OEX June 590 calls Sell IO OEX June 580 calls In all three cases, one is selling the higher implied volatility and buying options with lower implied volatilities. The first strategy is a simple bear spread. While it will Chapter 39: Volatility Trading Techniques 841 benefit from the fact that the options are skewed in terms of implied volatility, it is not a neutral strategy. It requires that the underlying drop in price in order to become profitable. There is nothing wrong with using a directional strategy like this, but the strategist must be aware that the skew is unlikely to disappear ( until expiration) and therefore the index price movement is going to be necessary for profitability. The second strategy would be best suited for moderately bearish investors, although a severe market decline might drive the index so low that the additional short puts could cause severe losses. However, statistically this is an attractive strat­ egy. At expiration, the volatility skewing must disappear; the markets will have moved in line with their real probability distribution, not the false one being implied by the skewed options. This makes for a potentially profitable situation for the strategist. The backspread strategy would work best for bullish investors, although some backspreads can be created for credits, so a little money could also be made if the index fell. In theory, a strategist could implement both strategies simultaneously, which would give him an edge over a wide range of index prices. Again, this does not mean that he cannot lose money; it merely means that his strategy is statistically superior because of the way the options are priced. That is, the odds are in his favor. In reality, though, a neutral trader would choose either the ratio spread or the backspread - not both. As a general rule of thumb, one would use the ratio spread strategy if the current level of implied volatility were in a high percentile. The back­ spread strategy would be used if implied volatility were in a low percentile current­ ly. In that way, a movement of implied volatility back toward the 50th percentile would also benefit the trade that is in place. Another interesting thing happens in these strategies that may be to their ben­ efit: The volatility skewing that is present propagates itself throughout the striking prices as OEX moves around. It was shown in the previous section's example that one should probably continue to project his profits using the distorted volatilities that were present when he establishes a position. This is a conservative approach, but a correct one. In the case of these OEX spreads, it may be a benefit. Assuming that the skewing is present wherever OEX is trading means that the at-the-money strike will have 16% as its implied volatility regardless of the absolute price level; the skewing will then extend out from that strike. So, if OEX rises to 600, then the 600 strike would have a volatility of 16%; or if it fell to 560, then the 560 puts and calls would have a volatility of 16%. Of course, 16% is just a representative figure; the "average" volatility of OEX can change as well. For illustrative purposes, it is convenient to assume that the at-the-money strike keeps a constant volatility. Example: Initially, a trader establishes a call backspread in OEX options in order to take advantage of the volatility skewing: 842 Initial situation: OEX: 580 Option June 590 call June 600 call A neutral spread would be: Buy 2 June 600 calls Sell I June 590 call Implied Volatility 15% 14% since the deltas are in the ratio of 2-to-l. Part VI: Measuring and Trading Volatility Delta 0.40 0.20 Now, suppose that OEX rises to 600 at a later date, but well before expiration. This is not a particularly attractive price for this position. Recall that, at expiration, a backspread has its worst result at the striking price of the purchased options. Even prior to expiration, one would not expect to have a profit with the index right at 600. However, the statistical advantage that the strategist had to begin with might be able to help him out. The present situation would probably look like this: Option June 590 call June 600 call Implied Volatility 17% 16% The June 600 call is now the at-the-money call, since OEX has risen to 600. As such, its implied volatility will be 16% ( or whatever the "average" volatility is for OEX at that time - the assumption is made that it is still 16% ). The June 590 call has a slightly higher volatility (17%) because volatility skewing is still present. Thus, the options that are long in this spread have had their implied volatility increase; that is a benefit. Of course, the options that are short had theirs increase as well, but the overall spread should benefit for two reasons: 1. Twice as many options are owned as were sold. 2. The effect of increased volatility is greatest on the at-the-money option; the in­ the-money will be affected to a lesser degree. All index options exhibit this volatility skewing. Volatility skewing exists in other markets as well. The other markets where volatility skewing is prevalent are usually Chapter 39: Volatility Trading Techniques 843 futures option markets. In particular, gold, silver, sugar, soybeans, and coffee options will from time to time display a form of volatility skewing that is the opposite of that displayed by index options. In these futures markets, the cheapest options are out-of­ the-money puts, while the most expensive options are out-of-the-money calls. Example: January soybeans are trading at 580 ($5.80 per bushel). The following table of implied volatilities shows how volatility skewing that is present in the soybean market is the opposite of that shown by the OEX market in the previous examples: January beans: 580 Strike Implied Volatility 525 12% 550 13% 575 15% 600 17% 625 19% 650 21% 675 23% Notice that the out-of-the-money calls are now the more expensive items, while out-of-the-money puts are the cheapest. This pattern of implied volatilities is called forward volatility skew or, alternatively, positive volatility skew. The distribution of soybean prices implied by these volatilities is just as incor­ rect as the OEX one was for the stock market. This soybean implied distribution is too bullish. It implies that there is a much larger probability of the soybean market rising 100 points than there is of it falling 50 points. That is incorrect, considering the historical price movement of soybeans. A strategist attempting to benefit from the forward ( or positive) volatility skew in this market has essentially three strategies available. They are the opposite of the three recommended for the $OEX, which had a reverse (or negative) volatility skew. First would be a call bull spread, second would be a put backspread, and third would be a call ratio spread. In all three cases, one would be buying options at the lower striking price and selling options at the higher striking price. This would give him the theoretical advantage. The same sorts of comments that were made about the OEX strategies can be applied here. The bull spread is a directional strategy and can probably only be expected to make money if the underlying rises in price, despite the statistical advan- 844 Part VI: Measuring and Trading VolatiRty tage of the volatility skew. The put backspread is best established when the overall level of implied volatility is in a low percentile. Finally, the call ratio spread has a great deal of risk to the upside ( and futures prices can fly to the upside quickly, espe­ cially if bad fundamental conditions develop, such as weather in the grain markets). The call ratio spread would best be used when implied volatilities are already in a high percentile. As a general comment, it should be noted that if the volatility skew disappears while the trader has the position in place, a profit will generally result. It would nor­ mally behoove the strategist to take the profit at that time. Otherwise, follow-up action should adhere to the general kinds of action recommended for the strategies in question: protective action to prevent large losses in the case of the ratio spreads, or the taking of partial profits and possibly rolling the long options to a more at-the­ money strike in the case of the backspread strategies. SUMMARY OF VOLATILITY SKEWING Whenever volatility skewing exists - no matter what market - opportunities arise for the neutral strategist to establish a position that has advantages. These advantages arise out of the fact that normal market movements are different from what the options are implying. Moreover, the options are wrong when there is skewing at all strikes, from the lowest to the highest. The strategist should be careful to project his profits prior to expiration using the same skewing, for it may persist for some time to come. However, at expiration, it must of course disappear. Therefore, the strategist who is planning to hold the position to expiration will find that volatility skewing has presented him with an opportunity for a positive expected return. SUMMARY OF VOLATILITY TRADING The theoretical trading of options, mostly in a neutral manner, has evolved into one large branch - volatility trading. This part of the book has attempted to lay out the foundations, structures, and practices prevalent in this branch of trading. As the read­ er can see, there are some sophisticated techniques being applied - not so much in terms of strategy, but in terms of the ways that one looks at volatility and in the ways that stocks can move. Statistical methods are used liberally in trying to determine the ways that either volatility can move or stocks can move. The probability calculators, stock price dis­ tributions, and related topics are all statistical in nature. The volatility trader is intent on finding situations in which current market implied volatility is incorrect, either in its absolute value or in the skew that is prevalent in the options on a particular under- Chapter 39: VolatiDty Trading Techniques 845 lying instrument. Upon finding such discrepancies, the trader attempts to take advantage by constructing a more or less neutral position, preferring not to predict price so much, but rather attempting to predict volatility. Most volatility traders attempt to buy volatility rather than sell it, for the rea­ sons that the strategies inherent in doing so have limited risk and large potential rewards, and don't require one to monitor them continuously. If one owns a straddle, any major market movements resulting in gaps in prices are a benefit. Hence, mon­ itoring of positions as little as just once a day is sufficient, a fact that means that the volatility buyer can have a life apart from watching a trading screen all day long. In addition, volatility buyers of stock options can avail themselves of the chaotic move­ ments that stocks can make, taking advantage of the occasional fat tail movements. However, since volatility and prices are so unstable, one cannot predict their movements with any certainty. The vagaries of historical volatility as compared to implied volatility, the differences between the implied volatility of short- and long­ term options, and the difficulty in predicting stock price distributions all compli­ cate the process of predicting volatility. Hence, volatility trading is not a "lock," but its practitioners normally believe that it is by far the best approach to theoretical option trading available today. Moreover, most option professionals primarily trade volatility rather than directional positions. , CHAPTER 40 Advanced Concepts As the option markets have matured, strategists have been forced to rely more on mathematics in order to select new positions as well as to discern how their positions will behave in fluctuating markets. These techniques can be used on simple strategies, such as bull spreads or ratio spreads, or on far more complex portfolios of options. First, the concept of implied volatility will be examined in more detail, prima­ rily as an aid in choosing new positions that have a positive expected return. Then, the concept of risk management will be explored. In effect, one can reduce his option position into several components of risk measurement that can be readily under­ stood. This chapter describes the techniques used to evaluate one's position, and shows how to use this information to reduce the risk in the position. The actual math­ ematical calculations required to perform these analyses are included at the end of the chapter. NEUTRALITY In many of the examples in previous chapters, it was generally assumed that one would take a "neutral" position in order to capture the pricing or volatility differen­ tial. Why this concentration on neutrality? Neutrality, as it applies to option positions, means that one is noncommittal with respect to at least one of the factors that influ­ ence an option's price. Simply put, this means that one can design an option position in which he can profit, no matter which way the underlying security moves. 846 Chapter 40: Advanced Concepts 847 Most option strategies fall into one of two categories: as a hedge to a stock or futures strategy (for example, buying puts to protect a portfolio of stocks), or as a profit venture unto itself. The latter category is where most traders find themselves, and they often approach it in a fairly speculative manner - either by buying options or by being a premium seller (covered or uncovered). In such strategies, the trader is taking a view of the market; he needs certain price action from the underlying security in order to profit. Even covered call writing, which is considered to be a con­ servative strategy, is subject to large losses if the underlying stock drops drastically. It doesn't have to be that way. Strategies can be devised that will have a chance to profit regardless of price changes in the underlying stock, as well as because of them. Such strategies are neutral strategies and they always require at least two options in the position - a spread, straddle, or some other combination. Often, when one constructs a neutral strategy, he is neutral with respect to price changes in the underlying security. It is also possible, and often wise, to be neutral with respect to the rate of price change of the underlying security, with respect to the volatility of the security, or with respect to time decay. This is not to imply that any option spread that is neutral will automatically be a money-maker; rather, one looks for an opportunity - perhaps an overpriced series of options - and attempts to capture that overpricing by constructing a neutral strategy around it. Then, regardless of the movement of the underlying stock, the strategist has a chance of making money if the overpricing disappears. Note that the neutral approach is distinctly different from the speculator's, who, upon determining that he has discovered an underpriced call, would merely buy the call, hoping for the stock to increase in price. He would not make money if XYZ fell in price unless there was a huge expansion in implied volatility - not something to count on. The next section of this chapter deals with how one determines his neu­ trality. In effect, if he is not neutral, then he has risk of some sort. The following sec­ tions outline various measures of risk that the strategist can use to establish a new position or manage an existing one. The most important of these risk measurements is how much market exposure the position currently has. This has previously been described as the "delta." Of near­ ly equal importance to the strategist is how much the option strategy will change with respect to the rate of change in the price of the underlying security. Also of interest are how changes in volatility, in time remaining until expiration, or even in the risk­ free interest rate will affect the position. Once the components of the option position are defined, the strategist can then take action to reduce the risk associated with any of the factors, should he so desire. 848 Part VI: Measuring and Trading Volatmty THE "GREEKS" Risk measurements have generally been given the names of actual or contrived Greek letters. For example, "delta" was discussed in previous chapters. It has become common practice to refer to the exposure of an option position merely by describing it in terms of this "Greek" nomenclature. For example, "delta long 200 shares" means that the entire option position behaves as if the strategist were merely long 200 shares of the underlying stock. In all, there are six components, but only four are heavily used. DELTA The first risk measurement that concerns the option strategist is how much current exposure his option position has as the underlying security moves. This is called the "delta." In fact, the term delta is commonly used in at least two different contexts: to express the amount by which an option changes for a I-point move in the underlying security, or to describe the equivalent stock position of an entire option portfolio. Reviewing the definition of the delta of an individual option (first described in Chapter 3), recall that the delta is a number that ranges between 0.0 and 1.0 for calls, and between -1.0 and 0.0 for puts. It is the amount by which the option will move if the underlying stock moves 1 point; stated another way, it is the percentage of any stock price change that will be reflected in the change of price of the option. Example: Assume an XYZ January 50 call has a delta of 0.50 with XYZ at a price of 49. This means that the call will move 50% as fast as the stock will move. So, if XYZ jumps to 51, a gain of 2 points, then the January 50 call can be expected to increase in price by 1 point (50% of the stock increase). In another context, the delta of a call is often thought of as the probability of the call being in-the-money at expiration. That is, ifXYZ is 50 and the January 55 call has a delta of 0.40, then there is a 40% probability that XYZ will be over 55 at January expiration. Put deltas are expressed as negative numbers to indicate that put prices move in the opposite direction from the underlying security. Recall that deltas of out-of­ the-money options are smaller numbers, tending toward 0 as the option becomes very far out-of-the-money. Conversely, deeply in-the-money calls have deltas approaching 1.0, while deeply in-the-money puts have deltas approaching -1.0. Note: Mathematically, the delta of an option is the partial derivative of the Black-Scholes equation ( or whatever formula one is using) with respect to stock price. Graphically, it is the slope of a line that is tangent to the option pricing curve. Chapter 40: Advanced Concepts 849 Let us now take a look at how both volatility and time affect the delta of a call option. Much of the data to be presented in this chapter will be in both tabular and graphical form, since some readers prefer one style or the other. The volatility of the underlying stock has an effect on delta. If the stock is not volatile, then in-the-money options have a higher delta, and out-of-the-money options have a lower delta. Figure 40-1 and Table 40-1 depict the deltas of various calls on two stocks with differing volatilities. The deltas are shown for various strike prices, with the time remaining to expiration equal to 3 months and the underlying stock at a price of 50 in all cases. Note that the graph confirms the fact that a low­ volatility stock's in-the-money options have the higher delta. The opposite holds true for out-of-the-money options: The high-volatility stock's options have the higher delta in that case. Another way to view this data is that a higher-volatility stock's options will always have more time value premium than the low-volatility stock's. In-the-money, these options with more time value will not track the underlying stock price move­ ment as closely as ones with little or no time value. Thus, in-the-money, the low­ volatility stock's options have the higher delta, since they track the underlying stock price movements more closely. Out-of-the-money, the entire price of the option is composed of time value premium. The ones with higher time value (the ones on the high-volatility stock) will move more since they have a higher price. Thus, out-of-the­ money, the higher-volatility stock's options have the greater delta. Time also affects delta. Figures 40-2 (see Table 40-2) and 40-4 show the rela­ tionships between time and delta. Figure 40-2's scales are similar to those in Figure 40-2, delta vs. volatility: The deltas are shown for various striking prices, with XYZ assumed to be equal to 50 in all cases. Notice that in-the-money, the shorter-term options have the higher delta. Again, this is because they have the least time value premium. Out-of-the-money, the opposite is true: The longer-term options have the higher deltas, since these options have the most time value premium. Figure 40-3 (see Table 40-3) depicts the delta for an XYZ January 50 call with XYZ equal to 50. The horizontal axis in this graph is "weeks until expiration." Note that the delta of a longer-term at-the-money option is larger than that of a shorter­ term option. In fact, the delta shrinks more rapidly as expiration draws nearer. Thus, even if a stock remains unchanged and its volatility is constant, the delta of its options will be altered as time passes. This is an important point to note for the strategist, since he is constantly monitoring the risk characteristics of his position. He cannot assume that his position is the same just because the stock has remained at the same price for a period of time. Position Delta. Another usage of the term delta is what has previously been referred to as the equivalent stock position (ESP); for futures options, it would be 850 FIGURE 40-1. Delta comparison, with XYZ = 50. 100 75 $ 40 Part VI: Measuring and Trading Volatility 45 55 60 At Expiration Stock Price Thus, a delta neutral straddle position would consist of buying 8 J anua:ry 50 calls and buying 11 Februa:ry 50 puts. The straddle has no market exposure, at least over the short term. Note that the delta neutral straddle has a significantly different prof­ it picture from the delta neutral ratio spread, but they are both neutral and are both based on the fact that the Janua:ry 50 call is cheap. The straddle makes money if the stock moves a lot, while the other makes money if the stock moves only a little. (See Figure 40-9.) Can these two vastly different profit pictures be depicting strategies in which the same thing is to be accomplished ( that is, to capture the underpriced nature of the XYZ Janua:ry 50 call)? Yes, but in order to decide which strategy is "best," the strategist would have to take other factors into consideration: the historical volatility of the underlying security, for example, or how much actual time remains until Janua:ry expiration, as well as his own psychological attitude toward selling uncovered calls. A more precise definition of the other risks of these two positions can be obtained by looking at their position gammas. Delta Neutral Is Not Entirely Neutral. In fact, delta neutral means that one is neutral only with respect to small price changes in the underlying securi­ ty. A delta neutral position may have seriously unneutral characteristics when Chapter 40: Advanced Concepts FIGURE 40-9. XYZ straddle buy. Cl) 8000 7000 6000 5000 4000 ~ 3000 ~ 2000 ! 1000 01------------------------ -1000 -2000 -3000 At January Expiration Stock Price 871 some of the other risk measurements are considered. Consequently, one cannot blithely go around establishing delta neutral positions and ignoring them, for they may have significant market risk as certain factors change. For example, it is obvious to the naked eye that the two positions described in the previous section - the ratio spread and the long straddle - are not alike at all, but both are delta neutral. If one incorporates the usage of some of the other risk measurements into his position, he will be able to quantify the differences between "neutral" strategies. The sale of a straddle will be used to examine how these vari­ ous factors work. Positions with naked options in them have negative position gamma. This means that as the underlying security moves, the position will acquire traits opposite to that movement: If the security rises, the position becomes short; if it falls, the posi­ tion becomes long. This description generally fits any position with naked options, such as a ratio spread, a naked straddle, or a ratio write. Example: XYZ is at 88. There are three months remaining until July expiration, and the volatility of XYZ is 30%. Suppose 100 July 90 straddles are sold for 10 points - the put and the call each selling for 5. Initially, this position is nearly delta neutral, as 872 Part VI: Measuring and Trading Volatility shown in Table 40-9. However, since both options are sold, each sale places negative gamma in the position. The usefulness of calculating gamma is shown by this example. The initial posi­ tion is NET short only 100 shares of XYZ, a very small delta. In fact, a person who is a trader of small amounts of stock might actually be induced into believing that he could sell these 100 straddles, because that is equivalent to being short merely 100 shares of the stock. TABLE 40-9. Position delta and gamma of straddle sale. XYZ = 88. Option Position Option Position Position Delto Delta Gamma Gamma Sell l 00 July 90 calls 0.505 -5,050 0.03 -300 Sell 1 00 July 90 puts 0.495 +4,950 0.03 -300 Total shares - 100 -600 Calculating the gamma quickly dispels those notions. The gamma is large: 600 shares of negative gamma. Hence, if the stock moves only 2 points lower, this trad­ er's straddle position can be expected to behave as if it were now long 1,100 shares (the original 100 shares short plus 1,200 that the gamma tells us we can expect to get long)! The position might look like this after the stock drops 2 points: XYZ: 86 Position Sold 1 00 July 90 calls Sold 100 July 90 puts Option Delta 0.44 0.55 Position Delta -4,400 +5,500 + 1 , 100 shares Hence, a 2-point drop in the stock means that the position is already acquiring a "long" look. Further drops will cause the position to become even "longer." This is certainly not a position - being short 100 straddles - for a small trader to be in, even though it might have erroneously appeared that way when one observed only the delta of the position. Paying attention to gamma more fully discloses the real risks. In a similar manner, if the stock had risen 2 points to 90, the position would quickly have become delta short. In fact, one could expect it to be short 1,300 shares in that case: the original short 100 shares plus the 1,200 indicated by the negative gamma. A rise to 90, then, would make the position look like this: Chapter 40: Advanced Concepts XYZ:90 Position Sold 100 July 90 calls Sold 1 00 July 90 puts Option Delto 0.56 0.43 Position Delta -5,600 +4,300 873 1,300 shares These examples demonstrate how quickly a large position, such as being short 100 straddles, can acquire a large delta as the stock moves even a small distance. Extrapolating the moves is not completely correct, because the gamma changes as the stock price changes, but it can give the trader some feel for how much his delta will change. It is often useful to calculate this information in advance, to some point in the near future. Figure 40-10 depicts what the delta of this large short straddle position will be, two weeks after it was first sold. The points on the horizontal axis are stock prices. The quickness with which the neutrality of the position disappears is alarm­ ing. A small move up to 93 - only one standard deviation - in two weeks makes the overall position short the equivalent of about 3,300 shares of XYZ. Figure 40-10 real­ ly shows nothing more than the effect that gamma is having on the position, but it is presented in a form that may be preferable for some traders. What this means is that the position is "fighting" the market: As the market goes up, this position becomes shorter and shorter. That can be an unpleasant situation, both from the point of view of creating unrealized losses as well as from a psycho­ logical viewpoint. The position delta and gamma can be used to estimate the amount of unrealized loss that will occur: Just how much can this position be expected to lose if there is a quick move in the underlying stock? The answer is quickly obtained from the delta and gamma: With the first point that XYZ moves, from 88 to 89, the posi­ tion acts as if it is short 100 shares (the position delta), so it would lose $100. With the next point that XYZ rises, from 89 to 90, the position will act as if it is short the original 100 shares (the position delta), plus another 600 shares (the position gamma). Hence, during that second point of movement by XYZ, the entire position will act as if it is short 700 shares, and therefore lose another $700. Therefore, an immediate 2-point jump in XYZ will cause an unrealized loss of $800 in the position. Summarizing: Loss, first point of stock movement = position delta Loss, second point of stock movement = position delta + gamma Total loss for 2 points of stock movement = 2 x position delta + position gamma 874 Part VI: Measuring and Trading Volatility FIGURE 40· 1 O. Proiected delta, in 14 days. 6000 4500 3000 Cl) 1500 ~ ro .c (/) 0 'E (1) 80 85 ~ ·5 -1500 95 XYZ Stock Price C" UJ -3000 -4500 Using the example data: Loss, XYZ moves from 88 to 89: -$100 (the position delta) Loss, XYZ moves from 89 to 90: -$100 (delta) - $600 (gamma) : -$700 Total loss, XYZ moves from 88 to 90: -$100 x 2 - $600 = -$800 This can be verified by looking at the prices of the call and put after XYZ has jumped from 88 to 90. One could use a model to calculate expected prices if that happened. However, there is another way. Consider the following statements: If the stock goes up by 1 point, the call will then have a price of: p 1 = Po + delta 5.505 = 5.00 + 0.505 (if XYZ goes to 89 in the example) If the stock goes up 2 points, the call will have an increase of the above amount plus a similar increase for the next point of stock movement. The delta for that sec­ ond point of stock movement is the original delta plus the gamma, since gamma tells one how much his delta is going to change. Chapter 40: Advanced Concepts p2 = p 1 +delta+ gamma, or substituting from above p2 = (p0 + delta) + delta + gamma = Po + 2 x delta + gamma 6.04 = 5.00 + 2 x 0.505 + 0.03 (in the example if XYZ = 90) 875 By the same calculation, the put in the example will be priced at 4.04 if XYZ imme­ diately jumps to 90: 4.04 = 5.00 - 2 X 0.495 + 0.03 So, overall, the call will have increased by 1.04, but the put will only have decreased by 0.96. The unrealized loss would then be computed as -$10,400 for the 100 calls, offset by a gain of $9,600 on the sale of 100 puts, for a net unrealized loss of $800. This verifies the result obtained above using position delta and position gamma. Again, this confirms the logical fact that a quick stock movement will cause unrealized losses in a short straddle position. Continuing on, let us look at some of the other factors affecting the sale of this straddle. The straddle seller has time working in his favor. After the position is estab­ lished, there will not be as much decay in the first two-week period as there will be when expiration draws near. The exact amount of time decay to expect can be calcu­ lated from the theta of the position: XYZ: 88 Position Sold l 00 July 90 calls Sold l 00 July 90 puts Option Theta -0.03 -0.03 Position Theta +$300 +$300 +$600 This is how the position looked with respect to time decay when it was first established (XYZ at 88 and three months remaining until expiration). The theta of the put and the call are essentially the same, and indicate that each option is losing about 3 cents of value each day. Note that the theta is expressed as a negative number, and since these options are sold, the position theta is a positive number. A positive posi­ tion theta means time decay is working in your favor. One could expect to make $300 per day from the sale of the 100 calls. He could expect to make another $300 per day from the sale of the 100 puts. Thus, his overall position is generating a theoretical profit from time decay of $600 per day. The fact that the sale of a straddle generates profits from time decay is not earth-shattering. That is a well-known fact. However, the amount of that time decay 876 Part VI: Measuring and Trading Volatility is quantified by using theta. Furthermore, it serves to show that this position, which is delta neutral, is not neutral with respect to the passage of time. Finally, let us examine the position with respect to changes in volatility. This is done by calculating the position vega. XYZ:88 Position Sold 1 00 July 90 calls Sold 100 July 90 puts Option Vega 0.18 0.18 Position Vega -$1,800 -$1,800 -$3,600 Again, this information is displayed at the time the position was established, three months to expiration, and with a volatility of 30% for XYZ. The vega is quite large. The fact that the call's vega is 0.18 means that the call price is expected to increase by 18 cents if the implied volatility of the option increases by one percent­ age point, from 30% to 31 %. Since the position is short 100 calls, an increase of 18 cents in the price of the call would translate into a loss of $1,800. The put has a sim­ ilar vega, so the overall position would lose $3,600 if the options trade with an increase in volatility of just one percentage point. Of course, the position would make $3,600 if the volatility decreased by one percentage point, to 29%. This volatility risk, then, is the greatest risk in this short straddle position. As before, it is obvious that an increase in volatility is not good for a position with naked options in it. The use of vega quantifies this risk and shows how important it is to attempt to sell overpriced options when establishing such positions. One should not adhere to any one strategy all the time. For example, one should not always be sell­ ing naked puts. If the implied volatilities of these puts are below historical norms, such a strategy is much more likely to encounter the risk represented by the posi­ tion vega. There have been several times in the recent past - mostly during market crashes - when the implied volatilities of both index and equity options have leaped tremendously. Those times were not kind to sellers of options. However, in almost every case, the implied volatility of index options was quite low before the crash occurred. Thus, any trader who was examining his vega risk would not have been inclined to sell naked options when they were historically "cheap." In summary then, this "neutral" position is, in reality, much more complex when one considers all the other factors. Chapter 40: Advanced Concepts Position summary Risk Factor Position delta = l 00 Position gamma = -600 Position theta = +$600 Position vega = -$3,600 877 Comment Neutral; no immediate exposure to small market movements; lose $100 for 1 point move in underlying. Fairly negative; position will react inversely to market movements, causing losses of $700 for second point of movement by underlying. Favorable; the passage of time works in the position's favor. Very negative; position is extremely subject to changes in implied volatility. This straddle sale has only one thing guaranteed to work for it initially: time decay. (The risk factors will change as price, time, and volatility change.) Stock price movements will not be helpful, and there will always be stock price movements, so one can expect to feel the negative effect of those price changes. Volatility is the big unknown. If it decreases, the straddle seller will profit handsomely. Realistically, however, it can only decrease by a limited amount. If it increases, very bad things will happen to the profitability of the position. Even worse, if the implied volatility is increasing, there is a fairly likely chance that the underlying stock will be jumping around quite a bit as well. That isn't good either. Thus, it is imperative that the strad­ dle seller engage in the strategy only when there is a reasonable expectation that volatilities are high and can be expected to decrease. If there is significant danger of the opposite occurring, the strategy should be avoided. If volatility remains relatively stable, one can anticipate what effects the passage of time will have on the position. The delta will not change much, since the options are nearly at-the-money. However, the gamma will increase, indicating that nearer to expiration, short-term price movements will have more exaggerated effects on the unrealized profits of the position. The theta will grow even more, indicating that time will be an even better friend for the straddle writer. Shorter-term options tend to decay at a faster rate than do longer-term ones. Finally, the vega will decrease some as well, so that the effect of an increase in implied volatility alone will not be as dam­ aging to the position when there is significantly less time remaining. So, the passage 878 Part VI: Measuring and Trading Volatility of time generally will improve most aspects of this naked straddle sale. However, that does not mitigate the current situation, nor does it imply that there will be no risk if a little time passes. The type of analysis shown in the preceding examples gives a much more in­ depth look than merely envisioning the straddle sale as being delta short 100 shares or looking at how the position will do at expiration. In the previous example, it is known that the straddle writer will profit if XYZ is between 80 and 100 in three months, at expiration. However, what might happen in the interim is another matter entirely. The delta, gamma, theta, and vega are useful for the purpose of defining how the position will behave or misbehave at the current point in time. Refer back to the table of strategies at the beginning of this section. Notice that ratio writing or straddle selling ( they are equivalent strategies) have the characteris­ tics that have been described in detail: Delta is 0, and several other factors are neg­ ative. It has been shown how those negative factors translate into potential profits or losses. Observing other lines in the same table, note that covered writing and naked put selling ( they are also equivalent, don't forget) have a description very similar to straddle selling: Delta is positive, and the other factors are negative. This is a worse situation than selling naked straddles, for it entails all the same risks, but in addition will suffer losses on immediate downward moves by the underlying stock. The point to be made here is that if one felt that straddle selling is not a particularly attractive strategy after he had observed these examples, he then should feel even less inclined to do covered writing, for it has all the same risk factors and isn't even delta neutral. An example that was given in the chapter on futures options trading will be e,,'Panded as promised at this time. To review, one may often find volatility skewing in futures options, but it was noted that one should not normally buy an at-the-money call (the cheapest one) and sell a large quantity of out-of-the-money calls just because that looks like the biggest theoretical advantage. The following example was given. It will now be expanded to include the concept of gamma. Example: Heavy volatility skewing exists in the prices of January soybean options: The out-of-the-money calls are much more expensive than the at-the-money calls. The following data is known: January soybeans: 583 Option Price Implied Volatility Delta Gamma 575 call 19.50 15% 0.55 .0100 675 call 2.25 23% 0.09 .0026 Chapter 40: Advanced Concepts Using deltas, the following spread appears to be neutral: Buy l January bean 57 5 call at 19 .50 Sell 6 January bean 675 calls at 2.25 Net position: 19.50 DB 13.50 CR 6 Debit 879 At the time the original example was presented, it was demonstrated through the use of the profit picture that the ratio was too steep and problems could result in a large rally. Now that one has the concept of gamma at his disposal, he can quantify what those problems are. The position gamma of this spread is quite negative: Position gamma = .01 - 6 x .0026 = -0.0056 That is, for every 10 points that January soybeans rally, the position will become short about 1/2 of one futures contract. The maximum profit point, 675, is 92 points above the current price of 583. While beans would not normally rally 92 points in only a few days, it does demonstrate that this position could become very short if beans quickly rallied to the point of maximum profit potential. Rest assured there would be no profit if that happened. Even a small rally of 20 cents (points) in soybeans - less than the daily limit - would begin to make this tiny spread noticeably short. If one had established the spread in some quantity, say buying 100 and selling 600, he could become seriously short very fast. A neutral spreader would not use such a large ratio in this spread. Rather, he would neutralize the gamma and then attempt to deal with the resulting delta. The next section deals with ways to accomplish that. CREATING MULTIFACETED NEUTRALITY So what is the strategist to do? He can attempt to construct positions that are neutral with respect to the other factors if he perceives them as a risk. There is no reason why a position cannot be constructed as veg a neutral rather than delta neutral, if he wants to eliminate the risk of volatility increases or decreases. Or, maybe he wants to elim­ inate the risk of stock price movements, in which case he would attempt to be gamma neutral as well as delta neutral. This seems like a simple concept until one first attempts to establish a position that is neutral with respect to more than one risk variable. For example, if one is 880 Part VI: Measuring and Trading VolatiRty attempting to create a spread that is neutral with respect to both gamma and delta, he could attempt it in the following way: Example: XYZ is 60. A spreader wants to establish a spread that is neutral with respect to both gamma and delta, using the following prices: Option October 60 call October 70 call Delta 0.60 0.25 Gamma 0.050 0.025 The secret to determining a spread that is neutral with respect to both risk meas­ ures is to neutralize gamma first, for delta can always be neutralized by taking an off­ setting position in the underlying security, whether it be stock or futures. First, deter­ mine a gamma neutral spread by dividing the two gammas: Gamma neutral ratio= 0.050/0.025 = 2-to-l So, buying one October 60 and selling two October 70 calls would be a gamma neutral spread. Now, the position delta of that spread is computed: Position Long 1 October 60 call Short 2 October 70 calls Net position delta: Delta 0.60 0.25 Position Delta +60 shares -50 shares + 10 shares Hence, this gamma neutral ratio is making the position delta long by 10 shares of stock for each l-by-2 spread that is established. For example, if one bought 100 October 60 calls and sold 200 October 70 calls, his position delta would be long 1,000 shares. This position delta is easily neutralized by selling short 1,000 shares of the stock. The resulting position is both gamma neutral and delta neutral: Option Position Option Position Position Delta Delta Gamma Gamma Short 1,000 XYZ 1.00 -1,000 0 0 Long 1 00 October 60 calls 0.60 +6,000 0.050 + 500 Short 200 October 70 calls 0.25 -5,000 0.025 - 500 Net Position: 0 0 Chapter 40: Advanced Concepts 881 Hence, it is always a simple matter to create a position that is both gamma and delta neutral. In fact, it is just as simple to create a position that is neutral with respect to delta and any other risk measure, because all that is necessary is to create a neutral ratio of the other risk measure (gamma, vega, theta, etc.) and then eliminate the resulting position delta by using the underlying. In theory, one could construct a position that was neutral with respect to all five risk measures (or six, if you really want to go overboard and include "gamma of the gamma" as well). Of course, there wouldn't be much profit potential in such a posi­ tion, either. But such constructions are actually employed, or at least attempted, by traders such as market-makers who try to make their profits from the difference between the bid and off er of an option quote, and not from assuming market risk Still, the concept of being neutral with respect to more than one risk factor is a valid one. In fact, if a strategist can determine what he is really attempting to accom­ plish, he can often negate other factors and construct a position designed to accom­ plish exactly what he wants. Suppose that one thought the implied volatility of a cer­ tain set of options was too high. He could just sell straddles and attempt to capture that volatility. However, he is then exposed to movements by the underlying stock He would be better served to construct a position with negative vega to reflect his expec­ tation on volatility, but then also have the position be delta neutral and gamma neutral, so that there would be little risk to the position from market movements. This can normally be done quite easily. An example will demonstrate how. Example: XYZ is 48. There are three months to expiration, and the volatility of XYZ and its options is 35%. The following information is also known: XYZ:48 Option Price Delta Gamma Vega April 50 call 2.50 0.47 0.045 0.08 April 60 call l.00 0.17 0.026 0.06 For whatever reasons - perhaps the historical volatility is much lower - the strategist decides that he wants to sell volatility. That is, he wants to have a negative position vega so that when the volatility decreases, he will make money. This can probably be accomplished by buying some April 50 calls and selling more April 60 calls. However, he does not want any risk of price movement, so some analysis must be done. First, he should determine a gamma neutral spread. This is done in much the same manner as determining a delta neutral spread, except that gamma is used. 882 Part VI: Measuring and Trading Volatmty Merely divide the two gammas to determine the neutral ratio to be used. In this case, assume that the April 50 call and the April 60 call are to be used: Gamma neutral ratio: 0.045/0.026 = 1.73-to-l Thus, a gamma neutral position would be created by buying 100 April 50's and sell­ ing 173 April 60's. Alternatively, buying 10 and selling 17 would be close to gamma neutral as well. The larger position will be used for the remainder of this example. Now that this ratio has been chosen, what is the effect on delta and vega? Option Position Option Position Option Position Position Delta Delta Gamma Gamma Vega Vega Long 1 00 April 50 0.47 +4,700 0.045 +450 0.08 + $800 Short 173 April 60 0.17 -2,941 0.026 -450 0.06 -1,038 Total: + 1,759 0 - $238 The position delta is long 1,759 shares of XYZ. This can easily be "cured" by shorting 1,700 or 1,800 shares ofXYZ to neutralize the delta. Consequently, the com­ plete position, including the short 1,700 shares, would be neutral with respect to both delta and gamma, and would have the desired negative vega. The actual profit picture at expiration is shown in Figure 40-11. Bear in mind, however, that the strategist would normally not intend to hold a position like this until expiration. He would close it out if his expectations on volatility decline were fulfilled ( or proved false). FIGURE 40-11. Spread with negative vega; gamma and delta neutral. 40000...., .... 10000 50 55 60 XVZ :Stock Price Chapter 40: Advanced Concepts 883 One other point should be made: The fact that gamma and delta are neutral to begin with does not mean that they will remain neutral indefinitely as the stock moves (or even as volatility changes). However, there will be little or no effect of stock price movements on the position in the short run. In summary, then, one can always create a position that is neutral with respect to both gamma and delta by first choosing a ratio that makes the gamma zero, and then using a position in the underlying security to neutralize the delta that is created by the chosen ratio. This type of position would always involve two options and some stock. The resulting position will not necessarily be neutral with respect to the other risk factors. THE MATHEMATICAL APPROACH The strategist should be aware that the process of determining neutrality in several of the risk variables can be handled quite easily by a computer. All that is required is to solve a series of simultaneous equations. In the preceding example, the resulting vega was negative: -$238. For each decline of 1 percentage point in volatility from .the current level of 35%, one could expect to make $238. This result could have been reached by another method, as long as one were willing to spell out in advance the amount of vega risk he wants to accept. Then, he can also assume the gamma is zero and solve for the quantity of options to trade in the spread. The delta would be neutralized, as above, by using the common stock. Example: Prices are the same as in the preceding example. XYZ is 48. There are three months to expiration, and the volatility of XYZ and its options is 35%. The fol­ lowing information is also the same: Option April 50 call April 60 call Price 2.50 1.01 Delta 0.47 0.17 Gamma 0.045 0.026 Vega 0.08 0.06 A spreader expects volatility to decline and is willing to set up a position where­ by he will profit by $250 for each one percentage decrease in volatility. Moreover, he wants to be gamma and delta neutral. He knows that he can eventually neutralize any delta by using XYZ common stock, as in the previous example. How many options should be spread to achieve the desired result? 884 Part VI: Measuring and Trading VolatiHty To answer the question, one must create two equations in two unknowns, x and y. The unknowns represent the quantities of options to be bought and sold, respec­ tively. The constants in the equations are taken from the table above. The first equation represents gamma neutral: 0.045 X + 0.026 y = 0, where xis the number of April 50's in the spread and y is the number of April 60's. Note that the constants in the equation are the gammas of the two calls involved. The second equation represents the desired vega risk of making 2.5 points, or $250, if the volatility decreases: 0.08 X + 0.06 y = - 2.5, where x and y are the same quantities as in the first equation, and the constants in this equa­ tion are the gammas of the options. Furthermore, note that the vega risk is negative, since the spreader wants to profit if volatility decreases. Solving the two equations in two unknowns by algebraic methods yields the fol­ lowing results: Equations: 0.045 X + 0.026 y = 0 0.08 X + 0.06 Y = - 2.5 Solutions: X = 104.80 y = -181.45 This means that one would buy 105 April 50 calls, since x being positive means that the options would be bought. He would also sell 181 April 60 calls (y is negative, which implies that the calls would be sold). This is nearly the same ratio determined in the previous example. The quantities are slightly higher, since the vega here is -$250 instead of the -$238 achieved in the previous example. Finally, one would again determine the amount of stock to buy or sell to neu­ tralize the delta by computing the position delta: Position delta = 105 x 0.47 - 181 x 0.17 = 18.58 Thus 1,858 shares of XYZ would be shorted to neutralize the position. Chapter 40: Advanced Concepts 885 Note: All the equations cannot be set equal to zero, or the solution will be all zeros. This is easily handled by setting at least one equation equal to a small, nonzero quantity, such as 0.1. As long as at least one of the risk factors is nonzero, one can determine the neutral ratio for all other factors merely by solving these simultaneous equations. There are plenty of low-cost computer programs that can solve simultane­ ous equations such as these. This concept can be carried to greater lengths in order to determine the best spread to create in order to achieve the desired results. One might even try to use three different options, using the third option to neutralize delta, so that he wouldn't have to neutralize with stock. The third equation would use deltas as constants and would be set to equal zero, representing delta neutral. Solving this would require solving three equations in three unknowns, a simple matter for a computer. As long as at least one of the risk factors is nonzero, one can determine the neu­ tral ratio for all other factors merely by solving these simultaneous equations. Even more importantly, the computer can scan many combinations of options that produce a position that is both gamma and delta neutral and has a specific position vega (-$238, for example). One would then choose the "best" spread of the available pos­ sibilities by logical methods including, if possible, choosing one with positive theta, so time is working in his favor. To summarize, one can neutralize all variables, or he can specify the risk that he wants to accept in any of them. Merely write the equations and solve them. It is best to use a computer to do this, but the fact that it can be done adds an entirely new, broad dimension to option spreading and risk-reducing strategies. EVALUATING A POSITION USING THE RISK MEASURES The previous sections have dealt with establishing a new position and determining its neutrality or lack thereof. However, the most important use of these risk measures is to predict how a position will perform into the future. At a minimum, a serious strate­ gist should use a computer to print out a projection of the profits and losses and posi­ tion risk at future expected prices. Moreover, this type of analysis should be done for several future times in order to give the strategist an idea of how the passage of time and the resultant larger movements by the underlying security would affect the posi­ tion. First, one would choose an appropriate time period - say, 7 days hence - for the first analysis. Then he should use the statistical projection of stock prices (see Chapter 28 on mathematical applications) to determine probable prices for the underlying security at that time. Obviously, this stock price projection needs to use volatility, and 886 Part VI: Measuring and Trading Volatility that is somewhat variable. But, for the purposes of such a projection, it is acceptable to use the current volatility. The results of as many as 9 stock prices might be dis­ played: every one-half standard deviation from -2 through + 2 (-2.0, -1.5, -1.0, -0.5, 0, 0.5, 1.0, 1.5, 2.0). Example: XYZ is at 60 and has a volatility of 35%. A distribution of stock prices 7 days into the future would be determined using the equation: Future Price = Current Price x eav-ft where a corresponds to the constants in the following table: (-2.0 ... 2.0): # Standard Deviations -2.0 - 1.5 - 1.0 -0.5 0 0.5 1.0 1.5 2.0 Projected Stack Price 54.46 55.79 57.16 58.56 60.00 61.47 62.98 64.52 66.11 Again, refer to Chapter 28 on mathematical applications for a more in-depth discussion of this price determination equation. Note that the formula used to project prices has time as one of its components. This means that as we look further out in time, the range of possible stock prices will expand - a necessary and logical component of this analysis. For example, if the prices were being determined 14 days into the future, the range of prices would be from 52.31 to 68.82. That is, XYZ has the same probability of being at 54.46 in 7 days that it has of being at 52.31 in 14 days. At expiration, some 90 days hence, the range would be quite a bit wider still. Do not make the mistake of trying to evaluate the position at the same prices for each time period (7 days, 14 days, 1 rnonth, expiration, etc.). Such an analysis would be wrong. Once the appropriate stock prices have been determined, the following quanti­ ties would be calculated for each stock price: profit or loss, position delta, position gamma, position theta, and position vega. (Position rho is generally a less important risk measure for stock and futures short-term options.) Armed with this information, the strategist can be prepared to face the future. An important item to note: A model Chapter 40: Advanced Concepts 887 will necessarily be used to make these projections. As was shown earlier, if there is a distortion in the current implied volatilities of the options involved in the position, the strategist should use the current implieds as input to the model for future option price projections. If he does not, the position may look overly attractive if expensive options are being sold or cheap ones are being bought. A truer profit picture is obtained by propagating the current implied volatility structure into the near future. Using an example similar to the previous one a ratio spread using short stock to make it delta neutral - the concepts will be described. Initial Position. XYZ is at 60. The January 70 calls, which have three months until expiration, are expensive with respect to the January 60 calls. A strategist expects this discrepancy to disappear when the implied volatility of XYZ options decreases. He therefore established the following position, which is both gamma and delta neutral. Position Delta Gamma Long 100 January 60 calls 0.57 0.0723 Short 240 January 70 calls 0.20 0.0298 Short 800 XYZ The risk measures for the entire position are: Position delta: -38 shares (virtually delta neutral) Position gamma: + 7 shares (gamma neutral) Position theta: + $263 Position vega: -$827 Theta Vega -0.020 0.109 -0.019 0.080 Thus, the position is both gamma and delta neutral. Moreover, it has the attrac­ tive feature of making $263 per day because of the positive theta. Finally, as was the intention of the spreader, it will make money if the volatility of XYZ declines: $827 for each percentage point decrease in implied volatility. Two equations in two unknowns (gamma and vega) were solved to obtain the quantities to buy and sell. The resulting position delta was neutralized by selling 800 XYZ. The following analyses will assume that the relative expensiveness of the April 70 calls persists. These are the calls that were sold in the position. If that overpricing should disappear, the spread would look more favorable, but there is no guarantee that they will cheapen - especially over a short time period such as one or two weeks. How would the position look in 7 days at the stock prices determined above? 888 Part VI: Measuring and Trading Vo/atillty Stock Price P&L Delta Gamma Theta Vega 54.46 1905 - 7.40 1.62 0.94 - 1.57 55.79 1077 - 4.90 2.07 1.18 - 1.96 57.16 606 1.97 2.13 1.53 - 2.90 58.56 528 0.74 1.65 2.00 -4.62 60.00 771 2.38 0.56 2.63 -7.22 61.47 1127 2.07 - 1.01 3.38 -10.63 62.98 1252 - 0.87 - 2.85 4.22 -14.56 64.52 702 - 6.73 - 4.67 5.07 -18.61 66.11 - 1019 -15.42 - 6.21 5.85 -22.31 In a similar manner, the position would have the following characteristics after 14 days had passed: Stock Price P&L Delto Gamma Theta Vega 52.31 4221 - 9.10 0.69 0.55 - 0.98 54.14 2731 - 6.93 1.69 0.75 - 0.89 56.02 1782 - 2.87 2.51 1.06 - 1.21 57.98 1717 2.17 2.44 1.61 - 2.69 60.00 2577 5.85 1.00 2.51 -6.00 62.09 3839 5.29 - 1.63 3.73 -11.05 64.26 4361 - 1.55 - 4.61 5.09 -16.90 66.50 2631 -14.80 - 7.02 6.31 -22.17 68.82 - 2799 -32.83 - 8.32 7.18 -25.72 The same information will be presented graphically in Figure 40-13 so that those who prefer pictures instead of columns of numbers can follow the discussions easily. First, the profitability of the spread can be examined. This profit picture assumes that the volatility of XYZ remains unchanged. Note that in 7 days, there is a small profit if the stock remains unchanged. This is to be expected, since theta was positive, and therefore time is working in favor of this spread. Likewise, in 14 days, there is an even bigger profit if XYZ remains relatively unchanged - again due to the positive theta. Overall, there is an expected profit of $800 in 7 days, or $2,600 in 14 days, from this position. This indicates that it is an attractive situation statistically, but, of course, it does not mean that one cannot lose money. Chapter 40: Advanced Concepts 889 Continuing to look at the profit picture, the downside is favorable to the spread since the short stock in the position would contribute to ever larger profits in the case that XYZ tumbles dramatically (see Figure 40-12). The upside is where problems could develop. In 7 days, the position breaks even at about 65 on the upside; in 14 days, it breaks even at about 67.50. The reader may be asking, "Why is there such a dramatic risk to the upside? I thought the position was delta neutral and gamma neutral." True, the position was originally neutral with respect to both those variables. That neutrality explains the flatness of the profit curves about the current stock price of 60. However, once the stock has moved 1.50 standard deviations to the upside, the neutrality begins to dis­ appear. To see this, let us look at Figures 40-13 and 40-14 that show both the posi­ tion delta and position gamma 7 days and 14 days after the spread was established. Again, these are the same numbers listed in the previous tables. First, look at the position delta in 7 days (Figure 40-13). Note that the position remains relatively delta neutral with XYZ between 57 and 63. This is because the gamma was initially neutral. However, the position begins to get quite delta short if XYZ rises above 63 or falls below 57 in 7 days. What is happening to gamma while this is going on? Since we just observed that the delta eventually changes, that has to mean that the position is acquiring some gamma. FIGURE 40-12. XYZ ratio spread, gamma and delta neutral. 4300 3400 2500 1600 ~ 700 a.. 0 -200 53 55 57 59 61 63 .-1100 -2000 Stock Price 890 FIGURE 40-13. XYZ ratio spread, position delta. -300 -800 fu -1300 w -1800 -2300 -2800 FIGURE 40-14. Stock Price XYZ ratio spread, position gamma. 100 Part VI: Measuring and Trading Volatility 67 0t----....----....----,---.---'"""".,------,----,---r-- -100 «l E E -300 «l 0 -500 -700 63 65 67 Stock Price Chapter 40: Advanced Concepts 891 Figure 40-14 depicts the fact that gamma is not very stable, considering that it started at nearly zero. If XYZ falls, gamma increases a little, reflecting the fact that the position will get somewhat shorter as XYZ falls. But since there are only calls cou­ pled with short stock in this position, there is no risk to the downside. Positive gamma, even a small positive gamma like this one, is beneficial to stock movement. The upside is another matter entirely. The gamma begins to become seriously negative above a stock price of 63 in 7 days. Recall that negative gamma means that one's position is about to react poorly to price changes in the market - the position will soon be "fighting the market." As the stock goes even higher, the gamma becomes even more negative. These observations apply to stock price movements in either 7 days or 14 days; in fact, the effect on gamma does not seem to be particu­ larly dependent on time in this example, since the two lines on Figure 40-15 are very close to each other. The above information depicts in detailed form the fact that this position will not behave well if the stock rises too far in too short a time. However, stable stock prices will produce profits, as will falling prices. These are not earth-shattering con­ clusions since, by simple observation, one can see that there are extra short calls plus some short stock in the position. However, the point of calculating this information in advance is to be able to anticipate where to make adjustments and how much to adjust. Follow-Up Action. How should the strategist use this information? A sim­ plistic approach is to adjust the delta as it becomes non-neutral. This won't do anything for gamma, however, and may therefore not necessarily be the best approach. If one were to adjust only the delta, he would do it in the following manner: The chart of delta (Figure 40-13) shows that the position will be approximately delta short 800 shares if XYZ rises to 64.50 in a week. One sim­ ple plan would be to cover the 800 shares of XYZ that are short if the stock rises to 64.50. Covering the 800 shares would return the position to delta neutral at that time. Note that if the stock rises at a slower pace, the point at which the strategist would cover the 800 shares moves higher. For example, the delta in 14 days (again in Figure 40-13) shows that XYZ would have to be at about 65.50 for the position to be delta short 800 shares. Hence, if it took two weeks for XYZ to begin rising, one could wait until 65.50 before covering the 800 shares and returning the position to delta neutral. In either case, the purchase of the 800 shares does not take care of the negative gamma that is creeping into the position as the stock rises. The only way to counter negative gamma is to buy options, not stock. To return a position to neutrality with 892 Part VI: Measuring and Trading Volatility respect to more than one risk variable requires one to approach the problem as he did when the position was established: Neutralize the gamma first, and then use stock to adjust the delta. Note the difference between this approach and the one described in the previous paragraph. Here, we are trying to adjust gamma first, and will get to delta later. In order to add some positive gamma, one might want to buy back (cover) some of the January 70 calls that are currently short. Suppose that the decision is made to cover when XYZ reaches 65.50 in 14 days. From the graph above, one can see that the position would be approximately gamma short 700 shares at the time. Suppose that the gamma of the January 70 calls is 0.07. Then, one would have to cover 100 January 70 calls to add 700 shares of positive gamma to the position, returning it to gamma neutral. This purchase would, of course, make the position delta long, so some stock would have to be sold short as well in order to make the position delta neutral once again. Thus, the procedure for follow-up action is somewhat similar to that for estab­ lishing the position: First, neutralize the gamma and then eliminate the resulting delta by using the common stock. The resulting profit graph will not be shown for this follow-up adjustment, since the process could go on and on. However, a few observations are pertinent. First, the purchase of calls to reduce the negative gamma hurts the original thesis of the position - to have negative vega and positive theta, if possible. Buying calls will add vega to and subtract theta from the position, which is not desirable. However, it is more desirable than letting losses build up in the posi­ tion as the stock continues to run to the upside. Second, one might choose to rerrwve the position if it is profitable. This might happen if the volatility did decrease as expected. Then, when the stock rallies, producing negative gamma, one might actu­ ally have a profit, because his assumption concerning volatility had been right. If he does not see much further potential gains from decreasing volatility, he might use the point at which negative gamma starts to build up as the exit point from his position. Third, one might choose to accept the acquired gamma risk. Rather than jeopardize his initial thesis, one may just want to adjust the delta and let the gamma build up. This is no longer a neutral strategy, but one may have reasons for approaching the position this way. At least he has calculated the risk and is aware of it. If he chooses to accept it rather than eliminate it, that is his decision. Finally, it is obvious that the process is dynamic. As factors change (stock price, volatility, time), the position itself changes and the strategist is presented with new choices. There is no absolutely correct adjustment. The process is more of an art than a science at times. Moreover, the strategist should continue to recalculate these prof­ it pictures and risk measures as the stock moves and time passes, or if there is a Chapter 40: Advanced Concepts 893 change in the securities involved in the position. There is one absolute truism and that is that the serious strategist should be aware of the risk his position has with respect to at least the four basic measures of delta, gamma, theta, and vega. To be ignorant of the risk is to be delinquent in the management of the position. TRADING GAMMA FROM THE LONG SIDE The strategist who is selling overpriced options and hedging that purchase with other options or stock will often have a position similar to the one described earlier. Large stock movements - at least in one direction will typically be a problem for such positions. The opposite of this strategy would be to have a position that is long gamma. That is, the position does better if the stock moves quickly in one direction. While this seems pleasing to the psyche, these types of positions have their own brand of risk. The simplest position with long gamma is a long straddle, or a backspread (reverse ratio spread). Another way to construct a position with long gamma is to invert a calendar spread - to buy the near-term option and to sell a longer-term one. Since a near-term option has a higher gamma than a longer-term one with the same strike, such a position has long gamma. In fact, traders who expect violent action in a stock often construct such a position for the very reason that the public will come in behind them, bid up the short-term calls (increasing their implied volatility), and make the spread more profitable for the trader. Unfortunately, all of these positions often involve being long just about every­ thing else, including theta and vega as well. This means that time is working against the position, and that swings in implied volatility can be helpful or harmful as well. Can one construct a position that is long gamma, but is not so subject to the other variables? Of course he can, but what would it look like? The answer, as one might suspect, is not an ironclad one. For the following examples, assume these prices exist: XYZ: 60 Option March 60 call June 60 call Price 3.25 5.50 Delta 0.54 0.57 Gamma 0.0510 0.0306 Theta 0.033 0.021 Vega 0.089 0.147 Example: Suppose that a strategist wants to create a position that is gamma long, but is neutral with respect to both delta and vega. He thinks the stock will move, but is not sure of the price direction, and does not want to have any risk with respect to 894 Part VI: Measuring and Trading Volatility quick changes in volatility. In order to quantify the statement that he "wants to be gamma long," let us assume that he wants to be gamma long 1,000 shares or 10 con­ tracts. It is known that delta can always be neutralized last, so let us concentrate on the other two variables first. The two equations below are used to determine the quanti­ ties to buy in order to make gamma long and vega neutral: 0.0510x + 0.0306y = 10 (gamma, expressed in# of contracts) 0.089x + 0.147y = 0 (vega) The solution to these equations is: X = 308, y = -186 Thus, one would buy 308 March 60 calls and would sell 186 June 60 calls. This is the reverse calendar spread that was discussed: Near-term calls are bought and longer­ term calls are sold. Finally, the delta must be neutralized. To do this, calculate the position delta using the quantities just determined: Position delta= 0.54 x 308 - 0.57 x 186 = 60.30 So, the position is long 60 contracts, or 6,000 shares. It can be made delta neutral by selling short 6,000 shares of XYZ. The overall position would look like this: Position Short 6,000 XYZ Long 308 March 60 calls Short 186 June 60 calls Its risk measurements are: Delta 1.00 0.54 0.57 Position delta: long 30 shares (neutral) Position vega: $7 (neutral) Position gamma: long 1,001 shares Gamma 0 0.0510 0.0306 Vega 0 0.089 0.147 This position then satisfies the initial objectives of wanting to be gamma long 1,000 shares, but delta and vega neutral. Finally, note that theta = -$625. The position will lose $625 per day from time decay. The strategist must go further than this analysis, especially if one is dealing with positions that are not simple constructions. He should calculate a profit picture as Chapter 40: Advanced Concepts 895 well as look at how the risk measures behave as time passes and the stock price changes. Figure 40-15 (see Tables 40-10, 40-11, and 40-12) shows the profit potential in 7 days, in 14 days, and at March expiration. Figure 40-16 shows the position vega at the 7- and 14-day time intervals. Before discussing these items, the data will be pre­ sented in tabular form at three different times: in 7 days, in 14 days, and at March expiration. The data in Table 40-10 depict the position in 7 days. Table 40-11 represents the results in 14 days. Finally, the position as it looks at March expiration should be known as well (see Table 40-12). In each case, note that the stock prices are calculated in accordance with the statistical formula shown in the last section. The more time that passes, the further it is possible for the stock to roam from the current price. The profit picture (Figure 40-15) shows that this position looks much like a long straddle would: It makes large, symmetric profits if the stock goes either way up or way down. Moreover, the losses if the stock remains relatively unchanged can be large. These losses tend to mount right away, becoming significant even in 14 days. Hence, if one enters this type of position, he had better get the desired stock move­ ment quickly, or be prepared to cut his losses and exit the position. The most startling thing to note about the entire position is the devastating effect of time on the position. The profit picture shows that large losses will result if the stock movement that is expected does not materialize. These losses are completely due to time decay. Theta is negative in the initial position ($625 of losses per day), and remains negative and surprisingly constant - until March expiration ( when the long calls expire). Time also affects vega. Notice how the vega begins to get negative right away and keeps getting much more negative as time passes. Simply, it can be seen that as time passes, the position becomes vulnerable to increases in implied volatility. This relationship between time and volatility might not be readily apparent to the strategist unless he takes the time to calculate these sorts of tables or figures. In fact, one may be somewhat confounded by this observation. What is happening is that as time passes, the options that are owned are less explosive if volatility increas­ es, but the options that were sold have a lot of time remaining, and are therefore apt to increase violently if volatility spurts upward. Figures 40-17 and 40-18 provide less enlightening information about delta and gamma. Since gamma was positive to start with, the delta increases dramatically as the stock rises, and decreases just as fast if the stock falls (Figure 40-18). This is stan­ dard behavior for positions with long gamma; a long straddle would look very similar. 896 FIGURE 40-15. Trading long gamma, profit picture. 80,000 60,000 40,000 20,000 -20,000 -40,000 -60,000 TABLE 40-1 O. Stock Price Part VI: Measuring and Trading Volatility Risk measures of long gamma position in 7 days. Stock Price P&L Delta Gamma Theta Vega 54.46 12259 - 58.72 8.28 4.15 - 5.74 55.79 5202 - 46.60 9.78 5.20 - 4.18 57.16 - 224 - 32.45 10.80 6.09 - 2.85 58.56 - 3670 - 16.91 11.25 6.73 - 1.94 60.00 - 4975 - 0.80 11.08 7.04 - l .63 61.47 - 3901 15.01 10.32 6.98 - 1.96 62.98 - 507 29.69 9.09 6.57 - 2.89 64.52 5105 42.56 7.54 5.87 -4.29 66. l l 12717 53. l 7 5.86 4.97 - 5.96 Notice that gamma remains positive throughout (Figure 40-17), although it falls to smaller levels if the stock moves toward the end of the pricing ranges used in the analyses. Again, this is standard action for a long straddle. Chapter 40: Advanced Concepts FIGURE 40-16. Trading long gamma, position vega. 55 60 0 -2 -4 al 0) ~ -6 -8 -10 Stock Price TABLE 40-11. 65 Risk measures of long gamma position in 14 days. Stock Price P&L Delta Gamma 52.31 24945 - 79.34 4.75 54.14 11445 - 67.68 8.00 56.02 277 -49.79 10.79 57.98 - 7263 -26.87 12.42 60.00 - 10141 - 1.44 12.47 62.09 - 7784 23.32 10.99 64.26 347 44.47 8.45 66.50 11491 60.12 5.55 68.82 26672 69.81 2.92 891 Theta Vega 2.10 - 9.91 3.91 - 7.87 5.76 - 5.56 7.21 - 3.73 7.88 - 3.04 7.60 - 3.78 6.47 - 5.71 4.82 - 8.20 3.09 -10.48 So, is this a good position? That is a difficult question to answer unless one knows what is going to happen to the underlying stock. Statistically, this type of posi­ tion has a negative expected return and would generally produce losses over the long run. However, in situations in which the near-term options are destined to get over­ heated - perhaps because of a takeover rumor or just a leak of material information 898 Part VI: Measuring and Trading Volatility TABLE 40-12. Risk measures of long gamma position at March expiration. Stock Price P&L Delta 46.19 81327 - 75.69 49.31 55628 - 89.84 52.64 22378 -110.50 56.20 - 21523 -136.65 60.00 78907 144.68 64.06 - 25946 117.44 68.39 19787 95.03 73.01 59732 79.05 77.95 96062 69.19 FIGURE 40-17. Trading long gamma, position gamma. (J) (I) 1200 1000 800 ~ 600 .c (/) 400 200 55 60 Stock Price Gamma Theta Vega - 3.65 -1.32 - 6.88 - 5.39 -2.25 -11.43 - 6.89 -3.33 -16.50 - 7.62 -4.28 -20.67 - 7.29 -4.79 -22.49 - 6.03 -4.70 -21.26 - 4.31 -4.10 -17.44 - 2.67 -3.24 -12.43 - 1.43 -2.41 - 7.69 65 about a company - many sophisticated traders establish this type of position to take advantage of the expected explosion in stock price. Other Variations. Without going into as much detail, it is possible to com­ pare the above position with similar ones. The purpose in doing so is to illustrate how a change in the strategist's initial requirements would alter the established Chapter 40: Advanced Concepts FIGURE 40-1 8. Trading long gamma, position delta. 6000 4000 2000 "' ~ 01---------,-----~rr------,,----- .s::. (J) -2000 -4000 -8000 -8000 55 65 Stock Price 899 position. In the preceding position, the strategist wanted to be gamma long, but neutral with respect to delta and volatility. Suppose he not only expects price movement (meaning he wants positive gamma), but also expects an increase in volatility. If that were the case, he would want positive vega as well. Suppose he quantifies that desire by deciding that he wants to make $1,000 for every one percentage increase in volatility. The simultaneous equations would then be: 0.050lx + 0.0306y = 10 (gamma) 0.089x + 0.147y = 10 (vega) The solution to these equations is: X = 243, y = -80 Furthermore, 8,500 shares would have to be sold short in order to make the position delta neutral. The resulting position would then be: Short 8,500 XYZ Long 243 March 60 calls Short 80 June 60 calls Delta: neutral Gamma: long 1,000 shares Vega: long $1,000 Theta: long $630 900 Part VI: Measuring and Trading VolatiHty Recall that the position discussed in the last section was vega neutral and was: Short 6,000 XYZ Long 308 March 60 calls Short 186 June 60 calls Delta: neutral Gamma: long 1,000 shares Vega: neutral Theta: long $625 Notice that in the new position, there are over three times as many long March 60 calls as there are short June 60 calls. This is a much larger ratio than in the vega neutral position, in which about 1.6 calls were bought for each one sold. This even greater preponderance of near-term calls that are purchased means the newer posi­ tion has an even larger exposure to time decay than did the previous one. That is, in order to acquire the positive vega, one is forced to take on even more risk with respect to time decay. For that reason, this is a less desirable position than the first one; it seems overly risky to want to be both long gamma and long volatility. This does not necessarily mean that one would never want to be long volatility. In fact, if one expected volatility to increase, he might want to establish a position that was delta neutral and gamma neutral, but had positive vega. Again, using the same prices as in the previous examples, the following position would satisfy these criteria: Short 2,600 XYZ Short 64 March 60 calls Long 106 June 60 calls Delta: neutral Gamma: neutral Vega: long $1,000 Theta: long $11 This position has a more conventional form. It is a calendar spread, except that more long calls are purchased. Moreover, the theta of this position is only $11- it will only lose $11 per day to time decay. At first glance it might seem like the best of the three choices. Unfortunately, when one draws the profit graph (Figure 40-19), he finds that this position has significant downside risk: The short stock cannot com­ pensate for the large quantity of June 60 calls. Still, the position does make money on the upside, and will also make money if volatility increases. If the near-term March calls were overpriced with respect to the June calls at the time the position was estab­ lished, it would make it even more desirable. To summarize, defining the risks one wants to take or avoid specifies the con­ struction of the eventual position. The strategist should examine the potential risks and rewards, especially the profit picture. If the potential risks are not desirable, the strategist should rethink his requirements and try again. Thus, in the example pre­ sented, the strategist felt that he initially wanted to be long gamma, but it involved too Chapter 40: Advanced Concepts FIGURE 40-19. Trading long gamma, 11 conventional" calendar. 7500 5000 2500 fJ) fJ) .3 :;:, 0 '§ 45 50 Q. -2500 -5000 At March Expiration -7500 Stock Price 901 75 much risk of time decay. A second attempt was made, introducing positive volatility into the situation, but that didn't seem to help much. Finally, a third analysis was gen­ erated involving only long volatility and not long gamma. The resulting position has lit­ tle time risk, but has risk if the stock drops in price. It is probably the best of the three. The strategist arrives at this conclusion through a logical process of analysis. ADVANCED MATHEMATICAL CONCEPTS The remainder of this chapter is a short adjunct to Chapter 28 on mathematical applications. It is quite technical. Those who desire to understand the basic concepts behind the risk measures and perhaps to utilize them in more advanced ways will be interested in what follows. CALCULATING THE "'GREEKS" It is known that the equation for delta is a direct byproduct of the Black-Scholes model calculation: ~ = N(dl) 902 Part VI: Measuring and Trading Volatility Each of the risk measures can be derived mathematically by taking the partial derivative of the model. However, there is a shortcut approximation that works just as well. For example, the formula for gamma is as follows: x=ln[ P ]/v-ft+v-ft s X (1 + r)t 2 r - e(-x212) - pv ✓ 27tt There is a simpler, yet correct, way to arrive at the gamma. The delta is the par­ tial derivative of the Black-Scholes model with respect to stock price - that is, it is the amount by which the option's price changes for a change in stock price. The gamma is the change in delta for the same change in stock price. Thus, one can approximate the gamma by the following steps: 1. Calculate the delta with p = Current stock price. 2. Set p = p + 1 and recalculate the delta. 3. Gamma = delta from step 1 - delta from step 2. The same procedure can be used for the other "greeks": Vega: 1. Calculate the option price with a particular volatility. 2. 3. Theta: 1. 2. 3. Rho: 1. 2. 3. Calculate another option price with volatility increased by 1 %. Vega = difference of the prices in steps 1 and 2. Calculate the option price with the current time to expiration. Calculate the option price with 1 day less time remaining to expiration. Theta = difference of the prices in steps 1 and 2. Calculate the option price with the current risk-free interest rate. Calculate the option price with the rate increased by 1 % . Rho = difference of the prices in steps 1 and 2. THE GAMMA OF THE GAMMA The discussion of this concept was deferred from earlier sections because it is some­ what difficult to grasp. It is included now for those who may wish to use it at some time. Those readers who are not interested in such matters may skip to the next sec­ tion. Chapter 40: Advanced Concepts 903 Recall that this is the sixth risk measurement of an option position. The gamma of the gamma is the anwunt by which the gamma will change when the stock price changes. Recall that in the earlier discussion of gamma, it was noted that gamma changes. This example is based on the same example used earlier. Example: With XYZ at 49, assume the January 50 call has a delta of 0.50 and a gamma of 0.05. If XYZ moves up 1 point to 50, the delta of the call will increase by the amount of the gamma: It will increase from 0.50 to 0.55. Simplistically, if XYZ moves up another point to 51, the delta will increase by another 0.05, to 0.60. Obviously, the delta cannot keep increasing by 0.05 each time XYZ gains anoth­ er point in price, for it will eventually exceed 1.00 by that calculation, and it is known that the delta has a maximum of 1.00. Thus, it is obvious that the gamma changes. In reality, the gamma decreases as the stock moves away from the strike. Thus, with XYZ at 51, the gamma might only be 0.04. Therefore, if XYZ moved up to 52, the call's delta would only increase by 0.04, to 0.64. Hence, the gamma of the gamma is -0.01, since the gamma decreased from .05 to .04 when the stock rose by one point. As XYZ moves higher and higher, the gamma will get smaller and smaller. Eventually, with XYZ in the low 60's, the delta will be nearly 1.00 and the gamma nearly 0.00. This change in the gamma as the stock moves is called the gamma of the gamma. It is probably referred to by other names, but since its use is limited to only the most sophisticated traders, there is no standard name. Generally, one would use this measure on his entire portfolio to gauge how quickly the portfolio would be responding to the position gamma. Example: With XYZ at 31. 75 as in some of the previous examples, the following risk measures exist: Option Option Option Position Position Delta Gamma Gamma/Gamma Gamma/Gamma Short 4,500 XYZ 1.00 0.00 0.0000 0 Short 100 XYZ April 25 calls 0.89 0.01 -0.0015 -15 Long 50 XYZ April 30 calls 0.76 0.03 -0.0006 - 3 Long 139 XYZ July 30 calls 0.74 0.02 -0.0003 - 4 Total Gamma of Gamma: -22 904 Part VI: Measuring and Trading Volatility Recall that, in the same example used to describe gamma, the position was delta long 686 shares and had a positive gamma of 328 shares. Furthermore, we now see that the gamma itself is going to decrease as the stock moves up ( it is negative) or will increase as the stock moves down. In fact, it is expected to increase or decrease by 22 shares for each point XYZ moves. So, if XYZ moves up by 1 point, the following should happen: a. Delta increases from 686 to 1,014, increasing by the amount of the gamma. b. Gamma decreases from 328 to 306, indicating that a further upward move by XYZ will result in a smaller increase in delta. One can build a general picture of how the gamma of the gamma changes over different situations - in- or out-of-the-money, or with more or less time remaining until expiration. The following table of two index calls, the January 350 with one month of life remaining and the December 350 with eleven months of life remain­ ing, shows the delta, gamma, and gamma of the gamma for various stock prices. Index January 350 call December 350 call Price Delta Gamma Gamma/Gamma Delta Gamma Gamma/Gamma 310 .0006 .0001 .0000 .3203 .0083 .0000 320 .0087 .0020 .0004 .3971 .0082 .0000 330 .0618 .0100 .0013 .4787 .0080 -.0000 340 .2333 .0744 .0013 .5626 .0078 -.0001 350 .5241 .0309 -.0003 .6360 .0073 -.0001 360 .7957 .0215 -.0014 .6984 .0067 -.0001 370 .9420 .0086 -.0010 .7653 .0060 -.0001 380 .9892 .0021 -.0003 .8213 .0052 -.0001 Several conclusions can be drawn, not all of which are obvious at first glance. First of all, the gamma of the gamma for long-term options is very small. This should be expected, since the delta of a long-term option changes very slowly. The next fact can best be observed while looking at the shorter-term January 350 table. The gamma of the gamma is near zero for deeply out-of-the-money options. But, as the option comes closer to being in-the-money, the gamma of the gamma becomes a pos­ itive number, reaching its maximum while the option is still out-of-the-money. By the time the option is at-the-money, the gamma of the gamma has turned negative. It then remains negative, reaching its most negative point when slightly in-the-money. From there on, as the option goes even deeper into-the-money, the gamma of the gamma remains negative but gets closer and closer to zero, eventually reaching (minus) zero when the option is very far in-the-money. Chapter 40: Advanced Concepts 905 Can one possibly reason this risk measurement out without making severe mathematical calculations? Well, possibly. Note that the delta of an option starts as a small number when the option is out-of-the-money. It then increases, slowly at first, then more quickly, until it is just below 0.60 for an at-the-money option. From there on, it will continue to increase, but much more slowly as the option becomes in-the­ money. This movement of the delta can be observed by looking at gamma: It is the change in the delta, so it starts slowly, increases as the stock nears the strike, and then begins to decrease as the option is in-the-money, always remaining a positive num­ ber, since delta can only change in the positive direction as the stock rises. Finally, the gamma of the gamma is the change in the gamma, so it in tum starts as a positive number as gamma grows larger; but then when gamma starts tapering off, this is reflected as a negative gamma of the gamma. In general, the gamma of the gamma is used by sophisticated traders on large option positions where it is not obvious what is going to happen to the gamma as the stock changes in price. Traders often have some feel for their delta. They may even have some feel for how that delta is going to change as the stock moves (i.e., they have a feel for gamma). However, sophisticated traders know that even positions that start out with zero delta and zero gamma may eventually acquire some delta. The gamma of the gamma tells the trader how much and how soon that eventual delta will be acquired. MEASURING THE DIFFERENCE OF IMPLIED VOLATILITIES Recall that when the topic of implied volatility was discussed, it was shown that if one could identify situations in which the various options on the same underlying securi­ ty had substantially different implied volatilities, then there might be an attractive neutral spread available. The strategist might ask how he is to determine if the dis­ crepancies between the individual options are significantly large to warrant attention. Furthermore, is there a quick way (using a computer, of course) to determine this? A logical way to approach this is to look at each individual implied volatility and compute the standard deviation of these numbers. This standard deviation can be converted to a percentage by dividing it by the overall implied volatility of the stock. This percentage, if it is large enough, alerts the strategist that there may be opportu­ nities to spread the options of this underlying security against each other. An exam­ ple should clarify this procedure. Example: XYZ is trading at 50, and the following options exist with the indicated implied volatilities. We can calculate a standard deviation of these implieds, called implied deviation, via the formula: 906 Part VI: Measuring and Trading Volatility Implied deviation = sqrt (sum of differences from mean) 2/(# options - 1) XYZ:50 Implied Option Volatility October 45 call 21% November 45 call 21% January 45 call 23% October 50 call 32% November 50 call 30% January 50 call 28% October 55 call 40% November 55 call 37% January 55 call 34% Average: 30.44% Sum of ( difference from avg)2 = 389.26 Implied deviation = sqrt (sum of diff)2/(# options - 1) = sqrt (389.26 I 8) = 6.98 Difference from Average -9.44 -9.44 -7.44 + 1.56 -0.44 -2.44 +9.56 +6.56 +3.56 This figure represents the raw standard deviation of the implied volatilities. To convert it into a useful number for comparisons, one must divide it by the average implied volatility. P d . . Implied deviation ercent eV1at10n = A . 1. d verage imp ie = 6.98/30.44 = 23% This "percent deviation" number is usually significant if it is larger than 15%. That is, if the various options have implied volatilities that are different enough from each other to produce a result of 15% or greater in the above calculation, then the strategist should take a look at establishing neutral spreads in that security or futures contract. The concept presented here can be refined further by using a weighted average of the implieds ( taking into consideration such factors as volume and distance from the striking price) rather than just using the raw average. That task is left to the reader. Chapter 40: Advanced Concepts 907 Recall that a computer can perform a large number of Black-Scholes calcula­ tions in a short period of time. Thus, the computer can calculate each option's implied volatility and then perform the "percent deviation" calculation even faster. The strategist who is interested in establishing this type of neutral spread would only have to scan down the list of percent deviations to find candidates for spreading. On a given day, the list is usually quite short - perhaps 20 stocks and 10 futures contracts will qualify. SUMMARY In today's highly competitive and volatile option markets, neutral traders must be extremely aware of their risks. That risk is not just risk at expiration, but also the cur­ rent risk in the market. Furthermore, they should have an idea of how the risk will increase or decrease as the underlying stock or futures contract moves up and down in price. Moreover, the passage of time or the volatility that the options are being assigned in the marketplace - the implied volatility - are important considerations. Even changes in short-term interest rates can be of interest, especially iflonger-term options (LEAPS) are involved. Once the strategist understands these concepts, he can use them to select new positions, to adjust existing ones, and to formulate specific strategies to take advan­ tage of them. He can select a specific criteria that he wants to exploit - selling high volatility, for example and use the other measures to construct a position that has little risk with respect to any of the other variables. Furthermore, the market-maker or specialist, who does not want to acquire any market risk if he can help it, will use these techniques to attempt to neutralize all of the current risk, if possible. Taxes In this chapter, the basic tax treatment of listed options will be outlined and sev­ eral tax strategies will be presented. The reader should be aware of the fact that tax laws change, and therefore should consult tax counsel before actually implementing any tax-oriented strategy. The interpretation of certain tax strategies by the Internal Revenue Service is subject to reclarification or change, as well. An option is a capital asset and any gains or losses are capital gains or losses. Differing tax consequences apply, depending on whether the option trade is a complete transaction by itself, or whether it becomes part of a stock transaction via exercise or assignment. Listed option transactions that are closed out in the options market or are allowed to expire worthless are capital transactions. The holding period for option transactions to qualify as long-term is always the same as for stocks ( cur­ rently, it's one year). Gains from option purchases could possibly be long-term gains if the holding period of the option exceeds the long-term capital gains holding period. Gains from the sale of options are short-term capital gains. In addition, the tax treatment of futures options and index options and other listed nonequity options may differ from that of equity options. We will review these points individually. HISTORY In the short life of listed option trading. there have been several major changes in the tax rules. When options were first listed in 1973, the tax laws treated the gains and losses from writing options as ordinary income. That is, the thinking was that only professionals or those people in the business actually wrote over-the-counter options, and thus their gains and losses represented their ordinary income, or means of mak­ ing a living. This rule presented some interesting strategies involving spreads, because the long side of the spread could be treated as long-term gain (if held for 908 Chapter 41: Taxes 909 more than 6 months, which was the required holding period for a long-term gain at that time), and the short side of the spread could be ordinary loss. Of course, the stock would have had to move in the desired direction in order to obtain this result. In 1976, the tax laws changed. The major changes affecting option traders were that the long-term holding period was extended to one year and also that gains or losses from writing options were considered to be capital gains. The extension of the long-term period essentially removed all possibilities of listed option holders ever obtaining a long-term gain, because the listed option market's longest-term options had only 9 months of life. All through this period there were a wide array of tax strategies that were avail­ able, legally, to allow investors to defer capital gains from one year to the next, there­ by avoiding payment of taxes. Essentially, one would enter into a spread involving deep in-the-money options that would expire in the next calendar year. Perhaps the spread would be established during October, using January options. Then one would wait for the underlying stock to move. Once a move had taken place, the spread would have a profit on one side and a loss on the other. The loss would be realized by rolling the losing option into another deep in-the-money option. The realized loss could thus be claimed on that year's taxes. The remaining spread - now an unrealized profit - would be left in place until expiration, in the next calendar year. At that time, the spread would be removed and the gain would be realized. Thus, the gain was moved from one year to the next. Then, later in that year, the gain would again be rolled to the next calendar year, and so on. These practices were effectively stopped by the new tax ruling issued in 1984. Two sweeping changes were made. First, the new rules stated that, in any spread position involving offsetting options - as the two deep in-the-money options in the previous example - the losses can be taken only to the extent that they exceed the unrealized gain on the other side of the spread. (The tax literature insists on calling these positions "straddles" after the old commodity term, but for options purposes they are really spreads or covered writes.) As a by-product of this rule, the holding period of stock can be terminated or eliminated by writing options that are too deeply in-the-money. Second, the new rules required that all positions in nonequity options and all futures be marked to market at the end of the tax year, and that taxes be paid on realized and unrealized gains alike. The tax rate for nonequity options was low­ ered from that of equity options. Then, in 1986, the long-term and short-term capi­ tal gains rates were made equal to the lowest ordinary rate. All of these points will be covered in detail. 910 Part VI: Measuring and Trading Volatility BASIC TAX TREATMENT Listed options that are exercised or assigned fall into a different category for tax pur­ poses. The original premium of the option transaction is combined into the stock transaction. There is no tax liability on this stock position until the stock position itself is closed out. There are four different combinations of exercising or assigning puts or calls. Table 41-1 summarizes the method of applying the option premium to the stock cost or sale price. Examples of how to treat these various transactions are given in the following sections. In addition to examples explaining the basic tax treatment, some supple­ mentary strategies are included as well. CALL BUYER If a call holder subsequently sells the call or allows it to expire worthless, he has a capital gain or loss. For equity options, the holding period of the option determines whether the gain or loss is long-term or short-term. As mentioned previously, a long­ term gain would be possible if held for more than one year. For tax purposes, an option that expires worthless is considered to have been sold at zero dollars on the expiration date. Example: An investor purchases an XYZ October 50 call for 5 points on July l. He sells the call for 9 points on September 1. That is, he realizes a capital gain via a clos­ ing transaction. His taxable gain would be computed as shown in Table 41-1, assum­ ing that a $25 commission was paid on both the purchase and the sale. TABLE 41-1. Applying the option premium to the stock cost or sale price. Action Call buyer exercises Put buyer exercises Call writer assigned Put writer assigned Net proceeds of sale ($900 - $25) Net cost ($500 + $25) Short-term gain: Tax Treatment Add call premium to stock cost Subtract put premium from stock sale price Add call premium to stock sale price Subtract put premium from stock cost $875 -525 $350 Chapter 41: Taxes 911 Alternatively, if the stock had fallen in price by October expiration and the October 50 call had expired worthless, the call buyer would have lost $525 - his entire net cost. If he had held the call until it expired worthless, he would have a short-term capital loss of $525 to report among his taxable transactions. PUT BUYER The holder of a put has much the same tax consequences as the holder of a call, pro­ vided that he is not also long the underlying stock. This initial discussion of tax con­ sequences to the put holder will assume that he does not simultaneously own the underlying stock. If the put holder sells his put in the option market or allows it to expire worthless, the gain or loss is treated as capital gain, long-term for equity puts held more than one year. Historically, the purchase of a put was viewed as perhaps the only way an investor could attain a long-term gain in a declining market. Example: An investor buys an XYZ April 40 put for 2 points with the stock at 43. Later, the stock drops in price and the put is sold for 5 points. The commissions were $25 on each option trade, so the tax consequences would be: Net sale proceeds ($500 - $25) Net cost ($200 + $25) Short-term capital gain: $475 -225 $250 Alternatively, if he had sold the put at a loss, perhaps in a rising market, he would have a short-term capital loss. Furthermore, if he allowed the put to expire totally worthless, his short-term loss would be equal to the entire net cost of $225. CALL WRITER Written calls that are bought back in the listed option market or are allowed to expire worthless are short-term capital gains. A written call cannot produce a long-term gain, regardless of the holding period. This treatment of a written call holds true even if the investor simultaneously owned the underlying stock (that is, he had a covered write). As long as the call is bought back or allowed to expire worthless, the gain or loss on the call is treated separately from the underlying stock for tax purposes. Example: A trader sells naked an XYZ July 30 call for 3 points and buys it back three months later at a price of 1. The commissions were $25 for each trade, so the tax gain would be: 912 Net sale proceeds ($300 - $25) Net cost ($100 + $25) Short-term gain: Part VI: Measuring and Trading Volatility $275 -125 $150 If the investor had not bought the call back, but had been fortunate enough to be able to allow it to expire worthless, his gain for tax purposes would have been the entire $275, representing his net sale proceeds. The purchase cost is considered to be zero for an option that expires worthless. PUT WRITER The tax treatment of written puts is quite similar to that of written calls. If the put is bought back in the open market or is allowed to expire worthless, the transaction is a short-term capital item. Example: An investor writes an XYZ July 40 put for 4 points, and later buys it back for 2 points after a rally by the underlying stock. The commissions were $25 on each option trade, so the tax situation would be: Net put sale price ($400 - $25) Net put cost ($100 + $25) Short-term gain: $375 -125 $250 If the put were allowed to expire worthless, the investor would have a net gain of $375, and this gain would be short-term. THE 60/40 RULE As mentioned earlier, nonequity option positions and future positions must be marked to market at the end of the tax year and taxes paid on both the unrealized and realized gains and losses. This same rule applies to futures positions. The tax rate on these gains and losses is lower than the equity options rate. Regardless of the actual holding period of the positions, one treats 60% of his tax liability as long-term and 40% as short-term. This ruling means that even gains made from extremely short­ term activity such as day-trading can qualify partially as long-term gains. Since 1986, long-term and short-term capital gains rates have been equal. If long-term rates should drop, then the rule would again be more meaningful. Example: A trader in nonequity options has made three trades during the tax year. It is now the end of the tax year and he must compute his taxes. First, he bought S&P Chapter 41: Taxes 913 500 calls for $1,500 and sold them 6 weeks later for $3,500. Second, he bought an OEX January 160 call for 3.25 seven months ago and still holds it. It currently is trad­ ing at 11.50. Finally, he sold 5 SPX February 250 puts for 1.50 three days ago. They are currently trading at 2. The net gain from these transactions should be computed without regard to holding period. Nonequity Original Current Gain/ Contract Price Price Cost Proceeds Loss S&P calls $1,500 $3,500 +$2,000 realized OEX January 160 3.25 11.50 $ 325 $1,150 + 825 unrealized SPX February 250 1.50 2.00 $1,000 $ 750 250 unrealized Total caeital gains +$2,575 The total taxable amount is $2,575, regardless of holding period and regardless of whether the item is realized or unrealized. Of this total taxable amount, 60% ($1,545) is subject to long-term treatment and 40% ($1,030) is subject to short-term treat­ ment. In practice, one computes these figures on a separate form (Section 1256) and merely enters the two final figures - $1,545 and $1,030- on the tax schedule for cap­ ital gains and losses. Note that if one loses money in nonequity options, he actually has a tax disadvantage in comparison to equity options, because he must take some of his loss as a long-term loss, while the equity option trader can take all of his loss as short-term. EXERCISE AND ASSIGNMENT Except for a specified situation that we will discuss later, exercise and assignment do not have any tax effect for nonequity options because everything is marked to mar­ ket at the end of the year. However, since equity options are subject to holding peri­ od considerations, the following discussion pertains to them. CALL EXERCISE An equity call holder who has an in-the-money call might decide to exercise the call rather than sell it in the options market. If he does this, there are no tax consequences on the option trade itself. Rather, the cost of the stock is increased by the net cost of the original call option. Moreover, the holding period begins on the day the stock is 914 Part VI: Measuring and Trading Volatility purchased (the day after the call was exercised). The option's holding period has no bearing on the stock position that resulted from the exercise. Example: An XYZ October 50 call was bought for 5 points on July 1. The stock had risen by October expiration, and the call holder decided to exercise the call on October 20th. The option commission was $25 and the stock commission was $85. The cost basis for the stock would be computed as follows: Buy 1 00 XYZ at 50 via exercise ($5,000 plus $85 commission) Original call cost ($500 plus $25) Total tax basis of stock Holding period of stock begins on October 21. $5,085 525 $5,610 When this stock is eventually sold, it will be a gain or a loss, depending on the stock's sale price as compared to the tax basis of $5,610 for the stock. Furthermore, it will be a short-term transaction unless the stock is held until October 21st of the follow­ ing year. CALL ASSIGNMENT If a written call is not closed out, but is instead assigned, the call's net sale proceeds are added to the sale proceeds of the underlying stock. The call's holding period is lost, and the stock position is considered to have been sold on the date of the assign­ ment. Example: A naked writer sells an XYZ July 30 call for 3 points, and is later assigned rather than buying back the option when it was in-the-money near expiration. The stock commission is $75. His net sale proceeds for the stock would be computed as follows: Net call sale proceeds ($300 - $25) Net stock proceeds from assignment of 100 shares at 30 ($3,000 - $75) Net stock sale proceeds $ 275 2,925 $3,200 In the case in which the investor writes a naked, or uncovered, call, he sells stock short upon assignment. He may, of course, cover the short sale by purchasing stock in the open market for delivery. Such a short sale of stock is governed by the Chapter 41: Taxes 915 applicable tax rules pertaining to short sales that any gains or losses from the short sale of stock are short-term gains or losses. Tax Treatment for the Covered Writer. If, on the other hand, the investor was assigned on a covered call - that is, he was operating the covered writing strategy and he elects to deliver the stock that he owns against the assignment notice, he has a complete stock transaction. The net cost of the stock was determined by its purchase price at an earlier date and the net sale proceeds are, of course, determined by the assignment in accordance with the preceding example. Determining the proceeds from the stock purchase and sale is easy, but deter­ mining the tax status of the transaction is not. In order to prevent stockholders from using deeply in-the-money calls to protect their stock while letting it become a long­ term item, some complicated tax rules have been passed. They can be summarized as follows: 1. If the equity option was out-of-the-money when first written, it has no effect on the holding period of the stock. 2. If the equity option was too deeply in-the-money when first written and the stock was not yet held long-term, then the holding period of the stock is eliminated. 3. If the equity option was in-the-money, but not too deeply, then the holding peri­ od of the stock is suspended while the call is in place. These rules are complicated and merit further explanation. The first rule mere­ ly says that one can write out-of-the-money calls without any problem. If the stock later rises and is called away, the sale proceeds for the stock include the option pre­ mium, and the transaction is long-term or short-term depending on the holding peri­ od of the stock. Example: Assume that on September 1st of a particular year, an investor buys 100 XYZ at 35. He holds the stock for a while, and then on July 15th of the following year - after the stock has risen to 43 - he sells an October 45 call for 3 points. Net call sale proceeds ($300 - $25) Net stock proceeds from assignment ($4,500 - $75) Net stock sale proceeds Net stock cost ($3,500 + $75) Net long-term gain $ 275 $4,425 $4,700 $4,700 $3,575 +$1, 125 916 Part VI: Measuring and Trading Volatllity Thus, this covered writer has a net gain of $1,125 and it is a long-term gain because the stock was held for more than one year (from September 1st of the year in which he bought it, to October expiration of the next year, when the stock was called away). Note that in a similar situation in which the stock had been held for less than one year before being called away, the gain would be short-term. Let us now look at the other two rules. They are related in that their differen­ tiation relies on the definition of "too deeply in-the-money." They come into play only if the stock was not already held long-term when the call was written. If the writ­ ten call is too deeply in-the-money, it can eliminate the holding period of short-term stock. Otherwise, it can suspend it. If the call is in-the-money, but not too deeply in­ the-money, it is referred to as a qualified covered call. There are several rules regard­ ing the determination of whether an in-the-money call is qualified or not. Before actually getting to that definition, which is complicated, let us look at two examples to show the effect of the call being qualified or not qualified. Example: Qualified Covered Write: On March 1st, an investor buys 100 XYZ at 35. He holds the stock for 3% months, and, on July 15th, the stock has risen to 43. This time he sells an in-the-money call, the October 40 call for 6. By October expiration, the stock has declined and the call expires worthless. He would now have the following situation: a $575 short-term gain from the sale of the call, plus he is long 100 XYZ with a holding period of only 3% months. Thus, the sale of the October call suspended his holding period, but did not elimi­ nate it. He could now hold the stock for another 8½ months and then sell it as a long­ term item. If the stock in this example had stayed above 40 and been called away, the net result would have been that the option proceeds would have been added to the stock sale price as in previous examples, and the entire net gain would have been short­ term due to the fact that the writing of the qualified covered call had suspended the holding period of the stock at 3½ months. That example was one of writing a call which was not too deeply in-the-money. If, however, one writes a call on stock that is not yet held long-term and the call is too deeply in-the-money, then the holding period of the stock is eliminated. That is, if the call is subsequently bought back or expires worthless, the stock must then be held for another year in order to qualify as a long-term investment. This rule can work to an investor's advantage. If one buys stock and it goes down and he is in jeopardy of hav­ ing a long-term loss, but he really does not want to sell the stock, he can sell a call Chapter 41: Taxes 917 that is too deeply in-the-money (if one exists), and eliminate the holding period on the stock Qualified Covered Call. The preceding examples and discussion summa­ rize the covered writing rules. Let us now look at what is a qualified covered call. The following rules are the literal interpretation. Most investors work from tables that are built from these rules. Such a table may be found in Appendix E. (Be aware that these rules may change, and consult a tax advisor for the latest figures.) A covered call is qualified if: 1. the option has more than 30 days of life remaining when it is written, and 2. the strike of the written call is not lower than the following benchmarks: a. First determine the applicable stock price (ASP). That is normally the closing price of the stock on the previous day. However, if the stock opens more than ll0% higher than its previous close, then the applicable stock price is that higher opening. b. If the ASP is less than $25, then the benchmark strike is 85% of ASP. So any call written with a strike lower than 85% of ASP would not be qualified. (For example, if the stock was at 12 and one wrote a call with a striking price of 10, it would not be qualified- it is too deeply in-the-money.) c. If the ASP is between 25.13 and 60, then the benchmark is the next lowest strike. Thus, if the stock were at 39 and one wrote a call with a strike of 35, it would be qualified. d. If the ASP is greater than 60 and not higher than 150, and the call has more than 90 days of life remaining, the benchmark is two strikes below the ASP. There is a further condition here that the benchmark cannot be more than 10 points lower than the ASP. Thus, if a stock is trading at 90, one could write a call with a strike of 80 as long as the call had more than 90 days remaining until expiration, and still be qualified. e. If the ASP is greater than 150 and the call has more than 90 days of life remain­ ing, the benchmark is two strikes below the ASP. Thus, if there are 10-point striking price intervals, then one could write a call that was 20 points in-the­ money and still be qualified. Of course, if there are 5-point intervals, then one could not write a call deeper than 10 points in-the-money and still be qualified. These rules are complicated. That is why they are summarized in Appendix E. In addition, they are always subject to change, so if an investor is considering writing an in-the-money covered call against stock that is still short-term in nature, he should check with his tax advisor and/or broker to determine whether the in-the-money call is qualified or not. 918 Part VI: Measuring and Trading Volatility There is one further rule in connection with qualified calls. Recall that we stat­ ed that the above rules apply only if the stock is not yet held long-term when the call is written. If the stock is already long-term when the call is written, then it is consid­ ered long-term when called away, regardless of the position of the striking price when the call was written. However, if one sells an in-the-money call on stock already held long-term, and then subsequently buys that call back at a loss, the loss on the call must be taken as a long-term loss because the stock was long-term. Overall, a rising market is the best, taxwise, for the covered call writer. If he writes out-of-the-money calls and the stock rises, he could have a short-term loss on the calls plus a long-term gain on the stock. Example: On January 2nd of a particular year, an investor bought 100 shares of XYZ at 32, paying $75 in commissions, and simultaneously wrote a July 35 call for 2 points. The July 35 expired worthless, and the investor then wrote an October 35 call for 3 points. In October, with XYZ at 39, the investor bought back the October 35 call for 6 points (it was in-the-money) and sold a January 40 call for 4 points. In January, on the expiration day, the stock was called away at 40. The investor would have a long­ term capital gain on his stock, because he had held it for more than one year. He would also have two short-term capital transactions from the July 35 and October 35 calls. Tables 41-2 and 41-3 show his net tax treatment from operating this covered writing strategy. The option commission on each trade was $25. Things have indeed worked out quite well, both profit-wise and tax-wise, for this covered call writer. Not only has he made a net profit of $850 from his transactions on the stock and options over the period of one year, but he has received very favorable tax treatment. He can take a short-term loss of $175 from the combined July and October option transactions, and is able to take the $1,025 gain as a long-term gain. TABLE 41-2. Summary of trades. January 2 July October January Bought 100 XYZ at 32 Sold 1 July 35 call at 2 July call expired worthless (XYZ at 32) Sold 1 October 35 call at 3 Bought back October 35 call for 6 points (XYZ at 39) Sold 1 January 40 call for 4 points (of the following year) 1 00 XYZ called away at 40 Chapter 41: Taxes TABLE 41-3. Tax treatment of trades. Short-term capital items: July 35 call: Net proceeds ($200 - $25) Net cost {expired worthless) Short-term capital gain October 35 call: Net proceeds ($300 - $25) Net cost ($600 + $25) Short-term capital loss 919 $175 0 $175 $275 - 625 ($350) Long-term capital item: 100 shares XYZ: Purchased January 2 of one year and sold at January expiration of the following year. Therefore, held for more than one year, qualifying for long-term treatment. Net sale proceeds of stock {assigned call): January 40 call sale proceeds ($400 - $25) Sold 1 00 XYZ at 40 strike {$4,000 $75) Net cost of stock (January 2 trade): Bought 100 at 32 {$3,200 + $75) Long-term capital gain $375 + 3,925 $4,300 - 3,275 $1,025 This example demonstrates an important tax consequence for the covered call writer: His optimum scenario tax-wise is a rising market, for he may be able to achieve a long-term gain on the underlying stock if he holds it for at least one year, while simultaneously subtracting short-term losses from written calls that were closed out at higher prices. Unfortunately, in a declining market, the opposite result could occur: short-term option gains coupled with the possibility of a long-term loss on the underlying stock. There are ways to avoid long-term stock losses, such as buy­ ing a put ( discussed later in the chapter) or going short against the box before the stock becomes long-term. However, these maneuvers would interrupt the covered writing strategy, which may not be a wise tactic. In summary, then, the covered call writer who finds himself with an in-the­ money call written and expiration date drawing near may have several alternatives open to him. If the stock is not yet held long-term, he might elect to buy back the written call and to write another call whose expiration date is beyond the date required for a long-term holding period on the stock. This is apparently what the hypothetical investor in the preceding example did with his October 35 call. Since 920 Part VI: Measuring and Trading VolatiRty that call was in-the-money, he could have elected to let the call be assigned and to take his profit on the position at that time. However, this would have produced a short-term gain, since the stock had not yet been held for one year, so he elected instead to terminate the October 35 call through a closing purchase transaction and to simultaneously write a call whose expiration date exceeded the one year period required to make the stock a long-term item. He thus wrote the January 40 call, expiring in the next year. Note that this investor not only decided to hold the stock for a long-term gain, but also decided to try for more potential profits: He rolled the call up to a higher striking price. This lets the holding period continue. An in-the­ money write would have suspended it. DELIVERING .,.,NEW" STOCK TO AVOID A LARGE LONG· TERM GAIN Some covered call writers may not want to deliver the stock that they are using to cover the written call, if that call is assigned. For example, if a covered writer were writing against stock that had an extremely low cost basis, he might not be willing to take the tax consequences of selling that particular stock holding. Thus, the writer of a call that is assigned may sometimes wish to buy stock in the open market to deliv­ er against his assignment, rather than deliver the stock he already owns. Recall that it is completely in accordance with the Options Clearing Corporation rules for a call writer to buy stock in the open market to deliver against an assignment. For tax pur­ poses, the confirmation that the investor receives from his broker for the sale of the stock via assignment should clearly specify which particular shares of stock are being sold. This is usually accomplished by having the confirmation read "Versus Purchase" and listing the purchase date of the stock being sold. This is done to clearly identify that the "new" stock, and not the older long-term stock, is being delivered against the assignment. The investor must give these instructions to his broker, so that the brokerage firm puts the proper notation on the confirmation itself. If the investor realizes that his stock might be in danger of being called away and he wants to avail himself of this procedure, he should discuss it with his broker beforehand, so that the proper procedures can be enacted when the stock is actually called away. Example: An investor owns 100 shares ofXYZ and his cost basis, after multiple stock splits and stock dividends over the years, is $2 per share. With XYZ at 50, this investor decides to sell an XYZ July 50 call for 5 points to bring in some income to his port­ folio. Subsequently, the call is assigned, but the investor does not want to deliver his XYZ, which he owns at a cost basis of $2 per share, because he would have to pay cap­ ital gains on a large profit. He may go into the open market and buy another 100 shares of XYZ at its current market price for delivery against the assignment notice. Chapter 41: Taxes 921 Suppose he does this on July 20th, the day he receives the assignment notice on his XYZ July 50 call. The confirmation that he receives from his broker for the sale of 100 XYZ at 50 - that is, the confirmation for the call assignment - should be marked "Versus Purchase July 20th." The year of the sale date should be noted on the con­ firmation as well. This long-term holder of XYZ stock must, of course, pay for the additional XYZ bought in the open market for delivery against the assignment notice. Thus, it is imperative that such an investor have a reserve of funds that he can fall back on if he thinks that he must ever implement this sort of strategy to avoid the tax consequences of selling his low-cost-basis stock. PUT EXERCISE If the put holder does not choose to liquidate the option in the listed market, but instead exercises the put - thereby selling stock at the striking price - the net cost of the put is subtracted from the net sale proceeds of the underlying stock. Example: Assume an XYZ April 45 put was bought for 2 points. XYZ had declined in price below 45 by April expiration, and the put holder decides to exercise his in-the­ money put rather than sell it in the option market. The commission on the stock sale is $85, so the net sale proceeds for the underlying stock would be: Sale of 100 XYZ at 45 strike ($4,500 - $85) Net cost of put ($200 + 25) Net sale proceeds on stock for tax purposes: $4,415 - 225 $4,190 If the stock sale represents a new position - that is, the investor has shorted the underlying stock - it will eventually be a short-term gain or loss, according to pres­ ent tax rules governing short sales. If the put holder already owns the underlying stock and is using the put exercise as a means of selling that stock, his gain or loss on the stock transaction is computed, for tax purposes, by subtracting his original net stock cost from the sale proceeds as determined above. PUT ASSIGNMENT If a written put is assigned, stock is bought at the striking price. The net cost of this purchased stock is reduced by the amount of the original put premium received. Example: If one initially sold an XYZ July 40 put for 4 points, and it was assigned, the net cost of the stock would be determined as follows, assuming a $75 commission charge on the stock purchase: 922 Cost of 100 XYZ assigned at 40 ($4,000 + $75) Net proceeds of put sale ($400 - $25) Net cost basis of stock Part VI: Measuring and Trading Volatility $4,075 - 375 $3,700 The holding period for stock purchased via a put assignment begins on the day of the put assignment. The period during which the investor was short the put has no bear­ ing on the holding period of the stock. Obviously, the put transaction itself does not become a capital item; it becomes part of the stock transaction. SPECIAL TAX PROBLEMS THE WASH SALE RULE The call buyer should be aware of the wash sale rule. In general, the wash sale rule denies a tax deduction for a security sold at a loss if a substantially identical security, or an option to acquire that security, is purchased within 30 days before or 30 days after the original sale. This means that one cannot sell XYZ to take a tax loss and also purchase XYZ within the 61-day period that extends 30 days before and 30 days after the sale. Of course, an investor can legally make such a trade, he just cannot take the tax loss on the sale of the stock. A call option is certainly an option to acquire the security. It would thus invoke the wash sale rule for an investor to sell XYZ stock to take a loss and also purchase any XYZ call within 30 days before or after the stock sale. Various series of call options are not generally considered to be substantially identical securities, however. If one sells an XYZ January 50 call to take a loss, he may then buy any other XYZ call option without jeopardizing his tax loss from the sale of the January 50. It is not clear whether he could repurchase another January 50 call­ that is, an identical call - without jeopardizing the taxable loss on the original sale of the January 50. It would also be acceptable for an investor to sell a call to take a loss and then immediately buy the underlying security. This would not invoke the wash sale rule. Avoiding a Wash Sale. It is generally held that the sale of a put is not the acquisition of an option to buy stock, even though that is the effect of assign­ ment of the written put. This fact may be useful in certain cases. If an investor holds a stock at a loss, he may want to sell that stock in order to take the loss on his taxes for the current year. The wash sale rule prevents him from repurchas­ ing the same stock, or a call option on that stock, within 30 days after the sale. Thus, the investor will be "out of" the stock for a month; that is, he will not be Chapter 41: Taxes 923 able to participate in any rally in the stock in the next 30 days. If the underlying stock has listed put options, the investor may be able to partially offset this neg­ ative effect. By selling an in-the-money put at the same time that the stock is sold, the investor will be able to take his stock loss on the current year's taxes and also will be able to participate in price movements on the underlying stock. If the stock should rally, the put will decrease in price. However, if the stock ral­ lies above the striking price of the put, the investor will not make as much from the put sale as he would have from the ownership of the stock. Still, he does realize some profits if the stock rallies. Conversely, if the stock falls in price, the investor will lose on the put sale. This certainly represents a risk although no more of a risk than owning the stock did. An additional disadvantage is that the investor who has sold a put will not receive the div­ idends, if any are paid by the underlying stock. Once 30 days have passed, the investor can cover the put and repurchase the underlying stock. The investor who utilizes this tactic should be careful to select a put sale in which early assignment is minimal. Therefore, he should sell a long-term, in­ the-money put when utilizing this strategy. (He needs the in-the-money put in order to participate heavily in the stock's movements.) Note that if stock should be put to the investor before 30 days had passed, he would thus be forced to buy stock, and the wash sale rule would be invoked, preventing him from taking the tax loss on the stock at that time. He would have to postpone taking the loss until he makes a sale that does not invoke the wash sale rule. Finally, this strategy must be employed in a margin account, because the put sale will be uncovered. Obviously, the money from the sale of the stock itself can be used to collateralize the sale of the put. If the stock should drop in value, it is always possible that additional collateral will be required for the uncovered put. THE SHORT-SALE RULE - PUT HOLDER'S PROBLEM A put purchase made by an investor who also owns the underlying stock may have an effect on the holding period of the stock. If a stock holder buys a put, he would nor­ mally do so to eliminate some of the downside risk in case the stock falls in price. However, if a put option is purchased to protect stock that is not yet held long enough to qualify for long-term capital gains treatment, the entire holding period of the stock is wiped out. Furthermore, the holding period for the stock will not begin again until the put is disposed of. For example, if an investor has held XYZ for 11 months - not quite long enough to qualify as a long-term holding - and then buys a put on XYZ, he will wipe out the entire accrued holding period on the stock. Furthermore, when he finally disposes of the put, the holding period for the stock must begin all over 924 Part VI: Measuring and Trading VolatHity again. The previous 11-month holding period is lost, as is the holding period during which the stock and put were held together. This tax consequence of a put purchase is derived from the general rules governing short sales, which state that the acquisi­ tion of an option to sell property at a fixed price (that is, a put) is treated as a short sale. This ruling has serious tax consequences for an investor who has bought a put to protect stock that is still in a short-term tax status. ✓,,Married" Put and Stock. There are two cases in which the put purchase does not affect the holding period of the underlying stock. First, if the stock has already been held long enough to qualify for long-term capital treatment, the purchase of a put has no bearing on the holding period of the underlying stock. Second, if the put and the stock that it is intended to protect are bought at the same time, and the investor indicates that he intends to exercise that particular put to sell those particular shares of stock, the put and the stock are considered to be "married" and the normal tax rulings for a stock holding would apply. The investor must actually go through with the exercise of the put in order for the "married" status to remain valid. If he instead should allow the put to expire worthless, he could not take the tax loss on the put itself but would be forced to add the put' s cost to the net cost of the underlying stock. Finally, if the investor neither exercises the put nor allows it to expire worthless but sells both the put and the stock in their respective markets, it would appear that the short sale rules would come back into effect. This definition of "married" put and stock, with its resultant ramifications, is quite detailed. What exactly are the consequences? The "married" rule was original­ ly intended to allow an investor to buy stock, protect it, and still have a chance of real­ izing a long-term gain. This is possible with options with more than one year of life remaining. The reader must be aware of the fact that, if he initially "marries" stock and a listed 3-month put, for example, there is no way that he can replace that put at its expiration with another put and still retain the "married" status. Once the original "married" put is disposed of - through sale, exercise, or expiration - no other put may be considered to be "married" to the stock. Protecting a Long· Term Gain or Avoiding a Long-Term Loss. The investor may be able, at times, to use the short-sale aspect of put purchases to his advantage. The most obvious use is that he can protect a long-term gain with a put purchase. He might want to do this if he has decided to take the long-term gain, but would prefer to delay realizing it until the following tax year. A pur­ chase of a put with a maturity date in the following year would accomplish that purpose. Chapter 41: Taxes 92S Another usage of the put purchase, for tax purposes, might be to avoid a long­ term loss on a stock position. If an investor owns a stock that has declined in price and also is about to become a long-term holding, he can buy a put on that stock to eliminate the holding period. This avoids having to take a long-term loss. Once the put is removed, either by its sale or by its expiring worthless, the stock holding peri­ od would begin all over again and it would be a short-term position. In addition, if the investor should decide to exercise the put that he purchased, the result would be a short-term loss. The sale basis of the stock upon exercise of the put would be equal to the striking price of the put less the amount of premium paid for the put, less all commission costs. Furthermore, note that this strategy does not lock in the loss on the underlying stock. If the stock rallies, the investor would be able to participate in that rally, although he would probably lose all of the premium that he paid for the put. Note that both of these long-term strategies can be accomplished via the sale of a deeply in-the-money call as well. SUMMARY This concludes the section of the tax chapter dealing with listed option trades and their direct consequences on option strategies. In addition to the basic tax treatment for option traders of liquidation, expiring worthless, or assignment or exercise, sev­ eral other useful tax situations have been described. The call buyer should be aware of the wash sale rule. The put buyer must be aware of the short sale rules involving both put and stock ownership. The call writer should realize the beneficial effects of selling an in-the-money call to protect the underlying stock, while waiting for a real­ ization of profit in the following tax year. The put writer may be able to avoid a wash sale by utilizing an in-the-money put write, while still retaining profit potential from a rally by the underlying stock. TAX PLANNING STRATEGIES FOR EQUITY OPTIONS DEFERRING A SHORT· TERM CALL GAIN The call holder may be interested in either deferring a gain until the following year or possibly converting a short-term gain on the call into a long-term gain on the stock. It is much easier to do the former than the latter. A holder of a profitable call that is due to expire in the following year can take any of three possible actions that might let him retain his profit while deferring the gain until the following tax year. One way in which to do this would be to buy a put option. Obviously, he would want to buy an 926 Part VI: Measuring and Trading Volatillty in-the-money put for this purpose. By so doing, he would be spending as little as pos­ sible in the way of time value premium for the put option and he would also be lock­ ing in his gain on the call. The gains and losses from the put and call combination would nearly equal each other from that time forward as the stock moves up or down, unless the stock rallies strongly, thereby exceeding the striking price of the put. This would be a happy event, however, since even larger gains would accrue. The combi­ nation could be liquidated in the following tax year, thus achieving a gain. Example: On September 1st, an investor bought an XYZ January 40 call for 3 points. The call is due to expire in the following year. XYZ has risen in price by December 1st, and the call is selling for 6 points. The call holder might want to take his 3-point gain on the call, but would also like to defer that gain until the following year. He might be able to do this by buying an XYZ January 50 put for 5 points, for example. He would then hold this combination until after the first of the new year. At that time, he could liquidate the entire combination for at least 10 points, since the strik­ ing price of the put is 10 points greater than that of the call. In fact, if the stock should have climbed to or above 50 by the first of the year, or should have fallen to or below 40 by the first of the year, he would be able to liquidate the combination for more than 10 points. The increase in time value premium at either strike would also be a benefit. In any case, he would have a gain - his original cost was 8 points (3 for the call and 5 for the put). Thus, he has effectively deferred taking the gain on the orig­ inal call holding until the next tax year. The risk that the call holder incurs in this type of transaction is the increased commission charges of buying and selling the put as well as the possible loss of any time value premium in the put itself. The investor must decide for himself whether these risks, although they may be relatively small, outweigh the potential benefit from deferring his tax gain into the next year. Another way in which the call holder might be able to defer his tax gain into the next year would be to sell another XYZ call against the one that he currently holds. That is, he would create a spread. To assure that he retains as much of his current gain as possible, he should sell an in-the-money call. In fact, he should sell an in-the­ money call with a lower striking price than the call held long, if possible, to ensure that his gain remains intact even if the underlying stock should collapse substantial­ ly. Once the spread has been established, it could be held until the following tax year before being liquidated. The obvious risk in this means of deferring gain is that one could receive an assignment notice on the short call. This is not a remote possibility, necessarily, since an in-the-money call should be used as protection for the current gain. Such an assignment would result in large commission costs on the resultant pur­ chase and sale of the underlying stock, and could substantially reduce one's gain. Chapter 41: Taxes 927 Thus, the risk in this strategy is greater than that in the previous one (buying a put), but it may be the only alternative available if puts are not traded on the underlying stock in question. Example: An investor bought an XYZ February 50 call for 3 points in August. In December, the stock is at 65 and the call is at 15. The holder would like to "lock in" his 12-point call profit, but would prefer deferring the actual gain into the following tax year. He could sell an XYZ February 45 call for approximately 20 points to do this. If no assignment notice is received, he will be able to liquidate the spread at a cost of 5 points with the stock anywhere above 50 at February expiration. Thus, in the end he would still have a 12-point gain - having received 20 points for the sale of the February 45 and having paid out 3 points for the February 50 plus 5 points to liqui­ date the spread to take his gain. If the stock should fall below 50 before February expiration, his gain would be even larger, since he would not have to pay out the entire 5 points to liquidate the spread. The third way in which a call holder could lock in his gain and still defer the gain into the following tax year would be to sell the stock short while continuing to hold the call. This would obviously lock in the gain, since the short sale and the call pur­ chase will offset each other in profit potential as the underlying stock moves up or down. In fact, if the stock should plunge downward, large profits could accrue. However, there is risk in using this strategy as well. The commission costs of the short sale will reduce the call holder's profit. Furthermore, if the underlying stock should go ex-dividend during the time that the stock is held short, the strategist will be liable for the dividend as well. In addition, more margin will be required for the short stock. The three tactics discussed above showed how to defer a profitable call gain into the following tax year. The gain would still be short-term when realized. The only way in which a call holder could hope to convert his gain into a long-term gain would be to exercise the call and then hold the stock for more than one year. Recall that the holding period for stock acquired through exercise begins on the day of exercise - the option's holding period is lost. If the investor chooses this alternative, he of course is spending some of his gains for the commissions on the stock purchase as well as sub­ jecting himself to an entire year's worth of market risk. There are ways to protect a stock holding while letting the holding period accrue - for example, writing out-of­ the-money calls - but the investor who chooses this alternative should carefully weigh the risks involved against the possible benefits of eventually achieving a long­ term gain. The investor should also note that he will have to advance considerably more money to hold the stock. 928 Part VI: Measuring and Trading Volatility DEFERRING A PUT HOLDER'S SHORT· TERM GAIN Without going into as much detail, there are similar ways in which a put holder who has a short-term gain on a put due to expire in the following tax year can attempt to defer the realization of that gain into the following tax year. One simple way in which he could protect his gain would be to buy a call option to protect his profitable put. He would want to buy an in-the-money call for this purpose. This resulting combina­ tion is similar in nature to the one described for the call buyer in the previous section. A second way that he could attempt to protect his gain and still defer its real­ ization into the following tax year would be to sell another XYZ put option against the one that he holds long. This would create a vertical spread. This put holder should attempt to sell an in-the-money put, if possible. Of course, he would not want to sell a put that was so deeply in-the-money that there is risk of early assignment. The results of such a spread are analogous to the call spread described in detail in the last section. Finally, the put holder could buy the underlying stock if he had enough avail­ able cash or collateral to finance the stock purchase. This would lock in the profit, as the stock and the put would offset each other in terms of gains or losses while the stock moved up or down. In fact, if the stock should experience a large rally, rising above the striking price of the put, even larger profits would become possible. In each of the tactics described, the position would be removed in the follow­ ing tax year, thereby realizing the gain that was deferred. DIFFICULTY OF DEFERRING GAINS FROM WRITING As a final point in this section on deferring gains from option transactions, it might be appropriate to describe the risks associated with the strategy of attempting to defer gains from uncovered option writing into the following tax year. Recall that in the previous sections, it was shown that a call or put holder who has an unrealized profit in an option that is due to expire in the following tax year could attempt to "lock in" the gain and defer it. The dollar risks to a holder attempting such a tax deferral were mainly commission costs and/or small amounts of time value premium paid for options. However, the option writer who has an unrealized profit may have a more difficult time finding a way to both "lock in" the gain and also defer its realization into the following tax year. It would seem, at first glance, that the call writer could mere­ ly take actions opposite to those that the call buyer takes: buying the underlying stock, buying another call option, or selling a put. Unfortunately, none of these actions "locks in" the call writer's profit. In fact, he could lose substantial investment dollars in his attempt to defer the gain into the following year. Chapter 41: Taxes 929 Example: An investor has written an uncovered XYZ January 50 call for 5 points and the call has dropped in value to 1 point in early December. He might want to take the 4-point gain, but would prefer to defer realization of the gain until the following tax year. Since the call write is at a profit, the stock must have dropped and is prob­ ably selling around 45 in early December. Buying the underlying stock would not accomplish his purpose, because if the stock continued to decline through year-end, he could lose a substantial amount on the stock purchase and could make only 1 more point on the call write. Similarly, a call purchase would not work well. A call with a lower striking price - for example, the XYZ January 45 or the January 40- could lose substantial value if the underlying stock continued to drop in price. An out-of-the­ money call - the XYZ January 60 - is also unacceptable, because if the underlying stock rallied to the high 50's, the writer would lose money both on his January 50 call write and on his January 60 call purchase at expiration. Writing a put option would not "lock in" the profit either. If the underlying stock continued to decline, the loss­ es on the put write would certainly exceed the remaining profit potential of 1 point in the January 50 call. Alternatively, if the stock rose, the losses on the January 50 call could offset the limited profit potential provided by a put write. Thus, there is no rel­ atively safe way for an uncovered call writer to attempt to "lock in" an unrealized gain for the purpose of deferring it to the following tax year. The put writer seeking to defer his gains faces similar problems. UNEQUAL TAX TREATMENT ON SPREADS There are two types of spreads in which the long side may receive different tax treat­ ment than the short side. One is the normal equity option spread that is held for more than one year. The other is any spread between futures, futures options, or cash­ based options and equity options. With equity options, if one has a spread in place for more than one year and if the movement of the underlying stock is favorable, one could conceivably have a long-term gain on the long side and a short-term loss on the short side of the spread. Example: An investor establishes an XYZ bullish call spread in options that have 15 months of life remaining: In October of one year, he buys the January 70 LEAPS call expiring just over a year in the future. At the same time, he sells the January 80 LEAPS call, again expiring just over a year hence. Suppose he pays 13 for the January 70 call and receives 7 for the January 80 call. In December of the following year, he decides to remove the spread, after he has held it for more than one year - specifi­ cally, for 14 months in this case. XYZ has advanced by that time, and the spread is worth 9. With XYZ at 90, the January 70 call is trading at 20 and the January 80 call is trading at 11. The capital gain and loss results for tax purposes are summarized in the following table (commissions are omitted from this example): 930 Option XYZ January 70 LEAPS call XYZ January 80 LEAPS call Cost $1,300 $1,100 Part VI: Measuring and Trading Volatllity Proceeds $2,000 $ 700 Goin/Loss $700 long-term gain $400 short-term loss No taxes would be owed on this spread since one-half of the long-term gain is less than the short-term loss. The investor with this spread could be in a favorable position since, even though he actually made money in the spread - buying it at a 6- point debit and selling it at a 9-point credit - he can show a loss on his taxes due to the disparate treatment of the two sides of the spread. The above spread requires that the stock move in a favorable direction in order for the tax advantage to materialize. If the stock were to move in the opposite direc­ tion, then one should liquidate the spread before the long side of the spread had reached a holding period of one year. This would prevent taking a long-term loss. Another type of spread may be even more attractive in this respect. That is a spread in which nonequity options are spread against equity options. In this case, the trader would hope to make a profit on the nonequity or futures side, because part of that gain is automatically long-term gain. He would simultaneously want to take a loss on the equity option side, because that would be entirely short-term loss. There is no riskless way to do this, however. For example, one might buy a pack­ age of puts on stocks and hedge them by selling an index put on an index that per­ forms more or less in line with the chosen stocks. If the index rises in price, then one would have short-term losses on his stock options, and part of the gain on his index puts would be treated as long-term. However, if the index were to fall in price, the opposite would be true, and long-term losses would be generated - not something that is normally desirable. Moreover, the spread itself has risk, especially the tracking risk between the basket of stocks and the index itself. This brings out an important point: One should be cautious about establishing spreads merely for tax purposes. He might wind up losing money, not to mention that there could be unfavorable tax consequences. As always, a tax advisor should be con­ sulted before any tax-oriented strategy is attempted. SUMMARY Options can be used for many tax purposes. Short-term gains can be deferred into the next tax year, or can be partially protected with out-of-the-money options until they mature into long-term gains. Long-term losses can be avoided with the purchase of a put or sale of a deeply in-the-money call. Wash sales can be avoided without giv­ ing up the entire ownership potential of the stock. There are risks as well as rewards Chapter 41: Taxes 931 in any of the strategies. Commission costs and the dissipation of time value premium in purchased options will both work against the strategist. A tax advisor should be consulted before actually implementing any tax strate­ gy, whether that strategy employs options or not. Tax rules change from time to time. It is even possible that a certain strategy is not covered by a written rule, and only a tax advisor is qualified to give consultation on how such a strategy might be inter­ preted by the IRS. Finally, the options strategist should be careful not to confuse tax strategies with his profit-oriented strategies. It is generally a good idea to separate profit strategies from tax strategies. That is, if one finds himself in a position that conveniently lends itself to tax applications, fine. However, one should not attempt to stay in a position too long or to close it out at an illogical time just to take advantage of a tax break. The tax consequences of options should never be considered to be more important than sound strategy management. The Best Strategy? There is no one best strategy. Although this statement may appear to be unfair and disappointing to some, it is nevertheless the truth. Its validity lies in the fact that there are many types of investors, and no one strategy can be best for all of them. Knowledge and suitability are the keys to determining which strategy may be the best one for an individual. The previous chapters have been devoted to imparting much of the knowledge required to understand an individual strategy. This chapter attempts to point out how the investor might incorporate his own risk/reward attitude and finan­ cial condition to select the most feasible strategies for his own use. The final section of this chapter describes which strategies have the better probabilities of success. GENERAL CONCEPT: MARKET ATTITUDE AND EQUIVALENT POSITIONS A wide variety of strategies has been described. Certain ones are geared to capitaliz­ ing on one's (hopefully correct) outlook for a particular stock, or for the market in general. These tend to be the more aggressive strategies, such as outright put or call buying and low-debit (high-potential) bull and bear spreads. Other strategies are much more conservative, having as their emphasis the possibility of making a rea­ sonable but limited return, coupled with decreased risk exposure. These include cov­ ered call writing and in-the-money (large-debit) bull or bear spreads. Even in these strategies, however, one has a general attitude about the market. He is bullish or bearish, but not overly so. If he is proven slightly wrong, he can still make money. However, if he is gravely wrong, relatively large percentage losses might occur. The third broad category of strategies is the one that is not oriented toward picking stock market direction, but is rather an approach based on the value of the option-what 932 Chapter 42: The Best Strategy? 933 is generally called volatility trading. If the net change in the market is small over a period of time, these strategies should perform well: ratio writing, ratio spreading (especially "delta neutral spreads"), straddle and strangle writing, neutral calendar spreading, and butterfly spreads. On the other hand, if options are cheap and the market is expected to be volatile, then these would be best: straddle and strangle buys, backspreads, and reverse hedges and spreads. Certain other strategies overlap into more than one of the three broad categories. For example, the bullish or bearish calendar spread is initially a neutral position. It only assumes a bullish or bearish bias after the near-term option expires. In fact, any of the diagonal or calendar strategies whose ultimate aim is to generate profits on the sale of shorter-term options are similar in nature. If these near-term profits are generated, they can offset, partially or completely, the cost oflong options. Thus, one might potentially own options at a reduced cost and could profit from a definitive move in his favor at the right time. It was shown in Chapters 14, 23, and 24 that diagonalizing a spread can often be very attractive. This brief grouping into three broad categories, does not cover all the strategies that have been discussed. For example, some strategies are generally to be avoided by most investors: high-risk naked option writing (selling options for fractional prices) and covered or ratio put writing. In essence, the investor will normally do best with a position that has limited risk and the potential of large profits. Even if the profit potential is a low-probability event, one or two successful cases may be able to over­ come a series of limited losses. Complex strategies that fit this description are the diagonal put and call combinations described in Chapters 23 and 24. The simplest strategy fitting this description is the T-bill/option purchase program described in Chapter 26. Finally, many strategies may be implemented in more than one way. The method of implementation may not alter the profit potential, but the percentage risk levels can be substantially different. Equivalent strategies fit into this category. Example: Buying stock and then protecting the stock purchase with a put purchase is an equivalent strategy in profit potential to buying a call. That is, both have limit­ ed dollar risk and large potential dollar profit if the stock rallies. However, they are substantially different in their structure. The purchase of stock and a put requires substantially more initial investment dollars than does the purchase of a call, but the limited dollar risk of the strategy would normally be a relatively small percentage of the initial investment. The call purchase, on the other hand, involves a much small­ er capital outlay; in addition, while it also has limited dollar risk, the l~ss may easily represent the entire initial investment. The stockholder will receive cash dividends while the call holder will not. Moreover, the stock will not expire as the call will. This 934 Part VI: Measuring and Trading Volatility provides the stock/put holder with an additional alternative of choosing to extend his position for a longer period of time by buying another put or possibly by just contin­ uing to hold the stock after the original put expires. Many equivalent positions have similar characteristics. The straddle purchase and the reverse hedge (short stock and buy calls) have similar profit and loss poten­ tial when measured in dollars. Their percentage risks are substantially different, how­ ever. In fact, as was shown in Chapter 20, another strategy is equivalent to both of these-buying stock and buying several puts. That is, buying a straddle is equivalent to buying 100 shares of stock and simultaneously buying two puts. The "buy stock and puts" strategy has a larger initial dollar investment, but the percentage risk is small­ er and the stockholder will receive any dividends paid by the common stock. In summary, the investor must know two things well: the strategy that he is con­ templating using, and his own attitude toward risk and reward. His own attitude represents suitability, a topic that is discussed more fully in the following section. Every strategy has risk. It would not be proper for an investor to pursue the best strategy in the universe (such a strategy does not exist, of course) if the risks of that strategy violated the investor's own level of financial objectives or accepted investment methodology. On the other hand, it is also not sufficient for the investor to merely feel that a strategy is suitable for his investment objectives. Suppose an investor felt that the T-bill/option strategy was suitable for him because of the profit and risk levels. Even if he understands the philosophies of option purchasing, it would not be proper for him to utilize the strategy unless he also understands the mechanics of buying Treasury bills and, more important, the concept of annualized risk. WHAT IS BEST FOR ME MIGHT NOT BE BEST FOR YOU It is impossible to classify any one strategy as the best one. The conservative investor would certainly not want to be an outright buyer of options. For him, covered call writing might be the best strategy. Not only would it accomplish his financial aims­ moderate profit potential with reduced risk-but it would be much more appealing to him psychologically. The conservative investor normally understands and accepts the risks of stock ownership. It is only a small step from that understanding to the covered call writing strategy. The aggressive investor would most likely not consider covered call writing to be the best strategy, because he would consider the profit potential too small. He is willing to take larger risks for the opportunity to make larg­ er profits. Outright option purchases might suit him best, and he would accept, by his aggressive stature, that he could lose nearly all his money in a relatively short time Chapter 42: The Best Strategy? 935 period. ( Of course, one would hope that he uses only 15 to 20% of his assets for spec­ ulative option buying.) Many investors fit somewhere in between the conservative description and the aggressive description. They might want to have the opportunity to make large prof­ its, but certainly are not willing to risk a large percentage of their available funds in a short period of time. Spreads might therefore appeal to this type of investor, espe­ cially the low-debit bullish or bearish calendar spreads. He might also consider occa­ sional ventures into other types of strategies-bullish or bearish spreads, straddle buys or writes, and so on-but would generally not be into a wide range of these types of positions. The T-bill/option strategy might work well for this investor also. The wealthy aggressive investor may be attracted by strategies that offer the opportunity to make money from credit positions, such as straddle or combination writing. Although ratio writing is not a credit strategy, it might also appeal to this type of investor because of the large amounts of time value premium that are gathered in. These are generally strategies for the wealthier investor because he needs the "stay­ ing power" to be able to ride out adverse cycles. If he can do this, he should be able to operate the strategy for a sufficient period of time in order to profit from the con­ stant selling of time value premiums. In essence, the answer to the question of "which strategy is best" again revolves around that familiar word, "suitability." The financial needs and investment objectives of the individual investor are more important than the merits of the strategy itself. It sounds nice to say that he would like to participate in strategies with limited risk and potentially large profits. Unfortunately, if the actual mechanics of the strategy involve risk that is not suitable for the investor, he should not use the strategy, no matter how attractive it sounds. Example: The T-bill/option strategy seems attractive: limited risk because only 10% of one's assets are subjected to risk annually; the remaining 90% of one's assets earn interest; and if the option profits materialize, they could be large. What if the worst scenario unfolds? Suppose that poor option selections are continuously made and there are three or four years of losses, coupled with a declining rate of interest earned from the Treasury bills (not to mention the commission charges for trading the secu­ rities). The portfolio might have lost 15 or 20% of its assets over those years. A good test of suitability is for the investor to ask himself, in advance: "How will I react if the worst case occurs?" If there will be sleepless nights, pointing of fingers, threats, and so forth, the strategy is unsuitable. If, on the other hand, the investor believes that he would be disappointed (because no one likes to lose money), but that he can with­ stand the risk, the strategy may indeed be suitable. 936 Part VI: Measuring and Trading Volatility MATHEMATICAL RANKING The discussion above demonstrates that it is not possible to ultimately define the best strategy when one considers the background, both financial and psychological, of the individual investor. However, the reader may be interested in knowing which strate­ gies have the best mathematical chances of success, regardless of the investor's per­ sonal feelings. Not unexpectedly, strategies that take in large amounts of time value premium have high mathematical expectations. These include ratio writing, ratio spreading, straddle writing, and naked call writing (but only if the "rolling for cred­ its" follow-up strategy is adhered to). The ratio strategies would have to be operated according to a delta-neutral ratio in order to be mathematically optimum. Unfor­ tunately, these strategies are not for everyone. All involve naked options, and also require that the investor have a substantial amount of money ( or collateral) available to make the strategies work properly. Moreover, naked option writing in any form is not suitable for some investors, regardless of their protests to the contrary. Another group of strategies that rank high on an expected profit basis are those that have limited risk with the potential of occasionally attaining large profits. The T­ hill/option strategy is a prime example of this type of strategy. The strategies in which one attempts to reduce the cost of longer-term options through the sale of near-term options fit in this broad category also, although one should limit his dollar commit­ ment to 15 to 20% of his portfolio. Calendar spreads such as the combinations described in Chapter 23 (calendar combination, calendar straddle, and diagonal but­ terfly spread) or bullish call calendar spreads or bearish put calendar spreads are all examples of such strategies. These strategies may have a rather frequent probability of losing a small amount of money, coupled with a low probability of earning large profits. Still, a few large profits may be able to more than overcome the frequent, but small, losses. Ranking behind these strategies are the ones that offer limited profits with a reasonable probability of attaining that profit. Covered call writing, large debit bull or bear spreads (purchased option well in-the-money and possible written option as well), neutral calendar spreads, and butterfuly spreads fit into this category. Unfortunately, all these strategies involve relatively large commission costs. Even though these are not strategies that normally require a large investment, the investor who wants to reduce the percentage effect of commissions must take larger positions and will therefore be advancing a sizable amount of money. Speculative buying and spreading strategies rank the lowest on a mathematical basis. The T-bill/option strategy is not a speculative buying strategy. In-the-money purchases, including the in-the-money combination, generally outrank out-of-the­ money purchases. This is because one has the possibility of making a large percent­ age profit but has decreased the chance of losing all his investment, since he starts Chapter 42: The Best Strategy? 937 out in-the-money. In general, however, the constant purchase of time value premi­ ums, which must waste away by the time the options expire, will have a burdensome negative effect. The chances of large profits and large losses are relatively equal on a mathematical basis, and thus become subsidiary to the time premium effect in the long run. This mathematical outlook, of course, precludes those investors who are able to predict stock movements with an above-average degree of accuracy. Although the true mathematical approach holds that it is not possible to accurately predict the market, there are undoubtedly some who can and many who try. SUMMARY Mathematical expectations for a strategy do not make it suitable even if the expect­ ed returns are good, for the improbable may occur. Profit potentials also do not determine suitability; risk levels do. In the final analysis, one must determine the suitability of a strategy by determining if he will be able to withstand the inherent risks if the worst scenario should occur. For this reason, no one strategy can be des­ ignated as the best one, because there are numerous attitudes regarding the degree of risk that is acceptable. Postscript Option strategies cannot be unilaterally classified as aggressive or conservative. There are certainly many aggressive applications, the simplest being the outright pur­ chase of calls or puts. However, options can also have conservative applications, most notably in reducing some of the risks of common stock ownership. In addition, there are less polarized applications, particularly spreading techniques, that allow the investor to take a middle-of-the-road approach. Consequently, the investor himself-not options--becomes the dominant force in determining whether an option strategy is too risky. It is imperative that the investor understand what he is trying to accomplish in his portfolio before actually implementing an option strategy. Not only should he be cognizant of the factors that go into determining the initial selection of the position, but he must also have in mind a plan of follow-up action. If he has thought out, in advance, what action he will take if the underlying entity rises or falls, he will be in a position to make a more rational decision when and if it does indeed make a move. The investor must also determine if the risk of the strategy is acceptable according to his financial means and objec­ tives. If the risk is too high, the strategy is not suitable. Every serious investor owes it to himself to acquire an understanding of listed option strategies. Since various options strategies are available for a multitude of pur­ poses, alrrwst every money manager or dedicated investor will be able to use options in his strategies at one time or another. For a stock-oriented investor to ignore the potential advantages of using options would be as serious a mistake as it would be for a large grain company to ignore the hedging properties available in the futures mar­ ket, or as it would be for an income-oriented investor to concentrate only in utilities and Treasury bills while ignoring less well known, but equally compatible, alterna­ tives such as GNMAs. 938 Postsaipt 939 Moreover, in today's markets, with options being available on futures, equities, and indices, the strategist in any one field should familiarize himself with the others, because any of them will provide profit opportunities at one time or another. Appendices Strategy Sullllllary Except for arbitrage strategies and tax strategies, the strategies we have described deal with risk of market movement. It is therefore often convenient to summarize option strategies by their risk and reward characteristics and by their market out­ look-bullish, bearish, or neutral. Table A-1 lists all the risk strategies that were dis­ cussed and gives a general classification of their risks and rewards. If a strategist has a definite attitude about the market's outlook or about his own willingness to accept risks, he can scan Table A-1 and select the strategies that most closely resemble his thinking. The number in parentheses after the strategy name indicates the chapter in which the strategy was discussed. Table A-1 gives a broad classification of the various risk and reward potentials of the strategies. For example, a bullish call calendar spread does not actually have unlimited profit potential unless its near-tenn call expires worthless. In fact, all cal­ endar spread or diagonal spread positions have limited profit potential at best until the near-term options expire. Also, the definition of limited risk can vary widely. Some strategies do have a risk that is truly limited to a relatively small percentage of the initial investment-the protected stock purchase, for example. In other cases, the risk is limited but is also equal to the entire initial investment. That is, one could lose 100% of his investment in a short time period. Option purchases and bull, bear, or calendar spreads are examples. Thus, although Table A-1 gives a broad perspective on the outlook for various strategies, one must be aware of the differences in reward, risk, and market outlook when actually implementing one of the strategies. 943 944 TABLE A-1. General strategy summary. Strategy (Chapter) Bullish strategies Call purchase (3) Synthetic long stock (short put/long call) (21) Bull spread-puts or calls (7 and 22) Protected stock purchase (long stock/long put) ( 17) Bullish call calendar spread (9) Covered call writing (2) Uncovered put write ( 19) Bearish Strategies Put purchase ( 16) Protected short sale (synthetic put) (4 and 16) Synthetic short sale (long put/short call) (21) Bear spread-put or call (and 22) Covered put write ( 19) Bearish put calendar spread (22) Naked call write (5) Neutral strategies Straddle purchase ( 1 8) Reverse hedge (simulated straddle buy) (4) Fixed income + option purchase (25) Diagonal spread (14, 23, and 24) Neutral calendar spread-puts or calls (9 and 22) Butterfly spread ( 10 and 23) Calendar straddle or combination (23) Reverse spread ( 13) Ratio write-put or call (6 and 19) Straddle or combination write (20) Ratio spread-put or call ( 11 and 24) Ratio calendar spread-put or call (12 and 24) Risk Limited Unlimited 0 Limited Limited Limited Unlimited 0 Unlimited 0 Limited Limited Unlimited Limited Unlimited Limited Unlimited Limited Limited Limited Limited Limited Limited Limited Limited Unlimited Unlimited Unlimited Unlimited Appendix A Reward Unlimited Unlimited Limited Unlimited Unlimited Limited Limited Unlimited 0 Unlimited 0 Unlimited 0 Limited Limited Unlimited 0 Limited Unlimited Unlimited Unlimited Unlimited Limited Limited Unlimited Unlimited Limited Limited Limited Unlimited 0 Wherever the risk or reword is limited only by the fact that o stock cannot foll below zero in price, the entry is marked. Obviously, although the potential may technically be limited, it could still be quite large if the underlying stock did foll a large distance. APPENDIX B Equivalent Positions Some strategies can be constructed with either puts or calls to attain the same prof­ it potential. These are called equivalent strategies and are given in Table B-1. They do not necessarily have the same potential returns, because the investment required may be quite different. However, equivalent positions have profit graphs with exact­ ly the same shape. Other equivalences can be determined by combining any two strategies in the left-hand column and setting that combination equivalent to the two corresponding strategies in the right-hand column. 945 946 TABLE B-1. Equivalent strategies. This Strategy is equivalent to Call purchase Put purchase Long stock Short stock Naked call write Naked put write Bullish call spread (long call at lower strike/ short call at higher strike) Bearish call spread (long call at higher strike/ short call at lower strike) Ratio call write (long stock/short calls) ... and is also equivalent to ... Straddle buy (long call/long put) Appendix B This Strategy Long stock/long put Short stock/long call (synthetic put) Long call/ short put (synthetic stock) Long put/ short call (synthetic short sale) Short stock/short put Covered call write (long stock/ short call) Bullish put spread (long put at lower strike/ short put at higher strike) Bearish put spread (long put at higher strike/ short put at lower strike) Straddle write (short put/short call) Ratio put write (short stock/ short puts) Reverse hedge (short stock/long calls) or buy stock/buy puts Butterfly call spread Butterfly put spread (long 1 call at each outside strike/ (long one put at each outer strike/ short 2 calls at middle strike) short two calls at middle strike) All four of these "butterfly" strategies are equivalent Butterfly combination Protected straddle write (bullish call spread at two (short straddle at middle strike/ lower strikes/bearish put spread at two higher strikes) long call at highest strike/ long put at lowest strike APPENDIX C Formulae Chapter references are given in parentheses. The following notation is used through­ out this appendix. X = current stock price s = striking price C = call price p = put price r = interest rate t = time (in years) B = break-even point u = upside break-even point D = downside break-even point p = maximum profit potential R = maximum risk potential Subscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. The formulae are arranged alphabetically by title or by strategy. 948 Annualized Risk (Ch. 26) Annualized risk = L INV 360 i 1 Hi where INVi = percent of total assets invested in options with holding periods, Hi length of holding period in days Bear Spread -Calls (Ch. 8) -Puts (Ch. 22) p = Cl - C2 R = s2 - s1 - P B = s1 + P R = P2 - Pl p = S2 - S1 - R B = s1 + P = s2 + Pl - P2 Black Model (Ch. 34): X s C p r Theoretical futures call price= e-rt x BSM[r = 0%] where BSM[r = O) is the Black-Scholes Model using r = 0% as the short-term interest rate Put price = Call price - e-rt x (f - s) where f = futures price current stock price striking price call price put price interest rate time (in years) B u D p R break-even point upside break-even point downside break-even point maximum profit potential maximum risk potential f futures price Appendix C Subscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. The formulae are arranged alphabetically by title or by strategy. Appendix C Black-Scholes Model (Ch. 28) where d1 andd2 ln N() V Delta Bull Spread = = = = = = Theoretical call price= xN(d 1) - se-rtN(d2) ln(x/s) + (r + ½v2)t vTt d1 -v-ft natural logarithm cumulative normal density function annual volatility N(d1) -Calls ( Ch. 7) -Puts (Ch. 22) Butterfly Spread R = C1 - C2 P = s2- s1 - R B = s2 - P = s 1 - c2 + c1 P = P2 -p1 R = s2- s1 - P B = s2- P 949 A butterfly spread combines a bull spread using strikes s1 and s2 with a bear spread using strikes s2 and s3. -if using all calls (Ch. 10) R = c1 + c3 - 2c2 -if using all puts ( Ch. 23) R =PI+ P2 - 2p2 -if using put bull spread and call bear spread ( Ch. 23) p = C2 + P2 - C3 - p 1 950 -if using call bull spread and put bear spread ( Ch. 23) R = P2 + c2 - PI c3 - s3 + s2 Then P = s3 - s2 - R or R = s3 - s2 - P D = s1 + R U = S3-R Combination Buy (Ch. 18) S1 < S2 Out-of-the-money: R = c2 + PI In-the-money: R = c1 + p2 - s2 + s1 D = s1 -P U = s2 + P Combination Sale (Ch. 20) X s C p r Out-of-the-money: P = c2 + PI In-the-money: P = c1 + p2 - s2 + s1 D = s1 -P current stock price striking price call price put price interest rate time (in years) B u D p R break-even point upside break-even point downside break-even point maximum profit potential maximum risk potential f futures price Appendix C Subscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a fonnula. The formulae are arranged alphabetically by title or by strategy. 950 -if using call bull spread and put bear spread ( Ch. 23) R = p2 + c2 - Pl - c3 - s3 + s2 Then P = s3 - s2 - R or R = s3 - s2 - P D = s1 + R U = S3-R Combination Buy (Ch. 18) S1 < S2 Out-of-the-money: R = c2 + Pl In-the-money: R = c1 + p2 - s2 + s1 D = s1 -P U = s2 + P Combination Sale (Ch. 20) Out-of-the-money: P = c2 + PI In-the-money: P = c1 + p2 s2 + s1 D = s1 - P X s C p current stock price striking price call price put price r interest rate t ~ time (in years) f futures price U = s2 + P B u D p R break-even point upside break-even point downside break-even point maximum profit potential maximum risk potential Appendix C Subscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. The formulae are arranged alphabetically by title or by strategy. 950 -if using call bull spread and put bear spread ( Ch. 23) R = P2 + c2 - PI - c3 - s3 + s2 Then P = s3 - s2 - R or R = s3 - s2 - P D =SI+ R U = S3-R Combination Buy (Ch. 18) S1 < S2 Out-of-the-money: R = c2 + PI In-the-money: R = cI + p2 - s2 + sI D = SI -P U = s2 + P Combination Sale (Ch. 20) Out-of-the-money: P = c2 + PI In-the-money: P = cI + P2 - s2 + sI D = sI -P X s C p current stock price striking price call price put price r interest rate t = time ( in years) f futures price U = s2 + P B u D p R break-even point upside break-even point downside break-even point maximum profit potential maximum risk potential Appendix C Subscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. The formulae are arranged alphabetically by title or by strategy. Appendix C Conversion and Reversal Profit (Ch. 27) Conversion: P = s + c - x - p + dividends - carrying cost Reversal: P = x + p - c - s - dividends + carrying cost where 951 . t {srt (simple interest) carrymg cos = s[l- (1 + r)-t] (compound interest, present worth) Covered Call Write (Ch. 2) P=s+c-x B =X-C Covered Straddle Write (Ch. 20) P=s+c+p x B = s - ½P = ½(x + s - p - c) Cumulative Normal Density Function (Ch. 28) Approximation by fifth-order polynomial a= 1- z(l.330274y 5 - l.821256y 4 + l.781478y 3 - .3565638y2 + .3193815y) 1 where y = l + .23164191crl z = .3989423e--0212 Then N(cr) = fa U-a Delta-see Black-Scholes Model Delta Neutral Ratio: -stock versus option (Ch. 6) ifcr>O ifcr Yesterday’s Close, then OBV = Yesterday’s OBV + Today’s Volume • If Today’s Close < Yesterday’s Close, then OBV = Yesterday’s OBV − Today’s Volume • If Today’s Close = Yesterday’s Close, then OBV = Yesterday’s OBV ONE-DAY REVERSAL—See Island Reversal. OPTION—The right granted to one investor by another to buy (called a call option) or sell (called a put option) 100 shares of stock, or one contract of a commodity, at a fixed price for a fixed period of time. The investor granting the right (the seller of the option) is paid a nonrefundable premium by the buyer of the option. OPTIONS RESEARCH, INC.—Founded by Blair Hull, later of Hull Trading Co. The first company to computerize the Black–Scholes Model. ORDER—See Limit Order, Market Order, and Stop Order. OSCILLATOR—A form of momentum or rate-of-change indicator usually valued from +1 to −1 or from 0% to 100%. OVERBOUGHT—Market prices that have risen too steeply and too quickly. OVERBOUGHT/OVERSOLD INDICATOR—An indicator that attempts to define when prices have moved too far and too quickly in either direction, and thus are liable to a reaction. OVERSOLD—Market prices that have declined too steeply and too quickly. PANIC—The second stage of a Bear Market when buyers thin out and sellers sell at any price. The downward trend of prices suddenly accelerates into an almost vertical drop, whereas volume rises to climactic proportions. (See also Bear Market.) PANIC BOTTOM—See Selling Climax. PASSIVE INDEXER—Investor who invests in a major index and holds it through up and down waves. PATTERN—See Area Pattern. PEAK—See Top. PENETRATION—The breaking of a pattern boundary line, trendline, or Support and Resistance Level. PENNANT—A Pennant is a Flag with converging, rather than parallel, boundary lines. (See also Flag.) 612 Glossary POINT AND FIGURE CHART—A method of charting believed to have been created by Charles Dow. Each day the price moves by a specific amount (the arbitrary box size), an X (if up) or O (if down) is placed on a vertical column of squared paper. As long as prices do not change direction by a specified amount (the Reversal), the trend is considered to be in force and no new column is made. If a Reversal takes place, another vertical column is started immediately to the right of the first, but in the opposite direction. There is no provision for time on a Point and Figure Chart. PREMATURE BREAKOUT—A breakout of an Area Pattern, and then a retreat back into the pattern. Eventually, the trend will break out again and proceed in the same direction. At the time they occur, false breakouts and premature breakouts are indistinguishable from each other or from a genuine breakout. PRICE/EARNINGS RATIO—Price of stock divided by earnings (which may or may not be real) to give the P /E ratio. Sometimes an unnatural, or imaginary, number. PRIMARY TREND—See Major Trend. PROGRAM TRADING—Trades based on signals from various computer programs, usually entered directly from the trader’s computer to the market’s computer system. EN: Usually indicates large volume transactions on large baskets of stocks by professional traders. PROGRESSIVE STOP—A stop order that follows the market up or down. (See also Stop.) PROTECTIVE STOP—A stop order used to protect gains or limit losses in an existing position. (See also Stop.) PULLBACK—Return of prices to the boundary line of the pattern after a breakout to the downside. Return after an upside breakout is called a Throwback. PUT—An option to sell a specified amount of a stock or commodity at an agreed time at the stated exercise price. RAIL A VERAGE—See Dow–Jones Transportation Average. RALLY—An increase in price that retraces part of the previous price decline. RALLY TOPS—A price level that finishes a short-term rally in an ongoing trend. RANGE—The difference between the high and low during a specific time period. REACTION—A decline in price that retraces part of the previous price advance. RECIPROCAL, MARKET—See Market Reciprocal. RECOVERY—See Rally. 613Glossary RECTANGLE—A trading area bounded on the Top and the Bottom with horizontal, or near horizontal, lines. A Rectangle can be either a Reversal or Continuation Pattern depending on the direction of the breakout. Minimum Measuring Formula: add the width (difference between Top and Bottom) of the Rectangle to the breakout point. RED PARALLEL—A line drawn parallel to the trendline (Red Trendline) that connects at least two Bottoms. The Red Parallel (basically a Return Line) is started off a high and used to estimate the next high point. RED TRENDLINE—A straight line connecting two or more Bottoms together. To avoid confusion, Edwards and Magee use a red line for Bottom Trendlines and a blue line for Top Trendlines. RELATIVE STRENGTH (RS or RS INDEX)—A stock’s price movement over the past year as compared with a market index (most often the Standard & Poor’s 500 Index). Value below 1 means the stock shows relative weakness in price movement (underperformed the market); a value above 1 means the stock shows relative strength over the one-year period. Equation for Relative Strength: Current S tock Price/Year-Ago Stock Price Current S &P 500/Year-Ago S&P 500 (See also Wilder Relative Strength Index.) RESISTANCE LEVEL—A price level at which a sufficient supply of stock is forthcoming to stop, and possibly turn back for a time, an uptrend. RETRACEMENT—A price movement in the opposite direction of the previous trend. RETURN LINE—See Ascending or Descending Trend Channels. REVERSAL GAP—A chart formation where the low of the last day is above the previous day’s range with the close above midrange and above the open. REVERSAL PATTERN—An Area Pattern that breaks out in a direction opposite to the previous trend. (See also Ascending Triangle, Broadening Formation, Broadening Top, Descending Triangle, Diamond, Dormant Bottom, Double Bottom or Top, Head-and- Shoulders Pattern, Rectangle, Rising or Falling Wedge, Rounding Bottom or Top, Saucer, Symmetrical Triangle, and Triple Bottom or Top.) RIGHT-ANGLED BROADENING TRIANGLE—Area Pattern with one boundary line horizontal and the other at an angle that, when extended, will converge with the horizontal line at some point to the left of the pattern. Similar in shape to Ascending and Descending Triangles, except they are inverted and look like Flat-Topped or Bottomed Megaphones. Right-Angled Broadening Formations generally carry Bearish implications regardless of which side is flat. But any decisive breakout (3% or more) through the horizontal boundary line has the same forceful significance as does a breakout in an Ascending or Descending Triangle. 614 Glossary RIGHT-ANGLE TRIANGLES—See Ascending and Descending Triangles. RISING WEDGE—An Area Pattern with two upward-slanting, converging trendlines. Normally, it takes more than three weeks to complete and volume will diminish as prices move toward the apex of the pattern. The anticipated direction of the breakout in a Rising Wedge is down. Minimum Measuring Formula: a retracement of all the ground gained within the wedge. ROUND LOT—A block of stock consisting of 100 shares of stock. ROUND TRIP—The cost of one complete stock or commodity transaction, that is, the entry cost and the offset cost combined. ROUNDING BOTTOM—An Area Pattern that pictures a gradual, progressive, and fairly symmetrical change in the trend from down to up. Both the Price Pattern (along its lows) and the Volume Pattern show a concave shape often called a Bowl or Saucer. There is no minimum measuring formula associated with this Reversal Pattern. ROUNDING TOP—An Area Pattern that pictures a gradual, progressive, and fairly symmetrical change in the trend from up to down. The Price Pattern, along its highs, shows a convex shape sometimes called an Inverted Bowl. The Volume Pattern is concave shaped (a bowl) as trading activity declines into the peak of the Price Pattern and increases when prices begin to fall. There is no measuring formula associated with this Reversal Pattern. RUNAWAY GAP—A relatively wide gap in prices that occurs in an advance or decline gathering momentum. Also called a “Measuring Gap” because it frequently occurs at just about the halfway point between the breakout that started the move and the Reversal Day that calls an end to it. Minimum Measuring Formula: take the distance from the original breakout point to the start of the gap and add it to the other side of the gap. RUNNING MARKET—A market wherein prices are moving rapidly in one direction with very few or no price changes in the opposite direction. SAUCER—See Rounding Bottom and Scallop. SCALLOPS—A series of Rounding Bottom (Saucer) Patterns where the rising end always carries prices a little higher than the preceding Top at the beginning of the pattern. Net gains will vary from stock to stock, but there is a strong tendency for it to amount to 10%–15% of the price. The total reaction, from the left-hand Top of each Saucer to its Bottom, is usually in the 20%–30% area. Individual Saucers in a Scallop series are normally five to seven weeks long, and rarely less than three weeks. The volume will show a convex or Bowl Pattern. SECONDARY TREND—See Intermediate Trend. SECULAR TREND—A major long-lived trend based in solid economic conditions, as opposed to cyclic or technical. 615Glossary SELLING CLIMAX—A period of extraordinary volume that comes at the end of a rapid and comprehensive decline that exhausts the margin reserves of many speculators or patience of investors. Total volume turnover may exceed any single day’s volume during the previous upswing as Panic Selling sweeps through the stock or commodity. Also called a Clean-Out Day, a Selling Climax reverses the technical conditions of the market. Although it is a form of a One-Day Reversal, it can take more than one day to complete. SEMILOGARITHMIC SCALE—Price or volume scale in which the distance on the vertical axis (i.e., space between horizontal lines) represents equal percentage changes. SENSITIVITY—An index used by Edwards and Magee to measure the probable percentage movement (sensitivity) of a stock during a specified percentage move in the stock market as a whole. EN: More or less equivalent, or with the same intent as beta. SHAKEOUT—A corrective move large enough to “shake out” nervous investors before the Primary Trend resumes. SHORT INTEREST—The number of shares that have been sold short and not yet repurchased. This information is published monthly by the New York Stock Exchange. SHORT SALE—A transaction in which the entry position is to sell a stock or commodity first and to repurchase it (hopefully at a lower price) at a later date. In the stock market, shares you do not own can be sold by borrowing shares from the broker and replacing them when the offsetting repurchase takes place. In the commodity market, contracts are created when a buyer and seller get together through a floor broker. As a result, the procedure to sell in the commodity market is the same as it is to buy. SHOULDER—See Head-and-Shoulders Pattern. SMOOTHING—A mathematical approach that removes excess data variability while maintaining a correct appraisal of the underlying trend. SPIKE—A sharp rise in price in a single day or two. STOCHASTIC—Random. STOCHASTICS—The Stochastic Oscillator, developed by George Lane, compares a security’s price closing level to its price range over a specific period of time. This indicator shows, Lane theorized, in an upward-trending market, prices tend to close near their high; and during a downward-trending market, prices tend to close near their low. As an upward trend matures, prices tend to close further away from their high; as a downward trend matures, prices tend to close away from their low. The Stochastic Indicator attempts to determine when prices start to cluster around their low of the day in an uptrending market, and cluster around their high in a downtrend. Lane theorizes these conditions indicate a Trend Reversal is beginning to occur. The Stochastic Indicator is plotted as two lines, the %D Line and %K Line. The %D Line is more important than the %K Line. The Stochastic is plotted on a chart with values ranging from 0 to 100. The value can never fall below 616 Glossary 0 or above 100. Readings above 80 are considered strong and indicate a price is closing near its high. Readings below 20 are strong and indicate a price is closing near its low. Ordinarily, the %K Line will change direction before the %D Line. However, when the %D Line changes direction prior to the %K Line, a slow and steady Reversal is often indicated. When both %K and %D Lines change direction, and the faster %K Line changes direction to retest a crossing of the %D Line, though does not cross it, the incident confirms stability of the prior Reversal. A powerful move is under way when the Indicator reaches its extremes around 0 and 100. Following a Pullback in price, if the Indicator retests extremes, a good entry point is indicated. Many times, when the %K or %D Lines begin to flatten out, the action becomes an indication the trend will reverse during the next trading range. STOCK SPLIT—A procedure used by management to establish a different market price for its shares by changing the common stock structure of the company. Usually a lower price is desired and established by canceling the outstanding shares and reissuing a larger number of new certificates to current shareholders. The most common ratios are 2-to-1, 3-to-1, and 3-to-2. Occasionally, a higher price is desired and a reverse split takes place where one new share is issued for some multiple number of old shares. STOP—A contingency order placed above the current market price if it is to buy, or below the current market price if it is to sell. A stop order becomes a market order only when the stock or commodity moves up to the price of the buy stop, or down to the price of a sell stop. A stop can be used to enter a new position or exit an old position. (See also Protective or Progressive Stop.) STOP LOSS—See Protective Stop. SUPPLY—Amount of stock available at a given price. SUPPLY LINE—See Resistance. SUPPORT LEVEL—The price level at which a sufficient amount of demand is forthcoming to stop, and possibly turn higher for a time, a downtrend. SYMMETRICAL TRIANGLE—Also called a Coil. Can be a Reversal or Continuation Pattern. A sideways congestion in which each Minor Top fails to attain the height of the previous rally and each Minor Bottom stops above the level of the previous low. The result is upper and lower boundary lines that converge, if extended, to a point on the right. The upper boundary line must slant down and the lower boundary line must slant up, or it would be a variety of a Wedge. Volume tends to diminish during formation. Minimum Formula: add the widest distance within the Triangle to its breakout point. TANGENT—See Trendline. TAPE READER—One who makes trading decisions by watching the flow of New York Stock Exchange and American Stock Exchange price and volume data coming across the electronic ticker tape. TEKNIPLAT™ PAPER—A specially formatted, two-cycle, semilogarithmic graph paper, with sixth-line vertical accents, used to chart stock or commodity prices. Check h t t p : // www.edwards-magee.com. 617Glossary TEST—A term used to describe the activity of a stock or commodity when it returns to, or “tests,” the validity of a previous trendline, or Support or Resistance Level. THIN ISSUE—A stock with a low number of floating shares and is lightly traded. THREE-DAYS-AWAY RULE—An arbitrary time period used by Edwards and Magee in marking suspected Minor Tops or Bottoms. THROWBACK—Return of prices to the boundary line of the pattern after a breakout to the upside. Return after a downside breakout is called a Pullback. TOP—See Broadening Top, Descending Triangle, Double Top, Head-and-Shoulders Top, Rounding Top, and Triple Top. TREND—The movement of prices in the same general direction, or the tendency or proclivity to move in a straight line. (See also Ascending, Descending, and Horizontal Parallel Trend Channels, Convergent Trend, Divergent Trend, Intermediate Trend, Major Trend, and Minor Trend.) TREND CHANNEL—A parallel probable price range centered about the most likely price line. TRENDING MARKET—Price continues to move in a single direction, usually closing strongly for the day. TRENDLINE—If we actually apply a ruler to a number of charted price trends, we quickly discover the line most often really straight in an uptrend trend is a line connecting the lower extremes of the Minor Recessions within these lines. In other words, an advancing wave in the stock market is composed of a series of ripples, and the bottoms of each of these ripples tend to form on, or very close to, an upward-slanting straight line. The tops of the ripples are usually less even; sometimes they also can be defined by a straight line, but more often, they vary slightly in amplitude, and so any line connecting their upper tips would be more or less crooked. On a descending price trend, the line most likely to be straight is the one that connects the tops of the Minor Rallies within it, while the Minor Bottoms may or may not fall along a straight edge. These two lines—the one that slants up along the successive wave bottoms within a broad up-move and the one that slants down across successive wave tops within a broad down-move—are the Basic Trendlines. You draw an Up Trendline by drawing the line on the inner side. You draw a Down Trendline by drawing it on the outside. You draw a Sideways Trendline on the bottom. TRIANGLE—See Ascending Triangle, Descending Triangle, Right-Angled Broadening Triangle, and Symmetrical Triangle. TRIPLE BOTTOM—Similar to a flat Head-and-Shoulders Bottom, or Rectangle, the three Bottoms in a Triple Bottom. TRIPLE TOP—An Area Pattern with three Tops widely spaced and with quite deep, and usually rounding, reactions between them. Less volume occurs on the second peak than the 618 Glossary first peak, and still less on the third peak. Sometimes called a “W” Pattern, particularly if the second peak is below the first and third. The Triple Top is confirmed when the decline from the third Top penetrates the Bottom of the lowest valley between the three peaks. 200-DAY MOVING A VERAGE LINE—Determined by taking the closing price over the past 200 trading days and dividing by 200, then repeating the process each succeeding day, always dropping off the earliest day. UPTICK—A securities transaction made at a price higher than the preceding transaction. UPTREND—See Ascending Trendline and Trend. UTILITY A VERAGE—See Dow–Jones Utility Average. V /D VOLUME—Is the ratio between the daily up-volume to the daily down-volume. It is a 50-day ratio determined by dividing the total volume on those days when the stock closed up from the prior day by the total volume on days when the stock closed down. V ALIDITY OF TRENDLINE PENETRATION—The application of the following three tests when a trendline is broken to determine whether the break is valid or whether the trendline is still basically intact: (1) the extent of the penetration, (2) the volume of trading on the penetration, and (3) the trading action after the penetration. V ALLEY—The V-shaped price action that occurs between two peaks. (See also Double Top and Triple Top.) VINCE, RALPH—Author of Handbook of Portfolio Mathematics where optimal f is described as a quantitative way to achieve optimal allocation and leverage of a portfolio. The Leverage Space Model achieves optimal bet sizing for maximizing gains while minimizing risk. VOLATILITY—A measure of a stock’s tendency to move up and down in price, based on its daily price history over the latest 12-month period. (See Appendix B, Resources, for the formula.) VOLUME—The number of shares in stocks or contracts in commodities traded over a specified period of time. “W” FORMATION—See Triple Top. WEDGE—A chart formation in which the price fluctuations are confined within converging straight (or practically straight) lines. WILDER RELATIVE STRENGTH INDICATOR (RSI)—Although relative strength, comparing a security price to a benchmark index price, has been around for some time, this indicator was developed by J. Welles Wilder, as explained in his 1978 book, New Concepts in Technical Trading. 619Glossary Relative Strength is often used to identify price Tops and Bottoms by keying on specific levels (usually “30” and “70”) on the RSI chart, which is scaled from 0 to 100. The RSI can also be useful to show the following: 1. Movement that might not be as readily apparent on the bar chart. 2. Failure Swings above 70 or below 30, warning of coming Reversals. 3. Support and Resistance Levels appear with greater clarity. 4. Divergence between the RSI and price can often be a useful Reversal indicator. The RSI requires a certain amount of lead-up time to operate successfully. 621 Bibliography Allen, R.C., How to Use the 4 Day, 9 Day and 18 Day Moving Averages to Earn Larger Profits from Commodities, Best Books, Chicago, 1974. Arms, R.W., Volume Cycles in the Stock Market. Market Timing Through Equivolume Charting, Dow Jones- Irwin, Homewood, IL, 1983. Arms, R.W., Jr., The Arms Index, TRlN, Dow Jones-Irwin, Homewood, IL, 1989. Bassetti, W.H.C., StairStops, MaoMao Press, San Geronimo, CA, 2009. Bassetti, W.H.C., Zen Simple Beat the Market with a Ruler, MaoMao Press, San Geronimo, CA, 2009. Bassetti, W.H.C., Sacred Chickens, the Holy Grail and Dow Theory, MaoMao Press, San Geronimo, CA, 2010. Bassetti, W.H.C., Ten Trading Lessons, MaoMao Press, San Geronimo, CA, 2010. Bassetti, W.H.C., Signals, MaoMao Press, San Geronimo, CA, 2011. 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Zweig, M., Winning on Wall Street, Warner Books, New York, 1986. 623 Index A ABC Vending Corp., 455, 576, 579 Absolute certainty, 275 Accelerating Downward Trend, 68 Accumulation, 14, 17, 43, 44, 107, 157, 159, 168, 184, 241, 245, 265, 327, 538, 542, 595 Pattern, 73, 401 Action Industries, 472, 576, 579 Activity, see Volume Acts of God, 12, 248 Acute Triangle, 79–80 Advisors, 252, 268, 310 ADXR Indicator, 595 Agricultural commodity, 247–248 AIQ Trading Expert Pro, 531–532 Amazon, 27, 335–336, 358, 477, 563, 573, 579 AMD, 475, 577, 579 American Locomotive, 63, 163, 433, 566, 570, 575, 580 American Stock Exchange (AMEX), 271, 309, 311, 312, 316, 349, 494, 524 , 616 Apex, 80, 83, 84, 87, 88, 94, 97, 99–100, 122, 128, 142, 145, 153, 201, 203–205, 209, 398–400, 404, 408, 412, 423, 440, 443, 596 Apex of Symmetrical Triangle, 414 Appel, Gerald, 542 Apple Computer Inc (APPL), 135, 366, 478–479, 577 Appreciated portfolio, protecting profits in, 285 –286 Arbitrage, 344, 596 Area Gap, see Common Gap Area Pattern, 8, 90, 145, 176, 184, 186, 198, 202, 221, 261, 264, 319, 423, 439, 596, 601, 604, 605, 611–614, 617–618 Area Reversal Pattern, 599 Arithmetic paper, 8, 229 Arithmetic scale, 8 , 58, 69, 143, 211–216, 596 Arms CandleVolume charting, 551–553 Arms Index, 545, 548–549 Aroon, 538, 542 Aroon Down, 538, 542 Aroon Oscillator, 538 Aroon Up, 538, 542 Ascending Channel, 596 Ascending Formation, 99 Ascending Pattern, 98 –99 Ascending Trend Channels, 596 , 599, 613 Ascending Trendline, 596, 618 Ascending Triangle, 84 –89, 94–95, 97–98, 114–115, 122, 135–136, 141, 147, 161, 166, 177–178, 189, 204, 294, 373–375, 395, 399, 408, 428, 434, 439–441, 465, 472, 596, 613–614 Asset allocation, 275, 278, 280–282, 491 Astrodata Inc. (ADA), 467, 576, 581 At-the-money, 283, 596 Automated trendline, 421–425, 540 Average(s), 4, 17, 19, 26, 41, 50, 99, 106, 112, 135, 145, 151, 181, 313, 347, 393–394, 428, 436, 445, 459, 481, 482, 596, 600 discount, 12 Dow, see Dow averages gaps in, 187 investor, 192 moving, see Moving averages support and resistance in, 206 trendlines in, 243 Average Directional Index (ADX), 538, 542, 595 Average True Range (ATR), 358–359, 538 Averaging Cost, 442, 485, 596–597 Avnet Electronics Corp., 448, 459, 575, 581 Axis, 196, 205, 597 B Balanced program, 481–486, 597 Bandwidth, 538, 598 Bar Chart, 31, 266, 304, 531, 532, 545, 550, 552, 554, 558, 597 Baruch, Bernard, 265 Basic Trendlines, see Trendlines Basing Points (BP), 31–40, 198, 239, 256, 258, 260, 299–300, 308, 314, 326, 328, 340, 357–359, 362–366, 368–370, 404, 414, 480, 504, 506, 574, 581, 597 Basket Trades, 389–390, 597 Bearish Move, 391, 451 Bearish Trend, 310, 482 in Industrial Rayon, 446 in Lorillard, 447 624 Index Bear Market, 13, 15, 225, 242, 264, 293, 299, 386, 413, 481, 509, 511–512, 597, 602, 611 signal, 519–521 Bear Market Bottom in Socony–Vacuum, 89, 109 Bear Market Rallies, 61, 63 rising wedges in, 144 Bear Market Selling Climax, 608 Bear Raiding, 168 Bent Neckline, see Neckline (NL) Bent neckline, 138, 444, 597 Beta, 310, 321, 322, 342–343, 346, 597 coefficient, 597 Bitcoin, 326–328 Black Scholes model, 266, 273, 531 Block Trades, 97–99, 105, 597 Blow-Off, see Climactic Top Blue Chips, 41, 280, 301, 320, 353, 437, 598 Blue Parallel, 373–374, 378–380, 410, 598 Blue Trend, 373, 375–379 Blue Trendline, 373–378, 578, 598 Bollinger Bands (BB), 266, 267, 537, 561–563, 598 Bollinger, John, 533, 561 Bona fide breakout, 600 Bond futures for asset allocation, 280 –282 traders and investors, 496 Book value, 4, 5, 175, 599 Bottom, 599 Kilroy, see Head-and-Shoulders Bottom Patterns, 57, 58, 117, 161, 458 Trendlines, 224, 273, 414 Bou ndar y, 54, 78, 599 Bowl Pattern, see Rounding Bottoms Bracketing, 599 Breakaway gaps, 47, 63, 91, 142, 162, 173–174, 177–182, 186, 202, 254, 258, 410, 412, 417, 423, 470, 599, 607 Breaking neckline, 47–49 Breakout failure, 603 Breakout Gap, 126, 175, 184 signals, 185 “Breakout of dormancy,” 73 Breakouts, 88, 108, 161, 418, 551, 599 decisive, 221, 377, 378 downside, 95, 99, 398, 408 premature, 85, 108 pullbacks, 224 from Right-Angle Triangles, 100 upside, 89, 99, 402, 408 Broadening Bottoms, 135 Broadening Formations, 121–122, 599, 608–609 volume during, 122–128 Broadening Pattern, 604 Broadening Price Formation, 130 –131 Broadening Price Patterns, 121, 122, 126, 131, 136 Broadening Tops, 122, 124, 125, 129, 133, 309, 400, 404, 408, 617 in Dow–Jones Industrial Average, 444 –445 Orthodox, see Orthodox Broadening Top Broad market, 243 Broad market background, 264 Broad Market Trend, 243 Brokerage firms, 270 Brokerage houses, 526–527 Brokers, 145, 146, 268, 269, 313, 347 Brooker, Brian, 27 Brunswick Corporation, 450 , 575, 581 Bullish Market, 321, 460, 481, 483 Bullish Move, 391, 406 Bull Market, 13–19, 23, 70, 226, 241, 264, 293, 299, 396–397, 481, 492, 493, 514, 518, 595, 599, 602 in commodities, 260 dynamic phase of, 157 Primar y, see Primary Bull Market Publicker, 116 Bull Market Advance, 159, 225, 294 Bull Market Concomitants, 159 Bull Market High, 52 Bull Market Peaks, 114 Bull Market Reaction, 219 Bull Market Top, 53, 86, 240 of Head-and-Shoulders Form, 50 Symmetrical Triangle Bottom, 80 Symmetrical Triangle Reversal, 78 in U.S. Steel, 127 in Westinghouse, 96 of Westinghouse Electric, 47 Bull Market Trend, 237 of General Motors, 230 Bull Market Trendlines, 229 Bull signal, 513–514 Bull trap, 139, 148, 326, 327, 420, 473 Bull Trend reaffirmation, 515 –516 Burndy Corporation, 449, 575, 582 Buy-and-Hold investor, 26, 27 Buying at the top, 487 C Call option, 599, 611 Candlestick charts, 7, 8, 182, 266, 267, 553 Candlesticks, 551, 599 Canny investor, 278 CANSLIM system, 316 Capital, 489 application in practice, 491–494 to use in trading, 489 –490 Cash, differences with future transactions, 277 Catastrophic Risk, 503 “Cats and dogs,” 15, 320, 493, 517, 599 Caveats, 330–331 of Moving Averages, 422 CBOT ® DJIASM Index futures, 276, 282 Cerro Corporation, 456, 576, 582 Chaff, 270 Chaikin Money Flow (CMF), 538 Chaikin Oscillator, 538 Chandelier Exit, 359, 537 625Index Chande Trend Meter (CTM), 538 Channel, 599 Chart(s), 157, 197, 261, 267, 269, 304, 505, 599, 605 Ascending Triangle, 399 associated dry goods winds up, 396 Broadening Tops, 400, 408 candlestick, 7, 8, 182, 266, 267, 553 Complex or multiple Head-and-Shoulders, 403 daily chart in Northern Pacific, 412 daily chart of Lehigh Valley R. R, 407 decorating graphic charts, 304 Diamond, 409 Diamond Pattern in American Can, 404 Double Tops and Bottoms, 409 Dow Theory, 393–399 Flags and Pennants, 410–411 Gaps, 411–413 Gulf, Mobile, and Ohio builds beautiful Wedge, 405 Head-and-Shoulders Bottom, 401–403 Head-and-Shoulders Top, 400–401 of New York Central, 175 One-Day Reversals, 410 Pennant in Martin–Parry, 406 Rectangles, 408 –409 Rectangles in Remington Rand, 401 Right-Angled Broadening Formations, 409 Right-Angle Triangles, 408 rounding Bottom in 1945, 397 Rounding Tops and Bottoms, 403 –406 Spiegel’s Bear Market, 262 of stocks, 163 Support and Resistance, 414 Symmetrical Triangle in allied stores, 398 Symmetrical Triangles, 406 –408 Trendlines, 414 trendlines in American steel foundries, 413 types of scales, 8 –9 Wedges, 409–410 wide Descending Triangle of, 262 Chart analysis, 304, 539–540 computer for, 304–305 Chart analysts, 259, 266 Commodity Research Bureau Index, 254 trading futures, 259 –260 Chicago Board of Trade (CBOT ®), 271 Chicago Board Options Exchange (CBOE), 273, 494 Chicago Mercantile Exchange, 276 –277, 312 Chicago, Milwaukee, St. Paul and Pacific, 440 Chrysler, 436 Classical technical analysis, 4 Clean-cut Triangle, 82 Clean-Out Day, see Selling Climax Climactic Top, 597, 600 Climax Day, see One-Day Reversal Climax, Selling, see Selling Climax Close-only charts, 267 Closing gap, 171–173 Closing prices, 18, 600 Closing the gap, 600, 601 Cloud, 269 Coil, see Symmetrical Triangle Colby, Robert, 21 Commission, 600 Commitments, 417–418 Commodity, 276 agricultural, 247–248 market, 615 traders, 298 Commodity Channel Index (CCI), 538 Commodity charts, technical analysis of application of Edwards and Magee’s methods, 252–259 chart analyst trading futures, 259 –260 rocket scientists, 249 –250 Turtles, 250–252 21st-century perspective, 249 variety of methods, 259 Common Gap, 175–177, 184, 596, 600 Comparative relative strength, 600 Complete Basing Points Procedure, 368–370 Complex Formations, 59 Complex Head-and-Shoulders Pattern, 59, 403, 600, 602, 610 EN, 60 ragged Kilroy Bottom, 61 strong movement toward lower interest rates evident, 60 Composite Average, 600 Composite Leverage, 498, 600 Composite Leverage Index, 492, 493 Compound Annual Growth Rates (CAGR), 32 Computer, 265 for charting analysis, 304 –305 technology, 267–268 Computer software packages, 267 Conant, James Bryant, 289 Confirmation, 16–19, 600–601 Congestion, 151, 601 Congestion Formations, 115, 175–176 Conservative investing, 310–311 Consolidating, 151 Consolidation Formation, 110, 151 a, 156 Bull Flag in February and Bear Flag in April 1936 compact type of price “Congestion,” 158 Consolidation Pattern, 167 down-sloping, converging price formation, 157 flag pictures on weekly and monthly charts, 158–159 Flags and Pennants, 151–153 Flag seemed for several weeks, 163 “Half-Mast” Pattern, 161 Head-and-Shoulders Consolidations, 160–162, 164 measuring formula, 154 –156 modern vs. old-style markets, 168–169 rectangular Consolidations, 159 reliability of Flags and Pennants, 156 –157 626 Index Consolidation Formation (Continued) scallops, 162–167 series of Flag-type Consolidations, 159 stock make long series of small Consolidation Patterns, 155 Consolidation Head-and-Shoulders, see Head-And- Shoulders Pattern Consolidation Pattern, 79, 94–97, 156, 161, 167, 190, 392, 600, 601, 604 Consolidations of Rectangle, 159 Construction of index shares and similar instruments, 311–312 Continuation Formation, see Consolidation Formation Continuation Gap, see Runaway Gap Continuation-of-Trend Pattern, 137 Continuation Pattern, see Consolidation Pattern Control Data Corp (CDA), 462, 576, 583 Controlling risk, 351, 499, 503 Convergent Pattern (Trend), 601 Copper Range Co., 452, 576, 583 Coppock Curve, 538 Correction, 601 Corrective trends, 226 –227 Correlation Coefficient, 500, 538 “Cost of carry,” 276–279 Costs, 390 Covering the gap, see Closing the gap “Cradle,” 205, 601 “Cradle point,” 440, 456 Crossovers, 422–424 Crucible Steel Co. of America, 457, 576, 583 Cyber trader, 316 Cyclical approach, 3 D Daily Range, 148, 173, 508, 601 Dampened risks, 313 Danaher Corp., 558 Day-to-day chart analysis, 196 “Day traders,” 31, 166, 168, 298, 302 Day trading, 168, 298 DecisionPoint Price Momentum Oscillator (PMO), 538 Definite warning, 428 Degree of fluctuation, 283, 345 Delaware, Lackawanna And Western, 432 “Delivery,” 276 Dell, 473–474 Delphic Options Research, 523 , 529 Demand, 70, 86, 98, 112, 117, 601 Demand Line, 98, 104, 176, 202 Descending Channel, 601 Descending Trend, 603 Descending Trend Channel, 374 –375, 599, 601, 613, 619 Descending Trendline, 601, 603 Descending Triangle, 92 , 97–99, 122, 136, 175, 294, 408, 601–602, 613–614, 617 Detrended Price Oscillator (DPO), 538 Diagonal Movements, 423 Diamond, 74, 127, 129, 130, 137– 139, 602 Pattern, 610 Reversal Formation, 128, 137–138, 409 DIAMONDS™ (DIA), 271, 274, 299, 312, 317, 323, 350, 351, 390 Directional tendency, 110 Discipline, 260, 287, 501, 542 Dissecting Dow Theory, 499 “Distance away” criteria, 194, 203 Distribution, 43, 44, 117, 136, 168, 602 f requency, 500 Line, 538, 542 Pattern, 90 planned, 98 Distribution period, 15, 17 Divergence, 4, 99, 212, 510, 511, 513, 600–602 definite, 166 negative, 610 Divergent Pattern, 206, 602 Divergent Trend, 617 Divergent Trend Channel, 376, 377, 379 Diverging boundary lines, 100 Diversification, 41, 298, 313, 319, 389, 390, 481–486, 602 Dividends, 23, 194, 277, 294, 297–298, 307, 310–311, 315, 341, 345, 348, 361, 419, 469, 602 Donchian system, 251 Dormant Bottom, 72–74, 602 Double Bottoms, 113–115, 118, 409, 602 Double Top, 103–105, 113–115, 118, 409, 602, 617 at Primary Trend Reversals, 118 Double trendlines, 222 –223, 603 Dow averages, 12 basic tenets, 12–14 major trend phases, 14–16 principle of confirmation, 16 –19 tide, wave, and ripple, 14 Dow Index futures, 277, 287 Dow Industrial Average (DIA), 481 Dow interpretation, 507–508 Dow–Jones Industrial Average (DJIA), 6, 41, 146, 311, 444–445, 454, 486, 600, 603, 606 Dow–Jones Industrial Index differences between cash and futures, 277 Dow Index futures, 277 exercising option, 284 exploiting market reversals, 285 fungibility, 276–277 futures and options, 275 , 284 investment and hedging strategies, 276 investment uses of Dow Index futures, 279 –282 marking-to-market trading, 276 option premiums, 283 options on Dow Index futures, 282 –283 option spreads in high-or low-volatility markets, 286–287 perspective, 287 portfolio yields improvement, 286 627Index profits in rising markets, 284 –285 protecting profits in appreciated portfolio, 285–286 settlement of futures contracts, 276 stock index futures to control exposure to market, 277–278 volatility, 283–284 Dow–Jones Stock Composite, 12 Dow–Jones Transportation Average, 603, 612 Dow–Jones Utility Average, 600, 603, 618 Down Channel, see Descending Channel Down-slanting boundary line, 79 –80 Downtick, 603 Downtrends, 143, 202, 242, 423, 429 Intermediate, see Intermediate downtrends Major, see Major downtrends Primar y, see Primary downtrends Dow principles, 16, 17, 23–24 Dow Theory, 3, 11, 18, 21–23, 28–29, 31, 41, 77, 207, 259, 264, 313, 365, 381, 393–399, 507, 533, 600, 601 in 20th and 21st centuries, 26 –27 Bear Market signal, 519 –521 bull signal, 513 –514 Bull Trend reaffirmation, 515 –516 closing price levels of Dow–Jones Industrial and Rail averages, 509, 510, 511, 512, 514 failure to confirm, 510 –511 final up-thrust, 519 first correction, 514–515 first severe test, 508 –510 five years of Dow interpretation, 507–508 intermediate trend investor, 23 –26 leaving investor in doubt, 23 Rails falter, 516–517 signs of major turn, 511–513 spring of 1946, 517–518 utilization, 507 Dow Theory Line, 151 Dow Theory replacement with John Magee’s Basing Points Procedure Dow-Jones Industrials (1924–1934), 39–40 fractal nature of market, 31 interesting charts ever made of Dow-Jones Industrials, 40 trades made by Magee Basing Points Procedure, 33–37 2008 top in industrials, 38 Drawdown, 498–499, 603 Dreman, David, 280, 496 Dunn and Hargitt, 251 E Eagle-Picher Lead, 436 “Earnest money,” see Futures “margins” Ease of Movement (EMV), 538 Economic tide, 264 Edwards and Magee’s methods, 252–258 stops, 258–259 Electronic marketplaces, 269 Electronic portfolio, 270 Elliott Wave Theory, 6, 528–531 Emotion-driven markets, 266 End Run, 83, 204, 205, 603 Equilibrium Line, 609 Equilibrium Market, 603 Equivolume charting, 550 result, 551–553 technique, 551 Evaluative Index, 397, 448, 482–483 Ex-Dividend, 90, 173, 175, 361, 443, 603 Ex-dividend gaps, 174, 603 breakaway gaps, 177–182 common or area gap, 175–177 continuation or runaway gaps and measuring rule, 182–184 exhaustion gaps, 185–186 two or more runaway gaps, 184–185 Exaggerated leverage, 272 Exception, 381 Exchange-traded fund (ETF), 271 , 317, 322, 603 Exchange Traded Notes (ECNs), 268, 321 Execution of buys, 376–377 Exercise, 283, 325, 603 exercising option, 284 price, 272, 282, 494 Exhaustion Gap, 184, 185–186, 258, 410, 603–604, 607 Experimental lines, 224 Expiration, 271, 284, 604 Exponential Moving Average (EMAs), 422, 537, 542, 609 Exponential Smoothing, 604 “Extent of decline” criterion, 193 Extent of penetration, 221 Extraordinary Risk, 503 F Facebook, 332 Fact chart analysis, 266 Failure to confirm, 510–511, 513–514, 515 Faith, Curtis, 251 Falling Wedge, 132, 139, 142–143, 410, 604 False Breakout, 604, 612 False moves, 48, 66, 81, 89, 108, 179, 487 False Signal, 66, 88, 129, 149, 266, 479, 604 Fan lines, 217, 218, 220, 227, 309, 604 Fan principle, 226–227 Fansteel Metallurgical, 434 , 448, 585 Filling the gap, see Closing the gap Final up-thrust, 519 Finance theory and practice developments in, 271 futures on indexes, 273 –274 MPT, 275 options, 271–272 options on futures and indexes, 274 options pricing models and importance, 273 628 Index Finance theory and practice ( Continued) quantitative analysis, 272 –273 wonders and joys of investment technology, 275 Fin de siècle, 139 First correction, 514–515 First severe test, 508 –510 Five-Point Reversal, see Broadening Pattern Flag-type Consolidation, 411 Flag, 151–159, 258, 410–411, 604 Flag Consolidation, 157, 179, 392, 465 Flag of mid-April, 175 Flat-Topped Broadening Formation, 136–137, 163 Flat-Topped Broadening Pattern, 151 Flat-Topped Price Formation, 177 Floating Supply, 73, 107, 117, 145, 315, 341, 604 Flying Tiger Corp, 471, 586 Force Index, 538 Forecasting methods, 11, 176, 421, 604 Formation, see Area Pattern Formula measurement, 154 –156, 160, 164, 596, 608 Fractal nature of market, 31 Dow-Jones Industrials (1924–1934), 39 interesting charts ever made of Dow-Jones Industrials, 40 trades made by Magee Basing Points Procedure, 33–37 2008 top in industrials, 38 Front-Month, 605 Fundamental analysis, 3, 6, 91, 266, 328, 605 essence of, 528–531 Funds tracking indexes, 603 Fungibility, 276–277 Futures “margins,” 277 Futures contract, 274, 276–277, 282, 283, 349, 494 Futures options, 283, 287, 313 to participate in market movements, 284 price of, 283 Future transactions, differences between cash and, 277 G Gains and losses, percentage, 496 Galbraith, John Kenneth, 326 Gamblers Anonymous, 302 Gaps, 171, 411–413, 423, 605 April–June Rectangle on 1945 chart of “ AW,” 172 in averages, 187 closing gap, 171–173 daily chart of Blaw–Knox, 176 ex-dividend gaps, 174–186 Island “shakeouts, 181 Island in “PA,” 183 Island Reversal, 186–187 monthly chart of Zenith Radio, 175 Panic Declines produce large Runaway Gaps, 178 small Island in right shoulder of Head-and- Shoulders Top, 180 SMC, 180 TLT, 183 Gates, Bill, 244 General Motors, 41, 99, 229, 230, 586, 598 straight-line Bull Market Trend, 230 General Semantics of Wall Street, The, 269 General Steel Industries, Inc. (GSI), 459, 586 Gilt-edged securities, 598 Gimlet-eyed investor, 270 Google, 321, 331, 339, 340, 343, 389, 586 Granite City Steel, 430 – 431, 586 Graph, see Chart “Graphic Stocks,” 437 Great Crash, The (1929), 326 Greenspan, Alan, 248 , 281 H “Hair splitting” theory, 521 “Half-Mast” patterns, 154, 161, 604, 608 Handbook of Portfolio Mathematics (Vince), 618 Head-and-Shoulders Bottom, 55, 57–59, 61–63, 161, 336, 395, 401–403, 587, 605, 607, 608 Head-and-Shoulders Consolidation, 160–162, 164, 605 Head-and-Shoulders Formation, 48, 88, 373 Head-and-Shoulders formula, 100, 162 Head-and-Shoulders Pattern, 47, 137, 241, 392, 414, 454, 605–606, 608, 610, 615 Head-and-Shoulders Reversal Pattern, 211 Head-and-shoulders to Dow Theory, 55 Head-and-Shoulders Top, 44, 45, 46, 48, 54, 57–59, 63, 75, 77, 103, 108, 118, 160, 161 , 180, 198, 202, 241, 247, 294, 357, 394, 400–401, 449, 454, 455, 466, 602, 605, 606, 608, 617 Daily chart of Chicago, 46 hypothetical daily stock chart, 45 starting in March, “HUM,” 46 variations in, 49 –52 Heavy Volume, 355, 356, 363, 398, 402, 435, 605, 606 Hedging, 137, 240, 246, 276, 279, 287, 312, 606 Hedging strategies using CBOT ® DJIASM futures contract, 276 High-risk stocks hope springs eternal, 332 –340 managing tulipomanias and internet frenzies and Bitcoin, 326–328 multitudinous lessons in Microsoft, 326 techniques for management of runaway issues, 328–332 High-volatility markets, option spreads in, 286 –287 Higher priced stocks, 353 Historical Data, 606 Hook Day, 606 Horizontal Channel, 213, 606 Horizontal Congestion Pattern, 178, 189 Horizontal Line Formations, 103 , 207 Horizontal Movements, 423 Horizontal pattern boundary, 177 Horizontal Trendline, 256, 333, 606 Hull, Blair, 267, 531, 611 Hybrid Head-And-Shoulders, 606 629Index I Ichimoku Cloud, 537 I C Industries (ICX), 49 “Ideal” trend, 197 “Implied volatility,” 284 In-the-money, 283 Indexes, 7, 19, 243, 261, 271, 310, 312, 314, 341, 343 funds tracking, 603 futures on, 273 –274 options on futures and, 274 Index funds, 299, 390 Index futures for asset allocation, 280 –282 “Indexing,” 310–311 Index Shares, 302, 310–312, 313, 390, 447 Individual stocks, 26, 41, 55, 112, 145, 146, 206, 243, 342, 447, 454, 484, 493, 495 Industrial Average, 11, 12, 13, 16, 18, 20, 23, 393, 444, 446, 454, 514, 515, 518, 600, 603 Industrial Rayon Corporation, 446 , 587 Inflationary and deflationary movements, 481 , 587 Information revolution, 265–266, 268, 270–271 Initial public offering share (IPO share), 327 –328, 607 Inside Day, 606 Insiders, 41–42, 168, 322, 327, 606 Inspiration Copper, 429 Intel, 319, 474, 475, 587 Intermediate Bottom, 64 , 87, 193, 202, 294, 384, 386, 414 Intermediate downtrends, 225 –226 Intermediate Reversals, 59, 200, 206 Intermediate Support, 197, 198, 226, 384, 385 Intermediate Support Range, 198 Intermediate Swing, 13, 507, 508 Intermediate Tops, 200, 211, 294, 361, 386, 414, 513 Intermediate Trend, 14, 41, 216, 224, 296, 380, 515, 519, 590, 606, 614 investor, 23–26 Intermediate Trendlines, 208 , 226, 229 Intermediate Uptrend, 194, 212, 213, 219, 222, 225 Intermediate Up Trendline (IUT), 52 , 176, 211, 212, 217, 220–221, 224 Internet-age markets, 351 Internet, 265, 268–269, 532 Internet Age, 269, 351, 393, 494 Internet frenzies and Bitcoin, 326 –328 Internet technical analysis sites, 305 , 531–533 Intraday gaps, 173 Inverted Bowl, see Rounding Top Inverted Triangles, 100, 121, 135–136 Investment advancements in investment technology, 271 bond and index futures for asset allocation, 280–282 developments in finance theory and practice, 271–275 finance theory and practice, 271 –275 futures and options on Dow–Jones Industrial Index, 275–287 increasing exposure with futures, 280 investment-oriented sites, 524–527 investment/information revolution tools, 265 portfolio protection, 279 –280 strategies using CBOT ® DJIASM futures contract, 276 uses of Dow index futures, 279 Investor, 297–298, 332, 351 cyber, 270 experienced, 268 gimlet-eyed, 270 long-term, 310–311 modern, 244 private, 312 sophisticated, 302 iPod, 479 Island Congestion, 186 Island Pattern, 147, 186, 187 Island Reversal, 182, 186–187, 607, 611 J Johns-Manville’s Primary Trend Reversal, 79 Jorion, Philippe, 500, 502, 524 July–August Flag, 158–159 K Kaufman’s Adaptive Moving Average (KAMA), 537 Kelly Criterion, 534, 535 Keltner Channels, 537 Key Reversal Days, 147–149 Kilroy bottom, 57–59, 63, 309, 336, 401, 587, 607 Kovner, Bruce, 357, 365 Kresge (S.S.) Co., 196, 437, 588, 591 L Laddering, 607 Lane, George, 615 Lane theorizes, 615 Leisurely pattern, 65 –66 Leverage, 258, 315, 607 Leverage factor, 534–535 Leverage Space Model, 351, 504, 618 Leverage Space Portfolios (LSP), 533–536, 607 Libby, McNeill And Libby, 436 Limit Move, 258, 607 Limit Order, 391, 607, 611 Limit Up, Limit Down, 607 Linear Moving Averages, 422 Line Chart, see Bar Chart Line in Dow Theory, 17–18, 607 Liquidating, 378 –379 Livingston Oil Company (LVO), 464, 588 Logarithmic scale, 211–216, 229, 607 Long-term charts, 9 Long-term investment problem, 293 Long-term investor, 293, 297, 299, 313, 314, 389 strategy and tactics for, 297–298 630 Index Long-term investor (Continued) strategy of, 299–300 viewpoint, 310–311 “Long side” of market, 41 Lorillard, 447, 588 Low-volatility markets, option spreads in, 286 –287 Lower-priced stocks, 353 “Lunatic fringe,” 3 M MacKay, Charles, 325 “M” Formation, 119, 602 Magee-type technical analysts, 266 Magee analyst, 267, 268, 270 Magee chart analysis, 266 , 270, 595 Magee Evaluative Index (MEI), 19, 300, 485–486, 491, 495, 503–504 Magee methodology, 260 Magee’s admonitions, 316 Magee’s Composite Leverage, 499 Magee’s concept of “sensitivity,” 342 Magee’s method, 252–259, 343, 497 Magee’s Sensitivity Index, 342, 354, 497 Magee’s simple-as-pie method, 32 Major Bear Market signal, 393 Major Bear Moves, 159 Major Bear Trend, 157, 226 Major Bull Market, 225 Major Bull trendlines, 241 Major charts, 9 Major Double Tops, 114 Major Downtrend, 242, 428–429, 439, 511–512, 519, 576, 579, 592 Major Market Turn, 60 Major Reversal, 106, 114, 123, 132 –133, 139, 158, 180, 491, 510, 513–514, 604–605 Major Reversal Formation, 66, 114, 123, 186 Major Reversal Patterns, 44, 605 Major Signals, 394 Major Trend, 17–18, 22, 97, 198–199, 212, 225, 229, 242, 296, 314, 356, 380–381, 384, 386, 393, 398, 430, 446, 449, 456, 482, 491, 493, 510, 512, 515, 607, 612 general outline of policy for trading in, 380 –381 of market, 410–411 Major Trend Channels, 242–243 Major trendlines, 227 accelerating uptrend of common stock, 231 Bull Market tops, 240 conservative investment-type utility stock, 232 decurving Major Bull Trend of high-grade preferred stock, 231 high-grade food issues, 236 low-priced building stock, 235 Major Bull Trend, 234 Major Downtrends, 242 Major Trend Channels, 242–243 primary Bear Market, 238 S&P long-term perspective, 239 S&P Reagan Crash, 239 speculative oil stock, 233 steel stocks, 234 straight-line uptrends in investment oil, 233 tobacco stocks, 236 trading Averages in 21st century, 244 trendlines in averages, 243 up-curving trend of speculative motors stock, 230 Major Turn, 121, 167, 226, 242, 290, 483, 487 signs, 511–513 Margin, 88, 108, 145, 147, 221, 223, 274, 276, 342, 345, 367, 445, 492, 495, 535, 607–608 decisive, 48, 57–58, 118, 128 transaction, 346 , 349 use, 345–346 Market, 3, 6, 11, 19, 27, 31, 42, 77, 82, 104–105, 121, 139, 143, 147, 192, 207, 256, 259, 264, 270, 274, 280, 285, 289, 297, 299, 312, 315, 327, 383, 427, 487, 493, 505, 507 Dow-Jones Industrials (1924–1934), 39 exploiting market reversals, 285 fractal nature, 31 indicator, 609 interesting charts ever made of Dow-Jones Industrials, 40 marking-to-market, 269 –270 marking-to-market trading, 276 technical trading effect on market action, 419–420 trades made by Magee Basing Points Procedure, 33–37 2008 top in industrials, 38 Market on Close, 608 Market Order, 297, 328, 608, 611, 616 Market Reciprocal, 497, 608, 612 Market Technicians Association, 499 Market Technicians Association of New York (MTANY), 6 Masonite, 431, 575, 588 Mass Index, 538 Mast, 152, 217, 392, 411, 604, 608 move, 410 Maximum drawdown, 27, 32, 502, 527, 603 Maximum retracement, 502 McClellan Oscillator, 608 McDermott, The Redoubtable Richard, 325 , 528 Measuring Formulae, 608 Measuring Gap, see Runaway Gap Measuring or Half-Mast Patterns, see Flag Measuring rule, 55, 65, 100, 154–155, 182–184, 392 Mechanical Dow Theory, 299 Mechanical systems, 250 , 252, 260, 296, 423 Megaphones, 608, 613 Melon, 194, 609 Memorex Corp. (MRX), 470 Metastock 9.0, 531–532 Mike Moody, 545, 556–561 Mining engineers, 326 631Index Minor Bottom, 88, 91–92, 122–123, 193, 198, 208, 210, 222, 354, 362–363, 373, 378–379, 386, 403, 413, 414, 417, 517, 608–609, 616–617 Minor Bottoms, 123, 208, 222, 361, 363, 373, 386, 413–414, 617 Basing Points, 362–365 Basing Points paradigm, 365 –366 complete Basing Points Procedure, 368 –370 narrative of events in chart, 367–368, 371–372 representative case fully analyzed using wave lows and new highs, 370–371 Variant 2 procedure, 370 Minor Correction, 209, 363, 386 Minor Fluctuations, 13, 74, 77, 99, 129–130, 138, 151, 186, 190 process, 153 Minor phenomena, 202 Minor Reaction, 95 –96, 115, 172, 181, 186, 362, 397, 407, 440, 605 Minor Reversal, 122–123, 155–156 Minor Reversal Areas, 157 Minor Setback, 17, 216, 432, 517 Minor Swings, 186 Minor Top, 79–80, 122, 198, 206, 354–355, 361, 363, 373–374, 378, 385, 414, 439, 444, 513, 616 Basing Points, 362–365 Basing Points paradigm, 365 –366 complete Basing Points Procedure, 368 –370 narrative of events in chart, 367–368, 371–372 representative case fully analyzed using wave lows and new highs, 370–371 Variant 2 procedure, 370 Minor Trend, 13–14, 82, 144, 229, 290, 386, 410, 507, 609 Minor Wave Pattern, 197 Minor Waves, 13, 223, 509 Misconceptions, 198 –200 Model-driven market, 266, 272 “Models,” 266–267, 273 Modern-style markets, 168 –169 Modern era development, 271 Modern Portfolio Theory (MPT), 275, 499 Momentum, 43, 49, 184, 326, 539, 611, 614 Momentum Indicator, 538, 542, 609 Money, 41, 249, 253, 265–266, 270, 272, 283, 299, 332, 348, 489–490, 608 management procedures, 503 –504 management rules, 258 Money Flow Index (MFI), 538 sophisticated risk and, 504 Monthly chart gaps, 171 Moving Average, 421, 424, 537, 539, 609, 610 150-Day Moving Average, 424 200-Day Moving Average Line, 31, 267, 299, 300, 317, 422, 423, 484, 618 50-Day Moving Average Line, 316, 422, 484, 604 crossovers and penetrations, 422 –424 PENTAD Moving Average system from formula research, 424 –425 Sensitizing Moving Averages, 422 Moving Average Convergence/Divergence (MACD), 538, 542–544, 609, 610 Histogram, 538 Moving Average Crossovers, 609 Moving Average Envelopes, 537 Moving Average Line, 422–423, 541, 598, 604, 609, 618 Multicolincarity, 598, 610 Multiple Bottoms, 414, 434 Multiple Formations, 66, 68 Multiple Head-And-Shoulders Pattern, see Complex Head-and-Shoulders Pattern Multiple Tops, 364, 403, 409, 414 Mutual funds, 43, 268, 390, 495 N Narrow Range Day, 610 NASA, 249 National Association of Securities Dealers Automated Quotations (NASDAQ), 19, 316 NASDAQ 100, 312, 480 Natural Hedge, 485, 610 Natural mechanical systems, 260 Natural method, 359, 610 NDX, 480, 577 Near progressive stops, 139 Neckline (NL), 47–49, 57, 597, 610 on multiple head-and-shoulders formations, 61 Ned Davis Research, Inc. (NDR), 424 Negative divergence, 610 Negative Volume Index (NVI), 538 Nelson Freeburg of Formula Research, 424 New commitments, 418 New Concepts in Technical Trading (Wilder), 618 “New Haven Investor,” 298 New York Stock Exchange (NYSE), 4, 269, 300, 311, 313, 316, 341 , 349, 615, 616 NOKIA (NOK), 475 Normal Range for Price, 344 , 346, 354, 497, 610 Normal Uptrend Channel, 141–142 Northrop Aircraft, 438 –439 Number-driven systems, 259 –260 Number-driven technical analysis, 4, 267, 610 Number-driven technical analysts, 266 O Odd lots, 351, 610 Old-style markets, 168–169 Old-time “plunger,” 168 On Balance Volume (OBV), 538, 610–611 One-Day Island Reversal, 607 One-Day Reversal, 42, 144–145, 410, 600, 615 One-Week Reversal, 147, 450, 589 Operational Risk, 501–504 Opportunity vs. Security, 308 Optimal formula, 534, 535 Optimization, 275 632 Index Options, 271–272, 611 on Dow index futures, 282–283 exercising, 284 on futures and indexes, 274 pricing models and importance, 273 spreads in high-or low-volatility markets, 286 –287 as strategic investment, 273 traders, 272 trading, 272 Options Research, Inc, 611 Oracle Corporation, 332, 468, 573, 576, 579 Order, see Limit Order; Market Order; Stop Order Orthodox Broadening Top, 123, 130–135 “Orthodox” investors, 419 Oscillator, 4, 7, 304, 419, 600, 611 Aroon, see Aroon Oscillator Chaikin, see Chaikin Oscillator Out-and-out boardroom gamblers, 168 Out-of-the-money, 283 strike price, 285 Overbought, 611 Oversold market, 486, 611 “Oversold-overbought” indicator, 485, 611 Overtrading, 351, 493, 496–498 P Pacific Coast Options Exchange, 531 Packard–Bell Electronics Corp (PKB), 465 Palm Computing, 327 Panic, 611 decline, 145, 157, 159, 171, 178, 192, 201 phase, 15, 147, 380 Panic Bottom, see Selling Climax Parabolic SAR, 359, 537 Paradigm-setting model, 271 Paradox, 496–498 Parallel Trend Channel, see Descending Trend Channel Parke, Davis and Company (PDC), 466 Passive Indexer, 611 Patience, 265 Pattern analysis, 357 bou ndar y, 203 gaps, 176, 184 resistance, 202–205 Peak, see Top Penetration(s), 422–424, 611 validity, 220–222 Pennant(s), 151–154, 410–411, 611 consolidations, 157 and flags, 608 reliability, 156–157 Pennant Consolidation, 392 PENTAD Moving Average system from formula research, 424 –425 %B Indicator, 538 Percentage Price Oscillator (PPO), 538 Percentage Volume Oscillator (PVO), 538 Performance measurement, 275 Personal body digital assistants (PBDAs), 268 Philosopher’s Stone, 249, 265, 275, 539 Pivot Points, 537, 543 Plain scale, 8 Planned distribution, 98 Point and figure (P&F), 392, 532, 545 analysis, 543 charting, 267, 532, 545, 612 technical analysis by Mike Moody, 556 – 561 Polaroid Corporation, 451 Polymath, 31 Pool operations, 105–112 Portfolio ordinary or operational risk, 502 –503 Portfolio protection, 279–280 Portfolio Risk Analysis screen, 529 , 530 Portfolio Risk Factor (PRF), 502 Portfolio risk management controlling risk, 503 measuring maximum drawdown, 502 overtrading, 496 –498 risk and money management procedures, 503 –504 risk and trend, 499 risk of portfolio, 499 risk of single stock, 498 –499 sophisticated risk and money management procedures, 504 VA R, 499–500 Portfolio Risk Strategy, 496, 497 Portfolio valuation, 275 Portfolio yields improvement, 286 Pragmatic analysts, 275 Pragmatic portfolio analysis, 502 portfolio extraordinary or catastrophic risk, 503 portfolio ordinary or operational risk, 502 –503 portfolio risk over time, 503 Pragmatic portfolio risk measurement, 500 determining risk for portfolio, 501 –502 risk of one stock, 500 –501 Pragmatic portfolio theory, 500 Premature breakouts, 108, 612 Preparatory buying signals, 375 –376 Preparatory selling signals, 379 Price Congestion Formation, 177 “Price–earnings ratio” index, 469 , 612 Price Relative/Relative Strength, 538 Price(s), 196 channels, 537 fluctuation, 261 of futures option, 283 line, 423 pattern, 52, 57, 70, 127, 135, 138, 614 Primary Bear Market, 238 , 242, 243, 507– 508 Primary Bull Market, 21 , 22, 41, 86, 122, 242 Primary Direction, 13 , 355, 363, 380, 381, 383, 385, 386, 391 Primary Downswing, 202 , 242 Primary Downtrends, 15 633Index Primary Market Trend, 26 Primary Reversal phenomenon, 118 Primary trends, 12 –14, 16 Pring’s Know Sure Thing (KST), 538 –539 Pring’s Special K, 539 Probable moves of stocks, 341–344 Profit-taking patterns, 168 Profit analysis, 530 Profits in rising markets, 284 –285 Program Trading, 311, 612 Progressive stop, 328, 355–357, 359, 370, 379, 612 Protective stop(s), 295, 353, 355, 356, 358, 361, 612, 616 Proxy markets, 278 Psychological grounds, 117 Psychological handicap, 293 Public Service Electric and Gas (PEG), 469 Pullback(s), 110, 202, 205, 224, 612, 617 Pullback Rallies, 58 “Pure investor,” 294–295 Put option, 272, 284, 285, 312, 611, 612 Q QID, 350 QQQ, 244, 271, 312, 313, 490 Quantitative analysis, 272 –273 Quantitative analysts, 266 R Rail Average, 513, 603 Rails falter, 516–517 Rally, 612 Rally Tops, 612 Range, 612 Rate of Change (ROC), 539 Reaction, 612 Reciprocal, Market, see Market Reciprocal Recover y, see Rally Recovery Trends, 202 Rectangle(s), 18, 151, 159, 173, 189, 373, 408–409, 606, 608, 613 to Dow Line, 112–113 patterns, 378 from Right-Angle Triangles, 113 in Socony–Vacuum, 106 tops, 103–105 Rectangular Consolidations, 159 Red Parallel, 373, 378, 379, 613 Red Trend, 373, 375, 376, 379, 380 Red Trendline, 373, 376, 377, 613 Relative Strength, 619 Relative Strength Index (RSI), 539, 598, 613, 618–619 Relative Strength Indicator, see Relative Strength Index (RSI) Reliability of flags and pennants, 156 –157 Repeated saucers, 162–167 Resistance, 189, 603, 616 Level, 155, 184, 189, 194, 198, 202, 206, 226 , 246, 613 Lines, 99, 196 Range, 189, 193, 196, 197 Zones, 192, 194, 197, 200, 206 Resources, 523 essence of fundamental analysis, 528 –531 important and indispensable sites, 523 investment-oriented sites, 524–527 leverage space portfolio model, 533 –536 references for further study, 524 Sharpe Ratio, 527 software packages and internet technical analysis sites, 531–533 volatility calculation, 527–528 Retracement, 118, 172, 603, 613 Return Line, 223, 225, 596, 601 Reversal Broadening Bottoms, 135 Broadening Formations, 121–122 The Diamond, 137–139 Falling Wedge, 142–143 Key Reversal Days, 148–149 One-Day Reversal, 144–145 Orthodox Broadening Top, 130–135 Right-Angled Broadening Formations, 135 –137 Rising Wedges common in Bear Market Rallies, 144 Runaway Days, 148 Selling Climax, 145–147 short-term phenomena of potential importance, 147–148 Spikes, 147–148 typical example, 128 –130 volume during broadening formations, 122 –128 wedge formations, 139–142 wedges on weekly and monthly charts, 143 – 144 Reversal Area, 42, 55, 158 Reversal Days, see Key Reversal Days Reversal Formation, 42, 50, 155, 168, 198 Reversal Gap, 613 Reversal Levels, 190 Reversal Pattern(s), 41, 42, 77, 132–133, 493, 602, 613 ADM turned sharply lower, 64 breaking neckline, 47–49 Descending Triangles, 98 –99 distinguishing characteristics, 115 –118 Dormant Bottom variation, 73 –74 Double and Triple Tops and Bottoms, 113–115 Double Bottoms, 118 Dow Theory, 41 fine Symmetrical Triangle Reversal Formation, 78 Head-and-Shoulders Bottoms, 57–59 Head-and-Shoulders to Dow Theory, 55 Head-and-Shoulders Top, 44, 45, 46, 63 “ideal” multiple top made by Budd in (1946), 62 intermediate bottom of complex class, 64 Johns-Manville’s Primary Trend Reversal (1942), 79 leisurely pattern, 65 –66 long multiple head-and-shoulders top, 63 634 Index Reversal Pattern(s) (Continued) MCA enjoyed 62excellent advance from (1980–1986), 62 measuring implications of Triangles, 100 multiple head-and-shoulders patterns, 59 –61 planned distribution, 98 pool operations, 105–112 price action confirmation, 52–55 prices break out of Symmetrical Triangle, 88–90 Rectangles, double and triple tops, 103 –105 Rectangles from Right-Angle Triangles, 113 relation of Rectangle to Dow Line, 112–113 reversal or consolidation, 94 –97 Right-Angle Triangles, 97–98 Rounding Tops and Bottoms, 66 –70 Rounding Turns affect trading activity, 70 –73 Sears Roebuck made Symmetrical Triangle Reversal, 78 slide in Amdahl occupied Bears, 65 Symmetrical Triangles, 79 –88 tendency to symmetry, 61 time to reverse trend, 42 –44 Triangles on weekly and monthly charts, 100 Triangular formations, 100 –101 Triple Tops and Bottoms, 118–120 typical Triangle development, 90 –94 variations in head-and-shoulders tops, 49 –52 volume, 44–45, 47, 74–75, 99–100 Rhythmic investing, 300 –302 Rhythmic Trading, 485 Richard Arms work, 545 Arms CandleVolume charting, 551–553 Arms Index, 545 –548 calculation, 548 Equivolume charting, 550 –551 using index, 548 –549 reasoning, 548 Right-Angled Broadening Formations, 135 –137, 409 Right-Angled Broadening Triangle, 606 , 613 Right-Angle Triangle(s), 97–98, 103, 139, 173, 408, 596, 601 chart, 99 rectangles from, 113 Ripple, 14 Rising Channel, 413 Rising Wedge(s), 139, 141, 143, 614 common in Bear Market Rallies, 144 Risk analysis, 529 management, 495–504 measurement, 502–503 and money management procedures, 503 –504 sophisticated, 504 “Risk-free” interest rate, 273 Rocket scientists, 249 –250 Round-trip costs, 389 Rounding Bottom(s), 66–70, 403–406, 599, 614 Rounding Top(s), 66–70, 403–406, 606, 614, 617 Rounding Turn(s), 66, 68 affecting trading activity, 70 –73 picture, 70 Round lots, 351, 614 RRG Relative Strength, 539 Runaway Days, 147, 148 Runaway Gap, 177, 182–186, 202, 258, 601, 608, 614 Runaway issues, 327 techniques for management of, 328 –332 Runaway or Continuation Gap, 392 Running Market, 614 S Saucer-Like Reaction Pattern, 99 Saucer Pattern, see Rounding Bottoms Scales, types of, 8 –9 Scallops, 162–167, 614 Schadenfreude, 326 Schannep, Jack, 21, 26 Scholes, Myron, 271 Schwager, Jack Secondary Reaction, 13, 18, 357, 493, 515, 516, 517, 519 Secondary Recovery swing, 508 Secondary Trend, see Intermediate Trend Secondary trends, 12 , 13, 17 Secular Trend, 614 “Self-correction,” 197 Selling Climax (SC), 138, 145–147, 190, 201, 600, 611, 615 Selling Climax Day, 615 Selling stock short, 379 Semilogarithmic paper, 8 Semilogarithmic Scale, 8 , 144, 220, 242, 607, 615 Sensitivity, 341, 342, 346, 354, 422, 495, 600, 615 Sensitivity Index, 322 , 342, 345, 346, 353, 492, 497 Sensitizing Moving Averages, 422 Settlement of futures contracts, 276 price, 276, 600 “Settlement date,” 276 Shakeout, 89, 145, 181, 221, 264, 505, 615 Sharpe Ratio, 499, 527 Short-term phenomena of potential importance, 147–148 Short-term profits, 297 Short-term trader, 190, 297, 389, 419 Shorting stocks, 284 Short Interest, 7, 348, 615 Short sale(s), 379–380, 400, 409, 615 Short selling, 145, 346–350, 485 “Short side” of market, 41 Shoulder, see Head-and-Shoulders Pattern “Sideways” chart pattern, 151 Sideways Movements, 423 Simple Moving Averages (SMAs), 422, 537, 549 Single stock risk, 498 –499 Sites, important and indispensable, 523 “Skullduggery,” 168, 169 635Index Skyrocket, 184, 185, 196, 321, 401, 493 effect, 71 run-up of Willys–Overland, 179 Slauson, John, 387 Slope, 539 “Smart money,” 265 Smoothing, 615 Software packages, 305, 531–533 “Special Opening Quotation,” 276 Speculative aims, 245 Speculative blow-offs, 326 Speculative stock, 345, 492 Speculator(s), 3, 145, 149, 274, 286, 293, 297–298, 300 agile, 148 com modit y, 246 psychology, 245 Spiegel’s Bear Market, 262 Spike(s), 147–148, 615 Spring of 1946, 517–518 SPY, see Standard & Poor’s Depositary Receipts (SPDRs) Standard & Poor (S&P), 274, 310–311, 482 Standard & Poor’s Depositary Receipts (SPDRs), 271, 274, 299, 317, 323, 351, 390 Standard Deviation, 539 Statistical approach, 3 Statistical driven technical analysts, 266 Statistics fundamentalists, 4 “Stepping off” point, 417 Stick to guns, 505 –506 Stochastic(s), 542, 615–616 Stochastic Indicator, 615 Stochastic Oscillator, 539, 615 StochRSI, 539 Stock(s), 12, 307, 353, 356, 414, 417, 482 alphabetic index of stock charts, 579 –593 averages, 483 chart, 7 construction of index shares and similar instruments, 311–312 at different times, 427–479 index futures to control exposure, 277 –278 instruments, 313s kinds of stocks long-term investors want, 311 long-term investor’s viewpoint, 310–311 Major Downtrends, 428 –429, 439 NDX, 480 opportunity vs . security, 308 options, 494 prices, 42, 266, 505 probable moves, 341–344 S & P, 308 S&P 500 in glory and tragedy, 309 selection of stocks to chart, 315 –323 SPY. for illustration, 309 trends, 218 StockCharts Technical Rank (SCTR), 539 Stock Exchange vigilance, 168 Stock market(s), 3, 189, 266 fundamentalist, 3 to newcomer, 427 Support–Resistance Level, 430 Stock Split, 616 Stop, 616 Stop Loss, see Protective Stop Stop orders, 353, 611 ATR, 358–359 natural method using by Turtles, 359 progressive stop, 355–357 SAR, 359 stop distances, 354 stop systems and methods, 357–358 survey of stop methods, 358 target stops, 359 Street, 3 Street firms, 325 “Strike” price, 282 Superior Oil Co (SOC), 458 Supply, 616 Supply and demand, 77 balance, 245 equation, 42 relation, 175 Supply Line, see Resistance Support, 189, 603 significance of support failure, 197 –198 Support and Resistance, 383 –387, 410, 414 in averages, 206 estimating support–resistance potential, 194–196 explanation, 191–193 levels, 198, 200, 264 locating precise levels, 196 –197 normal trend development, 190 pattern resistance, 202 –205 popular misconceptions, 198 –200 predictions, 189–190 principle, 189 repeating historical levels, 200 –202 round figures, 200 significance of support failure, 197 –198 t heor y, 202 volume on breaks through support, 205 –206 Support Level, 151, 189, 192, 198, 206, 210, 364, 383, 386, 391, 414, 417, 616 Support Line, 598 Support Range, 189, 192 Support–Resistance Level, 266, 430 Support–Resistance Theory, 224 “Swing” power, 307 , 345 Symmetrical Triangle, 80 , 600 Symmetrical Triangles, 79 –88, 103, 121, 151, 168, 203–205, 406–408, 609, 616 pattern, 603 prices break out, 88–90 T Tactical methods making new commitments, 418 636 Index Tactical methods (Continued) present commitments, 417–418 quick summation, 417 Tactical problem Hudson Motors, 295 long-term investor, 299 rhythmic investing, 300 –302 strategy and tactics for long-term investor, 297–298 strategy of long-term investor, 299–300 “Tangents,” 208 Tape Reader, 9, 166, 616 “Tape watchers,” 163, 166 Target stops, 359 Tax, 313 consequences, 277 selling, 517 Technical analysis, 4–6, 419, 478, 537 Bollinger Bands, 561–563 number driven tools, 537–545 Point & Figure technical analysis by Mike Moody, 556–561 Richard Arms work, 545 –553 and technology, 265–266 Technical chart patterns, measuring implications in, 391–392 Technical data, 6, 227, 528 Technical indicators, 538 –539 Technical Magee analyst and investors, 268 chaff, 270 information revolution, 270 –271 internet, 268–269 marking-to-market, 269 –270 separating wheat from chaff, 270 Technical overlays, 537–538 Technical regularity, 313 Technical trading effect on market action, 419 –420 “Teenie,” 272 TEKNIPLAT chart paper, 305, 443, 616 semilogarithmic chart sheet, 219 –220 Tenets, 12–14, 207, 507, 517 Test(s), 617 of authority, 216–220 Text diagrams, 565–578 Textron, 435, 575, 592 “Theoretical value” of future, 277 Thin Issue, 174, 356, 617 3COM, 319, 327, 331, 579 “Three-days-away” rule, 300 , 328, 361, 369, 414, 617 Throwback(s), 99, 110, 181, 202, 203, 221, 224–225, 612, 617 Tide, 14 Time requiring to reverse trend, 42 –44 scale, 8, 31 TLT chart, 258 Top, 611, 617 Broadening, see Broadening Top Double, see Double Top Head-and-Shoulders, see Head-and-Shoulders Top Rounding, see Rounding Top Triple, see Triple Top Top of Ascending Triangle, 177 Top Price Chart Formation, 598 Top Trendlines, 414, 598, 613 Total Capital (TC), 307, 492 , 498, 502, 503, 504 Total Composite Leverage, 297 Trader(s), 251, 284, 293, 296, 300, 315, 505 Traders, 358 Trades, 33–37, 409 Tradestation 2000i, 532 Tradestation 8, 532 Trading, 4 act ivit y, 17, 44–45, 80, 91, 122, 163, 185, 221, 316, 441, 511, 614 area, 103, 121, 151, 175, 423, 613 averages in 21st century, 244 costs, 390 opportunities, 42 , 163, 266, 475 range, 73, 79, 149, 186, 286, 599, 607, 609, 616 Transportation Average, 596, 600, 603 Treasury bonds, 253, 281 Trend(s), 12, 13, 14, 223, 229, 617 consolidation, 151 ranges, 222–223 and trendline studies, 264 Trend Channels, 214, 215, 223, 242–243, 356, 392, 617 in Bethlehem Steel, 213 Parallel Trend Channel, 373 –375, 378 Rising Trend Channel, 225 Trending Market, 252, 253, 286, 423, 595, 617 Trendline(s), 207–209, 209–211, 414, 429, 597, 616, 617 in action, 375 additional suggestions, 380 amendment of trendlines, 222 analysis, 357 arithmetic vs . logarithmic scale, 211–216 buying stock, 375–377 consequences of Trendline penetration, 224 –225 corrective trends, 226 –227 covering short sales, 379–380 double trendlines and trend ranges, 222 –223 experimental lines, 224 intermediate downtrends, 225 –226 liquidating, or selling long position, 378 –379 policy for trading in Major Trend, 380 –381 selling stock short, 379 tests of authority, 216–220 validity of penetration, 220 –222 Triangular Price Formations, 103 Triangular/Triangle(s), 79–80, 423, 608, 617 development, 90–94, 98 formations, 100–101 measuring implications, 100 patterns, 378 on weekly and monthly charts, 100 Triple Bottom(s), 113–115, 118–120, 617 637Index Triple Top, 103–105, 113–115, 118–120, 504, 568, 617–618 TRIX, 539 True Range, 358, 595 True Strength Index, 539 Tulipomania, 61, 308, 325, 331, 332, 339, 577, 593, 607 managing, 326–328 PALM, 329 Tulips, 241, 325, 329, 331, 339 “Turbulent period,” 485, 486 Twain, Mark, 26–27, 304, 365, 532 Turtle(s), 250–252, 259 natural method using by, 359 system, 258–260 U Ulcer Index, 539 Ultimate Oscillator, 539 United Artist Corporation (UNA), 460 Unnatural method, 610 Up-slanting bottom boundary, 92–93 line, 79–80, 91 Up Channel, 596 Uptick, 349, 350, 618 Up trendline, 208, 209, 210, 211, 216–217, 221, 596 , 617 Uptrends, 14, 104, 153, 158, 208, 212, 219, 225, 233, 422–423, 429, 432 U.S. Securities and Exchange Commission (SEC), 105 , 145, 168, 390 U.S. Smelting, Refining and Mining Co, 453 , 463 a, 428 Head-and-Shoulders Top in (1952) U.S. Steel, 4, 5, 79, 105, 127, 131, 147, 200, 201, 569 Utah–Idaho Sugar Co. (UIS), 461, 576, 593 Utility Average, see Dow–Jones Utility Average V Validity of Trendline Penetration, 618 Valley, 116, 118, 119, 176, 618 Value-at-risk procedure (VAR procedure), 499–500 Variance, 212, 311, 344, 501, 527, 536 Variant 2 procedure, 368, 370 Variations in head-and-shoulders tops, 49 –52 V /D volume, 618 “Vertical” Panic Declines, 157 “Vested interest,” 186, 199, 200, 201, 202 Vigor, 95, 144 , 197, 516 Vince, Ralph, 504, 533, 607, 618 Volatility, 283–284, 343, 354, 498, 500, 501, 528, 539, 618 calculation, 527–528 Volume-Weighted Average Price (VWAP), 538 Volume, 44–45, 47, 108, 193, 194, 264, 595, 616, 618 on breaks through support, 205 –206 during broadening formations, 122 –128 characteristics same as symmetrical type, 99 –100 confirmation, 398, 401, 407, 408, 432, 449 pattern, 46, 47, 57, 59, 63, 64, 67, 74–75, 137, 161, 196, 207, 216, 605, 614 by Price, 537–538, 543 of trading, 67, 193, 197, 221, 618 Vortex Indicator, 539 “Voyeur” feature, 532 W Wall Street investment banks, 325 Wall Street Journal, 11, 12, 243, 312 “Wash sales,” 107 Wave, 14 Wave analysis methods, 260 Wedge(s), 139, 409–410, 618 formations, 139–142 on weekly and monthly charts, 143 –144 Weighted Moving Averages, 422 West Indies Sugar, 437, 575, 593 Westinghouse Electric, 47, 237, 437, 442, 566, 568, 572, 575, 593 “W” Formation, see Triple Top Wide-Ranging Days, see Runaway Days Widening Channel effect, 243 Wilder Relative Strength Index (Wilder RSI), 595 , 610, 618–619 Wieckowicz, R.T., 307 Williams, Larry, 420, 531 Williams %R, 539 World Equity Benchmarks (WEBs), 312 World War II, end of, 515, 516 “W” Pattern, see Triple Top Wright, Charlie, 494 Wyckoff, Richard, 259, 392, 550 Wyckoff’s charts, 531 Y Yahoo! (YHOO), 330, 476, 477, 526, 577, 593 Z Zen, 269 ZigZag, 197, 383, 538 Zone, Resistance, 189, 192–194, 196, 197, 199–200, 202, 206, 387 ================================================================================ SOURCE: eBooks\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf ================================================================================ Robert D. Edwards John Magee W.H.C. Bassetti Routledge Taylor & Francis Croup A PRODUCTIVITY PRESS BOOK Technical Analysis of Stock Trends Eleventh Edition Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Technical Analysis of Stock Trends Eleventh Edition Robert D. Edwards John Magee W. H. C. Bassetti Routledge Taylor & Francis Group A PRODUCTIVITY PRESS BOOK Routledge Taylor & Francis Group 711 Third Avenue, New York, NY 10017 © 2019 by Taylor & Francis Group, LLC Productivity Press is an imprint of Taylor & Francis Group, an Informa business No claim to original U.S. Government works Printed on acid-free paper International Standard Book Number-13: 978-1-138-06941-1 (Hardback) This book contains information obtained from authentic and highly regarded sources. Reasonable efforts have been made to publish reliable data and information, but the author and publisher cannot assume responsibility for the validity of all materials or the consequences of their use. The authors and publishers have attempted to trace the copyright holders of all material reproduced in this publication and apologize to copyright holders if permission to publish in this form has not been obtained. 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Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Library of Congress Cataloguing-in-Publication Data Names: Edwards, Robert D. (Robert Davis), 1893- author. | Magee, John, 1901-author. | Bassetti, W. H. C., author. Title: Technical analysis of stock trends / Robert D. Edwards, John Magee, W.H.C. Bassetti. Description: Eleventh Edition. | New York : CRC Press, [2018] | Revised edition of the authors' Technical analysis of stock trends, c2013. | Includes bibliographical references and index. Identifiers: LCCN 2018010151 | ISBN 9781138069411 (hardback : alk. paper) Subjects: LCSH: Investment analysis. | Stock exchanges--United States. | Securities--United States. Classification: LCC HG4521 .E38 2018 | DDC 332.63/20420973--dc23 LC record available at https://lccn.loc.gov/2018010151 Visit the Taylor & Francis Web site at http://www.taylorandfrancis.com and the Productivity Press site at http://www.ProductivityPress.com 24800.35 25810.43 Low 24741.70 Close 25803 10 Volume 3 30 $ INDU Dow Jones Wuslriai Average inox l2Jifr20i8 ®5tocLCh»rtr com ♦ 108307 («430M) A 08 Apr Jul 24000 23000 22000 21000 Figure 0.1 DOW 25000! What a birthday present for the 11th edition! The Dow continues to set records since March of 2009, as vividly illustrated by this chart. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Contents Preface to the tenth edition Preface to the ninth edition Preface to the eighth edition In memoriam Preface to the seventh edition Preface to the fifth edition Preface to the fourth edition Preface to the second edition Foreword The Dow Theory is not infallible Replacing Dow Theory with John Magee's Basing points Procedure Important Reversal Patterns Important Reversal Patterns: continued Important Reversal Patterns: the Triangles More important Reversal Patterns Other Reversal phenomena Wedges on weekly and monthly charts Which gaps are significant? Support and Resistance Trendlines and Channels Major Downtrends A summary and concluding comments Perspective The all-important details Selection of stocks to chart The probable moves of your stocks What is a Bottom and what is a Top? Use of Support and Resistance Symmetrical Triangles Automated trendline: the Figure 37.26 Weekly, July 1961 through June 1962. This chart shows the Head-and-Shoulders Top Formation in the Industrial Average that preceded the collapse of April, May, and June 1962. Normally, especially in the charts of individual stocks, there would tend to be heavier volume on the left shoulder. The price pattern alone is sufficient to mark the pattern as a dangerously toppy situation. During the entire period in which this formation took shape, many individual stocks representing important companies were showing Top Reversal symptoms, as might be expected. Note, so far as this Head-and-Shoulders Pattern is concerned, the Reversal Signal is not definite until the neckline has been penetrated. Balanced and diversified Portfolio risk management Appendix A: The Dow Theory in practice Appendix B: Resources Appendix C: Technical Analysis beyond Edwards & Magee 09 10 11 12 13 14 IS It 17 List of Illustrations and Text Diagrams Alphabetic Index of Stock Charts Glossary Bibliography Index Range, 189, 193, 196, 197 Contents Preface to the eleventh edition Beyond Edwards & Magee I would be remiss if I did not note the passing of two important figures in the discipline of technical analysis—Richard Arms Jr. and Professor Hank Pruden of Golden Gate University. Well liked and admired they leave large gaps in the community. The article here by Arms is literally his last contribution to the field. Long the central figure in San Francisco, Hank Pruden, much loved and admired leaves the entire field with an enormous gap. He was my particular friend and mentor. He will be infinitely missed. The reader is advised to read the prefaces to previous editions. They are of a piece with the internal text and some practices—of notation and treatment may not make sense otherwise. Those who think gender should be catered to will find my previous comments on that issue. Why repeat it here? Let me address the central question focused on by this new edition: This book has studiously ignored an entire field of technical analysis—number driven and statistical analysis. This has left previous new readers without the guidance they need if they are uneasy with the qualitative method as invented (or discovered) by Edwards & Magee. That lack is resolved by Appendix C. There the new reader will find number-driven material presented from the point of view of an Edwards & Magee analyst. There also the reader will find presentations of tools by their creators—a very special treat, and extremely educational. I venture to say any analyst will have his field of vision broadened by Mike Moody's presentation of Point and Figure charting and the tools of Richard Arms, two prominent analysts for whom many of us, especially we chartists, have not given their work the study it deserves. The list of acknowledgments is as long as a Hollywood awards night. I will shorten it by pointing out previously acknowledged colleagues, assistants, and supporters in previous prefaces. Generally speaking, it is the usual suspects. Some especially merit additional mention here: Nehemiah Brown III, my much-valued and sometime graduate student helps me keep my spreadsheets rational and accurate. My old friend Mark Wainwright (a Tuck graduate) helps me solve technological problems. Part of the pleasure of preparing a new edition comes from interacting with these bright and capable people. I have not mentioned Ralph Vince (a formidable figure) or Chris Glon, Richard Arms, and Mike Moody. My efforts have been made easier by the support of Chip Anderson of stockcharts.com, an invaluable resource. I am also indebted to thinkorswim. If I mention them often it is a measure of their importance to my work— and not a paid promotion. W. H. C. Bassetti San Francisco, California June 15, 2018 Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Preface to the tenth edition A 10th milestone Sixty-three years. Sixty-three years and Technical Analysis of Stock Trends still towers over the discipline of technical analysis like a mighty redwood. An evergreen sequoia. And now a 10th edition. It is a propitious moment to refresh it for the new millennium, to prune its solecisms and obsolescence, and to further develop the sometimes prescient work of its originators. With this premise in mind, I have attempted to make the book shorter, simpler, and more usable in the modern context. I know there are still manual chartists out there. Occasionally they are ecstatic when they find that—as a profit-losing service—I still have TEKNIPLAT™ chart paper in my attic. Like travelers in the desert finding an oasis. But they are the 1%. Everyone else uses software, desktop or internet to do his charting (See note “About Gender” in the Preface to the eighth edition.). So, I have excised the material on manual charting from the new edition. Budding manual chartists may always turn to the eighth and ninth editions. I have also deleted Magee's chapters on “Composite Leverage” (Chapter 42 in the seventh edition, Appendix A in the eighth) as they are abstruse and cumbersome in the modern context—not to mention being rooted in manual chart analysis. I have made every attempt to summarize and replace Magee's work, as I believe it has intellectual validity. Primarily this is done in the present Chapter 42. I repeat, Magee's thinking and practical work predated much modern portfolio management and volatility theory. Additionally, Modern Portfolio Theory has still not caught up to his work on trend analysis and risk. All this material is available in previous editions. I have moved, perhaps, the most difficult chapter in the book, Chapter 4, to Appendix A. Edwards' chapter on the minutiae of the operation of Dow Theory has stopped more than one reader cold. Now it is available to the detail scholar, and the general reader is relieved of the necessity of slogging through it. Many critics deplored Chapter 16 from the seventh edition, which I relegated to an appendix in the ninth edition. This chapter covered an analysis of futures and derivatives using number-driven analysis. Critics said it was shallow. More important, it was completely extraneous to the theme of the book, chart analysis, not the exploration of statistical routines and indicators, which is a different branch of technical analysis. There are numerous books on the subject, starting with Murphy, Kirkpatrick, and Kaufman. I have deleted it along with other material in the book that was not compatible with Edwards and Magee's original intent. I quote here appropriate remarks from the preface to the eighth edition: About apparent anachronisms Critics with limited understanding of long-term trading success may think that discussions of “what happened in 1929” or “charts of ancient history from 1946” have no relevance to the markets of the present millennium. They will point out that AT&T no longer exists in that form, that the New Haven has long since ceased to exist as a stock, that many charts are records of long-buried skeletons. This neglects the value of the charts as metaphor. It ignores their representations of human behavior in the markets which will be replicated tomorrow in some stock named today.com or willtheynevergetit.com. Even more important, it ignores the significance of the past to trading in the present. I cite here material from Jack Schwager's illuminating book, The New Wizards of Wall Street. Schwager, in conversation with Al Weiss: “Precisely how far back did you go in your chart studies?” Answer: “It varied with the individual market and the available charts. In the case of the grain markets, I was able to go back as far as the 1840s.” “Was it really necessary to go back that far?” Answer: “Absolutely. One of the keys in long-term chart analysis is realizing that markets behave differently in different economic cycles. Recognizing these repeating and shifting long-term patterns requires lots of history. Identifying where you are in an economic cycle—say, an inflationary phase versus a deflationary phase—is critical to interpreting the chart patterns evolving at that time. Identification of original manuscript and revisions True believers (and skeptics) will find here virtually all of the original material written by Edwards and Magee, including their charts and observations on them. Changes and comments introduced by editors since the fifth edition have been rearranged and, when appropriate, have been identified as a revision by that editor. Maintaining this policy, where updates to the present technological context and market reality were necessary, the present editor has clearly identified them as his own work by beginning such annotations with “EN” for Editor's Note. (The eighth edition was the first to use editor's notes. Editor's notes for the ninth edition are identified as EN9, and notes added for the present edition are identified as EN10). So, we have here a simpler, shorter, clearer edition of the famous book— easier to read, easier to understand, and easier to use. None of the considerable virtues of the book have been affected. I have attempted to add to these virtues with my work on Magee's Basing Points Procedure (see Chapter 28, 28.1, and 28.2) and portfolio control and risk (see Chapter 42). In spite of my remarks, I have listened to critics of the hand-drawn charts in this book. These charts are the glory of the book and of the discipline of technical analysis. Their application to modern markets seems ridiculously obvious to me—and I am perhaps a dinosaur. So, I have decided to take a number of examples of the manual charts and post them at http://www.edwards-magee.com along with the same data charted by computer so skeptics can compare the two methods. These will be found at http://www.edwards-magee.com/manualcharts.html. The internet so extends one's capabilities and is so easy to use that it would be irresponsible not to avail oneself. In Figures 9.2 and 9.3, I have printed charts that demand— scream—to be viewed in a larger format. These will be found at http://www.edwards-magee.com/supercharts.html. The reader is urged to read the prefaces to the eighth and ninth editions. I have not repeated here all the editorial conventions detailed in those prefaces. W. H. C. Bassetti San Francisco, California Acknowledgments for the tenth edition So many colleagues and friends contribute to a book like this that one is in danger of getting into the Academy Awards syndrome—endless thank yous and acknowledgments until they bring out the hook and pull you off stage. So, I will not thank my parents and aunts and uncles and wife and family, although they should be and by this mention are thanked. More particularly, acknowledgments are due to my editorial and research assistant, Carlos Bassetti. My colleagues at Golden Gate University (GGU) are an invaluable source of advice, wisdom, and support, particularly Professor Henry Pruden. It is no mystery why he is internationally known and respected—besides being a world authority on Wyckoff. GGU has also furnished me with an unending supply of bright, formidable graduate students who have made major contributions to my work and to my thinking. Nehemiah Brown does his best to keep me semi-organized as to spreadsheets. Matt Mullens and Brian Brooker have assisted me with many of the Basing Point studies herein. Stergios Marinopoulos has stimulated and challenged me in my systems work. All these people are members in the local technical analysis fraternity and our much-valued organization, the Technical Securities Analysts Association of San Francisco. More remote colleagues have also assisted me in many invaluable ways— Jack Schannep with Dow Theory data, Robert Colby, also with Dow data; Tim Knight with Prophet data (now part of http://www.thinkorswim, http://www.tdamertrade.com), Chip Anderson at http://www.stockcharts.com, and Scott Brown of Metastock for support with charting software. I am indebted to Ralph Vince and Nelson Freeburg for material found herein that increases the value of this book. And finally, amigo Frangaise, and fellow chart enthusiast Chris Glon at http://www. publicharts.com, for his charts, assistance, and friendship. He has supplied some of the most interesting charts in this book. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Preface to the ninth edition Warp speed universe. Warp speed financial markets. The eighth edition of this classic book appeared when it seemed the millennium and paradise had been achieved and that, like Mackay's Tulipomania, the price of stocks would rise forever and men would rush from the world over and pay whatever price was asked for what-was-its-name.com, internet groceries, or ihype.com or icon.com or gotcha.com. and, feature this, Dow 36,000. The bubble was just in the process of bursting, of course. Before it burst, fabulous fortunes were made by roller blader and scooter tycoons and by young geeks with nothing but chutzpah and a laptop. One of my favorite stories is of the young entrepreneur who said, “Why don't I deserve it (the $100 million he made in the IPO)? I've devoted three years of my life to this project.” He is now dead. Now, many of those people are in prison and the hangover lingers on along with lying, cheating, and stealing on all sides. From Enron to Arthur Anderson, billions, if not trillions, fell into a black hole. As all this developed, I warned of the impending collapse in the John Magee Investment Letters on the web. There was nothing magical or brilliant about seeing what was going on; perspective and perception came from applying the lessons taught in this book by Edwards and Magee. Like Benedict XVI (in a different area), I am a humble worker in their vineyard. I press on attempting to modernize (where necessary) and extend their work, fit it to the modern situation, and make it even more useful to current day traders and investors. In this ongoing labor of love, I have been immeasurably assisted by my graduate students and colleagues at Golden Gate University in San Francisco. In constant interaction with them I have been stimulated to see important aspects of Edwards and Magee's work and develop and emphasize these elements in my teaching and in this new edition. Specifically, both long-term and short-term traders will find important new material in this edition. In my graduate seminars, I have seen the power of what Magee called the “Basing Points Procedure” and so have extended the treatment of this material. My interest in, and respect for, Dow Theory has recently increased as the result of a paper done with Brian Brooker for the Market Technicians Association (“Dissecting Dow Theory”). Material from that paper will be found in this edition. Short-term traders and futures speculators will appreciate extensive new material on commodity trading. These traders have been entirely too influenced by mechanical number- driven systems of recent years and need to restore perspective by mastering the material of this book. It was never the intent of this book to forecast or analyze current markets; rather, its purpose was, and is, to learn from history and the past to better deal with the present and the future. Current markets are analyzed (and forecast?) at the John Magee website. Nonetheless, the very process of keeping current involves picturing issues and instruments in play. The major indexes themselves in 2005 are in play, along with gold, silver, and oil. We don't know how they will pan out, but we can make an analysis with the data we have, for this is the situation the analyst is faced with every day. He doesn't know how it will turn out, but, by following the methods and principles taught in this book, he can put himself on the right side of the probabilities. This is no idle remark. The power and effectiveness of classical chart analysis can be seen by examining how it performed in the past at critical times. At the John Magee Technical Analysis website, the following comment was made in January 2000: Dow: The Dow can expect to find support at 10000 and is buyable, but in small commitments or portions of a portfolio or additions thereto. We expect to see it in a very large see saw from 9-12000 for some time and would hedge at the high end and increase commitments and lift hedges on oversold conditions at the low end. In November 2000, the following comment was made: November 18, 2000 There is really only one chart pattern of significance in these markets, and that is the big one, more than 12 months long now, and the pattern is a big serpent, whipping back and forth and, as Shakespeare said, signifying nothing. Nothing that is but more of the same. How will we know when it signifies something? Well, we won't really know till we know, but we'll let you know when we know. So, we would continue to pick likely shorts and employ short term trading strategies for traders, and hedge at interim tops and lift the hedges at bottoms. Based on the chart picture and last week's anemic behavior, we would not trade for bounces in the NASDAQ. If anything, it is a short, but a risky one. These past letters, dramatically illustrating the effectiveness of the methods of this book, may be found online through links at the address specified below. Your editor, personally, is not a genius for having made these analyses. It is the method which is to credit, and any number of my graduate students can make the same analyses, as can any alert chart analyst. The reader should not skip the prefatory material to the eighth edition. The same practices outlined there have been followed in this edition. Magee said the reader should not skim through this book and put it on his library shelf. Instead, it should be read and reread and constantly referred to and so the reader should, yes, so he should. Richard Russell, the dean of Dow Theory Analysts, has reportedly said the price of the Dow and the price of gold will cross in coming years. He has also remarked that the S&P appears to evince a 10-year head-and-shoulders pattern. Robert Prechter believes we are at the crest of the tidal wave and the tsunami cometh. Dow 36,000. Dow 3,000. This book contains the best tools to cope with whatever the future holds. W. H. C. Bassetti San Francisco, California May 1, 2005 A special note concerning resources on the Web In the age of instant and easy (and free) access to information on the internet, it would be foolish to ignore the opportunities available to interact with the material of this book. The reader will find free materials that augment the book at http://www.edwards-magee. com. For example, when the reader learns in Chapter 28 of the Basing Points Procedure, he will be able to go to the website and print out a PDF of material that he can place beside Figure 28.1 for instant and easy cross-reference, instead of having to turn pages constantly back and forth from the chart to the keys and commentary or having to bend the book into pretzels at a copy machine. In general, wherever references are made in the text to the website, it is for this purpose, to give the reader easy and flexible usage of the material. And, likewise, at this address the reader will find links to past letters that show how the method functioned in real time in real markets. A special note about Dow Theory Senator Everett Dirkson said one time that trying to get U.S. senators herded together and moving in one direction was like trying to transport bullfrogs in a wheelbarrow. Trying to synchronize the signals of the various Dow Theory analysts is a similarly challenging proposition. No Ayatollah exists to issue the final fatwa as to whether the signal is valid. Always one to abhor a vacuum, I have organized a committee at Golden Gate University to evaluate pronouncements of signals and opine as to whether the signals are valid. This committee died an unnatural death, unfortunately, for lack of demand as to its expertise. Acknowledgments for the ninth edition For professional assistance: Jack Schannep, Robert W. Colby, Curtis Faith, Greg Morris, John Murphy, Tim Knight, and Chi Huang. For assistance at Taylor and Francis: Richard O'Hanley, Raymond O'Connell, Pat Roberson, Andrea Demby, and Roy Barnhill. For research assistance and manuscript preparation: Brian Brooker and Grace Ryan, my fearsomely bright and efficient teaching and research assistants. And my inimitable technical assistant, Samuel W. D. Bassetti. At Golden Gate University for ongoing support and assistance: Professor Henry Pruden, Barbara Karlin, Janice Carter, Tracy Weed, and Cassandra Dilosa. Special appreciation goes to makers of software packages and their supportive executives for software used in the preparation of this and previous editions: John Slauson Adaptick 1082 East 8175 South Sandy, UT 84094 http://www.adaptick.com Steven Hill AIQ Systems P.O. Box 7530 Incline Village, NV 89452 702- 831-2999 http://www.AIQsystems.com Alan McNichol Metastock Equis International, Inc. 3950 S. 700 East, Suite 100 Salt Lake City, UT 84107 http://www.equis.com Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Preface to the eighth edition Here is a strange event—a book written in the mid-20th century retains its relevancy and importance to the present day. In fact, Technical Analysis of Stock Trends remains the definitive book on the subject of analyzing the stock market with charts. Knock-offs, look-alikes, and pale imitations have proliferated in its wake like seagulls after a productive fishing boat. But the truth is they have added nothing new to the body of knowledge Edwards and Magee originally produced and Magee refined up to the fifth edition. What accounts for this rare occasion of a book's passing to be a classic? To be more, in fact, than a classic, to be the manual or handbook for current usage? To answer this question, we must ask another: What are chart formations? Chart formations identified and analyzed by the authors are graphic representations of unchanging human behavior in complex multivariate situations. They are the depiction of multifarious human actions bearing on a single variable (price). On price, converge a galaxy of influences: fear, greed, desire, cunning, malice, deceit, naivete, earnings estimates, broker need for income, gullibility, professional money managers' need for performance and job security, supply and demand of stocks, monetary liquidity and money flow, selfdestructiveness, passivity, trap setting, manipulation, blind arrogance, conspiracy and fraud and double dealing, phases of the moon and sun spots, economic cycles and beliefs about them, public mood, and the indomitable human need to be right. Chart formations are the language of the market, telling us that this stock is in its death throes; that stock is on a rocket to the moon; that a life and death battle is being waged in this issue; and in that other, the buyers have defeated the sellers and are breaking away. They are, in short, the inerasable fingerprints of human nature made graphic in the greatest struggle in human experience, next to war. As Freud mapped the human psyche, so have Edwards and Magee mapped the human mind and emotions as expressed in the financial markets. Not only did they produce a definitive map, they also produced a methodology for interpreting and profiting from the behavior of men and markets. It is difficult to imagine further progress in this area until the science of artificial intelligence, aided by yet unimaginable computer hardware, makes new breakthroughs. If it is definitive, why offer a new edition? Unlike Nostradamus and Jules Verne (and many current investment advisors), the authors did not have a crystal ball or a time machine. Magee did not foresee the electronic calculator and made do with a slide rule. And while he knew of the computer, he did not anticipate that every housewife and investor would have 1,000 times the power of a Whirlwind or Univac I on his (her) desk (cf., “About Gender”). In short, the March of Time. The Progress of Science. The Inexorable Advance of Technology. Amazingly, the great majority of this book needed no update or actualization. Who is to improve on the descriptions of chart formations and their significance? But insofar as updates are necessary to reflect the changes in technology and in the character and composition of the markets, that is another story. Human character may not change, but in the new millennium, there is nothing but change in the character and composition of the markets. And while regulatory forces might not be completely in agreement, the majority of these changes have been positive for the investor and the commercial user. Of course, Barings Bank and some others are less than ecstatic with these developments. The most important additions to this book to reflect changes in the times, technology, and markets Generally speaking, these additions, annotations, and updates are intended to inform the general reader of conditions of which he must be aware for investing success. In most cases, because of the enormous amount of material, no attempt is made to be absolutely exhaustive in the treatment of these developments. Rather, the effort is made to put changes and new conditions in perspective and furnish the investor with the resources and proper guide to pursue subjects at greater length if desired. In fact, an appendix has been provided, entitled Resources (EN10: now Appendix B), to which the reader may turn when he has mastered the material of the book proper. The stubborn individualist may realize investment success with the use of this book alone (and paper, pencil, ruler, and chart paper [cf., Section on TEKNIPLAT™ chart paper]). Technology In order to equip this book to serve as a handbook and guide for the markets of the new millennium, certain material has been added to the text of the fifth and seventh editions. Clearly, the astounding advances in technology must be dealt with and put in the context of the analytical methods and material of the original. To achieve success in the new, brave world, an investor must be aware of and utilize electronic markets, the internet, the microcomputer, wireless communications, and new exchanges offering every kind of exotica imaginable. The advanced investor should also be aware of and understand some of the developments in finance and investment theory and technology—the Black- Scholes Model, Modern Portfolio Theory, Quantitative Analysis. Fortunately, all these will not be dealt with here because, in truth, one intelligent investor with a piece of chart paper, a pencil, and a quote source can deal with the markets, but that is another story we will explore later in the book. Some of these germane subjects will be discussed sufficiently to put them in perspective for the technical analyst, and then guides and resources will be pointed out for continued study. My opinion is that the mastery of all these subjects is not wholly necessary for effective investing at the private level. What need does the general investor have for an understanding of the Cox-Ross-Rubinstein (CRR) options analysis model to recognize trends? The Edwards-Magee model knows things about the market the CRR model does not. Trading and investment instruments The new universe of available trading and investment instruments must be taken into account. The authors would have been in paradise at the profusion of alternatives. In this future world, they could have traded the Averages (one of the most important changes explored in this book); used futures and options as investment and hedging mechanisms; practiced arbitrage strategies beyond their wildest dreams; and contemplated a candy store full of investment products. The value and utility of these products would have been immeasurably enhanced by their mastery of the charting world of technical analysis. As only one example, one world-prominent professional trader I know has made significant profits selling calls on stocks he correctly analyzed to be in down trends, and vice versa— an obvious (or, as they say, no-brainer) to a technician, but not something you should attempt at home without expert advice. Techniques like this occasioned the loss of many millions of dollars in the Reagan Crash of 1987. Changes and developments in technical analysis Have any new chart patterns (that is to say, changes in human behavior and character) emerged since the fifth edition? Not to my knowledge, although there are those who take the same data and draw different pictures from them. How else could you say that you had something new! different! better!? There are other ways of looking at the data that are interesting, sometimes valuable, and often profitable, which goes to prove that many are the ways and gateless is the gate to the great Dow. Point and figure charting have been used very effectively by traders I know, and candlestick charting depicts data in interesting ways. Furthermore, since Magee's time, aided by the computer, technicians have developed innumerable, what I call, number-driven technical analysis tools: (the puzzlingly named) stochastics, oscillators, exponential and other moving averages, etc., etc., etc. It is not the intent of this book to explore these tools in depth. That will be done in a later volume. These concepts are briefly explored in an appendix (Appendix C, 8th edition) supplied by Richard McDermott, editor of the seventh edition. I have also made additions to the book (see Chapter 18) to give a perspective on longterm investing, since Magee specifically addressed the second part of the book (on tactics) to the speculator. I have substantially rewritten Chapters 24 and 42 to reflect current ideas on portfolio management and risk management. I have expanded on the idea of rhythmic trading—an idea which is implicit in the original. I have expanded the treatment of runaway markets so the internet stocks of the 1990s might be put in perspective (see Chapter 23). And then, paradigms. Paradigms, as everyone should know by now, are the last refuge of a fundamentalist when all other explanations fail. Paradigm changes Whenever the markets, as they did at the end of the 20th century, depart from the commonly accepted algorithms for determining what their prices ought to be, fundamentalists (those analysts and investors who believe they can determine value from such fixed verities as earnings, cash flow, etc.) are confronted with new paradigms. Are stock prices (values) to be determined by dividing price by earnings to establish a reasonable price/earnings (p/e) ratio? Or should sales be used, or cash flow, or the phases of the moon, or—in the late 1990s—should losses be multiplied by price to determine the value of the stock? Technicians are not obliged to worry about this kind of financial legerdemain. The stock is worth what it can be sold for today in the market. The crystal ball Investors will get smarter and smarter, starting with those who learn what this book has to say. The professionals will stay one step ahead of them because they are preternaturally cunning and spend all their time figuring out how to keep ahead of the public, but the gap will narrow. Software and hardware will continue to advance, but not get any smarter. Mechanical systems will work well in some areas, yet not in others. Mechanical systems are only as good as the engineer who designs them and the mechanic who maintains them. Buying systems is buying trouble. Everyone should find his own method (usually some variant of the Magee method, in my opinion). All good things will end; all bad things will end. The bag of tricks with which the insiders bilk the public will get smaller and smaller. New and ingenious procedures will be developed by the insiders. The well of human naivete is bottomless. For every one educated, a new one will be born in a New York minute. It is deeply disturbing at the turn of the century that the owners of the NASDAQ and the NYSE should be thinking of going public. Could there be any more ominous sign that enormous changes are about to occur? Vigorous development of the systems, methods, procedures, and philosophy outlined in this book is about the only protective shield I know of to guard against inimical change. W. H. C. Bassetti San Geronimo, California January 1, 2001 About the editorial practices in this eighth edition Needless to say, one approaches the revision of a classic work with some trepidation. Every critic and reader has his or her (cf., “About Gender”) opinion as to how revision should be done—whether the authors' original text should be invisibly changed as though they had written the book in 2000 instead of 1948 and were omniscient, or whether errors and anachronisms were to be lovingly preserved, or footnoted, or ... etc., etc. (I have preserved Magee's favorite usage of “etc., etc., etc.” against the protestation of generations of English composition teachers because I like its evocation of an ever-expanding universe.) Notwithstanding every reader having an opinion, I am certain all critics will be delighted with the practices followed in this third millennium edition of the most important book on technical analysis written in the second millennium. Integrity of the original text By and large, the fifth edition has been the source of the authors' original text. Amazingly, almost no stylistic or clarifying emendation has been necessary to that edition. This is a tribute to the clarity, style, and content of the original—one might almost say awesome if the word were not in such currency on “Saturday Night Live” and the Comedy Central. Considering its complex subject was written in the middle of the last century and the markets were one-tenth of their present complexity, awesome may be the appropriate word. No change or update has been necessary to the technical observations and analysis. They are as definitive today as they were in 1950. While I have preserved the authors' original intent and text, I have taken the liberty of rearranging some of the chapters. Novices wishing to learn manual charting will find the appropriate chapters moved to appendices at the back of the book, along with the chapters on Composite Leverage and Sensitivity Indexes. About apparent anachronisms Critics with limited understanding of long-term trading success may think that discussions of “what happened in 1929” or “charts of ancient history from 1946” have no relevance to the markets of the present millennium. They will point out that AT&T no longer exists in that form, that the New Haven has long since ceased to exist as a stock, that many charts are records of long-buried skeletons. This neglects the value of the charts as metaphor. It ignores their representations of human behavior in the markets which will be replicated tomorrow in some stock named today.com or willtheynevergetit.com. Even more important, it ignores the significance of the past to trading in the present. I cite here material from Jack Schwager's illuminating book, The New Wizards of Wall Street. Schwager, in conversation with Al Weiss: “Precisely how far back did you go in your chart studies?” Answer: “It varied with the individual market and the available charts. In the case of the grain markets, I was able to go back as far as the 1840s.” “Was it really necessary to go back that far?” Answer: “Absolutely. One of the keys in long-term chart analysis is realizing that markets behave differently in different economic cycles. Recognizing these repeating and shifting long-term patterns requires lots of history. Identifying where you are in an economic cycle—say, an inflationary phase versus a deflationary phase—is critical to interpreting the chart patterns evolving at that time.” Identification of original manuscript and revisions True believers (and skeptics) will find here virtually all of the original material written by Edwards and Magee, including their charts and observations on them. Changes and comments introduced by editors since the fifth edition have been rearranged, and, when appropriate, have been identified as a revision by that editor. Maintaining this policy, where updates to the present technological context and market reality were necessary, the present editor has clearly identified them as his own work by beginning such annotations with “EN” for Editor's Note. Figure insertions are identified as “x.1, x.2.” Absolutely necessary revisions Not too long ago my youngest son, Pancho, overheard a conversation in which I referred to a slide rule. “What's a slide rule, Dad?” he asked. Well, needless to say the world has, in general, moved on from the time of Edwards and Magee when instead of calculators we had slide rules. Where time has made the text useless, moot, or irrelevant, that problem has unobtrusively been corrected. Where the passage of time has made the text obsolete, I have either footnoted the anachronism and/or provided a chapter-ending annotation, which are marked in the text with “EN.” It is absolutely essential to read the annotations; failure to do so will leave the reader stranded in the 20th century. In some cases, these annotations amount to new chapters—for example, trading directly in the averages was difficult in Magee's time. Nowadays, if there is not a proxy or option or index for some Index or Average or basket of stocks, there will be one in less than a New York minute (which, as everyone knows, has only 59 seconds). This new reality has resulted in major additions to this new edition, which are detailed in the Foreword. Major chapter additions necessary to deal with developments in technology and finance theory have been clearly identified as this editor's work by designating them as interpolations, viz., Chapter 18 (with the exception of Chapter 23, which I have surreptitiously inserted). Absolutely necessary revisions that arose in the 30 minutes since this editorial note was written In a number of instances, the book relayed information that, in those days of fixed commissions and monopolistic control by the existing exchanges, remained valid for long periods of time; for instance, brokerage commissions and trading costs. It is no longer possible to maintain such information in a printed book because of the rate of change in the financial industry. It must now be filed and updated in real time on the internet. Consequently, readers will be able to refer to the internet for this kind of ephemeral data. The general importance of the ephemera to the subject is always discussed. About gender I quote here from my foreword to the second edition of Magee's General Semantics of Wall Street (charmingly renamed according to the current fashions, Winning the Mental Game on Wall Street): About Gender in Grammar Ich bin ein feminist. How could any modern man, son of a beloved woman, husband of an adored woman, and father of a joyful and delightful daughter not be? I am also a traditionalist and purist in matters of usage, grammar, and style. So where does that leave me and my cogenerationalists, enlightened literary (sigh) men (and women), with regards to the use of the masculine pronoun when used in the general sense to apply to the neuter situation? In Dictionary of Modern American Usage, Garner notes: “English has a number of common-sex general words, such as person, anyone, everyone, and no one, but it has no common-sex singular personal pronouns. Instead we have he, she, and it. The traditional approach has been to use the masculine pronouns he and him to cover all persons, male and female alike ... . The inadequacy of the English language in this respect becomes apparent in many sentences in which the generic masculine pronoun sits uneasily.” Inadequate or not, it is preferable to s/he/it and other bastardizations of the English language. (Is it not interesting that “bastard,” in common usage, is never used of a woman, even when she is illegitimate?) As for the legitimacy of the usage of the masculine (actually neuter) pronoun in the generic, I prefer to lean on Fowler, who says, “There are three makeshifts: first, as anybody can see for himself or herself; second, as anybody can see for themselves; and third, as anybody can see for himself. No one who can help it chooses the first; it is correct, and is sometimes necessary, but it is so clumsy as to be ridiculous except when explicitness is urgent, and it usually sounds like a bit of pedantic humor. The second is the popular solution; it sets the literary man's (!) teeth on edge, and he exerts himself to give the same meaning in some entirely different way if he is not prepared to risk the third, which is here recommended. It involves the convention (statutory in the interpretation of documents) that where the matter of sex is not conspicuous or important the masculine form shall be allowed to represent a person instead of a man, or say a man (homo) instead of a man (vir).” Politically correct fanatics may rail, but so are my teeth set on edge; thus, I have generally preserved the authors' usage of the masculine for the generic case. This grammatical scourge will pass and be forgotten, and weak-willed myn (by which I intend to indicate men and women) who pander to grammatical terrorists will, in the future, be seen to be stuck with malformed style and sentences no womyn will buy. What would Jane Austen have done, after all? About Gender in Investors As long as we are on the subject of gender, we might as well discuss, unscientifically, gender in investors. Within my wide experience as a trading advisor, teacher, and counselor, it strikes me that the women investors I have known have possessed certain innate advantages over the men. I know there are women gamblers—I have seen some. But I have never seen a woman plunger (shooter, pyramider, pie-eyed gambler) in the markets, though I have known many men who fit this description. I have also noted among my students and clients that, as a group, women seem to have more patience than men. I refer specifically to the patience that a wise investor must have to allow the markets to do what they are going to do. These are wholly personal observations. I have made no study of the question and can't speak to the entire class of women investors— and do not personally know Barbra Streisand (who I understand is a formidable investor, especially in IPOs). But just as I believe the world would be better off if more women ran countries and were police officers, I expect the world of finance will benefit from the steadily increasing number of women investors and managers. A crucial question: sensitivity indexes and betas Long before the investment community had formalized the beta measure— the coefficient measuring a stock's volatility relative to the market—Magee and Edwards were computing a Sensitivity Index, which, for all practical purposes, was the same thing. Readers interested in this aspect of their work may find references in Resources (EN10: now Appendix B), which will enable them to obtain betas to plug into the Composite Leverage formula with which Magee intended to determine risk levels. The old appendix on Sensitivity Indexes has been consigned to Appendix A (8th edition), along with the chapter on Composite Leverage, both originals of which have been emended to reflect current practices in finance theory and practice. Betwixt and between, 1/8 of a dollar or 12.5 cents As this edition went to press, the financial services industry was once again threatening to implement decimals in stock prices. Pricing in eighths has endured long past its time because it was in the self-interest of the financial industry—it allowed brokers and market makers to enforce larger bid-ask spreads and fatten their profit margins. The importance for this book, and for traders, is what will happen as full decimalization occurs. Often in these pages, Magee will recommend placing a stop 1/8 off the low or high, or placing progressive near stops in eighths. We do not yet know what the psychological interval will be in the new era; it may be 12.5 cents, or more psychologically, 10 cents, or for gaming purposes, 9 or 11 cents. This remains to be seen. As all the charts in this book are in the old notation, that usage has been preserved in this edition. The editorial “I” Readers will quickly note the “editorial we” of Edwards and Magee has been replaced by the first-person voice—or, the “editorial I” or perhaps the “professorial I.” Well, there were two authors in Edwards and Magee, and there is only one of me; my text is immediately noticeable as mine, and the reader may discriminate quickly. As for the use of “I” as an expression of ego, the reader is assured that after 40 years in the market, the editor has no ego left to promote. Perhaps the best way to put the editor's sense of importance in perspective is to quote Dr. Johnson's definition of lexicographer from his dictionary. Some people might have thought Johnson self-important in creating the first English dictionary; his definition of his trade put that right: “Lexicographer: a writer of dictionaries. A harmless drudge.” An editor is something like the same. As this book goes to the printer, the publisher, recognizing the importance of the work done on this edition, will credit the editor as co-author of the eighth edition. John Magee would be pleased. We had a cordial master- student relationship, and nothing pleases a Zen master more than to transfer the dharma to a passionate student. Acknowledgments In General: John Magee, for his ever-patient tutoring. Blair Hull, for teaching me the mercurial nature of options. Bill Dreiss, for teaching me the nature of trading systems. Art von Waldburg, respected colleague and discoverer of the Fractal Wave Algorithm. Fischer Black, who should have lived to get the Nobel Prize. Bill Scott, friend and fellow trader. For specific support and assistance in the preparation of this eighth edition: Professor Henry Pruden, Golden Gate University, San Francisco, for invaluable support and advice. Martin Pring; Lawrence Macmillan; Mitch Ackles, Omega Research Corporation; Carson Carlisle; Edward Dobson; David Robinson; Shereen Ash; Steven W. Poser; Lester Loops, late of Hull Trading Company; Tom Shanks, Turtle. At St. Lucie Press, the dedication and support of the publisher, Drew Gierman, and Production Associate, Pat Roberson, have been invaluable, as has been the dedication of Gail Renard, the Production Editor. And special acknowledgment to my Research Assistant, Don Carlos Bassetti y Doyle. Special appreciation goes to makers of software packages used in the preparation of this and previous editions: AIQ Systems P.O. Box 7530 Incline Village, NV 89452 702-831-2999 http://www.AIQsystems.com Metastock Equis International, Inc. 3950 S. 700 East, Suite 100 Salt Lake City, UT 84107 http://www.equis.com Tradestation Omega Research 14257 SW 119th Avenue Miami, FL 33186 305-485-7599 http://www.tradestation.com Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com In memoriam This book is a memorial for John Magee, who died on June 17, 1987. John Magee was considered a seminal pioneer in technical analysis, and his research with co-author, Robert D. Edwards, clarified and expanded the ideas of Charles Dow, who laid the foundation for technical analysis in 1884 by developing the “Averages,” and Richard Schabacker, former editor of Forbes in the 1920s, who showed how the signals, which had been considered important when they appeared in the averages, were applicable to stocks themselves. The text, which summarized their findings in 1948, was, of course, Technical Analysis of Stock Trends, now considered the definitive work on pattern recognition analysis. Throughout his technical work, John Magee emphasized three principles: stock prices tend to move in trends; volume goes with the trend; and a trend, once established, tends to continue in force. A large portion of Technical Analysis of Stock Trends is devoted to the patterns which tend to develop when a trend is being reversed: Head and Shoulders, Tops and Bottoms, “W” patterns, Triangles, Rectangles, etc.— common patterns to stock market technicians. Rounded Bottoms and Drooping Necklines are some of the more esoteric ones. John urged investors to go with the trend, rather than trying to pick a bottom before it was completed, averaging down a declining market. Above all, and at all times, he refused to get involved in the game of forecasting where “the market” was headed, or where the Dow-Jones Industrial Averages would be on December 31st of the coming year. Rather, he preached care in individual stock selection regardless of which way the market “appeared” to be headed. To the random walker, who once confronted John with the statement that there was no predictable behavior on Wall Street, John's reply was classic. He said, “You fellows rely too heavily on your computers. The best computer ever designed is still the human brain. Theoreticians try to simulate stock market behavior, and, failing to do so with any degree of predictability, declare that a journey through the stock market is a random walk. Isn't it equally possible that the programs simply aren't sensitive enough or the computers strong enough to successfully simulate the thought process of the human brain?” Then John would walk over to his bin of charts, pull out a favorite, and show it to the random walker. There it was— spike up, heavy volume; consolidation, light volume; spike up again, heavy volume. A third time. A fourth time. A beautifully symmetrical chart, moving ahead in a well-defined trend channel, volume moving with price. “Do you really believe that these patterns are random?” John would ask, already knowing the answer. We all have a favorite passage or quotation by our favorite author. My favorite quotation of John's appears in the short booklet he wrote especially for subscribers to his Technical Stock Advisory Service: “When you enter the stock market, you are going into a competitive field in which your evaluations and opinions will be matched against some of the sharpest and toughest minds in the business. You are in a highly specialized industry in which there are many different sectors, all of which are under intense study by men whose economic survival depends upon their best judgment. You will certainly be exposed to advice, suggestions, offers of help from all sides. Unless you are able to develop some market philosophy of your own, you will not be able to tell the good from the bad, the sound from the unsound.” I doubt if any man alive has helped more investors develop a sound philosophy of investing on Wall Street than John Magee. Richard McDermott President, John Magee, Inc. September 1991 Preface to the seventh edition More than 100 years ago, in Springfield, MA, there lived a man named Charles H. Dow. He was one of the editors of a great newspaper, the Springfield Republican. When he left Springfield, it was to establish another great newspaper, the Wall Street Journal. Charles Dow also laid the foundation for a new approach to stock market problems. In 1884, he made up an average of the daily closing prices of 11 important stocks, nine of which were rails, and recorded the fluctuations of this average. He believed the judgment of the investing public, as reflected in the movements of stock prices, represented an evaluation of the future probabilities affecting the various industries. He saw in his average a tool for predicting business conditions many months ahead. This was true because those who bought and sold these stocks included people intimately acquainted with the industrial situation from every angle. Dow reasoned the price of a security, as determined by a free competitive market, represented the composite knowledge and appraisal of everyone interested in that security—financiers, officers of the company, investors, employees, customers—everyone, in fact, who might be buying or selling stock. Dow felt this market evaluation was probably the shrewdest appraisal of conditions to come that could be contained, since it integrated all known facts, estimates, surmises, and the hopes and fears of all interested parties. It was William Peter Hamilton who really put these ideas to work. In his book, The Stock Market Barometer, published in 1922, he laid the groundwork for the much-used and much-abused Dow Theory. Unfortunately, a great many superficial students of the market never understood the original premise of the “barometer” and seized on the bare bones of the theory as a sort of magic touchstone to fame and easy fortune. Others, discovering the “barometer” was not perfect, set about devising corrections. They tinkered with the rules of classic Dow Theory, trying to find the wonderful formula that would avoid its periodic disappointments and failures. Of course, what they forgot was the Averages were only averages at best. There is nothing very wrong with the Dow Theory. What is wrong is the attempt to find a simple, universal formula—a set of measurements that will make a suit to fit every man, fat, thin, tall, or short. During the 1920s and 1930s, Richard W. Schabacker reopened the subject of technical analysis in a somewhat new direction. Schabacker, who had been financial editor of Forbes Magazine, set out to find some new answers. He realized whatever significant action appeared in the average must derive from similar action in some of the stocks making up the average. In his books, Stock Market Theory and Practice, Technical Market Analysis, and Stock Market Profits, Schabacker showed how the “signals” that had been considered important by Dow theorists when they appeared in the Averages were also significant and had the same meanings when they turned up in the charts of individual stocks. Others, too, had noted these technical patterns, but it was Schabacker who collated, organized, and systematized the technical method. Not only that, he also discovered new technical indications in the charts of stocks; indications of a type that would ordinarily be absorbed or smothered in the averages, and, hence, not visible or useful to Dow theorists. In the final years of his life, Richard Schabacker was joined by his brother- in-law, Robert D. Edwards, who completed Schabacker's last book and carried forward the research of technical analysis. Edwards, in turn, was joined in this work in 1942 by John Magee. Magee, an alumnus of the Massachusetts Institute of Technology, was well oriented to the scientific and technical approach. Edwards and Magee retraced the entire road, reexamining the Dow Theory and restudying the technical discoveries of Schabacker. Basically, the original findings were still good; however, with additional history and experience, it was possible to correct some details of earlier studies. Also, a number of new applications and methods were brought to light. The entire process of technical evaluation became more scientific. It became possible to state more precisely the premises of technical analysis: that the market represents a most democratic and representative criterion of stock values; that the action of a stock in a free, competitive market reflects all that is known, believed, surmised, hoped, or feared about that stock; and, therefore, that it synthesizes the attitudes and opinions of all. That the price of a stock is the result of buying and selling forces and represents the “true value” at any given moment. That a Major Trend must be presumed to continue in effect until clear evidence of Reversal is shown. And, finally, that it is possible to form opinions having a reasonably high probability of confirmation from the market action of a stock as shown in daily, weekly, or monthly charts, or from other technical studies derived from the market activity of the security. It is important to point out that the ultimate value of a security to the investor or trader is what he or she ultimately receives from it. That is to say, the price the investor gets when it is sold, or the market price obtainable for it at any particular time, adjusted for dividends or capital distribution in either case. If, for example, he or she has bought a stock at $25 a share, and it has paid $5 in dividends and is now bid at $35, he or she has realized an accrued benefit of $5 plus $10, or $15 in all. It is the combination of dividends and appreciation of capital that constitutes the total gain. It seems futile to try to correlate or compare the market value of a stock with the “book value” or with the “value” figured on a basis of capitalized earnings or dividends, projected growth, etc. There are too many other factors that may also affect the value, and some of these cannot easily be expressed in simple ratios. For example, a struggle for control of a corporation can as surely increase the value of its securities in the market as a growth of earnings. Again, a company may lose money for years and pay no dividends, yet still be an excellent investment on the basis of its development of potential resources as perceived by those who are buying and selling its stock. The market is not evaluating last year's accomplishments as such; it is weighing the prospects for the year to come. Then, too, in a time of inflation, a majority of stocks may advance sharply in price. This may reflect a depreciation in the purchasing power of dollars more than improvement in business conditions—but it is important, nonetheless, in such a case to be “out of dollars” and “into” equities. As a result of their research from 1942 to 1948, Edwards and Magee developed new technical methods. They put these methods to practical use in actual market operation. Eventually, in 1948, these findings were published in their definitive book, Technical Analysis of Stock Trends. This book, now in its seventh edition, has become the accepted authority in this field. It has been used as a textbook by various schools and colleges and is the basic tool of many investors and traders. In 1951, Edwards retired from his work as a stock analyst and John Magee continued the research, at first, independently, and then from January 1953 to March 1956 as Chief Technical Analyst with an investment counseling firm. Meanwhile, beginning in 1950, Magee started on a new road, which, as it turned out, was destined to open up virgin fields of technical market research. Using the methods of Dow, Hamilton, Schabacker, and Edwards as a base, he initiated a series of studies intended to discover new technical devices. These investigations were long and laborious, and, often, they were fruitless. One study required four months of work, involved hundreds of sheets of tabulations, many thousands of computations, and proved nothing. But from this type of work, eventually in late 1951, there began to emerge some important new and useful concepts—new bricks to build into the structure of the technical method. The new devices are not revolutionary. They do not vitiate the basic technical approach. Rather, they are evolutionary and add something to the valuable kit of tools already at hand. The new studies often make it possible to interpret and predict difficult situations sooner and more dependably than any other method previously used. Mr. Magee has designated these newest technical devices the Delta Studies. They are basically an extension and refinement of the technical method. There is no magic in the Delta Studies. They do not provide infallible formulas for sure profits at all times in every transaction, but they have proved eminently successful over a period of years in practical use in actual market operations, as an auxiliary to the methods outlined in the book, Technical Analysis of Stock Trends. Through his technical work, John Magee emphasized these three principles: 1. Stock prices tend to move in trends. 2. Volume goes with the trends. 3. A trend, once established, tends to continue in force. A large portion of the book, Technical Analysis of Stock Trends, is devoted to the patterns that tend to develop when a trend is being reversed. Head and Shoulders, Tops and Bottoms, “W” Patterns, Triangles, Rectangles, etc., are common patterns to stock market technicians. Rounded Bottoms and Drooping Necklines are some of the more esoteric ones. Magee urged investors to go with the trend, rather than trying to pick a Bottom before it was completed or averaging down in a declining stock. Above all, and at all times, he refused to get involved in the game of forecasting where “the market” was headed, or where the Dow Jones Industrial Average® would be on December 31st of the coming year. Rather, he preached care in individual stock selection regardless of which way the market “appeared” headed. Finally, his service recommended short positions as regularly as it did long positions, based simply on what the charts said. Richard McDermott Editor and Reviser Technical Analysis of Stock Trends, Seventh Edition January 1997 Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Preface to the fifth edition During the 16 printings of the fourth edition of Technical Analysis of Stock Trends, very few changes have been made in the original text, mainly because the lucid presentation of market action by the late Robert D. Edwards covered so thoroughly the basic and typical market action of common stocks. There has seemed no reason, for example, to discard a chart picture illustrating some important technical phenomenon merely because it occurred several or many years ago. Instead, over the various printings of the book, pages have been added showing similar examples, or in some cases entirely new types of market action taken from recent history; but these demonstrate mainly that the inherent nature of a competitive market does not change very much over the years, and that “the same old patterns” of human behavior continue to produce much the same types of market trends and fluctuations. The principal change in this fifth edition, and it is a spectacular improvement, is that practically all of the chart examples drawn to the TEKNIPLAT™ scale have been redrawn and new plates of these have been substituted. In the course of this work, several minor errors of scaling, titling, etc., previously undiscovered, came to light and have been corrected. The difficult work of revision was initiated in our charting room by two ambitious teenagers, Anne E. Mahoney and Joseph J. Spezeski, who took on the entire job of preparing the finished drawings and making necessary corrections. This enormous project was undertaken and carried through by these two young people spontaneously. In order to free them entirely from other distractions, their regular charting work was taken over for a period of months by the rest of the chartroom staff, so that a great deal of credit is due to the fine efforts of the entire chartroom group. John Magee December 3, 1966 xli Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Preface to the fourth edition In the several years since publication of the first edition of this work, “the stock market goes right on repeating the same old movements in much the same old routine.” Nearly all of the technical phenomena outlined in the first edition have appeared many times since then, and we see no reason to expect these habits of stocks will change materially in the years ahead, barring revolutionary changes in the economy, such as the abolishment of the free market entirely. Since the basic nature of the market has not changed appreciably, it has been unnecessary to make sweeping alterations in the text of “Part One: Technical Theory.” The previous edition has been very carefully restudied, and revisions have been made where they were called for to bring the material up to date. In “Part Two: Trading Tactics,” more extensive changes were needed, due to the more specific nature of the material and some differences in the present margin requirements, trading rules, etc. Also, there have been some improvements in the application of technical methods at the tactical level, and these have been incorporated in this section. Somewhat less emphasis has been put on the use of stop-loss orders, since their need is not so great in the case of the experienced trader as it might be with the novice. The principle of always following the Major Trend has been modified to achieve better protection of capital through balance and diversification. In line with avoiding “all-out” situations, with their consequent dangers, the idea of using an Evaluative Index has been introduced, and this concept has modified somewhat the tactics of following the Major Trend. It also has a bearing on the Composite Leverage or determination of total risk. Type for the entire book has been reset in this edition. The illustrative charts originally used have been, in the main, retained, since they demonstrate the various points very well, but a new chapter includes a number of additional charts taken from the market history of recent years, showing how the same phenomena continue to appear again and again. The appendix (Appendix C, 5th edition) on the Sensitivity Indexes has been completely recomputed and extended to cover a broad list of the more important issues. The arduous labor of determining these index figures was undertaken by Frank J. Curto and Marcella P. Curto. Material help in proofreading and revision for this edition was given by Beverly Magee and Elinor T. Magee. John Magee January 1, 1957 Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Preface to the second edition It is, needless to say, gratifying to the authors of this treatise to report that not only has a large first edition been exhausted (although it was originally assumed it would suffice for many years), but also, the demand for copies has been increasing at a rather astonishing pace during the past six months without any “promotion” except word-of-mouth recommendation from one investor to another. In preparing this new edition, a careful perusal of everything that was written in the previous printing, checked by the market events of the past 24 months and compared with all of the additional chart data accumulated during that period, resulted in the not unexpected, but nevertheless mildly surprising conclusion that nothing of real consequence needed to be changed or amplified. Hence, only minor revisions of an editorial nature have been made. It would have been interesting to augment our already copious illustrations with a number of charts from current months of market action, but costs of engraving and printing have risen to such a distressingly high level that any additions of that sort would, it was found, be prohibitively expensive. Aside from their novelty, they would add nothing to the book; they would only be substituted for other charts of precisely the same nature and significance, and fully as pertinent to present-day conditions. The stock market, as I wrote in the original Foreword, “goes right on repeating the same old movements in much the same old routine. The importance of a knowledge of these phenomena to the trader and investor has been in no whit diminished.” We see the same forecasting patterns developing on the charts today that we have seen over and over again for the past 20 years. Neither the mechanics nor the “human element” of the stock market has changed, and there is no reason to think they will. Robert D. Edwards May 1, 1951 xlv Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Foreword This book has been written for the layman rather than for the Wall Street professional. But, it assumes the reader is already possessed of at least an elementary knowledge of the nature of stocks and bonds, and he has had some dealings with a broker and some familiarity with the financial pages of his newspapers. Hence, no attempt is made herein to define common stock market terms and procedures. Every effort, however, has been exerted to explain, in full, the theories and the terminology of our specific subject, technical market analysis. Part One is based, in large part, on the pioneer researches and writings of the late Richard W. Schabacker. Students of his Technical Analysis and Stock Market Profits (the latest revision of which is now out of print was made in 1937 by the present writer and Albert L. Kimball) will find in the pages of this section much that is familiar and, except for the illustrations, only a little that is really novel. It has been a matter of surprise, in fact, to the authors and other students of market technics that all the new controls and regulations of the past several years, the new taxes which have placed a heavy handicap on successful investors, the greatly augmented and improved facilities for acquiring dependable information on securities, even the quite radical changes in certain portions of our basic economy, have not much altered the “pattern” of the stock market. Certain of the evidences of pool manipulation that used to appear on the charts are now seldom seen. A few of the price formations that formerly were quite common, now appear rarely or may have lost much of their practical utility for the trader; they have been omitted from this text. Others have altered their habits slightly, or their consequences to a degree (but not their fundamental nature), which has, of course, been noted herein. The distressing thinness of the market at times—one of the undoubted effects of regulation—has resulted in a few more “false moves,” more spells of uninteresting (and unprofitable) inactivity. But, in the main, the market goes right on repeating the same old movements in much the same old routine. The importance of a knowledge of these phenomena to the trader and investor has been in no whit diminished. Part Two, which has to do with the practical application of these market patterns and phenomena, with the tactics of trading, is all new. For more than 15 years (his total market experience extends back nearly 30 years), John Magee has invested and traded exclusively via the technical theory, kept thousands of charts, made hundreds of actual trades, tested all sorts of applications, audited and analyzed methods, tactics, and results from every conceivable angle, depended on his profits for his living. His contribution is that of one who has tried and knows. It may well be added here—and will be often repeated in the following pages—that the technical guides to trading in stocks are by no means infallible. The more experience one gains in their use, the more alive one becomes to their pitfalls and their failures. There is no such thing as a sure- fire method of “beating the market”; the authors have no hesitancy in saying that there never will be. Nevertheless, a knowledge and judicious application of the xlvii principles of technical analysis does pay dividends—is more profitable (and far safer) for the average investor than any other of the presently recognized and established approaches to the problems of buying and selling securities. Robert D. Edwards July 1948 part one Technical theory Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter one The technical approach to trading and investing Few human activities have been so exhaustively studied during the past century, from so many angles and by so many different sorts of people, as the buying and selling of corporate securities. The rewards the stock market holds out to those who read it right are enormous; the penalties it exacts from careless, dozing, or “unlucky” investors are calamitous. No wonder it has attracted some of the world's most astute accountants, analysts, and researchers, along with a motley crew of eccentrics, mystics, “hunch players,” and a multitude of just ordinary hopeful citizens. Able brains have sought, and continue constantly to seek, for safe and sure methods of appraising the state and trend of the market, as well as discovering the right stock to buy and the right time to buy it. This intensive research has not been fruitless—far from it. There are a great many successful investors and speculators (using the word in its true sense, which is without opprobrium) who, by one road or another, have acquired the necessary insight into the forces with which they deal and the judgment, the forethought, and the all-important self-discipline to deal with them profitably. In the course of years of stock market study, two quite distinct schools of thought have arisen, providing two radically different methods of arriving at the answers to the trader's problem of what and when. In the parlance of “the Street,” one of these is commonly referred to as the fundamental or statistical, and the other as the technical. (In recent years a third approach, the cyclical, has made rapid progress, and although still beset by a “lunatic fringe,” it promises to contribute a great deal to our understanding of economic trends.) The stock market fundamentalist depends on statistics. He examines the auditors' reports, the profit-and-loss statements, the quarterly balance sheets, the dividend records, and the policies of the companies whose shares he has under observation. He analyzes sales data, managerial ability, plant capacity, and the competition. He turns to bank and treasury reports, production indexes, price statistics, and crop forecasts, to gauge the state of business in general, and reads the daily news carefully to arrive at an estimate of future business conditions. Taking all these into account, he evaluates his stock; if it is selling currently below his appraisal, he regards it as a buy. (EN9: And, no surprise, the buyer's name is Warren Buffet, and he buys the company, not the stock, for although this is an excellent way to buy companies, it is not a very good way to buy stocks.) EN: Read Robert Prechter's summation of the fundamental methodology as an amusing endnote at the end of this chapter. As a matter of fact, aside from the greenest of newcomers when they first tackle the investment problem, and to whom, in their inexperience, any other point of view is not only irrational but incomprehensible, your pure fundamentalist is a rare bird. Even those market authorities who pretend to scorn charts and “chartists” utterly are not oblivious to the “action” chronicled by the ticker tape, and they do not conceal their respect for the Dow Theory, which, whether they realize it or not, is, in its very essence, purely technical. Definition of technical analysis The term “technical,” in its application to the stock market, has come to have a special meaning, quite different from its ordinary dictionary definition. It refers to the study of the action of the market itself as opposed to the study of the goods in which the market deals. Technical Analysis is the science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in “the Averages” and then deducing from that pictured history the probable future trend. EN: With the advent of the computer, many schools of technical analysis have arisen. Number-driven technical analysis (e.g., moving average studies, oscillators, etc.) attempts to completely objectify the analysis of the markets. The work of Edwards and Magee is the embodiment and definition of “classical technical analysis.” The technical student argues thus: it is futile to assign an intrinsic value to a stock certificate. One share of U.S. Steel, for example, was worth $261 in the early fall of 1929, but you could buy it for only $22 in June 1932. By March 1937, it was selling for $126 and just one year later it was selling for $38. In May 1946, it had climbed back up to $97, and 10 months later, in 1947, had dropped below $70, although the company's earnings on this last date were reputed to be nearing an all-time high and interest rates in general were still near an all-time low. The book value of this share of U.S. Steel, according to the corporation's balance sheet, was about $204 in 1929 (end of the year), $187 in 1932, $151 in 1937, $117 in 1938, and $142 in 1946. This sort of wide divergence between presumed value and actual price is not the exception—it is the rule. It is going on all the time. The fact is the real value of a share of U.S. Steel common is determined at any given time solely, definitely, and inexorably by supply and demand, which are accurately reflected in the transactions consummated on the floor of the New York Stock Exchange (see Figure 1.1). Of course, the statistics fundamentalists study play a part in the supply- demand equation—that is freely admitted. But many other factors are affecting it as well. The market price reflects not only the differing value opinions of many orthodox security appraisers, but also all the hopes and fears and guesses and moods, rational and irrational, of hundreds of potential buyers and sellers, as well as their needs and their resources—in total, factors that defy analysis and for which no statistics are obtainable, but that nevertheless are synthesized, weighed, and finally expressed in the one precise figure at which a buyer and a seller get together and make a deal (through their agents, their respective stock brokers). This is the only figure that counts. Moreover, the technician claims, with complete justification, that the bulk of the statistics the fundamentalists study are past history, already out of date and sterile because the market is not interested in the past or even in the present. It is constantly looking ahead, attempting to discount future developments, weighing and balancing all the estimates and guesses of thousands of investors who look into the future from different points of view and through glasses of many different hues. In brief, the going price, as established by the market itself, comprehends all the fundamental information the statistical analyst can hope to learn (plus some that is perhaps secret from him or known only to a few insiders) and much else besides of equal or even greater importance. All of which, admitting its truth, would be of little significance were it not for the fact, which no one of experience doubts, that prices move in trends and trends tend to continue until something happens to change the supply- demand balance. Such changes are usually detectable in the action of the market. Certain patterns or formations, levels or areas, appear on the charts that have a meaning and that can be interpreted in terms of probable future Figure 1.1 Monthly price ranges of U.S. Steel common from January 1929 to December 1946. Compare the great swings in the market price for this stock—from 1929 (extreme high, 261 3/4) to 1932 (extreme low, 21 1/4), from 1932 to 1937, from 1937 to 1938, from 1942 to 1946—with its book values for those years as cited on the previous page. trend development. They are not infallible, it must be noted, but the odds are definitely in their favor. Time after time, as experience has amply proved, they are far more prescient than the best informed and most shrewd of statisticians. The technical analyst may go even further in his claims. He may offer to interpret the chart of a stock whose name he does not know, so long as the record of trading is accurate and covers a long enough term to enable him to study its market background and habits. He may suggest he could trade with profit in a stock knowing only its ticker symbol, completely ignorant of the company, the industry, what it manufactures or sells, or how it is capitalized. Needless to say, such practice is not recommended, but if your market technician is really experienced at his business, he could, in theory, do exactly what he claims. Should the reader, at this point, find the technical approach to trading or investing, as explained in the foregoing, completely abhorrent, perhaps he had better close the book now, for it is primarily the technical approach, the science of technical analysis, with which the remainder of the book deals. EN: The Elliott Wave Theory: perspective and comments from a Magee investment letter of the 80s. This week, we had the pleasure of attending the December meeting of the Market Technicians Association of New York (MTANY). Long-term subscribers will remember the MTANY as the organization that honored John Magee with its Man of the Year award in 1978. The speaker was Robert Prechter, publisher of “The Elliott Wave Theorist,” an investment advisory that bases its forecasts on interpretations of R. N. Elliott's work on the stock market. Of primary interest to subscribers are Prechter's comments on technical analysis itself. The Elliott Wave Theory, it must be remembered, is really no more than a “catalog” of stock market price movements, laid one on top of the other, so to speak, until a grand, underlying, and enduring pattern is observed; in short, pure technical analysis. Among Prechter's definitions and observations regarding fundamental analysis are the following: 1. First, let's define "technical" versus "fundamental" data ... technical data is that which is generated by the action of the market under study. 2. The main problem with fundamental analysis is its indicators are removed from the market itself. The analyst assumes causality between external events and market movements, a concept which is almost certainly false. But, just as important (and less recognized), is that fundamental analysis almost always requires a forecast of the fundamental data itself before conclusions about the market are drawn. The analyst is then forced to take a second step in coming to a conclusion about how those forecasted events will affect the markets! Technicians only have one step to take, which gives them an edge right off the bat. Their main advantage is they don't have to forecast their indicators. 3. What's worse, even the fundamentalists' second step is probably a process built on quicksand. ... The most common application of fundamental analysis is estimating companies' earnings for both the current year and next year and recommending stocks on that basis. . And the record on that basis alone is very poor, as Barron's pointed out in a June 4 article, which showed that earnings estimates averaged 18% error in the 30 Dow Jones Industrial Average (DJIA) stocks for any year already completed and 54% error for the year ahead. The weakest link, however, is the assumption that correct earnings estimates are a basis for choosing stock market winners. According to a table in the same Barron's article, a purchase of the 10 DJIA stocks with the best earnings estimates would have produced a 10-year cumulative gain of 40.5%, while choosing the 10 DJIA with the worst earnings estimates would have produced a whopping 142.5% gain. We enjoyed Prechter's polished exposition of a technical approach, which is different from our own. As for his observations about fundamental analysis, we simply couldn't agree more. chapter two Charts Charts are the working tools of the technical analyst. They have been developed in a multitude of forms and styles to represent graphically almost anything that takes place in the market as well as to plot an “index” derived therefrom. They may be monthly charts on which an entire month's trading record is condensed into a single entry, or they may be weekly, daily, hourly, transaction, “point-and-figure,” and candlestick charts. They may be constructed on arithmetic, logarithmic, or square-root scale, or they may be projected as “oscillators.” They may delineate moving averages, proportion of trading volume to price movement, average price of most active issues, odd-lot transactions, the short interest, and an infinitude of other relations, ratios, and indexes—all technical in the sense that they are derived, directly or indirectly, from what actually has been transacted on the exchanges. Fortunately, we shall not need to concern ourselves with most of these charts; they are of interest only to the full-time economic analyst. Many of these charts have derived from a completely futile (so far, at least) endeavor to discover a “mechanical” index or combination of indexes that will always, automatically, without ever failing or going wrong, give warning of a change in trend; in our experience, such charts are often confusing and sometimes downright deceptive at a most critical juncture. This book, however, is designed for the layman, the professional who cannot spend all of his hours on his investing or trading operations, but to whom these operations are, nevertheless, of sufficient importance or interest to warrant his devoting at least a few minutes a day to their study and management. (EN9: In retrospect, this is an underestimation of the importance of the work. In the 21st century, the best professionals are acutely aware of the importance of trend analysis and use this work as their textbook.) The theories and methods outlined herein will require only the simplest form of stock chart—a record of the price range (open, high/low and close) and volume of shares traded each day. These daily graphs will be supplemented, for certain purposes that will be discussed later in this text, by weekly or monthly charts, which for most stocks can be easily generated by almost all commercially available investment software and websites. Nearly all the illustrations throughout the following chapters are examples of such daily charts. They are easy to make and maintain manually, requiring only a supply of graph or cross-section paper (almost any kind can serve), a daily newspaper that gives full and accurate reports on stock exchange dealings, a sharp pencil, and a few minutes of time. EN: Alternatively, numerous data services are available for use with computer software packages, not to mention internet sites (which are mentioned in Appendix B, Resources). The use of this technology eliminates the burden of manual chart keeping. If there is a drawback to this technology, it might be in the loss of the “feel” the investor gets through manual charting. It is customary in preparing ordinary daily stock charts to let the horizontal axis represent time, with the vertical cross-lines (or as some prefer, the spaces between them) from left to right, thus standing for successive days. The vertical scale is used for prices, with each horizontal cross-line then representing a specific price level. Space is usually provided at the bottom of the sheet to plot volume, that is, the number of shares that change hands each day. The newspapers publishing complete stock market reports give the day's turnover or volume (exclusive of odd-lot transactions that for our present purpose may be disregarded), the highest and lowest price at which each stock sold during the day, the closing price (which is the price at which the last sale effected during the day was made), and usually the opening or first sale price. On our charts, the daily price range is plotted by drawing a vertical line connecting the points representing the high and the low. Then a short horizontal “tick” is added, either crossing the vertical range line or extending out to the right from it, at the level of the closing price. Sometimes all transactions in a stock during a day take place at one and the same price; the high, low, and close are thus all on level and the only mark on our chart will be the horizontal dash representing the closing figure. Volume is depicted by drawing a vertical line up from the baseline of the chart. The opening price need not be recorded. (EN10: Candlestick charts require this piece of data.) Experience has shown that it seldom, if ever, has any significance in estimating future developments, which is all that ordinarily should interest us. The closing price is important, however. It is, in fact, the only price that many casual readers of the financial pages ever look at. It represents the final evaluation of the stock made by the market during the day. The closing price may be registered in the first hour of trading, provided no other sales are subsequently affected, but, it nevertheless becomes the figure upon which a majority of prospective traders base their plans for the following day. Hence, its technical significance is evident and will appear in various contexts in later chapters. Different types of scales Many specific suggestions as to the details of charting are deferred for discussion in Section II of this book, but there is one chart feature that may well be considered here. Until recent years, nearly all stock price charts were kept on the common form of graph paper ruled to what is known as plain or arithmetic scale. But more and more chartists have now come to use what is known as semilogarithmic paper, or sometimes as ratio or percentage paper. Our experience indicates that the semilogarithmic scale has definite advantages in this work, and most of the charts reproduced in this book employ this scale. The two types of scales may be distinguished at a glance: on arithmetic paper, equal distances on the vertical scale (i.e., between horizontal lines) represent equal amounts in dollars, whereas on the semilogarithmic paper, they represent equal percentage changes. Thus, on arithmetic paper, the distance between 10 and 20 on the vertical scale is exactly the same as that from 20 to 30 and from 30 to 40. On the semilogarithmic scale the difference from 10 to 20, representing an increase of 100%, is the same as that from 20 to 40 or from 40 to 80, in each case representing another 100% increase. Percentage relations, it goes without saying, are important in trading in securities. The semilogarithmic scale permits direct comparison of high- and low-priced stocks and makes it easier to choose the one offering the greater (percentage) profit on the funds to be invested. It facilitates the placing of stop-loss orders. Area patterns appear much the same on either type of paper, but certain trendlines develop more advantageously on the ratio scale. Almost anyone can quickly become accustomed to making entries on semilogarithmic paper. (We recommend its use.) Its advantages, however, are not so great as to require one to change—one who, because of long familiarity and practice, prefers an arithmetic sheet. Such percentage calculations, as may seem to be required, can be made on another sheet or in the head, and the results then can be entered on the arithmetic chart, if a record is desired. Several firms specializing in the manufacture of graph paper and other engineers' and architects' supplies now offer sheets specifically designed for stock charting, on which heavier lines to define the business week mark each sixth day on the time scale, and the price scale is subdivided into eighths to represent the standard fractions of the dollar in which stocks are traded on all U.S. exchanges. (EN9: Eighths went the way of the New Haven and now decimals reign.) These sheets are available in various sizes and with either arithmetic or logarithmic price and volume scales. EN: This paper is only of interest to the manual chartist, as modern software, as detailed in Appendix B, Resources, enables the computer chartist to easily switch between price scales and methods of charting. References to such paper are also found there. On weekly charts, each vertical line represents a week's worth of trading. The price range for the week is plotted thereon and usually the total volume, but the closing price may be omitted. The range extends from the highest price at which the stock sold on any day during the week to the lowest price at which it sold on any day; these two extremes might, and sometimes do, occur on the same day, but the weekly chart makes no distinction as to day. Monthly charts are prepared in the same way but do not, as a rule, record volume. These two charts—often referred to as long- term or major charts—are used chiefly for determining important support and resistance levels and for marking long-term trends. Weekly charts—if the reader prefers to keep his own—can be posted easily from the Sunday morning editions of those daily newspapers (e.g., the New York Times or Barron's Business and Financial Weekly) that publish a summary of the previous week's transactions. In concluding this chapter on the construction of the charts that we shall study in succeeding chapters, it can well be said that there is no special virtue, certainly no magic, in the chart itself. It is simply a pictorial record of the trading history of the stock or stocks in which we may be interested. To the person possessed of a photographic memory, no chart work is necessary; his mind records all the necessary data—he carries his charts in his head. Many of the expert “tape-readers” who have no use for charts are gifted with that rare memory talent that renders reference to graphic records unnecessary. But most of us are not so blessed; to use the chart is necessary and useful because it lends itself conveniently to the type of analysis that indicates future probabilities. There is a saying on Wall Street to the effect that “there is nothing wrong with charts— the trouble is with the chartists,” which is simply another way of expressing the truth that it is not the chart but its interpretation that is important. Chart analysis is neither easy nor foolproof. Yet, it is not at all uncommon for some casual investor who has no idea whatever of market technics to pick up a chart by chance and see in it something he had not hitherto suspected, something perhaps that saves him from making an unfavorable commitment. If you have never used stock charts, and have never paid much attention to them, you may be surprised at some of the significant things you will detect as soon as you begin to study them seriously. EN9: Surprise and astonishment are the words used to describe the reactions of even professionals when they are fully exposed to a coherent presentation of the methods of Edwards and Magee. I have often commented that no understanding of other (number driven statistical) methods of technical analysis is possible without a firm grasp of the concepts and principles of this book. Some other comments are worth noting relevant to Edwards' discussion. For manual charting, semilog remains the superior scale. Given the ease of changing scale and time frames on internet sites (e.g., prophet.net, thinkorswim.com, tdameritrade.com, and stockcharts.com) and in the standalone software, one may switch from a close-up of a month to a long- range perspective of years. In this process, it is important to maintain perspective. Multiyear log charts of large ranges lose graphic importance at the top as chart intervals shrink. This distortion must be countered by breaking the time frame into smaller increments. Thus, instead of five years of a chart that spans a range of 10-200, we look at five charts of one year each as well as the five-year chart. In the modern era, a new graphic representation has gained enormous popularity—candlestick charting. In this method, color is added to the chart by coloring the body of the candlestick—white for rising prices, black for falling prices (or colors of your choice). Thus, the direction of the trend is dramatized. Also, candlestick patterns are said to be of value in recognizing trend reversals and other trend states. A host of other charting methods exists: Three Line Break, Renko, Kagi... These may be researched in Nison's book, Beyond Candlesticks. I will not treat these in this book, but I do include them in an appendix on examination of Point and Figure charting. chapter three The Dow Theory The Dow Theory is the granddaddy of all technical market studies. Although it is frequently criticized for being “too late” and occasionally derided (particularly in the early stages of a Bear Market) by those who rebel against its verdicts, it is known by name to nearly everyone who has had any association with the stock market, and it is respected by most. Many who heed it in greater or lesser degrees in determining their investment policies never realize that it is purely and simply “technical.” It is built upon and concerned with nothing but the action of the stock market (as expressed in certain averages), deriving nothing from the business statistics on which the fundamentalists depend. There is much in the writings of its original promulgator, Charles H. Dow, to suggest he did not think of his theory as a device for forecasting the stock market, or even as a guide for investors, but rather as a barometer of general business trends. Dow founded the Dow-Jones Financial News Service and is credited with the invention of stock market averages. He outlined the basic principles of the theory, which was later named after him, in editorials he wrote for the Wall Street Journal. Upon his death in 1902, his successor, William P. Hamilton, as editor of the Journal, took up Dow's principles and, in the course of 27 years of writing on the stock market, organized and formulated them into the Dow Theory as we know it today. Before we proceed to an explanation of the theory, it will be necessary to examine the stock averages that it employs. Long before the time of Dow, the fact was familiar to bankers and businessmen that the securities of most established companies tended to go up or down in price together. Exceptions—stocks that moved against the general financial tide—were rare, nor did they as a rule persevere in that contrary course for more than a few days or weeks at a time. It is true that when a boom was on, the prices of some issues rose faster and farther than others, and when the trend was toward depression, some stocks declined rapidly whereas others would put up considerable resistance to the forces that were dragging down the market. The fact remained, however, that most securities tended to swing together. (They still do and always will.) This fact, as we have said, has long been commonly known and accepted (so completely taken for granted that its importance is usually overlooked), for it is important— tremendously important—from many angles in addition to those that come within the province of this volume. One of the best reasons for a student of market technics to start with the Dow Theory is because that theory stresses the general market trend. Charles Dow is believed to have been the first to make a thorough effort to express the general trend (or, more correctly, level) of the securities market in terms of the average price of a selected few representative stocks. As finally set up in January of 1897, in the form that has continued to date and used by Dow in his studies of market trends, there were two Dow-Jones Averages. One was composed solely of the stocks of 20 railroad companies, for the railroads were the dominant corporate enterprises of his day. The other, called the Industrial Average, represented all other types of businesses and was made up, at first, of only 12 issues. This number was increased to 20 in 1916 and to 30 on October 1, 1928. The Dow Averages The stocks included in these two Averages have been changed from time to time to keep the lists up to date and as nearly representative as possible of their respective groups. Only General Electric, of the present 30 industrial stocks, was included in the original Industrial Average, and that was dropped at one time (in 1898) and subsequently reinserted. In 1929, all stocks of public utility companies were dropped from the Industrial Average and a new Utility Average of 20 issues was set up; in 1938, its number was reduced to 15. The 20 rail, 30 industrial, and 15 utility stocks are now averaged together to make what is known as the Dow-Jones Stock Composite. The history of these Averages, the various adjustments that have been made in them and their method of computation is an interesting story in itself, which the reader may want to look up elsewhere. EN: See Appendix B, Resources, for references. Note also there is now a proliferation of Dow-Jones Averages. For our present purpose, it remains only to add that the Dow Theory pays no attention to the Utility or Composite Averages; its interpretations are based on the Rail and Industrial Averages only. EN: The Rails are now known as Transportations. In recent years, the values of the Dow-Jones Averages have been computed for the end of each hour of trading as well as the end of the day. EN: Now computed in real time and available over the internet, these hourly figures are published in the Wall Street Journal as well as on all market tickers. In fact, presently, the Averages are computed in real time, a necessity for options and futures trading that takes place on them. The Wall Street Journal also prints in each issue a summary of the important highs and lows of each average by date for the preceding two or three years. Their daily closing prices are reported in many other metropolitan daily newspapers. Basic tenets To get back to the Dow Theory, here are its basic tenets: 1. The Averages discount everything (except “acts of God”): Since they reflect the combined market activities of thousands of investors, including those possessed of the greatest foresight and the best information on trends and events, the Averages in their day-to-day fluctuations discount everything known, everything foreseeable, and every condition that can affect the supply of or the demand for corporate securities. Even unpredictable natural calamities, when they happen, are quickly appraised and their possible effects discounted. 2. The Three Trends: The “market,” meaning the price of stocks in general, swings in trends, of which the most important are its Major or Primary Trends. These are the extensive up or down movements that usually last for a year or more and result in general appreciation or depreciation in value of more than 20%. Movements in the direction of the Primary Trend are interrupted at intervals by Secondary Swings in the opposite direction— reactions or corrections that occur when the Primary Move has temporarily “gotten ahead of itself.” (Both Secondary and the intervening segments of the Primary Trend are frequently lumped together as Intermediate Movements—a term we shall find useful in subsequent discussions.) Finally, the Secondary Trends are composed of Minor Trends or day-to-day fluctuations that are unimportant to Dow Theory. 3. The Primary Trends: These, as aforesaid, are the broad, overall, up and down movements that usually (but not invariably) last for more than a year and may run for several years. So long as each successive rally (price advance) reaches a higher level than the one before it, and each Secondary Reaction stops (i.e., the price trend reverses from down to up) at a higher level than the previous reaction, the Primary Trend is up. This is called a Bull Market. Conversely, when each Intermediate Decline carries prices to successively lower levels and each intervening rally fails to bring them back up to the top level of the preceding rally, the Primary Trend is down. This is called a Bear Market. (The terms Bull and Bear are frequently used loosely with reference, respectively, to any sort of up or down movements, but we shall use them in this book only in connection with the Major or Primary Movements of the market in the Dow sense.) Ordinarily— theoretically, at least—the Primary Trend is the only one of the three trends with which the true long-term investor is concerned. His aim is to buy stocks as early as possible in a Bull Market—just as soon as he can be sure that one has started—and then hold them until (and only until) it becomes evident it has ended and a Bear Market has started. He knows he can safely disregard all the intervening Secondary Reactions and Minor Fluctuations. The trader, however, may well concern himself also with the Secondary Swings, and it will appear later on in this book that he can do so with profit. 4. The Secondary Trends: These are the important reactions that interrupt the progress of prices in the Primary Direction. They are the Intermediate Declines or corrections that occur during Bull Markets and the Intermediate Rallies or recoveries that occur in Bear Markets. Normally, they last for three weeks to many months, rarely longer. Normally, they retrace from one-third to two-thirds of the gain (or loss, as the case may be) in prices registered in the preceding swing in the Primary Direction. Thus, in a Bull Market, prices in terms of the Industrial Average might rise steadily, or with only brief and minor interruptions, for a total gain of 30 points before a Secondary Correction occurred. That correction might then be expected to produce a decline of not less than 10 points and not more than 20 points before a new Intermediate Advance in the Primary Bull Trend develops. Note, however, the one-third/two-thirds rule is not an unbreakable law; it is simply a statement of probabilities. Most Secondaries are confined within these limits; many of them stop very close to the halfway mark, retracing 50% of the preceding Primary Swing. They seldom run less than one-third, but some of them cancel nearly all of it. Thus, we have two criteria by which to recognize a Secondary Trend. Any price movement contrary in direction to the Primary Trend that lasts for at least three weeks and retraces at least one-third of the preceding net move in the Primary Direction (from the end of the preceding Secondary to the beginning of this one, disregarding Minor Fluctuations) is labelled as Intermediate Rank, that is, a true Secondary. Despite these criteria, however, the Secondary Trend is often confusing in its recognition, and its correct appraisal at the time it develops, and while it is in process poses the Dow theorist's most difficult problem. We shall have more to say about this later. 5. The Minor Trends: These are the brief (rarely as long as three weeks—usually less than six days) fluctuations that are, so far as the Dow Theory is concerned, meaningless in themselves, but which, in toto, make up the Intermediate Trends. Usually, but not always, an Intermediate Swing, whether a Secondary or the segment of a Primary between successive Secondaries, is made up of a series of three or more distinguishable Minor Waves. Inferences drawn from these day- to-day fluctuations are quite apt to be misleading. The Minor Trend is the only one of the three trends that can be “manipulated” (although it is, in fact, doubtful if under present conditions even that can be purposely manipulated to any important extent). Primary and Secondary Trends cannot be manipulated; it would strain the resources of the U.S. Treasury to do so. Right here, before we go on to state a sixth Dow tenet, we may well take time out for a few minutes to clarify the concept of the three trends by drawing an analogy between the movements of the stock market and the movements of the sea. The Major (Primary) Trends in stock prices are like the tides. We can compare a Bull Market to an incoming or flood tide that carries the water farther and farther up the beach until finally it reaches high-water mark and begins to turn; it then follows the receding or ebb tide, comparable to a Bear Market. But all the time, during both ebb and flow of the tide, the waves are rolling in, breaking on the beach, and then receding. Although the tide is rising, each succeeding wave pushes a little farther up onto the shore and, as it recedes, does not carry the water quite so far back as did its predecessor. During the tidal ebb, each advancing wave falls a little short of the mark set by the one before it, and each receding wave uncovers a little more of the beach. These waves are the Intermediate Trends, Primary or Secondary, depending on whether their movement is with or against the direction of the tide. Meanwhile, the surface of the water is constantly agitated by wavelets, ripples, and “cat's-paws” moving with or against or across the trend of the waves—these are analogous to the market's Minor Trends, its unimportant day-to-day fluctuations. The tide, the wave, and the ripple represent, respectively, the Primary or Major, the Secondary or Intermediate, and the Minor Trends of the market. Tide, wave, and ripple A shore dweller who had no tide table might set about determining the direction of the tide by driving a stake in the beach at the highest point reached by an incoming wave. Then, if the next wave pushed the water up beyond his stake, he would know the tide was rising. If he shifted his stake with the peak mark of each wave, a time would come when one wave would stop and start to recede short of his previous mark; then he would know that the tide had turned and had started to ebb. That, in effect (and much simplified), is what the Dow theorist does in defining the trend of the stock market. The comparison with tide, wave, and ripple has been used since the earliest days of the Dow Theory. It is even possible that the movements of the sea may have suggested the elements of the theory to Dow. But the analogy cannot be pushed too far. The tides and waves of the stock market are not as regular as those of the ocean. Tables can be prepared years in advance to predict accurately the time of every ebb and flow of the waters, but no timetables are provided by the Dow Theory for the stock market. We may return to some points of this comparison later, but we must proceed now to take up the remaining tenets and rules of the Theory. Major trend phases 1. The Bull Market: Primary Uptrends are usually (but not invariably) divisible into three phases. The first is the phase of accumulation during which farsighted investors, sensing that business, although now depressed, is due to turn up, are willing to pick up all the shares offered by discouraged and distressed sellers and to raise their bids gradually as such selling diminishes in volume. Financial reports are still bad— in fact, often at their worst—during this phase. The public is completely disgusted with the stock market—out of it entirely. Activity is only moderate but beginning to increase on the rallies (Minor Advances). The second phase is one of fairly steady advance and increasing activity as the improved tone of business and a rising trend in corporate earnings begin to attract attention. It is during this phase that the technical trader normally is able to reap his best harvest of profits. Finally comes the third phase when the market boils with activity as the public flocks to the boardrooms. All the financial news is good, price advances are spectacular and frequently make the front page of the daily papers, and new issues are brought out in increasing numbers. It is during this phase that one of your friends will call up and blithely remark, “Say, I see the market is going up. What's a good buy?”—oblivious to the fact it has been going up for perhaps two years, has already gone up a long way, and is now reaching the stage at which it might be more appropriate to ask, “What's a good thing to sell?” In the last stage of this phase, with speculation rampant, volume continues to rise, but “air pockets” appear with increasing frequency; the “cats and dogs” (low-priced stocks of no investment value) are whirled up, but more and more of the top-grade issues refuse to follow. 2. The Bear Market: Primary Downtrends are also usually (but again, not invariably) characterized by three phases. The first is the distribution period (which really starts in the later stages of the preceding Bull Market). During this phase, farsighted investors sense the fact that business earnings have reached an abnormal height and unload their holdings at an increasing pace. Trading volume is still high, although tending to diminish on rallies, and the public is still active but beginning to show signs of frustration, as hoped-for profits fade away. The second phase is the panic phase. Buyers begin to thin out and sellers become more urgent; the downward trend of prices suddenly accelerates into an almost vertical drop, whereas volume mounts to climactic proportions. After the Panic Phase (which usually runs too far relative to then-existing business conditions), there may be a fairly long Secondary Recovery or a sideways movement, and then the third phase begins. This is characterized by discouraged selling on the part of those investors who held on through the Panic or, perhaps, bought during it because stocks looked cheap in comparison with prices that had ruled a few months earlier. The business news now begins to deteriorate. As the third phase proceeds, the downward movement is less rapid, but it is maintained by more and more distress selling from those who have to raise cash for other needs. The “cats and dogs” may lose practically all their previous Bull Advance in the first two phases. Better-grade stocks decline more gradually, as their owners cling to them to the last. In consequence, the final stage of a Bear Market is frequently concentrated in such issues. The Bear Market ends when everything in the way of possible bad news, the worst to be expected, has been discounted, and it is usually over before all the bad news is “out.” The three Bear Market phases described in the preceding paragraph are not the same as those named by others who have discussed this subject, but the writers of this study feel they represent a more accurate and realistic division of the Primary down moves of the past 30 years. The reader should be warned, however, that no two Bear Markets are exactly alike, and neither are any two Bull Markets. Some may lack one or another of the three typical phases. A few Major Advances have passed from the first to the third stage with only a brief and rapid intervening mark-up. A few short Bear Markets have developed no marked Panic Phase and others have ended with it, as in April 1939. No time limits can be set for any phase; the third stage of a Bull Market, for example, the phase of excited speculation and great public activity, may last for more than a year or run out in a month or two. The Panic Phase of a Bear Market is usually exhausted in a very few weeks if not in days, but the 1929 through 1932 decline was interspersed with at least five Panic Waves of major proportions. Nevertheless, the typical characteristics of Primary Trends are well worth keeping in mind. If you know the symptoms that normally accompany the last stage of a Bull Market, for example, you are less likely to be deluded by its exciting atmosphere. Principle of confirmation 1. The two Averages must confirm: This is the most-often questioned and the most difficult to rationalize of all the Dow principles. Yet it has stood the test of time; the fact it has worked is not disputed by any who have carefully examined the records. Those who have disregarded it in practice have, more often than not, had occasion to regret their apostasy. What it means is that no valid signal of a change in trend can be produced by the action of one Average alone. Take, for example, the hypothetical case shown in Diagram 3.1. In this, we assume that a Bear Market has been in effect for several months and then, starting at a, the Industrial Average rises (along with the Rails) in a Secondary Recovery to b. On their next decline, however, the Industrials Diagram 3.1 A hypothetical daily market chart to show how one average may fail to confirm the other's Dow signal. Closing prices, indicated by short horizontal dashes, are connected with vertical lines to make the day- to-day trend easier to follow. At this point, the Industrials have “signaled” a change in trend from down to up. But note the Rails during this period: their decline from b to c carried them lower than a, and their subsequent advance from c to d has not taken them above b. They have (so far) refused to confirm the Industrials and, hence, the Major Trend of the market must be regarded as still down. Should the Rails go on to rise eventually above their b, then, and then only, would we have a definite signal of a turn in the tide. Until such a development, however, the chances remain that the Industrials will not be able to continue their upward course alone, that they ultimately will be dragged down again by the Rails. At best, the direction of the Primary Trend is still in doubt. This example illustrates only one of the many ways in which the principle of confirmation applies. Note also that at c, it might have been said that the Industrials had thus far not confirmed the Rails in continuing the Downtrend, but this had to do only with the continuation or reaffirmation of an existing trend. It is not necessary that the two Averages confirm on the same day. Frequently, both will move into new high (or low) ground together, but there are plenty of cases in which one or the other lags behind for days, weeks, or even a month or two. One must be patient in these doubtful cases and wait until the market declares itself in definite fashion. 2. “Volume goes with the trend”: Those words, which you may often hear spoken with ritual solemnity but little understanding, are the colloquial expression for the general truth that trading activity tends to expand as prices move in the direction of the prevailing Primary Trend. Thus, in a Bull Market, volume increases when prices rise and dwindles as prices decline; in Bear Markets, turnover increases when prices drop and dries up as they recover. To a lesser degree, this holds for Secondary Trends also, especially in the early stages of an extended Secondary Recovery within a Bear Market, when activity may show a tendency to pick up on the Minor Rallies and diminish on the Minor Setbacks. But to this rule, again, there are exceptions, and useful conclusions can seldom be drawn from the volume manifestations of a few days, much less from a single trading session; it is only the overall and relative volume trend over a period of time that may produce helpful indications. Moreover, in Dow Theory, conclusive signals as to the market's trend are produced in the final analysis only by price movement. Volume simply affords collateral evidence that may aid interpretation of otherwise doubtful situations. (We shall have much more to say in later chapters about volume in specific relation to other technical phenomena.) 3. “Lines” may substitute for Secondaries: A line in Dow Theory parlance is a sideways movement (as it appears on the charts) in one or both of the Averages, which lasts for two or three weeks or, sometimes, for as many months, in the course of which prices fluctuate within a range of approximately 5% or less (of their mean figure). The formation of a Line signifies that pressure of buying and selling is more or less in balance. Eventually, of course, either the offerings within that price range are exhausted and those who want to buy stocks have to raise their bids to induce owners to sell, or else those who are eager to sell at the Line price range find that buyers have vanished and that, in consequence, they must cut their prices to dispose of their shares. Hence, an advance in prices through the upper limits of an established Line is a Bullish Signal and, conversely, a breakdown through its lower limits is a Bearish Signal. Generally speaking, the longer the Line (in duration) and the narrower or more compact its price range, the greater the significance of its ultimate breakout. Lines occur often enough to make their recognition essential to followers of Dow's principles. They may develop at important Tops or Bottoms, signaling periods of distribution or of accumulation, respectively, but they come more frequently as interludes of rest or Consolidation in the progress of established Major Trends. Under those circumstances, they take the place of normal Secondary Waves. A Line may develop in one Average while the other is going through a typical Secondary Reaction. A price movement out of a Line, either up or down, is usually followed by a more extensive additional move in the same direction than can be counted on to follow the “signal” produced when a new wave pushes beyond the limits set by a preceding Primary Wave. The direction in which prices will break out of a Line cannot be determined in advance of the actual movement. The 5% limit ordinarily assigned to a Line is arbitrarily based on experience; there have been a few slightly wider sideways movements that, by virtue of their compactness and well-defined boundaries, could be construed as true Lines. (Later in this book, we shall see that the Dow Line is, in many respects, similar to the more strictly defined patterns known as rectangles that appear on the charts of individual stocks.) 4. Only closing prices used: Dow Theory pays no attention to any extreme highs or lows that may be registered during a day and before the market closes, but takes into account only the closing figures, that is, the average of the day's final sale prices for the component issues. We have discussed the psychological importance of the end-of-day prices under the subject of chart construction and need not deal with it further here, except to say that this is another Dow rule that has stood the test of time. It works thus: suppose an Intermediate Advance in a Primary Uptrend reaches its peak on a certain day at 11:00 a.m., at which hour the Industrial Average figures at, say, 152.45, and then falls back to close at 150.70. All that the next advance will have to do to indicate the Primary Trend is still up is register a daily close above 150.70. The previous intraday high of 152.45 does not count. Conversely, using the same figures for our first advance, if the next upswing carries prices to an intraday high at, say, 152.60, but fails to register a closing price above 150.70, the continuation of the Primary Bull Trend is still in doubt. In recent years, differences of opinion have arisen among market students as to the extent to which an Average should push beyond a previous limit (Top or Bottom figure) to signal (or confirm or reaffirm, as the case may be) a market trend. Dow and Hamilton evidently regarded any penetration, even as little as 0.01, in closing price as a valid signal, but some modern commentators have required penetration by a full point (1.00). We think the original view has the best of the argument—that is, that the record shows little or nothing in practical results to favor any of the proposed modifications. One incident in June 1946, to which we shall refer in the following chapter (EN10: Now in Appendix A), shows a decided advantage for the orthodox “any-penetration-whatever” rule. 5. A trend should be assumed to continue in effect until such time as its reversal has been definitely signaled: This Dow Theory tenet is one that, perhaps more than any other, has evoked criticism. Yet, when correctly understood, it, like all the others we have enumerated, stands up under practical test. What it states is really a probability. It is a warning against changing one's market position too soon, against “jumping the gun.” It does not imply that one should delay action by one unnecessary minute once a signal of change in trend has appeared. But it expresses the experience that the odds are in favor of the man who waits until he is sure, and against the other fellow who buys (or sells) prematurely. These odds cannot be stated in mathematical language such as 2-1 or 3-1; as a matter of fact, they are constantly changing. Bull Markets do not climb forever and Bear Markets always reach a Bottom sooner or later. When a new Primary Trend is first definitely signaled by the action of the two Averages, the odds that it will be continued, despite any near-term reactions or interruptions, are at their greatest. But as this Primary Trend carries on, the odds in favor of its further extension grow smaller. Thus, each successive reaffirmation of a Bull Market (new Intermediate high in one average confirmed by a new Intermediate high in the other) carries relatively less weight. The incentive to buy, the prospect of selling new purchases at a profit, is smaller after a Bull Market has been in existence for several months than it was when the Primary Uptrend was first recognized; this 12th Dow tenet says, “Hold your position pending contrary orders.” A corollary to this tenet, which is not so contradictory as it may at first seem, is this: a reversal in trend can occur any time after that trend has been confirmed. This can be taken simply as a warning that the Dow Theory investor must watch the market constantly if he has any commitment in it. EN: Modern market importance of Dow Theory and necessity for moving to a new composite market theory Dow Theory has much to recommend it. Concepts embodied within Dow Theory retain their validity to the present day and retain their importance as the foundation thinking for technical analysis. Concepts of waves, major, secondary, and minor movements are absolutely descriptive of the reality of the market. Other constructs within Dow Theory are similarly important— that all information is discounted; that major market movements are like the tide and, as it were, raise all boats; that trends tend to continue. These are not just theoretical musings, but observations of reality. In addition to its technical validity, the Dow has now taken on a mythic dimension. It has a symbolic function that interacts with its originally intended purpose. Dow and Hamilton saw their measurement of the market as an economic barometer for the entire economy; its use as a tool for investing in the market came later. In the opinion of this editor, the Dow Theory is no longer adequate to its original purpose—or even to its secondary purpose. It is a simple theory propounded in a simple time. Expounders of Dow Theory have implicitly recognized the necessity for evolutionary changes to the doctrine with the addition of the Rails (now Transportations) and the Utilities ad infinitum. Thirty stocks may have been sufficient originally to reflect the U.S. economy. No one would deny that simple paradigm must be changed to reflect an economic structure geometrically more diverse than that of Dow and Hamilton. Entering the twenty-first century, the U.S. and global economy require more sophisticated econometrics than the Dow alone. For that reason, I consider that to fulfill the functions of the old Dow, we now must consider a variety of averages and indexes to measure the state of the market—not to mention the economy, which is another question, although not altogether another question, but at least another question. Magee foreshadowed some instruments of great value to this end in his writings, specifically on the Magee Evaluative Index (Chapter 38), which may be used for the entire market, and not just for one summary index or average. The value and power of this tool are still little used and understood. In twenty-first-century markets, there are not just broad tides and markets flowing in one direction as they might on Magee's Cape Cod. Instead, the currents, riptide, and crosscurrents are like the economy of the country, moved West. They are now symbolized by the Pacific Ocean roaring in and out of San Francisco Bay. Although the Dow is in a secondary Downtrend, the broader Standard & Poor's 500 is going to new highs, and although they are both whipping sideways, the National Association of Securities Dealers Automated Quotations (NASDAQ) is rocketing into space. For this reason, I now believe that only a composite of the three indexes can express the true state of the markets as a whole. And, in addition, to dissect the entrails of the market, the Magee Evaluative Index should be run across the three indexes. The Dow Theory required the Rails and Industrial Averages move in harmony to signal Bull or Bear Markets. In this century, there is a similar need for harmonic convergence among the averages to indicate to us the state of the markets as a whole. When all three indexes agree in the direction of their trends, up or down or sideways, Bulls may be assumed to be safe in general, and vice versa for Bears. Failure of the three to be in harmony is a clear sign of mixed markets and advises one to arrange his bets and portfolio to correspond with economic uncertainty. Capital should flow naturally to the most productive area. What reason is there to ride the Dow down when the NASDAQ is raging up? If the investor follows the philosophy of this book, he will never sit passively through an extended Downtrend. At the very least, he will be hedged, if not outright short. (As Edwards and Magee preferred and as this editor prefers.) EN10: Notes on Edwards' description of Dow Theory We must keep in perspective Edwards' description of Dow Theory. When he speaks of Secondaries of 10 and 20 points, or a Primary of 30 points, we should be reminded that the entire market could be accommodated in the backseat of a Packard. The top in 1929 was approximately 386 and the bottom approximately 64; hence, 10, 20, or 30 points constituted important percentage moves. Similarly, a primary market move of 20%, although still of importance, hardly describes the violence and range of modern markets. From March 2009 to November 2017, the Dow moved from 6469.95 to 23,602.12—a move of 17,132.17 or 264%. chapter four The Dow Theory's defects EN10: Figures 2-9 from the ninth edition now appear in Appendix A along with Edwards' detailed account of Dow Theory operations. Our readers, we suspect, heaved a deep sigh of relief when they closed the preceding chapter (EN10: Chapter 4 in the ninth edition, now Appendix A), which covered a difficult, tedious, and, at times, confusing subject. Some may even wish at this point that the Dow Theory had never been conceived. Others doubtless spotted one or more of its real or supposed defects and have questions to ask. Before we proceed to more interesting chart matters, we had better devote a few pages to clearing up these questions. First, let's take up the charge of “second-guessing,” which is so often flung at writers on Dow Theory. It is a charge that will continue to crop up so long as opinions differ among Dow theorists at critical periods (which, unfortunately, is often the case). Even the most experienced and careful Dow analysts find it necessary occasionally to change their interpretations when a stand first ventured is rendered untenable by some subsequent action of the market. They would not attempt to deny it, but, they say, in the long run, surprisingly little is lost by such temporary misinterpretations. Many of them publish their comments regularly and can refer you to the printed files of opinions and advice expressed before and during the event, as well as after it. Regarding Chapter 4 in the ninth edition (now Appendix A), the reader, if he cares to check such records, will find that the interpretations given therein (aside from the remarks made “in retrospect” and so labeled) were precisely the interpretations published at the time by the best-established Dow analysts. EN9: Although, in the modern age Richard Russell (now deceased) (dowtheoryletters. com) was senior in terms of reputation, a host of other Dow theorists (actually trying to round them up is like herding cats) inhabit the scene, among them Jack Schannep (thedowtheory.com) and Richard Moroney (dowtheory.com) who must be taken into account when consulting the sacred-chicken bones. Robert W. Colby (robertwcolby.com) is also currently doing authoritative work in Dow Theory. Note that it is the chicken that is sacred, and the bones only secondarily. The Dow Theory is too late The objection that the Dow Theory is too late is more valid. It is sometimes expressed in the rather intemperate statement that “the Dow Theory is a surefire system for depriving the investor of the first third and the last third of every Major Move, and sometimes there isn't any middle third!” Or, to give a specific example: A Primary Bull Market started in 1942 with the Industrial Average at 92.92 and ended in 1946 at 212.50, for a total gain of 119.58 Average points, but the strict Dow theorists could not buy until the Industrials were up to 125.88 and could not sell until prices had already declined to 191.04; thus, capturing, at best, only about 65 points, or not much more than half of the total move. This specific statement cannot be disputed, yet the answer to the general objection is to “try to find a man who first bought his stocks at 92.92 (or even within 5 points of that level) and stayed 100% long throughout the intervening years, and finally sold out at 212.50, or within 5 points thereof.” The reader is welcome to try; he will, in fact, find it very difficult to locate even a dozen who did as well as the Dow Theory. A still better answer, because it comprehends all of the hazards of every known kind of Bull and Bear Market to date, is the overall dollars and cents record of the past 60 years. We are indebted to Richard Durant for permission to reprint the following computation of what would, in theory, have resulted if a fund of only $100 could have been invested in the stocks of the Dow-Jones Industrial Average on July 12, 1897, when a Primary Bull Market was signaled by the Dow Theory, and those stocks were thereafter sold and repurchased when, and only when, the Dow Theory had definitely confirmed a change in the Major Trend (see Table 4.1). Table 4.1 The Dow Theory's 60-Year Record SignalDate Dow Jones Average Price Loss (V) Change (%) Capital Gain Accumulated Profit Bought7/12/189744.61 100 Sold 12/16/189963.84 43.11 143.11 Bought10/20/190059.44 Sold 6/1/190359.59 0.25 0.36 143.47 Bought7/12/190451.37 Sold 4/26/190692.44 79.95 114.7 258.18 Bought4/24/190870.01 Sold 5/3/191084.72 21.01 54.25 312.42 Bought10/10/191081.91 Sold 1/14/191384.96 3.72 11.63 324.05 Bought4/9/191565.02 Sold 8/28/191786.12 32.45 105.16429.22 Bought5/13/191882.16 Sold 2/3/192099.96 21.67 92.99 522.21 Bought2/6/192283.7 Sold 6/20/192390.81 8.49 44.36 566.56 Bought12/7/192393.8 Sold 10/23/1929305.85 226.071,280.811,847.38 Bought5/24/193384.29 Sold 9/7/1937164.39 95.03 1,755.543,602.92 Bought6/23/1938127.41 Sold 3/31/1939136.42 7.07 254.793,857.7 Bought7/17/1939142.58 Sold 5/13/1940137.5 V -3.56 -137.453,720.26 Bought2/1/1943125.88 Sold 8/27/1946191.04 51.76 1,925.745,646 Bought10/2/1950228.94 Sold 4/2/1953280.03 22.32 1,259.956,905.95 Bought1/19/1954288.27 Sold 10/1/1956468.7 62.59 4,322.4811,228.43 In brief, an investment of $100 in 1897 would have become $11,228.43 in 1956 simply by buying the Industrial Average stocks each time the Dow Theory announced a Bull Market and holding them until the Dow Theory announced a Bear Market. During this period, the investor would have made 15 purchases and 15 sales, or about one transaction every two years on average. The record is not perfect. It shows one losing transaction and three instances in which reinvestment would have been made at a higher level than the preceding liquidation. But, at that, it hardly needs defending. Also, it takes no account of commissions and transfer taxes, but neither does it include the dividends the investor would have received during the time he held his stocks; the latter would have added many more dollars to the fund. For the enlightenment of the man who believes in “just buying good stocks and putting them away,” compare these results with the best that could have been done by buying shares only once at the lowest price recorded by the Industrial Average during these entire 60 years and selling them only once at the highest: $100 invested at the all-time low, 29.64, on August 10, 1896, would have become only $1,757.93 at the then all-time high, 521.05, 60 years later on April 6, 1956. Compare this to the $11,228.43 gained from the Dow Theory program. EN: This record of the Dow Theory is updated to end of year 2017 in Table 4.2. I have left this record as is so that the reader may clearly distinguish my work from that of Edwards. The Dow Theory is not infallible The Dow Theory is not infallible. It depends on interpretation and is subject to all the hazards of human interpretive ability. But, again, the record speaks for itself. The Dow Theory frequently leaves the investor in doubt The fact that the Dow Theory frequently leaves the investor in doubt is true in one sense, yet not in another. There is never a time when the Dow Theory does not afford a presumptive answer to the question of the direction of the Primary Trend. That answer will be wrong for a relatively short time at the beginning of each new Major Swing. There will also be times when a good Dow analyst should say, “The Primary Trend is still presumably up, but it has reached a dangerous stage, and I cannot conscientiously advise you to buy now. It may be too late.” Frequently, however, the above objection simply reflects the inability of the critic mentally to accept the fundamental concept that the Averages discount all the news and statistics. He doubts the Dow Theory because he cannot reconcile its message with his own ideas, derived from other sources, of what stocks should do. The theory is usually more nearly right. This criticism in other cases reflects nothing but impatience. There may be weeks or months (as, e.g., during the formation of a Line) when the Dow Theory cannot “talk.” The active trader quite naturally rebels, but patience is a virtue in the stock market as elsewhere—in fact, essential if serious mistakes are to be avoided. The Dow Theory does not help the Intermediate Trend investor It is perfectly true that the Dow Theory does not help the Intermediate Trend investor, as it gives little or no warning of changes in Intermediate Trend. Yet, if a fair share of these can be captured, the profit amounts to more than can be derived from the Primary Trend alone. Some traders have worked out supplementary rules on the basis of Dow principles SignalDate Average Price Loss (V) Percentage Change (%) Capital Gain Accumulated Wealth 1 Buy 7/12/189744.61 100.00 2 Sell 12/16/189963.84 43.11 143.11 3 Buy 10/20/190059.44 4 Sell 6/1/190359.59 0.25 0.36 143.47 5 Buy 7/12/190451.37 6 Sell 4/26/190692.44 79.950 114.70 258.18 7 Buy 4/24/190870.01 8 Sell 5/3/191084.72 21.01 54.25 312.42 9 Buy 10/10/191081.91 10Sell 1/14/191384.96 3.72 11.63 324.05 11Buy 4/9/191565.02 12Sell 8/28/191786.12 32.45 105.16 429.22 13Buy 5/13/191882.16 14Sell 2/3/192099.96 21.67 92.99 522.21 15Buy 2/6/192283.7 16Sell 6/20/192390.81 8.49 44.36 566.56 17Buy 12/7/192393.8 18Sell 10/23/1929305.85 226.07 1280.811,847.38 19Buy 5/24/193384.29 20Sell 9/7/1937164.39 95.03 1755.543,602.92 21Buy 6/23/1938127.41 22Sell 3/31/1939136.42 7.07 254.79 3,857.70 23Buy 7/17/1939142.58 24Sell 5/13/1940137.5 X -3.56 -137.453,720.26 25Buy 2/1/1943125.88 26Sell 8/27/1946191.04 51.76 1925.745,646.00 27Buy 10/2/1950228.94 28Sell 4/2/1953280.03 22.32 1259.956,905.95 29Buy 1/19/1954288.27 30Sell 10/1/1956468.7 62.59 4322.4811,228.43 31Buy 5/2/1958459.56 32Sell 3/3/1960612.05 33.18 3725.7914,954.22 33Buy 2/23/1961654.42 34Sell 4/26/1962678.68 3.71 554.37 15,508.59 35Buy 11/9/1962616.13 36Sell 5/5/1966899.77 46.04 7139.4922,648.08 37Buy 1/11/1967822.49 38Sell 10/24/1967888.18 7.99 1808.8424,456.92 39Buy 10/1/1968942.32 40Sell 2/25/1969899.8 X -4.51 -1103.5623,353.36 41Buy 10/27/1969860.28 42Sell 1/26/1970768.88X -10.62 -2481.1720,872.19 (Continued) Table 4.2 (Continued) The Dow Theory's 121-Year Record SignalDate Average Price Loss (X) Percentage Change (%) Capital Gain Accumulated Wealth 43Buy 9/28/1970758.97 44Sell 7/28/1971872.01 14.89 3108.68 23,980.87 45Buy 2/10/1972921.28 46Sell 2/23/1973959.89 4.19 1005.02 24,985.88 47Buy 1/27/1975692.66 48Sell 10/24/1977802.32 15.83 3955.70 28,941.58 49Buy 6/6/1978866.51 50Sell 7/2/1981959.19 10.70 3095.53 32,037.11 51Buy 10/7/1982965.97 52Sell 1/25/19841231.89 27.53 8819.43 40,856.54 53Buy 11/6/19841244.15 54Sell 10/15/19872355.09 89.29 36482.0777,338.61 55Buy 2/29/19882071.62 56Sell 10/13/19892569.26 24.02 18578.11 95,916.72 57Buy 6/4/19902935.19 58Sell 8/3/19902809.65X -4.28 -4102.4291,814.30 59Buy 1/18/19912646.78 60Sell 10/5/19923179 20.11 18462.21110,276.51 61Buy 11/25/19923266.22 62Sell 8/4/19988487.31 159.85 176278.26286,554.76 63Buy 11/2/19988706.5 64Sell 9/23/199910318.59 18.52 53058.30339,613.06 65Buy 11/8/20019587.52 66Sell 6/25/20029126.8 X -4.81 -16319.81323,293.25 67Buy 1/6/20038773.57 68Sell 11/21/200712799.04 45.88 148332.69471,625.94 69Buy 4/18/200812849.36 70Sell 9/29/200810365.45X -19.33 -91170.02380,455.93 71Buy 4/9/20098083.38 72Sell 6/30/20109774.02 20.92 79572.41460,028.33 73Buy 9/27/201010812.04 74Sell 8/2/2011 11866.62 9.75 44870.04504,898.37 75Buy 12/23/201112294 76Sell 6/4/201212101.46 -1.57 -7907.36496,991.01 77Buy 1/18/201313649.7 78Sell 8/20/201516990.69 24.48 121646.78618,637.78 79Buy 10/19/201517084.49 80Sell 1/6/201616906.51 -1.04 -6444.74612,193.04 81Buy 4/20/201618053.6X 82Sell 6/24/201617400.75 -3.62 -15926.29596,266.75 83Buy 9/7/201618526.14 84Sell 12/29/201724719.22 33.43 199325.26795,592.01 that they apply to Intermediate Movements, but these have not proved to be satisfactory. The remainder of our book is devoted to a better approach to this problem. The Dow Theory is a mechanical device designed to tell the direction of the Primary Market Trend, which is important because, as said at the beginning of this book, most stocks tend to go with the trend. The Dow Theory does not and cannot tell you which individual stocks to buy, aside from those stocks that make up the Averages. That, again, is a problem for the remainder of this book. EN: An old criticism, irrelevant in modern markets. “The Dow Theory does not tell you which stocks to buy.” This was true at the time Edwards wrote this, but in modern markets, the investor can buy substitute instruments that almost perfectly mimic its behavior (DIA). This is possible because the investor can trade in surrogates for the Dow Averages in present markets (see Chapter 15). The Dow Theory in the 20th and 21st centuries As may be seen in Table 4.2, augmenting Table 4.1, the Dow Theory continued to provide its user an advantage over the unaware Buy-and-Hold Investor. From its original investment of $100 in 1897, the Dow Theory investment would have grown to $795,592.01 by December 29, 2017, with the long trade still open. Table 4.2 shows the details, including the post-2000 bust drawdown. To my mind, this table is a powerful demonstration of the effectiveness of methodical technical investing, be it Dow Theory or some other robust method—which I will discuss in Chapter 5. By contrast, the buy-and-hold investment of $100, if bought at the low, 29.64, and sold at the close, December 29, 2017, would have grown to $55,411.83. I am indebted to Jack Schannep of TheDowTheory.Com (http://www.thedowtheory. com) for the data recapitulated here. On Schannep's website, a clear exposition of the Dow Theory and its record may be found—much more complete than that which is found here, outside of Edwards' magisterial presentation. Minor discrepancies are acknowledged within these and others' data, a point that will be raised by purists. This is occasioned by disagreements within the priestly circles of those who keep the sacred records. That is, not all theorists are in 100% agreement as to the exact date or nature of the signals. (Some will say the reentry date of October 1, 1956 should have been October 7, 1957, for example.) Meaning some judgment is involved in interpretation of the entrails. The Dow Theory is not a 100% objective algorithm, just as chart analysis is not reducible to an objective algorithm. (I am allowed to jest at the priesthood as I am a minor acolyte in these matters. It would not be seemly for the uninitiated to burlesque.) In brief, an investment of $100 in 1897 would have become $795,592.01 simply by buying the Industrial Average stocks each time the Dow Theory announced a Bull Market and holding them until the Dow Theory announced a Bear Market, and then selling, with the entire equity reinvested on each trade. The Technical Investor would have had this amount in pocket marked to market at the end of 2017, as opposed to the $55,411.83 of his dozing counterpart, or the Trust Department of the Rip Van Winkle Bank of Sleepy Hollow. And, in addition, he would not have been illiquidified during Bear Markets. Whether the Dow Theory retains its validity over the market as a whole, there can be no question that it still calls the turn for its sector of the market, which as Jack Schannep correctly notes, has five times the capitalization of the NASDAQ (see Table 4.2). As Mark Twain observed, everybody talks about the Dow Theory, but nobody does anything about it. Perhaps that is not precisely what Twain said, but close enough for government work. As further inquiry into the inner workings of the Dow Theory, I initiated a series of studies of the record with Brian Brooker, who holds a master's of science in finance from Golden Gate University, and Matt Mullens, and Nehemiah Brown III my graduate students at Golden Gate University. Included here are some of the results of our study, from the book, Sacred Chickens, the Holy Grail and Dow Theory (Amazon). It seems obvious that the risk characteristics of Dow Theory investing are unique, and I will belabor the obvious. The Buy-and-Hold Investor mentioned above for comparison with the Dow Theory Investor not only realized less profit over the period of his investment but also experienced greatly expanded risk over the life of the investment. At first blush, all the profits garnered by the reversing investor in Table 4.3 represent risk actually experienced by the Buy-and-Hold Investor—but that is only first blush. A little deeper thought reveals the true extent of the Buy-and-Hold Investor's risk is measured by maximum drawdowns over any given period of time. It is not necessary to theorize about this question; the measurement is empirical. When viewed in perspective, these risks are startling. From the top in 2000 to the low in 2002, a 39% drawdown occurred. Is this disquieting? A 41% drawdown occurred during the Reagan crash of 1987. A mere bagatelle. The Hoover drawdown from 1929 to 1932 was 89%. Such things are unlikely to happen again. The big guys would step in and support the market. Clearly, the way to reduce market risk to zero is to be out of the market. Less obviously, or perhaps blatantly, the second most important way to reduce risk is to be right about the trend—or to not be wrong. Moreover, because of the nature of the Dow Theory, much time is spent on the sidelines by the Dow investor. This is a natural reduction of risk. In fact, of the total days from 1897 to 2018, 44,193, the Dow Investor spent 15,492 (or about 35% of the time) days at the beach or at the S&L. But his accumulated profits have not been credited with interest, as this is a “pure” study. As will be readily apparent, Table 4.3 is much richer in data than just the duration of investments in the long side of the market. Acting on the maxim (my own) that it is unwise to invest on only one side of the market, I have computed the accumulated profits gained by trading the Dow long and short. After all, the market goes down as well as up, and for a reversing system a liquidation of longs is a signal to go short. If the record on the long side is impressive, showing accumulated profits to 2018 of $795,592.01, how much more impressive is the accumulated profit of $5,757,390.17 garnered from trading both sides of the Dow, long and short? The reader who listens carefully will hear the metamessage. For the great majority of investors, it is the long run that is important. In the right-now culture of the internet and computer age and the get-rich-quick mentality, one wonders whether there are still such investors, outside of the very rich and very intelligent. Perhaps there are still a few aging readers of early editions of this book, and, not to despair, perhaps some new converts. A note of caution is in order here: beware of spreadsheets run amuck. As the spreadsheet serenely grinds through a trade it doesn't care how it may be creating a fantasy universe. Likewise, the more transactions the greater the eventual figure as the compounding effect of reinvesting the total bankroll on every roll of the dice. This being said, putting the matter into mathematical perspective and discounting inflated totals still makes the performance impressive—much more so considering most professional fund managers can't beat the market. Table 4.3 Performance of Dow Theory through 2017: Longs and Shorts Accumulated Trade#SignalDate PricePL%Profit BullBear 1 Long7/12/189744.61 100.00 2 Short12/16/189963.8443.11 143.11 887 3 Long10/20/190059.446.89 152.97 308 4 Short6/1/190359.590.25 153.36 954 5 Long7/12/190451.3713.79174.51 407 6 Short4/26/190692.4479.95314.04 653 7 Long4/24/190870.0124.26390.24 729 8 Short5/3/191084.7221.01472.23 739 9 Long10/10/191081.913.32 487.89 160 10 Short1/14/191384.963.72 506.06 827 11 Long4/9/191565.0223.47624.83 815 12 Short8/28/191786.1232.45827.60 872 13 Long5/13/191882.164.60 865.66 258 14 Short2/3/192099.9621.671,053.20631 15 Long2/6/192283.7 16.271,224.52 734 16 Short6/20/192390.818.49 1,328.54499 17 Long12/7/192393.8 -3.29 1,284.79 170 18 Short10/23/1929305.85226.074,189.282147 19 Long5/24/193384.2972.447,224.02 1309 20 Short9/7/1937164.3995.0314,088.941567 21 Long6/23/1938127.4122.5017,258.28 289 22 Short3/31/1939136.427.07 18,478.73281 23 Long7/17/1939142.58-4.52 17,644.33 108 24 Short5/13/1940137.5-3.56 17,015.68301 25 Long2/1/1943125.888.45 18,453.66 994 26 Short8/27/1946191.0451.7628,005.931303 27 Long10/2/1950228.94-19.8422,449.90 1497 28 Short4/2/1953280.0322.3227,459.79913 29 Long1/19/1954288.27-2.94 26,651.78 292 30 Short10/1/1956468.762.5943,333.29986 31 Long5/2/1958459.561.95 44,178.32 578 32 Short3/3/1960612.0533.1858,837.46671 33 Long2/23/1961654.42-6.92 54,764.35 586 34 Short4/26/1962678.683.71 56,794.52198 35 Long11/9/1962616.139.22 62,028.94 197 36 Short5/5/1966899.7746.0490,584.421273 37 Long1/11/1967822.498.59 98,364.60 251 38 Short10/24/1967888.187.99 106,220.70286 39 Long10/1/1968942.32-6.10 99,745.90 343 40 Short2/25/1969899.8-4.51 95,245.10147 41 Long10/27/1969860.284.39 99,428.35 244 42 Short1/26/1970768.88-10.6288,864.6391 (Continued) Table 4.3 (Continued) Performance of Dow Theory through 2017: Longs and Shorts Trade#SignalM/D/Y Price PL% Accumulated Profit BullBear 43 Long 9/28/1970758.97 1.29 90,010.00 245 44 Short 7/28/1971872.01 14.891,03,415.97303 45 Long 2/10/1972921.28 -5.65 97,572.80 197 46 Short 2/23/1973959.89 4.19 101,661.99411 47 Long 1/27/1975692.66 27.84129,964.33 588 48 Short 10/24/1977802.32 15.83150,539.921084 49 Long 6/6/1978866.51 -8.00 138,495.90 225 50 Short 7/2/1981959.19 10.70153,309.11 135 51 Long 10/7/1982965.97 -0.71 152,225.45 572 52 Short 1/25/19841231.8927.53194,131.30415 53 Long 11/6/19841244.15-1.00 192,199.27 462 54 Short 10/15/19872355.0989.29363,819.94475 55 Long 2/29/19882071.6212.04407,611.06 362 56 Short 10/13/19892569.2624.02505,526.50997 57 Long 6/4/19902935.19-14.24433,526.27 84 58 Short 8/3/19902809.65-4.28 414,984.06645 59 Long 1/18/19912646.785.80 439,039.89 234 60 Short 10/5/19923179 20.11 527,322.9460 61 Long 11/25/19923266.22-2.74 512,855.15 124 62 Short 8/4/19988487.31159.851,332,659.972799 63 Long 11/2/19988706.5 -2.58 1,298,243.21 42 64 Short 9/23/199910318.5918.521,538,625.09373 65 Long 11/8/20019587.527.08 1,647,636.37 777 66 Short 6/25/20029126.8 -4.81 1,568,460.62229 67 Long 1/6/20038773.573.87 1,629,163.97 195 68 Short 11/21/200712799.0445.882,376,653.391780 69 Long 4/18/200812849.36-0.39 2,367,309.47 149 70 Short 9/29/200810365.45-19.331,909,684.83149 71 Long 4/9/20098083.3822.022,330,123.36 192 72 Short 6/30/20109774.0220.922,817,468.97447 73 Long 9/27/201010812.04-10.622,518,248.26 89 74 Short 8/2/2011 11866.629.75 2,763,872.05309 75 Long 12/23/201112294 3.60 2,863,413.76 143 76 Short 6/4/201212101.46-1.57 2,818,568.99164 77 Long 1/18/201313649.712.793,179,171.86 228 78 Short 8/20/201516990.6924.483,957,326.79944 79 Long 10/19/201517084.490.55 3,979,173.89 60 80 Short 1/6/201616906.51-1.04 3,937,720.3079 81 Long 4/20/201618053.66.78 4,204,890.74 105 82 Short 6/24/201617400.75-3.62 4,052,834.4765 83 Long 9/7/201618526.146.47 4,314,950.73 75 84 MtoMkt12/31/201724719.2233.435,757,390.17480 85 15417 Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter five Replacing Dow Theory with John Magee's Basing points Procedure I have humorously compared the interpretation of the market using Dow Theory to the ancient Romanpractice of haruspication—that is, the examination of animal or bird entrails to forecast the future. DowTheory analysts examine the market and venture their expert opinions as to whether Dow Theory saysthe market is a buy, a sell, or a hold. Sometimes it seems as if they might be sitting on a tripod at Delphiand inhaling substances legal in California but forbidden in Washington, D.C. Additionally, from thesame data they often extract different conclusions. (No disrespect of Dow theorists is intended. Some ofmy best friends are Dow analysts.) From this observation came the motivation to look for a better way.That better way is found in Chapter 28 in which Magee outlined (and I have further articulated) a methodthat is eminently adaptable to long-long term investing. We are talking about investments that might lastfor years. One reason the rich get richer is they practice this kind of investing. They correctly assessbusiness conditions and economic circumstances and take deeply entrenched positions that, in secularbull markets, return them profits beyond the hope of swing traders and midterm traders. Perhaps in somecases they even use Dow Theory. Whatever they use, they are not chased from the market, except by truechanges in the major trend. Investing on this time scale has never been easy—except for the well-capitalized mature and patientinvestor. Using Magee's Basing Points Procedure, it is now possible for the general investor to invest onthe Dow Theory (or longer) time scale. To demonstrate the power of this procedure, I undertook anumber of studies. The first and most important of these was a study of the Dow Industrials since 1900using Dow Theory. By studying the Industrials, we have an excellent benchmark in the performance ofDow Theory over that time. The fractal nature of the market A fact that all traders know in their bones was enunciated by the polymath, Benoit Mandelbrot, whostated market price behavior is fractal. Fractal literally means self-similar at all scales. In other words, atwo-minute bar chart exhibits the same kind of formations and characteristics as a daily chart, and sodoes a weekly chart. If you were presented a chart and told to determine the time scale, you would beunable to answer from the data alone. When you read about moving average systems in Chapter 36, youwill see—as you probably know already—that a 10-day moving average system trades 10 times as muchas a 200-day moving average system. The closer you are to the market, the more prone you are to be ledastray by noise. This is one reason day traders are so seldom successful—noise and random price activitymake for difficult data to analyze. Important traders of my acquaintance trade on weekly data: in otherwords, they trade using one bar to represent a week of market activity. Not surprisingly, they tradeinfrequently compared with daily bar traders. Considering these facts, I constructed a Basing Points Procedure using weekly bars to test the method.Instead of using “three-days-away” data to determine Basing Points, I used “three-bars-away” data. Itook all the Industrials data and back studied it to see what the performance would have been usingMagee's procedure. The results are impressive; not eye-popping in terms of profits but sufficient.Furthermore, when considering operating characteristics overall, especially in ease of operation, theMagee method wins hands down. The results of using Magee's simple-as-pie method are superior to the results obtained by using thecomplex and often obtuse Dow Theory. Later in this chapter, I will summarize the results of the studyand illustrate the tables. • Profits produced by the Magee Procedure are superior to those produced by the Dow Theory:$1,147,486.52 as opposed to $795,592.01. • Profits produced by Variant 2 of the Magee Procedure were $2,982,577.83. • Compound Annual Growth Rates (CAGR) were also similar: 7.9% (Variant 1) versus 7.87% and 8.37%for Variant 2. • Risk profiles were also quite similar: average drawdown for Dow Theory was 13.78% and for theMagee Procedure was 16%. Maximum drawdown was 25.3% for Dow Theory and 30% for the MageeProcedure. • Also pertinent to risk, considering long-side trades only, the Dow Theory was out of the market 36% ofthe time and the Magee Procedure 35%. This is a little remarked fact about Dow Theory—and unknownbefore this about Magee's Procedure. This is a radically important fact; it means each procedure is risk-free more than a third of the time. Calculating the out-of-market returns is such a hairy process, it wasnot undertaken. • As a result of differences in drawdowns and stop methods, Magee's Procedure is operationally superiorto Dow Theory. Since 1900, the Dow Theory has made 42 trades, the Magee Procedure has made 25.Considering the similarity of risk and profit characteristics, a system that trades less is preferable—lesscost, less slippage, fewer chances to lose market position. This is to say, better control of the vigorish. In short, the Magee Basing Points Procedure represents the best alternative to the Dow Theory for thetrue long-term investor. It can be used on weekly bars, in which case its full long-term power isevidenced. It also can be used on daily bars for a more sensitive approach. The Basing Points Procedure may be operated in two ways, which I call Variant 1 and Variant 2. Variant1 sets stops based on wave lows. Variant 2, in addition to wave lows, uses new wave highs (see Chapter28). Table 5.1 denotes trades for the Basing Points Procedure, Variant 1. Table 5.2 denotes trades for theBasing Points Procedure, Variant 2. Keys to trades are shown in Figures 5.2 and 5.3. Readers, andinvestors in general, have every right to be skeptical of academic studies. Every morning, the mailbox isfull of “can't fail” “get-rich-quick” systems being sold by Wall Street hucksters who always showmouthwatering profits. Yet these are always paper studies. By contrast, the Magee Basing PointsProcedure has been in operation in the market for some years, and its effectiveness has beendemonstrated. It exited, and shorted, the market in January 2008 and remained short until March 2009. In2011, the Procedure exited longs and went short in late July before the Greek debt crisis. Letters writtenin real time during these events are in the http://www. edwards-magee.com archives and are available foraudit. Charts made at the time follow here. (See Figures 5.2 and 5.3. Figure 5.1 shows a detailed chart ofthe analysis of the top of the 2007 market and the short that resulted in early 2008.) Table 5.1 Trades Made by the Magee Basing Points Procedure, Variant 1 Date Signal Wave High Wave Low Stop Price P/L Long% Accum Lng Riskpts Risk% DurationDuration LongShort 9/24/1900Long 53.0050.35 143.1 6/17/1901 78.30 371 9/30/1901Short 64.0311.0320.81172.8814.2718.22 11/2/1903 42.20 7/11/1904Long 52.02 1015 1/15/1906 103.00 8/5/1907Short 76.7624.7547.57255.1326.2425.481120 1/11/1907 53.00 3/23/1908Long 67.77 231 9/27/1909 100.50 1/31/2010Short 91.11 23.3434.43342.979.39 9.34 679 9/25/1911 72.90 4/22/1912Long 88.58 812 9/30/1912 94.20 12/9/1912Short 85.88-2.70-3.05332.528.32 8.83 231 12/21/1914 53.20 3/29/1915Long 60.26 840 11/13/1916110.13 8/27/1917Short 84.6524.4040.49467.1425.4823.14882 12/17/1917 65.90 8/19/1918Long 84.56 357 11/3/1919 119.60 8/9/1920Short 83.72-0.84-0.99462.5035.8830.00721 8/22/1921 63.90 10/24/1921 Long 72.10 441 3/19/1923 105.40 7/23/1923Short 87.4015.3021.22560.6518.0017.08637 10/22/1923 85.76 1/21/1924Long 96.51 182 9/2/1929 386.10 10/21/1929Short 319.30222.79230.841854.8666.8017.302100 7/4/1932 40.60 4/24/1933Long 70.97 1281 3/8/1937 195.60 9/6/1937Short 166.5495.57134.674352.8529.0614.861596 3/28/1938 97.50 7/18/1938Long 136.89 315 9/11/1939 157.80 5/13/1940Short 135.95-0.94-0.684323.0621.8513.85665 4/27/1942 92.70 7/6/1942Long 105.99 784 5/27/1946 213.4 9/16/1946Short 172.4366.4462.697033.1740.9719.201533 6/13/1949 160.6 10/24/1949 Long 184.27 1134 4/9/1956 524.4 9/23/1957Short 468.26283.99154.1217872.7356.1410.712891 10/21/1957 416.2 Table 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1 Date SignalWave High Wave Low Stop Price P/L Long % Accum Lng Risk ptsRisk% DurationDuration LongShort 6/23/1958Long 465.77 273 1/4/1960 688.2 9/26/1960Short 582.64116.8725.0922357.51105.5615.34826 10/24/1960 564.2 4/3/1961Long 664.66 189 11/13/1961741.3 5/7/1962Short 654.46-10.20-1.5322014.4486.8411.71399 6/25/1962 524.6 12/31/1962 Long 640.66 1/17/1966 1000.6 238 5/9/1966Short 878.18237.5237.0730176.13122.4212.231225 10/10/1966 735.7 10/14/1968 Long 937.71 889 12/2/1968 994.7 6/9/1969Short 895.4-42.31-4.5128814.5199.309.98238 5/25/1970 627.5 1/11/1971Long 827.40 581 1/8/1973 1067.2 5/14/1973Short 871.2543.855.3030341.63195.9518.36854 12/2/1974 572.1 12/10/1975 Long 713.58 940 9/20/1976 1026.3 5/23/1977Short 904.12190.5426.7038443.24122.1811.90530 2/27/1978 742.13 8/14/1978Long 875.60 448 9/4/1978 907.73 3/24/1980Short 780.15-95.45-10.9034252.39127.5814.05588 4/21/1980 759.13 8/4/1980Long 930.96 133 3/30/1981 1030.98 8/3/1981Short 877.8-53.16-5.7132296.66153.1814.86364 8/9/1982 769.98 10/4/1982Long 902.82 427 8/24/1987 2746.7 10/19/1987 Short 2071.511,168.69129.4574104.67675.1924.581841 8/24/1987 1616.2 1/23/1989Long 2234.53 7/20/1998 9367.94 462 8/24/1998Short 8141.865,907.33264.37270011.561,226.0813.093500 7/20/1998 7402.61 3/8/1999Long 9015.28 196 1/10/2000 11750.28 2/21/2000Short 9889.28874.009.69296188.211,861.0015.84350 10/7/2002 7197.49 9/1/2003Long 9314.67 1288 10/8/2007 14198.1 1/7/2008Short 12503.043,188.3734.23397572.061,695.0611.941589 3/2/2009 6469.95 Table 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1 Wave Wave Stop P/L Accum Risk Duration Duration Date Signal High Low Price Long % Lng pts Risk % Long Short 5/4/2009 Long 8564.52 484 12/31/200910428.05 12/29/2017 Markto 16928.03 24719.22 16154.70 749914.46 188.62 1147486.52 14291.17137.05% 3161 market 12/29/17 Table 5.2 Trades Made by the Magee Basing Points Procedure, Variant 2 Date SignalStopProfit% Accumulated Profit Duration Long Duration Short 9/25/1900Buy 143.10 6/18/1901 371 10/1/1901Sell64.0311.0320.81172.88 11/3/1903 7/12/1904Buy52.02 1015 1/16/1906 8/6/1907Sell76.7624.7547.57255.13 1120 1/12/1907 3/24/1908Buy67.77 231 9/28/1909 2/1/1910Sell91.11 23.3434.43342.97 679 9/26/1911 4/23/1912Buy88.58 812 10/1/1912 12/10/1912Sell85.88-2.70-3.05332.52 231 12/22/1914 3/30/1915Buy60.26 840 11/14/1916 8/28/1917Sell84.6524.4040.49467.14 882 12/18/1917 8/20/1918Buy84.56 357 11/4/1919 8/10/1920Sell83.72-0.84-0.99462.50 721 8/23/1921 10/25/1921Buy72.10 441 3/20/1923 7/24/1923Sell87.4015.3021.22560.65 637 10/23/1923 1/22/1924Buy96.51 182 9/3/1929 10/22/1929Sell337.92241.41250.141963.032100 7/5/1932 Date SignalStopProfit% Accumulated Profit Duration Long Duration Short 4/25/1933Buy70.97 1281 3/9/1937 9/7/1937Sell166.5495.57134.674606.691596 3/29/1938 7/19/1938Buy136.89 315 9/12/1939 5/14/1940Sell135.95-0.94-0.684575.16665 4/28/1942 7/7/1942Buy105.99 784 5/28/1946 9/17/1946Sell172.4366.4462.697443.311533 6/14/1949 10/25/1949Buy184.27 1134 4/10/1956 9/24/1957Sell468.26283.99154.1218914.982891 10/21/1957 6/24/1958Buy465.77 273 1/5/1960 9/27/1960Sell582.64116.8725.0923661.29826 10/25/1960 4/4/1961Buy664.66 189 11/14/1961 5/8/1962Sell654.46-10.20-1.5323298.21399 6/26/1962 1/1/1962Buy640.66 1/18/1966 238 5/10/1966Sell878.18237.5237.0731935.851225 10/11/1966 10/15/1968Buy937.71 889 12/3/1968 6/9/1969Sell895.40-42.31-4.5130494.83238 5/26/1970 1/12/1971Buy827.40 581 1/9/1973 5/15/1973Sell871.2543.855.3032111.01 854 12/3/1974 12/11/1975Buy713.58 940 9/21/1976 5/24/1977Sell904.12190.5426.7040685.06530 2/28/1978 8/15/1978Buy875.60 448 9/5/1978 3/25/1980Sell780.15-95.45-10.9036249.82588 4/22/1980 Table 5.2 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 2 Date SignalStop Profit % Accumulated Profit Duration Long Duration Short 8/5/1980Buy 930.96 133 3/31/1981 8/4/1981Sell 877.80-53.16-5.7134180.04364 8/10/1982 10/5/1982Buy 902.82 427 8/25/1987 10/20/1987Sell 2458.461555.64172.3193075.781841 8/25/1987 1/24/1989Buy 2234.53 7/21/1998 462 8/25/1998Sell 8141.865907.33264.37339135.653500 7/21/1998 3/9/1999Buy 9015.28 196 9/21/1999 9/21/1999Sell 10470.081454.8016.14393862.09196 1/3/2000 10/15/2002Buy 8138.30 1120 10/1/2002 1/28/2003Sell 7984.95-153.35-1.88386440.54105 10/8/2006 3/18/2003Buy 8220.90 49 5/11/2004Sell 9966.411745.5121.23468491.88420 2/28/2005Buy 10887.90 7/30/2007Sell 13110.422222.5220.41564123.97882 10/1/2007 3/23/2009Buy 7411.89 3/2//2009 602 12/29/2017Mark to24719.2217307.33233.511881396.573262 Market This study and the use of Magee's Basing Points Procedure to replace Dow Theory is explained inexquisite detail in the book Sacred Chickens, the Holy Grail and Dow Theory (available athttp://www.amazon.com). Figure 5.1 How the 2008 top in the Industrials was managed with Basing Points. Certainly, one of the most interesting charts of the last 20 years. Here we can see the stairstops rising ashigher wave lows are made. Moreover, one—or two—of those instances of surprising serendipity occurs.The Basing Point stop is quite close to a stop that would have been calculated from the neckline of thehead-and-shoulders formation. The very long-term trendline from 2003 intersects prices very near theBasing Point calculated stop, calling to mind the “rule of multiple techniques,” which states anyconclusion arrived at by multiple techniques is much more probable than that using only one method.This Basing Points system—or method, or what-have-you— remained short until March 2009. 116.47 Chapter five: Replacing Dow Theory with John Magee's Basing points Procedure Figure 5.2 The Dow-Jones Industrials 1924-1934. This is a period of the chart covered in Figure 5.3. Figure 5.3 This is one of the most interesting charts ever made of the Dow-Jones Industrials. It showsevery trade made by Dow Theory since the beginning and also shows trades made by Magee's BasingPoints Procedure. Technical Analysis of Stock Trends chapter six Important Reversal Patterns In our discussion of certain deficiencies in the Dow Theory from the point of view of the practical trader, wementioned the fact that it did not tell us what specific stocks to trade in. (EN9: Obviously, no longer aproblem as the investor may buy the DIA and trade the Average like a stock.) A conservative and wealthyinvestor, more interested in safety than maximum profit, can solve this problem by making up acomprehensive and thoroughly diversified list of sound, well-seasoned “blue chip” issues and handing hisbroker an order to buy the lot when the Dow Theory signals a Bull Trend. Some of his selections will dobetter than others; some may “go sour,” but wide diversification will ensure he gets a fair Average result.Better results should be obtained if we can find a way to select for purchase the most favorably situated issuesat any given time and can manage to sell them promptly and switch to others whenever the prospects for thefirst have been fully discounted. There is the possibility, too, of increasing our gains if we can, at times, buy with safety earlier in an uptrendthan the Dow theorist does, and sell before the market has reacted far enough to give a Dow Bear Signal. We mentioned also the fact that the Dow Theory is of little or no assistance in trading on the IntermediateTrends. There is obviously more money to be made if we can get the benefit of each up move without havingto write off some of our profits in each reaction. Or, if we can profit both ways by trading on both the “longside” and “short side” of the market. Finally, although all stocks tend to move with “the market” as typified in the Averages, there are, in fact, widevariations in the price paths of individual issues. An average, after all, is just that, a device for expressing inone figure a diversity of other figures. A Primary Bull Market ended in the Dow-Jones Industrial Average onMay 29, 1946, but United Airlines registered its highest price in December 1945; General Motors saw its peakin January 1946; Goodyear in April, DuPont in June, and Schenley in August. Is there a way of capitalizingon these divergences? Technical analysis of the charts of individual stocks definitely answers the first and most important of thesefour problems: the matter of selection. It frequently, but not always, gives us a running start on the DowTheory; it also, in large part, takes care of the question of the Intermediate Trend, although there are certainreservations as to policy and risk in connection with both these points that will be taken up in due course.Finally, careful technical analysis should, in nearly every case, get us out of a stock that “tops out” ahead ofthe Averages long before it has suffered any considerable decline, often in time to transfer funds to otherissues that have yet to complete their advances. Just as the Averages constantly discount all known and foreseeable factors affecting the future of securityprices in general, the market action of an individual issue reflects all the factors affecting its individual future.Among these factors, and expressed in its chart, are the general market conditions that influence all stocks toa greater or lesser degree, as well as the particular conditions applying to the particular stock, including theoperations of “insiders.” Let us assume right from the start that you, the reader, are not a member of that mysterious inner circle knownto the boardrooms as “the insiders.” Such a group—genuinely entitled to be called insiders, thoroughlyinformed on every fact, figure, and development that might determine the fortunes of a certain corporation—may exist from time to time and may influence the market price of its stock (EN9: and wind up in prison).But it is fairly certain that there are not nearly so many “insiders” as the amateur trader supposes and that theydo not cause one-tenth of the market movements for which the public blames them. It is even more certainthat insiders can be wrong; they would, in fact, be the first to admit it. Frequently, their plans are upset bysome development that they could not foresee or by some blind force that puts to scorn all expert estimates ofvalue. Any success they have, however, can be accomplished only by buying and selling on the floor of theExchange. [EN9: No longer strictly true. Insiders sold stock to their companies in the tulip (dot.com) bubble,which went unreported publicly for up to a year. Still, only an isolated problem.] They can do neither without altering the delicate poise of supply and demand that governs prices. Whatever they do is sooner or laterreflected on the charts where you, the “outsider,” can detect it, or at least detect the way in which the supply-demand equation is being affected by insiders' operations, plus all other prevailing market factors. So, you donot need to be an insider to ride with them frequently. Important Reversal Patterns Stock prices move in trends. Some of those trends are straight, some are curved; some are brief and some arelong-continued; some are irregular or poorly defined and others are amazingly regular or “normal,” producedin a series of action and reaction waves of great uniformity. Sooner or later, these trends change direction;they may reverse (as from up to down), or they may be interrupted by some sort of sideways movement andthen, after a time, proceed again in their former direction. In most cases, when a price trend is in the process of reversal, either from up to down or from down to up, acharacteristic area or pattern takes shape on the chart, which becomes recognizable as a Reversal Formation.Some of these chart pictures are built and completed quickly, whereas others may require several weeks toreach a stage at which one can surely say a Reversal of Trend is definitely indicated. Speaking in broadgeneralities, the greater the Reversal Area—the wider the price fluctuations within it, the longer it takes tobuild, and the more shares transferred during its construction—the more important its implications. Thus,roughly speaking, a big Reversal Formation suggests a big move to follow and a small pattern, a small move.Needless to say, the first and most important task of the technical chart analyst is to learn to know theimportant Reversal Formations and to judge what they may signify in terms of trading opportunities. There is one recognized Reversal Pattern that appears and is completed within a single day's trading, and is, inconsequence, named the “One-Day Reversal.” At times, it has great significance—such as calling a halt, atleast temporarily, to any up or down move—but in its ordinary manifestations, it does not imply much of animmediate move in the opposite direction. It is a useful pattern, and we shall have more to say about it later,but the price formations from which extensive new trends proceed take time to build. One does not bringinstantly to a stop a heavy car moving at 70 miles an hour and, all within the same split second, turn it aroundand get it moving back down the road in the opposite direction at 70 miles an hour. Time required to reverse a trend We do not need to lean on a racing automobile analogy to explain why it takes time (and volume and priceaction) to produce an important Trend Reversal. The logic of it is plain enough if we take but a moment toexamine it. We can do so most easily by describing what might have (and, doubtless, many times has)happened in specific terms. Suppose a certain well-informed and well-financed coterie (EN9: A congerie ofmutual funds, for example) decides the shares of a certain company, now selling around 40, are cheap; thatthis company's affairs are progressing so satisfactorily that, before long, it will attract the attention of manyinvestors; and that its stock will be in demand at much higher levels, perhaps at 60 or 65. Our group realizes ifthey manage their market operations skillfully, if nothing unforeseen intervenes to upset their calculations,they can “take” 20 points out of the situation. So they proceed to buy in all offerings, going about thisbusiness as quietly as possible, until they have accumulated their line, which may run to several thousandshares and represent practically all of the current floating supply of the issue. Then they wait. Professionalsbecome suspicious and the rumor circulates that there is “something doing in PDQ,” or other canny bargainhunters discover the company's bright prospects, or chart analysts detect the signs of accumulation in thestock's action. Buyers now find the stock is scarce; there are few offerings on the books, and they have toraise their bids to get it—an advance starts. The up-move gathers momentum as more and more traders are attracted by rising prices. It is helped along bythe good reports (higher earnings, increased dividend, etc.), which our group knew were to be expected.Eventually, prices approach the level at which they had planned to take profits. But this operation, thedistribution of their holdings may require even more patient and skillful handling than did the accumulation.Suppose they have 20,000 shares to unload; they cannot throw all of the shares on the market at once— doing so would defeat their own ends immediately and, perhaps, permanently. They must feed their line out little bylittle, trying to avoid attention, feeling their way along and never permitting a surplus of offerings to kill thedemand. If activity in their stock has reached a level of, say, 2000 shares transferred daily, they may be able todispose of 500 shares a day from their holdings without bringing the price down. (They will be competing,sooner or later, with others who have followed their play, bought lower down, and will be ready to take profitsas soon as the advance shows signs of weakening.) So they start to sell when the rising trend appears to haveattained maximum momentum, or as it nears their price objective, but well before it has reached its probablelimit, and they push out their shares as rapidly as buyers will take them. Before long—as a rule, before they have distributed their entire line—a lull in demand will occur. Perhapsprospective buyers sense the increase in supply. A reaction develops. Our group quickly ceases selling,withdraws its offers, and perhaps even buys back a few shares to support prices if they threaten to drop toofar. With supply temporarily held off the market, the decline halts and the advance resumes. Our group lets itproceed this time until it carries prices into new high ground; this reassures other holders and brings in morebuyers. As soon as the pot is once again merrily boiling, distribution is started anew and, if the maneuver hasbeen well directed, completed in perhaps two or three weeks, before the second wave of demand has beenexhausted. Our group is now out of its stock with a nice profit; its 20,000 shares have passed into other hands. If theygauged the market correctly and distributed their line at a price about as high as the situation would bear,demand will have been satiated for a long time to come. Prices will probably first drift back to somewherenear the level at which they were supported on the previous dip and then rally feebly on the strength of a littlenew buying from traders who were waiting for just such a minor reaction, meet sales from other traders whofailed to seize the opportunity to take their profits on the preceding volume Top and are now anxious to getout, and then break down into a decline of Intermediate or Major proportions. You can see now why, under one specific set of circumstances, a Top area (a chart pattern of distribution)takes time and volume to complete. Nevertheless, it does not matter whether we have to deal with the highlyorganized operations of a single group of insiders or of an investment syndicate or, as is more often the case,the quite unorganized activities of all the investors variously interested in an issue—the result is pretty muchthe same. Distribution, which is simply Wall Street's way of expressing the process of supply overcomingdemand, takes time and a change in ownership (turnover) of a large number of shares. And it is amazing tosee how these patterns of distribution, which hereafter we shall find it simpler to refer to as “Tops,” tend toassume certain well-defined forms. Most of the same pattern forms appear also as “Bottoms,” in whichmanifestation they signify accumulation instead of distribution. The Head-and-Shoulders Top Formation If you followed closely and were able successfully to visualize how the foregoing example of distributionwould appear on a chart, you saw a Head-and-Shoulders Top Formation. This is one of the more commonand, by all odds, the most reliable of the Major Reversal Patterns. You probably have heard this patternmentioned, as many traders are familiar with its name, but not so many really know it and can distinguish itfrom somewhat similar price developments that do not portend a real Reversal of Trend. The typical or, if you will, the ideal, Head-and-Shoulders Top is illustrated in Diagram 6.1. You can easily seehow this formation got its name. It consists of the following: A. A strong rally, climaxing a more or less extensive advance, on which trading volume becomes veryheavy, followed by a Minor Recession on which volume runs considerably lower than it did during thedays of rise and at the Top. This is the “left shoulder.” B. Another high-volume advance that reaches a higher level than the top of the left shoulder, and thenanother reaction on less volume that takes prices down to somewhere near the bottom level of the preceding recession, somewhat lower perhaps or somewhat higher, but, in any case, below the top of theleft shoulder. This is the “Head.” C. A third rally, but this time on decidedly less volume than accompanied the formation of either the leftshoulder or the head, which fails to reach the height of the head before another decline sets in. This is the“right shoulder.” D. Finally, decline of prices in this third recession down through a line (the “neckline”) drawn across theBottoms of the reactions between the left shoulder and head, and the head and right shoulder,respectively, and a close below that line by an amount approximately equivalent to 3% of the stock'smarket price. This is the “confirmation” or “breakout.” Note that each and every item cited in A, B, C, and D of Diagram 6.1 is essential to a valid Head-and-Shoulders Top Formation. The lack of any one of them casts in doubt the forecasting value of the pattern. Innaming them, we have left the way clear for the many variations that occur (for no two Head-and-Shouldersare exactly alike) and have included only the features that must be present if we are to depend on the patternas signaling an important Reversal of Trend. Let us examine them in greater detail (see Figures 6.1 through6.12). Volume is important First, let us consider the matter of volume. It is always to be watched as a vital part of the total picture. Thechart of trading activity makes a pattern just as does the chart of price Diagram 6.1 A hypothetical daily stock chart. Price in the upper part and volume at bottom—drawn to showhow an ideal Head-and-Shoulders Top Reversal Formation would develop. A, B, C, and D refer to essentialfeatures listed on the previous page. ranges. The two go together and each must conform to the requirements of the case. But note also that volumeis relative. When we speak of high volume, we mean a rate of trading notably greater than has beencustomary in that particular stock during that particular period under examination. The exact number of sharestraded is not important, and it will not ordinarily signify anything for our purposes to compare a daily volumeof, say, 6500 shares in Radio Corporation with 500 in Bohn Aluminum and Brass. The former may be verylow and the latter very high as judged by the proper technical criterion, which is, in each case, the averagerecent activity in the same issue. In the case of a Head-and-Shoulders Top, as mentioned, high volume attendsthe making of the left shoulder; this means that activity on the rise to and at the top of the left shoulder shouldbe greater than on the preceding rally waves in the same issue, followed by a Minor Recession on dwindlingactivity, and then a new advance on high volume. The action thus far does not differ from what we shouldexpect of normal wave development within a continuing uptrend. In these respects, any two typical,successively higher waves in an advance may, as you can see, become the left shoulder and head,respectively, of a Head-and-Shoulders Reversal. Figure 6.1 Starting in March, “HUM” formed a broad Head-and-Shoulders Top pattern on the daily chart.August's decline penetrated the neckline by 3%, confirming the Reversal Pattern. The minimum objective forthe Head-and-Shoulders Top would be 18. Figure 6.2 Daily chart of Chicago, Milwaukee, St. Paul, & Pacific common from January 1 to June 29, 1946.Head-and-Shoulders that topped this issue's Primary Advance in February was unmistakable, despite thesmall size of shoulders (SS). Note the volume pattern. Measuring implication (see following pages) of thisformation was carried out by April. Rectangular price congestion of March 30 to May 4 is a subject ofChapter 9. “ST” fell to 11 1/2 in October. 44 40 38 34 36 32 30 Figure 6.3 Bull market top of Westinghouse Electric in 1946 was the “wide-swinging,” powerful type ofHead-and-Shoulders Pattern (S-H-S). Decline that broke neckline (NL) on February 13 produced a breakawaygap (G) discussed in Chapter 12. Measuring formula (see following pages) called for initial decline to 33. Thepossible Bottom Head-and-Shoulders Pattern (S?-H?-S?) formed in March was never completed (see Chapter7). Note the failure of prices to push up through the neckline of the latter at any time, despite several rallyefforts in late spring while general market Averages were actually reaching new high levels. By the following November, “WX” had broken on down to 21 1/2. Study in detail the change in volume pattern after the end ofJanuary. The first suggestion a Head-and-Shoulders is really developing may come when the volume record shows thatactivity accompanying the most recent Top was somewhat less than the one preceding it. If this volumedisparity is conspicuous, and if it becomes evident from the way prices are receding that the second andhigher rally has ended, then the chart should be tabbed with a “red” signal and further developments shouldbe scrutinized. But such a preliminary warning does not always appear and should not be taken as conclusivewhen it does. Roughly estimated, about one-third of all confirmed Head-and-Shoulders Formations showmore volume on the left shoulder than on the head, another third show about equal volume, and the final thirdshow greater volume on the head than on the left shoulder. Another warning—or, more often, the first—comes when prices drop in the course of the second reaction(i.e., from the head) below the level of the Top of the left shoulder. Such action, as we shall see later on in ourspecific study of Support and Resistance levels, is significant of weakness in the price structure. So far it isMinor, it may be only temporary, and it is certainly not conclusive. Nevertheless, when this occurs, put adouble red tab on your chart. Breaking the neckline The real tip-off appears when activity fails to pick up appreciably on the third rally, the right shoulder. If themarket remains dull as prices recover (at which stage you can draw a tentative “neckline” on your chart) andif, as they approach the approximate level of the left shoulder Figure 6.4 A large Head-and-Shoulders Topping Pattern evolved in “TDY” over five months, withDecember's high-volume plunge through the neckline confirming the Trend Reversal. Because this was a veryexpensive stock, you might have considered buying the April 260 puts instead of selling “TDY” sharesoutright. Our measured objective in this issue was 44 points from penetration of the 264 neckline, or 220. Top and begin to round over (volume is still relatively small), your Head-and-Shoulders Top is at least 75%completed. Although the specific application of these pattern studies in trading tactics is the province of thesecond part of this book, we note here that many stock traders sell or switch just as soon as they are sure alow-volume right shoulder has been completed, without waiting for the final confirmation named under D asthe breaking of the neckline. Nevertheless, the Head-and-Shoulders is not complete, and an important Reversal of Trend is notconclusively signaled until the neckline has been penetrated downside by a decisive margin. Until theneckline is broken, a certain percentage of Head-and-Shoulders developments, perhaps 20%, are “saved”—that is, prices do not go lower, but simply flounder listlessly for a period of time in the general range of theright shoulder, then eventually firm up and renew their advance. Finally, in rare cases, a Head-and-Shoulders Top is confirmed by a decisive neckline penetration and stillprices do not go down much farther. “False moves” such as this are the most difficult phenomena with whichthe technical analyst has to cope. Fortunately, in the case of the Head-and-Shoulders, they are extremely rare.The odds are so overwhelmingly in favor of the downtrend continuing once a Head-and-Shoulders Formationhas been confirmed, it pays to believe the evidence of the chart no matter how much it may appear to be outof accord with the prevailing news or market psychology. One thing is worth noting about Head-and-Shoulders Formations that fail completion or produce falseconfirmations—that is, such developments almost never occur in the early stages of a Primary Advance. AHead-and-Shoulders Formation that does not work is a warning that even though there is still some life in thesituation, a genuine turn is near. The next time something in the nature of a Reversal Pattern begins to appearon the charts, it is apt to be final. Figure 6.5 “ICX” was in a powerful uptrend for more than a decade and gains were spectacular. But theupward momentum began to fade and topping indications were evident. The August peak fulfilled theobjective of the measuring flag formed during 1985. The August gap to new highs was quickly filled,indicating it was an Exhaustion Gap. The reaction back to Support, followed by a slow, relatively low-volumerally to the July high, formed a credible right shoulder. The final week's high-volume plunge through theneckline confirmed the Reversal. The minimum objective for the Head-and-Shoulders Pattern was 19 1/4, thetop of the 1985 Flag. A possible alternative cover point was the Bottom of the Flag at 14 1/4. Variations in Head-and-Shoulders Tops There is a tendency, surprising when one thinks of all the vagaries of news and crosscurrents that mayinfluence day-to-day trading, for Head-and-Shoulders Patterns to develop a high degree of symmetry. Theneckline tends to be horizontal and the right shoulder tends to resemble the left in price confirmation(although not, of course, in volume); there is a sort of satisfying balance to the overall picture. But symmetryis not essential to a significant Head-and-Shoulders development. The neckline may slope up (from left toright) or down. The only qualification on an up-sloping neckline is that the Bottom of the recession betweenthe head and right shoulder must form appreciably below the general level of the Top of the left shoulder. It issometimes said that a down-sloping neckline indicates an unusually weak situation. This is so obvious that itis apt to be given even more weight than it deserves. A share of that excessive weakness, it should be noted,will have already been discharged by the time the down-sloping pattern is formed and prices have broken theneckline. The measuring formula, which we shall discuss later, applies to such situations. Due to the tendency toward symmetry in shoulder development, some traders, as soon as the neckline hasformed, will draw on their charts a line parallel to the neckline, extending from the top of the left shoulderthrough the head and on to the right. This furnishes a guide as to the approximate height the right shoulderrally should attain and, 208 192 176 160 152 144 Sales 100's 50 40 30 20 10 :: ■ ::: ■::r ■ b 1 1 . ::: ::::: M T - •• ’I1 m izn::: .....8• F)T T DC)NTT nn 1333133t J: ::::: j 4 S£ ■H S :::: : ::r. |(||:::::lllll• • 4 fl !:!!!! . . ftftift:ft tTTTTTTTTTT 1 TV '*•T uni Ulf' »<1 i!iti 1 1 ’ i3.....-I* ufti nr'it i'HIiiit 11 •.1 i nt id I B ;; nTr mm j :: tin :::: i ini: E :IfMl tffl || H s Hi TT i HHT ?tHtti: : !£!!!!!! :::nnns:ii:mi i|fl5I 1936-1 937 nr4 :*n ;3 1 1i 1 £11 ! 33~ : H*J.33iiii 1 - 111IB i iS r iiiiiil.i ■■ I ... ■ III ... lllll■ru... S H II nt ■’... •4* iiiii- i sim... i 1 1 111 II Iiil JANUARY FEBRUARY MARCH OCTOBER NOVEMBER DECEMBER 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27 Figure 6.6 Reversal Formations, which develop in important stocks while the general market is stillapparently in a strong trend, are often difficult to believe, much less act on. But they may be highlysignificant. DuPont topped out in 1936, four months ahead of the Averages. Despite its extended rightshoulder (but note volume), Reversal implications were clear on December 19. The Pullback of January,meeting supply at the old neckline level, and the second try in March were interesting and typical of such ageneral market situation. Compare with Figure 6.11. 48 44 40 38 36 34 32 Sales 100's 50 40 30 20 10 H S 1937 APRIL CONSOLIDATED EDISON Lili udlh kill uBilhihil FEBR U A R Y'" MARCH---: IMEUS JANUARY 2 9 16 23 30 Figure 6.7 Another 1937 Bull Market Top of Head-and-Shoulders Form, with only one quick Pullback(February 10). In this case, volume increased sharply on February 5 with the initial break through the neckline(NL). Measuring formula was satisfied in March. Study this picture in connection with “ED's” long-rangechart (Figure 10.4) in Chapter 10; turn back to it later when you come to the Support-Resistance study inChapter 13. 20 19 18 17 16 Sales 100's 250 200 150 100 50 S: 1946 S MAY REPUBLIC AVIATION RA FEBRUARY MARCH APRIL HEHF “ii w fllf p J-if i] 1'1Ht]l||g H Figure 6.8 The six-month-long Head-and-Shoulders Top of Republic Aviation in 1946. Such a patternbecame a possibility to be watched for when prices broke down in May below the level of the February high(first S). Refer to requirement B. Note also how the Head-and-Shoulders Measuring Formula (Chapter 7) isapplied to patterns with up-slanting necklines. Minimum downside requirement here was 12 1/2, reached inNovember. The quick Pullback on July 27 gave a last good selling opportunity. Figure 6.9 After a sharp reaction from its 1983 high, which lasted a year and pushed “DIS” back to long-termSupport, the Bulls took over and sent Walt and friends on a trip to the moon. But beginning in April, the rocket began to lose power, and it looked like reentry had begun. Since the big-volume days of spring, thisissue etched out a large Head-and-Shoulders Top. High-volume penetration of the neckline by 3% confirmedthe Reversal. Sales 100's 500 400 300 200 100 ::::: SI NEW YORK CENTRAL 1945 APRIL MAY JUNE t . JULY AUGUST SEPTEMBER ' 7 • 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 25 29 Figure 6.10 New York Central made a Head-and-Shoulders Top in June 1945. Intermediate Up Trendline(IUT) was broken by drop from head on July 5. Minimum measuring implication was carried out at 24 onAugust 18. Reaction ended a few days later at 22 3/4. Prices recovered to projected neckline (see September25), dropped again to 26 7/8 in October, and then pushed up, giving “rebuy” signal (on Fan Line construction)at 30 in the first week of November. Final Bull Market High was made in January at 35 1/2. The period fromAugust 1945 to February 1946 was difficult for technical traders in this stock. Those who sold at 26-27 inJuly 1945 could, however, congratulate themselves in May 1947 when “CN” hit 12. consequently, a selling level. But you will not see very many formations as perfect and symmetrical as ourideal picture, a fact the several actual examples accompanying this chapter amply illustrate. Either shouldermay, in fact, go higher or take more time than the other. Either or both may come up nearly to the level of thehead (but not equal it, or else no Head-and-Shoulders exists) or both may fall considerably short of it. Ifactivity attending the right shoulder is abnormally dull, that shoulder is apt to be low but protracted in time. Ingeneral, there seems to be a balanced relation between the three elements of price pattern, time, and volumethat is practically impossible to express in words or figures, but comes with experience to sense in itsdevelopment. However, there are no laws beyond those stated in our A, B, C, and D of Diagram 6.1; withinthose limits, look for an infinity of minor variations. Price action following confirmation: the measuring formula The final step, the downside penetration of the neckline, may be attended by some increase in activity, but itusually is not at first. If volume remains small for a few days as prices drift lower, a “Pullback” movefrequently ensues that brings quotations up again to the neckline level (rarely through it). Normally, this is the“last gasp”; prices then turn down quickly, as a rule, and break away on a sharply augmented turnover.Whether or not a Pullback Rally will occur after the initial penetration seems often to depend on the conditionof the market in general. If the whole market trend is turning down at the same time as our individual issue,which has just completed its Head-and-Shoulders, there will probably be no Pullback; 136 128 120 112 104 96 88 80 76 72 68 64 Sales 100's 125 100 75 50 25 UNION CARBIDE & CARBON UK 1929 AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER 6 13 20 27 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 1421 28' Figure 6.11 The great 1929 Bull Market Top was characterized by many impressive Head-and-ShouldersFormations, of which this is an interesting example. Note the small Head-and-Shoulders Pattern ofSeptember, which became the head of a much larger formation of the same character. The Pullback of October 9 to the upper neckline afforded a second chance to get out at 128 to those who did not sellimmediately when this first line was decisively penetrated on September 28. The larger pattern “broke” onOctober 19, with a quick pullback on October 22. Less than a month later “UUK” had lost half its peak value.By 1932 it had fallen to 15 1/2. Although such a catastrophic decline as 1929-1932 may never come again, themoral is, nonetheless, plain: never scorn a Head-and-Shoulders Formation. Patterns such as this merge intothe “multiple” types discussed in Chapter 7. Although this example is selected from the 1929 portfolio, theywere not at all uncommon in the mid-20th century. Several modern examples appear in our later pages. prices instead will tend to accelerate their decline, with activity increasing as they leave the vicinity of theTop. If, on the other hand, the general market is still firm, then an attempt at a Pullback is likely. Also, theodds seem slightly to favor a Pullback if the neckline has been broken before much of a right shoulderdeveloped, but certainly no sure rules can be laid down. In any event, the Pullback Rally is of practicalinterest chiefly to the trader who wants to sell the stock short, or who has sold it short and has then to decidewhere he should place a stop-loss order. Now we come to one of the most interesting features of this basic Reversal Formation— the indication that itgives as to the extent (in points) of the move that is likely to follow the completion of a Head-and-Shoulders.Measure the number of points down vertically Figure 6.12 Dow Jones Industrials, Head-and-Shoulders Top 2007-2008; edwards-magee.com identified thismassive Head-and-Shoulders Formation in early 2008, after having already exited the market in January 2008and wrote the following letter. Note "A low" and "B low"; if this yearlong formation is a massive Top(perhaps a double-headed Head-and-Shoulders) and A low is its lower boundary, then a low of 9680 ispredicted. If B low is the defining point, the predicted low is 10836. Remember Niels Bohr and the difficultyof forecasting? Again, it is not necessary to believe this scenario to know how to bet. The Dow is in a six-month downtrend, the last 21/2 months of which are sideways, with lower highs in the sidetrend. The low of9680 is a probable minimum. Mark Hulbert says Richard Band is predicting a 16000 Dow. Watch out for lowflying eggs (as in getting egg on your face). Then the Dow went to 6469.95 in the great Bush Bear Market. Technical Analysis of Stock Trends from the Top of the head to the neckline as drawn in Figure 6.4. Then measure the same distance down fromthe neckline at the point at which prices finally penetrated it following the completion of the right shoulder.The price level thus marked is the minimum probable objective of the decline. Let us hasten to state one important qualification to the Head-and-Shoulders Measuring Formula. Refer backto our original set of specifications for a Head-and-Shoulders. Under A, we required “strong rally climaxing amore or less extensive advance.” If the up-move preceding the formation of a Reversal Area has been small,the down-move following it may—in fact, probably will—be equally small. In brief, a Reversal Pattern has tohave something to reverse. So, we really have two minimums: one being the extent of the advance precedingthe formation of the Head-and-Shoulders and the other derived from our measuring formula, whichever is thesmaller will apply. The measuring rule is indicated on several of the examples that illustrate this chapter. Youcan see now why a down-sloping neckline indicates a “weaker” situation than an up-sloping neckline, and justhow much weaker, as well as the fact that more than half of the minimum expected weakness has alreadybeen expended in the decline from the top of the head to the penetration of the neckline. The maximum indications are quite another matter, for which no simple rules can be laid down. Factors thatenter into this are the extent of the previous rise, the size, volume, and duration of the Head-and-ShouldersFormation, the general market Primary Trend (very important), and the distance that prices can fall beforethey come to an established Support Zone. Some of these are topics for later discussion. Relation of Head-and-Shoulders to Dow Theory Without doubt, some readers have already suspected the Head-and-Shoulders Pattern is, in a sense, just anadaptation of the principles of Dow Theory to the action of an individual stock. So it is. The decline of pricesfrom the head to the neckline, the rally to the right shoulder, and then the ensuing decline that breaks theneckline set up a sequence of lower Tops and Bottoms analogous to those that signal a downtrend in DowTheory. This logical relation of the Head-and-Shoulders to Dow Theory is another reason, in addition to itsbasic importance, frequency, and dependability, why we have placed it first in our study of ReversalFormations. But it also is more definite, gives advance warnings that are relatively easier to detect, and isquicker with its signals in the case of up-sloping necklines. Moreover, it requires no specified minimum timefor any of its component moves, and no confirmation by another stock or Average. There are Head-and-Shoulders Bottoms (EN: An undescriptive term for a bottom formation that I wouldprefer to call the “Kilroy Bottom.” See Figure 7.4.) as well as Tops, with equally important implications. TheBottom Formations will be taken up in our next chapter. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter seven Important Reversal Patterns: continued Head-and-Shoulders (EN: or Kilroy) Bottoms A formation of the Head-and-Shoulders type may develop at an important Reversal ofTrend from down to up. In that case, it is called a Head-and-Shoulders Bottom, and itsprice pattern (as compared with a Top) is turned upside down, that is, it stands on itshead. EN: The present Editor has always been impatient with the undescriptive natureof the term “Head-and-Shoulders Bottom,” and so he has renamed it the “KilroyBottom.” See Figure 7.4. The volume pattern is somewhat the same (not turned upsidedown) as at a Top but with some important changes in the latter half of the formation,which we shall discuss in detail. We can lay down specifications for it in much thesame words as we used for the Head-and-Shoulders Top. Here they are, with theportions that differ in principle from the Top printed in italics (see Figures 7.1 through7.25): A. A decline, climaxing a more or less extensive downtrend, on which tradingvolume increases notably, followed by a Minor Recovery, on which volume runsless than it did during the days of final decline and at the Bottom. This is the “leftshoulder.” EN9: Or left hand. B. Another decline that carries prices below the Bottom of the left shoulder, onwhich activity shows some increase (as compared with the preceding recovery)but usually does not equal the rate attained on the left-shoulder decline, followedby another recovery that carries above the Bottom level of the left shoulder and onwhich activity may pick up, or at any rate exceed that on the recovery from the leftshoulder. This is the “head.” EN9: Or nose. C. A third decline on decidedly less volume than accompanied the making ofeither the left shoulder or head, which fails to reach the low level of the headbefore another rally starts. This is the “right shoulder.” EN9: Or right hand. D. Finally, an advance on which activity increases notably, which pushes upthrough the neckline (EN9: Or fenceline) and closes above by an amountapproximately equivalent to 3% of the stock's market price, with a conspicuousburst of activity attending this penetration. This is the “confirmation” or“breakout.” The essential difference between Top and Bottom Patterns, you can see, lies in theirvolume charts. Activity in Head-and-Shoulders Bottom Formation usually begins toshow uptrend characteristics at the start of the head and always to a detectable degreeon the rally from the head. It is even more marked on the rally from the right shoulder. It must be present on the penetration of the neckline, or else the breakout is not to berelied on as a decisive confirmation. An important basic principle of techniques that is involved here merits furtherdiscussion. Wall Street has an old saying that expresses it: “It takes buying to put stocksup, but they can fall of their own weight.” Thus, we trust, and regard as conclusive, anyprice break (by a decisive margin) down through the neckline of a Head-and-ShouldersTop 18 17 16 15 14 13 Sales 100's 125 100 75 50 25 .... Hr p- U .. LOCKHEED AIRCRAFT LK OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH ' I 2 9 16 23 30.6 .13.20-27 4 -11-18 25 1'8 '15 22 29 5 12 19 26: 4 11-18 25 Figure 7.1 After “rounding over” in October 1943 in the last phase of a long declinefrom 41 in 1940, Lockheed made a conspicuous two-month Head-and-ShouldersBottom. Note especially, on the above chart, the volume on the rally in early Decemberand in the first week of January with reference to points B and D on the precedingpages. “LK” dropped back to 15 again in June 1944, and then ran up quickly to 23 byNovember, finally reaching 45 in January 1946. One advantage of logarithmicallyscaled charts is they expand, and thus call attention to important formations thatdevelop at low price levels, and that would be obscured on an arithmetic scale. even though it occurs on a light turnover, but we do not trust a breakout from a Head-and-Shoulders Bottom unless it is definitely attended by high volume. A low-volumebreakout from a Bottom Pattern may only be premature, to be followed after more“work” around the Bottom levels by a genuine advance, or it may be a “false” moveentirely. It pays generally to wait and see. This same distinction in volume developmentapplies to some of the other Reversal Patterns we shall take up later in this chapter. Other differences between Top and Bottom Head-and-Shoulders do not involve anynew principles. It can be said that Bottoms are generally longer and flatter, that is, theytake more time in relation to depth of pattern in points than do Tops. This is particularlytrue when they occur at Reversals in the Primary Trend. The overall volume at Bottomstends to be less than at Tops, and the turns tend to be more “rounded.” In theconstruction of a Head-and-Shoulders Top, the activity that goes into the left shoulderusually exceeds that on any preceding rally in the entire uptrend. In a downtrend, on theother hand, there may be Panic Selling in some of the earlier phases of decline, whichruns the volume chart up to a mark higher than any that is subsequently registered inthe final Bottom Formation. None of these differences, however, affects our essentialHead-and-Shoulders specifications. The measuring implications of the Head-and-Shoulders Bottom are the same in allrespects and are applied in the same way as with Tops. Tendency toward symmetry isagain the rule, with variations as to slope of neckline, relative size of shoulders aboutthe same as in Tops. Reactions to the neckline following the initial breakout from theBottom type appear in about the same frequency and proportions as do the PullbackRallies, which follow the initial breakdown from the Top type. 19 18 17 16 15 14 13 12 11 10 9 Sales 100's 125 100 75 50 25 DOME MINES DM NL S S H ■ ' .Ell ill.I.lit -U —r ■ il.nl, .,111 ill III Illi I Hi 111 i III I ill III ’ A T S ' O ' N ’ D 1 J ’ F ’ M Figure 7.2 Weekly charts are particularly useful for detecting Major Bottom Reversalsbecause Bottom Formations characteristically take longer to build than Tops. DomeMines made a typical Head-and-Shoulders base, 13 months' long, at its Primary TrendReversal in 1942. Note the volume pattern. (Volume detail, however, is better studiedon daily charts.) Dome's powerful Head-and-Shoulders Bottom was “high” enough tobe conspicuous on an arithmetic monthly chart. It reached 25 in 1944. Multiple Head-and-Shoulders Patterns The Head-and-Shoulders Formations we have examined up to this point have been,despite minor variations, relatively simple and clear-cut, consisting of three well-defined elements. We come now to a group of related patterns that carry much the sametechnical significance but have more elements and are much less clearly defined. Theseare the Multiple Head-and-Shoulders Tops and Bottoms, also known as ComplexFormations. We need not take much of our space to define or lay down specificationsfor them, as they may be described quite sufficiently as Head-and-Shoulders Reversalsin which either the shoulders or the head, or both, has been doubled or proliferated intoseveral distinct waves. Almost any combination is possible, of which only a few can be illustrated in the actualchart examples reproduced in this chapter. Formations of this type appear with fairfrequency at Primary Bottoms and Tops, but more often at Bottoms than at Tops. They Figure 7.3 With a strong movement toward lower interest rates evident since June, thetiming of the low in “FNM” is not surprising. Neither is the massive width (fromMarch through October) of its evolving pattern, which closely matches that of the huge,complex Inverse Head-and-Shoulders Bottom in Treasury Bills (December 1984),September 25, 1984. Even the slight timing lag is appropriate. Figure 7.4 EN: At the risk of being considered a comic (actually, a satirist), I suggestthat, although the image is comical, the pattern is more descriptive of theincongruously named “Head-and-Shoulders Bottom” than the present terminology. Left hand equals left shoulder, right hand equals right shoulder, nose equals head, andneckline equals fence line, or, as easily, neckline. I am teaching all of my students tothink and use these terms, which makes much more sense than the absurd “upside downHead-and-Shoulders Bottom standing on its head.” One hundred years from now, thiscontribution to the nomenclature will be accepted as totally descriptive andappropriate, and the term “Head-and-Shoulders Bottom” will have disappeared fromthe lexicon. A common form consists of two left shoulders of approximately equal size, a singlehead, and then two right shoulders, again, of approximately even size and balancing thetwo on the left. Another is made up of two heads with two or more shoulders on eitherside. Still another form, of which you will usually find several good examples at anyMajor Market Turn, consists of double shoulders on either side of a head, which isitself composed of a small but quite distinguishable Head-and-Shoulders development. Figure 7.5 A ragged Kilroy (or, if from the old school, a Head-and-Shoulders) Bottomthat ended the Bear Market (or first phase thereof) of 2001-2002. Some seven and ahalf months in formation it threw a few knuckle balls and curves and looked right up toMarch 2003 as though it were a Bear Market rally. Once the neckline was taken out,there was no arguing with it—it was a real Bottom. It balked at the neckline for acouple of months before becoming a full Bull. Complex economic and political realities affected the markets: the terrorist attacks of September 11, 2001, which put paid to thetulipomania of the roaring 1990s and the ill-advised tax cuts of the Bush Jr.administration. Using the formula of cut taxes and increase spending to start a war, themarket was sufficiently stimulated to rally exuberantly. The downtrend line is drawnhere and the reader should have no trouble seeing the break of the long-term downtrendas well as the Kilroy Bottom demanded a shifting of gears from Bear to Bull. Tendency to symmetry We have mentioned the tendency toward symmetry in the simple Head-and-ShouldersFormation. Patterns of the Multiple or Complex type show an even stronger urgetoward symmetry—so strong, in fact, that it may be counted on in determining tradingpolicy. If there are two shoulders on the left, there are almost always two on the right ofnearly the same size and duration. (One does not know that a Multiple is in the processof formation until its right shoulder becomes evident.) Except in volume, the right-handhalf of the pattern is, in the great majority of cases, an approximate mirror image of theleft. Necklines on Multiple Head-and-Shoulders Formations are not always easy to drawbecause the reactions between the shoulders and heads may not stop at levels that allfall on a single line. Up-sloping and down-sloping variants seldom appear in this classof patterns; necklines are almost always very close to the horizontal. Sometimes, it ispossible to estimate by simple inspection where the critical line really lies. More often,there are two necklines, an inner and an outer, and no price movement of consequenceis to be expected until the outer has been penetrated (which is simply anotherexpression of that tendency toward symmetry referred to above). Curiously enough, the “power” of a Multiple Head-and-Shoulders Pattern is more aptto be over rather than underestimated. One might think, in view of the length of timeand Figure 7.6 “MCA” enjoyed an excellent advance from 1980 to 1986, but the goingbecame increasingly difficult after the turn of the year, when this issue began tochallenge its 1985 high. Although the Bulls did manage to set a new high-water mark inApril, a series of Pullbacks kept this issue well away from any further tests. Indeed, alarge Complex Head-and-Shoulders Top appeared to be unfolding with the MajorNeckline penetrated slightly on the sell-off. 26 24 22 20 19 Sales 100's 125 100 75 50 25 DECEMBER JANUARY FEBRUARY MARCH APRIL MAY : 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25’ Figure 7.7 An “ideal” Multiple Top made by Budd in 1946, with two heads. Observeaccompanying volume. Prices often break away from Complex Formations morereluctantly than from the simple Head-and-Shoulders type. The late-March rally, whichwent back through the old neckline, was greater than normal in that respect, but thegeneral market Averages were pushing to new highs at this time. Repenetration of aneckline does not, of itself, cancel the implications of a Reversal Formation. Sales 100's 125 100 75 50 25 SIL RL G G AMERICAN LOCOMOTIVE LA 1946 APRIL MAY JUNE AUGUST SEPTEMBER 6 13 20 27 3 10 17 24 31 7 14 21 28 6 13 20 27 4 Figure 7.8 The long Multiple Head-and-Shoulders Top made by American Locomotivein 1946 displays very well the sort of volume pattern—irregular but taking on definitely Bearish character in its latter half—that is normal to this formation. Therounded Bear Market Rally of August (compare price and volume trends) was unable toattain the old neckline and was stopped at a Resistance (RL) created by earlier Bottomlevels (see Chapter 13). G and G mark Breakaway Gaps that were not “covered” (seeChapter 12). Figure 7.9 From a Head-and-Shoulders Top in February, Digital plunged sharply lowerinto midJune, retracting roughly two-thirds of the 1983-1985 advance. The summer lowwas the head of a Broad, Complex Head-and-Shoulders (EN: Or Kilroy) Bottom.“DEC,” however, had already enjoyed a high-volume penetration of the neckline andwas, therefore, in a buying position. ARCHER DANIILS MIDLAND 300 32 30 20 15 28 26 24 800 81 82l 83 22 16 15 Sales a 100's I MARCH APRIL MAY JUNE ~ACGU T SEPTEMBER OCTOBER NOVEMBER DECEMBER XD.035 XD.035 5 % STK. XD.035 Figure 7.10 After testing its 1980 high in mid-1983, “ADM” turned sharply lower,retracing roughly 40% of the 1982-1983 advance by mid-1984. The summer low,however, appeared to be a Bottom. Indeed, if one looked at the volume pattern from April to November and correlated it with price activity, it was not difficult to make agood case for a Complex Head-and-Shoulders Bottom. A neckline through the closesgave us a go signal on a penetration of 20 5/8. Figure 7.11 An Intermediate Bottom of the Complex class, abnormal in its lack ofsymmetry but, nonetheless, easy to recognize. Low volume on reactions after the Headwas completed gave the usual (and essential) Bullish Confirmation. The sluggish startof the new trend was a common feature of Multiple Head-and-Shoulder Reversals. Figure 7.12 The slide in Amdahl occupied the Bears from March to June before a sharprally gave notice that the Bulls were still alive. After that, a choppy sideways tradingrange evolved with Support near the Pullback lows established earlier in the year.Overall, there was a fine symmetry to this chart, including volume, which indicated theprice action from March to September was actually a Broad Head-and-ShouldersBottom. Entry was on a 3% breakout of the neckline with a minimum objective of 193/4. amount of trading entering into its construction, that it would signal a move (in reversedirection to the trend preceding it) of greater extent than the simple Head-and-Shoulders. Yet, in its immediate consequences, at least, the Complex showsconsistently less power. Minimum measuring rules for the two types of formations arethe same and are applied in the same manner. The difference between the patternsappears in the price action after the minimum has been reached. The first downswingout of a plain Head-and-Shoulders Top, not counting any early Pullback Rally, willfrequently carry out the minimum measuring implications of that pattern quickly andrun well beyond it. From a Multiple Top, the first downswing is often more leisurely,and very seldom does it exceed the bare minimum—a probability well worthremembering when you are dealing with an Intermediate rather than a Primary Top. Ifthe Complex does develop at a turn in the Primary Trend, prices will eventually gomuch farther; however, even then, there is usually a strong recovery (or reaction, in thecase of a Bottom) from the “minimum rule” level. A leisurely pattern The volume attending the construction of Multiple Head-and-Shoulders conforms ingeneral to the “laws” we have previously stated and explained for simple Head-and-Shoulders Reversals. During the earlier stages of Multiple Formation development, thevolume chart may show much irregularity with little recognizable pattern, but in thelatter stages, its correspondence with the Head-and-Shoulders Trend should be plainlyseen. There is something about Multiple Head-and-Shoulders Patterns that is especiallypleasing to technical chart followers. Due to their symmetrical tendencies, it isfascinating to watch them evolve to completion. Once completed, however, they maytry your patience by their seeming reluctance to “get going” with a new trend. On thataccount, it becomes 10 Sales 100's 1000 800 600 400 200 P J S S PUBLIC SERVICE CORP. OF N. J. A ’ M : Li ■J'A'S'O'N'D'J' I'M Figure 7.13 Another variant of the Head-and-Shoulders within a Major ReversalFormation. The smaller Head-and-Shoulders Pattern was easily overlooked on the dailychart. Moreover, although it was six months long, this pattern in itself did notnecessarily imply Primary Reversal. Although, when it pushed "PJ's" prices up inOctober through the great supply that had been lodged at 12-13 the previous December,something more than a Secondary Advance could obviously be in prospect. An up-move of consequence was not finally signaled, though, until February 1943 when theupper neckline was penetrated and prices closed at 14. Public Service “threw back” to12 in November 1943 (to the old neckline exactly), but then advanced steadily to 30.Study this again when you take up Support and Resistance in Chapter 13. This chartreiterates the point that, whereas Top Formations are often completed in a relativelyshort time, Major Bottoms usually require many months, and call for a great deal ofpatience. Allowing for the greater time needed, however, most Top Patterns have theircounterparts in Bottom Formations. easy at times to jump to the conclusion that they have “blown out,” that is, produced afalse signal. Actually, except in the matter of extent of move, which we have alreadydiscussed, they are fully as reliable as the plain Head and Shoulders. False moves arerelatively rare with both. And in those extraordinary cases when a Complex Formationdoes go wrong, it still stands, like the plain Head-and-Shoulders, as a warning that thefinal Reversal is near. Rounding Tops and Bottoms The Multiple Formations we have just examined are produced by a sort of extension orproliferation of the ordinary Head-and-Shoulders Pattern. Carry this process still furtherand the Complexes merge into our next class of Reversals, known as Rounding Turns. 24 22 20 19 18 17 16 15 14 Sales 100's 125 100 75 50 25 L-ii-’-L ■ ■, NATIONAL SUPPLY NS 1946 Uuuilyiil APRIL 6 13 20 27 4 11 18 25 1 8 15 22 29 6 ' 13 20 27 ' 3 10 17 24 31 7 14 21 28’ Figure 7.14 Still another form the Complex Reversal may take. This can be describedas a Head-and-Shoulders Pattern with two widely separated heads. Study its volumepattern, noting the breakout on June 20 and the subsequent Pullback. Compare it withBethlehem Steel's Bottom Reversal shown in Chapter 12, Figure 12.12. 72 68 64 60 56 Sales 100's 125 100 75 50 25 • il. -fL .. S " 4 T—• $3 ............... SUM mt? % ■ $|l •■■■- 1 . .. tttf?:::j: •iiiH SfeSi O T xti:: git aS HH 1 ait ••PHILIPS PETROLEUM I 1946 fig 1 Pl Ml ■Eft HS I I 1 H rni TH In [ HI nn] .. . H .4i;iL ......... iil 4* I- -1■ |t+ idlluiUiu wuiLin 1 lliitlL mil H Kill HFHF iliiiiliilhiliililillLilIll.lli illillllil jlili APRIL MAY JUNE ’ JULY * AUGUST SEPTEMBER ■ 6 13 20 27 4 11 18 25’1’8 15’22’29 6 13 20 27 3 10 17 24 31 7 14 21 28 Figure 7.15 Major Top Reversal Patterns in high-priced investment issues arefrequently long and “flat.” The 1946 Top of Phillips Petroleum could be classified aseither a Multiple Head-and-Shoulders or an irregular Rounding Top. An importanttrendline (see Chapter 14) was broken downside in July. In our first approach to the theory of chart Reversal Patterns, we saw why it takes timeand a considerable volume of trading to swing an established trend in prices from up todown or down to up. In the Head-and-Shoulders type of Reversal, the trend surges,struggles, and attacks again and again before it finally gives up and retreats. During thisstruggle, the balance between the forces of supply and demand fluctuates, often wildly, AMERICAN & FOREIGN POWER 2d PFD. A FPD Pr 1945 26 Sales 100's 125 100 75 50 25 JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBE 7 14 21 28 4 11 18 Figure 7.16 The war-end reaction of 1945 in American & Foreign Power 2d Preferred,as well as in many other issues, took the form of a Rounding Bottom. Compare theprice and volume trends. By October 4, the implications were plain to see. until finally the one overcomes the other. In the Multiple Formations, a similar processgoes on but rather less violently and, over a period of time, the progressive change fromone force to the other becomes clearly apparent. The Rounding Turn is a much simpler and more logical manifestation of this technicalphenomenon. It pictures simply and plainly a gradual, progressive, and fairlysymmetrical change in the trend direction, produced by a gradual shift in the balance ofpower between buying and selling. If, for example, the buying has been stronger than the selling for some time past, weknow the result will have been a general upward trend in the price of our stock, asindicated by our pictorial chart record of its trading history. So long as the buyers of thestock remain more anxious, more numerous, more aggressive, and more powerful thanthe sellers, that preceding upward trend will continue. Now, suppose the selling grows alittle stronger while the buying either weakens slightly or remains stationary at itsprevious strength; this slight change in the technical balance will be indicated by aslowing up of the previous advance. As the selling increases in relative power, it willfinally become equal to the buying power, with the result of the market level neithermoving up nor down but remaining, for a time, quite stationary (except for Minor andinsignificant fluctuations). Assume the new development continues and the selling pressure grows until it is finallystronger than buying power. Now the balance is moving the other way. There are nowmore sellers than buyers, and the result will be a gradual decline in the marketquotations for the stock. If this change in the balance of power is fairly steady andcontinues to its logical conclusion, we can see, even without the aid of a chart, that ourpicture of the price movement for that stock would be one of a long advancing trendslowly beginning to round off, holding in stationary suspense for a time, and thencommencing a retreat, reversing the previous upward movement into a new andAccelerating Downward Trend. 20 15 10 5 AMERICAN SAFETY RAZOR ARZ I IMSgggiiHi ........ 1931 ! 1932 1933 11934 .1935 ■'"1936 0937 0938 0939 0 940 [1941 0942 [1943T1944 ,1945 j 1946. Figure 7.17 Monthly chart on an arithmetic scale. American Safety Razor's 1932 MajorBottom was a Head-and-Shoulders and also its 1936 Bull Top. Its 1942 to 1946 Bull Market started from a Rounding Bottom nearly two and a half years long. Monthlychart study pays. Rounding Bottoms are commonly referred to as Bowl or Saucer Patterns. RoundingTops are sometimes called Inverted Bowls. Despite the logic of their construction,neither type appears as frequently as Head-and-Shoulders Formations. RoundingBottoms occur most often in low-priced stocks, in an extended, flat-bottomed form thatusually takes many months to complete. There was a host of such developments during1942 and 1943 among issues selling under $10.00 a share. (It should be noted here that“Saucer” Bottoms of two or three months' duration also appear frequently, one rightafter another, in the charts of low-priced issues during an extended up-movement. Theircharacteristics and denotations will be discussed in the section “Consolidation.”) Tops of the Rounding type are rare among stocks in the lower and medium-priceranges, but they are found occasionally in the charts of those high-priced commonstocks that command an AA rating among wealthy investors and do not ordinarilyinterest the general public. They also appear frequently in the charts of high-gradepreferred stocks, quite naturally because the demand for their shares reflects chieflytwo factors—supply of funds seeking conservative investment and interest rates—bothof which tend to change very slowly. The speculative appeal that produces wide-swinging price fluctuations is absent in such issues. The same line of reasoningexplains why Rounding Tops almost never develop 30 20 10 Sales 100's 200 100 1939 Figure 7.18 Monthly chart of Budd Company. Note that 1942 was the first year toproduce a dull Saucer-Shaped Pattern, a Rounding Bottom of Major import. “BF”climbed from below 3 in 1942 to above 26 in 1946. am :dH igl J il / 1 !l,li„! iie; X Zu Bi liihlll,liili; 30 20 10 Sales 100's 100 50 Figure 7.19 Similar formation in CertainTeed Products, which rose from below 2 in1942 to above 25 in 1946. Study volume, 1940 to 1945. The up-curving type of MajorBull Trend shown on these charts will be discussed in Chapter 15. in lower priced, speculative common stocks; Bull Markets in those stocks are toppedoff by excited public buying that pays little or no heed to long-range investmentconsiderations. How Rounding Turns affect trading activity We have not yet mentioned the volume half of the Rounding Turn picture, which isinteresting, as well as meaningful. In the case of Rounding Bottoms, its pattern isusually as clean-cut and decisive as the price pattern. The first step in the gradualconquest of supply by demand, which produces a Rounding Bottom, appears as alessening in selling pressure. Volume, which has been running high, graduallydecreases. Demand is still timid, but the pressure on it is less; so, while prices still decline, the pace is slower and the trend curves more and more to the horizontal. At theBottom, with the two forces technically in balance, relatively few transactions arerecorded. Then demand begins to increase, and as the price curve turns up, tradingbecomes more active. Volume accelerates with the trend until often it reaches a sort ofclimactic peak in a few days of almost “vertical” price movement on the chart. In such formations, the tips of the volume lines at the bottom of the chart, whenconnected, will describe an arc that often roughly parallels the arc formed by the price 20 27 5 J. I. CASE 1932 nninniiiiinunnniiiiiinniiinui.nniuiiiii.iiiiii,,iii.li.^iiihiiniTnin.Hiiiiiiiiit MARCH APRIL MAY JUNE 12 1 9 26 ' 2 ■ 9 : 1 6 23 30 7 14r21 :2.8'4 31 '18 25 T 2 ' 12 19 26: 2 Figure 7.20 A classic example of Rounding Bottom at the Major Trend Reversal of1932. The jump out of line on June 10 and subsequent return to the Saucer Pattern is acommon development in Rounding Bottoms. “Bowl” above. These patterns, when they occur after an extensive decline, are ofoutstanding importance, for they nearly always denote a change in Primary Trend andan extensive advance yet to come. That advance, however, seldom carries in a“skyrocket” effect, which completes the entire Major Move in a few weeks. On thecontrary, the uptrend that follows the completion of the pattern itself is apt to be slowand subject to frequent interruptions, tiring out the impatient trader, but yieldingeventually a substantial profit. Let us repeat that trading volume should ebb to an extreme low at the Bottom of aBowl Pattern if its implications are to be trusted. After prices have passed dead center,however, and have begun their first gradual climb with as yet only a slight pickup inactivity, something in the nature of a premature breakout may occur. Without warning,a burst of buying may shoot quotations straight up for a day or two. These incidents areby no means rare, but, almost invariably, prices will quickly drop back again into theirformer channel, and the gradual rounding movement is resumed. There is no particulardanger for the trader in these premature bursts, but if he is tempted to jump in on such a sudden showing of strength, he should realize there probably will still be need forpatience. A classic example of this type of premature break is shown in Figure 7.20. See Chapter 16 for some very important 2005 rounding bottoms and their consequencesup to 2011. 42 40 38 36 34 32 30 28 26 Sales 100's 25 20 15 10 5 GAMEWELL GO. JANUARY FEBRUARY MARCH JUNE ; 8 15 22 29 5 12 19 26 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 Figure 7.21 An extreme case of Dormant Bottom. There were many days in the firstfour months during which no shares were traded. A “buy” signal appeared on April 26.Note the volume. Figure 7.22 The March 1935 reaction produced many Rounding Bottoms. This oneverges on the dormant type. The gap (G), a Breakaway through a Resistance Level, wasnot closed until late 1937 (see Chapter 12). 20 19 18 17 16 15 14 13 12 :-:i :t 1988 APPLIED MAGNETICS CORP APM :| C I Sales 100's JUNE 1000 800 600 400 200 Figure 7.23 In a broad trading range (11—17 1/2) during 1988, "APM" turned downfrom Resistance in the summer. The reaction, however, was slow, forming a Saucer-likePattern from July through November on generally Bullish price-volume correlation. Ofparticular note was the fact the low point of the Saucer was above the February low,that is, higher lows were beginning to emerge. The High-Volume Rally through theShort-Term Downtrend Line signaled the start of the next up-leg. O1 ... . I1RU JUNE "JOEY— AUGUST—SEPTEMBER OCTOBER ' NOVEMBER DECEMBER 18 25 2 19 16 23 30 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 3 10 17 24 31 The Dormant Bottom variation One sort of Major Bottom chart picture has been called a Dormant Bottom. Thisvariation relates logically to our Bowl Pattern, being, in effect, an extreme developmentof the "extended, flat-bottomed form" to which we have alluded above. It appearscharacteristically in "thin" stocks, that is, those in which the total number of shares outstanding or, more particularly, the floating supply of shares is very small. In suchissues, a normal day's turnover may be only two or three hundred shares in an activerising market. Finally, weeks and sometimes months will pass during which no saleswill be registered for days at a time, or only an occasional lot at a figure that fluctuateswithin a fractional range, making the chart appear "flyspecked." Eventually, there may appear a sudden and usually quite inexplicable flurry of activity.Several hundred shares appear on the tape and prices advance sharply. This "breakoutof dormancy" can be a premature move, such as we have noted in connection withtypical Rounding Bottoms, to be followed by several more weeks of inactivity, or it canbe the first lift in a sort of step-up process with shorter and shorter intervals betweeneach step, until a consistent uptrend finally develops. In any event, it is a signal that weare dealing with an important Accumulation Pattern. What has happened to form these Dormant Bottoms is easy to guess. With relativelyfew shares outstanding, and only an occasional lot put up for sale "at the market,"investors (perhaps insiders connected with the company) would succeed only inrunning the price up out of reach if they started to bid for the stock. So they simply"hold a basket under it," as the saying goes, quickly picking up anything that is offeredbut never reaching for it, Figure 7.24 Cray Research, a powerhouse stock for over a decade. Trading at under$1.00 in 1976, it reached 135 3/4 before the late April gap, through the Bottom of aseven-week Diamond, started the decline. However, after the High-Volume Rally inmid-January, “CYR” also managed to form an impressive Rounding Top. The concavevolume pattern, clearly evident after the high-volume decline to Support that followedthe Diamond breakdown, was particularly significant in illuminating this ToppingPattern. until eventually the tree is shaken clean. Then they may raise their bids a point or so; ifthat seems to bring out a lot of stock for sale, they go back to their waiting tactics. Volume pattern at Tops The volume pattern on Rounding Tops is seldom as clearly defined as at Bottoms.Indeed, it is apt to be rather high and irregular throughout the entire rounding-overmovement in prices. Under scrutiny, one can usually see some signs of a change fromBullish to Bearish activity in the Minor Fluctuations after the peak has been passed, butthe volume warnings do not become conspicuous in most cases until the downtrend hasbegun to accelerate toward the vertical. We know of no measuring formula that can be applied to Rounding Turns (except forthe minimum qualifications we mentioned in connection with Head-and-Shoulders, thatis, they cannot be counted on to produce a greater move than the preceding price swingin the opposite direction), but they almost never deceive. Their implications can beroughly estimated from the magnitude of the trends that led to them and the length oftime they take in the rounding-over process. The Rounding Turns that often appear onweekly and monthly charts, thus, have major import. This leads us to the general consideration of weekly and monthly chart patterns. Thusfar, we have been speaking in detail of only daily chart developments, but all of theformations we have taken up appear, as well, in the much larger swings into whichdaily movements 30 28 26 24 22 NORTHERN INDIANA PUBLIC' SERVICE NI 1984 14 13 11 Sales 100's ill ^ L , P „ AY JUNE . J ULY ■7 14 21 28 4 11 18 25 3 1017 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 411 18 25 1 8 15 22 29 6 13 XD. 375 XD. 39 XD .39 Figure 7.25 1984. We love the Scalloping tendency of Northern Indiana PublicService. Although it is obviously not a pattern portending rocket-like advance, thetechnical picture brightens with the high-volume breakout through Resistance at chartend. are condensed on weekly and monthly charts, and with identical significance. Thus,volume record may not be quite so easy to read (climactic activity may occur on oneday of a week and the other days run dull, which would not show at all in the week'stotal figure), but it is less critical and may almost be disregarded. Head-and-ShouldersTops are particularly plentiful on monthly charts and should be accorded due respect. Infact, any clearly defined pattern, which is built to completion on a weekly or monthlychart, is proportionately significant (bearing in mind that “a Reversal must havesomething to reverse”). Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter eight Important Reversal Patterns: the Triangles We come next to an entirely different family of technical patterns, the Triangles, a group that has not been as well represented on the charts of the decade of the 1940s as it was during the 1920s and 1930s (EN10: In plentiful supply in modern markets of the 2000s). Their scarcity in that decade is regrettable because they are an intriguing lot with excellent profit potential. Before we examine them in detail, however, a quick review of the basic theory, which gives meaning and value to technical analysis, may be appropriate. That theory can be summarized in the following brief statements (see Figures 8.1 through 8.25). 1. The market value of a security is determined solely by the interaction of supply and demand. 2. Supply and demand are governed at any given moment by many hundreds of factors, some rational and some irrational. Information, opinions, moods, and guesses (shrewd or otherwise) as to the future combine with blind necessities in this equation. No ordinary man can hope to grasp and weigh them all, but the market does this automatically. 3. Disregarding Minor Fluctuations, prices move in trends that persist for an appreciable length of time. 4. Changes in trend, which represent an important shift in the balance between supply and demand, however caused, are detectable sooner or later in the action of the market itself. By this time, the fact expressed in the italicized words of the last statement may have begun to raise some misgivings in your mind. The complaint that the Dow Theory is often “late” has already been discussed. The Reversal Patterns studied in the two preceding chapters give no certain signal until after the trend has changed, usually “sooner” as compared with Dow Theory, but never at the absolute top or bottom price. The man who sells a stock as soon as, but not until, a Head-and-Shoulders Top has been completed on its chart may cash in on no more than half of the total decline from its extreme high to extreme bottom; this is due to the very terms of our measuring formula, the first half of the decline can have taken place before the Top Reversal Formation was finally confirmed. Make up your mind that there is no help for it. Somebody managed to sell his shares at the very top eighth of a point on the peak of the Head (and some poor devil bought them). The seller was just plain lucky. His exploit can be truly compared with a hole-in-one in golf; even a complete duffer occasionally enjoys that thrill. But the more experienced a player, the better satisfied he is to land safely on the green and not too far from the cup. The more experienced an investor, the less concerned he is with getting the last point, or even the last 10 points, out of his market commitments. No one can ever be sure at the time that he is selling at the final high. No rules or methods have ever been devised—or ever will be—to ensure buying within fractions of the Bottom or selling within fractions of the Top. Of course, a man can make certain of buying a stock at its absolute low provided he is prepared to take at that figure every last 26 24 22 20 19 18 17 Sales 100's 50 40 30 20 10 HUDSON BAY MINING & SMELTING HD 111 S O N D ' r F ’M i T F ‘ M^A—M: II : A--S 1 O~’~N ; D ' Figure 8.1 A fine Symmetrical Triangle Reversal Formation on a weekly chart. Upper boundary sloping down from February 1942 recovery high at 21 and lower boundary sloping up from “Pearl Harbor” Bottom at 16 3/8 converge to an apex of about 18 5/8. From this Major Bottom Pattern, “HD” advanced to 45 in 1946. Note the shrinkage in volume as a pattern formed and the increase as the price broke out through the Top in October 1942. Breakout came not quite three-quarters of the way over from the first Top to the apex. 48 44 40 38 Sales 100's 250 200 150 100 50 1946 SEARS, ROEBUCK _ APRIL MAY JUNE JULY AUGUST SEPTEMBER 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28’ Figure 8.2 Sears Roebuck made a Symmetrical Triangle Reversal at its Bull Market Top in 1946, and then it went into another long Triangle that turned out to be a Consolidation rather than Reversal Formation. (Logarithmic volume scaling minimizes volume variations.) Sell signal was given at 44 1/2 and again at 41. Decline continued to 30 1/2. 80 76 72 68 64 60 56 52 Sales 100's 50 40 30 20 10 S' O 'N ' D 1 J ' F ' M ' A 1 M J 'J 'A » S ' O ' N ' D ' J ' F 'M Figure 8.3 Johns-Manville's Primary Trend Reversal in 1942 developed out of a Symmetrical Triangle that also had some aspects of a Head-and- Shoulders Pattern with a long right shoulder. Although this is a weekly chart, the volume here is worthy of detailed study in connection with the price action. “JM” (old stock) advanced more than 100 points in the next four years. share offered, even to the entire outstanding issue if necessary. It might, in theory, require as much as $3.7 billion to “put a bottom” under U.S. Steel at 70 (EN9: ca. 1950s) in case you are tempted. The reader, who at this point may think we “protest too much,” will see more excuses for the foregoing remarks when we take up the habits of Triangles, for these formations are not always indicative of Trend Reversal. On the contrary, except in certain rather uncommon varieties, they are more apt to signal what may most conveniently be termed Consolidation, terminating an up or down move only temporarily and setting the stage for another strong move in the same direction later on. (Schabacker called such chart formations “Continuation Patterns.”) The reason for including Triangles in this section of our studies under the general heading of Reversal Formations is that they do, at times, develop at periods of Major Trend change, and those are, by all odds, the periods that are the most essential for the investor to recognize. Symmetrical Triangles The most common form of a Triangle is composed of a series of price fluctuations, each of which is smaller than its predecessor, each Minor Top failing to attain the height of the preceding rally, and each Minor Recession stopping above the level of the preceding Bottom. The result is a sort of contracting “Dow Line” on the chart—a sideways price area or trading range whose Top can be more or less accurately defined by a down-slanting boundary line and whose Bottom can be similarly bounded by an up- slanting line. This type of Triangle is called a Symmetrical Triangle. If we wanted to make a more accurate application of the language of geometry, we might better call it an Acute Triangle because it is not at Figure 8.4 Logarithmic price scaling on weekly chart emphasizes important technical developments at low price levels. “DH's” Symmetrical Triangle Bottom started a Bull Market that reached 57 in 1945. Note the Throwback to apex of Triangle, not an uncommon development. The apex itself is a strong Support (see Chapter 13). all necessary that its Top and Bottom boundaries be of equal length or, in other words, that they make the same angle with the horizontal axis. However, there is a very strong tendency in these formations to approximate the symmetrical form; so, the established name will do well enough. This pattern is also sometimes referred to as a “Coil.” While the process of contraction or coiling, which makes up the price action of the Symmetrical Triangle Pattern, is going on, trading activity exhibits a diminishing trend, irregularly perhaps, but nevertheless quite noticeably as time goes on. The converging upper and lower boundary lines of the price formation come together somewhere out to the right (the future in the time sense) of the chart, at the apex of our Triangle. As prices work their way along in narrower and narrower fluctuations toward the apex, volume ebbs to an abnormally low daily turnover and, if we are dealing with a typical example, comes the action that first suggested the name “Coil.” Suddenly and without warning, as though a coil spring had been wound tighter and tighter and then snapped free, prices break out of their Triangle with a notable pickup in volume, and leap away in a strong move that tends to approximate in extent the up or down move that preceded its formation. There is seldom any clue given on the one chart containing the Triangle to tell in which direction prices are going to break out of the pattern until that action finally occurs. Sometimes you can get a pretty good idea of what is likely to happen by observing what is going on at the same time in the charts of other stocks (which is an important topic for 28 CUBAN - AMERICAN SUGAR 26 24 1945 22 20 19 18 Sales 100's 125 100 75 50 25 AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER" 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27'3 10 17 24 1 8 15 22 29 ’ Figure 8.5 Triangles often form as a part of a larger and more important pattern of some other type. Here a symmetrical figure constitutes the latter half of a Rounding Turn. Note the premature breakout on October 17, return to pattern, and then final breakaway on November 8. 24 22 20 19 18 17 16 15 14 Sales 100's 125 100 75 50 25 NATIONAL GYPSUM NG RY JUNE “ FEBRUARY MARCH “ APRIL-----MAY------JUNE--------JULY i 3 1017 24 3 4047 24 31 7 44 21 28 5~12 1926- 2 : <462338 7 i 14 >2128’ Figure 8.6 Prices in this Symmetrical Triangle squeezed way out into the apex before erupting. Breakout at that stage is unreliable; above is a fair sample of the false moves that occur there. Real move was down. 16 15 14 24 22 20 19 18 17 Figure 8.7 Recovery rallies from “Panic” Bottoms are often capped by Triangles, for those are periods in which doubt and indecision are prevalent. The doubt in such cases, however, is usually resolved in favor of renewed decline. “Panic” Bottoms seldom hold. This chart shows a typical Symmetrical Pattern topping the recovery from the famous Selling Climax of October 19, 1937. Note Pullback to apex. later discussion). Often, however, there is nothing to do but wait until the market makes up its mind which way to go. And “making up its mind” is just what the market seems to be doing when it builds a Triangle; everything about this pattern appears to exemplify doubt, vacillation, and stalling until finally a decision is reached. Some cautions about Symmetrical Triangles A compact, clean-cut Triangle is a fascinating picture, but it has its tricky features. The beginner in technical chart analysis is quite naturally prone to look for Triangles constantly, and will often think he has detected them when, in fact, something entirely different is in the process of development. Remember, it takes 2 points to determine a line. The top boundary line of a price area cannot be drawn until two Minor Trend Tops have been definitely established, which means prices must have moved up to and then down away from both far enough to leave the two peaks standing out clear and clean on the chart. A bottom boundary line, by the same token, cannot be drawn until two Minor Trend Bottoms have been definitely established. Therefore, before you can conclude that a Symmetrical Triangle is building, you must be able to see four Reversals of Minor Trend. If it comes after an advance in prices, you must first have a Top, next a Bottom, then a second Top lower than the first, and finally a second Bottom higher than the first Bottom (and prices must move up away from the second Bottom before you can be sure it is a Bottom). Then, and only then, can you draw your boundary lines and proceed on the assumption you have a Symmetrical Triangle. 26 24 22 20 19 18 17 16 Sales 100's 125 100 75 50 25 VERTIENTES - CAMAGUEY SUGAR 1946 ’ 6 13 20 27 4 11 18 25 18 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28 Figure 8.9 The other side of the story—an imposing Symmetrical Triangle which failed badly, although for the alert and experienced technician, there were warnings of something amiss in March and April. Eastern Airlines built, in late 1946 and early 1947, a formation which, so far as price pattern was concerned, left little to be desired. Prices broke out topside decisively in late March. A Throwback in April met normal Support at the upper Triangle boundary, but the subsequent advance fell short, weakened, and finally broke down, producing an “end run” around the apex. Warnings referred to were high and irregular volume, particularly on reactions, in February and March—not characteristic of valid Triangle development— and failure of prices to push up rapidly and vigorously after the April 14 Throwback. Figure 8.8 A Major Symmetrical Triangle Top in which prices squeezed out into the apex and then produced a false move upside (see Figure 8.6). “VEC,” as a matter of fact, was a bad actor technically, but this particular breakout would be suspect anyway. APRIL EASTERN AIRLINES EAL 24 22 20 19 18 17 16 Sales 100's J '■I 4 ...A.. NOVEMBERDECEMBER JANUARY i 9 16 23 30 7 14 21 28 4 11 18 25 1 ;EBRUARY MARCH 8 15 22 1 U 8 15 22 2 AUGUST SEPTEMBER 9 16 23 30 6 13 20 27 4 19 18 17 16 15 14 13 12 11 10 9 Sales 100's 50 40 30 20 10 Figure 8.10 A weekly chart. The seventh-month Consolidation area of 1944 —in “NG,” undefinable at first, developed eventually into a typical Symmetrical Triangle. Two months after the high-volume breakout in January 1945, prices reacted nearly to apex level and then pushed away rapidly. Minimum measuring implications of this Triangle were satisfied at 16. Figure 8.11 A small Symmetrical Triangle that tended toward the “Ascending” type. Note that the higher volume that developed within this pattern in early January came on a rally. This sort of action is fairly typical of very “thin” stocks. AMERICAN BANK NOTE ABN Figure 8.12 An Ascending Triangle 10 months long, which was the start of a Major Bull Trend, carrying “ABN” to 45. Refusal of prices to react to the lower pattern boundary, as here in August 1942, is a frequent development in strong formations, a warning of near completion and breakout. 38 Sales 100's 1946 CELANESE CORPORATION CZ Jlll.iliiiliilLilnliillil.llil. lllliyihiliiillLliUliii JANUARY FEBRUARY^ MARCH ~ APRIL _ MAY JUNE 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28’ 5 12 19 26 2 9 16 23 30' Figure 8.13 Premature breakouts from Right-Angle Triangles, such as appeared in Celanese in March 1946, are temporarily disappointing to the trader who buys on them, but they eventually work out all right. Celanese, before its 1946 split, was subject to frequent and peculiar shakeouts, as here on March 9 and 26. 26 24 22 20 19 18 17 16 15 Sales 100's 50 40 30 20 10 BRIGGS MANUFACTURING CO. ik M2 J ' J A sjo'nj d;j’ F ’M Life. S' O ' N ' D~'~J JliUi T" 1 Hil'L 1 ]l •n j r:** Figure 8.14 A steep recovery from a Panic Bottom (the “Pearl Harbor” selling) flattened out into a fine Ascending Triangle. Note the horizontal Supply Line at 19, above a gradually rising Demand Line. The breakout at the end of September signaled initiation of an advance of some consequence. It turned out to be a Primary Bull Market, which took Briggs up to 53. 112 SEARS ROEBUCK 104 96 88 80 76 Sales 100's 125 150 25 50 25 OCTOBER NOVEMBER DECEMBER 'JANUARY FEBRUARY MARCH Figure 8.15 Sears' 1936 Bull Market Top was a Symmetrical Triangle, out of which it declined 15 points. An Ascending Triangle then produced an Intermediate Recovery to the Supply Zone (see Chapter 13) at the lower side of the top Triangle. Compare this chart with the 1946 Top in Figure 8.2. 40 38 36 34 32 30 28 26 24 22 20 Sales 100's 50 40 30 20 10 SOUTHERN RAILWAY PFD. APRIL MAY JUNE JULY AUGUST : 4 :11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 2^ 1 ' 8 15'23 29 ' 1936 Figure 8.16 An Ascending Triangle at an Intermediate Bottom. This chart runs from April through August 1936. Extreme shrinkage in trading volume during this formation indicated a very strong technical situation. Another point to remember—and one that does not conform at all to the “Coil” simile— is the farther out into the apex of the Triangle prices push without bursting its boundaries, the less force or power the pattern seems to have. Instead of building up more pressure, it begins to lose its efficacy after a certain stage. The best moves (up or down) seem to ensue when prices break out decisively at a point somewhere between half and three- quarters of the horizontal distance from the base (left-hand end) to the apex. If prices continue to move “sideways” in narrower and narrower fluctuations from day to day after the three-quarter mark is passed, they are quite apt to keep right on to the apex and beyond in a dull drift or ripple that leaves the chart analyst completely at sea. The best thing to do in such cases is go away and look for something more promising elsewhere in your chart book. A third tricky point is that it becomes necessary sometimes to redraw one or both boundaries of a Triangle before it is finally completed (i.e., before prices break out and move away from it in a decisive fashion). This can happen, for example, when, after the first two Rally Tops have established a down-slanting upper boundary line, the third rally starting from the lower boundary pushes up and through the original Top line by a moderate 19 18 17 16 15 14 13 12 11 Sales 100's ARMOUR & COMPANY MARCH AUGUST SEPTEMBEROCTOBER NOVEMBER DEC'E.mBeRJANI ARY FEBRUAR Figure 8.17 One of the early 1947 disappointments (to the Bulls) was the failure of “AM” to break out topside from the long Ascending Triangle depicted above. Here is a case where supply at 15 finally overwhelmed demand. A pattern such as this indicates a potentially strong underlying situation for the long pull. Ordinarily, the consequence of an Ascending Triangle's “failure” of this sort is the development either of an extended Rectangular base within the general range of the Triangle (in this case, 10 to 15), or formation of a Double Bottom at or near the earlier low (in this case near 10). However, “AM” dropped lower after several more attempts to overcome the Major Supply at the 15 level, which was not substantially penetrated until 1955. margin and then, without developing a recognizable breakout volume on this move, stops short of surpassing the highest level of the preceding (second) pattern Top. When prices subsequently drop back again into pattern, it is necessary to abandon the original upper boundary line and draw a new one across the highs of the first and third rally tops. How prices break out of a Symmetrical Triangle Prices may move out of a Symmetrical Triangle either up or down. There is seldom, if ever, as said above, any clue as to direction until the move has actually started, that is, until prices have broken out of their triangular “area of doubt” in decisive fashion. In a very general way, the precepts laid down for breakouts from Head-and-Shoulders Formations apply here as well. For example, the margin by which prices should close beyond the pattern lines is the same, roughly 3%. It is equally essential that an upside break in prices be confirmed by a marked increase in trading volume; lacking volume, do not trust the price achievement. But a downside breakout, again as in the case of the Head-and-Shoulders, does not require confirmation by a pickup in activity. As a matter of record, volume does visibly increase in most cases, but in a majority of down breaks, it does not do so to any notable extent until after prices have fallen below the level of the last preceding Minor Bottom within the Triangle, which, as you can see, may be several points lower than the boundary line at the place (date) of the actual breakout. The curious fact is a downside breakout from a Symmetrical Triangle attended to right from the start by conspicuously heavy volume is much more apt to be a false signal rather than the start of a genuine downtrend that will be worth following. This is particularly true if the break occurs after prices have worked their way well out into the apex of the Triangle; a high volume crack then frequently—we might even say usually—develops into 12 11 10 9 8 7 6 Sales 100's 125 100 75 50 25 SOCONY-VACUUM OIL i ' J ' A ' S ■ O ' N ' •D'1 T IM 1 S : O ' N 1 D ' J ‘M 1 M ’ A r M ; J Figure 8.18 The 1942 Bear Market Bottom in Socony-Vacuum was an unusual Head-and-Shoulders Formation, with the head consisting of an Ascending Triangle. Note the increase in volume on the breakout from the Triangle in July and again on the break through Head-and-Shoulders neckline in October. a two- or three-day “shakeout,” which quickly reverses itself and is followed by a genuine move in the up direction. All of the above the reader will have undoubtedly found most disconcerting. Here is a pretty technical pattern, and it cannot always be trusted. Unfortunately, Symmetrical Triangles are subject to false moves to a far greater extent than the Head-and-Shoulders Formation or any of the other formations we have discussed or will discuss later. Unfortunately, some of these false moves cannot be identified as such until after a commitment has been risked (although good trading tactics should prevent their occasioning much more than a trivial loss). Unfortunately again, even a typical shakeout, such described in the preceding paragraph, may produce a double cross, proceeding right on down in a genuine decline. No technical chart formation is 100% reliable and, of all our present subject, is the worst offender. But most Symmetrical Triangles—lacking an actual statistical count, our experience would suggest more than two-thirds of them—behave themselves properly, produce no false signals that cannot be spotted before any damage is done. Upside breakouts on high volume may be premature in the sense that prices return to pattern and do some more “work” there before the genuine uptrend gets under way, but they seldom are false. We shall have a little more to say about false signals in this chapter and more later on that we trust will be helpful in developing the experience a trader needs to defend himself against them. 125 100 75 50 25 Sales 100's BATH IRON WORKS ilk JUNE : I JANUARY FEBRUARY MARCH APRIL MAY " JUNE 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 2^ '4 11 18 25 1 8 15 22 29 Figure 8.19 Due to a dividend of $1.00 went ex on March 14, the lower boundary of this Descending Triangle Top in “BIW” had to be dropped 1 point from 33 and redrawn at 32. Despite the added leeway thus afforded, however, the original pattern implications were quickly carried out. Prices pulled back three times to the new lower boundary line of this Triangle on April 4, April 16, and May 31—unusual, but explained by the existence of a strong general market uptrend during this period. Whenever a stock goes ex-dividend during the formation of an Area Pattern of any type, the lines bounding that pattern should immediately be adjusted to the new value by lowering them a distance corresponding to the amount of the dividend. A typical Triangle development The several actual chart examples of Symmetrical Triangles that illustrate this chapter will serve, we trust, to give the reader a working acquaintance with their appearance in various manifestations. Yet it may help to clear up some of the more important points if we describe in detail just how a typical pattern develops step by step. Let us suppose you are watching a stock on your charts that has climbed, with only the normal, brief hesitations and inconsequential reactions, from around 20 to 30, 32, 35, and is still moving up. (Let's hope you bought it at 20!) Lower down, its turnover ran between 300 and 600 shares daily, but now, above 30, it has attracted quite a following, and daily volume has increased to around 1,000. As it approaches 40, activity shoots up to nearly 2,000 shares, the market “churns” between 39 and 40, and then prices begin to drop. As they fall back, you (especially if you own the stock) watch it with some concern, but you know it is hardly likely that it is going to go straight down again to 20; stocks do not act that way. (EN9: Sometimes they do now, in the twenty-first century.) If the trend of this issue has actually been reversed, it should, nevertheless, spend some more time and effort around its top levels and make some sort of a Distribution Pattern. REVERE COPPER & BRASS 1946 20 19 18 Sales 100's 125 100 75 50 25 ....... APR I L .......... M AY " * J UNE H J ULY AUGUST "S EPTEMBER 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28’ Figure 8.20 On the basis of “fundamentals,” Revere was an attractive holding in 1946, which may account for its reluctance to “give up” when the market generally started downhill in earnest in June of that year. Its fluctuations from mid-May to late August constructed a fine, large Descending Triangle, in which, however, Bearish Volume Signals had already appeared in late June and on July 23. The breakout came (with a wide Breakaway Gap) on August 27. Prices clung to the edge of the pattern for four days and then collapsed. The small formations outlined in April and May are Flags, to be discussed in Chapter 11. The decline continues for 10 days with the turnover also declining quite appreciably. By the time prices have worked back to 33, volume is running at about 700 shares daily. At 33, it may pick up again for a single day to 800 or 900 shares, but the reaction stops there, and after a day or two, prices begin to climb again with little change in their turnover rate. In eight or nine days, quotations have gotten back into the upper 30s and activity increases and reaches, say, 1,200 shares on the day 39 is reached. Instead of going on to 40 or beyond, however, a new reaction sets in and prices drift back to 37. (Perhaps you will find this growing picture easier to visualize if you pencil its development on a scrap of chart paper.) Now it is evident that a second Top has formed at 39; you can now draw a tentative pattern line (there are other names for this, as we shall see later) on your chart across the two extreme high ranges (not closing prices), which will slant downward from left to right. So far you have only one Bottom point, so you cannot draw lines from that, but this second decline brings out even less trading activity than the first. Volume ebbs to 400 shares and the down move halts at 34; the price track “rounds out” and turns up again; trading is very dull, but it begins to pick up as 36 is reached. This action defines a second Minor Bottom and now you can draw a Bottom “tangent,” an up-slanting line across the extreme low prices registered on the two reactions, the first at 33 and the second at 34. Your two pattern lines will converge, meeting near the 36H Figure 8.21 The 1937 Bull Market Top in Westinghouse was this Descending Triangle, which started in January and broke on February 15. Prices hung at the lower edge of the Triangle for four days, fell away, and then pulled back to its lower line on March 4 at the time when the general market Averages were making their final Bull highs. level about four weeks ahead (i.e., to the right) on your chart. You have a Symmetrical Triangle—but you do not know whether prices are going to fall out of it eventually or shake off present doubts and push up in a new advance worth following. You can only watch further developments very closely and be prepared to take whatever action is, in due time, indicated. The second rally picks up a little in activity, attains a daily turnover of about 700 shares, and pushes up to 38 and on for part of a day to 38 3/4. This nudges through the previously drawn pattern line by perhaps a quarter of a point (because each swing is shorter in points traveled and, accordingly, in duration). But the volume on this Minor Penetration is less than on the preceding Top (at 39) and buying again ebbs. As the price range line falls back to 37 and 36, draw a new upper tangent across the first Top at 40 and the last Top at 38%. There is the suggestion here in this slight “lift” that the balance may be swinging slightly to the demand side, but do not count on it. Pinpoint accuracy is not to be expected; Triangles must be allowed some leeway. On the third reaction, activity dwindles away to the lowest yet. The up- slanting Bottom boundary will be reached at about the 35 level, if prices continue their present course. It is worth noting now whether they will come all the way down to it this time because if they do not—if their recession is halted half a point or so above it—that action would give some significance to the previous bulge through the upper boundary. But this does not happen; the drift continues right on down to 35, and now volume is running at the rate of only 200 shares daily, less than it ran in the early stages of the original advance above 20. This is a critical spot. The price track flattens out momentarily, turns up feebly, yet keeps hitching Figure 8.22 A series of Triangles, Symmetrical and Descending, which evolved during the 1929-1932 Bear Market in Hudson Motors. Note that at no time during this decline did anything resembling a Major Bottom appear. Note also how each Triangle's measuring implications were carried out before any temporary halt or consequential rally developed. Follow your daily charts for the proper timing of your trading operations but keep an eye always on the long-range pictures that evolve on weekly and monthly projections, so as to maintain your perspective on the Major Trend. up, crosses 36%, picks up activity, reaches the (new) upper Triangle boundary at 37% and, on the next day, punches through on a turnover of 1,500 shares to close at 39%. This is a breakout; the doubt is resolved and (barring a false move, unlikely at this point) the trend is once again up. Note that it was not necessary for prices to surpass the previous high at 40 to produce this signal—that is one of the interesting things about Symmetrical Triangles. Figure 8.23 The curious, and in its early stages confusing, Major Bottom Formation that American Rolling Mills constructed in 1941-1943. The recovery from the “Pearl Harbor Panic” of 1941 ran into a large Symmetrical Triangle that broke out on the downside in April 1942. The subsequent decline satisfied the measuring requirements of that Triangle, but it did not carry below the December low. The rally of June and reaction of August-September built the whole area out into another and larger Symmetrical Triangle, out of which prices broke on the upside in September. Then the reaction to the apex of the latter, in December 1942, and the following advance built up into a 15-month Ascending Triangle, which constituted the final Major Bottom for a trend that carried prices up eventually to 42 in 1946. The low volume on the June and August- September reactions, the increase on the October markup, and, even more, the January 1943 rise and breakout in February were unmistakably of Major Bullish implications. It takes time, remember, to build a foundation for a Bull Market. Reversal or Consolidation We started to discuss Symmetrical Triangles as Reversal Patterns, yet our example has turned out to be, instead, a Consolidation Pattern, that is, only a sort of resting stage in a continued uptrend. Well, three out of four of these formations will turn out to be just that; the fourth is the dangerous one (if you own the stock). How would it differ? The example described might have been a Reversal instead of a Consolidation Formation any time up to the point of the decisive breakthrough to 39. If it had been a typical Reversal, the first change probably would have appeared shortly after the final rally started up from the third Bottom at 35. That rally would have petered out at about 36%, and prices would have started to drift back again. Then, with the activity increasing slightly, the Bottom boundary would be penetrated. As quotations dropped to 34, daily volume might mount to 600 or 700 shares. Any further decline would constitute a down signal, resulting in a further pickup in turnover and an acceleration in the price decline as the stop-loss orders (to be discussed later) spotted under 34 were “touched off.” Before we leave our typical example, we might make some mention of the post-breakout reactions or Pullbacks that sometimes occur. As in the case of the Head-and-Shoulders 36 34 32 30 28 26 24 22 20 19 18 17 16 15 14 13 Sales 100's 250 200 150 100 50 GOODRICH ( B. F. ) COMPANY lull -L L X ~F ‘ M 1 AM J LU 'J'A'S'O'N'D'J’F'M A S O~N—D 1 J Figure 8.24 A beautifully compact Ascending Triangle that turned out to be the Major Bear-to-Bull Reversal in Goodrich in 1942. The breakout from this pattern (in April) was not signaled by any extraordinary pickup in activity so far as this weekly record shows (but remember significant volume detail is often hard to see in a weekly plotting). The Triangle's measuring implications were carried out by the first upswing, which reached 18)4 at the end of May. Supply had to be absorbed in the 18 to 21 range (refer to this chart when you study Support and Resistance in Chapter 13), but a Major Up Signal was given in September when prices erupted through that zone with a conspicuous increase in trading volume. Formation, the initial breakout move from a Symmetrical Triangle may halt before prices are carried very far away from the pattern and be followed by a Minor Reaction, usually lasting only two or three days, which will carry quotations back to the nearest pattern boundary. Thus, in our first example in which the break, when it came, took our stock up through the top side to 39/, the next day might have seen a push on to 40, and then prices might have backed off again in a couple of days of decreased activity to 37% or 38. The up-move would then normally be resumed with greater vigor. Downside breakouts are sometimes followed in much the same manner by pullbacks to the lower boundary ebay Inc-(Nasdaq NM) 57.75 0.240 0.417% - X A / T r w — --4— -3 w n i ill 1998-2003 Prophet Financial Systems, Inc. I Terms of use apply. Volume (Millions) i J . . 1 11 ILJ! 02 Apr Jul Oct 03 Apr Jul Oct 63 57 51 45 42 39 36 33 30 27 24 125 100 75 50 25 0 Figure 8.25 A real-time chart from prophet.net. The volume blowout in July 2002 drew attention to eBay and the sloping line was drawn at that time. Although the lines are sloppy and the pattern is ragged, it looked at the time like a Descending Triangle with all its implications. Nevertheless, when it broke out of the pattern on emphatic volume in October 2003 the handwriting was on the wall. eBay was for real. So, what's for real? It could really make money, not just capture free eyeballs, like its internet brethren and sistern. It actually performed a service of economic benefit to many people, unlike the internet fantasy follies. See Figure 10.26 for a longer perspective on eBay. Lessons for the attentive: power of trendlines; alarm- clock nature of unusual volume; not believing any forecast. Forecast in this case would have been for a downtrend if, as it seemed, the pattern was a descending triangle. of the pattern, after which the decline is resumed with an increase in volume. However, these post-breakout reactions occur less often with Triangles than they do with Head-and-Shoulders Patterns. Another matter we might take up before going on to study the next formation is the rationale of the Symmetrical Triangle. It may help to fix its characteristics in mind if we try to deduce what sequence of events might typically produce it. Of course, any effort of this sort can result only in a gross oversimplification, which will not fit all of the Triangle's various manifestations, but it is an interesting mental speculation—and one not without benefit to our understanding of the general theory of chart formations. Let us turn back again to our typical example. We started with a stock that ran up rather steadily from around 20 to 40 and then reacted. It is fairly obvious what happened at 40: many investors had substantial paper profits, approaching 100% at that price. (A “round figure” such as 40, 50, 75, or 100 is apt to become a sort of mental profit objective and, hence, bring in increased selling.) Some of them were ready to cash in and did so, temporarily swinging the technical balance from demand to supply; they sold less freely, of course, as prices receded. Other would-be investors had been attracted to the stock, but too late to “get aboard” below 30. Unwilling to “chase” it up to 40, they welcomed the reaction and, by the time prices had dropped back to 33, enough of them were ready to buy to swing the balance back again to the demand side of the equation. Watching the ensuing rally, however, were the owners of the stock who had failed to grab their profits near 40 on the previous advance and had made up their minds to be a little less greedy if given a second opportunity. Their offerings began to come in above 37, say, and were sufficiently copious at 39 to stem the advance at that level. Behind the scenes, we can imagine this process repeated again and again, with new money constantly coming in and meeting supply from owners increasingly anxious to cinch their profits. Eventually, the offerings of the latter are all absorbed, or perhaps withdrawn, and then professionals, as well as hopeful investors, suddenly discover there is no stock ahead on the books and rush to buy results. Since the advance (or decline) that follows the completion of a Symmetrical Triangle usually runs to worthwhile trading proportions (we shall discuss measuring implications later), there would be an evident advantage to the trader who could tell in advance of the breakout which way prices were going to move. The odds are, as already stated, the new move will proceed in the same direction as the one before the Triangle's formation. These odds are greatest, of course, in the early stages of either a Primary Bull or Bear Market with the chances of Reversal increasing as those Major Trends mature. Nevertheless, the charts of other stocks often furnish valuable collateral evidence; thus, if at the same time you detect a Symmetrical Triangle in the process of formation in “PDQ,” a majority of your charts are showing Saucers or Head-and-Shoulders Bottoms or Ascending Triangles or some other pattern of typically Bullish import, it is a fair assumption that your Symmetrical Triangle will break out topside. There are times when advance indications of this sort are strong enough to justify taking a position on it. The Right-Angle Triangles We mentioned Ascending Triangles in the preceding paragraph. The Ascending and Descending are the Bullish and Bearish manifestations, respectively, of our next class of patterns, the Right-Angle Triangles. In many respects, in most in fact, they perform like their Symmetrical cousins, but with this very gratifying difference: they give advance notice of their intentions. Hence, their names, for the supposition always is that prices will ascend out of the Ascending form and descend from the Descending form. The Symmetrical Triangles, as we have seen, are constructed of a series of successively narrower price fluctuations that can be approximately bounded across their Tops by a down-sloping line and across their Bottoms by an up- sloping line. Right-Angle Triangles are distinguished by the fact that one of their boundaries is practically horizontal, whereas the other slants toward it. If the top line is horizontal and the bottom line slopes up to meet it somewhere out to the right of the chart (at the apex), the Triangle is of the Ascending persuasion. If the bottom line is horizontal and the top line slopes down, the Triangle is Descending. These formations are perfectly logical and easy to explain. The Ascending Triangle, for instance, pictures in the simplest and most normal form what happens when a growing demand for a certain stock meets a large block of shares for sale at a fixed price. If the demand continues, the supply being distributed at that price will eventually be entirely absorbed by new owners looking for still higher levels, and prices will then advance rapidly. A typical Ascending Pattern starts to develop in much the same way as the “ideal” Symmetrical Triangle previously described, with an advance in our certain stock from 20 to 40 at which point sufficient supply suddenly appears on the market to fill the orders of all buyers and produce a reaction. Sensing the temporary satiation of demand, some owners may dump their holdings on the decline, but offerings are soon exhausted as prices drop back to, say, 34, and renewed demand then stimulates a new rally. This runs into supply again at 40, and again, all buyers are accommodated at that level. The second recession, however, carries quotation down only to 36 before another up-move develops. But the pool or inside group that is distributing at 40 still has some of its holdings left to sell, so it may take more time, another backing away and another attack at the 40 line before the supply there is exhausted and the trend can push along up. A planned distribution This type of market action evidences a planned campaign by owners of a fairly large quantity of shares to liquidate at a predetermined price. It contains little of the element of doubt that we mentioned as characterizing the Symmetrical Pattern. So long as demand persists, the distributing pool knows it can ultimately cash in its entire line at 40 and need not sell for less. It is equally apparent, so long as demand keeps coming in at higher and higher levels that, once the supply at 40 has all been absorbed, the market will advance rapidly and easily. As soon as prices break out above 40, those who took over the supply at that figure will feel their judgment has been vindicated and will not be disposed to sell until they, in turn, can register a good profit. The crux of the matter is contained in the two preceding sentences. Demand must continue to come in at higher and higher levels, otherwise, our formation will cease to be an Ascending Triangle. Plus, the overhead supply must eventually be absorbed, permitting an upside breakout. If demand begins to falter any time before the Supply Line (horizontal Top boundary) has been broken through, the ensuing reaction may drop prices down “out of pattern,” and then the chart technician is faced with the necessity of revising his chart picture. One might think that such a development, blasting the earlier promise of the chart, would occur fairly often, but, as a matter of experience, it is surprisingly rare. We say “surprisingly” because it is obvious that in many cases of Ascending Triangle development, the group selling creates its Top boundary or Supply Line must believe that level to be just about as high as the stock has any right to go. As holders of a large enough block to influence the market for several weeks, sometimes months, their judgment is hardly to be scorned. Yet, once it becomes evident the lower boundary or Demand Line is slanting up, the odds are certainly somewhere in the neighborhood of 9-1 that the new buyers will eventually have the best of it. On occasion, the third reaction or fourth reaction within an Ascending Triangle Formation will break down through the previously established up- slanting Demand Line (lower boundary), but it will be halted at the same level as the previous reaction. The pattern from there on is apt to develop as a Rectangle, a formation to be discussed in our next chapter, and should be treated as such. (The tactics of trading on Ascending and Descending Triangles, including protection against the rare cases of collapse, will be taken up in Section II.) Descending Triangles Descending Triangles have a horizontal lower boundary or Demand Line and a downsloping upper boundary or Supply Line. It is evident they are created by reverse market conditions than those of the Ascending Pattern; however, their implications are equally strong and their failures equally rare. Development of a Descending Formation hinges on a campaign by a group or syndicate (often an investment trust) (EN9: or Mutual Fund or a takeover group) to acquire a large block of shares in a certain company at a predetermined price below the market. Their orders are placed and allowed to stand until executed at that level. If the successive rallies therefrom, which their buying generates, are stifled by new supplies of stock for sale at lower and lower levels (thus creating the typical Descending picture on the chart), orders to buy are eventually all filled and quotations break through and on down. The mere breaking of the critical line, which many traders have seen function as a support under the market for a more or less extended period, often shakes the confidence of holders who had not previously considered selling. Their offerings now come on the market and accelerate the decline. Volume characteristics same as the Symmetrical type The volume section of the Right-Angle Triangle's chart requires little comment. It will ordinarily present a picture practically identical with that accompanying the development of a Symmetrical Triangle. Activity tends to lessen as prices move out toward the apex. In the Ascending Formation, there will usually be a pickup on each rally and an ebb in turnover on each decline within the pattern; in the Descending Formation, the opposite is true, but sometimes it is not quite so evident. These Minor fluctuations do not affect the overall diminishing trend of volume until the breakout point is reached. As to breakouts, practically everything discussed about the Symmetrical Triangle will apply as well to the Right-Angle type. Upside breakouts (from an Ascending Pattern, of course) are attended by a conspicuous increase in trading volume; if not, they should be treated as suspect. Downside breakouts (from Descending Patterns) may not evince much of a pickup in activity, but turnover usually speeds up the second or third day out of pattern. Throwback reactions to the pattern's boundary line after a breakout are fairly common; their occurrence seems to depend largely on general market conditions. Thus, if prices break down out of a Descending Triangle in an individual stock at a time when the rest of the market is firm, a Pullback Rally is fairly certain to intervene before any extensive further decline takes place. This chart, and a number that have preceded it, illustrate an important point for the market technician that may well be restated here: When a large number of individual issues, after an extensive advance, make well-defined Reversal Patterns of plainly Bearish import, break down out of them, and then succeed only in pulling back no farther than their lower boundaries or “Resistance Lines” at a time when the Averages are going on up to new highs, the whole market is in a dangerous condition and a Major Downturn is imminent. Divergences of this particular sort between many important issues and the Averages seldom develop at Intermediate Turns. The warning is particularly pointed when stocks of the caliber of Westinghouse, DuPont, General Motors, and others fail to “confirm” new highs in the Averages. Refer back to Figures 6.3, 6.6, 6.9, and 8.15, for example, and compare the “timing” in those with the trend of the Averages for the same periods. The Saucer-Like Reaction Pattern of October to January in the above chart analyzes into a Complex Head-and-Shoulders Consolidation, a formation that will be taken up in Chapter 11. Incidentally, “WX” continued on down to 130 in April 1937, made a Rectangle base there, and recovered to 158 (see above Descending Triangle) in August and then fell to 88 in November. Compare this daily chart with the monthly chart of “WX” for 1935 to 1938 in Figure 15.15. Good, reliable breakouts from Right-Angle Triangles usually occur at about the same stage of pattern completion as they do in Symmetrical Triangles. The earlier the breakout, the less apt it is to be a false move (although false moves from Right-Angle Formations are considerably rarer, it should be noted, than from Symmetrical). In those infrequent cases when prices “squeeze” right on out of the apex without producing a definite breakout, the pattern seems to lose much of its power. Measuring implications of Triangles In Chapter 6, we stated a minimum measuring rule to apply to price movements developing from a Head-and-Shoulders Formation, and we can lay down a somewhat similar rule for Triangles—one that applies to both the Symmetrical and the Right-Angle species. The method of deriving the Triangle formula is not easy to explain in words, but the reader can familiarize himself with it quickly by studying its application on several of the actual examples that illustrate this chapter. Assuming we are dealing with an up-movement (upside breakout), draw from the Top of the first rally that initiated the pattern (in other words, from its upper left-hand corner) a line parallel to the Bottom boundary. This line will slope up away from the pattern to the right. Prices may be expected to climb until they reach this line. Also, as a rule, they will climb, following their breakout from the pattern, at about the same angle or rate as characterized their trend before entering the pattern. This principle permits us to arrive at an approximate time and level for them to attain the measuring line. The same rules apply (but measuring down, of course, from the lower left corner) to a descending move. Although application of the above formula does afford a fair estimate of the extent of move to be expected from a Triangle, it is neither as definite nor as reliable as the Head-and-Shoulders formula. Do not forget the important qualification that the Triangle has somehow lost a part of its potential strength if the breakout is delayed until prices are crowded into the apex. Triangles on weekly and monthly charts We have seen in preceding studies how Head-and-Shoulders Formations may appear on the long-range (weekly or monthly) charts and will have importance commensurate with their size. Triangles also may develop on weekly charts with their implications usually clear and dependable, but the coarse Triangular Patterns—which can be found on graphs of monthly price ranges, especially the great, loose convergences that take years to complete — had better be dismissed as without useful significance. Other Triangular formations There are other patterns of price consolidation or congestion that can be bounded by converging lines and might, therefore, be classified as Triangles. However, they deviate from the true Triangles of this chapter so markedly in one or more important respects that they are best treated under other headings elsewhere, such as Flags, Pennants, and Wedges. Still another group of chart patterns develops between diverging boundary lines, on which account they have sometimes been called Inverted Triangles. But their causes, characteristics, and forecasting implications are so radically different that we have chosen to rename them Broadening Formations and discuss them in a later chapter. The reader may have become dismayed at this point by our frequent recourse to such qualifying adverbs as usually, ordinarily, and the like. It cannot be avoided if one wishes to present a true picture of what actually happens. No two chart patterns are ever precisely alike; no two market trends develop in quite the same way. History repeats itself in the stock market, but never exactly. Nevertheless, the investor who familiarizes himself with the historical pattern, with the normal market action, and refuses to be tempted into a commitment in the belief that “this time will be different,” will be far and away ahead of the fellow who looks for the exception rather than the rule. The beginner is proverbially lucky. He will find Triangles, Head-and- Shoulders, or other significant patterns, one after the other, on his charts, watch them develop, and see them carry through with profitable moves according to rule, until the exception comes along—or he will overlook the larger picture while concentrating on some Minor Pattern development— and suddenly awake to the fact he is caught in a very bad play. Hence, we constantly emphasize the nonconforming movements. Our words of qualification are necessary because technical analysis of market action is not an exact science and never will be. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter nine More important Reversal Patterns The Rectangles, Double and Triple Tops The Triangular Price Formations, which we examined in Chapter 8, can be either Reversal or ConsolidationPatterns. In the case of the Right-Angle Triangles, we know as soon as they have attained recognizable form inwhich direction the trend will (or should) proceed. With the Symmetrical Triangles, we have no way of knowingwhether they point up or down until prices finally break away from them, although the odds are, as we have seen,the previous trend will be continued rather than reversed. In this respect, and in many others, our next class oftechnical formations, the Rectangles, resemble the Symmetrical Triangles. There are, in fact, so many points ofsimilarity between them that we can forego any long and detailed discussion. (For illustrations in this chapter, seeFigures 9.1 through 9.18.) A Rectangle consists of a series of sideways price fluctuations, a “trading area,” as it is sometimes called, whichcan be bounded both top and bottom by horizontal lines. A glance at any one of the examples that illustrate thesepages will show how it got its name. On rare occasions, you may discover a chart pattern whose upper and lowerboundary lines are parallel but either slightly down-sloping or up-sloping. So long as their departure from thehorizontal is trivial, they may be treated as Rectangles. You will also find, on occasion, patterns whose boundaries,while nearly horizontal, tend somewhat to converge. These may be considered Rectangles or SymmetricalTriangles; it does not matter which because the “prognosis” will be the same in either case. If you will give a quick mental review also to the Head-and-Shoulders, the Complex, and the Rounding types offormations, you will see how, if you disregard the volume part of their charts, any one of these patterns mightmerge or grade into a Rectangle. As a matter of fact, however, you will seldom be left in doubt as to properclassification because the circumstances of trading, the type of buying and selling, which produce Rectangles aredifferent, which is usually apparent. We characterized the Symmetrical Triangle as a “picture of doubt.” The Rectangle might, with even greaterpropriety, be called a picture of conflict. Of course, any fairly compact price formation represents conflict in thesupply-demand sense. A Head-and-Shoulders Top, for example, portrays a conflict between “strong” sellers and“weak” buyers with the outcome already clearly seen before the combat has ended. But a Rectangle defines acontest between two groups of approximately equal strength—between owners of the stock who wish to dispose oftheir shares at a certain price and others who wish to accumulate the stock at a certain lower figure. They bat theball back and forth (up and down, that is) between them until ultimately, and usually quite suddenly, one team isexhausted (or changes its mind) and the other proceeds to knock the ball out of the lot. Nobody (often, not even thecontestants themselves) can tell who is going to win until one line or the other is decisively broken. We speak of two groups operating in the development of a rectangular trading area because, under present-dayconditions, that is what is usually the fact behind the scenes. This, it should be noted, does not imply“manipulation” in any invidious sense. An investment trust or an estate or, in some cases, an individual heavystockholder has good 26 24 22 20 NASH - KELVINATOR NK Sales 100's 250 200 150 100 50 Illi OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30' Figure 9.1 Although its Bottom boundary had a slight tendency to “lift,” the formation that put a Top on Nash-Kelvinator in 1946 was an unmistakable four-month distribution Rectangle. Long and rather loose RectangularPatterns of the type shown here may not evince constantly and noticeably diminishing volume, but note,nevertheless, the general, although irregular, downtrend in volume from mid-October to mid-February. 56 52 48 44 LIMA LOCOMOTIVE WORKS LMW Sales 100's 50 40 30 20 10 OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 3 10 17 24 3 10 17 24'31 Figure 9.2 Consolidation Rectangles in uptrends have been less common in recent years than during the 1920s andearly 1930s. The large price gap (G) in this example is of the “last in pattern” type, which we shall come to inChapter 12. When a gap within a pattern area is followed by breakout from that pattern, as in this case, the gap isinfrequently closed quickly. and sufficient reasons for selling at the top price (the “Supply Line” of the Rectangle) with no intent to mislead thepublic. Another investment trust or a group of insiders interested in the company may have equally good and, fromtheir point of view, wise reasons for buying at the bottom price (“Demand Line”). Such are the forces at work inthe market at the start of most Rectangular Chart Patterns, but if the “spread” between top and bottom 96 80 76 72 68 64 60 56 52 48 44 Sales 100's 125 100 75 50 25 JANUARY LOEW'S, INC. LW FEBRUARY MARCH OCTOBER" NOVEMBER "DECEMBEi I 7 J i/i J oi"! oe I _ IQ T IO F QZ : Figure 9.3 A perfect example of Consolidation Rectangle that formed in Loew's near the end of the 1932-1937Bull Market. In this case, a large block of “inside” stock was distributed at 64 to 65 but taken over around 62 byother investors who had the satisfaction of seeing it go on up to 87 the following August. Note the Throwbackfollowing breakout in January. lines is wide enough (say 8%-10% of the market value of the stock), the situation may quickly attract a followingfrom quick-turn scalpers and the professional element. Thus, a syndicate holding a large block of U.S. Steel maydecide to liquidate at 76, whereas another group decides to invest heavily in “Steel” at 69. The price of X willnaturally fluctuate for a time between those two levels. Traders, seeing this, will try to ride the play, buying at 69and selling at 76 (perhaps also selling short at 76 and covering at 69). Their operations will tend to accentuate orextend the Rectangle, although the number of shares involved in such parasitic trading is seldom great enough toaffect the final outcome. As a matter of fact, this type of trading inside a Rectangle can be quite profitable at times,especially if protected by judicious stops (see Section II). Pool operations In times past, before the U.S. Securities and Exchange Commission (SEC) outlawed the practice, Rectangles werefrequently created by the well-organized operations of a single “pool” or syndicate. Such a pool might undertake toaccumulate a large block of 13 Sales 100's 250 200 150 100 50 III :::: :::: rKt sg ■ ::h::::: ::::::: ::: :::: •ddfe Sd*Jrs i HE|r —:i7WiF14^ ill;: Sr 1 $ giilpil j TtHf H Hr *ii‘* Bii Eai££ :x:•hti- 8 $88ihiiuhaamj:iiiidt — SOCONY-VACUUMOIL SOV 1946 x glsLlL, ...........:::::::::::: 7-7:T7:7jt:jLx mint::: ::: q 1 :::: :::: :::: :::: It ill! tttrr i <••• U —— 114 „ 1 n|lj|1 _ i..... JimHIII . ...T ■41 Hirfjj- '' HU TT F’ -J mJ "ill' I :i11111U111 ill Bl 1 llill Li Oil11; . ! ih AUGUST in I H/i. Hi ’ 6 '13'20 27 7 JUNE JULY Figure 9.4 Here is a Rectangle in Socony-Vacuum, a low-priced stock characterized by fluctuations within anarrow range. After reaching a high of 18 in December 1945, it fell back to 15 and then rallied in mid-1946 asshown above. In late August, prices broke down through an Intermediate Trendline (see Chapter 14) and four dayslater fell out of the Rectangle. This formation, in conjunction with the earlier and higher Top, implied lower levelsfor “SOV” for some time to come. See also comment under Figure 9.5. 1946 60 Sales 100's YOUNGSTOWN SHEET & TUBE YB .. .. APRIL MAY JUNE JULY 6 13 "20 27 4 11 18 25 1 8 15 22 29 6 :13 20 27 T3 AUGUST SEPTEMBER 10 17 24 31 7 14 21 28 Figure 9.5 Another long, loose Rectangle of Major Reversal implications, somewhat similar to that pictured inFigure 9.1. Both an Intermediate and Major Up Trendline (to be discussed later) were decisively punctured by“YB” in August, just before its Rectangle broke down. Under Figure 8.21, we discussed one sort of warning of aPrimary Downturn that may be derived from the comparison of individual stock charts with the Averages. Here isanother hint: the better-grade steels and oils (see “SOV,” Figure 9.4) frequently hold up, or make strongerSecondary Recoveries, after the Averages have turned down at Major Tops. The Street sometimes speaks of“distribution under cover of strength in the steels.” 64 60 56 52 48 44 40 Sales 100's 50 40 30 20 10 T H StHtrHU flpXfflr Hm ;;;;p ttttt flIknft imdHH- tr± HFttS! it imt4r nr H-F fl i| || :::::: iii •fl01KU ■•::T Hi: . Il laliilwj'jiw■Tihm :::: . ■ t tU|t”»+’■14444 •- i ■ 11*11 ’ i tHt Ttiti £ O HHidm tfmtr•• fl :::::::: : : : : T tint intiInn ddt flr:::; ::: FS T fl :::: ■ III 1 J HF .“iiiuiiii! X M .Ht-ntptn*rt • flttt::ffiSr flgGtmiit- Jfffl: L w ffi■ESih . Xi. lalfl11111 iX*--1 4 »11 4 •-fl::: flit ....................... i■ ii11■ ■11 IIIIIIIIIIIII :::::::::::::::::::::::t- + it*::■■!**!:*!:::::::::::: s& Illi. 1 ttflxltliti iiti: i t:::EASTERN AIRLINES EAL ■ t: «ttx kt< kiji -fl.3 ft ■i1»* : ffi y jinisSiS IIIIII i JIIIIIIIIII IIIII '■<: i IIIIII11mimu lit 11Hiailllllllllllll llllllllllltlllllllllllliiimuim44 1945 'rgSsi :gggygffiS'g| i;fl H? —* i- -.; * Is i.iHlI i | i| ■W | |flflflip xufl1n Uifl-fl I* i; IS UMHRI *"* «fl -1 ...... 1 II 11 i 1111 . i • TT 111 . ... i Hii iliiui Ji 1 hl1III H 1 1 ' 7 ' 5 3 26 2 9 16 23 30' 6 13 20 T7 3 10 JANUARY . FEBRUARY MARCH APRIL MAY Figure 9.6 The Rectangle in early 1945 in “EAL” was actually the final stage of a nearly two-year Consolidationin the rise, which started around 17 in 1942 and ended above 125 in December 1945. G, G mark gaps (see Chapter12), the first a Breakaway and the second a Measuring Gap, which marked the probable objective of the move as55. When prices reached that level, another Consolidation developed, a Symmetrical Triangle. Neither of thesegaps was “closed” during the following two years. stock in a certain company with a view to marking it up and taking profits when some piece of good news, ofwhich they had inside knowledge, eventually became public. To acquire the desired “line,” they would find itnecessary first to shake out shares held by other traders and uninformed investors. They might start their campaignby suddenly selling short a few hundred shares to quench any current demand and start a reaction. Then, on thatreaction to the previously determined accumulation level, they would start to buy, scattering their orders carefullyand avoiding any publicity. Their buying would, sooner or later, engender a rally, but then they would “plant”rumors around the boardrooms to the effect that such-and-such insiders were selling, or that a projected mergerwas being called off, or a dividend would have to be passed, and, if necessary, they would ostentatiously let out afew of their own recently purchased shares to give color to the rumor. The process might be repeated several timeswith the “pool” gradually securing more and more shares on balance until, finally, its intended line is completed orcould not shake out more of the floating supply. Often, what was going on was fairly evident to the alert chartistback in the 1920s even before the operation was concluded, and perfectly evident, of course, as soon as pricesbroke out topside from their Rectangle. But such tactics are no longer permitted. “Wash sales” are strictly condemned; the constant policing of allexchange transactions and prompt investigation by the SEC of any suspicious news or activity in a stockeffectually deters the blatant “pool” manipulations of previous years. This probably is the chief reason whyRectangles are nowhere near so common on the charts of the 1950s as they were in the 1920s. (EN: Not uncommonin the 2000s.) Sales 100's 250 200 150 100 50 AMERICAN ZINC, LEAD & SMELTING ZA S H : S S H H MARCH DECEMBER ' JANUARY FEBRUARY ......». L1I11L1. .■■■. ...11 ih.^. „ a.^1 U li AUGUST SEPTEMBER OCTOBER NOVEMBER Figure 9.7 An extraordinary, fine, long Rectangle that developed after “ZA” had broken down out of a Head-and-Shoulders Top in February 1946. A perfect opportunity to sell this stock short was given by its Pullback of July 17-18 after prices had broken out of the Rectangle on the 15th. The Multiple Head-and-Shoulders Bottom that itsubsequently made from September to November produced a recovery to 11, but prices later fell to 6 in early 1947. u-T J ■tgl rx -t- Perhaps we can clear up various details of the Rectangle formation most quickly and easily by comparison withthat most nearly related chart pattern, the Symmetrical Triangle, as follows: • Volume—Follows the same rules as in the Triangles, gradually diminishing as the Rectangle lengthens. Anycontrary development, unless it be a momentary news flurry, is suspect. • Breakouts—Here also the same rules apply as with Triangles. Review volume requirements, margin ofpenetration, and so on thereunder. • False moves—Much less frequent from Rectangles than from Symmetrical Triangles. A clearly definedRectangle is, in fact, almost as reliable as a Head-and-Shoulders, although not as powerful in its implications. • Premature breakouts—Slightly more frequent, perhaps, from Rectangles than from Triangles. (Note: Both false moves and premature breakouts, in the sense in which we employ these terms, areindistinguishable at the time they occur from genuine breakouts. Following both false and premature breaks, pricesreturn inside the pattern. But, in the case of a false move, the trend ultimately proceeds out of pattern in theopposite direction, while in the case of the premature move, the trend finally breaks out again and proceeds in thesame direction.) Figure 9.8 In this weekly chart showing Sears Roebuck's 1942 Bear Market Bottom, a Consolidation Rectangle(June to November) forms the right shoulder of a large “unbalanced” Double Head-and-Shoulders Pattern. 22 20 19 18 17 16 BELL AIRCRAFT BLL 1945 15 14 13 Sales 100's 125 100 75 50 25 »rt. •fern’ FEBRUARY MARCH uoULuIllll APRIL 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 Figure 9.9 After advancing to 16 in January 1945, “BLL” dropped back to 13 and then constructed a 15-weekRectangle. Note that the down gap (G) on April 30 was caused by a $1.00 dividend going off. The revised bottomline of the pattern, drawn $1.00 lower, was not violated. Figure 9.10 A brief and very “high” Rectangle formed in September 1937 in the rapid Bear Market Decline of“KN,” followed by a Descending and then a Symmetrical Triangle Consolidation. • Pullbacks—Return of prices to the boundary of the pattern, subsequent to its initial penetration (breakout), takesplace more frequently with Rectangles than with Symmetrical Triangles. Our estimate would be that a Pullback orThrowback (the first is the common term for a rally after a downside breakout, and the second for a reactionfollowing an upside breakout) occurs within three days to three weeks in about 40% of all cases. • Directional tendency—The Rectangle is more often a Consolidation Formation than a Reversal Formation, theratio being about the same as with Symmetrical Triangles. As Reversal Patterns, Rectangles appear morefrequently at Bottoms (either Major or Intermediate) than at Tops. Long, thin, dull Rectangles are not uncommonat Primary Bottoms, sometimes grading into the type of Flat-Bottomed Saucer or Dormancy described in Chapter7. • Measuring implications—A safe minimum measuring formula for the Rectangle is given by its width. Pricesshould go at least as far in points beyond the pattern as the difference in points between the top and bottom lines ofthe pattern itself, though they may go much farther. Generally speaking, the brief, wide-swinging forms, whichappear nearly square in shape on the chart and in which turnover is active, are more dynamic than the longer andnarrower manifestations. Moves out of the latter almost always hesitate or react at the “minimum” point beforecarrying on. Figure 9.11 This formation, constructed by United Aircraft in 1942, was not completed and could not be called aDouble Bottom until prices rose above 31 in February 1943. (See following pages.) Figure 9.12 INCO quickly recovered from the Reagan Crash of 1987 and by year's end, it was nearly back to its1987 high; the latter was decisively broken in April 1988. The powerful rally continued to carry “N” higher. Butthe August reaction, followed by a poor rally in September, created a large Head-and-Shoulders Top. The earlySeptember decline broke the neckline to confirm the Reversal and the subsequent Throwback, to NecklineResistance, was an excellent selling point. 52 48 44 40 38 36 34 32 30 28 26 24 22 Sales 100's REPUBLIC STEEL RS G AUGUST J’ J •G— t1 3 H III billIII lill IIhl JANUARY FEBRUAR^““MARCH APRIL--MAY ” JUNE ’’ JULY : 1 8 15 22 29 5 12 19 26 2 9 16 23' 2 9 16 23 30 6 13 20 27 4 11 18 25 P"8 15 22 29 6T13 20 Figure 9.13 Owing to the long-time-between-Tops requirement for true Double Top Reversals, these formationscan seldom be seen to advantage on a daily chart, but here is a good 1946 example in Republic Steel. Note the fivemonths and 20% decline between Tops. This chart contains many interesting lesser technical formations also. The“Broadening” Swings (see Chapter 10) in June and July, as the second Top was made, and the rounding rally inAugust were extremely Bearish in their implications. Relation of rectangle to Dow Line The resemblance of this individual stock chart formation, which we have discussed under the name of Rectangle,to the Average formation known to Dow theorists as a “Line” has doubtless occurred to you. Obviously, theirrationale and forecasting implications are much the same, but true Rectangles with sharply delimited Top (Supply)and Bottom (Demand) boundaries are truly characteristic only of trading in individual issues. Line formations inthe Averages are seldom rigorously defined, with successive Minor Heights forming quite precisely at a certainhorizontal tangent and successive Bottoms at a similarly precise horizontal level. If you will examine the separatecharts of the issues composing an Average at a time when the Average is “making a Line,” you will surely findsome of them showing an irregular uptrend, others showing an irregular downtrend, still others may be formingTriangles, and a few may be constructing Rectangles, or what not, but it is the algebraic sum of all these more orless divergent pictures that makes up the Average “Line.” To be sure, there is some tendency on the part of active traders to sell (or buy) stocks when a certain Averagereaches a certain figure, regardless of the status of individual issues involved. An investment counsel willoccasionally advise his clients, for example, to “sell all speculative holdings when the Dow Industrials reach 500”(EN: or 5,000 or 15,000). But trading commitments based solely on general Average levels are so seldom followedconsistently that they have little effect. (EN10: In the modern era, with the availability of index exchange-tradedfunds, this is no longer true.) 19 18 17 16 15 14 13 12 11 10 9 Sales 100's 50 40 30 20 10 Figure 9.14 Shares of “AMR,” then selling for around 90, were split 5-for-1 in April 1946, resulting in a quickrally to a new high. But the overall aspect of a Double Top with the high made the previous December wasnevertheless apparent and confirmed when prices broke down through the “valley” level on August 28. Popularbuying brought in by “splits” is usually short-lived and only temporarily distorts the broad picture. Rectangles from Right-Angle Triangles In the preceding chapter, we referred to a type of partial “failure” in the development of a Right-Angle Trianglethat necessitates reclassifying the Triangle as a Rectangle. Now that we have examined the latter pattern in detail,we need say little more about this phenomenon, except to note the odds still appear to be somewhat in favor ofultimate breakout in the direction originally implied by the incipient Triangle. The fact there is this slightpresumption, however, certainly does not warrant disregard of an opposite breakout from the rectangularreconstruction. Double and Triple Tops and Bottoms To some of the old hands in the Street, our relegation of that good old byword, the Double Top, to a Minor Positionin our array of Reversal Formations may seem almost sacrilegious. It is referred to by name perhaps more oftenthan any other chart pattern by traders who possess a smattering of technical “lingo” but little organizedknowledge of technical facts. True Double Tops and Double Bottoms are exceedingly rare; Triple Forms are evenrarer. Additionally, the true patterns (as distinguished from chart pictures that might mistakenly 22 20 19 18 17 16 15 14 13 12 11 Sales 100's 25 20 15 10 5 CONTAINER CORPORATION CNR 111 S’ O ' N ‘ D~*~J 1 F 1 M A 1 M 1 J 1 J A S 1 O~N 1 D~~J F ’ M Figure 9.15 The Major Reversal Formation in “CNR” at the start of a Primary Advance that reached 54. Note howan attempt at an Ascending Triangle turned into a Double Bottom. be called such but are really assignable to some one of our other Reversal Formations) can seldom be positivelydetected until prices have gone quite a long way away from them, and can never be foretold or identified as soonas they occur from chart data alone. But we are getting ahead of our story; we should first define what we are talking about. A Double Top is formedwhen a stock advances to a certain level with, usually, high volume at and approaching the Top figure, then retreatswith diminishing activity, then comes up again to the same (or practically the same) top price as before with somepickup in turnover, but not as much as on the first peak, and then finally turns down a second time for a Major orConsequential Intermediate Decline. A Double Bottom is the same picture upside down; the Triple types makethree Tops (or Bottoms) instead of two. It is not difficult to skim through a book of several hundred monthly charts and pick out two or three examples ofMajor Double Tops and, perhaps, one or two Double Bottoms. One will find cases in which stocks made twosuccessive Bull Market Peaks several years apart at almost identical levels. Such phenomena stand out, in distantretrospect, like the proverbial sore thumb, which undoubtedly accounts for the undue awe with which the amateurchartist regards them. He neglects, for the moment, to consider the fact a thousand other issues might have donethe same thing but did not—that some of these even acted, for a time, as though they were going to Double Top,but then went on through and higher. Is there any practical utility for the trader or investor in the Double Top concept? Yes, there is, but it will be easierfor us to formulate it if we first consider what is not a Double Top. Refer back for a moment to the AscendingTriangles and the Rectangles previously studied; 20 19 18 17 TRINITY INDUSTRIES INC. 16 15 14 13 12 11 Sales 100's 500 400 300 200 100 MAY U 2330 6 13’2027 4 *11’18’25* 1 * 8’15*22*29’ 6'1____ X D.125 X D.125 Ufu . ±. ;ra SB 3 DAY ONE REVERSAL. 10 iiill EpTEMBER OCTOBER LY AUGUST SE - - - - ---- 3’20*27 3 *10’17*24’31’ 7 *14’21 '28' 5 ’12*19 Figure 9.16 Although Trinity Industries did not have the well-formed pattern exhibited by our otherrecommendations, we found the high-volume plunge, with the low of the day the third test of the year's low, a verybeguiling technical situation. Basically, it was a Triple Bottom with a One-Day Reversal to get the uptrend started. when these start to evolve, the majority of the time their first step is the construction of two Tops at an identicallevel with an intervening recession, and with less volume on the second Top than on the first. In the ordinarycourse of events, a third Top will develop there, and ultimately, prices will break through and move on up to stillhigher levels. Thus, we see we must have some rule or criterion to distinguish a true Double Top Reversal Patternfrom the Double Tops that do not imply Reversal when they appear as a part of a Consolidation Area in an uptrend. Distinguishing characteristics No absolute and unqualified rule can be laid down to fit all cases involving stocks of different values and markethabits, but one relative distinction quickly suggests itself when we study these different kinds of chart formations:if two Tops appear at the same level but quite close together in time and with only a Minor Reaction between them,chances are they are part of a Consolidation Area; or, if a Reversal of Trend is to ensue, there will first be morepattern development—more “work” done—around those top ranges. If, on the other hand, there is a long, dull,deep, and more or less rounding reaction after the initial peak has appeared, and then an evident lack of vitalitywhen prices come up again to the previous high, we can at least be suspicious of a Double Top. How deep is deep, and how long is long? Fair questions, to which, unfortunately, it is impossible to give simple,definite answers, but we can attempt approximations. Thus, if the two Tops are more than a month apart, they arenot likely to belong to the same Consolidation or Congestion Formation. If, in addition, the reaction between thefirst and second high reduces prices by 20% of their top value, the odds swing toward a Double Top 64 60 56 52 48 44 40 38 Sales 100's 50 40 30 20 10 ! 6 113 120 2 7 4 11 18'25 1 ■ 8 115 22 29 6 43 20:27 3 1047 24 37 7 14'21 28 Figure 9.17 Publicker made its Bull Market high only a few weeks after it was listed on the “big board.” Then itstarted to build a Descending Triangle but pulled up out of it. The final outcome was a Triple Top, completed inAugust (see Figures 8.17 and 9.15). interpretation. But both of these criteria are arbitrary, and not without exception. There are cases in which the twopeaks have occurred only two or three weeks apart, and others in which the “valley” between them descended onlyabout 15%. Most true Double Tops, however, develop two or three months or more apart. Generally speaking, thetime element is more critical than the depth of the reaction. The greater the time between the two highs, the less theneed of any extensive decline of prices in the interim. Given the conditions we have specified, namely, two Tops at approximately the same level but more than a monthapart on the chart, with somewhat less activity on the second advance than on the first, and a rather dull orirregular and rounding type of recession between them, we can then be suspicious that a Double Top Reversal hasactually evolved. Should a small Head-and-Shoulders or Descending Triangle start to develop at the second Top, asis frequently the case, we can be on guard, to the extent of protecting long commitments at once with a close stopor by switching to something else with a more promising chart picture. Yet, even all these signs together are not final and conclusive. The situation can still be saved, and often is. Let ustake a look at what is, presumably, going on behind the scenes to create our chart picture up to this point. The firstTop on relatively high volume was a normal incident and tells us little except that here, for the moment, demandmet with sufficient supply to stop the advance and produce a reaction. That supply may have represented onlytraders' profit-taking, in which event the trend is likely to push on up after a brief setback. But, when the reaction drifts off lower and lower until it has given up 15% and more of the stock's peak market value, and flattens outwithout any prompt and 8 7 6 5 412 4 31 32 Sales 100's 125 100 75 50 25 Figure 9.18 In the ordinary course of events, at the time this Bottom Pattern developed in “NG,” consisting, as itdid, of fluctuations for 10 long months within a range of only 1 full point, most traders would pay no attention toit. Certainly, it suggested very little opportunity for short-term profits. On an arithmetically scaled chart, thepattern could hardly be seen. Logarithmic price scaling, however, as we have remarked in an earlier chapter, hasthe great advantage of bringing to light the percentage importance of significant market action at very low pricelevels. vigorous rebound, it becomes evident that either the demand was pretty well played out on the last advance or theselling represented something more than short-term profit cashing. The questions then are these: did the first highgive evidence of important distribution, and is there much more to meet at the same price range? Nevertheless, as our chart picture shows, demand did finally come in and absorb enough of the floating supply toturn the trend around. When prices pushed up and began to run into selling again near the level of the first Top,that was to be expected on “psychological” grounds; many quick-turn operators naturally would take profits at theold high (perhaps with the intention of jumping right back in at a still higher price if the old high should beexceeded). Hence, a Minor Hesitation there was quite in order. But selling in sufficient quantity to produce anotherextensive reaction would be quite another matter. We have, by now, established a zone of Supply or Resistance atthe peak levels and a zone of Support or Demand at the Bottom of the valley between. The final and decisivequestion now is this: will the “valley” Support reappear and stop the second decline? The conclusive definition of a Double Top is given by a negative answer to that last question. If prices, on theirrecession from the second peak, drop through the Bottom level of the valley, a Reversal of Trend from up to downis signaled, which is usually a signal of major importance. Fully confirmed Double Tops seldom appear at turns inthe Intermediate Trend; they are characteristically a Primary Reversal phenomenon. Hence, when you are sure youhave one, do not scorn it. Even though prices may have already receded 20%, the chances are they have very muchfarther to go before they reach bottom. As to measuring implications, the Double Top affords no formula comparable with what we have attributed toHead-and-Shoulders and Triangle Formations, but it is safe to assume the decline will continue at least as farbelow the valley level as the distance from peak to valley. It may not be so in one interrupted slide; on the contrary,considerable time may be required to carry out the full descent in a series of waves. Pullbacks to the “valley” pricerange, following the first breakthrough, are not uncommon. (Take into account the general rule that a ReversalFormation can be expected to produce no more than a retracement of the trend that preceded it.) One more point: we have said the Tops need not form at precisely the same level. Use here the 3% rule we havepreviously laid down as a measuring stick for breakouts. A first Top at 50, for example, and a second at 51 1/2would come within this limit. Curiously enough, the second peak often does exceed the first by a fraction. Theimportant points are (1) that buying cannot push prices up into the clear by a decisive margin, and (2) the Supportbelow is subsequently broken. Double Bottoms In identifying a Double Bottom, we can apply all of the precepts we have formulated for the Double Top Pattern,but upside down. The differences between the two pictures are just what you might expect them to be, having inmind the characteristic differences between Head-and-Shoulders Tops and Bottoms, for example. Thus, the secondBottom is usually conspicuously dull (little trading volume) and is apt to be quite rounded, whereas the second Topin a Double Top is moderately active and nearly as sharp and “spiky” in contour as the first. The rally up from thesecond Bottom shows an increase in turnover, and volume should pick up to a marked degree as the valley level, ormore properly, in this case, the height between the two Bottoms, is surpassed. Double Bottoms appear just about asfrequently as do Double Tops at Primary Trend Reversals, and Double Bottoms also occur sometimes at the end ofIntermediate Corrections in a Major Uptrend. If you are familiar with some of the jargon of the Street, it has probably occurred to you that the second low of aDouble Bottom is an example of the market action so often referred to as a “test.” In a sense, that is just what it is—a test or corroboration of the Support (i.e., demand) that stemmed the first decline at the same level. The successof that test is not proved, however—and this is a point to remember—until prices have demonstrated their abilityto rise on increasing volume above the preceding high (the height of the rally between the two Bottoms). Until such time, there is always the possibility a second test (third bottom) may be necessary, or even a third, and thatone of these will fail with prices then breaking on down into further decline. This thought leads us to our next typeof Reversal Formation. Triple Tops and Bottoms Logically, if there are Double Tops, then we might expect that there will also be Triple Tops, which will develop insomewhat similar fashion. The fact is that Reversal Formations, which can only be classed as Triple Tops, dooccur, but they are few and far between. Many patterns evolve at an important turn from up to down in the trendthat contains three Top points, but most fall more readily into the category of Rectangles. For that matter, anyHead-and-Shoulders Formation, particularly if it be rather “flat” with the head not extending much above the levelof the two shoulders, might be called a sort of Triple Top. The true Triple Top (as distinct, that is, from other types of three-peak formations) carries a recognizable familyresemblance to the Double Top. Its Tops are widely spaced and with quite depth and usually rounding reactionsbetween them. Volume is characteristically less on the second advance than on the first, and still less on the third,which often peters out with no appreciable pickup in activity. The three highs need not be spaced quite so far apartas the two that constitute a Double Top, and they need not be equally spaced. Thus, the second Top may occur onlyabout three weeks after the first and the third six weeks or more after the second. Also, the intervening valleysneed not bottom out at exactly the same level; the first may be shallower than the second and vice versa. Also, thethree highs may not come at precisely the same price; our 3% tolerance rule is again useful here. Yet, despite allthese permissible variations, there should be, and generally is, something suspiciously familiar about the overallpicture, something that immediately suggests the possibility of a Triple Top to the experienced chartist. The conclusive test, however, is a decline from the third Top that breaks prices down through the level of the valleyfloor (the lower one, if the two valleys form at different levels). Not until that has occurred can a Triple Top beregarded as confirmed and actually in effect; so long as demand persists at the valley price range, the trend can beturned up again. Only in those cases in which activity is conspicuously lacking on the third peak and then begins toshow Bearish characteristics by accelerating on the ensuing decline is one justified in “jumping the gun.” Note this formation qualifies as a Triple Bottom in every detail—spacing between Bottoms, extent in percent ofintervening rallies, volume. Of course, its completion in October 1942 did not necessarily forecast that “NG”would climb to 33, as it ultimately did. But the fact that many other stocks were making sound Major BottomFormations at higher price levels at the same time certainly warranted the conclusion that “NG” was on its way up,and that it was a bargain at 5. Triple Bottoms are simply Triple Tops turned upside down, with the same qualifications noted when discussingDouble Bottoms. The third low should always be attended by small volume, and the rise therefrom must show adecided increase in turnover and carry prices decisively above the Tops of the rallies that formed between theBottoms. One is never justified in “jumping the gun” on a presumed Triple Bottom Formation unless nearly everyother chart in the book is in an unmistakably Bullish position. The risk of premature buying is expressed in asaying one sometimes hears in the boardrooms to the effect of “a Triple Bottom is always broken.” This is not atrue saying. Once a Triple Bottom has been established and confirmed by the necessary up-side breakout, itseldomly fails—it almost always produces an advance of distinctly worthwhile proportions. But an uncompleted“possible” Triple Bottom chart picture must be regarded as treacherous. Stick to the breakout rule and you will besafe. Triple Tops are sometimes referred to as “W” Patterns because of their occasional resemblance to that capital letteron the chart. There is a sort of hybrid between the Double and Triple Top, in which the middle one of the threeTops does not attain the height of the first and third, and thus, even more strikingly resembles a “W.” For the samereason, Double Tops are sometimes called “M” Formations. Because the elements in Double and Triple patterns are normally spaced well apart in time, they are often easier todetect and appreciate on a weekly chart than on a daily. Monthly graphs disclose numbers of widely spread Doubleand Triple Bottoms but, on the other hand, are too coarse to reveal many good Double and Triple Top Patterns. In our foregoing discussion of the Triple Top, we referred to a sort of intuition that comes with experience andenables a technical analyst to recognize the potentialities for Reversal of a certain chart development, sometimeslong before it has reached a conclusive stage. This is a not uncommon talent, but it is one that is seldom attainedexcept through searching study and long experience (in which the latter usually involves a few expensivemistakes). The reader of this book need not despair of acquiring “chart sense” and without undue cost—if he willconcentrate on his study, watch, check, and double-check every new development on his charts, and “keep score”on himself. It has been said that chart interpretation is not a science but an art. It is not an exact science, to be sure, because ithas no rules to which there are not exceptions. Its finer points defy expression in rule or precept. It requiresjudgment in appraisal of many factors, some of which may seem, at times, to conflict radically with others. But tocall it an art, which implies the need for genius, or at least for a high degree of native talent, is certainly improper.Say, rather, that it demands skill, but a skill that can be acquired by anyone of ordinary intelligence. chapter ten Other Reversal phenomena We have considered so far eight classes of chart patterns that appear at more or less important Reversals ofdirection in the trend of prices. They are as follows: 1. The Head-and-Shoulders 2. Multiple or Complex Head-and-Shoulders 3. Rounding Turns 4. Symmetrical Triangles 5. Right-Angle Triangles 6. Rectangles 7. Double and Triple Tops and Bottoms 8. One-Day Reversal Of these, numbers 1, 2, 3, and 7 develop most often at Major Turns, whereas numbers 4, 5, and 6 occurmore frequently at Intermediate Stages. Numbers 1, 2, 3, and 5 give indication before they are completedas to which way the price trend is likely to proceed from them. Numbers 4 and 6 give no such indicationand, as we have seen, are rather more apt to signal Consolidation or Continuation than Reversal. But all ofthem can, and on occasion do, appear at both Major Tops or Bottoms. EN: Number 8 appears typicallyafter uncontrollable moves, up and down. We have yet to take up a few other technical patterns that, because of their limited significance, rarity, ordoubtful utility to long-term traders, have been relegated to the end of our Reversal studies (see Figures10.1 through 10.28). The Broadening Formations In concluding our discussion of Triangles in Chapter 8, we mentioned certain types of price congestion ortrading areas that have sometimes been called “Inverted Triangles” because, starting with very narrowfluctuations, they widen out between diverging rather than converging boundary lines. Herein, we havechosen to classify them instead as Broadening Patterns since, except for that inverted resemblance insuperficial appearance, they are quite different in nature and trend implications. If the Symmetrical Triangle presents a picture of “doubt” awaiting clarification and the Rectangle apicture of controlled “conflict,” the Broadening Formation may be said to suggest a market lackingintelligent sponsorship that is out of control—a situation, usually, in which the “public” is excitedlycommitted and is being whipped around by wild rumors. Note though we say it only suggests such amarket; there are times when it is obvious those are precisely the conditions that create a BroadeningPattern in prices, yet other times when the reasons for it are obscure or undiscoverable. Nevertheless, thevery fact that chart pictures of this type make their appearance, as a rule, only at the end or in the finalphases of a long Bull Market lends credence to our characterization of them. 34 Sales 100's 125 100 75 50 25 Figure 10.1 The Symmetrical type of Broadening Formation, which develops most frequently in the laterand more “excited” stages of a Primary Bull Market, is perfectly exemplified in this Crane Companychart. Note that the Broadening Pattern here started to form in December 1945 after a 10% reaction; if ithad formed on Top of a rally, it would have been suspected as a possible Broadening Top. Nevertheless, itcarried the usual Bearish implications. "CR" topped out at 49% in June. ::::: H 1 if MMMWM:::::::::::::iiimiiiiiiiMiaaimiiaai a a a a a aa i a a a a::::::::::::::::::::::::::laaaiiaalaai! HE :::: ...... 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L1.1 ,, 11 1 111 T ; jttn it; : II ■ n Il . ;Ji| NOVEM iioii7r?z BER DECEMBER JANUARY FEB! 4 1 8 15 22 29 5 12 19 26 2 » 9 ““MARCH ■ 9 16 23 3 Hence, after studying the charts for some 20 years and watching what market action has followed theappearance of Broadening Price Patterns, we have come to the conclusion they are definitely Bearish inpurport—that, while further advance in price is not ruled out, the situation is, nevertheless, approaching adangerous stage. New commitments (purchases) should not be made in a stock that produces a chart of this type, and any previous commitments should be switched at once or cashed in at the first goodopportunity. The Broadening Formation may evolve in any one of three forms, comparable, respectively, to invertedSymmetrical, Ascending, or Descending Triangles. The "Symmetrical" type, for example, consists of aseries of price fluctuations across a horizontal axis, with each Minor Top higher and each Minor Bottomlower than its predecessor. The pattern may thus be roughly marked off by two diverging lines, the uppersloping up (from left to right) and the lower sloping down. But these Broadening Patterns arecharacteristically loose and irregular, whereas Symmetrical Triangles are normally regular and compact.The converging boundary lines of a Symmetrical Triangle are clearly defined as a rule, and the Tops andBottoms within the formation tend to fall with fair precision on those boundary lines. In a BroadeningFormation, the rallies and declines usually do not all stop at clearly marked boundary lines. Volume during Broadening Formations Another distinction between Triangle and Broadening Formation is in the volume chart. The constructionof a true Triangle is attended, as we have seen, by diminishing activity, starting with high volume on thefirst Minor Reversal that initiates the pattern, but growing less and less as prices fluctuate in ever-smallerwaves out toward the apex. Then activity picks up again after prices have broken out of the Triangle,immediately and sharply if the breakout is through the topside. With the Broadening Formation, on theother hand, trading activity usually remains high and irregular throughout its construction. If it developsafter 240 224 208 176 160 152 144 136 128 120 112 104 80 76 Sales 100's 250 200 150 100 50 AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER Figure 10.2 Although this particular Major Reversal Formation appeared on the charts more than 35 yearsago, it is so perfectly developed and on such a large scale that it may well stand as our elementary modelfor an Orthodox Broadening Top. 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Iiiii hi LL bhi | JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER 7 1421 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 18 15 22 29 Figure 10.8 Another example of the Flat-Topped type of Broadening Price Pattern that appeared near theend of 1945. “LS” went on up to 63 in 1946. Prices broke out of this formation with a Breakout Gap (G)and another Breakout Gap appeared on December 3. G-G marks an “Island.” See Chapter 12 for Gaps. 76 72 68 Sales 100's 250 200 150 100 50 U. S. STEEL X 1946 AUGUST 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24' 31 7 14 21 28 Figure 10.9 The 1946 Bull Market Top in U.S. Steel was a three-month Diamond that might also beconstrued as a Head-and-Shoulders. 24 AMERICAN BOSCH CORP. 22 20 19 18 17 16 Sales 100's 50 40 30 20 10 194-5 ilLyil IL. ’ 7 14 2121 4 11 18 25 1 8 15 22 29 6 13 20 27' 3 10 17 24' 1 8 15 22 29 Figure 10.10 A Diamond (November) that broke out topside and thus functioned as Consolidation ratherthan Reversal. obviously furnishes no clue, while the very looseness and lack of definition of the price pattern preventthe drawing of any line that surely says, “this far and no farther.” (We are referring now to the“Symmetrical” type only of Broadening Formation.) Once prices have run well away, either up or down,from the pattern area, it becomes plain that a breakout has occurred, but by that time, it may be too late torisk a trade on the situation; the move may already have gone too far. What can we do about BroadeningFormations then? Well, 44 40 38 36 34 32 30 28 26 24 Sales 100's 125 100 75 50 25 Figure 10.11 Diamond Reversal Formations are often easier to detect on weekly than on daily charts.Trace out the price swings and volume in this May-June 1946 Diamond in Shell. Note also the remarkableDescending Triangle that developed from September 1946 to February 1947, and the March Pullback toits apex, another ideal place to sell short. we have already noted 9 times out of 10 they carry Bearish implications. They appear most often at ornear an important topping out of the trend. Hence, it is reasonably safe to assume that prices, when theyfinally break away from the formation, will go down, or if they do go up, will very soon turn around and come back down again. Therein lies one answer to the problem of what to do about a BroadeningFormation. In addition, the price action within the formation, in many cases, furnishes an advance indication ofbreakout direction. If the trend is going to break down from the Broadening Area, the last rally within thearea may fail to rise as high as its predecessor, thus breaking the sequence of ever higher Tops within thepattern. Alternatively, if the trend is going to emerge on the topside, the last reaction within the patternmay fail to depress prices as low as the preceding reaction. These “failures” within the pattern occur, aswe have stated, in a majority of all Broadening Formations. Note that one cannot be sure of such asignificant development (what we have referred to above as a failure, for lack of a better descriptivename) until prices go on and out the other side of the formation or, more precisely, have exceeded the lastpreceding move in that direction by a decisive margin (our 3% rule again). A typical example No doubt the foregoing paragraph sounds rather complicated. It will be easier to visualize thedevelopment of a “failure” signal if we cite an example using actual price figures. Easier yet, perhaps, ifthe reader will sketch out our example on a scrap of chart paper. Suppose stock XYZ, after advancingsome 30 points on gradually increasing turnover, runs into heavy selling at 62 and reacts to 58. But thereis still plenty of interest in the issue; it stops Created with TradeStation 2000i by Omega Research© 1999 Figure 10.12 Technicians in the future will look back with amazement at the Top, which put theexclamation point on the Bull 1990s. The most amazing thing being that what was going on at the timewas recognizable and subject to analysis with a ruler (see Resources). The analysis furthermore indicatedthe party was over (or at least the fat lady was in the process of singing). As Edwards noted, theBroadening Top, which had (and has) implications of its own, morphed into a Diamond, which threw off afalse signal, breaking out on the upside, which developed into another triangular-like pattern (could belooked at as ragged triangular or ascending—only bottom line shown here), which after a head fake brokedown, made a modified V-Bottom and returned to the top of what could be looked at as a monsterrectangle. The top horizontal line, drawn in August 2000, stops the 2001 rally cold and from there it is aslippery slide to the tragedy of September 11, 2001. It was obvious that the investor had no business being long and that trading strategy was in order. Was there any prescience in recognizing the mulish sidewaystrend of the market? None whatsoever. Is all this hindsight? The reader may see for himself by examiningthe record of how this market was analyzed at the time at the edwards-magee.com newsletter archives. at 58 and then swings up to a new peak at 63. It “churns” there for a day or two and drops back again, thistime to 56% before it is halted by another burst of buying. Its third rally takes it up to 62, where ithesitates and falls back to 59, but it is then picked up again and carried on to 65. (By this time, aBroadening Formation has become evident on the chart.) At 65, there is a great show of trading, followedby another reaction that drops quotations quickly back to 60. Support appears there momentarily andprices fluctuate for three or four days between 60 and 62 and then fall away again, finally to close at 56,with volume running high all through this phase. A fourth rally starts, but now the traders who bought inat 60 on the preceding downswing are frightened and looking for a chance to “get out even,” and theadvance is stifled at that level. Quotations start to slip and soon are down to 55, below the previous patternBottom. When this occurs, the “failure” of the preceding rally is confirmed—its failure, that is, to riseabove 65 and, thus, carry on the Broadening Movement. The decline below 56, by virtue of that failure,may be regarded as a breakout. If you followed the foregoing example closely, you will have noted there can be (and very often are)Minor Fluctuations inside the pattern that do not affect its outcome. Thus, the rise from 56% to 65 reallyconsisted of three moves, first from 56% to 62, then from 62 back to 59, and, finally, from 59 up to 65.The reaction from 62 had no significance so long Figure 10.13 Hudson is another stock that ended its Bull Market in 1946 with a Major Diamond, whichalso could be taken as a Complex Head and Shoulders. This formation was plain on the weekly chart but hard to see on the daily. Note how the Diamond gave a sell signal about 2 points higher than the Head-and-Shoulders. The 14%-17% area at the end of the year, when construed as a weak Rectangle, was barelyfulfilled in February 1947. as it stopped above 56% and was succeeded by a new rise carrying beyond the previous pattern high,which, in this case, had been 63. The example just detailed is one of the more common types in which the failure occurs on a rally and thebreakout eventuates on the downside. But it could have been converted into the opposite form if the lastdecline had stopped at 60, and then, instead of fluctuating for a few days between 60 and 62 and breakingdown again, had pushed right back up and past 65. That action would have given us a failure on a declineand an upside breakout. (The odds would be, however, that the final Top was not far away.) The Orthodox Broadening Top There is one particular manifestation—a special case, as the mathematicians might say—of theBroadening Price Formation whose general nature we have discussed in the preceding paragraphs. Thisparticular form appeared at the 1929 Tops of many of the active and popular stocks of that day, but it hasdone so with less frequency at Bull Market highs since 1929, and rarely has done so at high-volume Topspreceding extensive Intermediate Declines, as in 1933 and 1934. It is known to market technicians underthe specific name of Broadening Top, and although it conforms to our general descriptions for allSymmetrical 120 112 104 96 88 80 76 Sales 100's 500 400 300 200 100 *G U. S. STEEL X tllHWHHlHtt j 1937 APRIL MAY ' JUNE ’ JULY AUGUST SEPTEMBER 3 10 17 24 1 8 15 22 29 5 12U9 26 3 10 17 24 31 7 ’14 21 28 4 11 18 25 Figure 10.14 As U.S. Steel approached the Top of its Secondary Recovery in August 1937, its pricefluctuations tended to grow narrower, between upward sloping but converging boundaries, while volumediminished. This pattern—a Wedge—carried a definitely Bearish message. The entire swing from July tothe end of August was essentially a Rounding Top. The three Gs mark Breakaway Gaps (see Chapter 12),the last (September 7) made as prices broke down through a Support Level (see Chapter 13). Broadening Price Patterns, it has been so precisely defined, and so often cited in technical writings, thatwe may well take some time to examine it. The Orthodox Broadening Top has three peaks at successively higher levels with two Bottoms betweenthem, with the second Bottom lower than the first. The assumption has been it is completed and in effectas an important Reversal indication just as soon as the reaction from its third peak carries below the levelof its second Bottom. Perhaps we can best see what this formation is like if we examine one of the classic patterns thatdeveloped in 1929. Our chart (Figure 10.2) shows the daily market action (price and volume) of AirReduction from July 1 to December 31 of that year. We have numbered from 1 to 5 the significant turningpoints within the Broadening Top that ended that stock's Bull Market in October. A Broadening PricePattern was not detectable until prices had started to move up from the second Minor Low (point 4); bythen 3 had formed above 1 and 4 below 2. New highs at 5 (a and b), followed by the definite downsidebreakout at B (nearly 6% under 4), completed the pattern and, according to the rules, signaled a MajorTrend Reversal. In this case, there can be no doubt as to the importance of the Reversal indication because, as our chart shows, the price of Air Reduction dropped from above 220 on October 18 to below80 on November 14, just four weeks later, and the final Bottom was not seen until nearly three years laterin 1932. There are some fine points of this classic example that should be noted. First, a new high, that is, a thirdand higher Top, was made at 5a and the subsequent reaction was halted at 195, well above 4, andsucceeded by renewed advance. This looked like one of the advance notices (“failures”) to which we havereferred on a preceding page, portending an upside breakout. But the example before us will serve toemphasize the warning 72 68 1936 64 Mil 60 56 52 48 LOEW'S, INC. LW 44 Sales 100's 125 100 75 50 25 JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER 4 11 18 25: 1 8 15'22 29 5 12 19 26 3 10 17 24 31 '7 14 21 ' 28 5 12 19 26' Figure 10.15 An “ideal” Falling Wedge that developed in Loew's in 1936. Note the volume trend therein,which is irregular but generally diminishing. July produced a small Flag (see Chapter 11), and at the endof the year, “LW” went into a Rectangle out of which prices “skyrocketed” to 75. that we attached thereto—that such an indication is not to be trusted until prices have decisively exceededthe previous Top. At 5b Air Reduction was traded briefly at 223, 2 points, but less than 3% higher than 5a,and the day closed with quotations below 5a. The break on October 24 (to B) took prices more than 3%under the level of 4. Now occurred a development typical of Broadening Tops—a Pullback Rally (to B)retracing about half of the ground lost between the last pattern Top (5b) and the end of the initial breakoutmove (B). Such a recovery (and failure) will be attempted, according to our experience, in at least four outof five Broadening Top Patterns, and it may not fail until it has regained two-thirds of the precedingdecline, although it usually peters out around or even below the halfway mark. As stated, this is a classic example; there were many others at that time. The very fact that so manyevolved at the 1929 peak, which was followed by history's most disastrous losses, probably accounts forthe extremely Bearish implications market technicians have ascribed to the Broadening Top Formation.We regard it now with somewhat less awe; its measuring implications are probably no greater than thoseof a large, high-volume Head-and-Shoulders, but it is a pattern characteristic of the last stages of aPrimary Uptrend. The insistence that the third Top (our number 5), when followed by a decline below the second Bottom(our number 4), completes the Reversal Pattern may be regarded, in the light of experience, as setting toostrict a limitation because Broadening Formations do, on occasion, go on to make a fourth and higher Top.Yet this rule may be, and usually is, justified by the fact the overall indications are undeniably Bearishand, hence, one should not wait too long to get out. On the other hand, the requirement for a third Topdoes seem to be justified on the score that Major Reversals are seldom completed until at least three 96 88 80 76 72 68 64 60 56 52 48 44 40 38 36 34 32 30 28 26 24 Sales 100's 125 100 75 50 25 SCHENLEY DISTILLERS Figure 10.16 Wedges seldom appear at Major Trend Reversals, but Schenley's Bull high in 1946 wasmade at the end of an eight-month Rising Wedge, plainly seen on its weekly chart. The dashed line at 60marks a Support Level (see Chapter 13) that served to stem the subsequent decline for nine weeks. attempts have been made to push prices on in the direction of the previous trend. This is the reason whypioneer technical students lumped together many formations under the classification “Five-PointReversals.” The Broadening Top is a Five-Point Reversal (our numbers 1-5) and so it is a Head-and- Shoulders. A Broadening Top might, in fact, be called a Head-and-Shoulders with a high right shoulderand a down-sloping neckline. 76 72 68 64 60 56 52 48 44 40 38 36 34 32 Sales 100's T' . Til i _ 1 till!Jl Jly-ludMuiKlllJ .. MARCH MAY AUGUST TRANSCONTINENTAL & WESTERN AIRLINES TWA OCTOBER N APRIL 13 20 2 JANUARY FEI 12 19 26 2. ¥ li -I1,1 Figure 10.17 There are many interesting and technically significant features in this 12-month daily chartrecord of “TWA.” Note the extraordinary One-Day Reversal, December 3, which marked its Major Top.Although the next four weeks produced a sort of poorly formed Descending Triangle, the Reversal Daywas the only clear-cut and unmistakable signal to sell. When you study Pennants, turn back to this chartfor its November Pennant. Its long Intermediate Down Trendline was tentatively broken in August 1946,without confirming volume (see Chapter 14). Note that at no time during the decline did a “Buy” Patternappear. 56 52 1946 48 44 40 38 36 Sales 100's 125 100 75 50 25 GREYHOUND CORP. UllulllLillU AUGUST 1 8 15 22 29 6 :13 20 27 3 :10 17 24 :31 7.14 2128 Figure 10.18 The strong One-Day Reversal that marked Greyhound's 1946 Bull Market high; note theclimax volume. A less conspicuous Reversal Day appeared on August 26. It is suggested the reader goback over all charts in the preceding chapters; he will find many Reversal Days of greater or lesserconsequence. Many gaps (G) were of measuring type (see Chapter 12). Figure 10.19 Apple, 1987 Reagan Crash. Does this plunge appear to be out of the blue? Not really.Numerous signs are given: break of major trendline; short-term momentum down before the crash in anenvironment of extreme top psychology; then the crash itself, the Panic Selling exhibiting the typicalpattern of short covering; and then further decline. Why no Broadening Bottoms? All of the other types of Reversal Formations we have studied thus far can occur as either Tops orBottoms; they can develop at the end of a decline to turn the trend up or at the end of an advance to turnthe trend down. But this does not seem to be true of the Broadening Formation. It has been assumed in thepast that Broadening Bottoms must exist, but the writer has never found a good one in his examination ofthe charts of thousands of individual stocks over many years, and only one or two patterns that bore a resemblance to it in the charts of the Averages. Apparently, the circumstances that create BroadeningFormations do not exist after a prolonged decline in prices. This would seem to bear out our earliercharacterization of this sort of pattern as suggesting active, excited trading with much public (and, hence,not too well-informed or managed) participation. Such conditions are naturally associated with the finalphases of a Bull Market. Right-Angled Broadening Formations Price patterns of the “Inverted Triangle” shape, having a horizontal Top or Bottom boundary, occur aboutas often as the symmetrical type, which is to say, not nearly as often as true Triangles, Rectangles, and soon. In the mid-twentieth century, there were very few of them (EN9: Still scarce in the 2000s). Althoughthe true Right-Angle Triangle with a horizontal top line and up-slanting bottom line is called an AscendingTriangle, just as its counterpart with 40 35 30 25 Figure 10.20 The Panic Selling of October 19, 1937, produced a conspicuous Climax Reversal Day innearly all leading stocks, as well as in the Averages. This New York Central chart shows, beside theSelling Climax (SC), its Head-and-Shoulders Recovery Top of July-August and a Consolidation Rectanglethat ended as a Triangle in early October. “CN” made a final Bear Market low the following March at10%. On a logarithmic price scale, its down trendline from August was not broken until June 1938. a horizontal bottom boundary and a down-slanting top boundary is called a Descending Triangle, wecannot apply these terms to the Inverted or Broadening Forms. Generally speaking, Right-AngledBroadening Formations carry Bearish implications, regardless of which side is horizontal, in nearly thesame degree as the symmetrical manifestations. Obviously, however, they differ essentially from Symmetrical formations in one respect: a horizontal sideindicates either accumulation or distribution at a fixed price, depending on which side is horizontal.Logically, it follows any decisive break through that horizontal side has immediate forceful significance.Thus, if a Broadening Price Pattern with a flat top boundary develops after a good advance, and if pricesfinally burst up through that top line on high volume and close above it to a conclusive extent (roughly3%), then it is safe to assume the preceding uptrend will be resumed and carried on for a worthwhilemove. This does happen, although it is rare. The odds favor the opposite, that is, the eventual victory ofthe forces of distribution that created the horizontal Top and a breakaway into an extensive decline. Moreover, if an advance is to ensue from a Flat-Topped Broadening Formation, chances are the thirdreaction in the formation will be attended by much diminished trading activity Figure 10.21 Dow Industrials, 1987 Reagan Crash. Rumors proliferated—ironically, one that Reagan hadAlzheimer's. Proximate cause: professional panic exacerbated by an ill-considered portfolio insurancescheme propagated by academics. Note the authoritative (lower) trendline here (75 days) is broken bymore than 2% (Magee's suggestion) in early September. The broken upper trendline (25 days) would havepulled the ripcord for the more agile trader. Savvy investors were hedging and liquidating throughSeptember, and fund managers panicked in October. According to the Brady Report, Hull Trading Co.bought the bottom on October 20, thus saving American capitalism. instead of the continued high or irregular volume characteristic of Bearish Broadening Movements; eitherit or the fourth reaction will be halted and reversed above the low point of the preceding reaction. Thisturns the formation into a Consolidation Head-and-Shoulders, a Continuation-of-Trend Pattern, which weshall take up in Chapter 11. The message here for the trader owning a stock whose chart begins to developa Broadening Formation of this type is to watch the third reaction. If it carries below the second andvolume does not fall off to a marked degree, sell out on the next rally. (You can always repurchase thesame stock, if you wish, without much “loss of position” should prices finally and, improbably, recoverand push up through the Top.) Right-Angled Broadening Formations with horizontal lower boundaries (flat Bottoms) almost alwaysbreak down. Once prices have fallen below the lower boundary line, there is frequently a Pullback Rallyto that line, either in a few days or in two or three weeks, similar to the Pullbacks that so often follow thebreakdown from a Head-and-Shoulders Top. (Note that the third or fourth rally in a pattern that starts out as a Flat-Bottomed Broadening Formationmay fail to carry prices as high as its predecessor, in which case a Head-and-Shoulders deal will instill. Inother words, every Head-and-Shoulders begins as a Broadening Formation and the statement of thatrelation takes us logically to our next type of Reversal picture.) The Diamond The Diamond Reversal Formation might be described either as a more or less Complex Head-and-Shoulders with a V-shaped neckline or as a Broadening Formation which, after two or three “swings,”suddenly reverts into a regular Triangle that is nearly always of the Symmetrical form. So far as theaccompanying volume pattern is concerned, the latter is NC NATIONAL CASH REGISTER 24 22 20 19 18 17 16 15 14 13 12 11 Sales 100's 50 40 30 20 10 ! i*’-: ..... u O-^"D J~:~F M A ? M 1 J r J A 1 S ; O' N ' D ; J 1 F ' M Figure 10.22 The Selling Climax discussed on the preceding pages is typically a one-day phenomenon,and on only one occasion (April 1939) in history has a general market One-Day Reversal signaled thefinal low of a Primary Bear Trend (although many individual stocks evinced a Selling Climax on theircharts in March 1938). possibly the better description; its name obviously derives from its pictorial resemblance to theconventional diamond shape. Although it is fairly conspicuous and easily detected when it appears on the charts, the Diamond is not acommon pattern. Since its development requires fairly active markets, it rarely occurs at BottomReversals. Its “natural habitat” is Major Tops and the High-Volume Tops that precede extensiveIntermediate Reactions. Many Multiple Head-and-Shoulders Formations are borderline Diamond cases;that is, they permit the drawing of slightly bent necklines. The reader is cautioned, however, against tryingtoo hard to make Diamonds out of price patterns of the Head-and-Shoulders type. There is a temptation todo so because a V-shaped neckline may promise to give an earlier (and, hence, more profitable) breakoutsignal than the straight neckline of the Head-and-Shoulders. It is much safer to stick to the latter, however,unless the second half of the formation consists of a series of cleancut, converging Minor Fluctuations,which plainly demands definition by converging boundary lines, and unless activity shows some tendencyto diminish during this period as it would in a Triangle. The Diamond requires little further comment. Our illustrations will suffice to acquaint you with its typicaldetails. It carries a minimum measuring implication that, having studied March September IO ctober November I December QUALCOMM (58.7500, 62.0625, 58.0000, 59.8750, ^1.5625) . j- 2000 44^^100000 Februaryl tpril May L|ll|.lllllllllJ.ill lllj.iL II ||. t......iiL..... June July August I Created with Meta Stock www.equis.com 210 - 200 190 - 180 170 160 - 150 - 140 - 130 - 120 - 110 100 - 90 • 80 70 - 60 - 50 40 30 -10000 9000 - 8000 • 7000 - 6000 - 5000 4000 - 3000 Figure 10.23 A church spire top in Qualcomm. The December gap might be mistaken for a buy signal, asmight be the runaway days, but they are actually hand-engraved invitations to leave the party with nearprogressive stops a hair off the day's low. Also valid is the exit on the Key Reversal on day two after thegap. How does the trader know this is a blow-off and not a signal to pyramid? By the age, length, state,and slope of the market. When trendlines go vertical, blow-off management must be used. The return tothe base of the first runaway day is notification that it is a Bull trap—the first Bull trap. The second Bulltrap is the breakout of the triangle in March. A wonderful chart filled with fin de siecle and fin demillennium lessons. the Head-and-Shoulders and Triangle formulas, you can probably deduce for yourself. Prices should moveat least as far from the breakout point as the greatest width in points of the pattern from its Top (head) toBottom (V in neckline). This, it must be emphasized, is a minimum rule and subject only to the usualqualification that a Reversal Formation must have something to reverse. Generally, the new trend carriesprices eventually well beyond the minimum measurement. Wedge Formations All of the chart formations we have discussed up to this point can and do develop at changes in the MajorTrend of prices; a few of them seldomly occur at any other change than a Major Reversal. We have toconsider three patterns that are ordinarily Minor, or, at most, only Intermediate in their trend implications.They are useful, nevertheless, in trading operations. One of them, the Wedge, we have already alluded to(in Chapter 8) as having some resemblance to the Triangles. The Wedge is a chart formation in which the price fluctuations are confined within converging straight (orpractically straight) lines but differs from a Triangle in that both boundary lines either slope up or slopedown. In a Symmetrical Triangle, the Top border slants down, whereas the Bottom border slants up. InRight-Angle Triangles, one boundary slopes either up or down, but the other is horizontal. In a RisingWedge, both boundary lines slant up from left to right, but because the two lines converge, the lower mustproject at a steeper angle than the upper. In a Falling Wedge, the opposite is true. MSFT(D)- Da ilyNASDAQ L= 2 Bull Trap 7.56+0.35+1.29% w B =27.55 1 A =27.56 ll I'D O =27.67 Hi= 2773 Lo= 2 .44C =27.56V = 57145012 44.06 RunawayD iys 1 v J Departmentof usticeG ip M L JISJI V Nr 1 If3530 V RunawayGap I L J J L ExhaustionGap A N ll ii S OND00FMAMJ JA SON Created with TradeStation Figure 10.24 Microsoft. A Key Reversal Day in March. Department of Justice breakaway gaps: runawaygaps, exhaustion gaps. Selling Climax. As usual, further lows are achieved. A cornucopia of chartists' delights. Figure 10.25 eBay. As eBay broke its trendline and drifted sideways, it became a good subject for KeyReversal Day trading. Note several instances. 8 26 24 22 20 18 16 14 12 10 32 30 28 Figure 10.26 If you cannot deliver groceries electronically what good is the internet? Meg Whitman (acompetent, well, more than competent, CEO) and eBay found a use for it: the biggest flea market everinvented (and growing every day). Every military commander knows the axiom, Exploit Success! andeBay exploits and exploits and exploits. Is there a fundamental lesson here for the technician? Absolutely.Although the technician should be able to take a nameless chart and trade it competently (CEO of his ownship) no real information or data should be ignored. In this case, the real information—that eBay was an800-pound gorilla (or flea)—fit the chart perfectly. So eBay separated itself from a bunch of nags to runlong and hard. Handicappers know to always keep an eye on winning jockeys: Whitman. Ellison atOracle. Moore at Intel. Gates at Microsoft. Jobs at Apple (and Pixar and NEXT and so on ... and so on ..In2005, what is to be done with eBay? Draw a trendline, raise your stops, and sell it if it reverses. Superficially, one might think because an Ascending Triangle with one horizontal and one up-line is aBullish picture, the Rising Wedge, with both of its pattern lines up, should be even more Bullish. But suchis not the case. Remember, the flat top of an Ascending Triangle signifies a supply of shares beingdistributed at a fixed price; when that supply has been absorbed (and the rising lower boundary lineindicates it will be absorbed), the pressure is off and prices will leap forward. In a Rising Wedge, on theother hand, there is no evident barrier of supply to be vaulted, but rather, a gradual petering out ofinvestment interest. Prices advance, but each new up-wave is feebler than the last. Finally, demand failsentirely and the trend reverses. Thus, a Rising Wedge typifies a situation that is growing progressivelyweaker in the technical sense. It might be said any advance in prices, no matter what shape it may take on the chart, weakens thetechnical status of the market. Prospective buyers are—or, at least, should be—more reluctant to pay highprices than low, and owners are more willing to sell at high prices than at low; in other words, any sort ofrise tends to increase supply and diminish demand. (Although theoretically true, the preceding statementmust be qualified by the fact that rising prices actually attract rather than discourage public buying.) Thedifference between a Rising Wedge and what might be called a normal Uptrend Channel (of which we LU (Lucent Tech Inc) 08/26/2006 3:34 PM EDT Figure 10.27 Lucent. Late twentieth- and early twenty-first-century schizophrenia. Runaway Days,Breakaway Gaps. Maalox is to be prescribed for the investor. Ecstasy for the trader. Reversal Days andshort-term tactics win the day when the subject is insane. An excellent example of fitting the trader to thestock. Why would a rational investor own such a stock? shall have more to say later) is the Wedge sets a sort of limit on the advance. Its converging boundarylines focus on a point near where the advance will halt and reaction will set in. We can state most of the essential facts about the Up-Pointed Wedge Formation in a few short sentences.It can develop either as a sort of Topping-Out Pattern on a previously existing uptrend or start to formright at the Bottom of a preceding downtrend. It (the Wedge) normally takes more than three weeks tocomplete; a shorter pattern of this shape is nearly always better classified as a Pennant, which we willdiscuss in the next chapter. Prices almost always fluctuate within the Wedge's confines for at least two-thirds of the distance from the base (beginning of convergence) to the apex; in many cases, they rise clearto the apex, and in some, they actually go a short distance beyond, pushing on out at the Top in a last-gasprally before collapsing. Once prices break out of the Wedge downside, they usually waste little time beforedeclining in earnest. The ensuing drop ordinarily retraces all of the ground gained within the Wedge itself,and sometimes more. Trading volume in a Wedge tends to follow the regular Triangle Pattern, diminishinggradually as prices move up toward the apex of the Wedge. The Falling Wedge Except for the fact it is pointed down, the Falling Wedge appears in all respects like the rising form justdescribed, except the price trend that follows its completion differs in character. When prices break out ofa Rising Wedge, they usually fall away rapidly, but when they Figure 10.28 In the caption to Figure 10.27, the editor asked, apparently rhetorically, why a rationalinvestor would own Lucent. The picture here shows what happens when apparently rational investors donot set a stop to protect themselves from irrational volatility. The market knows things investors do notknow, but it will reveal these things to the most basic of investors if he reads the chart. This chart is addedfor the ninth edition to pick up the picture where the eighth left off. move out of a Falling Wedge, they are more apt to drift sideways or in a dull “Saucering-around”movement before they begin to rise. The Rising Wedge may, therefore, call for quick action to secureprofits, whereas with a Falling Wedge, the trader ordinarily can take his time about making hiscommitment for the ensuing rise. Both types of wedges should be well defined on the chart. Unless a trend pattern is quite compact withfrequent fluctuations, nicely bounded by lines that clearly converge to a point, and their up (or down) slantis marked, the Wedge construction must be considered doubtful. You will find borderline cases in whichone of the pattern lines so nearly approaches the horizontal in direction that it resembles a Right-AngleTriangle, and the latter would carry quite different implications for future trend development. It is difficultto lay down any hard and fast rules for distinguishing the two. If one boundary line is nearly horizontal, orif the daily closing prices tend to fall at about the same level, then the formation is more safely construedas a Triangle. The reader need not let this problem worry him unduly, as he will rarely be left in doubt forlong after he has acquired a little experience with charts. One soon gets to recognize the characteristic“symptoms” of the different formations and make correct diagnoses almost instinctively. Wedges on weekly and monthly charts Most true Wedges are too short-lived (seldom longer than three months) to take on a recognizabledefinition on a monthly chart, but they may be spotted occasionally on the weeklies. Longcontinued, gradual downtrends, when plotted on arithmetic scale, sometimes assume the Wedgeform. Thus, an entire Major Bear Decline on any arithmetic monthly chart may appear like a giantFalling Wedge. This is due to the fact that the up and down fluctuations that compose the MajorSwing, while maintaining about the same extent in percentage, tend to shorten in terms of points(dollars) as prices move from higher to lower levels. Such Major chart patterns are not the trueWedges we have discussed herein. When plotted on semilogarithmic scale, these same moveswould normally show a Parallel or even slightly widening, instead of Converging, Channel. Rising Wedges common in Bear Market Rallies As a final note, we might add that the Rising Wedge is a quite characteristic pattern for Bear MarketRallies. It is so typical, in fact, that frequent appearance of Wedges at a time when, after anextensive decline, there is some question as to whether a new Bull Trend is in the making may betaken as evidence that the Primary Trend is still down. When a Major Bear Swing ends in a Head-and-Shoulders Bottom, the last Rising Wedge will often appear as prices rally from the left shoulderto the neckline and just before they break down to the head (final low). A Rising Wedge on anarithmetically scaled weekly chart is almost invariably a Bear Market phenomenon, expressing thediminishing vigor that is the normal property of any reaction against a prevailing Primary Trend. The One-Day Reversal We referred in Chapter 6 to a price pattern known as the One-Day Reversal. This particulartechnical Reversal indication, when taken alone, can be accorded only temporary or strong MinorTrend significance. True, it may appear at the very peak of a long advance, forming perhaps on thehigh day of the head in a Head-and-Shoulders Pattern, which will be followed by a long decline,but it can hardly be credited with forecasting that entire decline; all it really signaled was the turn inthe “head” itself. A One-Day Reversal may just as well occur, for example, at the beginning (thefirst peak) of a Symmetrical Triangle which only Consolidates instead of Reversing the previousuptrend. Even so, as you can see, it warns us of at least temporary exhaustion of Bullish forces. On the downside, a One-Day Reversal often appears in magnified and conspicuous form at the endof a Panic Sell-Off, in which case it usually is referred to as a Climax Day or Selling Climax. Thismanifestation of it has special significance, which we shall take up later. First, however, just what isa One-Day Reversal? To begin, it is a day of unusually high volume, exceeding, as a rule, by a notable margin any tradingturnover registered in any one-market session for the past several months. It comes after a fairlylong and steady advance (or a similar decline), on which activity has been increasing gradually.Prices push right ahead from the opening gong as if nothing could stop them. Frequently, even theopening sales are so far beyond the previous day's closing level as to leave a large gap on the chart.(We shall discuss gaps later.) The tape runs late and before the advance (or decline) halts, priceshave been carried as far in an hour or two as three or four days would ordinarily take them. But thehalt does come finally, maybe at the end of the first hour or perhaps not until late in the day. Then quotations “churn,” registering only fractional changes to and fro, with the tape still “fast” andoften running late by spurts. Suddenly, the trend reverses and prices move just as rapidly in theopposite direction. The session ends with a final burst of activity that puts the price at the closeright back where it started the day. There has been an enormous amount of activity, and quotationsmay have traversed intraday a range of 2% or 3%, but the net change from the previous day at theend of trading is very small. One-Day Reversals at Tops appear quite often in the charts of individual stocks that are thin(relatively small floating supply of shares), have had an active advance, and have attracted a largepublic following. They rarely develop in the Averages. Selling Climaxes (One-Day Reversals atBottoms), on the other hand, are found conspicuously in the Averages at the end of many abnormalor Panic Declines. One-Day Reversals, as already stated, do not carry Major Trend implications. The nimble in-and-out trader can capitalize on them—maybe pick up several points if he has funds available andjumps in at the right moment. But, as a rule, the new trend (i.e., the trend at the close of the day)does not carry very far right away; prices usually “work” around in the nearby ranges for some timeand build some sort of area pattern before they move away in a swing of Intermediate proportions.The One-Day Reversal, as a phenomenon that occurs frequently within or at the start of morepregnant technical formations, gives an important clue to probable trend developments. In anyevent, it is an urgent warning to watch closely the chart in which it has appeared to see what patternof price action may follow and be prepared for the worthwhile move when it comes. The type of false move or shakeout described in Chapter 8 as occurring at the apex end of aSymmetrical Triangle often takes the form of a One-Day Reversal. The Selling Climax In the “bad old days” when stocks could be bought by putting up as little as 10% of their cost incash and there were no restrictions on short selling, professional operators could (and tradition saysthey often did) organize Bear Raids to shake out weakly margined holdings. By selling short inquantity at a favorable moment when the “public” had gotten itself pretty well extended on the longside, they could break prices down. Brokers then would send out calls for more margin from their“long” accounts, many of whom could not or would not put it up, with the result of their stocksdumped on the market, which in turn produced further declines. The professionals could then stepin, cover their shorts with a profit, and secure a line of long stock for the next advance. Bear Raidsof this sort were effectively checked by the imposition of the Securities and Exchange Commission(SEC) regulations, but margin calls and forced selling will always exist as a market factor so longas stocks can be bought on margin and whenever prices drop extensively following a spree ofpublic buying. Most true Selling Climaxes, if not all, have been produced by distress selling such as referred to inthe preceding paragraph. They have come at the end of rapid and comprehensive declines thatexhausted the margin reserves of many speculators and necessitated the dumping of their shares atwhatever the market would bring. This process is progressive—feeding upon itself, so to speak—with each wave of forced sales jeopardizing another lot of margined accounts, until, at last, millionsof shares are tossed overboard, willy-nilly, in a final cleanup. Such is a Selling Climax in which thetotal turnover may exceed any single day's volume during the previous upswing. It is a harvest time for traders who, having avoided the Bullish infection at the top of the market, have funds in reserveto pick up stocks available at panic prices. Obviously, a cleanout day or Selling Climax radically reverses the technical condition of themarket, for in its process, shares have passed from weak hands into strong hands at very muchlower prices. The ominous weight of potential selling that has been overhanging the market hasbeen removed. Usually, the Panic has carried quotations (although only temporarily, as a rule) wellbelow even conservative values based on current business conditions. A Selling Climax need not be completed, and the Reversal of Trend actually becomes evident,within a single day. We have classified it as a variety of One-Day Reversal, but some of them haveactually spread out over two days, with the decline exhausted and coming to a halt late on the firstday, too near the end of the session to permit much recovery. The next day sees an extensive rallyright from the opening gong, as it is immediately apparent then, if not late on the preceding day,that there are no more distress offerings. The all-time percentage record for Selling Climaxes is held by October 29, 1929. Prices in terms ofthe Dow-Jones Industrial Average opened that day practically at their high, 252.38, which was morethan 8 points below the previous day's closing level. Panic selling flooded the Exchange from thestart; before it was over, the Industrial Average had lost 40.05 points. From that low, 212.33, itrallied in the final two hours to 230.07 for a gain of nearly 18 points and went on up another 28points the following day. This 1929 climax set the alltime record also for daily turnover: 16,410,000shares were traded in those five hours, more than twice as many as in any one day during the entirepreceding Bull Market. But the low level of October 29 was broken a week later, and the bottom ofthat particular early phase of the 1929-1932 Bear Market was not reached until November 13. EN:See comments on the following page on the Reagan Crash of 1987. The Panic of 1937 ended with a classic Selling Climax on October 19, another “Black Tuesday” instock market annals. The Dow Industrials had closed at 125.73 the night before; prices had alreadyfallen without a rally of consequence from a high of 190 in mid-August, and margin accounts werenearly all in a precarious situation. The telephones had worked overtime the preceding day bybrokers demanding additional margin, most of which was not forthcoming. When the Exchangeopened on the 19th, quotations hit the toboggan under a flood of offerings. By 11:30 a.m., with theIndustrial Average around 115, the selling was over and offerings disappeared. An hour later, priceswere jumping a point between sales and the day closed at 126.85, recovering its entire loss. Volumeon that climax was 7,290,000 shares, double that of any day at the top of the preceding BullMarket. An intraday high of 141.22 was reached 10 days later, but the Panic Low was subsequentlybroken on November 20, 1937, and that Bear Market finally ended at 98.95 (Dow-Jones Industrials'closing level) on March 31, 1938. EN: No wonder investors have instinctual angst on October 19. In 1987, the Bear returned tocreate another great Panic—on the very same date. From a high of 2746.65 on August 25 the Dowbungeed to a low of 1,616.21 on October 20. The actual full-blown panic took place from October14 (high 2,485.15) to October 20 (low 1,616.21) with October 19 and 20 traversing a range of547.95 points or 25% of the market at that point. Top to bottom, 1130 points were lost, comprisinga retracement of 41%. The more things change the more they stay the same, as Andre Malraux issaid to have remarked. Actually, he said it in French, which is more elegant, and expresses the sameidea: Plus ga change, c'est plus la meme chose. Readers should not assume that similar crashes willnot occur in the future. The foregoing were general market climaxes, a phenomenon that produces (or rather is producedby) simultaneous selling in practically every actively traded individual issue. A Climax Bottom, asa matter of fact, appears in an individual stock chart, as a rule, only as a concomitant of a generalmarket cleanout, although there are cases in which some particular and completely unexpectedpiece of bad news affects one certain company and causes panicky liquidation of its shares alone,terminating with a One-Day Reversal. The Top Reversal Day, on the other hand, is normally amanifestation of an individual stock rather than of the general market average. The two outstanding examples of Selling Climaxes (cited above) and numbers of others that haveappeared at the conclusion of various Panic Sell-offs offered extraordinary opportunities for a quickturn to the trader who was smart (or lucky) enough to get in at the bottom. He could cash in a fewdays later with exceptional profits. Professional operators capitalize on such opportunities. Theproblem is to recognize the climactic nature of the selling in time to seize the chance—and that isnot as easy as it may have sounded in our discussion. Just to emphasize the possibilities of error,there was a 30-point drop, followed by a 30-point recovery, on a turnover of nearly 13 millionshares, on October 24, 1929, but the trader who did not grab his profits within 48 hours never hadanother chance to get out even (in terms of the Averages, that is). But it is not impossible to recognize a Selling Climax, if you have friends in the Street to keep youinformed on the condition of margin accounts and the amount of necessitous selling to be expected.EN: This information is now not difficult to come by. It is easily obtainable in the general financialpress. The climax comes after a decline approaching Panic proportions. The day usually opens witha substantial Downside Gap (opening prices considerably below the previous night's closing);offerings appear too great to be absorbed; prices collapse; volume is extreme; the market isexceptionally “broad” with nearly every listed stock crowding into the record. Then, some timeafter 11:00 a.m., perhaps not until afternoon, the selling appears to dry up; a few issues continue todecline while others begin to climb. Suddenly prices are jumping, which is the time to act. Buy astock that has been thoroughly depressed but normally has a good following at all times (e.g., U.S.Steel). Do not hang on too long; take a reasonable profit as soon as it is available and sell, in anyevent, whenever the recovery shows signs of bogging down. Remember, a One-Day Reversal is not a dependable Major Trend indicator. Selling Climaxes donot normally occur at the final Bottoms of Bear Markets—weak holdings usually have been shakenout long before that stage is reached. Only one Primary Downtrend in all the record has, in fact,ended with the first Panic Phase, that being the five-month Bear Market of 1938-1939 that wasfollowed by an equally short Bull Market. Occasionally, a weekly chart will produce a formation that might be called a “One-Week Reversal,”in some such conspicuous fashion as is shown above in “NC.” In this instance, the subsequent riseproves that a Major change in its technical balance occurred in December 1941. Curiously enough,no other obvious Reversal Pattern appeared on the weekly chart at this turn in the Primary Trend of“NC.” (Its daily chart showed an Ascending Triangle.) But this example of a One-Week Reversal isnot shown to give the idea that such phenomena carry important technical indications. On thecontrary, most “Reversal weeks” are followed by very disappointing moves. One remaining Reversal Formation, the Island Pattern, involves the whole subject of Gaps, whichwill be taken up in detail in Chapter 12; thus, we will defer our discussion of the Island Reversaluntil then. Short-term phenomena of potential importance Very short-term phenomena—of a one-day or a few days' duration—can sometimes be indicative ofnot only short-term direction, but also give hints as to long-term price behavior. Gaps (see Chapter12) and One-Day Reversals (this Chapter) belong to this group. Other short-term patterns of interestinclude Spikes, Key Reversal Days (sometimes merely called Reversal Days), and Runaway Days(sometimes called Wide-Ranging Days). Spikes On the day it occurs, a Spike is not immediately identifiable for by definition it protrudes Head-and-Shoulders above days before and after if it is at or near a Top and plunges much below thesurrounding days if it occurs at a Bottom. So after a day that exhibits an unusually wide range, thesubsequent days must be observed to discriminate the day from a Runaway Day. Both are the marksof a far-ranging battle between Bulls and Bears, with the close giving a clue as to whom theeventual winner will be. The importance of the spike is highlighted by the following: 1. The strength and length of the action that preceded it. 2. The close of the day, whether up on a Bottom or down on a Top. 3. Its prominence when compared with the days before and after it. An extremely wide-range day at the end of a long Bull move that closes down after making unusualnew highs might even be construed as a one-day signal. Whether one trades on it or not woulddepend on his particular style and taste and the nature of his trading—long range, scalping, and soon. In fact, the Spike might also be a One-Day Reversal—that pattern in which an opening gapoften is followed by avid buying that collapses and closes below the opening or at the low of theday. Such action might be compared with an army pursuing a seemingly defeated enemy only todiscover the retreat was a ruse, then turning and fleeing the other way in a rout. Turn this description on its head and you have a Spike Bottom. It is not infrequent that a Spike willbe followed by significant price movement in the opposite direction. Figure 10.23 illustrates amodern Spike. Figures 1.1 and 7.16 show some spikes on Edwards' and Magee's charts. Runaway Days A Runaway Day is a day that stands out on the chart as having an unusually long range, oftenopening at the low and closing at the high, or vice versa for Bear runaways. Here the enemy hasretreated precipitously, or treacherously, to draw the Bulls into a trap. The holders and sellerscannot or will not satisfy the eager demand of the buyers and so the price transverses perhaps twoto three times the daily range. Although the agile speculator may jump on this charging train andrealize a nice scalp, it is the following days that reveal the true significance. Nice consolidation andcontinued volume will confirm the day as significant while a tapering of volume and rounding orvolatile pullback will call into question its validity. Although these days may be taken as hair-trigger buy signals (or sell signals, depending) the return of prices to the low of the Runaway Day will probably indicate the day was a false signal and a trade in the opposite direction is shaping up.See Figure 7.20 for runaways complete with gaps. One such example is shown in Figure 10.24 in which a bull trap precipitated by a Runaway Daywith a subsequent collapse foretold the 50% decline in Microsoft stock in 2000. Key Reversal Days The Key Reversal Day pattern occurs when one sees a new high in an up-move and then a closebelow the close of the previous day. As a short-term trading signal it has much to recommend it, butlike every other technical pattern, judgment and timing are required to profit from it. In a BullMarket, there will be some if not many such interim highs marked by Key Reversal Days. On theKey Reversal Day at a major or important Top, the trader shorts the stock on the close with a stop atthe high of the reversal day, or slightly above. He may then exit on the profit side on the occurrenceof a Key Reversal Day in the opposite direction, or on a profit target, or a chart pattern. Ifadventurous, he may use the trade as the first of accumulating a position for an anticipated BearMarket, adding other positions as more significant patterns occur and as support levels are broken. This pattern also is useful in trading range markets, as shown in some internet stocks from 2000,where trading with Key Reversal Days would have allowed the trader to escape unscathed in theminicrash of the NASDAQ in early 2000 (see Figures 10.25 and 10.27 for eBay and Lucent.) Of all the Very Short-Term Patterns, Gaps, One-Day Reversals, Key Reversal Days, Spikes, andRunaway Days, it should be noted that the return of prices to the origination of the formation marksthe formation as a false signal and a reason to reverse the trade direction and look for significantprofits. Clearly, these are the tactics of scalpers and speculators, but it profits the long-term investor toknow and understand them. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter eleven Consolidation Formations An army, which has pushed forward too rapidly, penetrated far into enemy territory, sufferedcasualties, and outrun its supplies, must halt eventually, perhaps retreat a bit to a more easilydefended position and dig in, bring up replacements, and establish a strong base from which later tolaunch a new attack. In the military parlance with which we have all become more or less familiarthese past few years, that process is known as consolidating one's gains. Although it will not do tooverwork the analogy, there is much in the action of the stock market that may be compared to amilitary campaign. When a stock pushes ahead (up or down) too fast, it reaches a point at which theforces that produced its move are exhausted. Then it either reverses its trend (in a Major orIntermediate sense), reacts to a good Support Level, or Consolidates its position, in some sort of“sideways” chart pattern composed of Minor Fluctuations, until it has caught up with itself, so tospeak, and is ready to go on again. (For illustrations in this chapter, see Figures 11.1 through 11.18.) We already have had occasion to refer to Consolidation Formations in our study of SymmetricalTriangles and Rectangles; exactly how those two chart formations might either reverse the previoustrend or Consolidate it in preparation for its continuation were shown. We noted about three out offour Symmetrical Triangles will turn out to be Consolidations rather than Reversals—andRectangles in about the same proportion. Even a Flat-Topped Broadening Pattern constructed at theTop of an Intermediate Advance may, despite its normally Bearish implications, be converted into aConsolidation or Continuation Formation if its Flat Top is decisively penetrated on the upside. A Dow Theory Line in the chart of one of the Averages may be a Consolidation or ReversalFormation, but is rather more likely to be the former than the latter. A Dow Line is, of course, a sortof loose Rectangle. The fact is almost any sort of sideways price pattern, such as is often termed a“Congestion” or trading area, provided trading volume tends to diminish during its construction(and provided it does not show definite broadening tendencies), usually functions as aConsolidation. But most areas of Trend Consolidation are fairly well defined, taking on arecognizable pattern. Flags and Pennants We do not need to spend more time here on the Triangles and Rectangles; they have been examinedin both their Reversal and Consolidation manifestations in previous chapters. Our first twoformations, which are characteristic of Consolidation only, are the Flags and Pennants, which arecuriously related in certain aspects to Triangles, Rectangles, and Wedges. A Flag looks like a flag on the chart. That is, it does if it appears in an uptrend; the picture isnaturally turned upside down in a downtrend. It might be described as a small, compactparallelogram of price fluctuations, or a tilted Rectangle that slopes back moderately against theprevailing trend. Let us consider the Uptrend Flag first. It usually forms after a rapid and fairlyextensive advance that produces a nearly vertical, or at least quite steep price track on the charts.On such moves, volume normally shows a progressive increase until it reaches a high rate. Thisvolume (since every transaction signifies a sale as well as 24 22 20 19 18 17 16 15 14 13 12 11 Sales 100's 125 100 75 50 25 1945 MARTIN - PARRY MAY JUNE APRIL 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25'1 8 15 22 29 Figure 11.1 This is a typical and practically perfect Flag, constructed May 12 to June 2, 1945, inMartin-Parry. Daily turnover diminished to a low rate as prices settled down for exactly three weeksafter their swift advance from 11 to 16 1/2 but held up away from the lower boundary line duringthe third week, and then burst out topside with high volume in another straight-line push from 15 to21. Study this chart again when you come to the Flag-measuring formula later in this chapter. Thedashes at 12 indicate the upper range of an old Resistance Level (see Chapter 13). a purchase) is a warning that many holders of the stock are taking profits. Eventually the pressureof profit-taking halts the markup. Prices “churn” without further gain and then react 2 or 3 pointson reduced turnover. A new rally occurs but fails to equal the previous high or attain the previoustop volume. Another reaction carries quotations slightly below the preceding Bottom with further diminution of activity and then follows a series of similar Minor Fluctuations, each of whose Topsand Bottoms are successively a trifle lower than its predecessor, and with volume shrinkingmarkedly and constantly as the pattern develops. On the chart, the initial, steep up-move followedby the compact, sideways, and slightly down-sloping price Congestion Area, which can be roughlybounded, top and bottom, by parallel lines, takes on the appearance of a mast (or halyard) with aflag flying from its peak, hence, the name of the formation. Sometimes each rally and setback within the Flag takes three or four days, rarely more. In othercases, prices will skip back and forth between the upper and lower Flag boundaries in a single dayor two, in which event the pattern on the chart consists of an almost solid block of price range lines.The wider the pattern (from top to bottom) the longer time, 24 22 20 19 18 17 16 15 14 Sales 100's NATIONAL GYPSUM NG 1945 JUNE IL JULY AUGUST ■ ■aBf Mlffl® • •• It tffit ■ J It li II L i j I ii 'SEPTEMBER OCTOBER NoVEmBi ------- ---------------- 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 ' 8 Figure 11.2 Another typical Flag of three weeks' duration, August 30 to September 18. ThisNational Gypsum chart overlaps that in Figure 8.6, showing the false move at the apex of the May-June Symmetrical Triangle. A buy signal was given when prices pushed up through the old apexlevel on August 23 with increased volume. Most interesting is the second Symmetrical Triangle thatformed in October-November, an almost exact replica of the first, but with a downside false moveat its apex. The sharp increase in volume on November 27 left no doubt as to its being aConsolidation rather than Reversal Pattern. “NG” went on up to 33. naturally, it should take for each swing within it to be completed. This process of MinorFluctuations may continue for only five days to a week if the Flag is narrow, or it can go on for aslong as three weeks. Daily turnover by that time usually will have shrunk to a relatively low ebb.Then, suddenly, prices will erupt with a new burst of activity from the end of the Flag and pushstraight up again in another advance that practically duplicates the original “mast” atop which theFlag was constructed. We have spoken of the Flag pattern as being moderately down-slanting, but the very short and“solid” ones will frequently develop horizontally and look like small squares. (On rare occasions, apattern of the Flag type in an uptrend will even slope up a trifle.) Flags form on steep down moves in much the same manner and with precisely the sameimplications as they do in uptrends. Down Flags, of course, tend to slope up—that is, they simplyinvert the picture presented by an Up Flag. Trading volume diminishes during their formation andincreases again as prices break down away from them. The Pennant: a pointed Flag The only important difference between a Pennant and a Flag is the former is bounded byconverging boundary lines rather than parallel lines. The normal Pennant, in other words, is a small,compact, sloping Triangle. It slants down when it appears in an uptrend, and it 24 22 20 19 18 17 16 15 Sales 100's 250 200 150 100 50 2 9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 Figure 11.3 Flags of the “Half-Mast” type appear most often in the later and most active stages of aPrimary Advance. The above example (January) was the last Consolidation Formation before“NK's” 1937 Bull Market Top. Note the Rectangle Reversal Pattern in March and the series of step-down patterns that followed. slants up in a downtrend. It forms, as a rule, after a rapid advance (or decline), and trading volumeshrinks notably during its construction. In fact, activity tends to diminish even more rapidly in aPennant than in a Flag (which we naturally would expect on account of the progressively shorterfluctuations that compose it), and it may drop almost to nothing before the Pennant is completedand prices break away from it in a new and rapid move. The Pennant might also be described as a short, compact Wedge, characterized by markeddiminution of activity. When, as is usual, it slants back against the preceding trend, its forecastingimplications are similar to those of the Wedge, in that prices break out of it in a direction oppositeto its slant. But there are rarer Minor variations of the Pennant, comparable with those sometimesfound in the Flag, in which the price area is very short and “solid” and practically horizontal (like aSymmetrical Triangle), or in which the slope is actually slightly in the same direction as thepreceding trend instead of against it. When prices move out of the last-named type, they ordinarilydo so, not in a sudden straight-line breakaway, but rather in an accelerating curve with volumeincreasing gradually instead of abruptly at the break; the whole pattern resembles a curved horn thatruns to a long, slender point. Do not let these variations worry you; there is nothing deceptive abouttheir appearance; their kinship to the more common, normal form is quite apparent. The measuring formula The same approximate measuring formula applies to the Pennant as to the Flag. They are both“Half-Mast” Patterns that ordinarily form after a fairly steady and rapid (steep) price movement. Inapplying the measuring rule, go back to the beginning of that immediately preceding move, to thepoint at which it broke away from a previous Consolidation or 16 Sales 100's 125 100 75 50 25 JANUARY OCTOBER in 117I9413 FEBRUARY MARCH OVE M BER DECEMBER VANADIUM CORP. Figure 11.4 Sometimes a stock will make a long series of small Consolidation Patterns in itsuptrend, one following right on the heels of another as successive groups of traders buy in whileothers take their profits on previous purchases. In this sequence of step-ups in Vanadium, the FlagPattern formed in January 1937 ran a few days over, but the volume breakout of February 4 left nodoubt the trend was still up. A final Top was made at 39 1/2 in March. Note the strong buy signalgiven on December 14. Refer to this record again in connection with Support and Resistancestudies in Chapter 13. Reversal Formation (or through a significant trendline or Resistance Level, with which laterchapters are concerned), a point recognizable as a rule by a quick spurt in activity, and measurefrom there to the Minor Reversal level at which the Flag or Pennant started to form. Then measurethe same distance from the point at which prices break out of the Flag or Pennant, and in the samedirection. The level thus arrived at is the minimum expectation of this type of ConsolidationPattern. As a matter of fact, advances from Flags 68 64 60 56 52 48 BRIGGS 44 40 Sales 100's 250 200 150 100 50 JANUARY" 1 4 1 n 11 4 11 18 25 i.tiiliihtilhiiltttq - FEBRUA R MARCH 1 8 15 22 29 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 Figure 11.5 A Bull Flag in February and a Bear Flag in April 1936, in Briggs. The Top betweenwas a Symmetrical Triangle. April 30 was a Reversal Day. Prices recovered to 64 1/2 in November1936, making there a long-term Major Double Top with this March high. The Support-ResistanceZone at 51-53, indicated by dashed line, was still effective in 1946 (see Chapter 13). or Pennants in an uptrend generally go farther (in terms of points or dollars) than the precedingmove, whereas declines may not carry quite so far. Hence, the formula is best applied on asemilogarithmic chart by measuring actual chart distance rather than by counting points. You cancheck this by referring to the examples illustrating this study. Reliability of Flags and Pennants These pretty little patterns of Consolidation are justly regarded as among the most dependable ofchart formations, both as to directional and measuring indications. They do fail occasionally, butalmost never without giving warning before the pattern itself is completed. All that is necessary toguard against such failures is to strictly apply the tests as to the authenticity of the patternincorporated in their description. These are as follows: 1. The Consolidation (Flag or Pennant) should occur after a “straight-line” move. 2. Activity should diminish appreciably and constantly during the pattern's construction andcontinue to decline until prices break away from it. 3. Prices should break away (in the expected direction) in not more than four weeks. A patternof this type that extends beyond three weeks should be watched with suspicion. The matter of practical trading on these particular formations will be taken up in Section II of thisbook, which is devoted to tactics. Our second test deserves some further 72 68 64 60 56 52 48 44 40 38 36 Sales 100's 500 400 300 200 100 iittii ANACONDA COPPER OCTOBER “N OV E MB R DECEMBER ANUARY " ' FEBRUARY MARCH ' : 3 '10' 17 7 '14'21 '28 1 5 '12 r19 r26 1 2 1 9 116 '23 <30 1 6 113 l20 1 27 1 6 l13 '20'27 1 Figure 11.6 The down-sloping, Converging Price Formation of November 4 through December 9might be called either a short Wedge or a Pennant. Note the small Flag in October; also RunawayGaps November 4 and February 19, and the Breakout Gap December 10. comment here though. If a pattern begins to develop on the chart—which, so far as the price picturealone is concerned, qualifies as a Flag or Pennant, but during which trading volume remains high orobviously irregular instead of diminishing—then the outcome is more apt to be a quick reactionagainst, rather than continuation of, the previous trend. In other words, such high or irregularactivity formations are characteristically Minor Reversal Areas rather than true Consolidations.Watch the volume half of your chart at all times. Where they may be expected Flag and Pennant Consolidations are characteristic of fast moves. Therefore, they show up mostfrequently in the later, dynamic phase of Bull Markets, after the first accumulation and the moreorderly early markup stages have passed. Hence, the appearance of these patterns may be taken as awarning that an advance is approaching its final weeks. The rapid phase of a Major Bear Trend, onthe other hand, is its second stage, often characterized by almost “vertical” Panic Declines. TheFlags and Pennants that develop therein are usually short— completed in a matter of three or fourdays rather than weeks. In the late months of a Bear Market, formations that evolve on the charts inthe Flag or Pennant similitude often will run too long (four weeks or more), begin to show anincrease in volume on the rallies, and be succeeded by only dull and limited reactions. Figure 11.7 An example (in June 1944) of the brief and compact type of price “Congestion” thatcan be classed as a Flag. The advance here started at 5 from a 13-month Symmetrical Triangle ofwhich only the last two months appear above. The measuring implication of this tiny Flag was notfulfilled until after prices had undergone a sort of Triangular Consolidation in July. In general, it may be said these particular chart patterns are most common (and most dependable) inuptrends. The appearance, after a Major Decline, of price pictures that, at the start, assume thedowntrend Flag or Pennant form must be regarded with caution. Unless such developments holdstrictly to the limitations we have stated above under the heading of “reliability,” do not trade onthem. Flag pictures on weekly and monthly charts One of our requisites for a dependable Flag (or Pennant) was it should not take more than fourweeks to complete its pattern and break out in a new move. It stands to reason, therefore, that a true Flag cannot show up at all on a monthly chart and barely appears on a weekly chart. You will findprice areas on long-range charts, patterns that have taken 8 or 10 weeks to as many months,sometimes a year or two, in their construction, which assume the shape of a Flag, but do not expectthem to function as Flags. Examined in detail on a daily chart, these same long areas almost alwayswill be found to contain price formations having entirely different significance. Frequently, what isreally a Major Reversal Area following a long, rapid advance will look something like a Flag whenit is condensed on a monthly chart. So, do not trust such pictures on long-range charts; do not takeit for granted that they represent Consolidation for a new rise; find out what the detailed dailyplotting for the same period says. The July-August Flag ran for five weeks—too long to be trusted without additional technicalevidence (see point 3 under “Reliability of Flags and Pennants”). The danger in 28 26 24 22 20 19 18 17 16 15 14 13 12 Sales 100's 50 40 30 20 10 MULLINS MANUFACTURING B MNS 1936 MAY AUGUST SEPTEMBER 1 Figure 11.8 Another example of the series of Flag-type Consolidations that may form in a rapid,third-phase Bull Market Advance. Mullins went from 15 to above 39 in six months in 1936,dropped back to 31, and then rose again in March 1, 1937, to its previous high, making a MajorDouble Top. (Note that “MNS” was split 2-for-1 in 1937.) such prolonged formations is either when the breakout finally appears it will fail to follow through,or prices will keep drifting right on down. For the moment—on August 25—it looked as thoughthis Flag had “gone stale,” but when prices rose above the previous high on August 27, with a smartpickup in volume, purchases were obviously safe. Rectangular Consolidations: an early phase phenomenon In contrast with Flags and Pennants, which are typically last-stage Bull Market Concomitants,Consolidations of the Rectangle class are found more often in the earlier phases of Bull Trendevolution. In Major Bear Moves, Rectangles may develop in the first stage just before a PanicDecline, or in the last stage preceding a strictly limited final sell-off. The latter manifestationpresumably betokens premature accumulation by interests who feel that prices have already gonelow enough to suit their purposes. (They come out all right, if they are able to hold on through theremainder of the Bear Swing and long enough for the next Bull Market to put prices back up againto profitable levels.) Sales 100's 125 100 75 50 25 WYANDOTTE WORSTED WYO V JUNE 1—_____ JANUARY FEBRUARY ----- ______ _____ ^22'29 5 112'19^6 2 1 9*16'23 2 1 9 )16l23l30 6 ‘13 l20T2^rTr11 t18l29 1 1 8 1151 Figure 11.9 The vertical lines marked “M” show how the measuring formula is applied to a FlagPattern. Note the first measurement is taken from the level at which the mast leaves the previous“Congestion” up to the peak of the Flag. This same distance is then measured up from the Flagbreakout. In “WYO,” the formula worked out exactly. Trading commitments should normally have been cashed in above 36 on this move. They might then have been reinstated when it becameapparent by April 2 that a Rounding Bottom was completed (note volume) for a new advance. Head-and-Shoulders Consolidations All our references to the Head-and-Shoulders Formations up to this point (see Chapters 6 and 7)have considered that pattern as typifying a Reversal of Trend, and, in its normal and commonmanifestation, that is most definitely the Head-and-Shoulders function. But, occasionally, priceswill go through a series of fluctuations that construct a sort of inverted Head-and-Shoulders picture,which in turn leads to continuation of the previous trend. There is no danger of confusing such Continuation or Consolidation Formations with regular Head-and-Shoulders Reversals because, as stated, they are inverted or abnormal with respect to thedirection of the price trend before their appearance. In other words, one of the patterns thatdevelops in a rising market will take the form of a Head-and-Shoulders Bottom. Those that appearin decline assume the appearance of a Head-and-Shoulders Top. By the time these price formationsare completed (left shoulder, head, and right shoulder evident), there is no question as to theirimplications. But at the head stage, before the right shoulder is constructed, there may be—usuallyis—considerable doubt as to what really is going on. AMERICAN WOOLEN WY 1946 44 ** 100's 125 0 100 1 75 ■■■■ 50 mi 25 ii( JANUARY-FEBRUARY MARCH APRIL MAY JUNE 5 12:1926 2' 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 : 8 15 22 29- Figure 11.10 A 1946 chart that delighted technicians contains a perfect “Half-Mast” Pattern inJanuary, with measuring gaps (G, G) above and below it; a downside Flag in early February (checkmeasurement); a fine Ascending Triangle at the bottom of this reaction with a Throwback in April,giving an ideal “buy spot.” The volume pattern in Consolidations of this type does not follow the rule for Reversal Head andShoulders. In a downtrend, for example, the Consolidation Formation resembled in its price contoura Head-and-Shoulders Top, but the attendant volume will diminish instead of increase on the leftshoulder and head as well as on the right shoulder. The same holds true for the “Bottom” Patternsthat develop as Consolidation in an advance market; however, Breakouts resemble, in all respects,those arising from Reversal Formations. Head-and-Shoulders Consolidations of the Complex or Multiple type seldom appear on the charts.Theoretically, they might and should be as easy for the chart technician to handle as the simpleforms. The formula for determining the probable minimum price move (beyond the neckline) from aHead-and-Shoulders Reversal Formation was discussed in Chapter 6. To anyone familiar with theverities of stock market trends and the endless variety of pictures that the charts can present, it isamazing how accurately that formula works out and how often the first consequential move awayfrom a Head-and-Shoulders Top or Bottom will carry through to the point (or a little beyond)implied by the measurement of the formation. But, the same formula applied to ConsolidationPatterns of the Head-and-Shoulders form does not work out as well. Such patterns are usually quite“flat,” and the ensuing move generally MO(D) Daily NYSE L = 65.41 +0.42 +0.65% B = 0.00 A = 0.00 O = 65.65 Hi = 65.65 Lo = 65.05 C = 65 .41 V = 4968500 69.00 60.00 56.00 52 .51 52.00 48.00 45.00 42.00 OND04FMAMJ J A SOND05 39.00 F M A M Created with TradeStation Figure 11.11 MO. Talk about your technician's delights. Altria Group throws off some pretty gooddelights here: a breakaway gap and run days to the downside, a down flagpole with flag, andpattern gaps. But they are good pattern gaps and really interesting. Then a triangle complete with abreakaway and an up flagpole with flag. The non-technician probably is suffering from nausea atthis point. It is a roller coaster that bodes ill for everyone. Additionally note a completely tradablesituation for the alert short-term technician. extends well beyond the measurement implied thereby, although, in some cases, it may not go quiteas far. Consequently, the Head-and-Shoulders formula cannot be applied to Consolidation Areaswith the assurance that it sets up a definite and dependable objective; one has to look, in thesecases, to a variety of other chart indications to appraise the probable proportions of the move tofollow. Scallops: repeated Saucers Our next chart picture differs from the Consolidation Formations previously discussed, in that itdoes not constitute a more or less definite area of Congestion or fluctuation to which one or morecritical boundary lines can be affixed. We could, perhaps, take it up as well in a subsequent chapterunder the general heading of normal trend action. Yet it is a pattern so characteristic of certain typesof stocks and certain types of markets, and so nearly related to the principle of Consolidation forfurther advance, that it may be better treated here. When a stock for which there is a large number of shares outstanding, and for which there is, at alltimes, a fairly active and “close” market emerges from a long-time Bottom (as exemplified by thepast history of Radio Corporation and Socony-Vacuum), which will often make a long MajorAdvance in a series of “Saucers.” These successive patterns, each of which resembles, in both priceand volume action, the Reversal Formation described in Chapter 7 as a Rounding Bottom, areslightly uptilted, that is, the rising end always carries the price a little higher than the preceding Topat the beginning of the Saucer. The net gain accomplished by each Saucering movement will varyfrom stock to stock, but there seems 28 26 24 22 20 19 18 17 16 15 14 Sales 100's 50 40 30 20 10 | Bl::::: H ■ ;4; jgEitS:Htgigg• : • sjililii :::::::::: ■" 11II •:::: SUH SB .Eli*• ::::. ::±AMERICAN LOCOMOTIVEtlj LA |:S ftm11 II HlHsn:::::::::::::: HTH :::::::::: ::::Z jffi SI 7 I | ::: TTTTTT ffi •|ii It js ;£ .....:::::::::: |BWI ttllltUII ftftttftft ■ ..... iii : i :Hs 7 :::::: if i o •:::: ffi S:: H L il • BidJt ill :::••Hl: ta;-::: 11 ttjft Si w : :|?i ::::: • HHr!.. af ir.... Hjpggj : :: Bg ii H :: 4::: ..... li ::::: fl :::::ii::: ii:::rnflnSjpxsp II gg 1 1Hi fl ss fl flf1935 S Hr | .-r.r •fl .-11.rfcrSttoS 1 i r# 1 i lift fl iflrm ..... nm •fl iftr £ :: Bw II i liilni i ii li diL ::::: : ... ( Ba, tiiiii "jji |||l[ili" .7. io UH? I flit ’ 1 JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER ' 6 13’ 2 '27 3 10 7 Figure 11.12 A Flag (end of November) that seemed for several weeks to have failed completely.Prices, however, rose quickly to 36 1/4 from their December 23 low, thus finally carrying throughaccording to formula. Note the Flat-Topped Broadening Formation that started the move. to be a strong tendency for it to amount to about 10%-15% of the price of the issue. The totalreaction from the left-hand lip of each Saucer to its Bottom level is usually a little greater, from20% to 30%, and the length (duration) of the Saucers is normally five to seven weeks, rarely lessthan three. Thus, the overall advance is slow but steady, in much the same sense as the progress ofthe man who eventually got out of the deep well by climbing three steps for each two that heslipped back. The charts of stocks that take this sort of course show a picture of strikingly similar andsymmetrical Rising Scallops, one succeeding another with little or no pause between. Tradingactivity runs up to a peak at the latter stage of each Scallop, as the previous high is approached andexceeded, then diminishes into dullness as prices curve down and flatten out at the Bottom of thenext Saucer, picking up again as prices curve up into their next rise. The trading opportunities afforded by stocks of the Saucering habit hardly require extendedcomment (although we shall set down some detailed specifications in Section II of this book). TheBottom level of each Scallop is usually easy to detect by watching price trend and volume, and so isthe topping out at the end. Yet it is curiously a fact that most “tape watchers” handle such stocks inthe wrong way, becoming interested in them and buying when they show activity (“make a newhigh on volume”) and neglecting them entirely when they are in the dull, rounding-out stage oftheir trends. Sales 100's 500 400 300 200 100 ANACONDA COPPER 1936 (ULY AUGUST SEPTEMBER OCTOBER 7 14 21 28 5 12 19 26 Figure 11.13 Typical of the form that Head-and-Shoulders Consolidation Patterns may take, bothas to price pattern and volume, was this development in Anaconda. Measuring formula for the smallFlag in October should be applied from the point of breakout through the Head-and-Shouldersneckline. Figure 11.14 A 1945 Head-and-Shoulders Consolidation in which both of the shoulders and thehead took a “Saucer” form. Compare price and volume trends. Prices advanced to 31 1/2 in July,came back again to 25 1/2 in August, and then shot up to 40 in November. 14 13 12 MIAMI COPPER 11 1945 10 Sales 100's 125 100 75 50 25 UpiMullxUi IL JULY" lllhnl AUGUST S OCTOBER NOVE' 23 30 7 14 21 28 4 11 18 25 1 8 15 22 9 6 13 20 27 3 10 17 24 1 8 15 Figure 11.15 Part of a genuine “Scallop” uptrend, typical except for the short duration andrelatively small decline in the October Saucer. The next Scallop, which started in December,dropped prices back to 12 1/2 in January, and then carried them to 18 1/2 in February. A four-monthSaucer, from February 1945 to June, preceded this chart. Note the position traders found themselvesin if they bought at 9 on the “new high volume” in June. COMMONWEALTH EDISON CWE 1945 28 Sales 100's 125 100 75 50 25 Hi—— il l tlLili.itJlil I lltifliliidillil 11 i 1 lililll 11 (Jll 111 lyjlillilllil iilli.ljll DECEMBER JULY AUGUST SEPTEMBER OCTOBER NOVEMBER ___________ 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29 Figure 11.16 Although the Scalloping habit characteristically appears in low-priced issues, it issometimes found in widely held, semi-investment stocks of medium price, such as “CWE.” 19 18 17 16 15 14 13 12 11 Sales 100's 250 200 150 100 50 INTERNATIONAL TEL. & TEL. IT 1944 JANUARY FEBRUARY MARCH APRIL MAY JUNE 8 -15 22 29 5 12 19 26 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 Figure 11.17 This chart shows the last five months of a broad, 13-month Saucer-like Consolidationin “IT,” which followed its rapid run up from 3 to 16 in late 1943 and early 1944. “IT” is an erraticactor, and its volume is apt to be particularly deceptive in day-to-day movements. Major PricePatterns in it, however, are dependable. This final phase of its long Consolidation (distribution andre-accumulation) first took the form of a Rectangle (with a premature breakout) and then anAscending Triangle. Its 1945-1946 Bull Market Top was a massive Head-and-Shoulders. Many boardroom tape watchers scorn charts with unfortunate consequences to their capital in thelong run. Genuinely expert tape readers—those who are able to show fairly consistent profits intheir trades—are really extremely rare. (EN: For “tape readers” substitute “day traders,” 99% ofwhom are unsuccessful.) When you do meet such an individual, you will find that he either, ineffect, “carries charts in his head” or else takes a careful look at the record before he buys on aticker showing activity. As a stock with the Scalloping habit finally works up in price to 15 or so, its pattern tends tobecome less regular; it begins to depart from the smooth, narrow Saucer-like curve of the lowerlevels. Above 20, it is apt to break away entirely from the Scallop sequence and produce, from thereon, more rapid straight-line advances, interspersed with sharp reactions and standard types ofConsolidation Formations, which are characteristic at all times of medium- and high-priced issues.(There are exceptions: some high-priced preferred stocks for which there is always a market, butwhose trends depend almost entirely on the gradual changes in prevailing interest rates and supplyof funds for investment, have a persistent Scallop habit in their Primary Upswings.) We have named rather specific price levels (15 and 20) in the preceding paragraph, but price is notthe sole factor determining the departure of a stock from a Scallop Trend. The only safe assumptionis that, once such a habit is detectable, it will be continued until the chart shows a definitedivergence from it, and such divergence usually takes first the form 19 18 17 16 15 14 13 12 11 10 9 Sales 100's 50 40 30 20 10 Figure 11.18 There are times when a Consolidation Pattern gives the only good technical signalthat a Reversal in an issue's Primary Trend has actually taken place. Although cases of a MajorTurn, particularly a Bottom, without some sort of recognizable Reversal Formation on the chart arequite rare, they do occur. This weekly chart of Flintkote illustrates such a phenomenon. A BearMarket low, from which it rose to 47 in 1946, was made at 8 5/8 in December 1941. Withoutdeveloping any important technical foundation on either a daily or weekly chart, its first upswingtook it to 11 7/8 the following April. From that point, it went into a six-month Symmetrical Triangleand then broke out topside at the three-quarters stage on increased volume. This action, plus the factit immediately thereafter burst up through an old and highly significant Resistance Level at 12, wassufficient to mark it as being in at least a strong Intermediate if not a full Primary Uptrend. Thecombination of technical developments illustrated in this chart—a large Consolidation Patternforming just under a Major Resistance and then a breakout upside from both—is something towatch for when it appears a Reversal from a Bear to Bull Trend is due. Resistance Levels will bediscussed in Chapter 13. of a greater-than-wanted advance arising at the end of one of the Saucers. Consequently, if youhave previously taken a position in it at a favorable point (near the Bottom of a Scallop), you willunlikely be hurt when the stock finally alters its action. Very low-priced issues may persist in a Scalloping Trend right up to their Major Bull Tops, andeven attempt another Saucer Movement following what turns out to have been the final high, whichattempt then fails to carry out the previous successively higher and higher pattern. Such failures arenot difficult to detect; the change from the previous pattern appears before any appreciable damageis done to a properly assumed commitment. Modern versus old-style markets We have mentioned in our discussion of Reversal Formations that some of them have appeared lessfrequently in the charts of the 1960s than they did in prior years, and others more frequently. Thesame is true of Consolidation Formations. Patterns of the compact, strictly defined sort such asRectangles and Right-Angle Triangles are less common now. Symmetrical Triangles are apt to besomewhat looser than they were in the 1920s and 1930s—not as clean-cut and conspicuous on thecharts. Typical profit-taking patterns such as Flags and Pennants seem to be as common as ever,whereas “normal” trend pictures, including those formations associated with normal trenddevelopment (such as Head-and-Shoulders, Rounding Turns, and so on), are more common. The reasons for these changes are fairly apparent; Securities and Exchange Commission (SEC)regulations, higher margin requirements, greater public sophistication, and a more conservative—we might better say more pessimistic—approach to the problems of investment and stock tradinggenerally have all played a part in this evolution. SEC and Stock Exchange vigilance have doneaway with the flagrant pool manipulations designed to take advantage of the “lambs” of formeryears. Nowadays, there is even very little of the more “legitimate” sort of syndicate operationplanned to facilitate large-scale accumulation or distribution. It is still possible for “insiders” to hold back for a limited time, or to prematurely releaseannouncements of good or bad portent with regard to the affairs of a particular corporation to servetheir personal strategic purposes. But the stock purchase and sales of officers, directors, andprincipal owners are now too closely watched to allow a great deal of “skullduggery.”(Nevertheless, the average investor had better still be a trifle skeptical as to the probability of anygreat advance in the market following publication of a good report.) Collusion between investmentadvisory services and trading pools has been effectively outlawed. (It is safe to say it never did existas flagrantly, even in the 1920s, as many amateur traders seem to think.) The SEC (with thethorough cooperation of the Stock Exchange) polices the investment counsel profession thoroughly,constantly, and most effectively. No well-established investment counsel can afford to indulge indeceptive or collusive practices even if the desire were there. Most professionals go far beyond themost reasonable needs to safeguard themselves against any contacts that, however innocent oruseful, might be viewed with suspicion. The old-time “plunger” has not disappeared entirely, but high margins and regulations preventing“Bear Raiding” have made present-day stock markets relatively difficult and unprofitable for him.The out-and-out boardroom gamblers (EN: day traders rushing to and fro probably exacerbatesdaily volatility) still come in, although high margins have cramped them too. In recent years, theyhave appeared in numbers only in the final stages of Bull Markets. (EN: Note the day-trading crazethat infected the markets in the late 1990s.) Their operations never did affect the charts muchexcept to augment activity. On the other hand, higher taxes and greater regulation have most certainly not provided safer,closer, or more stable markets for the small investor. Higher margins have not prevented Panic Collapses. If anything, markets have been “thinner” on the downside, more vulnerable to rapid anddrastic decline than they were before modern regulation. We still have the very same sort of Bulland Bear Markets, and much the same sort of market trend development as 50 years ago. Thesurprising thing is not that a few types of chart patterns that were, on occasion, produced byunregulated trading are now less common, but rather that the great majority of technical phenomenahave been practically unaffected. The chart student of 1907 would be quite at home with the chartsof 1966. (EN: And with those Chapter eleven: Consolidation Formations 169 of 2000. That is why so little change has beennecessary to bring Edwards' classic account current to the third millennium. EN9: A note to a note.Pools and manipulators disappear and are replaced by some new pernicious form of skullduggery.Specialists and market makers are hauled before the bar of justice for cheating. In the twenty-firstcentury, hedge funds proliferate like rabbits in Australia. For any exacerbation of volatility theycause, they probably make up for in additional market liquidity. The same patterns keep appearingbecause, computers to the contrary notwithstanding, humans are eventually responsible for pullingthe trigger. It does seem that frequently patterns are not so neat as they were “in the old days.”Trendlines, especially horizontal lines, seem to be more “zones” than hard and fast lines and morejudgment might be necessary in interpretation. But everything that Edwards says here might havebeen written in 2005 instead of in the mid-twentieth century.) Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter twelve Gaps A gap, in the language of the chart technician, represents a price range at which (at the time itoccurred) no shares changed hands. This is a useful concept to keep in mind because it helps toexplain some of their technical consequences, which are illustrated in Figures 12.1 through 12.13. Gaps on daily charts are produced when the lowest price at which a certain stock is traded on anyone day is higher than the highest price at which it was traded on the preceding day. When theranges of any two such days are plotted, they will not overlap or touch the same horizontal level onthe chart; there will be a price gap between them. For a gap to develop on a weekly chart, it isnecessary for the lowest price recorded at any time in one week be higher than the highest recordedduring any day of the preceding week. This can and does happen, of course, but for obvious reasonsnot as often as daily gaps. Monthly chart gaps are rare in actively traded issues; their occurrence is confined almost entirely to those few instances in which a Panic Decline commences just before theend of a month and continues through the first part of the succeeding month. Which gaps are significant? From the earliest days of stock charting, gaps attracted attention. These “holes” in theprice trend graph were conspicuous. It was only natural that observers should attachimportance to them and should try to assign some special significance to theiroccurrence. But the result was unfortunate, for there soon accumulated a welter of“rules” for their interpretation, some of which have acquired an almost religious forceand are cited by the superficial chart reader with little understanding as to why theywork when they work (and, as is always the case with any superstition, an utterdisregard of those instances where they do not work). We refer to this situation asunfortunate not so much because the gap “rules” are wrong, but rather because theirblind acceptance has barred the way to a real understanding of a gap's implications andthe establishment of a more logical basis for its uses in trading. The most common superstition is that “a gap must be closed.” Sometimes it is statedmore cautiously in such words as follows: “If a gap is not closed in three days, it willbe closed in three weeks, and if it is not closed in three weeks, it will be closed in threemonths, etc.” There are numerous variations, but they all add up to the belief that a gapmust be closed and the trend is not to be trusted until the gap has been covered. It is thelatter inference that leads to error. Closing the gap But first, what is meant by “closing” or “covering” a gap? Suppose a stock in anAdvancing Trend moves up day after day, from 20 to 21, 22, 23, 24, and closes onenight at the top of its range for that day, at 25. The next morning it opens at 26 andkeeps right on moving up from there. This action leaves a 1-point gap, between 25 and26, on the chart. Then suppose the rise continues to 28, halts there and is followed by areaction in the course of which prices 16 15 14 13 12 11 10 Figure 12.1 The April-June Rectangle on this 1945 chart of "AW" contained a numberof insignificant Pattern Gaps. The two larger gaps marked “G” are of the Continuationor Runaway class. Note that prices closed at or near the top on each day that made agap; neither of these was closed for two years. slip to 28, and then halts there and is followed by a reaction in the course of whichprices slip back to 27, 26, and finally to 25. The return move has carried prices backthrough the gap area (25-26); the gap has thereby been covered or closed. In brief, agap is closed when a subsequent price trend comes back and retraces the range of thegap. Must a gap be closed before prices move very far away from it? Certainly not. Will itbe closed eventually? Probably, yes. If it is not closed by the next Minor Reaction,there is a chance it will be covered by the next Intermediate Retracement, and if notthen, pretty surely by the next great Major Swing in the opposite trend. But that maybe years later—hardly a matter of interest to the ordinary trader. The investor whobought Chesapeake and Ohio shares at 260 on October 21, 1929, counting on theclosing of the gap which that issue had made on the preceding Friday, 2 points downfrom 266 to 264, had to wait nearly seven years to get out even. Not until it neared theTop of the next Major Bull Market did CO attain an equivalent market value (65, sinceit was split 4-for-1 in 1930). In the meantime, he saw his investment shrink in 1932 toless than a sixth of his purchase price. As a matter of fact, there were hundreds of gaps made in the charts of the 1929-1930 markets that never have been covered since then,and many of them, it is safe to say, never will be closed. If you will think the matter over for a moment, you will see that the probabilities wehave stated above for a gap's being closed apply just as well to a stock's returning toany price range at which it has once been traded, gap or no gap. 120 112 104 Sales 100's 250 200 150 100 50 BETHLEHEM STEEL ii BS 1937 Gt APRIL MAY JUNE JULY AUGUST SEPTEMBER 3 10 17 24 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 4 11 18 25 Figure 12.2 The large up-gap made on July 5 in this chart was a typical BreakawayGap, occurring as prices broke out of the complex base for the July-August SecondaryRecovery. (Compare this chart with Figure 7.14.) Another type of Breakaway Gap—through a trendline—occurred on August 26. That of September 7 was primarily due to the “ex-dividend,” whereas that of September 18 was still another type of breakaway—through a Support Level. The first gap marked, on April 26, must be classified as aRunaway; it made a sort of an “Island” of the whole April-June complex base. Another point: there are thousands of price gaps made in trading—some of them quitewide—that do not appear at all on the standard daily range charts because they aremade during a single day and not between one day's closing and the next day'sopening. Such intraday gaps are ordinarily overlooked entirely; the gap theorists areoblivious of them, although their significance is often greater than that of manyinterday gaps. Practically every emphatic breakout move from a strictly definedRectangle or Right-Angle Triangle is attended by a gap, but only those few show up onthe charts that occur at the day's opening gong. If we seem to have “protested too much” in the foregoing, it is only because we wantour readers to study this topic with an open mind, free from preconceived notions as toany mystic qualities that gaps may possess. Turning to the other side of the picture,some gaps have technical import. Some gaps are useful to the chart analyst inappraising trend possibilities. Let us see what we can make of them. 26 24 22 20 19 18 17 16 15 14 13 12 11 10 9 8 Sales 100's 500 400 300 200 100 ZENITH RADIO jG S rM H Figure 12.3 A potent Breakaway Gap that showed on Zenith's weekly chart when itbroke out of a Head-and-Shoulders Bottom in early 1942. Note high volume developedbeyond the gap, suggesting it would not be quickly closed. The April reaction stoppedshort of it. In fact, this gap still had not been closed in 1956, more than 14 years later. Ex-dividend gaps First, however, we must eliminate from consideration the gaps that do not meananything. An eighth-point gap obviously has no technical significance as it representsonly the minimum permitted change in price. By the same token, a gap of a quarter ofa point or even a half point in a high-priced stock, such as Norfolk & Western (beforethe split), represents only a normal, in fact tight, spread between successive bids. Inbrief, to carry interest for the chart technician, a gap must be wider than the usualchanges in price that occur under normal or prevailing trading conditions. A secondclass of gaps that have no forecasting implications are those formed consistently andhabitually by “thin” issues in 40 30 20 10 1936 | 1937 | 1938 | 1939 | 1940 | 1941 | 1942 1943 | 1944 1945 [ 1946 Figure 12.4 As a matter of interest, this monthly chart of Zenith Radio is reproducedfor comparison with Figure 12.3. The Head-and-Shoulders Bottom is easily seen. the medium- and high-price brackets. You can spot them easily; if your chart of acertain issue shows numerous gaps as a regular thing, then no one of them is apt tomean anything special. Finally, gaps that appear on the charts when a stock goes ex-dividend (whether thedividend be in cash, stock, rights, or warrants) possess no trend implications. They areoccasioned not by a change in the Supply-Demand relation that governs the trend, butrather by a sudden and irreversible alteration in the actual book value of the issue. Also of interest in this chart is the Descending Triangle, which started to form inMarch, but it was never completed—a deceptive and discouraging picture until theApril 7 gap was made. The Flag of mid-April “measured” the move from 9 1/2 to 14. The gaps measured thetwo halves of it, on either side of the Flag. Eliminating the technically meaningless types named above, we are left with the gapsthat occur infrequently (and that are not occasioned by an ex-dividend change in value) in issues that are so closely and actively traded as ordinarily to produce “solid” charts.A 1-point gap, for example, in the chart of New York Central would be an unusualevent; it would demand attention and presumably have some forecasting significance. Such gaps, for the purposes of our study, may be divided into four classes: Common orArea Gaps, Breakout Gaps, Continuation or Runaway Gaps, and Exhaustion Gaps. The common or area gap This type of gap gets its name from its tendency to occur within a trading area or PriceCongestion Pattern. All of the Congestion Formations we have studied in the precedingchapters—both Reversal and Consolidation types—are attended by a diminution intrading turnover. The more strictly defined sorts—the Triangles and Rectangles—show BLAW - KNOX 30 28 26 24 Sales 100's 125 100 75 50 25 F EBRUARY .......M ARCH .......APR ’ 9 16 23 2 9 16 23 30 6 13 2C 4 11 18 25 8 15 22 29 13 20 27 Figure 12.5 The early 1946 daily chart of Blaw-Knox contained a number ofinteresting technical features. Its spurt from 19 to 25 in December 1945 was followedby a nine-week Rectangle Consolidation, the end of which appears in the chart above.Prices erupted from this Rectangle on February 11 with a typical Breakaway Gap. Fourdays later, another gap appeared on even greater volume, and prices closed at the top ofthe day's range. This looked like a Runaway Gap, in which case continuation to 32 wasimplied according to the “rule” stated above. (Note the Rectangle “measurement”called for only 31.) On the following day, however, a One-Day Reversal, from 31 backto 30, appeared and the next session closed the February 15 gap, which now had to berelabeled, tentatively, as an Exhaustion Gap. Prices subsequently dropped back to thesupport of the nine-week Rectangle, rallied grudgingly along an establishedIntermediate Up Trendline, and broke that on April 24 to return again to the 25 support.In May, another advance took “BK” up once more to 30, where it bumped against thepreviously broken trendline. That was its last effort; in late July, the “valley” level at25 was penetrated and a Major Double Top had been completed. To return to theFebruary 15 gap, this is fairly typical of many cases in which it is impossible to saywhether Continuation or Exhaustion is being signaled until two or three days after theday the gap is made. this characteristic most conspicuously. Moreover, activity in these patterns tends to beconcentrated pretty much at or near the top and bottom edges, their Supply andDemand Lines, while the area in between is a sort of “no-man's land.” It is easy to see,therefore, why gaps develop frequently within such areas. You will find numbers ofgood examples of Pattern Gaps in the charts illustrated in Chapters 8 and 9. Such Pattern Gaps are usually closed within a few days, and for obvious reasons,before the Congestion Formation in which they have appeared is completed and pricesbreak away from it, but not always. Sometimes a gap will develop in the last traverseof prices across the pattern area just before a breakout, and in such cases, it is notclosed for a long time, nor is there any reason why it should be. The forecasting significance of Common or Pattern Gaps is practically nil. They havesome use to the technician simply because they help him recognize an Area Pattern—that is, their appearance implies a Congestion Formation is in the process ofconstruction. If, for example, a stock moves up from 10 to 20, drops back to 17, and then returns to 20, making a gap in the course of that rally, it is a fair assumption thatfurther pattern development will take place between approximately 17 and 20. This is aconvenient thing to know and may, on occasion, be turned to profit in short-termtrading policy. Pattern Gaps are more apt to develop in Consolidation than in Reversal Formations.Thus, the appearance of many gaps within an evolving Rectangle or SymmetricalTriangle BALTIMORE & OHIO BO Sales :S ; 100's °™ 250 KJ 200 .....I 150 ....... 100 ...... 50 ...... S' OCTOBER .ilJi.ulilu liui.n.dli.nii.ii.i. ■VEMBER DECEMBE FEBRUARY MARCH 13 110117'24'31'7 ;14-21'281 5 l12'19'2612 1 9 116!23'301 6 113'20 271 6 l13!20'27' Figure 12.6 This is a good example of a Runaway Gap that performed according torule. After reacting from 26 1/4 in late 1936, “BO” formed a Head-and-ShouldersBottom (the left shoulder was a Triangle) and broke out of it on February 6, 1937. Asmall Flag formed immediately thereafter, calling for 28. At that level, another Flagdeveloped which signaled 30 1/4 or better. As prices reached this latter goal, however,a gap was made, on March 3, on extraordinary volume. The next two days confirmed this to be a Runaway or Continuation Gap. As such, it implied further advance(measuring from the Head-and-Shoulders neckline) to 37 plus. “BO” made its BullMarket high at 40 1/4 on March 17. The measuring-gap rule should be used forpurposes of “getting out” rather than “getting in.” It does not guarantee a move willcontinue to the implied limit, but it does give assurance the move is near an end whenthe rule has been fulfilled. reinforces the normal expectation that the pattern in question will turn out to be aConsolidation rather than a Reversal Area. Breakaway gaps The Breakaway type of gap also appears in connection with a Price CongestionFormation, but it develops at the completion of the formation in the breakaway move.Any breakout through a horizontal pattern boundary, such as the Top of an AscendingTriangle, is likely to be attended by a gap. In fact, it is safe to say that most of themare. And, if we consider what goes on in the market to create a Flat-Topped PriceFormation, it is easy to see why Breakaway Gaps should be expected. An AscendingTriangle, for example, is produced by persistent demand for a stock meeting a largesupply of it for sale at a fixed price. Suppose that supply is being distributed at 40.Other holders of the stock, who may have intended originally to liquidate at 40.5 or 41,see quotations come up to 40 time after time, stop there, and turn back. They tend, inconsequence, either to join the crowd selling at 40, 48 44 40 38 36 34 32 30 28 26 24 22 20 19 18 17 Sales 100's 250 200 150 100 50 Figure 12.7 Panic Declines often produce large Runaway Gaps. The September 7 gapin this chart, judged by its size, volume, subsequent action, and the fact that it wasmade in “new low ground,” marked it as being of the measuring type. The implied goalwas 26 or below. All other gaps in this chart were obviously of the “common” variety. or else to figure that once through 40, prices will go much higher; they may eitherlower or raise their selling price. The result is a “vacuum” on the books, a dearth of offerings in the price range immediately above the pattern. Hence, when the supply at40 in our Ascending Triangle example is finally all absorbed, the next buyer of thestock finds none offered at 40.125 or 40.25 and he has to bid up a point or more to gethis shares, thus creating a Breakaway Gap. As we remarked earlier in this chapter, gaps of this type actually occur on almost everydecisive breakout from a Horizontal Congestion, although many of them do not showon the charts because they occur during a day and not between one day's close and thefollowing day's opening. Breakaway Gaps also develop at times when prices move outof other types of Reversal or Consolidation Formations; they are not uncommon inconnection 19 18 17 16 15 14 13 12 11 10 9 8 7 Sales 100's 500 400 300 200 100 1944 WILLYS - OVERLAND WO JULY AUGUST SEPTEMBER 8 15 22 29 6 13 20 27' 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 30! Figure 12.8 The "skyrocket" run-up of Willys-Overland in June 1944 was marked by anumber of small gaps. The first two were too small to have much technicalsignificance. The larger gap made June 16 was marked by the "stickiness" of prices onthat day as Exhaustion. A small Flag Consolidation ensued. The June 27 gap also actedlike an Exhaustion Gap insofar as price action was concerned, but volume had declinedinstead of climbing to a new peak. On June 28, prices jumped away again, so the June27 gap was marked as another Runaway with an implied objective of 18 1/4 plus,which had already been reached. Note the Head-and-Shoulders Reversal that formedand the subsequent Intermediate Reaction. with Head-and-Shoulders Patterns, for instance, and they even occur on the penetrationof trendlines, which we shall discuss in a subsequent chapter. What forecasting value can we ascribe to them? First, they serve to call attention to,and emphasize the fact of, a breakout. There can be little doubt that a genuine breakouthas eventuated when prices jump out of a pattern with a conspicuous gap. False movesare seldom attended by gaps. Second, they carry the suggestion that the buying demand(or selling pressure, as the case may be) that produced the gap is stronger than wouldbe indicated by a gapless breakout. Hence, it may be inferred the ensuing move willcarry 48 44 40 38 36 Sales 100's 50 40 30 20 10 Figure 12.9 “SMC” is a thin stock whose daily chart is usually “full of holes,” but thislarge gap that appeared on its weekly chart in September 1946 evidently possessedtechnical significance. Treated as a Runaway measuring from the eight-weekCongestion at 68, it called for a downside objective of 44 or below, which was dulyfulfilled. 40 38 Sales 100's 50 40 30 20 10 Hlttf SHL,:::::: III 1 A. O.SM ■aHSSHT 1ITH . CO1RPOI>A’I4OI< SMC It-#: g..:::: b 1 rid1: rwmmWas J n 1 iFmj}gi ■■::"I: :iii i i w •u :::H 1 :?: ::|i S•:$ liu g=:|: oiw:ffll Bl! :::::i a :::::::::::::::: ..... HutHui UM. .7 : l|» ; ;j •;G M B II "-f ; : " I TI mj » It ■p Sr ' ll 1945-947 M ^IJi 1 J 1 Set T *| IS 1 r pppp: ss 4|||+ t - it I » TT H fOl ::::: Ptff•• J:5 mtmt Sw rrrn ■:•1 J Htt;::ii .= ■rg£gg 11 ihi Siiffi, :uiah iis 4r......■ : L II lillr II f jttW 1 With illh s nt H MlTi i i ill ri tt,II N D1 - ■ F' MA 1 M 1 ’ J ' A ■ 1 O N ' D T T ' M 1 A ' M 1946 laaaagi!! JANUARY FEBRUARY MARCH APRI MAY JUNE 5 12 19 26 2 9 46 23 2 : 9 16 23 30 6 13 20 27 4 11 18 251 8 15 22 29' Figure 12.10 A small Island in the right shoulder of the Head-and-Shoulders Top thatmarked this issue's Major Reversal. The Island served only to emphasize the chart'sBearish implications. Figure 12.11 Island “shakeouts” are not uncommon in “thin” stocks. Why they shoulddevelop as they do is hard to explain, but their forecasting implications are obvious. prices farther or faster, or both. It does not do to make too much of this point; it is alogical inference and one that has been borne out in the majority of cases, but it has itsexceptions and may prove most disappointing on occasion. Nevertheless, other thingsbeing equal, of two stocks that emerged from Ascending Triangles at the same time,we should choose to buy the one that gapped out over the one that pushed its way outby small fractional steps. Except for the presumption of somewhat greater “steam” behind the move, theBreakaway Gap carries no particular measuring implication, nor any other forecastingsignificance. The next question is this: should we expect a Breakaway Gap to be closedwithin a relatively short time? Or, to put the question in more practical and pragmaticterms: should we defer buying in the expectation that it will be closed before anyworthwhile move develops? To give a fair answer to that question, it is necessary to scrutinize the volume oftransactions before and after the gap. If a great many sales were recorded at the takeofflevel from which prices jumped the gap, but relatively few as prices moved away fromthe far side of the gap, then there is a chance—perhaps about 50-50—that the nextMinor Reaction will carry prices back to the edge of the pattern of origin, thus fillingthe gap. On the other hand, if high volume developed at the far side of the gap, and a great many transactions took place there as prices moved on away from the gap, thenthe chances are remote that any near-term Throwback will close the gap. In such cases,a Throwback reaction is almost always stopped at the outside of the gap. (One is constantly tempted in a work of this sort to employ the words always or neverwithout qualification. Unfortunately, the authors have never been able to discover arule of techniques to which the market did not, on rare occasion, produce an exception.It is always necessary to be on guard against such exceptional developments. Many ofthem are caused by general market conditions that counteract the technical trend inindividual issues. Keep an eye on the charts of the “Averages,” as well as the particularissues in which you are interested.) Where Breakaway Gaps develop intraday, the daily chart cannot, of course, indicatehow the day's volume was distributed. In that event, it may be necessary to examinethe 128 120 112 104 96 88 80 76 72 68 64 60 56 Sales 100's 250 200 150 100 50 FEBRUARY MARCH Ulilllliimilj APRIL 2 9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 Figure 12.12 This Island Reversal Pattern at Bethlehem Steel's Major Top in 1937 is a“classic,” yet it was followed by a curious and disturbing abnormality in the strongrally that developed on March 30. Those who sold out on the Island's signal around 95on March 19 or 20 were startled, and, if they had also sold short, justifiably alarmedwhen prices jumped up a week later, not only through the second gap level but wellabove it. But eventually, as can be seen, everything worked out according to theoriginal forecast. This incident will illustrate a general principle: when a clear-cuttechnical pattern of unquestionable significance has been completed on your charts, donot let some apparently contrary development that occurs shortly thereafter lead you toforget or neglect the previous plain signal. Give such situations time to work out.Figure 12.2 shows the sequel to the above chart and, incidentally, another Island.Compare the volume. ticker tape or ask your broker to refer to the published record of individual transactionsto which most brokerage firms subscribe. (EN: This data may now be easily obtained.See Appendix D, Resources. EN9: Candlestick charts, now much in use, will allow theanalyst to see the intraday breakaway gap.) Lacking any clear-cut volume clue, it issafest to figure that a Breakaway Gap will not be filled until long after the full moveimplied by the pattern of origin (usually a move of Intermediate Extent in the Dowsense) has been carried out. Continuation or runaway gaps and the measuring rule Less frequent in their appearance than either of the two forms we have discussedabove, gaps of the Continuation or Runaway type are of far greater technicalsignificance because 44 40 38 36 34 32 30 28 Sales 100's 125 100 75 50 25 1936 GE GT PENN SYL .VANIA RAILROA D JULY AUGUST SEPTEMBER- OCTOBER NOVEMBERDECEMBER ■4 11 18 25' 1 8 15 22 29 5 12 19 26 3 '10 17 24 31 7 14 21 28 5 12 19 26 Figure 12.13 This looked like an Island in “PA,” but the second gap was actuallyattributable to a $0.50 dividend which went ex on November 20 and, therefore, had tobe discounted technically. Due to this dividend, it was necessary to lower the SupportLine at 40 (see Chapter 13) by half a point. That Support, therefore, was not violated inDecember and prices subsequently advanced to above 50 the following March. TlTiSfBres20*YewTreaaryitarfETf HjseieW etedOiftain 27-t«id7W Open';;;, L«wi2SuL«tiae7IMreuuCIH - IS (*122»> Cd 9 « 23 St kl I 13 20 27 Dec4 11 IS » 2011 Figure 12.14 TLT shown here in computer notation produces gaps in profusion. As thereader can see, if one just traded in the direction of the gap many short-term scalpswould be garnered. This chart also lends perspective to the hand drawn charts. A gap isa gap is a gap. they afford a rough indication of the probable extent of the move in which they occur.For that reason they have sometimes been called “Measuring” Gaps. Both the Common or Pattern Gap and the Breakout Gap develop in association withPrice Formations of the Area or Congestion type, the former within the formation andthe latter as prices move out of it. The Runaway Gap, on the other hand, as well as theExhaustion Gap, which we will take up later, is not associated with Area Patterns, butoccurs in the course of rapid, straight-line advances or declines. When a dynamic move starts from an area of accumulation, the upward trend of priceswill seem often to gather “steam,” to accelerate for a few days, perhaps a week ormore, and then begin to lose momentum as supply increases when the very extent ofthe advance invites more and more profit-taking. Trading volume jumps to a peak on the initial breakout, tapers off somewhat in the middle of the advance, and then leapsup again to a terrific turnover as the move is finally halted. In such moves—and inrapid declines of corresponding character—a wide gap is quite likely to appear at thetime when the Runaway is at its height, when quotations are moving most rapidly andeasily with relation to the volume of transactions. That period comes normally at justabout the halfway point between the breakout that inaugurated the move and theReversal Day or Congestion Pattern that calls an end to it. Hence, a Continuation orRunaway Gap affords an approximate measurement of the move in which it develops.Its inference is that prices will go as much farther beyond the gap as they already havegone between the beginning of the move and the gap, as measured directly (andvertically) on the chart. Since there is a tendency for advances to run, in terms of points, beyond the pricelevels arithmetically implied by this rule, and for declines to be more strictly limited,the gap-measuring rule works out particularly well when applied directly onsemilogarithmic scale charts. On arithmetic charts, look for a trifle more on the upsideand a trifle less on the downside. (In any event, you will be wise to “bank” onsomething short of the theoretical goal.) Runaway Gaps are easy to find and identify in retrospect, but our task is to recognizethem as such at the time they appear; there is no danger of confusing them with Patternor Breakout Gaps. With those aside, any gap that shows up in a fast advance or declineafter prices have moved well away from an Area Formation (or the penetration of animportant trendline or break through a potent Support or Resistance Level, which weshall discuss later) may be a Runaway Gap. What then becomes necessary is todistinguish it from our next type, the Exhaustion Gap. Usually, the price and volumeaction on the day following the gap furnishes the evidence required for a safediagnosis. Two or more runaway gaps It will be much easier to bring out the characteristics distinguishing Runaway andExhaustion Gaps when we take up the latter in detail. Before doing so, we mustmention those cases in which two and, rarely, even three gaps intervene in a fast moveand are evidently all classifiable as of the Continuation or Runaway breed. It does nothappen often and is particularly unlikely to appear in the chart of a fairly large andactive issue, but one of the thinner stocks in the midst of a “skyrocket” move may goskipping along for three or four days, making gaps between each successive pair. Theonly question of practical importance that arises in such cases is this: where should thehalfway measuring point be located? No quick and easy rule can be laid down, butstudious inspection of the chart, especially of the volume trend, will usually afford ananswer. Remember that halfway in these fast moves tends to come at the stage at which prices are moving most easily and rapidly with respect to the number oftransactions recorded (hence the tendency to gap). If there are two gaps, the halfwaystage may very likely have been reached somewhere between them. Inspect your chartcarefully and try to “average” the picture mentally; look for what appears to be thecenter of “thinness” and use that for your measuring level. But remember also thateach successive gap brings the move inevitably nearer to Exhaustion, so let yourjudgment lean to the conservative side; do not expect too much of the second or thirdgap. Exhaustion gaps The Breakout Gap signals the start of a move; the Runaway Gap marks its rapidcontinuation at or near its halfway point, and the Exhaustion Gap comes at the end.The first two of these are easily distinguished as to type by their location with respectto the preceding price pattern, but the last is not always immediately distinguishablefrom the second. Exhaustion Gaps, like Runaway Gaps, are associated with rapid, extensive advances ordeclines. We have described the Runaway type as the sort that occurs in the midst of amove that accelerates to high velocity and then slows down again and finally stops asincreasing Resistance overcomes its momentum. Sometimes, however, “skyrocket”trends evidence no such gradual increase of Resistance as they proceed, showing notendency to lose momentum, but rather continue to speed up until, suddenly, they hit astone wall of supply (or, in cases of a decline, demand) and are brought to an abruptend by a day of terrific trading volume. In such moves, a wide gap may appear at thevery end, that is, between the next to the last and the last day of the move. This gets thename of Exhaustion Gap because the trend seems thereby to have exhausted itself inone final leaping spurt. The best test of whether a gap formed in a rapid, straight-line advance or decline is ofthe Continuation or Exhaustion type comes on the day after the gap (more precisely,the day that makes the gap), although there are frequently other clues in the precedingchart picture. If trading activity mounts to an extraordinary height during the sessionfollowing the gap, and particularly if the previous trend in prices does not appear to becarried along at a pace commensurate with that day's activity, the gap is probably ofthe Exhaustion class. This interpretation is reinforced, in fact, made a virtual certainty,if the day after, the gap develops into a Reversal Day (as described in Chapter 10) withthe closing price registered back near the edge of the gap. Evidence that may be derived from the chart anteceding the gap may be enumerated asfollows: If the trend has already carried out the full implications of the price formationor Congestion Area from which it emerged, Exhaustion is more likely than Continuation. By the same token, if the reasonable measuring implications of thepattern of origin are still far short of attainment, the gap is probably of theContinuation type. An Exhaustion Gap is seldom the first gap in a runaway move; it isusually preceded by at least one Continuation Gap. Thus, you may ordinarily assume(unless the contrary appears from other and weightier indications) the first gap in arapid advance or decline is a Continuation Gap, but each succeeding gap must beregarded with more and more suspicion, especially if it is wider than its predecessor. We have referred to Exhaustion Gaps as wide gaps. Width is, of necessity, relative inthis study; it is impossible to lay down any exact rules to define wide or narrow. Do notlet this bother you too much. Recognition of what constitutes an unusually wide gapfor the particular stock you have under observation soon comes with a little chartingexperience. Runaway Gaps are usually not covered for a considerable length of time, as a rule, notuntil the market stages a swing of Major or full Intermediate proportions in theopposite direction. But Exhaustion Gaps are quickly closed, most often within two tofive days, a fact that furnishes a final clue to distinguish Exhaustion fromContinuation, if it should still be needed at that stage. This, incidentally, upsets thecommon superstition that all gaps must be closed before the trend can be trusted tocontinue very far. In the case of the Runaway Gap, it is not closed, but the trend movesright along, nevertheless, and often for a surprising distance. In the case of theExhaustion Gap, the closing of it actually contributes to the signal the trend has runout. An Exhaustion Gap, taken by itself, should not be read as a sign of Reversal, or even,necessarily, of Reversal at all. It calls “stop,” but the halt is ordinarily followed bysome sort of area pattern development that may, in turn, lead to either Reversal orContinuation of the move before the gap. In practically every case, however, enough ofa Minor Reaction or delay ensues from the formation of an Exhaustion Gap before anew trend is established to warrant closing out commitments at once. (One can alwaysreenter if it subsequently appears that the previous trend is to be resumed.) The Island Reversal We mentioned (at the end of Chapter 10) a Reversal Pattern, the Island, which was tobe taken up under the general study of gaps. The Island Pattern is not common and it isnot, in itself, of major significance in the sense of denoting a long-term Top or Bottom,but it does, as a rule, send prices back for a complete retracement of the Minor Movethat preceded it. An Island Reversal might be described as a compact trading range separated from themove that led to it (and that was usually fast) by an Exhaustion Gap and from the move in the opposite direction that follows it (and that is also equally fast, as a rule) by aBreakaway Gap. The trading range may consist of only a single day, in which event itnormally develops as a One-Day Reversal, or it may be made up of from several daysto a week or so of Minor Fluctuations within a compact price zone. It is characterized,as might be expected, by relatively high volume. The gaps at either end occur atapproximately the same level (they should overlap to some extent) so that the wholearea stands out as an Island on the chart, isolated by the gaps from the rest of the pricepath. We have said an Island does not, of itself, appear as a Major Reversal Formation, butIslands frequently develop within the larger patterns at turning points of Primary orimportant Intermediate consequence, as, for example, in the head of a dynamic Head-and-Shoulders Top. By the same token, they appear occasionally at the extremes of theMinor Swings that compose a Triangle or a Rectangle (in which event, the gaps that setthem off are really better classified as Common or Pattern Gaps). The reasons why Islands can and do develop—in other words, why gaps can and dorepeat at the same price level—will be more apparent when we take up the generalsubject of Support and Resistance in a later chapter. Suffice it to repeat at this pointthat prices can move most rapidly and easily, either up or down, through a range wherelittle or no stock changed hands in the past, where, in other words, previous ownershave no “vested interest.” Sometimes the second gap—the Breakaway that completes the Island—is closed a fewdays later by a quick Pullback or reaction. More often it is not. Rarely, the first gap—the Exhaustion Gap that starts the Island—is covered in a few days before the secondgap appears, in which event the Island Congestion takes on a sort of V-Shape (if it is aTop), and there is no clear “open water” across the chart horizontally between theIsland and the trends preceding and following it. Yet, in any of these variations, theinterpretation remains the same: the preceding Minor Move should be practicallyretraced. An Island Pattern is not easy to trade on unless it be for a short-term “scalp,” as,obviously, a good share of the retracement already may have been accomplished by thetime the Island is charted and an order to buy or sell on its indications can be executed.If the entering gap is recognized as an Exhaustion Gap, the trader who is interested inthe stock presumably will take action before the second gap forms and before theIsland is in evidence. Perhaps the greatest utility that Islands have for the chart analystis that of calling attention to a situation of putting him on the alert as to itspotentialities. Gaps in the Averages Gaps appear also in nearly all Averages but, for obvious reasons, with rather lessfrequency than in the charts of individual issues. Although it is not necessary for all ofthe stocks composing an average to make a gap simultaneously to produce a gap in theAverage figures, a majority of them must. As might therefore be expected, Common orPattern Gaps are particularly rare in Average charts, but Breakaway and Runawaytypes are not uncommon, although they are small as compared with the size of suchgaps in single stocks. Exhaustion Gaps, and, in consequence, Islands, again are rare.The conditions that create an Exhaustion Gap seldom develop in a sufficient number ofindividual issues at any one time to produce a counterpart in the Averages. The technical interpretation of gaps in Averages is, in the main, the same as in singlestocks. The authors have not found that an Average gap possesses any peculiar potencyor significance over and above that attributable to a gap in the chart of any actively andclosely traded single issue. The broader, and hence, most representative market indexes show the fewest andsmallest gaps. EN: On the other hand, the NASDAQ is quite volatile and a good gapproducer. It is suggested the reader review this chapter after he has finished studying theprinciples of Support and Resistance in Chapter 13. (EN9: The truth is there is nothingmore that need be said about gaps, and the truth also is that no modern examples needbe added. But gaps are fun, so see Figure 11.11 and Chapter 16 for modern examples.) Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter thirteen Support and Resistance As illustrated by Figures 13.1 through 13.12, the phenomena we shall study in this chapter aremarkedly different in kind from those discussed in preceding sections. We shall look at the stockmarket from a new angle and, in so doing, may find it possible to develop some very practicaladditional rules to guide us in selecting stocks for purchase or sale, in estimating their potentialmoves, and in foreseeing where they are likely to “run into trouble.” As a matter of fact, someexperienced traders have built their “systems” almost entirely on the principles of what we callSupport and Resistance, paying no attention to the specific pictorial patterns of price and volumeaction we have been investigating in preceding pages. Support and Resistance phenomena are not, by any means, unrelated to the various patterns andformations previously studied. We have already had occasion to hint at a basic principle of Supportand Resistance in our explanation of gaps, and, as you read on, you will find a number of the otherpatterns of price behavior are explained thereby, or at least become more readily understood. The term Support is commonly used in the Street. In one or more of its connotations, it must befairly familiar to the reader. For example, we may hear such-and-such a crowd is supporting XYZ at50 or is prepared to support the market by buying all stock offered on any 5-point concession. Forthe purposes of this chapter, we may define Support as buying, actual or potential, sufficient involume to halt a downtrend in prices for an appreciable period. Resistance is the antithesis ofSupport; it is selling, actual or potential, sufficient in volume to satisfy all bids and, hence, stopprices from going higher for a time. Support and Resistance, as thus defined, are nearly but not quitesynonymous with demand and supply, respectively. A Support Level is a price level at which sufficient demand for a stock appears to hold a downtrendtemporarily at least, and possibly reverse it, that is, start prices moving up again. A Resistance Zone,by the same token, is a price level at which sufficient supply of a stock is forthcoming to stop, andpossibly turn back, its uptrend. There is, theoretically, a certain amount of supply and a certainamount of demand at any given price level. (The relative amount of each will vary according tocircumstances and determine the trend.) But a Support Range represents a concentration of demand,and a Resistance Range represents a concentration of supply. According to the foregoing definitions, you can see the top boundary of a Horizontal CongestionPattern such as a Rectangle is a Resistance Level, and its bottom edge is a Support Level; the topline of an Ascending Triangle is unmistakably a Resistance Level, and so on. But we are moreinterested now in the reasons why Support or Resistance, as the case may be, can be anticipated toappear at certain price ranges. Within reasonable limits, and with a certain few exceptions to beexamined later, it is quite possible to do this. Expert chart readers are frequently able to make someamazingly accurate predictions as to where an advance will encounter Resistance (supply) or wherea declining trend will meet Support. The basis for such predictions—the elementary data from which Support and Resistance theories arederived—is that turnover in any given issue tends to be concentrated at the several price levels atwhich a large number of shares changed hands in times past. Since any level at which a greatvolume of transactions takes place usually becomes a Reversal point (Major, Intermediate, or Minor)in that stock's trend, it follows naturally that Reversal Levels tend to “repeat.” However, here is theinteresting and the important fact that, curiously enough, many casual chart observers appear never to grasp: these critical price levels constantly switch their roles from Support to Resistance and fromResistance to Support. A former Top, once it has been surpassed, becomes a Bottom zone in asubsequent downtrend; and an old Bottom, once it has been penetrated, becomes a Top zone in alater advancing phase. Normal trend development Perhaps we can make this plainer by citing a typical example of normal trend development. Supposea stock in a Bull Trend moves up from 12 to 24, and there runs into a large volume of selling. Theresult is a reaction that may take the form of a full Intermediate Correction to, say, 18, or a series ofMinor Fluctuations forming a Consolidation Pattern between, say, 24 and 21, the effect being thesame in either case. Following this Correction or Consolidation, a new advance gets under way andcarries the price on up to 30 before running again into supply in sufficient concentration to stifle themove. Now another reaction is evidently due. Again, it may take the form of a sidewaysConsolidation Pattern or an Intermediate Correction. If the latter, where will that corrective setbackbe reversed, or in other words, will it meet Support? The answer is at 24, the level of the first Top inthe trend. That is the level (below current quotations) where a large turnover had previouslyoccurred. Then it functioned as Resistance, producing a halt or Reversal in the first upswing; now itfunctions as Support, stemming and reversing, at least in a Minor sense, the latest downswing. Why should this be? It will be easier to suggest an answer to that question if we first go on with asimilar example of typical action in a downtrend. This time, suppose our stock makes a Major Topand declines from, say, 70 to 50. There, at 50, a temporary Selling Climax occurs; there is a largeturnover, prices rally, perhaps slip back for a “test” of 50, and then stage a good recovery to 60. At60, buying peters out, the trend rounds over, turns down, and accelerates in renewed decline, whichcarries to a new low at 42. Again, a wave of buying comes in and a second recovery swing getsunder way. We can confidently expect this recovery (from 42) will run into strong Resistance at 50.The price level that functioned as a Support for the first phase of decline, now that it has beenbroken through the downside by the second phase, will reverse its role and function as Resistance tothe second recovery move. The former Bottom level will now become a Top level. Here, we may ask again why this should be so, and now we can suggest an answer. In the exampleof downtrend action cited in the preceding paragraph, our stock first dropped to 50, ran intoconsiderable volume there, reversed its trend, and rallied to 60 with activity dwindling on the rise. Alot of shares changed hands at 50, and for every seller there was a buyer. A few of those buyers mayhave been covering short positions and, having done so, had no further interest in the issue. Othershort-term traders and professionals may have purchased simply because they sensed a temporaryBottom in the making and hoped to scalp a few points on the ensuing rally; presumably, they (or atleast some of them) took their profits and were out before prices broke very far on the next decline.But a majority of those who acquired shares at 50, it is safe to say, did so because they thought thestock was cheap at that price, figuring it had gone low enough. Only a few months ago, it was sellingabove 70; surely, it was a bargain at 50 and could be picked up and put away “for the long term.” The explanation Imagine yourself, for the moment, in the place of those new owners. They see prices turn up, reach55, 58, 60; their judgment appears to have been vindicated. They hang on until the rally peters outand prices start to drift off again, slipping to 57, 55, 52, and finally 50. They are mildly concernedbut still convinced the stock is a bargain at that price. Most likely, there is momentary hesitation in the decline at 50 and then prices break on down. Briefly, there is hope the break is only a shakeout tobe recovered quickly, but that hope vanishes as the downtrend continues. Now our new ownersbegin to worry. Something has gone wrong. When the stock gets down below 45, the former bargaindoes not look so good. “Well, I guess I picked a lemon that time, but I won't take a loss in it. I'll justwait until it gets back up to 50 some day where I can get out even (except for expenses), and thenthey can have it.” (Does this sound familiar, by any chance?) We can skip over the next few swings that “followed the rules” and go on to the change in thepicture, which came with the first notable violation of a Support Level in 1946. Prices had pushed upthe first of February nearly to 54, well out above the Tops around 46, which formed the previousNovember. The late-February reaction should have “caught Support” I 1944 I 1945 I 1946 I 1947 ! Figure 13.1 Why now was so much time spent and "work" done during mid-1945 under 33-34? Wecannot see it on this chart, but the previous monthly history shows that the Bottoms of longCongestion Areas were made in this zone in late 1939 and late 1940. These old Bottoms,representing Support, originally, were able to produce some supply (Resistance) five years later.Once prices had worked through that supply, however, they were able to rise quickly to 44, and thentheir subsequent reaction found Support just where you might have expected—at 33-34. Support hadturned to Resistance and then to Support again. around 46—but it did not; it crashed on down to the “round figure” 40. This was an ominous(although not necessarily “fatal”) development. Thereafter, a massive Symmetrical Triangle was formed and broke downside in September. The first Panic Decline in the Bear Market is no respecter of Support Levels. This one was noexception, although it is noteworthy that prices “bounced” several times from the important old 33-34 zone. By November, the Top Triangle's measurement had been exactly fulfilled. (You should turnback to this record and study it again after you have read further in this chapter.) Take the opposite side of the picture—the uptrend process. You, along with many others, boughtXYZ at 12, carried it up to 24, decided that was plenty high for it, and cashed in. Thereupon XYZreacted to 20, and you congratulate yourself on your astuteness. But then, unexpectedly, it turnsaround and rushes up to 30. Now you do not feel as smart knowing that was a better stock than yougave it credit for being. You wish you had it back, yet you will not pay more for it; if it comes backdown to 24, the price at which you sold, you'll “reinstate your position.” Perhaps you have never been in either of these situations. Perhaps your own reactions would not, insuch cases, have been the same as those we have indicated. If you have had a fair amount ofexperience in the market—have some knowledge of the psychology of the “average investor”—youknow the pictures described are typical. At this point, you may not be satisfied we have succeeded in giving an adequate explanation for ourbasic principle of Support and Resistance Levels. Remember, however, that the supply and demandbalance in the market is nearly always a delicate thing. Only a moderate oversupply at any one pricewill suffice to stifle an advance; only a little extra demand concentrated at a certain level will stem adecline. Remember, other traders are watching the tape as well and will be quick to sense anychange in the situation and be quick to join the parade whenever a change in trend appears to bedeveloping. Consequently, orders to buy or sell a few hundred shares may induce the transfer ofseveral thousand. Another point worth bearing in mind is that the traders and investors who (because of thepresumption their previous mistakes in either selling or buying prematurely) created Support andResistance Levels are not necessarily ignorant or inexperienced. On the contrary, we must list themamong the wiser and more alert of those who operate in the market. To make one more use of ourprevious theoretical example of typical downtrend action, those who bought at 50 were certainlysmarter than those who bought at the top (70) or on the way down to 50, even though the latter pricewas broken later on. Giving them credit for somewhat superior judgment, it follows that they may beexpected to appraise later developments pretty carefully and display something better than a woodenand stubborn determination to “get out even” when it comes to selling on a Recovery Move. Hence,in a marked Bear Trend “overhanging supply”; that is, stock bought at higher levels by holders nowwaiting for a good chance to unload, will begin to come on the market below the theoreticalResistance Level. Wise owners will be willing to sacrifice a point or so to avoid getting caught in aworse loss. By the same token, “sold-out Bulls,” when a Major Uptrend is under way, may be willing to pay apoint or two more to replace the shares they had previously cashed in too soon. Thus, it ischaracteristic of reactions in well-established (second phase) Bull Markets to drop back only to thevery uppermost limits of a Support Range—and for recoveries in established Bear Markets to reachonly the lowest edges of Resistance Zones, or perhaps even fail of that by an appreciable margin. Weshall have more of this sort of thing to point out later on, but first we must take up two other matters—how to estimate the potential importance of Support and Resistance Zones, and how to moreaccurately locate the centers of axes of such zones. Estimating Support-Resistance potential To go back to first principles, the Resistance that an upward move may meet at any given leveldepends on the quantity of stock overhanging there—the number of shares previously bought at thatprice by owners who now would like to get out without loss. Obviously then, volume is our firstcriterion in estimating the power of a Resistance Range. An old Minor Bottom level, at which onlyfour or five hundred shares changed hands, cannot set up much Resistance to a subsequent advance,but a Selling Climax Bottom, where several thousand shares were bought, will provide a lot ofpotential supply after prices have dropped well below it, at some later date, and then attempt to riseup through it again. A long Rectangle or a Descending Triangle has a number of Bottoms at the same level. We can get acrude approximation of the amount of Resistance there by summing up the volume of trading on allits Bottoms, but then some discount must be taken for the shares that may have been bought at theBottom of the pattern in its early stages and then sold near the Top before it was completed. In brief,a single, sharp, high-volume Bottom offers somewhat more Resistance than a series of Bottoms withthe same volume spread out in time and with intervening rallies. Another criterion is the extent of the subsequent decline. Or, to put it another way, how far priceswill have to climb before they encounter the old Bottom zone whose Resistance potential we areattempting to appraise. Generally speaking, the greater the distance, the greater the Resistance.Suppose PDQ sells off from 30 to 20, “churns” at that level for several days, rallies to 24, and thendrifts back down to 19. Investors who picked it up at 20 will not be greatly concerned at that stage. Ifa rally now develops from 19, there will be little or no disappointed selling at 20. Should prices dipto 18 before the rally starts, there may be some supply forthcoming at 20, but still not a formidablequantity. From 17, Resistance will become evident. In brief, prices have to break far enough belowthe price at which a trader bought his stock to convince him that he made a bad investment and,hence, that he should sell when he gets a chance to do so without too great a loss. It is impossible to formulate any precise rule or equation to define how far a decline must proceed toset up Resistance above it. However, do not look for much supply to come out of a Bottom level inthe low-middle price ranges (20-35) unless the trend later takes quotations more than 10% under it.This 10% rule cannot be applied to very low-priced issues. A man may buy a stock at 5 and see itdrop to 4 or 3.5 with considerable equanimity despite the fact he stands a loss of 30% at the latterfigure. His “dollar” loss looks small, and he still thinks it will be easy for his stock to get back up to6 or 7; so, he is willing to wait. Another factor enters into and reinforces the “extent of decline” criterion. If our PDQ rallies, asbefore, from 20 to 24 and then drops rapidly to 12, not only will many of the old owners at 20 bethoroughly disgusted and glad to get out at that price, given an opportunity, but the new owners at 12also will be pleased to take 20 (66 2/3% profit) and quick to do so if they detect any signs of troublethere. New buyers at 18, needless to say, would not be quite so ready to sell at 20. A third criterion for appraising the Resistance potential at an old Bottom level is the length of timethat has elapsed since it was formed and the nature of general market developments in the interim.You will, no doubt, find it reasonable to suppose that an Intermediate Bottom formed in the earlystages of a Bear Market will offer relatively little Resistance after prices have fallen far below it,have taken perhaps the better part of a year 56 52 48 44 40 38 36 34 Sales 100's 50 40 30 20 10 Figure 13.2 Support-Resistance Levels in a long Intermediate Uptrend. The reader will need noguidance in applying the principles stated in this chapter to the Bendix weekly chart reproducedabove. Observe that when prices broke down in 1945 through a long trendline, their decline stopped,nevertheless, at the Support set up by the previous November's Top. to make a Major base, and then have gradually climbed up to it again four or five years later. Tosome small extent, this is true. A supply only a year or two old is apt to be more effective than onethat is four or five years old, but the latter does not lose all of its potency by any means. In fact, it isoften surprising how effective the Resistance will be at a very old Bottom zone, provided it has notbeen “attacked” in the interim, and provided no changes have been made in the capitalization of thecompany that might obscure, in the mind of the owner, the original cost of his stock. Under the latterheading, we would put split-ups and large stock dividends, or even an unusually generous cash“melon.” We do not mean to imply that an investor is ever actually deceived as to the actual cost ofhis shares, no matter how they may have been split, or what dividend distribution has been made,but his disappointment (and desire to get out even) may be abated. If, however, a Resistance Zone has once been attacked—if prices have come back up to it, hit it, andthen retreated—some of its power has obviously been removed. Some of its overhanging supply hasbeen used up in repelling the first attack. The next advance, therefore, will have less stock to absorbat that level. Here again, the volume chart may be looked to for some approximation of the amountof Resistance consumed. In any event, it is an odds-on assumption that a third attack at a ResistanceLevel will succeed in penetrating it. We have named three criteria—volume, distance away, and time elapsed—to be used in assessingthe amount of Resistance to be expected at any given level. At this point, it must be apparent (andperhaps disappointing) to the reader that his own judgment must play a large role in applying them.This cannot be helped; it is impossible to set up an exact mathematical formula for any of them. But, after all, the problem is not too complicated. The general principles are simple enough and, webelieve, easy to understand. We can look back at the charted history and see where, in the lastpreceding downtrend, a Bottom formed that may produce more or 30 25 20 15 10 5 Figure 13.3 For Major Support-Resistance Level study, monthly charts are most useful. This onepresents many points of interest. Observe how important levels are formed and how, once formed,they appear again, and reverse their roles. The price scale shows 1947 values with previous yearsadjusted for the splits of 1933 and 1946. less Resistance when the current advance reaches back up to its range. We have to estimate howmuch supply resides there, how many shares were bought originally at that price and are still held byowners who may welcome a chance to get out even. The greatest danger in applying judgment to the measuring of these factors lies in underestimatingthe amount of Resistance to be expected. Guard against that effort; it is safer always to overestimateit. You may be Bullishly disposed yourself; you may say, “Those fellows who were hung up there inthis stock must realize that conditions have improved, and they will not be so anxious now to sell.”Don't count on it. Recall, they have been “hung up” for a long time; even if they are mildly Bullishon the market in general, they may be so disappointed with this particular stock that they want toswitch out of it and try something else. (The stubborn and often costly refusal of the averageAmerican investor to “take a loss” operates even against timely switching.) Everything we have said in the foregoing paragraphs about estimating potential Resistance appliesas well—but in a reverse direction, of course—to estimating potential Support. The principles areprecisely the same, even though the underlying rationale may be less easy to grasp. 40 30 20 10 Sales 100's 800 400 Figure 13.4 Particularly noteworthy in this monthly record is the Resistance met in 1939, 1940,1941, and even in 1944, at the Bottom level (just above 26), the three-month Congestion of 1936.Also, the appearance eight years later (!) in 1945 of Resistance at the Bottom level (28) of the High-Volume Top Congestion of 1936-1937. 50 IM jff :::: II II T Ttfl ±g: tFftCftftI ft ft fffifF IT I 1Ff ft 1 gift1 ::::: ■tl 1 4 4 J £; H w i ..........r :jKRESG,i ..... (S.S.)CX).s IM K ;c :: • w ■ ITIIT W ft ffl S: I ■ 1 r rntt g tftft ■ ••ft Bl i ffti m ffl ft-Illin 1 4 ttr TT’ T 1 ft X I i ftl •ii u ft 1:Ml ::: : gH a B 4' tintn 4ftf: i 1 illhggj I- *1 ■•: Jt , iji;1 I §ii F- iftft ft ft t r grf ::Iffil : f "T 1 t TT tt i 111 - I ::: g n ttfti 1 -W I n + ft ffiff II ft ■ F T In Jffl± 1 1 w J. ::: t 1 ; u ::: 4g itgii|m ft 1 tilt* : ii t iiii 193619371938 19391940 19411942 1943 1944 1945 | 1946 Prices were able to “skyrocket” when that Resistance was finally overcome. You will find thatseveral additional Support-Resistance Lines might have been drawn on this chart. Note MajorBottom Formations of 1937-1938 and 1942. Locating precise levels Our next problem to consider is how, in practical day-to-day chart analysis, we can locate as exactlyas possible the limits of a Support or Resistance Range and, in many cases, the specific price figurerepresenting the core or axis of such a range. In the theoretical examples we have made up so far toillustrate basic principles, we have used even figures, but in actual trading, the levels are seldom sonicely marked. Even the sharp and relatively patternless Bottom of a Recession may consist of aweek of price fluctuations within a narrow range. Perhaps the lowest day of that week's Congestionwill appear on the chart as a One-Day Reversal, or there will be two or three days that “spike” downbelow the general mass. Here again, although no mathematical rule can be laid down, it is easy torelate the price and volume patterns visually, and by simple inspection, arrive at a near estimate ofthe figure at which supply in quantity is likely to be forthcoming. Look particularly at the closinglevels of the days making up the Bottom Congestion and average them mentally; this figure is apt tobe pretty close to the “center of gravity” of the entire Resistance Area. Some supply is likely to start coming in as soon as a subsequent advance reaches the bottommostfraction of the Resistance Zone, and more and more will appear as the move pushes up into it.Sometimes, it is possible to predict “to a hair” just how far prices will penetrate a Resistance Rangeby carefully comparing the vigor (volume of trading) on the advance with the volume registered atvarious levels in the original formation of the Resistance. This takes experience, but it is experiencethat you will find quite easy and not at all costly to gain. In most cases, however, it is neithernecessary nor particularly desirable to be so exacting. Nearly every chart in this book shows some example of Support and Resistance phenomena, and thereader should make it a point when he has finished this chapter to go back over and study them all indetail. The practical application of the rules we have been discussing will be greatly clarified.Equally instructive, if you can manage to obtain such a collection, is a study of the Support andResistance Levels appearing in the monthly charts of all actively traded stocks over a period of 10 years or more. EN: Easily generated by most currently available software and on the internet atstockcharts.com and other sites. You will undoubtedly be amazed to see how Tops, Bottoms, andSideways Congestions tend to form at the same approximate levels in successive Major Swings,while prices move freely and rapidly, up or down, through the ranges between such levels. It ishardly necessary to dwell on the practical dollars-and-cents value of such information that may bederived from the chart history. This brings up a matter that we may as well pause to consider here—the kind of charts most usefulfor locating and appraising Support and Resistance Levels. For near-term Minor Moves, the dailychart is naturally the only source of information, and a daily chart record that extends back for a yearor more may, if necessary, be used in the location of levels of Intermediate Trend importance. Thewriters have found, however, that a daily chart does not give the perspective on the long range thatone really needs to determine Major and Intermediate Support and Resistance Zones. It is apt tooveremphasize the potential of a recently set up Minor Support (or Resistance) Zone and obscure theimportance of a true Intermediate Level. For true perspective, a weekly chart, showing volume aswell as price ranges, and covering at least the whole previous Major Bull and Bear cycle, is mostdesirable. Also, very good results can be obtained with a little study and experience from monthlycharts. To return to our study of Support phenomena, we have had several occasions to refer in previouschapters to a “normal” trend. What we have had in mind might perhaps be better called an “ideal”trend because, like so many other so-called normal things, it represents a pattern from which thefacts of experience frequently deviate. In stock trends, nevertheless, this normal or ideal appears as afairly common pattern. If it is an uptrend, it consists of a series of zigzags (EN10: think waves, as inChapter 28), each “zig” carrying prices to a new high and each “zag” taking them back to theapproximate top of the preceding “zig.” To illustrate with figures, up to 10, back to 6, up to 15, backto 10, up to 20, back to 15, up to 26, back to 20, and so on. Such a move is what technicians refer toas “self-correction” and regard as particularly sound and, hence, likely to be continued. You can seeit really represents a reaction to the nearest Minor Support Level following each step forward. If youbecome interested in an issue with such a trend pattern, the normal return to a Support produces agood place to buy. Significance of Support failure Sooner or later, however, a normal Minor Wave Pattern is bound to be broken up. This generallyoccurs in one of two ways (although there is an infinity of possible variations). In one, prices spurtaway in an advance out of all proportion to the previous succession Figure 13.5 A monthly chart of Jewel Tea Company with its Major Support-Resistance Levelsmarked. Note the reversal of roles. of up waves. Such a move is seldom followed by a reaction to the Support now left far behind, butrather, by the construction of some sort of Area Pattern—which may be either Consolidation orReversal. The other type of disruption appears when a reaction does not halt and reverse at the level of theprevious Minor Top, but sifts on down through that zone, perhaps to the level of the preceding MinorBottom. This move has “broken its Support,” and any such action carries a distinct warning of achange in trend, a particularly emphatic warning if activity shows a tendency to increase as or afterthe Support is violated. Note we said change in trend rather than Reversal because the puncturing ofa Minor Support Level may signify only a halt for sideways Consolidation, yet it may also foretokenan impending Reversal; either of these is a change. If you will now call to mind the picture of a typical Head-and-Shoulders Top, you will see thedecline from the head constitutes just such a break in Minor Support because it comes down throughthe level of the top of the left shoulder. You will recall this decline is often the first intimation wehave that something in the nature of a Reversal Formation is developing. Thus, even the violation of a nearby Support Level has a practical meaning in technical chartanalysis. The breaking of a Minor Support should always be regarded as the first step in the Reversalof the Intermediate Trend. (If it turns out to be Consolidation only, there will be an opportunity laterto reenter an abandoned commitment if desired.) By the same token, the breaking of an IntermediateSupport Range is frequently the first sign of a Reversal in the Major Trend. We do not believe it isnecessary to expatiate further on this principle. Recommended trading tactics based thereon arediscussed in Section II of this book; Support and Resistance Levels are particularly useful as BasingPoints for stop-loss orders, which are discussed there. Popular misconceptions The reader will understand all we have said here about the breaking of Supports applies as well, butin reverse direction to the penetration of Resistance Levels. One more point may well be mentionedbefore we leave this subject; if you happen to have spent much time in 44 40 38 36 34 32 30 28 26 Sales 100's 50 40 REMINGTON RAND RR .. Figure 13.6 When prices broke down out of the large Descending Triangle that formed onRemington Rand's weekly chart in 1946, the decline might have halted, at least temporarily, around37 at the level of the four-week Congestion made in April and should have “caught Support” at 35-36, the level of the February top. Failure of the latter carried Major Trend significance. Note laterResistance at 40 1/2. boardrooms, you will have noticed the concepts of Support and Resistance prevalent there aresomewhat different from those outlined in this chapter. For example, if X has advanced to 62,reacted to 57, and then pushed on to 68, many traders will speak of 57 as being the Support Level,presumably because that was the last price at which X was supported in sufficient strength to turn itstrend from down to up. We, as you have seen, would name the vicinity of 62 as the Support Range.The distinction is important to grasp and sometimes extremely important in practical results. Admittedly, it does not come easy to think of a former Top as denoting the level at which a laterBottom should form, or vice versa; it would seem superficially to be much more logical to relate Topto Top and Bottom to Bottom. Moreover, it is perfectly true, to use our X example again, that someof the investors who wanted to buy it at 57 might not have succeeded in getting it before the secondadvance to 68 took it away, and their buy orders might still stand at 57 or might be reentered on anyreturn to that price. Nevertheless, there is certainly no assurance that such is the case; there is no“vested interest” in X at 57 that will “automatically” bring in new buying. On the other hand, wehave seen how there is a sort of vested interest set up at an old Bottom that produces selling(Resistance), and thereby creates a new Top, and at an old Top that produces buying (Support) andthereby creates a new Bottom. The reader is urged to keep this concept well in mind. Any analytical study of the chart records willquickly show it is much easier for prices to push up through a former Top level than through theResistance set up at a previous volume Bottom (and vice versa, of course, with respect to declines).You will find a little selling may come in at a former high, but usually only enough to cause a briefhalt rather than the more or less extensive reactions or Consolidations that develop when the trendcomes up against a real Resistance Zone. 26 24 22 20 19 18 17 16 Sales 100's 125 100 75 50 25 ::::::::: TO II it** ’iff”" — urn «; 4 fe i .....32 to te At 44 :::::::::: is ill — i IIffl 3..pl klliBhl as jg a A 1 1 i 1 I N ■ 3$ 1 II TOTO... ***♦..... ffif 4I H ! jmSm I H P 4r4t Hr444+ H .41141114 IgS ill!1 III llllll!!! III 1 H!’!!*' Hr HUM .Hi :::: YORK CORPORATION YOK rttt aims Bj HIII Ul!1HIHHH. p r ttt tttffliHttittt rliHil n HHH n mt.................... rr mi.- 1 < 11 < ■ ij ill 1945 1946 ;; sH4 1 Mn-TOTOII "" jgtggHggg sor — — kni&int 1 ii I lili ... ....hp III........ .,1. ...... 1 Illi Jluyll ill ill ..... Lilij mil i ill li I 1 3 '10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 OC MARCH Figure 13.7 York is a relatively thin stock, which normally makes many small, technicallymeaningless gaps, but its large, high-volume gap of October 8, 1945, demanded attention. It lookedlike a Runaway Gap, and as such implied continuation to 26 1/2 plus, but prices halted their advanceat 24 1/2 and went into a three-month Rectangle. An upside breakout on January 10, 1946, carriedout the minimum measurement of the Rectangle (and October gap); prices then reacted. See sequelin Figure 13.8. The round figures There are certain other levels that may, at times, evidently produce considerable Resistance orSupport without any reference to a previous “vested interest.” We have in mind the “round” figures20, 30, 50, 75, 100, etc. In setting a goal for taking profits when we buy a stock, it is natural for us tothink in terms of such round prices. If a low-priced stock has advanced steadily from around 10, it ispretty certain on this account to meet with profittaking sales at 20, especially if that figure representsa new high for several years. In fact, any time an issue gets out into new all-time high ground, wherethere is nothing in its chart history to indicate otherwise, it is a fairly safe bet that Resistance willappear at the round figures. In old and actively traded stocks, such as U.S. Steel (EN: or IBM andGE), the round figures diminish in importance. Repeating historical levels If, once they had been set up, important Support and Resistance Levels always “worked,” we shouldsee Intermediate Tops and Bottoms form at exactly the same ranges year after year in one Bull andBear cycle after another. As a matter of fact, there is a well-marked tendency for this to occur in old-line, actively traded stock. In General Electric, for example, the 22-24, 34-35, 40-42, and 48-50zones were characterized by large turnover (and, consequently, by many Intermediate Reversals oftrend) throughout the 1920s and into the 1950s. In Southern Pacific, there are historical Support andResistance Zones at 21-22, 28-30, 38-40, and 55-56. In U.S. Steel, 42-45, 55-58, 69-72, 78-80, and93-96 are conspicuously marked as Reversal 26 24 22 20 19 18 17 16 Sales 100's 50 40 30 20 10 YORK CORPORATION YOK ___ AUGUST SEPTEMBER, , '22 29 6 [13 5'027 3 l10l17l24 1 31T7 114*21 '28 r 6 13 20 27 4 11 18 25 1 8 15 Figure 13.8 The February reaction in Figure 13.7 met momentary Support at 24; prices bounced farenough to close the February 7 gap and then broke down through the Rectangle Top-Line Supporttechnically a distinct warning. Then a Symmetrical Triangle formed, but the breakout came too nearthe apex, produced only a rally to the former high, and then an “end run.” One did not need to waitfor the Double Top signal on August 22 to forecast a decline of more than minor consequence. Ranges. Additionally, many other stocks might be cited. (EN9: While the particular stocks are deador transmogrified, the principle is alive and well.) Over long periods, however, such Support and Resistance Levels do tend to be gradually modified,broadened, or “blurred” as new ones are created. One source of many important new Supply Zonesis a Bear Market Panic. For this is the one type of decline that can be counted on to pay no heedwhatsoever to previous underlying Support Zones. Panics (which, as seen in our earlier study ofPrimary Swings in connection with Dow Theory, typify the second phase of Bear Markets), oncethey get under way, seem to sweep away all potential Support in their calamitous plunges until theyexhaust themselves in a general market Selling Climax for which may or may not come at a levelthat bears a relation to some previously established Support. To use U.S. Steel again as an example,the 1937 Panic Decline took the stock down through its 93-96 range, hesitated briefly at the 78-80level, and then plunged through 69-72 and 55-58 to stop just above 50. In the 1946 Panic, X againbroke swiftly through 78-80 and 69-72 to halt at 66. When there is a large turnover at a Panic Bottom in any given stock, that level acquires a strong“vested interest” for the future and will usually furnish conspicuous Resistance to a subsequentadvance (after another Bear Market Decline has taken quotations below the Panic Level). This discussion of Panics brings us back to a consideration of Support and Resistance performanceat other stages of the Primary Trend. Bearing in mind the relation of Resistance to volume, it is easyto see why in a long drawn out but otherwise typical Bear Swing in which trading interestdiminishes to a very low ebb as the final low is approached, the next to the last Intermediate Bottommay produce relatively little supply and, consequently, only a small reaction when the new uptrendreaches its level. Add to this the fact that many of the buyers in the last stages of a Major Decline aredeliberate scale-down investors who fully expect prices will go lower and, hence, are not easilyshaken out. The slow progress so often seen in the first part of a new Primary Bull Market is due notso much to overhead Resistance as to lack of impatient public bidding. The Recovery Trends that follow precipitous Bear Market Panics usually exhaust themselves, forobvious reasons, long before they get back up to the last Resistance Level left behind in that PrimaryDownswing (which is usually the Bottom of the first Intermediate Decline from the extreme Top ofthe cycle), but they often meet supply at a lower Resistance Zone set up in the preceding BullMarket. Look way back on your charts, therefore, when sizing up the prospective advance in suchsituations. A further thought along that line is this: there is no law that requires an advancing trend to keep righton climbing until it reaches a distant overhead Supply Zone. It is true, as a corollary that we havealready mentioned to our Support and Resistance Theory, that prices can and do rise easily through aprice range at which no Bottoms or Congestion Areas have formed in previous downtrends, but ifthe first established Resistance Level is a long way above, the advance may exhaust itself before itgets there. Heavy supply may come in for other reasons at a lower level. Think, then, of a distantResistance Level as a maximum possibility rather than as a certain goal. However, between twostocks whose purchase you are considering, you should select the one, other things being equal, withthe “thinner” track overhead and can rise farther before it encounters a charted Supply Zone. Pattern Resistance We can revert now to some of the Minor phenomena discussed in connection with Reversal andConsolidation Patterns in earlier chapters. Take gaps, for instance. You will now see why it is easyand, hence, quite in order for a reaction that comes soon after a gap has been made to slip back andclose that gap. There is no “vested interest” whatever in the range through which prices skipped to form the gap on the chart. You will also see why such a reaction may stop short and reverse as soonas it has closed the gap, provided there was a high-volume turnover in the price range immediatelypreceding the gap. Such is usually the case with a Breakaway Gap. Any gap, for the same reason, is easy to close once a reaction starts prices moving back in thatdirection, if it is not too far away and if there are no intervening Resistance Levels to stop thereaction before it gets there. In the case of a Runaway Gap, however, there is no reason why areaction should halt as soon as it has covered the gap range; on the contrary, it will probablycontinue on through the “thin” price track that preceded the gap. Pullbacks and Throwbacks—the quick return moves that we noted as developing so often shortlyafter a breakout from a Head-and-Shoulders or other Area Pattern—exemplify the principles ofSupport and Resistance. When prices break down, for example, out of a Descending Triangle, thehorizontal lower boundary of the formation, which was originally a Demand Line, promptly reversesits role and becomes a Resistance Level. Any attempt to put prices back up through it, therefore,after a decisive breakout, is stopped by supply at or near the line. By the same token, the neckline ofa Head-and-Shoulders Top, which was a Demand Line, becomes a Resistance Level after it has beenbroken. The Top or Supply Line of a Rectangle becomes a Support after prices have pushed above iton volume and by a decisive margin. 76 72 68 64 60 56 52 48 44 Sales 100's 50 40 30 20 10 GOODYEAR TIRE GT id N ' D ’ J 'F'M'A'M'J ' J 'A'S'O'N ' D ' I 1~F'1'Mf A M Figure 13.9 We first discussed Pullbacks in connection with the Head-and-Shoulders in Chapter 6and refer to them again in this chapter as Support-Resistance phenomena. At least one Pullback tothe neckline (after the breakout) occurs in the great majority of cases. Many Head-and-ShouldersFormations produce two, the first within a few days after the breakout and before prices have gottenvery far away, and the second weeks later, sometimes after the minimum measurement of the Head-and-Shoulders has been fulfilled. Goodyear saw the unusual number of four Pullbacks to its 1946neckline in the first two weeks after the August breakout, another in October, a third in November,and a fourth in February 1947, which met the Double Resistance of the neckline and the downtrendline (see Chapter 14) projected from the 1946 April head and August right shoulder. Earlier in this chapter, in our discussion of the three criteria for appraising the amount of Resistanceto be expected at a former Bottom level, we named “distance away” as one of the criteria and statedas a general rule that prices should have gone at least 10% beyond that level in a medium-pricedstock before much Resistance would be set up. This 10%-away rule does not apply in the case of aThrowback to a well-defined area formation when it follows shortly after a breakout. All that isnecessary to establish strong Resistance to such moves at the pattern boundary is a conclusivebreakout. The Symmetrical Triangle has a different sort of Support and Resistance “field.” You will recall thatthe first Reversal point in the formation of a Symmetrical Triangle (a Top, if it forms on a risingtrend, or a Bottom if on a decline) is normally accompanied by high trading volume, but that activitydiminishes rapidly on succeeding fluctuations within its converging boundaries. Consequently, onceprices have broken out of the Triangle and have proceeded well beyond the level of the pattern's firstReversal point, that level, because of the volume of shares traded there, becomes a Support (orResistance) against a subsequent reaction. But, if the breakout move does not carry beyond theTriangle's first Reversal Level by a clear margin, any Throwback will probably bring quotationsback to the extended (sloping) pattern boundary. If the reaction does not occur until the trend hasworked out to or beyond the Triangle's apex, then the Throwback usually will not meet Support (or 30 1945 28 26 24 22 20 19 Sales 100's 500 400 300 200 100 INTERNATIONAL TEL. & TEL. IT ' 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 Figure 13.10 Several examples of the Support “field” of the Symmetrical Triangle appear in this1945 daily chart of “IT.” Following the belated February 5 breakout from the first Triangle, pricesreturned on the 9th to the level of the mid-January Top, but then suffered a more extensive reaction,which came down on February 26 to the Triangle's apex level. This was a critical juncture. The apexpoint itself is a strong Support (or Resistance), but its level becomes weaker as time passes. In thiscase an “end run” might have been developing. Stop-loss orders should always be entered under anapex level (see Chapter 27). Here the apex held, however, and prices went into another “Coil,”breaking out topside on March 10. Their next reaction was supported, as was to be expected after an early breakout like this, at the Top Pattern Line. The price track from mid-March to the end of Aprilfell into an Ascending Triangle Pattern, the top boundary of which functioned as Support in June butwas broken in July. Refer to Figure 11.17. Figure 13.11 In this instance, a belated upside breakout (August 10) from a Symmetrical Trianglefailed quickly and the subsequent reaction, after holding for several days at the apex level, finallybroke down for an “end run.” Thereafter, note the apex level turned into a Resistance againstRecovery Moves. Resistance) until it has carried back to the level of the apex, which, in brief, represents theconcentration level or axis of the Triangle's Support and Resistance. The intersection of the two converging boundary lines of a Symmetrical Triangle has sometimesbeen called a “cradle.” The axis Support (or Resistance) is strongest near the cradle point and getsweaker as the axis line (apex level) is extended out to the right on the chart (i.e., as time passes).Thus, if a late breakout move fails to carry prices very far from the Triangle area, and the trend thenpeters out, flattens, and begins to react after the cradle point has been passed in terms of time, itsaction, as it reaches the axis line, must be closely watched. (A stop-loss order may be indicatedhere.) Should the axis Support fail to hold, the reaction may plunge through and accelerate in a moreextensive swing, which has aptly been termed an “end run around the line.” Volume on breaks through Support On those occasions when prices fail to retreat when they hit a Resistance (or Support) Range, butperhaps after holding there for several days, push on through, there is nearly always a suddenacceleration and a marked pickup in volume. This may be taken as confirmatory evidence of adecisive break and, consequently, an indication the move will carry on. The reasons for this volumeincrease are obscure. Some say, “It takes volume to overcome 64 60 56 52 NL 48 44 SOUTHERN RAILWAY 40 38 36 34 Sales 100's 125 100 75 50 25 ' APRIL MAY JUNE JULY AUGUST SEPTEMBER ; 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24'31 7 14 21 28 Figure 13.12 Here is a typical case of two Pullbacks to a Head-and-Shoulders neckline, the firstimmediately after the breakout and the second three weeks later. Note the initial breakthrough“bounced” from the early April Top Support and the late July decline met Support at the generalApril-May Congestion Area. However, what this chart particularly illustrates is how volumeincreases when a good Support Range is penetrated. Note the decided pickup on August 27, whenthe April-May area was left behind. Resistance,” which is true enough, but the volume usually comes after the Resistance has beenpenetrated. Therefore, others say, “The volume is evidence that technicians see what has happenedand are now jumping in.” But that line of thought, in the authors' opinions, also has little tosubstantiate it. (We shall have more to say about the questionable influence of technicians on thetrend later on.) Many of the arguments over volume change versus price change smack of the oldhen-or-egg riddle. In any event, causes for many technical phenomena, such as this one, may be leftto the academicians, provided the practical implications are clear. Support and Resistance in the Averages As has been the case with nearly every other technical phenomenon we have studied, the principlesof Support and Resistance apply, with suitable allowances, to Averages as well as to individual stocks. Since an Average reflects the combined charts of the majority of the issues that compose it,but with a minority of them frequently evincing quite divergent patterns, it follows naturally thatSupport and Resistance Zones in the Averages cannot be as sharply and narrowly construed. MinorTops and Bottoms in the Averages, particularly, are less dependable as Resistance Levels. Clearlydefined and important Intermediate Reversals, however, as they nearly always represent Reversals inthe entire market (practically all stocks), will normally produce strong Resistance (or Support, as thecase may be) in the subsequent Average Trend. When the Averages break down through a Support Level, but simultaneously one or more stockshold firm at or above their corresponding individual Supports, there is a presumption that thoseparticular stocks are in a stronger position than others to participate in the next recovery. The phrase“other things being equal” should be added, however, for there are qualifications to this presumptionthat must be considered. For instance, it may be that the stock that has resisted decline will, for thatvery reason, be less attractive to new buyers than one that broke drastically and is now purchasableat a more “attractive” price. Many of the claims made regarding future prospects for stocks that have, by one criterion or another,previously evinced “better-than-Average” or “worse-than-Average” market performance permitargument either way. It is safest to treat all such relative performance indications as only one minorfactor to be appraised in the overall chart picture. chapter fourteen Trendlines and Channels One of our basic tenets in this system of technical stock chart analysis— indeed, a fact that any neophyte can quickly verify for himself by inspection of the market records for whatever period he chooses—is that prices move in trends. The market, in general, and the many stocks that compose it, do not jump up and down in an altogether random fashion; on the contrary, they show definite organization and pattern in their charted course. (For illustrations in this chapter, see Figures 14.1 through 14.17.) Prices move in trends. These trends may be either up or down or sideways (horizontal). They may be brief or of long duration. They may be classified as Major (Primary), Intermediate (Secondary), or Minor, according to the rules of Dow Theory, or as Horizontal Line Formations. (The distinction between a short Intermediate and an extended Minor Trend is often more difficult to make with individual stocks than it is with the Averages, but it is not so important.) Sooner or later, trends change; they may change by reversing from up to down or down to up, or they may also change direction without reversing as from up to sideways and then perhaps to up again, or from a moderate slope to a steep slope, and vice versa. Profits are made by capitalizing on up- or downtrends by following them until they are reversed. The investor's problem is to recognize a profitable trend at the earliest possible stage of its development and then later to detect, again as quickly as possible, its end and Reversal. The Reversal of any important trend is usually characterized, as we have already seen, by the construction of some sort of joint price and volume pattern—in brief, of a Reversal Formation. The Trendline All of the foregoing statements regarding trends have been expressed or implied in earlier chapters of this text. It is our purpose now to examine trends, as such, more closely, to see how they may be plotted most effectively on the charts, and to determine to what extent they can be used to reinforce or supplement the technical forecasts derived from our other chart formation and Support-Resistance studies—sometimes to furnish even earlier forecasts or warnings of change. One of the first discoveries a new student is likely to make when he begins to inspect stock charts with a critical eye is that nearly all Minor and most Intermediate Trends follow nearly straight lines. A few readers will, perhaps, dismiss this as perfectly natural, something to be taken for granted. But the majority become increasingly amazed and excited as they delve deeper. Not only the smaller fluctuations, but also the great Primary Swings of several years' duration frequently appear on the charts as though their courses had been plotted with a straight-edge ruler. This phenomenon is, in truth, the most fascinating, impressive, and mysterious all the stock charts exhibit. If we actually apply a ruler to a number of charted price trends, we quickly discover the line that most often is really straight in an uptrend is a line connecting the lower extremes of the Minor Recessions within those trends. In other words, an advancing wave in the 52 48 44 40 38 36 34 32 30 28 26 Sales 100's : ATLANTIC REFINING AFI .......... IMlltlUb 1945 ■Ulul 1946 1944 1947 Figure 14.1 A series of Intermediate Trendlines drawn to illustrate the “basic” principle (see “How Trendlines Are Drawn”) on a weekly chart of Atlantic Refining, extending from January 1944 through August 1947. Observe that each up trendline required two distinct Bottom points to determine it, and each down trendline, two Tops. In some cases, the two determining points were formed only a few weeks apart, as in August and September 1945. The Bottom points that fixed the early 1946 up trendline, on the other hand, were months apart—February and June. Note that only final Trendlines are shown here. Many other experimental lines might have been drawn on this chart originally, including several uptrends whose Intermediate authority was questionable because they were “too steep”—as in early 1944, late 1945, and early 1946. There are also some interesting examples of Pullbacks (after trendline penetration) that are discussed later in this chapter. Note July 1944, April 1945, September 1945, and May 1947. stock market is composed of a series of ripples and the Bottoms of each of these ripples tend to form on, or very close to, an upward-slanting straight line. The Tops of the ripples are usually less even; sometimes they also can be defined by a straight line, but more often, they vary slightly in amplitude, and so any line connecting their upper tips would be more or less crooked. On a Descending Price Trend, the line most likely to be straight is the one that connects the Tops of the Minor Rallies within it, while the Minor Bottoms may or may not fall along a straight edge. These two lines—the one that slants up along the successive wave Bottoms within a broad up-move and the one that slants down across successive wave Tops within a broad down-move—are the basic trendlines. It is unfortunate that a more distinctive name for them has never been devised than the threadbare word “line,” which has so many other uses and connotations. A few analysts have called them “tangents,” a term that has the advantage of novelty, but, because it is a distinct perversion of the true meaning of the word tangent, confuses many readers even more. Perhaps tangent will eventually become established in this new sense. We shall be satisfied herein with the overworked “line,” and will give it some distinctiveness in its present context by joining it to trend in the one word “trendline.” Figure 14.2 This 1935-1936 daily chart of Atchison illustrates how the latter part of a long, strong Intermediate Advance may accelerate away from its trendline. Notice the action in late January and early February. Prices dropped back to 66 in April 1936 after this Up Trendline was broken at the end of March. Note also at the point at which the December 1935 reaction met Support, the trendline coincided with a Triangle apex level. Such “coincidences” appear frequently in technical studies. Trendlines, you may have heard it said, “are made to be broken,” but that is one of those exasperatingly sententious remarks that fails to clarify anything. Of course they are broken; they are all always broken, ultimately, and some very shortly after they are set up. The problem is to decide which breaks (i.e., penetrations by a price movement) are of important technical significance and which are of no practical consequence, requiring possibly only a Minor Correction in the drawing of the original trendline. There are no 100% certain quick answers to this problem; the significance of some penetrations cannot be determined as soon as they appear, but rather must await confirmatory indications from other chart developments. In a great majority of instances, however, an important break—one that requires a prompt review and possibly a revision of trading policy—is easy to recognize. How Trendlines are drawn First, how are trendlines drawn? A straight line is mathematically determined by any two points along it. To draw a trendline, therefore, we require two determining points— two established Top Reversal points to fix a Down Trendline and two established Bottom Reversal points to fix an Up Trendline. The principle here is the same as the one we laid down in our specifications for drawing Triangle boundary lines in Chapter 8. The fact is that boundary lines of Triangles and Rectangles, as well as necklines of Head-and-Shoulders Formations, are simply special types of trendlines. Suppose we start with a Major Bottom point and describe how a series of Up Trendlines might develop therefrom. To make this first illustration simple, let us assume the Bear 36 34 CRANE COMPANY 32 30 28 26 Sales 100's 125 100 75 50 25 JANUARY FEBRUARY MARCH ApRIL MAY JUNE ■ 6 M3 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 Figure 14.3 Trendlines that defined the short-term swings in Crane Company in 1945. Note three Bottoms formed on the first up-line and the third rally (late February) in this advance failed to reach a line drawn across the earlier Tops parallel to the Basic Trendline. A failure of this sort frequently precedes a break in the trend. The same thing happened at the end of the second uptrend in late May. “Failures” and the use of parallel or “Return” Lines will be discussed later in this chapter. The downtrend in March assumed a Wedge form. Observe how the April 6 reaction met Support at its previously penetrated Top line. In June, a rally met Resistance at the previously broken Up Trendline. Such Pullbacks are common. The small Complex Head-and-Shoulders in June was never completed because prices did not break down out of it by the required margin. Market Bottom in our stock consisted of a Rectangle area between 6.5 and 8, and the last move in this formation arose from the 6.5 level, broke through the pattern's Top at 8, and proceeded to 9. From 9, prices reacted to 8 and then headed back up again. As soon as this last rally had gone far enough to leave the dip to 8 showing in the clear as a Minor Bottom, we could draw our first Up Trendline because we then had two Bottom points, the second (8) higher than the first (6.5), to fix its slope. This would be a Minor Up Trendline. We would rule it in lightly on our chart in pencil and extend it on up and ahead for, perhaps, a week or more. (It will help you to visualize our example if you sketch it on a scrap of chart paper.) To proceed, suppose prices push up to 10, then move sideways for a few days, or dip slightly, until they have approached and touched, once more, our extended Minor Trendline. Then they start to move up in a third advance, but they run into supply again without making much progress, quickly make a fourth contact with the trendline, hesitate, and then break down through it. If prices now close clearly below the line and if there has been some pickup in trading volume evident on the penetration, we may conclude our first Minor Trend is completed, plus our stock either will build some sort of Consolidation Pattern before it stages another advance or it will suffer a more extensive “Correction” than any of the brief dips it registered during its first Minor Upswing. The whole Minor Uptrend we have described as an example in the foregoing paragraphs might well have run its course in two weeks; our first trendline would then have been very steep—too steep, obviously, to hold for any very long period of time. Now, let us assume a series of downward fluctuations produces the more extensive correction that we have foreseen as one probability following the trendline break that carries prices back to the Support Level set up at the Top of the original Rectangle, that is, at 8. (From our previous Support-Resistance studies, we would recognize this as a prime “buy spot.”) Assuming 32 30 28 26 24 22 20 Sales 100's 250 200 150 100 50 COMMERCIAL SOLVENTS CV 1946 MAY ‘JANUARY- , ' 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 JUNE 8 15 22 29 Figure 14.4 Intermediate Downtrend and Uptrend in Commercial Solvents in 1946. Note the increased volume on the March 30 penetration of the basic Down Trendline (and, at the same time, a breakout from a small Head-and-Shoulders Bottom). The drop through the lower parallel at the end of February had no technical significance. The Up Trendline from the March low was broken on June 14, simultaneously with a breakout from a Descending Triangle, which, as it turned out, was the final Bull Market Top. that subsequent developments pursue a normal course, prices should not linger long at 8, but should start promptly on a new series of advancing fluctuations. As soon as this becomes evident and the new Bottom at 8 is “in the clear,” we can rule in a new trendline across the original base point at 6.5 and the new point at 8. This should be, and probably is, an Intermediate Up Trendline that will not be penetrated for several weeks, maybe for several months, until the Intermediate Advance tops out. Subsequently, if that Intermediate Top takes the form of a Head-and- Shoulders Reversal Pattern, our Intermediate Up Trendline may be broken by the recession from the top of the head to the neckline. As a rule, however, the final advance in a strong Intermediate Move accelerates far enough away from the extended trendline to leave room (to the right on the chart) for considerable pattern construction before the line is again touched and penetrated. Hence, the actual puncturing of the trendline is more apt to occur either on the decline from the right shoulder to the neckline, or at about the same time as prices break down through the neckline to complete the Head-and-Shoulders signal. It is surprising to see how often the two lines, neckline and trendline, are broken simultaneously. In other instances, and there are many of them also, in which the trendline is the first to be punctured, perhaps shortly after prices turn down from the right shoulder, we do not have to wait for a neckline break but can take action at once. Here is one type of trendline indication that produces a working signal a little earlier, and often at a much more favorable price level, than is given by the completion of a Reversal Formation. Arithmetic versus logarithmic scale By this time, the more mathematically inclined among our readers must have begun to ponder the difference between trendlines projected on the ordinary or arithmetic scale 20 19 18 17 Sales 100's - — ii iln i n> PHILLIPS PETROLEUM P 1935 1936 1937 1938 Figure 14.5 Valid trendline penetration and its normal consequences— Reaction or Consolidation—is illustrated on nearly every chart in this chapter and on many others throughout the book. This weekly chart of Phillips Petroleum is reproduced here to show an outstanding exception. The Intermediate Up Trendline projected from “P's” September 1936 low up across its early October and late-November Bottoms was penetrated downside decisively the third week of May 1937. Moreover, a Multiple Head-and-Shoulders Top Reversal Pattern had been forming since February, with a critical neckline at 52. And the then-current Bull Market had already run for four years; “P” had come all the way up from 2! Cover up the chart from July 1, 1937, and you will agree there was plenty of reason for any technician to sell at once without waiting for the 52 neckline to be broken. But this, as we have said, was one of the exceptions that occurs to all technical patterns and rules. “P” turned right around and shot up to 64 before it was finished. Nevertheless, developments such as this carry a valuable warning. They very seldomly appear unless the Major Trend has almost run out; any further rise is dangerous to follow. and on the logarithmic or ratio scale. A series of points that fall on a perfectly straight, up-sloping line on arithmetic chart paper will, when transferred to a semilogarithmic sheet, produce a curved line that rises sharply at first and then gradually rounds over. Points that fall on a straight line on a semilogarithmic sheet will produce an accelerating curve on an arithmetic sheet, a line that slants up more and more steeply the farther it is projected. As a matter of fact, this variance is of little or no importance in defining Minor Trends, as they seldom run far enough for the dissimilar characteristics of the two types of scales to become effective. The same holds true for average Intermediate Moves of normal slope. However, when it comes to very long and strong Intermediates, the divergence may become marked and may make a considerable difference in the time and level of ultimate trendline penetration. Therein lies one of the strongest reasons for using semi-logarithmic paper in charting stocks for technical analysis. Let us postpone further discussion of this point until we take up Major Trends and go on now with the Intermediate Lines that are much the same on either type of scale, concentrating on Intermediate Uptrends. (Intermediate Moves, rather than Minor, are emphasized for the obvious reason Minors are of little practical importance in either trading or investing.) 40 Sales 100s 125 100 75 50 25 PX PARAMOUNT PICTURES 1945-1946 Jllll llllfllll —MARCH Biu_____ OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY ....._____ 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2V9 16 23 2 9 16 23 30 Figure 14.6 Double Trendlines (see next section) usually are not evident until after a trend has run for several months. In Paramount's accelerated phase of Intermediate Uptrend, which began in October 1945, the double nature of the basic trendline was not detectable until January 1946. The inner (upper) line was broken again in April, but the outer (lower) line was not decisively penetrated downside until May, at the Bull Market Top. 96 88 80 76 Sales 100's 125 100 75 50 25 Figure 14.7 Trend Channels in Bethlehem Steel in 1945. Prices burst out of the 92-98 Horizontal Channel (Rectangle) on the upside in January 1946 and went on to 114. A short-term trader might have sold around 94-96 in early November (because of the uptrend break) and rebought at 99 in January on the Rectangle breakout. (See discussion of Channels.) 14 Sales 100's 500 400 300 200 100 MARCH ’JUNE S PN APRIL M11M "DECEMBER • 24 1-8 15 22 29 JANUAR^FEBRUAR^ 5 12 19 26 2 9 16 23 AUGUST SEPTEMBER ’ 10 17 24 31 7 14 21 28 5 ’ Figure 14.8 A 10-month downtrend, extraordinarily long and straight, which was nicely defined by Double Basic Trendlines above the Price Channel and also by a double set of Return Lines below it. The Major Top started with a strong One-Day Reversal on December 3, 1945 and worked out into a Descending Triangle that broke February 19, 1946. The Symmetrical Triangle beginning to appear in September 1946 also broke out downside. 1 7 14 21 28 5 12 19 26 2 9 16 23 30 7 • 14 21 28 4 11 18 25 18 15 22 29 Figure 14.9 Well-marked Intermediate Basic Trendline and Return Lines in Southern Pacific, 1945. Note the Flags within Trend Channels—an up Flag in June and a down Flag in August. The Uptrend Channel, which began August 22, ran until February 1946. 34 32 30 28 26 Sales 26 24 22 20 19 18 Figure 14.10 Note the extent by which prices failed to come down to their Return Line in late November measured the distance by which they advanced through and above the Basic Down Trendline in early December. This rule is stated in the discussion of Trend Channels. Sales Figure 14.11 Six months of an Uptrend Channel that actually started to form in December 1943. It was broken downside in August 1945. To go back to first principles, granting that price advances trend up in more or less straight lines, it follows that finding and drawing the lines that accurately define those trends, they will serve two purposes: 1. When the trendline is broken (i.e., when prices drop down through it in decisive fashion), it signals the advance has run out. It calls time for the intermediate-term trader to sell out that issue and to look for reinvestment opportunities elsewhere. 2. When a small Top Reversal Pattern forms on the chart of an issue well up and away from that issue's Intermediate Up Trendline, so that there apparently is room for 24 22 20 19 18 17 16 Sales 100's 125 100 75 50 25 NASH - KELVINATOR NK 1946 g JULY AUGUST SEPTEMBER ApRIL MAY, , , JUNE , , 6 13 20 27 4 11 18 25 1 8 15 22 29" 6 13 20 27 3 10 17 24' 317 14 21 28 Figure 14.12 The downtrend that started in June 1946 in Nash-Kelvinator, signaled by the break of both its Intermediate and Major Up Trendlines (MUT) on July 15, made a nice channel until September. An Intermediate Down Trendline, drawn across the June 17 and July 1 highs, held for the August rally. The Return Line, drawn parallel to it across the June 20 low, held in late July but remained intact for only a few days at the end of August. The August rally in both price and volume pattern showed Bear Market characteristics. Compare this chart with Figure 8.25 and you will see that a Major Double Top was signaled on July 23. the downside implications of the Reversal Formations to be carried out before the trendline is violated, then the intermediate-trend trader may well decide to ignore the small Reversal Pattern. He can hold on so long as the trendline holds. The advantages of the first-named trendline function are obvious. Those of the second, although less obvious to the inexperienced, are equally important to the investor who has learned it is an expensive practice to switch out of every holding as soon as it shows evidence of a Minor Setback, provided the chance of further Intermediate Advance still exists. To accomplish these purposes it is necessary, as we have said, to find and draw the line that accurately defines the Intermediate Trend, and then to recognize when that line has been broken in decisive fashion. Our earlier quick review of how a trendline is constructed did not attempt to cover these points thoroughly. Tests of authority The following are some of the tests that may be applied to judge the technical validity, or authority, of an Up Trendline: 1. The greater the number of Bottoms that have developed at (or very near) a trendline in the course of a series of Minor Up Waves, the greater the importance of that line in the technical sense. With each successive “test,” the significance of the line is increased. Figure 14.13 The decline that took Macy down through an Intermediate Up Trendline (IUT) in June 1946 turned out to be also the drop from the head of a “Flat-Shouldered” Head-and-Shoulders Top, which was, in turn, part of a larger Complex. The upper neckline was broken June 19 and the lower on July 16. Note Pullbacks to each. F1, F2, and F3 are tentative Fan Lines. Prices were finally able to clear F3 in December, but by that time, a Primary Bear Market had been signaled, so the Fan Rule no longer applied. Fans call the turn only on Secondary (Corrective) Moves. A first and tentative Up Trendline can be drawn as soon as two Bottoms have formed, the second higher than the first, but if prices move back to that line a third time, make a third Bottom there, and start a renewed advance, then the validity of that line as a true definition of the trend has been confirmed by the action of the market. Should a fourth Bottom later form on it, and prices move up away from it again, its value as a trend criterion is very considerably enhanced. 2. The length of the line, that is, the longer it has held without being penetrated downside by prices, the greater its technical significance. This principle, however, requires some qualification. If your trendline is drawn from two original Bottoms that are very close together in time—say, less than a week apart—it is subject to error; it may be too steep or (more often) too flat. If the latter, prices may move away from it and stay high above it for a long time; they may then turn down and have declined well along in an Intermediate Correction before the trendline thus drawn is reached. But if the trendline has been drawn from Bottoms that are far enough apart to have developed as independent wave components of the trend you are trying to define, with a good rally and “open water” between them, then it is more apt to be the true trendline. Greater weight should be given to the number of Bottoms that have formed on a trendline (Test 1) than to its length alone (Test 2). 3. The angle of the trendline (to the horizontal) is also, to some degree, a criterion of its validity as a true delimiter of Intermediate Trend. A very steep line can easily be broken by a brief sideways Consolidation move—as, for example, by a compact Flag forming on an advance of the “mast” type—only to have prices shoot up again in another extensive advance. Such steep lines are of little forecasting value to the technician. The flatter, more nearly horizontal the trendline, the more important it is technically and, in consequence, the greater the significance of any downside break through it. ARKANSAS BEST 34 30 32 25 20 15 28 10 26 85 I— >80'81',82:83 84 8687 24 - 22 20 19 18 17 16 15 14 13 12 11 Sales 100's JANUARY Fl ARKANSAS BEST' F1 tati EBRUARY MARC 11412128 7 1141211 AUGUST 7 114'21128 4 XD.09 XD.09 Figure 14.14 “ABZ” dropped sharply following its late January high, capping off a nearly uninterrupted two-year rally. But despite the rapidity and severity of the Pullback, it was, in fact, a picture-perfect reaction, which stopped just above excellent long-term Support at the 1983 high after retracing almost exactly 50% from its January peak. Not only is the reaction a classic, but so, too, is the Fan Line development, which, when coupled with the recently completed Head-and-Shoulders Bottom, suggests “ABZ” has reversed its short-term downtrend. But “steep,” as applied to stock trends, is a relative term and one that we defies exact definition. Experience, which can only be gained by studying many charts and by actually building and working with them over a period of many months, brings an almost intuitive ability to distinguish between a trendline that is “too steep to hold” and one whose angle of rise is reasonable and should be maintained until such time as the trend is actually reversed from Intermediate Up to Intermediate Down. Trend slopes will vary from stock to stock according to their characteristic market habits. They will vary also according to the stages of the Primary Cycle—tending to become somewhat steeper in its later phases. The more chart history you have on any particular issue in which you are interested, the better able you will be to judge its present trend. (The foregoing statement, we might remark, applies to the interpretation of most other technical patterns and phenomena as well as to trendlines.) 38 36 34 32 30 Sales 100's 125 100 75 50 25 56 52 48 44 40 38 36 Sales 100's 50 40 30 20 10 Figure 14.15 A valid application of the Three-Fan Principle. Note prices after they pushed up through F1 in March fell back to it but did not repenetrate it. When F2 was broken in late March, prices came back to it at the end of April but did not go below it. F3 was surmounted in May. This was a Bull Market Reaction; "AS" made its final Top above 64 in August. The March-May pattern might be called a weak Double Bottom. DELAWARE & HUDSON DH JULY ' AUGUST SEPTEMBER ’OCTOBER NOVEMBER DECEMBER 8 15 22 29 5 12 19 26 2 9 16 23 30 7 14 21 28^4 11 18 25 29 16 23 30 Figure 14.16 Try the Three-Fan Principle on this chart of the late 1944 Bull Market Reaction out of a Symmetrical Triangle in "DH." F1 should be drawn from the August 30 high down across the September 12 closing. F2 is already marked on the chart but not labeled. F3 would extend from August 30 across the Rally Top of November 9. It was surmounted on increased volume November 21. The mid-September to November price pattern looked at first like a Descending Triangle, but volume began to rise in October. One clue to relative steepness is afforded to those who employ the TEKNIPLAT semilogarithmic chart sheet, which has been used for most of the illustrations in this book. When projected on this scale, Intermediate Uptrends on the daily charts, in the great majority of issues selling in the 10 to 50 range, rise at an angle of approximately 30 degrees to the horizontal. Some will be a trifle flatter, some a trifle steeper, but it is surprising to see 30 28 26 24 22 BUCYRUS ERIE CO. 1984 20 19 18 17 16 15 14 13 12 F. 11 Sales ~ 100's 1000 800 600 400 200 M ARCH APRIL MAY IUNE IUL Y AUGUST SEPTEMBER O CTOBER N OVEMBER DECEMBER ~ 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 301 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 <10 17 24 1 8 15 22 29 XD. 11 XD. 11 Figure 14.17 In a downtrend throughout the first half, “BY” gave back a large part of its 1983 rally by mid-summer. Nevertheless, the 1982 low held the Bears in check, and over the following several months, this issue etched out an excellent Fan Pattern. Fan Line 1 gave way in mid-September on a high-volume penetration. The advance quickly lost its momentum, but old Resistance-new Support contained the Pullback perfectly, setting the stage for a rally through Fan Line 2. This occurred in mid-November on good volume. Following a five-week correction, “BY” charged through Fan Line 3 on the best volume of the three breakouts. how often the trendline falls very close to the 30-degree slope in stocks of average volatility and activity. Thin, highly speculative issues and heavy investment stocks offer exceptions, the former usually steeper and the latter flatter. The semilogarithmic scale has the virtue of reducing all movements, regardless of price level, to a ratio or percentage basis. On a straight arithmetic scale, the trendline will ordinarily be steeper on a stock trading in the On weekly charts employing the same price scale, the angle of Intermediate Advance will be much steeper than on the daily plotting. Different scaling will produce different angles. It is pure happenstance that TEKNIPLAT sheets tend to produce the 30-degree ascending line. Unfortunately, TEKNIPLAT paper is no longer produced but a comparable analysis is Validity of penetration We have these three criteria, then, for appraising the authority or accuracy of an Intermediate Up Trendline: (1) the number of times it has been “tested” or contacted without breaking, (2) its length or duration, and (3) its angle of ascent. Given a trendline that, by the application of one or more of these criteria (preferably by at least two of them), appears to be a reasonably accurate delimiter of the trend, our next problem is to determine when it has been finally and definitely broken. Again, we can set up three tests or criteria, two of which are practically identical with the rules laid down in earlier chapters for determining decisive breakouts from Reversal or Consolidation Formations. The first is extent of penetration. To be decisive, prices must not only push through the line but also close beyond it by a margin equal to about 3% of the stock's price. This does not need to be accomplished in a single day, although it often is. The 3% penetration may come as a result of two or three days of gradual decline. The second is volume of trading. We saw how activity should always be expected to rise notably on a genuine upside breakout from an Area Pattern but need not increase to confirm a downside break. We have seen how, in many cases, volume does not show much increase on the first day of a down-break from Descending Triangles, for example, but usually it picks up rapidly as the decline proceeds. In our present discussion, we are dealing with Up Trendlines, and their penetration is, therefore, analogous to a downside breakout. We should expect the same rules to apply, and in general, they do. Given a close beyond the line by a price margin of 3%, it is not necessary for volume to have expanded much at that point to confirm the validity of the penetration. The fact is, however, that the breaking of an Intermediate Up Trendline, much more often than not, is attended by some visible intensification of trading activity. To that extent, then, an increase in volume may be regarded as confirmation of a decisive penetration. It is a particularly useful adjunct in borderline cases. If, for example, prices start to decline from a point somewhat above the trendline, move down through it on conspicuously expanding turnover, and close beyond it, say, only 2% of the price but at or near the bottom of the day's range, then our 3% margin rule has not been satisfied, but the lesser margin plus the volume action may be construed as decisive. Beware, however, and do not be stampeded into a hasty commitment by the shakeout move that cracks down through a trendline with a great flurry of activity—perhaps several minutes of late tape—and then turns up again to close the day back above the trend or at least very close to it. This may very well be—in fact, usually is—a false move so far as that particular moment is concerned. But watch the next few days' performance very closely; the technical situation is evidently critical, or else a shakeout could not have been easily staged. The third test is also one that applies particularly to breaks that are borderline so far as margin of penetration is concerned. Suppose a stock that is quoted in the neighborhood of 40 declines through a well-established Intermediate Up Trendline and closes 1 or 1 1/4 points below it—a margin that is only slightly less than our specified 3%—without much, if any, enlargement in trading volume. Suppose it fluctuates there for a day or two in a dull and narrow market and then starts to rally; if there is no pickup in activity on this recovery move—if prices simply edge up feebly to the underside of the trendline and tend to “round over” there without being able to close clearly above it—then the situation is indeed critical, and the slightest sign of renewed selling pressure may be taken as a signal that the uptrend has been decisively broken. Such a return move as we have described in the preceding paragraph is known as a Throwback or Pullback. We previously described analogous developments that follow breakouts from Head-and-Shoulders and other patterns, and we will have more to say about them in connection with trendlines later on. The three tests we have been discussing, which help to establish the validity of a trendline penetration, cannot, unfortunately, be applied inflexibly and without a modicum of judgment. The majority of Intermediate Trendlines can hardly be said to possess the precision of pattern boundary lines, and even in the latter, some leeway must be allowed. There are exceptions, as we have taken occasion to remark several times before, to every technical rule of price action, but judgment in the establishing of significant trendlines and in interpreting their penetrations does come with experience. Amendment of Trendlines When a trendline is broken by a margin less than decisive, and prices subsequently rally back up through it again, doubt naturally arises as to the continued authority of the original line. Should it be discarded, revised, or allowed to stand as is? Here again, judgment and experience must be called into play, but a few general principles are helpful in deciding. If the original trendlines depended on only 2 points, that is, on the first two Bottoms across which it was projected and the indecisive penetration occurred when prices returned to it for the third time, then the line had better be redrawn across the original first and the new third Bottoms. (Of course, you will not do this until prices have moved up from the third Bottom point and it has become clearly established as a Minor Bottom.) Or, you may find in such cases that a new line drawn across the second and third Bottoms works better; if the first Bottom was a Reversal Day with its closing level well above the low of its range, you may find this new line, when extended back, strikes just about at that closing level. If, on the other hand, the original trendline has been “tested” one or more times after it was drawn—if, that is, a third and perhaps a fourth Bottom have formed on it without penetrating it and have thus “confirmed” it—then the subsequent indecisive penetration may be disregarded and the original line considered to be still in effect. An intraday break through an established trendline that, however, does not result in prices closing beyond the line may be disregarded and the line left as is. In fact, as has already been suggested, the closing prices frequently make a better trendline than the extreme intraday lows of successive Bottoms, which is most apt to be true with “thin” stocks subject to erratic swings. A bit of experimenting with different lines often pays. A thin, transparent ruler is especially useful for trendline study. There is another type of price action that may require redrawing a trendline. Sometimes, after a line has been projected up across the first two Minor Bottoms in an advancing trend, a third Minor Bottom will form, not on that line, but well above it. In such cases, let the original line stand, but draw in a new one across the second and third Bottom points, and watch developments. If the rally from the third Bottom peters out quickly, and the new trendline, as a consequence, is soon broken, then the original trendline is probably the correct one. But, if the third Bottom turns out to be a “strong” one, and the new line stands up well for several weeks (and if it was not, patently, too steep to begin with), then the old line may be abandoned and the new one regarded as the better trend definer. Double Trendlines and trend ranges In the course of your “cutting and trying” in an effort to fit a good line to an Intermediate Uptrend, you may find that two parallel lines, perhaps a point or so apart in a stock selling in the 30s, will define the true trend pattern much better than any single line that can be drawn. Sharp Bottoms and shakeout thrusts in such cases will often fall along the outer or lower line, while the duller, more rounded reactions will stop at or near the upper or inner line. Or the two lines will mark off a range somewhere within which successive Minor Down Waves tend to halt and reverse. Such Double Trendlines are really plentiful, although most chart technicians seem to be quite unaware of them. It pays to develop an eye for them—to watch constantly for trends to which they can be applied. They will clear up many situations in which attempts to find a single critical line lead only to frustration and to your finally giving up in disgust. Trends that you find are best defined by Double Trendlines (or by a very Broad Trendline, if you prefer) cannot be regarded as having ended until the outer, lower line has been decisively penetrated. In that connection, note what we said at the beginning of this topic: sharp, shakeout Bottoms tend to fall on the outer line. The recoveries from such Bottoms are usually just as sharp, and prices, therefore, rally back above the upper, inner line quickly. Warning of an impending break in the trend is given when prices come down to the outer line steadily, rather than by the quick “shake” type of reaction, and then have difficulty rallying back through the inner line. Watch such developments closely. A break down may not follow; the situation may still be “saved,” but the chances are that the trend is near its end. Trend Channels At the start of this trend study, we applied the term Basic Trendline to the line that slopes up across the Wave Bottoms in an advance and to the line that slopes down across the Wave Tops in a decline. Furthermore, we noted the opposite Reversal Points, that is, the wave crests in an advance and the wave troughs in a decline, were, as a rule, less clearly delimited. That is one of the reasons why all of our discussion up to this point has been devoted to Basic Trendlines. Another reason is that the technician's most urgent task is to determine when a trend has run out, and for that purpose, the Basic Line is all important. In a fair share of normal trends, however, the Minor Waves are sufficiently regular to be defined at their other extremes by another line. That is, the Tops of the rallies composing an Intermediate Advance sometimes develop along a line that is approximately parallel to the Basic Trendline projected along their Bottoms. This parallel might be called the Return Line because it marks the zone where reactions (return moves against the prevailing trend) originate. The area between Basic Trendline and Return Line is the Trend Channel. Nicely defined Trend Channels appear most often in actively traded stocks of large outstanding issue—least often in the less popular and the relatively thin equities that receive only sporadic attention from investors. The value of the Trend Channel concept for the technical trader would hardly seem to require extended comment here; its tactical utilization is discussed in the second half of this book. Its greatest utility, however, is not what usually appeals to the beginner when he first makes its acquaintance, namely, the determination of good profit-taking levels. Experienced technicians find it more helpful in a negative sense. Thus, once a Trend Channel appears to have become well established, any failure of a rally to reach the Return Line (top parallel of the channel in an Intermediate Advance) is taken as a sign of deterioration in the trend. Furthermore, the margin by which a rally fails to reach the Return Line (before turning down) frequently equals the margin by which the Basic Trendline is penetrated by the ensuing decline before a halt or Throwback in the latter occurs. By the same token, given an established Trend Channel, when a reaction from the Return Line fails to carry prices all the way back to the Basic Trendline but bottoms out somewhere above it, the advance from that Bottom will usually push up out of the channel on the top side (through the Return Line) by a margin approximately equal to the margin by which the reaction failed to reach the bottom of the channel (Basic Trendline). Experimental Lines Your experienced technician, in fact, is constantly drawing trendlines of all sorts—Minor, Intermediate, and Major—on his charts. He will first very lightly pencil them in wherever he can find an excuse to draw one. Many will quickly prove to be of no significance; those he may erase. Others will “stand out,” showing evidence of technical authority, which he will make heavier or color, as suggested later on. He will be constantly on the watch for Double Trendlines and will draw tentative Return Lines to mark off possible channels at every opportunity. As soon as he has what appears to be a Basic Up Trendline, for example projected from two Bottoms, he will go back to the Top of the rally between those two Bottoms and draw from that parallel to the Bottom Trendline. If the next rally comes up to that parallel, stops there and turns down, he has a probable Return Line and channel established. This practice of drawing in and experimenting with every trendline, which the price action permits or suggests, is earnestly recommended to the reader of this book, particularly if the technical approach is new to him. It is the quickest way—in fact, the only way— of acquiring the experience we have stressed as essential to recognition, judgment, and utilization of trendline implications in trading. Perhaps we should add here one “don't” for the beginner. You will have noted we have not mentioned a line projected from a Bottom to a Top, or vice versa. Trendlines are always drawn across two or more Bottoms, or two or more Tops. They should never be drawn to cross through the price track. (Prices may cross their extensions later, but this should not have happened at the time the lines are first drawn.) If you did not know better, you might, for example, put in a line from the Top of the left shoulder to the Top of the right shoulder of a Head-and-Shoulders Formation, thus cutting through the head, but such a line would have no technical validity. Consequences of Trendline penetration: Throwbacks At the beginning of this chapter, we mentioned the probable consequences of a breakdown through an Intermediate Up Trendline. To repeat, if an Intermediate Up Trendline has been constructed, has qualified as technically significant by the tests previously discussed, and has then been decisively broken, the inference is the uptrend is finished. And the consequences to be expected are either a full Intermediate Recession or a period of Consolidation (usually becoming a recognizable Area Formation). Technical indications of other sorts may be seen on the chart, which will suggest which of these two consequences is the more likely. In either event, the Intermediate Trend trader will certainly look twice before attempting to find further profit in that particular situation at that time. A more immediate but less important probable consequence of trendline penetration has also been mentioned—the “Pullback.” Pullbacks that follow breakouts from Reversal and Consolidation Formations have been described in our earlier studies of those price patterns. It is easy to understand why a rally that develops after prices break out through the lower boundary of a Rectangle, for example, will be stopped when it gets back to that boundary by the Resistance (supply) now residing there. Support-Resistance Theory enables us to rationalize most of the Throwback moves that occur after prices have broken out of other types of Reversal or Consolidation Areas. The Pullbacks that follow trendline penetrations cannot be thus rationalized; yet they occur much more frequently, and they appear to be stopped much more exactly at the old trendline level than is the case with Area Formations. Why should prices, after they have thrust down through a rising trendline, perhaps for several points, turn back up and ascend to or very near the old trendline, stop there, and then go off in renewed decline? The Top of that Pullback Rally may be 2 or 3 points above the original penetration level, because the trendline is sloping up all the time; nevertheless, there it stops, falters, and gives up. No one knows why supply should overcome demand or why Resistance should be so plainly evident at that particular point whose level is determined by two variants—the slope of the line and the time it is reached. You cannot reasonably expect a Pullback Rally to climb all the way back to a trendline that is ascending at a very steep angle, which may mean the attainment of a new high price for the entire Intermediate Uptrend; yet even that happens in more than just a few cases. What can be counted on in the great majority of typical Up Trendlines (those that slant up at a normal or fairly flat angle) is that after the line has been broken, a Pullback Rally will develop, either in a few days or in the usual Minor Wave tempo and will carry prices back up to the projected trendline. Throwbacks do not occur, it should be noted, when prices erupt through a Return Line, that is, break out of the top side of an Uptrend Channel. Or, more correctly stated, the Return Line does not function as a Support against a Throwback after prices have gone through it. An unusually strong upswing in a Rising Trend Channel may carry beyond the top of the Channel as defined by its Return Line, but the next reaction may go right back down through it without evidencing any hesitation at its level. The Throwback is one of the mysteries in trendline price action to which we alluded at the outset. The technical analyst who studies trends and trendlines over any considerable period will discover many other even more mysterious phenomena that cannot find space in this treatise, as no way has yet been found to put them to practical use in trading and investing. They are extraordinarily interesting in retrospect, but they are not subject to forecast. Intermediate Downtrends In all of the foregoing discussion of trends and trendlines, we have concentrated on uptrends; we have, in fact, had in mind specifically Intermediate Advances in the direction of the Primary Trend, that is, within a Major Bull Market. Those particular trends are most apt to develop “normally” and are most amenable to trendline definition. Intermediate Down Moves in a Major Bear Market may well be taken up next. Before discussing the respects in which they differ from Primary Advances, recall that the Basic Trendline on a down-move is the line projected across the Tops of the rallies within it. The Trend Channel will be to the left of that trendline and below it on the chart. The Return Line (if any) will define the Bottom of the channel. Intermediate (Bear Market) Downtrends are far less regular and uniform in their development than Bull Market Advances. Their angles of decline are characteristically steeper, and this is particularly true, of course, of the Panic Moves typical of the second phase of a Bear Market, as in our discussion of Major Trends in Chapter 3. Moreover, prices have a tendency to drop away from any trendline drawn across the first two Rally Tops; in other words, to curve down or accelerate as the move proceeds. This shows plainly on an arithmetically scaled chart and even more conspicuously on a semilogarithmic sheet. The practical results of this down-curving tendency are not so important, insofar as it delays the penetration of the original trendline and, hence, the giving of a signal of trend change. The fact is prices tend to thrash around for some time, making a base at the Bottom of one of these precipitous declines. In so doing, they work out sideways on the chart and the trend frequently does not turn up visibly until after the trendline has finally been reached and broken through on the upside after all. Thus, there is justification for drawing down trendlines and keeping them in view even though they may seem, for some time, simply to travel off into space with no apparent relevance to the actual trend of prices. It naturally follows from the above that Return Lines on most Bear Market Declines have little practical utility; they are, more often than not, very quickly broken downside. Good channels are hard to find. However, and this is of considerable practical importance, the very last Intermediate Downswing in a Major Bear Market is the last Primary Move that leads to the final, longterm Bottom, which is usually cleaner, more regular, and less precipitous—in other words, it is a more nearly normal trend of the sort we expect to find in most Intermediate Advances in a Bull Market (except that it slants down instead of up). This interesting habit is, as we said, of practical importance. Knowing it, we have an additional and very useful clue to the end of a Bear Market. When, after a Major Bear Trend has proceeded for some time and distance, and has experienced at least one Panic Sell-Off, it then goes off in another but less active and more orderly decline, and this decline develops and follows a good trendline. Watch it closely though. If this Intermediate holds to its steady and not-too-steep downward course—if its trendline is contacted several times by Minor Rallies or it produces a fairly consistent channel and prices do not “fall out of bed” down through its parallel Return Line, then the eventual upside penetration of this trendline may well signal a Major Turn, that is, the inception of a new Bull Market. Corrective trends: the Fan Principle In this study of Intermediate Trendlines, we have left to be taken up last the subject of Secondary or Corrective Trends. These are the Intermediate Declines that interrupt the Primary Advances in a Bull Market, and the Intermediate Recoveries that alternate with Primary Declines in Bear Markets. Intermediate Reactions against the Major Direction of the market take a variety of forms. Sometimes, as we have seen in our earlier study of chart patterns, they run out into Consolidation Formations—Triangles, Rectangles, and so on—in which the net price reaction is of minor consequence, but time is consumed in backing and filling before the Primary Trend can be resumed. In such cases, there is no basis for drawing an Intermediate Trendline, nor is one needed for any practical purpose. At the other extreme, so to speak, we find Corrective Swings that develop as a more or less orderly straight-line return of moderate slope to the nearest good Intermediate Support or Resistance Level, retracing perhaps a third to a half of the preceding Primary Swing. These reactions produce good trendlines, as a rule, and the eventual penetration of their trendlines is a good technical signal of Reversal. Intermediate Corrections clearly of this type are relatively rare. A third form taken by Intermediate Corrections is nearly as common as the first named above (Consolidation Pattern) and much more common on the charts than the second. In a Bull Market, it starts with a sharp reaction that proceeds for several days—perhaps for as much as two weeks—producing a steep Minor Trendline. This line is broken upside by a quick Minor Rally, after which prices slide off again in a duller and less precipitate trend. A second Minor Trendline may now be drawn from the original high point across the Top of the upthrust that broke the first trend. This second trendline is broken by another partial recovery thrust, and a third and still duller and flatter sell-off ensues. A third trendline can now be drawn from the original high across the Top of the second upthrust. The whole move, by this time, has taken roughly and irregularly a “Saucering-out” form. The three trendlines drawn from the original Reversal points from which the Corrective Decline started, each at a flatter angle than its predecessor, are known as Fan Lines. The rule is when the third Fan Line is broken upside, the low of the Intermediate Correction has been seen. There are exceptions to this rule—as there are to every so-called rule of technical chart analysis. Rarely, a correction of this type will go on to make another dip to a new low for the whole corrective move before prices really start to round up again. But the Three-Fan Principle works in the great majority of cases. Moreover, it offers the trader an opportunity to take a position at a point at which he can logically employ a very near stop order and, thus, limit his loss to a controlled amount if the rule does not work out. It is interesting to note that prices consistently throw back in these movements to the preceding Fan Line after each upthrust. The new Primary Swing, once the low has been passed, usually starts slowly and carries out for a time the Saucer picture. The Three-Fan Rule works just as well in calling the turn on Intermediate Recoveries in a Bear Market, the majority of which take the rounding form that is adapted to its use. Note, however, that the Fan Principle is normally applied only to corrective moves, that is, to determine the end of Intermediate Reactions in a Bull Market and the end of Intermediate Recoveries in a Bear Market. Major Trendlines will be outlined in the following chapter, but before we leave this study of Intermediate Trends, it will be well to state again that the practical application of trendlines in actual trading requires experience and the good judgment to be attained only therefrom. Some technical analysts depend largely on trendline studies, few attempt to use trendlines almost exclusively, but the majority have found they are best employed as an adjunct to other technical data. Technical analysis of a stock chart is something like putting together a jigsaw puzzle. There are many items to be considered, among them volume, pattern, and the measurements derived therefrom, Support and Resistance Levels, trendlines, and general market prospects—and all fit into place to get the complete picture. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter fifteen Major Trendlines In the preceding chapter on Intermediate Trendlines, mention was made of the distinctive effects produced by arithmetic and semilogarithmic plotting, but it was noted that these differences were unimportant in connection with Minor Trends or Intermediate Trends of average duration. When we come to Major Trends, however, we find the difference does become important. Major Trendlines are illustrated by Figures 15.1 through 15.20. If you will examine a large collection of arithmetically scaled monthly charts covering 10 years or more of market history, you will quickly see that Bull Trends, in the great majority of actively traded, more or less speculative common stocks, tend to accelerate. They start slowly and push up at a steeper and steeper angle as they approach a Major Top. This up- curving path takes them farther and farther away from any straight trendline drawn from two Bottom points in the first, slow-moving stage of advance. As a consequence, they top out and have gone down a long way in a recession that may be of Major consequence before their straight trendline is again touched. Many of the stocks that show such typical accelerating curves in their advance (Major) Trends on arithmetic paper produce straight trends on a logarithmic scale. As a consequence, their logarithmic Major Trendlines are broken more quickly, and usually at a higher price level, when at last their trends do top out and turn down. In the case of such stocks, then, the logarithmic scale gives a better trend signal. But there are other stocks—mostly of the more substantial investment or semiinvestment type—that tend to advance in straight arithmetic trends. Consolidated Edison, General Motors, and Libbey-Owens-Ford Glass are examples. (The trends of these on a logarithmic scale show a decelerating curve.) Still a third class, made up largely of highgrade preferred stocks, produces a rounding over or decelerating Bull Trendline even on the arithmetic scale. And, finally, there are a number of issues whose normal Bull Market Trendlines fall somewhere between our first two types—that is, they curve up away from a straight path on the arithmetic scale, but curve over to the right (breaking through a straight line) on the logarithmic scale. (EN: Fortunately, in this age of computers and easily processed data, there is analytical software that allows the analyst to instantaneously switch between the scales. Desktop packages are available[(see Appendix B, Resources] and a number of internet sites have these capabilities.) All of which, the reader, at this point, no doubt finds most discouraging. Some stocks do this and some stocks do that, but what help is there for us in such a mix-up? The answer lies in studying the history of each issue in which you may be interested. Most stocks do not change their habits and their technical characteristics much from one Bull and Bear cycle to the next. An issue, like General Motors, that produces a straight-line Bull Trend on an arithmetic chart in one Primary Upswing is likely to repeat that performance in the next. EN10: GM after the fall will, we suspect, retain its previous habits, but that remains to be seen. As a matter of interest, stocks do sometimes change over a long period of years. Companies that were regarded as extremely speculative when their shares were first listed 60 40 20 Sales 100's 4000 2000 Figure 15.1 The straight-line Bull Market Trend of General Motors on an arithmetic monthly chart: 1941 low, 28 5/8; 1946 high, 80 3/8. Figure 15.2 The up-curving trend of a speculative motors stock, Hudson Motors. Compare this with “GM”: 1941 low, 2 5/8; 1946 high, 34. Figure 15.3 Typical decurving Major Bull Trend of a high-grade preferred stock. This is Curtis Publishing $7.00 Preferred: 1942 low, 12; 1945 high, 154. 30 20 10 Sales 100's 1200 1000 Figure 15.4 The accelerating uptrend of the common stock of the same publishing company: 1942 low, 3/8; 1946 high, 26. Figure 15.5 A conservative investment-type utility stock makes a straight- line Major Bull Trend. This is Commonwealth Edison: 1942 low, 17 3/8; 1946 high, 36 1/8. Leverage is an important factor in trends. 15 10 5 Figure 15.6 The up-curving trend of a low-priced “junior” utility, International Hydro-Electric: 1942 low, 1/4; 1946 high, 15 1/2. Sales 100's 400 200 Figure 15.7 A speculative oil stock, Houston Oil: 1942 low, 2 1/4; 1946 high, 30. Compare this picture with “SOH” in Figure 5.8. Figure 15.8 Straight-line uptrends in an investment oil, Standard Oil of Ohio: 1942 low, 10 1/8; 1946 high, 30. Note: trendline unbroken until 1948. Figure 15.9 Steel stocks have the speculative or accelerating type of Primary Uptrend, Republic Steel: 1942 low, 13 3/8; 1946 high, 40 7/8. Figure 15.10 The normal Major Bull Trend of heavy industrial issues is up- curving, American Car & Foundry: 1942 low, 20; 1946 high, 72 3/8. 40 80 60 Figure 15.11 A low-priced building stock, Celotex Corporation: 1942 low, 6 1/8; 1946 high, 38 1/8. Figure 15.12 A highly speculative, low-priced issue, traded on the Curb Exchange, Claude Neon Lights: 1942 low, 1/8; 1946 high, 9. Figure 15.13 The tobacco stocks follow the investment type of trend. This is Liggett & Myers: 1942 low, 50 1/2; 1946 high, 103 1/2. Note the Double Trendline. 70 60 50 40 Sales 100's 400 200 Figure 15.14 High-grade food issues (Corn Products Refining) resemble the tobaccos: 1940 low, 40 1/4; 1946 high, 75 3/4. 192 176 160 152 144 136 128 120 112 104 96 88 80 76 72 68 64 60 56 52 48 44 Sales 100's 1935 1936 1937 1938 Figure 15.15 In the process of “pulling back” to a very steep Up Trendline, prices may easily go to a new high. Note the Pullback of August 1936 in this weekly chart of Westinghouse Electric. The second, less steep line turned out to be the true Major Bull Trend. Note that the February-April price pattern in 1936 could not be considered a true Double Top Reversal of Primary import because the recession between the two highs was only about 10% of the Top's value (around 122). Figure 8.21 shows on a daily chart the final Top Reversal Formation that “WX” made in 1937. may attain an increasingly important and stable position in the general economy, with the result that, eventually, their stock acquires a solid investment rating. Their Bull Market Trends will then gradually change from an up-curve to a straight line and, finally, to a decelerating curve. Other old, established corporations may lose position and rating, as well as shift from the investment type of trendline to the speculative. But, it is true in general, that Major Patterns do repeat. If you are keeping your own set of manual monthly charts, you can choose whichever scale you please. But most technical chart followers prefer to buy their long-range pictures readymade, thereby getting a much more extensive history of many more issues than they could hope to chart themselves. Since the only comprehensive portfolios of monthly charts that are available at reasonable cost are arithmetically scaled, you will possibly have to make these serve all purposes. (EN: No longer necessary because of the availability of good software and internet chart sites. See Appendix B, Resources.) You will find with a little experimentation that an architect's French curve can be used to plot good Major Uptrend Lines on many of the issues whose normal Bull Trends accelerate away from a straight line. 400 360 320 280 240 200 160 120 DOW - JONES INDUSTRIAL AVERAGE ranmnnninnmnsjwssss :::::::::::::: Figure 15.16 The 1929-1932 Primary Bear Market was the only one in all stock market records that produced a Straight-Line Major Downtrend. Trace also the Support and Resistance Levels throughout this 14-year history of the Dow Industrials. Each rally in the great Bear Move stopped at or near a previous Bottom level. Each decline stopped near the level of a Congestion in the 1924-1929 Bull Market. See also the level of 1937 Top. (Source: Chart courtesy of Market Research, Inc., at http:// wwwbarchart.com.) Figure 15.17 S&P Reagan Crash. As can be clearly seen, this crash sent numerous signals, starting with the breaking of a Major Trendline by more than 2% in late August. Once this occurs extreme caution and watchfulness must be exercised. The darker and darker complexion of things is brought out by the “smart selling,” which shows many “downthrust days" toward the end (October 10-20). The April trendline breaks (by more than 2%) would have ejected the trend trader also to be put back long in June. Observance of the 2%-3% trendline-break rule or use of Basing Points and progressive stops (see Chapters 27 and 28) would have avoided much needless grief. Figure 15.18 S&P Long-Term Perspective. Viewed from afar it seems an exercise in futility to attempt to “time the market.” One must keep in perspective the crashes in market prices are timed to coincide with personal and business needs for short-term liquidity, or cash. One must also remember the market behavior from 1965-1982, as well as the table of Dow Theory Performance from Chapter 4 (Table 4.2). Figure 15.19 Three Bull Market Tops, 1929, 1987, 1998. Notice here that in each case the crash occurred after the nearest important trendline had been decisively broken—usually trendlines of approximately three months by 2% or more, and sometimes accompanied by reversal formations. All historic tops will show evidence of attempts to resume the trend after a break of this kind. Belief dies hard. Nonetheless, hedging or exiting on these trend breaks proves to be the best strategy over and over again. Figure 15.20 The Bull 1990s top in the S&P gave much clearer readings than the Dow top, with the broken trendlines being paramount. But while the Dow flirted with the emotions of Bulls who wanted to believe in the Dow 36,000, the S&P broke its trendlines and went south for the winter, a potentially very long winter. This might have started off as a rounding top and then became a complex-complex top, and you can even see traces of a Head-and-Shoulders top in it. It is the editor's opinion we may never see such unruly tops again in this generation. The pent-up greed, lust, and naivete as even the bootblacks (they still have those don't they?) rushed to get the latest tulip bulbs. Tulips are like century plants; they only bloom once each hundred years. A little old lady with a ruler could have saved her portfolio here. All it takes is not believing the hype (Dow 36,000 indeed!) and making an unemotional analysis and honoring the stops. The tests for the technical significance of a Major Trendline are substantially the same as those specified for Intermediate Lines in the preceding chapter. A little more leeway must be allowed on penetrations— again, a matter of judgment—but you are dealing with coarse data and long swings here, and what you want from your monthly charts, primarily, is perspective on the broad picture. One more point regarding the construction of Major Bull Trendlines: the best lines—the most useful—are drawn, as a rule, not from the absolute low of the preceding Bear Market but starting from the next Intermediate Bottom. The accumulation area at the beginning of a Bull Market is usually long and drawn out in time and relatively flat. The first trendline that can be drawn from the extreme low point may, therefore, be too nearly horizontal to express the genuine Bull Trend that starts with the markup phase. The several charts showing Major Trendlines that illustrate this chapter will demonstrate this point (EN: Especially Figure 15.14). It applies as well to many Intermediate Moves that start from Area Formations. Take the Head- and-Shoulders Pattern, for example: the true Intermediate Trendline usually starts from the right shoulder rather than from the head. Major Downtrends From the technical analyst's point of view, it is regrettable that few Bear Markets haveproduced Major Trendlines of any practical significance on the charts of individualstocks. A notable exception was the long Bear Market of 1929-1932, which producedmagnificently straight trendlines on the arithmetic plotting of a host of issues (as wellas in the Averages, to which we shall refer later). But it is almost impossible to findother instances in which a Bear Trendline having any forecasting value can be drawnon either arithmetic or semilogarithmic scale. The normal Major Bear Market Trend is not only steeper than the normal Bull Trend(because Bear Markets last, on the average, only about half as long as Bull Markets),but it is also accelerating or down-curving in its course. This feature is accentuatedand, hence, particularly difficult to project effectively on the semilogarithmic scale. The technician cannot expect to obtain much in the net of it, help from his MajorTrendlines in determining the change from a Primary Downswing to a PrimaryUpswing. This should not be taken, however, as advice to not draw trendlines on aMajor Down Move, or to disregard entirely any trendlines that may develop withsome appearance of authority. If you do not expect too much of them, they may,nevertheless, afford some useful clue as to the way in which conditions are tending tochange. The student of stock market action who is not altogether concerned with dollars andcents results from his researches will find Bear Market Trendlines a fascinating fieldof inquiry. They do some strange things even though they fail in the practical functionof calling the actual Major Turn and go shooting off into space, they sometimesproduce curious reactions (or, at least, appear to produce what would be otherwiseinexplicable market action) when the real price trend catches up with them months oryears later. But such effects, interesting as they may be, are, in our present state ofknowledge, uncertain and unpredictable. (EN: This fact may persist into the mists ofthe future and be thought of like Fermat's Last Theorem. Our present state ofknowledge in the twenty-first century is no further advanced than it was in Magee'stime.) We must dismiss this rather unfruitful topic with the reminder that one clue to the endof a Primary Bear Market is afforded by the Intermediate Trendline of its final phase,which we cited in the preceding chapter. Major Trend Channels Another difficulty is met when trying to draw Return Lines and construct channels forMajor Trends on an arithmetic chart. Owing to the marked tendency for prices tofluctuate in ever-wider swings (both Intermediate and Minor) as they work upward ina Primary Bull Market, their channel grows progressively broader. The Return Linedoes not run parallel to the Basic Trendline (assuming there is a good Basic Trendlineto begin with) but diverges from it. Occasionally, a stock produces a clear-cut MajorChannel Pattern, but the majority do not. A large Rectangle base was made on this weekly chart in April, May, and June 1937,but observe the poor volume that accompanied the breakout and rise from thatformation—an extremely Bearish indication for the Major Trend. The “measurement”of the Rectangle was carried out by August, but that was all. As is usually the case, it was impossible to draw a Major Down Trendline that hadany forecasting value on this chart. The beautiful straight trendlines that appeared inthe 1929-1932 Primary Bear Market led many chart students to expect similardevelopments in every Bear Market, but the fact is that 1929-1932 was unique in thatrespect. Semilogarithmic scaling will correct, in many cases, for the Widening Channel effectin Bull Trends, but then we run into the opposite tendency in Primary Bear Markets,and for that, neither type of scaling will compensate. Trendlines in the Averages Practically everything stated in the preceding chapter regarding IntermediateTrendline development in individual stocks applies, as well, to the various Averages.The broad Averages or Indexes, in fact, produce more regular trends and, inconsequence, more exactly applicable trendlines. This may be partly due to the factmost Averages are composed of active, well-publicized, and widely owned issueswhose market action individually is “normal” in the technical sense. Another reason isthe process of averaging smooths out the vagaries of component stocks, and the resultmore truly reflects the deep and relatively steady economic trends and tides. In any event, it is a fact that such averages as the Dow-Jones Rails, Industrials, and65-Stock Composite, The New York Times 50, and Standard & Poor's Average of 90stocks (the last two named being probably the most scientifically composed to typifythe entire broad market) do propagate excellent trendlines on their charts. (EN: As thereader will note, most of these indices are obsolete. In the modern age, the S&P 500probably best fulfills this function.) The very accuracy of their trends, particularly their Intermediate Moves, permits us toconstrue their trendlines more tightly. Less leeway need be allowed for doubtfulpenetrations. Thus, although we ask for a 3% penetration in the case of an individualstock of medium range, 2% is ample in the Averages to give a dependable breaksignal. Experienced traders know it pays to heed the Broad Market Trend. It is still easier toswim with the tide than against it. EN: Trendlines in the Averages and Trading in the Averages Numerous averages and indexes have come online since the fifth edition, includingthe S&P 100, S&P 500, Russell 2000, and so on. It would be an exercise in dailyjournalism to attempt to list all the indexes now available, as new ones spring up likeweeds after the spring rain. This is because the invention of a widely adopted indexcan be very lucrative for its creator S&P and Dow-Jones collect licensing fees fromthe “use” of their indexes by the exchanges. The constant addition of new tradinginstruments requires that current lists be kept in Resources, and the reader may alsoconsult the Wall Street Journal, Barron's, and the Investor's Business Daily whereprices of indexes and averages are reported. Online brokerages and financial newssites also offer up-to-the-minute lists and quotes on virtually all trading instruments.A list and links to these sites may also be found in Appendix B, Resources, and athttp://www.edwards-magee.com. As of the turn of the century, the most important of these indexes joining the Dow areprobably the S&P 500, the S&P 100, and the NASDAQ. In fact, these are probablysufficient for economic analysis and forecasting purposes, and certainly good tradingvehicles by means of surrogate instruments, options, and futures. Some would includethe Russell 2000 in this list. These indexes and averages have been created to fillneeds not addressed adequately by the Dow-Jones Averages. With this proliferation of measures of the market and various parts of it, a differentquestion arises questioning the value of the Dow alone in indicating the BroadMarket Trend. Limited research has been done on this question; however, my opinionis the Broad Market Trend must now be determined by examining the DowIndustrials, the S&P 500, and the NASDAQ Composite. Trading the Averages in the 21st century As pointed out in other new chapters and notes in the eighth edition, the ability totrade the Averages instead of individual stocks is a powerful choice offered bymodern markets. The index ETFs offer ideal vehicles for investing: The DIA, SPY, QQQ and IWM give the modern investor unparalleled flexibility and convenience.Magee was of the opinion that the Averages offered technical smoothness oftenlacking in individual issues. This would seem to be true intuitively. After all, just as amoving average smooths data, the average of a basket of stocks should dampen pricevolatility. Of course, as Mandelbrot pointed out, in a 10-sigma market stormeverything sinks. Illustrated in this chapter are several detailed cases following Magee's suggestion ofAverage trading. I attempt to demonstrate here two perspectives: one, the horror ofthe immediate, what the crash and panic look like as they occur; and two, what thecrash and panic look like in retrospect. We all live in the present, except for the greatbillionaires who can afford to doze through horrific Bear Markets. Bill Gates' networth varied by $16 billion or $17 billion in early 2000. This would put the ordinaryinvestor out of business. So the ordinary investor, you and I, have to respect the great yawning Bear Market.We must step to the sidelines and let the bear eat the foolish virgins, to borrow aBiblical metaphor. You will remember Magee opined that a trendline break of 2% was sufficient to causeliquidation of longs when analyzing the Averages. In the accompanying figures, thishypothesis is examined. EN9: In respect to the breaking of trendlines (by 2% or 3%), I should note thebreaking of a trendline is as much a warning as a signal to act. The break, instead ofa change of trend to the reverse, may indicate a change of trend to the sideways—intoa reversal or continuation pattern. chapter sixteen Technical analysis of commodity charts (EN9: Following the practice of allowing thereader to discriminate between the work of Edwards and Magee and that of the editor,a section on commodity trading, Chapter 16, has been added to the ninth edition. Seesame.) A little thought suggests the variously interesting and significant patterns we haveexamined in the foregoing chapters on stock charts should logically appear as well inthe charts of any other equities and commodities that are freely, constantly, andactively bought and sold on organized public exchanges. In general, this is true. Theprice trends of anything for which market value is determined solely (or for allpractical purposes within very wide limits) by the free interplay of supply anddemand will, when graphically projected, show the same pictorial phenomena of riseand fall, accumulation and distribution, congestion, consolidation, and reversal that we have seen in stock market trends. Speculative aims and speculators' psychologyare the same whether the goods dealt in are corporate shares or contracts for the futuredelivery of cotton bales. (For illustrations in this chapter, see Figures 16.1 through16.13.) It should be possible in theory, therefore, to apply our principles of technical analysisto any of the active commodity futures (wheat, corn, oats, cotton, cocoa, hides, eggs,etc.) for which accurate daily price and volume data are published. It should be, thatis, if proper allowance is made for the intrinsic differences between commodityfutures contracts and stocks and bonds. In previous editions of this book (EN9: up to the eighth), traders who cast longingeyes on the big, quick profits apparently available in wheat, for example, werewarned that commodity charts were “of very little help,” as of 1947. It was pointed out that successful technical analysis of commodity futures charts hadbeen possible up to about 1941 or 1942, but the domination of these marketsthereafter by government regulations, loans, and purchases completely subject to thechanging (and often conflicting) policies and acts of the several governmentalagencies concerned with grains and other commodities had seriously distorted thenormal evaluative machinery of the market. At that time, radical reversals of trendcould and did happen overnight without any warning so far as the action of the marketcould show. The ordinary and orderly fluctuations in supply-demand balance, whichcreate significant definite patterns for the technician to read, did not exist. Yet, whilefortunes were made (and lost) in wheat, corn, and cotton futures during the World WarII period, it is safe to say they were not made from the charts. During the past five or six years, however, the application of technical methods tocommodity trading has been reexamined. Under 1956 conditions, it appears thatcharts can be a most valuable tool for the commodity trader. The effects of presentgovernment regulation have apparently resulted in “more orderly” markets withoutdestroying their evaluative function. Allowing for the various essential differencesbetween commodities and stocks, the basic technical methods can be applied. 104 96 88 80 76 72 68 64 60 Sales 100's SEPTEMBER OATS Chicag< sir 1118'25 11 8 15'22T 8 15'22295112119263 W17124W7r142r28''5Ti219l26t 2 1 9 Figure 16.1 Oats, for obvious reasons, traced more “normal” patterns than Wheatduring the 1940s. This chart contains an H & S bottom, a Symmetrical Triangle thatmerged into the Ascending form, a gap through a former top level, and an interestingtrendline. The Island shake-out through the trendline was an extremely deceptivedevelopment. It may be in order here to discuss briefly some of the intrinsic differences betweencommodity futures and stocks referred to above and to some of the special traits ofcommodity charts. First, the most important difference is the contracts for futuredelivery, which are the stock-in-trade of the commodity exchange, have a limited life.For example, the October cotton contract for any given year has a trading life of about18 months. It comes “on the board” as a “new issue,” is traded with volumeincreasing more or less steadily during that period, and then vanishes. Theoretically, itis a distinct and separate commodity from all other cotton deliveries. Practically, itseldom gets far out of line with such other deliveries as are being bought and soldduring the same period, or with the “cash” price of the physical cotton in warehouses.Nevertheless, it has this special quality of a limited independent life, as a consequenceof which long-term Support and Resistance Levels have no meaning whatever.(EN10: This absolute may not be absolute. Evaluate the longterm charts for yourissue to see whether influence is evident.) Second, a very large share of the transactions in commodity futures—as much as 80%certainly in normal times—represents commercial hedging rather than speculation.(EN10: Less true in the twenty-first century.) It is, in fact, entered in to obviate riskand to avoid speculation. Hence, even near-term Support and Resistance Levels haverelatively less potency than with stocks. Also, because hedging is to a considerabledegree subject to seasonal factors, there are definite seasonal influences on the commodity price trends that the commodity speculator must keep in mind, even ifonly to weigh the meaning of their apparent absence at any given period. A third difference is in the matter of volume. The interpretation of volume withrespect to trading in stocks is relatively simple, but it is greatly complicated incommodities by the fact that there is, in theory, no limit to the number of contracts fora certain future delivery that may be sold in advance of the delivery date. In the caseof any given stock, the number Figure 16.2 In contrast with the grains, the technical action of the Cotton futuresmarkets has been fairly consistent with normal supply-demand functioning ever since prices rose well above government support levels. In this daily chart of the 1947October delivery (New York Cotton Exchange), the reader will find a variety offamiliar technical formations, including critical trendlines, a Head-and-Shoulders topthat was never completed (no breakout), and Support-Resistance phenomena muchthe same as appear in stock charts. Double trendlines are not at all unusual in Cottoncharts. of shares outstanding is always known. As this is written (1956), there are in thehands of stockholders 13,700,203 common shares of Consolidated Edison, and thatquantity has not varied for many years nor is it likely to change for several years tocome. Every transaction In the case of commodity future contracts—say, September wheat—trading beginslong before anyone knows how many bushels of wheat will exist to be delivered thatcoming September, and the open interest at some time during the life of the contractmay exceed the potential supply many times over, and all quite legitimately. (EN9: Asalways, volume data is a supplementary indicator to price. No one makes a profit onit.) One more important difference may be mentioned. Certain kinds of news—aboutweather, drought, floods, and so on that affect the growing crop, if we are dealingwith an agricultural commodity—can change the trend of the futures marketimmediately 1997 1998 1999 2000 2001 2002 2003 2004 Created with TradeStation Figure 16.3 A Rounding Bottom in Gold 1997-2004. “These patterns, when theyoccur after an extensive decline, are of outstanding importance, for they nearlyalways denote a change in Primary Trend and an extensive advance yet to come. Thatadvance, however, seldom carries in a ‘skyrocket' effect, which completes the entireMajor Move in a few weeks. On the contrary, the uptrend that follows the completionof the pattern itself is apt to be slow and subject to frequent interruptions, tiring outthe impatient trader, but yielding eventually a substantial profit.” So said RobertEdwards in remarking on Rounding Bottoms in stock charts. As may be seen here,this Rounding Bottom consists of a downtrend, a false signal off the Double Bottom(upon which a pretty penny might have been made by the agile trader), and ahandsome uptrend—and it all looks like a huge Rounding Bottom. and drastically and are not foreseeable given the present stage of our weatherknowledge. Analogous developments in the stock market are extremely rare. (EN:Except for acts of God and Alan Greenspan [and Ben Bernanke]). It is not the purpose of this book to explain the operation of commodity futuresmarkets, nor to offer instruction to those who wish to trade therein. This brief chapteris included only as a starter for readers who may want to pursue the study further.They should be advised that successful speculation in commodities requires far morespecialized knowledge and demands more constant daily and hourly attention. Theordinary individual can hope to attain a fair degree of success in investing insecurities by devoting only his spare moments to his charts, but he might better shuncommodity speculation entirely unless he is prepared to make a career of it. (EN: The editor has been, during his checkered career, a registered commoditytrading advisor. At the beginning of that career, I discussed these subjects with Mageeand received essentially the above comments, which are here reproduced from thefifth edition. Subsequently, I observed among my associates and partners, and on myown, that futures are eminently tradable with the adaptation of techniques andmethods described in this book. It is also true, as Magee says, that futures trading isso different in tempo, leverage, and character that the novice risks life, limb, andcapital in entering the area unescorted. Resource references are essential reading, butthe beginner is urged to educate himself before beginning trading with extensive studyand paper trading.) Figure 16.4 Gold, October 2011. The momentous earth-shaking power of a massiverounding bottom is vividly dramatized by the gold chart since 2005, as well as thepower of chart analysis to anticipate it. Regrettably, the editor did not compute theprice target implications of the pattern in the ninth edition in 2005. That computationwas made at the http://www.edwards-magee.com website at the time. There it wascomputed as follows (and the reader can do it for himself): depth of pattern, 248.20plus neckline 507.40, target 755.60. In fact, the possibility was entertained that theentire formation from 1980 to 2008 might be a Rounding Bottom. In which case, thedepth was 700.70, added to the neckline of 959 and resulted, actually achieve, in atarget of 1,660. Remember Edwards said these were probable minimummeasurements. Technical analysis of commodity charts, part 2: a 21st-century perspective In the search for the Philosopher's Stone, more sweat and money have been put intothe area of commodities and futures than were ever expended in the securities arena.There is a simple reason for this—great fortunes are made and lost with much greaterrapidity in the futures area than in securities. Of all the great dramatic moments instock market history, few are so memorable as the great Hunt silver market, or Sorosfacing off against the Bank of England, or of gold soaring to $1,000 an ounce(deferred contracts). And the saga continues in 2005: $50 oil? $60? $70? $100? Andthe effects, economic and psychological! In dimly lit garrets and brightly lit computerrooms thousands of researchers concoct systems to trade these markets—corn,soybeans, silver, copper ... Rocket scientists At times, individual traders and groups of traders have plundered (harvested?) thesemarkets for fairy tale profits. I know whereof I speak, having been a principal inCalifornia's first licensed commodity trading advisor that was founded by the NASArocket scientist R. T. Wieckowicz. During the 1970s, as the stock markets groundfutilely around the 1,000 level on the Dow, the futures markets returned yearly gainsin the 100% range. Consistently. For years. Those were the years of the Californiasystems traders and the beginning of computerized trading. From the primeval slimeof NASA, rocket scientists emerged to create a renaissance in market technology. Atthe time it seemed clear that science and genius had at last conquered the markets andthat clients would come buzzing from the world over like bees to a honey @SI.P(D) - Weekly COMEX L = 7.035 +0.077 +1.11% B = 0.000 A = 0.000 O =6.985 Hi = 7.085 Lo = 6.980 C = 7.045 V = 145 N 1998 1999 2000 2001 2002 2003 2004 2005 Created with TradeStation Figure 16.5 A Rounding Bottom in Silver, 1998-2005. The apparent RoundingBottom in silver, combined with the same pattern in gold, would seem to cast a pallover the economic situation for some time to come in 2005. This coincides with theapparent long-term patterns setting up in the securities markets. If the best that can behoped for in securities is a 1965-1982 kind of widely whipping market, commoditiesmay react as they did in the 1970s—with tidal wave markets. These markets can betraded by the well-capitalized chart analyst who is well seasoned. Tyros will losemoney learning the game whatever markets they trade. Their chances will beimmeasurably improved by applying the techniques taught in this book. In addition tothe technical pattern pictured here, there is every reason to suspect that a largefundamental shortage of silver bullion exists and will worsen. Ted Butler, athttp://www.doomgloom.com, is a long-term silver analyst (and associate of the editor)who anticipates a new silver blow-off is coming. One wonders what Nelson andBunker Hunt are doing at present. A very cautious investor (like Warren Buffet who isreported to have invested $1 billion in silver bullion) may defeat futures silvervolatility by buying the bullion. pot and that the rivers of profits would last forever. They did last for some time, andthen the markets changed. Mechanical systems that cut through the markets like areaper in a wheat field in Bull Markets grind up capital like sausage in sidewaysmarkets. Science and genius were revealed as the happy combination of man,moment, system, and market. Turtles? During the 1980s from the sea came crawling the Turtles. Progeny of the proteantrading wizard, Richard Dennis, the Turtles again harvested outsize profits from themarkets, reportedly running in the 80% yearly range. The so-called Turtles got theirname from a comment that Dennis is reported to have made that traders were madenot born, and he was going to raise traders like turtles. Additional reading about theTurtles is available in Jack Schwager's fascinating books, including Market Wizardsand others. Schwager's books are required reading for aspiring futures traders.Additionally, the trading manual of the Turtles will be found online athttp://www.originalturtles.org. This workbook, written by S K05(D)- n DailyCOM4EXL = 6.900-0.CC3-0.04%B =6.92 C A=6.93 5 O =6.9CCHi = 6.9C5Lo =6.9CCC =6.9CCV /=6 A' 1 1 A ’8.CCC . "7 cnn 0 s A A 7.500 , nc\c\c\ A 11 c V 1I 7.000 3H9CH < cnn ( 1 1 . -1 Y T 1/ 0.500 . 6 000 h r A M J J A S O N D 05 F M A M Created with TradeStation Figure 16.6 Silver, May 2005. Although the long-term silver outlook may be Bullish,the short term will be very volatile, especially for the thinly capitalized trader. Thenshort-term tactics must be adopted. The Island Top here at 1 is a gentle invitation tothe trader to take his profits and be gone. Even to short, with a stop just above thehigh. The run day after 1 adds a note of urgency to the invitation. The gap ispunishment for the hard of hearing and a bonus for the quick-witted (everybody whosurvives in futures is either quick witted or extremely well financed). The stop movesdown to the top of the gap day, then to the top of the next gap day, and for the veryapt profits are taken on the next run day down, on the principle of sell weakness, buyweakness. The tight trendline at 2 crossed by the heavy run day is a buy signal with the stop moving to the bottom of the gap at 3, where it is taken out a few days later bythe long-range day down. The run day at 4 is a short signal with the stop being at theday's high. Is it necessary to say short-term futures trading can be quite rapid? Thereis always bullion or associated stock plays. Curtis Faith, an original Turtle, contains virtually all of the elements necessary in atrader's systems and procedures manual. The manual was prepared according to thetraining Dennis gave his Turtles. Serious traders do not operate without some suchdocument. Certainly all of the serious traders I have known (a considerable number)have had fully developed manuals like the Turtle workbook. I cite the Turtleworkbook rather than others in my possession because it is publicly available athttp://www.originalturtles.org (as well as in the 9th edition of this book) and becauseit is beautifully articulated. In the late 1990s, the Turtles were made into turtle soup in the futures markets as themajority of systems traders wound up as hamburger meat. Is there a moral? Yes. Themarkets giveth and the markets taketh away. Science and genius are again revealed tobe the happy combination of man, method, moment, and market. The Turtle system is basically an adaptation of Richard Donchian's channel breakoutsystem. In the Donchian system, the trader goes long when the 20-day high is brokenand sells and goes short when the 20-day low is broken. In the 1970s, Dunn andHargitt evaluated a number of mechanical trading systems and found that Donchian'ssystem was superior to the others evaluated at that time. Will Donchian's system stillwork? Yes, Figure 16.7 Silver, October 2011. Here is what happened in silver after the ninthedition was published. Could there be any greater vindication of the value of chartslooking at the issue six years later? Just as in the case of gold, the analysis allowedthe analyst to anticipate a monster Bull Market. On http://www.edwards-magee.com,the authors wrote letters all during this time pointing out the silver Bull. Measuringthe entire formation, the depth is 33.96, added to the neckline of 37.5 equals 71.46.This seems quite fanciful to us, but that is the measurement. in broadly trending markets. Will the Turtle system still work? Yes, in broadlytrending markets. Plus, like virtually all mechanical systems, they do not knowwhether they are in a broadly trending market or not. They are blind—all they see areones and zeros. The addition to these systems of prudently applied chart analysis willimmeasurably improve their performance and risk characteristics. The application of Edwards and Magee's methods to 21st-century futuresmarkets During my career as a commodity trading advisor, I have known a number ofsuccessful traders and advisors who used what I would describe as Magee-type chartanalysis to make their trades. Often, other elements were input into their decision-making process, but manual charting was a key factor in their operations. Some ofthese traders used simple trendline analysis with price or volume filters and someused a combination of trendlines and support and resistance. All were trend followers. Having looked at the futures markets with some attention over the past several years,it seems to me there is no reason why chart analysis should not work as well now infutures as it has always worked in stocks. Essentially, the questions raised bysecurities trading are the same as those presented by futures trading in the analysis ofa chart. Is there a trend? Where are support and resistance? Is there a breakout? Arethere waves and wavelets? How do you enter and how do you exit? The great bug-a-boo of securities traders coming to the futures trading is the speed ofthe game. Like college football players stepping up to the NFL, there is a brutallearning curve and rookies are the most likely to get killed. I am not going to makeany effort here to present a primer for new futures traders, but rather, I will look atsome futures charts at the end of this chapter to show the journeyman that chartanalysis can be used Figure 16.8 Treasury Bonds. The double-pump triple-nod head fake is a specialty offutures markets. The fear and greed factor are multiplied by 10, like the leverage. Buthere in September 2004 Bonds, we can see how simple chart analysis can serve thetrader. The downtrend from March (1) is completely manageable with a simpletrendline and trend analysis. The end of the downtrend in May is marked by twostrong run days. At any rate, the stop would have been at May 1, using a Basing Pointkind of analysis. If we were going to trade it long, this would have been traded for ascalp (because we do not know whether or not there is a bottom). The break of thetrendline at 2 is an engraved invitation to get long and the trendline at 3 keeps us longuntil broken by the signal day at the end of July. This would put us short again,whereas a two-day trade as the signal day on the trendline at 4 puts us long again.Obviously, we are using very tight, short trendlines and long-range days (or run days)as signals. The use of the run day as a signal, combined with other indicators, iscommon in my experience among traders. as a decision-making method in these dramatic markets. Again, chart analysis has theweakness (or strength) of being a qualitative process. It will not make decisions forthe average trader, as a mechanical system will. On the other hand, a breakout is a breakout. A gap is a gap, leaving aside the questionof limit move gaps for the moment. A trend is a trend. And here is the great advantage that a firm grasp of charting methods can give the practitioner. It can give him theperspective to recognize the essential nature of the market at hand and choose to waitor to enter. Mechanical methods not having the qualitative discrimination of anexperienced chartist will blindly take every trade until they are out of money. Theexperienced chart analyst can sit back and say, this market has not yet made a bottomand the time to begin trading it long has not yet come. Or, he can recognize theessential differences between a trading and a trending market and adjust his tacticsaccordingly. As Magee noted in Chapter 16: Under what might be called normal market conditions, those chart patterns whichreflect trend changes in most simple and logical fashion work just as well withcommodities as with stocks. Among these we would list Head-and-Shouldersformations, Rounding Tops 306 303 300 297 294 291 288 285 282 279 276 273 270 Isi 1998-2004 Prophet Financial Systems, Inc. I Terms of use apply. Figure 16.9 Commodity Research Bureau Index, April 2005 Futures. Just asTriangles often work in securities, they often work in futures. Breakaway gap, secondbreakaway gap, runaway gap, second runaway gap—this is the formation before thesecond runaway gap is somewhat quizzical—it might be considered a flag, but it hasthe same effect, and depending on the trader's operating methods, the stop would bejust under the gap/run day anyway. It will not take much study for the reader to seethe principles of chart analysis used in this entire book are validated here. The maindifference is in the setting of stops, and in fact, the same stop methods may be used ifthe trader is sufficiently well financed. and Bottoms, and basic trendlines. Trendlines, in fact, are somewhat better definedand more useful in commodities than in stocks. Other types of chart formations whichare associated with stocks with short-term trading or with group distribution andaccumulation, such as the Triangles, Rectangles, Flags, etc., appear less frequently incommodities and are far less reliable as to either direction or extent of the ensuingmove. Support and Resistance Levels, as we have already noted, are less potent in commodities than in stocks; sometimes they seem to work to perfection, but just asoften they don't. For similar reasons, gaps have relatively less technical significance. These words remain true today, as do virtually all the principles enunciated in thisbook by Edwards and Magee and myself. In fact, if most futures charts were given toan Figure 16.10 Commodity Research Bureau (CRB), long-term view. It does not takemuch analysis of this 10-year CRB chart to see a huge Double Bottom and to considerits implications. If China and India are going to compete with us for natural resources,we could see an entirely new economic paradigm, if the reader will excuse the term.Clearly, there is a Bull market in commodities. In Chapter 42, Pragmatic PortfolioManagement, it is suggested that capital should flow to markets that are moving,rather than remaining committed to markets that are mired in mulish trends.Furthermore, it is suggested in that chapter that a good natural hedge is to go long onthe uptrend of an index and short the components of it that are in downtrends. TheCRB is somewhat thin but might lend itself to this strategy. Figure 16.11 The 20-year bonds as expressed in the TLT; ETF Bonds displayclassical signals of absolute clarity. Figure 16.12 September, 1994. Coffee was so easy in retrospect that it should beengraved on a brass plate. The long is taken on the breakout of the horizontaltrendline. The position is never in any danger, as there is no down-wave ofsignificance until May when stops are advanced to stay 5% under lows (Basing Points). The May down-wave allows a Basing Point stop to be established. Thebreakaway gap is a windfall profit. The flag tells us that more is coming—as it doeswith another gap and run days—until the spike reversal, which is a clear signal to beout on the close. A gap up on the open, an exploration up, and a close down—anabsolutely clear message of reversal from the market. 256 Technical Analysis of Stock Trends Figure 16.13 The May 11 top in silver. In the first quarter of 2011, silver took off in aroaring uptrend. Any surprise here, after looking at the Bounding Bottom? As seen inthe chart, it came near to going parabolic. The top notice came on April 25—interestingly on a reversal bar. Reading the Candlestick, the market gapped wide onthe opening and took a long excursion down to close the opening gap. Then bargainhunters thought they were getting a good price on silver and drove the price back up,so it did not close on the lows. The next day, it gapped down on the open andbasically wandered down all day long—the party was over. The signs were subtle. Chapter sixteen: Technical analysis of commodity charts 257 analyst, without issue identification and dates would not be identifiable as commoditycharts. When limit moves appear, the difference slaps one in the face. On this point Imight differ from Magee slightly as regards to gaps. Obviously, limit move gaps havebreathtaking significance. All in all, it seems to me gaps often say the same thing tofutures analysts as they do to stock analysts. Another mathematical reason might be adduced for the practicality of using simplechart analysis to trade futures. That is the tautological nature of the method. A trend isa trend, and a trendline is a trendline. If you enter a suspected trend (setting a protective stop at a technically analyzed place) and follow the trend using BasingPoints or observing the trendline and exiting on a break and reversal there will be nodifference from doing the same with a stock. Well, some difference. Due to theleverage, you will be required to be hyperaware of risk. In futures, the penalty forholding a position through “a normal reaction” can be extremely harsh. That is whystops are so important. The TLT chart from late 2008 is a spectacular display of patterns and signals. Thispattern has appeared many times before and will appear again in the future. Prices break out of a sideways pattern on a strong gap. The gap is across the trendline,which is what makes the signal significant. Every gap is not a signal. In this case, thegap is extra significant because there is a power bar on the gap day—it should bebought. This is called a breakaway gap. Prices continue to progress, and a few dayslater another gap occurs. This is a runaway gap and is another signal. Shortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vividmessages to traders. Robert Edwards described how they are used. He said, “The flagflies at half-mast,” meaning after a rocket-like advance and this formation, pricesshould advance on at least as far as they had come. Power bars (signals) exit from the flag, and then another gap occurs. This is theexhaustion gap. This is a message to exit longs and to short the issue. The messagecould not have been clearer. The skilled trader, first of all, catches the original signal—the power bar exiting fromthe sideways pattern. He then pyramids on the subsequent signals. Exiting from theflag, a good trader should have a boatload of this issue, and at the top, selling after theexhaustion gap, he should have made at least a small killing. Stops Some traders set their stops using money management rules rather than technicallyidentified points. I believe it is always better to find the technical point using a BasingPoint, or support and resistance. To me it makes better sense to adjust position size tocontrol risk as I describe in Chapter 26. The use of money management stops hasbeen very successful for many traders. If some logical and disciplined method ofsetting and observing stops is not installed, the trader is assured of failure. A money management stop is, simply enough, a stop calculated by deciding to risk2% (or 3% or 4% or x%) of capital on a trade. For example, William O'Neil says thatwhen a stock trader enters a position, he should set a stop 8% under his entry price. This is a little crude, and not strictly speaking, a money management stop, but it isbetter than no risk calculation at all. In a stricter sense, if we said we wanted to limitthe risk of the trade to 3% of capital, we would use the 8% rule to set the stop and theScott Procedure in Chapter 26 to determine the number of shares or contracts. TheTurtle system contains similar procedures. Numerous studies have proven the size ofthe risk per trade—1%, 2%, 3%—is directly correlated to equity volatility. The 25th looked like a reversal day. The gap down on the 26th could have beenconsidered the closing of an exhaustion gap—not apparent here because the tails(shadows) of the candlesticks obscure the complete price behavior. (EN10: In the 10th edition, a new section on stops in Chapter 27 examines a numberof stop methods.) A variety of methods As noted above, a competent chart analyst may, in my opinion (and in Magee'sopinion), perform profitably in the futures markets. There are other questions, ofcourse, namely of character, temperament, intelligence, judgment, and so on. Let usleave those questions to Dr. Elder and confine ourselves to the method question. Chartanalysts proved their abilities in the futures markets long before computers existed. Infact, long before in the case of Japanese rice traders, enlightening their efforts withcandlesticks in the eighteenth century. In the 1970s, I saw point and figure chartists enjoy great success at Dean Witter andMerrill Lynch and other major firms in futures. I have seen least squares curve fitters,moving average calculators, and abstruse statistical analysts all enjoy profitableoutings in commodities. Not to speak of the Turtles who, using naturalistic high-lowsystems, harvested good profits in the markets. As the saying goes, gateless is the gateand many are the ways to the great Dow. Although I have enjoyed great successmyself using mechanical number-driven systems over the years, I have become moreand more attracted to “natural” systems. Chart analysis is essentially natural, as is theTurtle system. The Dow Theory is a natural system in which no mathematicalalgorithm comes between the analyst and the data. The essential, more, quintessential,weakness of all number-driven systems is their blindness. They do not have the abilityto discriminate between the forest and the trees. The experienced human chartist cansee (and hear) the changing rhythms of the market and respond to them, responding tofactors too subtle (and even subconscious) to program. Nevertheless, even naturalsystems, like the Turtle systems, can fall into this trap. When the markets learn a lotof capital is waiting just above the 20-day high, they will set a trap for it. For“markets” you may read “they.” If you apply the knowledge of this book to suchsituations, you may avoid the trap. Everything you need to know as a chart analyst trading futures “Jack be nimble, Jack be quick, Jack jump over the Candlestick.” Yes, it is true, as theleverage is 10 times greater and the speed is 10 times faster. I have illustrated inFigure 16.9 the combination of a very tight trendline with a run day, which it seems tome is a good current (twenty-first century) combination. Otherwise, the same qualitiesthat make a good securities trader make a good futures trader once the great leap toleveraged quick-fire markets is made. If you have been successful trading stocks, youwill probably be successful trading futures, and you probably should practice onstocks while studying futures. A sobering fact I often recount to my graduate studentsis that Richard Wyckoff worked in the securities business for eight years beforemaking his first investment; he studied the markets an additional six years beforetrading. The Magee methodology will serve as a valuable cornerstone of your futuresoperations and you must never cease studying. Mechanical systems have theirattractions, especially when seasoned with experienced chart analysis. No methodwill survive unless practiced with diligence, persistence, judgment, and patience.Time and again you will hear famous traders say discipline is the secret of theirsuccess. What they mean by discipline is their ability to measure and contain the risk,set a stop based on technical or money management procedures, and then honor thestop. The most important lesson the futures trader has to learn from Edwards andMagee is the ability to see the character of the market, trading or trending, and then toadjust his tactics accordingly. In the next great Bull Market in commodities, which is inevitable, these methods andsystems derived from them will once again reap windfall profits. I have attempted in the ninth edition of this classic book to show the book'susefulness to the intelligent futures trader. Simple classical chart analysis alone can besuccessful in the futures markets in the hands of an experienced competent analyst.Natural mechanical systems such as the Turtle system have been effective and will beagain, perhaps with some tweaking (such as imposing a chart analysis superstructure).Wave analysis methods such as the Basing Points Procedure of Chapter 28 can beused. Even number-driven systems, such as moving averages, can be successful,especially if combined with chart analysis. chapter seventeen A summary and concluding comments We began our study of technical stock chart analysis in Chapter 1 with a discussion of the philosophy underlying the technical approach to the problems of trading and investing. We could ask the reader to turn back now and review those few pages to recapture a perspective on the subject that must have been dimmed by the many pages of more or less arduous reading that have intervened. (For illustrations in this chapter, see Figures 17.1 through 17.4.) It is easy, in a detailed study of the many and fascinating phenomena that stock charts exhibit, to lose sight of the fact they are only the rather imperfect instruments by which we hope to gauge the relative strength of supply and demand, which, in turn, exclusively determines what way, how fast, and how far a stock will go. Remember, in this work, it does not matter what creates the supply and the demand. The fact of their existence and the balance between them are all that count. No man, no organization (and we mean this verbatim et literatim) can hope to know and accurately appraise the infinity of factual data, mass moods, individual necessities, hopes, fears, estimates, and guesses that, with the subtle alterations ever proceeding in the general economic framework, combine to generate supply and demand. Nevertheless, the summation of all these factors is reflected virtually instantaneously in the market. The technical analyst's task is to interpret the action of the market itself—to read the flux in supply and demand mirrored therein. For this task, charts are the most satisfactory tools thus far devised. Lest you become enrapt, however, with the mechanics of the chart— the minutiae of daily fluctuations—ask yourself constantly, “What does this action really mean in terms of supply and demand?” Judgment, perspective, and a constant reversion to first principles is required. A chart, as we have said and should never forget, is not a perfect tool nor a robot; it does not give all the answers quickly, easily, or positively, in terms anyone can read and translate at once into certain profit. We have examined and tested exhaustively many technical theories, systems, indexes, and devices that have not been discussed in this book (chiefly because they tend to shortcircuit judgment) to see the impossible by a purely mechanical approach to what is far from a purely mechanical problem. The methods of chart analysis that have been presented are those that have proved most useful because they are relatively simple and easily rationalized since they stick closely to first principles. Additionally, they are of a nature that does not lead us to expect too much of them and they supplement each other and work well together. Let us review these methods briefly. They fall roughly into four categories: 1. The Area Patterns or formations of price fluctuation that, with their concomitant volume, indicate an important change in the supply-demand balance. They can signify Consolidation, a recuperation or gathering of strength for renewed drive in the same direction as the trend that preceded them. Or they can indicate Reversal, the playing out of the force formerly prevailing, and the victory of the opposing force, resulting in a new drive in the reverse direction. In either case, they may be described as periods during which energy is brewed or pressure is built up to propel prices in Figure 17.1 Spiegel's Bear Market started in April 1946 from a Symmetrical Triangle that changed into a Descending Triangle. Note the Pullback in June and two Flags. This history is carried on in Figure 17.2, which overlaps Figure 17.1; this chart shows the move that ensued from the wide Descending Triangle of early 1947, culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels. Technical Analysis of Stock Trends Figure 17.2 Overlapping Figure 17.1, this chart shows the move that ensued from the wide Descending Triangle of early 1947, culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels. Chapter seventeen: A summan/ and concluding comments a move (up or down) that can be turned to profit. Some of them provide an indication as to how far their pressure will push prices. These chart formations, together with volume, furnish the technician with most of his “get-in” and many of his “get-out” signals. Volume, which has not been discussed in this book as a feature apart from price action, and which cannot, in fact, be utilized as a technical guide by itself, deserves some further comment. Remember it is relative that it tends naturally to run higher near the top of a Bull Market than near the bottom of a Bear Market. Volume “follows the trend,” meaning it increases on rallies and decreases on reactions in an overall uptrend, and vice versa. But use this rule judiciously; do not place too much dependence on the showing of a few days and bear in mind that even in a Bear Market (except during Panic Moves), there is always a slight tendency for activity to pick up on rises. (“Prices can fall of their own weight, but it takes buying to put them up” as Edwards said.) A notable increase in activity, as compared with previous days or weeks, may signify either the beginning (breakout) or the end (climax) of a move, temporary or final. (More rarely, it may signify a “shakeout.”) Its meaning, in any given case, can be determined by its relation to the price pattern. 2. Trend and trendline studies supplement Area Patterns as a means of determining the general direction in which prices are moving and of detecting changes in direction. Although lacking the nice definition of Area Formations, they may frequently be used for “get-in” and “get-out” purposes in short-term trading, as well as provide a defense against premature relinquishment of profitable long-term positions. 3. Support and Resistance Levels are created by the previous trading and investment commitments of others. They may indicate where it should pay to take a position, but their more important technical function is to show where a move is likely to slow down or end, and at what level it should encounter a sudden and important increase in supply or demand. Before entering a trade, look both to the pattern of origin for an indication of the power behind the move and to the history of Support-Resistance for an indication as to whether it can proceed without difficulty for a profitable distance. SupportResistance studies are especially useful in providing “cash-in” or “switch” signals. 4. Broad market background, including the Dow Theory, should not be scorned. This time-tested device designates the (presumed) prevailing Major Trend of the market. Its signals are “late,” but with all its faults (like the greatly augmented following it has acquired in recent years resulting in a considerable artificial stimulation of activity at certain periods), it is still an invaluable adjunct to the technical trader's toolkit. The general characteristics of the various stages in the stock market's great Primary Bull and Bear cycles, which were discussed in our Dow Theory chapters, should never be lost to view. This brings us back to the idea of perspective, which we emphasized as essential to successful technical analysis at the beginning of our summary. The stock that does not, to some degree, follow the Major Trend of the market as a whole is an extraordinary exception. More money has been lost by buying perfectly good stocks in the later and most exciting phases of a Bull Market, and then selling them, perhaps from necessity, in the discouraging conditions prevailing in a Bear Market, than from all other causes combined. Hence, keep your perspective on the broad market picture. The basic economic tide is one of the most important elements in the supply-demand equation for each individual stock. It may pay to buck “the public,” but it does not ever pay to buck the real underlying trend. Major Bull and Bear Markets have recurred in fairly regular patterns throughout all recorded economic history, and there is no reason to suppose they will not continue to recur for as long as our present system exists. It is well to keep in mind that caution is in order whenever stock prices are at historically high levels and that purchases will usually work out well eventually when they are at historically low levels. If you make known your interest in your charts, you will be told the chart analyst (like the Dow theorist) is always late—buying after prices have already started up (maybe not until long after the “smart money” has completed its accumulation) and sells after the trend has unmistakably turned down. Partly true, as you have no doubt already discovered for yourself. The secret of success lies not in buying at the very lowest possible price and selling at the absolute top, but rather in the avoidance of large losses. (Small losses you will have to take, and as quickly as possible as warranted by the situation.) One of the most successful “operators” Wall Street has ever seen, Bernard Baruch, a multimillionaire and a nationally respected citizen today, is reputed to have said never in his entire career had he succeeded in buying within 5 points of the bottom or selling within 5 points of the top! (EN: For perspective, the 5 points mentioned constituted roughly 10% of the market at that time.) Before we leave this treatise on theory and proceed to the more practical matters of application and market tactics that are the province of Section II of this book, the reader will, we hope, forgive one more admonition. There is nothing in the science of technical analysis that requires one always to have a position in the market. There is nothing that dictates something must happen every day. There are periods—sometimes long months—when the conservative trader's best policy is to stay out entirely. What is more there is nothing in technical analysis to compel the market to go ahead and complete (in a few days) a move the charts have foretold; it will take its own good time. Patience is as much a virtue in stock trading as in any other human activity. Technical analysis and technology in the 21st century: the computer and the internet: tools of the investment/information revolution The purpose of this section is to put computer and information technology into proper context and perspective for chart-oriented technical analysts. In John Magee's time, in his office in Springfield, Massachusetts, there was a chart room—a room filled with all-age chartists from teenagers to senior citizens. These people spent all their time keeping charts and assisting Magee in interpretation. These were wonderful and intelligent people who developed marvelous insights into the stocks they charted as well as created the manual charts that adorn this book. Today, that room and all those technicians have been replaced by a beige (sometimes lime) box that sits crowded on our desktops and that is often worshipped as a fount of insight and wisdom: “Computer, analyze my stocks.” Unfortunately, the computer does not have the discrimination and pattern recognition ability of the people in that chart room. Undeterred by this weakness in computer technology, traders and investors have poured incalculable money and effort into computer-aided research, attempting to discover the keys to market success. More money has been spent in this effort than was ever put into the search for the philosopher's stone. Much of it was wasted, but it has not all been spent in vain. In some areas, it has been quite productive. But no fail-safe algorithm, in spite of all this effort, has been found for investment success, and certainly not for stock trading. The research has demonstrated that even the algorithm of “buy low, sell high” has fatal flaws in it. To fully understand the importance of the computer, the reader should appreciate some basic differences in participants' approach to the markets, or, we might say, schools of analysts and investors. We will not bother with fundamental analysts here, as they are of a different religious persuasion. Chart analysts, or Magee-type technical analysts, pretty much confine their analysis of the market to the interpretation of bar charts. (This does not mean their minds must be closed to other inputs. On the contrary—anything that works.) Another chart analyst school uses point and figure charts, and another candlestick charts. Another breed of technical analysts takes basic market data, price and volume, and uses them as the input to statistical routines that calculate everything from moving averages to mystically designated indicators like %R or Bollinger Bands (see Glossary); they are known as statistical or number-driven technical analysts. All these analysts attempt to invest or trade stocks and other financial instruments (not including options) using some form of what is called technical analysis— that is, they all take hard data that people cannot lie about, misrepresent, and manipulate, (unlike the data inputted to fundamental analysis like earnings, cash flow, sales, etc.) as input to their analysis. Using number-driven or statistical technical analysis, these latter schools attempt, just as chart analysts do, to predict market trends and trading opportunities. This can be more than a little difficult because the stock and bond markets are behavioral markets driven by human emotion, perhaps the most important of many variables influencing price. Plus, human emotion and behavior dictates manic and depressive elements, which have not yet been quantified. Yet, some chart analysts believe they can recognize it when they see it on the charts. In another area, the computer has yielded much more dramatic and profitable results, but that is in a model-driven market, namely the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting irony, emotion-driven markets, the stock markets, are used as the basis for derivatives, or options, whose price is determined largely by the operation of algorithms called “models;” for example, the Black Scholes model. Quantitative analysts believe, as does this editor, the options markets can be successfully gamed through quantitative analysis. Results of skilled practitioners indicate this belief is accurate. Alas, life is not so simple for the simple stock trader. Stock prices having nothing to do with mathematics, except for being expressed as natural numbers, are not susceptible to easy prediction as to their future direction. Not even with Magee chart analysis or any other form of analysis— technical, fundamental, or psychic. (From a theoretical point of view, each trade made on the basis of a chart analysis should be looked at as an experiment made to confirm a probability. The experiment is ended quickly if the trend does not develop.) The fact chart analysis is not mechanizable is important. It is one reason chart analysis continues to be effective in the hands of a skilled practitioner. Not being susceptible to mechanization, counterstrategies cannot be brought against it, except in situations whose meaning is obvious to everyone, for instance, a large important Support or Resistance Level or a glaringly obvious chart formation. These days everyone looks at charts to trade even if they do not believe in their use. In these obvious cases, some market participants will attempt to push prices through these levels to profit from volatility and confusion. Indeed, human nature has not changed much since Jay Gould and Big Jim Fisk. When these manipulations of price occur, they create false signals—Bull and Bear traps. Interestingly, the failure of these signals may constitute a reliable signal in itself—but in the direction opposite to the original signal. The importance of computer technology Of what use and importance then is this marvelous tool—the most interesting tool man (homo) has acquired since papyrus? (Numerous computer software packages available are capable of executing the functions described in the following discussion.) If the computer cannot definitively identify profitable opportunities, what good is it? Probably the most important function the computer has for the Magee analyst is the automation of rote detail work. Data can be gathered by downloading from database servers. Charts can be called up in an instant. Portfolio accounting, maintenance, and tax preparation can be disposed of with one hand while drinking coffee with the other. All in all, this might make it sound as though the computer is a great tool, but with a pretty dull edge. Not strictly true. There is at least one great leap forward for Magee analysts with this tool, leaving aside the rote drudgery it saves. This great advantage is portfolio analysis. In Appendix B, Resources, a complex portfolio analysis of the kind used by professional traders (Blair Hull and Options Research Inc.) is illustrated. Even simpler portfolios of the average investor can benefit from the facilities afforded by most portfolio programs, either on the net or in commercial software packages (locations and software identified in Appendix B, Resources). Another advantage is the ability to see basic data displayed in many different forms: point and figure charts, candlestick charts, close-only charts —these are prepared in the flick of an eyelash and may indeed contribute to understanding the particular situation under the magnifying glass. The effortless quantification of some aspects of analysis may be useful—volume studies, for instance, and given the popularity of moving averages, seeing the 50- and 200-day moving averages can be interesting. These moving averages are considered significant by many market participants—even fundamental analysts. The analysis of any of these should be considered in relation to the current state of the market as understood by the careful chart analyst. But what about (the strangely named) stochastics, Bollinger Bands, %R, MACD, Moving Averages (plain vanilla, exponential, crossover, etc.), price/volume divergence, RSI (plain vanilla and Wilder), VP Trend, TCI, OBV, Upper/Lower Trading Bands, ESA Trading Bands, and AcmDis? Well, there is a certain whiff of alchemy to some of them, and some have some usefulness sometimes. What is more, all systems work beautifully at least twice in their lives: in research and in huge monumental Bull Markets. These number-driven indicators are also the times when trading genius is most likely to be discovered. (EN9: It is also true, as I have said, that you can drive a nail with a screwdriver. And the inventor of a tool may be fabulously successful with it while its adopters lose their assets.) It is also possible the excess of technical information created by these indicators may be like the excess of fundamental information—another shell to hide the pea under, another magician's trick to keep the investor from seeing what is truly important, and what is necessary and sufficient to know to trade well. Perhaps the investor would be better off with a behavioral model because the markets are behavioral. Number-driven technical analysis can do many things, some like Dr. Johnson's dog, which walked on its hind legs, but they cannot put the market in perspective—only the human mind can do that. Number-driven models after all do not consider skirt lengths, moon cycles, sun spots, the length of the economic cycle, or the Bullish or Bearish state of the market (if Bear Markets still exist) (EN9: A wry ironical comment written before the market crash of the 2000s.) In the end, the human brain is still the only organ capable of synthesizing all this quantitative and qualitative information and assessing those elements that cannot be reduced to ones and zeros. The educated mind is still the best discriminator of patterns and their contexts. Summary 1 The computer is a tool, a powerful tool, but a tool nonetheless. It is not an intelligent problem solver or decision maker. We use a mechanical ditch digger to dig a ditch, but not to figure out where the ditch should be. The multitude of indicators and systems should be viewed with a skeptical eye and evaluated within the context of informed chart analysis. Sometimes an indicator or technique will work for one user or its inventor but strangely mislead the chart analyst who tries to use it—or buys it, even based on a verified track record. Therefore, the experienced investor keeps his methods and analysis simple until he has definitive knowledge of any technique, method, or indicator he would like to add to his repertoire. Most of all, he depends on his own observations and experience to evaluate his and others' trading techniques. Other technological developments of importance to the technical Magee analyst and all investors The computer is not the only technological development of interest to the technical investor. A number of information revolution technologies need to be put in perspective. These are, in broad categories, the internet and all its facilities, developments in electronic markets, and advances in finance and investment theory and practice. This last is treated in the final section of this chapter. Owing to the enormous body of material on these subjects, no attempt will be made to explore these subjects exhaustively, but the general investor will be given the information he needs to know to put these subjects in their proper perspective. Resources will point the analyst to avenues for further investigation if the need is felt. First of all, are there any technological developments of whatever sort that have made charting obsolete? No. Are there any developments that have made trading a guaranteed success? No. The only sure thing is some huckster will claim to have a sure thing. Those who believe such claims are the victims of their own naivete. The Internet: the eighth wonder of the modern world (EN9: Appendix B, Resources, for the ninth edition has been enormously expanded and is of paramount importance to modern investors.) The internet has been called the most complex project ever built by man, which is probably true. Complex, sprawling, and idiosyncratic, it has something for everyone, especially the investor. Every form of investment creature known to man has set up a site on the internet and waits like the hungry arachnid for the casual surfer: brokers and advisors—technical and fundamental; newspapers, news magazines, newsgroups, and touts; mutual funds, mutual fund advisories, critics and evaluators of all the above; database vendors, chat rooms, electronic marketplaces and exchanges, and Exchange Traded Notes (ECNs)—the only unfilled niche that seems to exist is investment pornography. Perhaps naked options will be able to satisfy this need. This is a bewildering array of resources. How does one sort them out? The implications of all this for the electronic or cyber investor may be further expanded to indicate the services and facilities available: quotes and data; portfolio management and accounting; online interactive charting; automatic alerts to PBDAs (personal body digital assistants or gizmos carried on the body, for example, cell phones and handheld computers, and so on); analysis and advice; electronic boardrooms; and electronic exchanges where trading takes place without intermediaries. Appendix B, Resources, supplies the specifics on these categories while this chapter supplies perspective. It is one thing to contemplate this cornucopia of facilities and another thing to appreciate the importance and priority of its elements. What good are real-time quotes if you are only interested in reviewing your portfolio once a week, except for special occasions? What good are satellite alerts and virtual reality glasses to a long-term investor? It is easy for the investor with no philosophy or method to be drawn into the maelstrom of electronic wonders and stagger out of it a little wiser and much poorer. Observe then the goods and services of all of this are of importance to the levelheaded investor with his feet on the ground and his head out of the clouds (or Cloud). This, hopefully not, abstract investor, the object of our attention here, needs what? He needs data, charts, and a connection to a trading place. Data are available at the click of a mouse. A chart occupies the screen in another click. Another click and a trade is placed. In the Internet Age, it would be tautological to attempt to describe this process in prose when live demonstrations are as close as the desktop computer and an internet connection. A demonstration of this rather simple process (easy to say when one does it without thinking) may be seen at locations linked in Appendix B, Resources. The trade will be made, of necessity, through a broker of some sort, perhaps an electronic broker or even a non-virtual broker who communicates via telephone. This will occur shortly, if not already, an electronic pit where one matches wits with a computer instead of a market maker or specialist. How long brokers will be necessary is a question that is up in the air in the new century. (The broker who earns his keep will always be with us, and welcome, too.) Electronic marketplaces where investors meet without the necessity of a broker or specialist are already proliferating (see Appendix B, Resources) and will continue to gain the advantage for the investor over the trading pit, which is one of the last remaining edges the professionals hold over off-floor traders. Suffice it to say, their initial phases will undoubtedly be periods of dislocation, risk, and opportunity as their glitches are ironed out. Placing electronic orders, whether to an electronic exchange or to the New York Stock Exchange, has certain inherent advantages over oral orders. No one can quarrel about a trade registered electronically as opposed to orally where the potential for disagreement exists. In addition, the trader has only handled the data once—rather than making an analysis, calling a broker, recording the trade, and passing it to the portfolio. If he just hits the trade button and the transaction is routed through his software package, no one will have any doubt as to where an error might lie. The manual method presents an opportunity for error at each step. Rest assured, errors occur and can be disastrous to trading. The efficiency and ease of the process with a computer have much to recommend it— automation of trade processing, elimination of confusion and ambiguities, audit tracks, automation of portfolio maintenance, and, perhaps most important of all, automatic mark-to-market of the portfolio (the practice of valuing a portfolio at its present market value whether trades are open or closed). Marking-to-market This book might have been entitled Zen and the Art of Technical Analysis if that title were not so hackneyed and threadbare. It conveys, nonetheless, the message of Zen in the art of archery, that of direct attachment to reality and the importance of the present moment. In his seminal book The General Semantics of Wall Street (now Winning the Mental Game on Wall Street), John Magee inveighed at some length against the very human tendency to keep two sets of books in the head—one recording profits, open and closed, and another recording losses, but only closed losses. Open losses were not losses until booked. Having an electronic portfolio accountant that refuses to participate in such self-deception has much to recommend it. If the portfolio is always marked to the market when the computer communicates with the data vendor, or the trade broker, it is difficult not to see red ink, and to see the equity of the account reflects all trades, open and closed. Separating the wheat from the chaff It requires a gimlet-eyed investor to pick his way through the minefield of temptations in electronic investing and number-driven technical analysis. Playing with the toys, seeing what the pundits have to say, and fiddling with “research” can subtly replace profitable trading as the activity. Actually, almost all the research the Magee analyst must do is addressed in this book. Chaff Chat rooms, touts, news, predictions, punditry, brokerage house buy, sell, hold, strong hold, weak buy, strong buy, and any other species of brokerage house recommendation should be taken at face value. Remember, brokerage firms survive by selling securities and make their money in general on activity. Actually, much of their money is made servicing their institutional clients and distributing their clients' shares to their retail clientele—a blatant conflict of interest that blew up in their faces in the early 2000s, resulting in many fines and some jail terms (plus ga change ... ). In the surging Clinton- Gore Bull Markets of the 1990s, all of these worked. In a serious Bear Market, none of them will work. (EN9: A serious Bear Market started in earnest in 2000 and was correctly identified with Magee chart analysis as may be seen from the John Magee Letters at the http://www.edwards- magee.com.) Summary 2 Never in the history of the markets have so many facilities for private investors been available. The computer is necessary to take advantage of those facilities. Data may be acquired automatically via internet or dial-up sites at little or no cost. A (as they say) plethora of websites offer cyber investors everything from portfolio accounting to alerts sent to their personal body- carried devices (cell phones, pagers, handheld PDAs, and so on). Some of these even offer real-time data, which is a way for the unsophisticated trader to go broke in real time. Many of these sites offer every kind of analysis from respectable technical analysis (usually too complicated) to extraterrestrial channeling. Internet chat rooms will provide real-time touting and numerous rumors to send the lemmings and impressionable scurrying hither and yon. But, one expects, not the readers of this book. Of more importance, the information revolution and the computer will: 1. Relieve the analyst of manual drudgery, accelerate all the steps of analysis: data gathering, chart preparation, portfolio accounting, and analysis and tax preparation. 2. Give the analyst virtually effortless portfolio accounting and mark- to-market prices—a valuable device to have to keep the investor from mixing his cash and accrual accounting, as Magee says. 3. Enable processing of a hitherto unimaginable degree. An unlimited number of stocks may be analyzed. Choosing those to trade with a computer will be dealt with in Chapter 21, Selection of Stocks to Chart. 4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no pit traders or locals to fiddle with prices. Advancements in investment technology, part 1: developments in finance theory and practice Numerous pernicious and useless inventions, services, and products litter the internet and the financial industry marketplace; but modern finance theory and technology are important and must be taken into consideration by the general investor. This chapter will explore the minimum the moderately advanced investor needs to know about advances in theory and practice. And it will point the reader to further resources if he desires to continue more advanced study. Instruments of limited (or non) availability during the time of Edwards and Magee included exchange traded options on stocks, futures on averages and indexes, options on futures and indexes, and securitized indexes and averages, as a partial list of only the most important instruments. Undoubtedly, one of the most important developments of the modern era is the creation of trading instruments that allow the investor to trade and hedge the major indexes. Of these, the instruments created by the Chicago Board of Trade (CBOT®) are of singular importance. These are the CBOT® DJIASM Futures and the CBOT® DJIASM Futures Options, which are discussed in greater detail at the end of this chapter. (EN9: Not so singular, perhaps. Probably of greater importance to readers of this book are the AMEX iShares, particularly DIA, SPY, and QQQ, which are instruments (ETFs) that offer the investor direct participation in the major indexes as though they were stocks.) General developments of great importance in finance theory and practice are found in the following sections. Options From the pivotal moment in 1973 when Fischer Black (friend and college classmate) and his partner, Myron Scholes, published their—excuse the usage—paradigm-setting Model, the options and derivatives markets have grown from negligible to trillions of dollars a year. The investor who is not informed about options is playing with half a deck. The subject, however, is beyond the scope of this book, which hopes only to offer some perspective on the subject and guides to the further study necessary for most traders and many investors. Something in the neighborhood of 30% or more of options expire worthless. This is probably the most important fact to know about options. (There is a rule of thumb about options called the 60-30-10 rule: 60% are closed out before expiration, 30% are “long at expiration,” meaning they are worthless, and 10% are exercised.) Another fact to know about options occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on October 16 were worth hundreds of dollars on October 19—if you could get the broker to pick up the telephone and trade them. (The editor had a client at Options Research, Inc. during that time who lost $57 million in three days and almost brought down a major Chicago bank; he had sold too many naked puts.) The most sophisticated and skilled traders in the world make their livings (quite sumptuous livings, thank you) trading options. Educated estimates have been made that as many as 90% of retail options traders lose money. That combined with the fact that by far it is the general public that buys (rather than sells) options should suggest some syllogistic reasoning to the reader. With these facts firmly fixed in mind, let us put options in their proper perspective for the general investor. Options have a number of useful functions, such as offering the trader powerful leverage. With an option, he can control much more stock than by the direct purchase of stock—his capital stretches much further. So options are an ideal speculative instrument (Exaggerated leverage is almost always a characteristic of speculative instruments.), but they can also be used in a most conservative way—as an insurance policy. For example, a position on the long security side may be hedged by the purchase of a put on the option side. (This is not a specific recommendation to do this. Every specific situation should be evaluated by the prudent investor with professional assistance as to its monetary consequences.) The experienced investor may also use options to increase yield on his portfolio of securities. He may write covered calls or naked puts on a stock to acquire it at a lower cost (e.g., he sells out of the money put options. This is a way of being long the stock; if the stock comes back to the exercise price, he acquires the stock. If not, he pockets the premium.) There are numerous tactics of this sort that may be played with options. Played because, for the general investor, the options game can be disastrous, as professionals are not playing. They are seriously practicing skills the amateur can never hope to master. Many floor traders, indeed, would qualify as idiot savants—they can compute the “fair value” of options in their heads and make money on price anomalies of 1/16, or, as they call it, a “teenie.” For perspective, the reader may contemplate a conversation the editor had with one of the most important options traders in the world who remarked casually that his fortune was built on teenies. The reader may imagine at some length what would be necessary for the general investor to make a profit on anomalies of 1/16. (EN10: The advent of digital pricing has given market makers and specialists even more flexibility to beat the investor by shaving spreads, theoretically, to $0.01.) This does not mean the general investor should never touch options; it just means he should be thoroughly prepared before he goes down to play that game. In options trading, traders speak of bull spreads, bear spreads, and alligator spreads. The alligator spread is an options strategy that eats the customer's capital in toto. Among these strategies is covered call writing. This strategy is touted as being an income producer on a stock portfolio. There is no purpose in writing a call on a stock in which the investor is long—unless that stock is stuck in a clear congestion phase that is not due to expire before the option expires. Besides, if the stock is in a downtrend, it should be liquidated, but to write a call on a stock in a clear uptrend is to make oneself beloved of the broker, whose good humor improves markedly with account activity and commission income. The outcome of a covered call on an ascending stock is that the writer (you, dear reader) has the stock called at the exercise price, losing his position and future appreciation, not to mention costs. The income is actually small consolation, a sort of booby prize—a way of cutting your profits while increasing your costs. Nevertheless, covered writes are justified and profitable in some cases. Quantitative analysis The investor should be aware of another area of computer and investment technology that has yielded much more dramatic and profitable results, but that is in a model-driven market—namely, the options markets. Quantitative analysts, those who investigate and trade the options markets, are a breed apart from technical analysts. In an interesting irony, behavioral markets, the stock markets, are used as the basis for derivatives, or options whose price is determined largely by the operation of algorithms called “models.” The original model that created the modern world of options trading was the Black-Scholes options analysis model, which assumed the “fair value” of an option could be determined by entering five parameters into the formula: the strike price of the option, the price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility of the stock. The eventual universal acceptance of this model resulted in the derivatives industry we have today. To list all the forms of derivatives available for trading today would be to expand this book by many pages, and it is not the purpose of this book anyway. The purpose of this paragraph is to sternly warn general investors who are thinking of “beating the derivatives markets” to undergo rigorous training first. The alternative could be extremely expensive. At first, the traders who saw the importance of this model and used it to price options virtually skinned older options traders and the public, who traded pretty much by the seat of the pants or the strength of their convictions, meaning human emotion. But professional losers learn fast and now all competent options traders use some sort of model or anti-model, or anti-antimodel to trade. True to form, options sellers, who are largely professionals, take most of the public's (the buyers) money. This is the way of the world. Options pricing models and their importance After the introduction of the Black-Scholes model, numerous other models followed, among them the Cox-Ross-Rubinstein, the Black Futures, and others. For the general investor, the message is this: he must be acquainted with these models and what their functions are if he intends to use options. Recall, the model computes the “fair value” of the option. One way professionals make money off amateurs is by selling overpriced options and buying underpriced options to create a relatively lower risk spread (for themselves). Not knowing what these values are for the private investor is like not knowing where the present price is for a stock; it is a piece of ignorance for which the professional will charge him a premium to be educated about. Unfortunately, many private options traders never get educated, in spite of paying tuition over and over again. But ignorance is not bliss—it is expensive. Technology and knowledge works its way from innovators and creative geniuses through the ranks of professionals and sooner or later is disseminated to the general public. By that time, the innovators have developed new technology. Nonetheless, even assuming that professionals have superior tools and technology, the general investor must thoroughly educate himself before using options. As it is not the province of this book to dissect options trading, though the reader may find references in Appendix B, Resources. Here it would not be untoward to mention one of the better books on options as a starting point for the moderately advanced and motivated trader. Lawrence McMillan's Options as a Strategic Investment is necessary reading. In addition, the newcomer may contact the Chicago Board Options Exchange (the CBOE) at http://www.cboe.com, which has tutorial software. Futures on indexes Futures, like options, offer the speculator intense leverage—the ability to control a comparatively large position with much less capital than the purchase of the underlying commodity or index. Futures salesmen are fond of pointing out the fact that, if you are margined at 5% or 10% of the contract value, a similar move in the price of the index will double your money. They are often not so conscientious about pointing out a similar move against your position will wipe out your margin (actually earnest money). Unlike (long) options, a mishap in the market can result in more than the loss of margin; it can become a deficit account and debts to the broker—in other words, losses of more than 100%. For this, among other reasons, it is wise not to plunge into futures without considerable preparation. This preparation might well begin, for the adroit investor, with the reading of Schwager's Technical Analysis, Schwager on Futures, currently one of the better books on the subject. Let us say that, instead of using futures to speculate, we want to use them as a hedge for our portfolio of Dow-Jones DIAMONDS (DIA) or portfolio of Dow-Jones stocks. Now we are purchasing insurance, rather than speculating. As an oversimplified example, the investor might see the failure of the DJIA to break through a top as the beginning of a congestion zone (a consolidation or reversal pattern). He could then hedge his position by shorting the Dow-Jones futures. Now he is both long and short—long the cash, short the futures. He would place a stop on the futures above his purchase price to close the trade if the market continued rising. If the market fell, he would maintain the futures position until he calculated that the reaction had passed its worst point, or until it were definitely analyzed to have reversed. He would then take his profits on the futures position (taxable), but his cash position would be intact, and presumably, the greater capital gains on those positions would be safe from taxation, and also safe from the costs, slippage, and difficulties of reestablishing the stock position. Options on futures and indexes Conservative as well as speculative use may be made of options. For example, the investor might, after a vigorous spike upwards, feel the Standard & Poor's (S&P) 500, or the SPYs which he is long, were overbought. He might then buy an index put on the S&P as a hedge against the expected decline. If it occurs, he collects his profit on the option and his cash position in the S&P is undisturbed. If the index continues to climb, he loses the option premium—an insurance policy he took out to protect his stock portfolio. Note: The tactics described here are for the reader's conceptual education. Before executing tactics of this kind, or any other unfamiliar procedure, the investor should thoroughly inform himself and rehearse the procedure, testing outcomes through paper trading before committing real capital. He must, in short, figure out how you lose. A number of websites offer facilities of this kind, and the investor may also build on his own computer a research or paper-trading portfolio segregated from his actual transactions. The trader might also choose to buy an option on a future. At the CBOT®, the trader can trade both options and futures on the DJIA. These can be used as the above examples for speculating or hedging, except in this case, the successful option buyer might wind up owning a futures contract instead of the cash position. This could be disconcerting to one not accustomed to the futures market, especially if large price anomalies between futures and cash occurred, as happened in 1987 and 1989 when futures prices went to huge discounts to cash. A primary reason for employing the futures would be for leverage and the reason for using the options on futures would be the analysis that uncertainty was in store and the wish to only risk the amount of the options premium. Obviously, a speculator can choose to forget the stock or futures part of the portfolio and trade only options. Before taking such a step, the trader should pass a postgraduate course. The proportion of successful amateur option traders to successful professional traders is extremely skewed. In fact, one might say all successful options traders are professionals. Modern Portfolio Theory Modern Portfolio Theory (MPT) is a procedure and process whereby a portfolio manager may classify and analyze the components of his portfolio in such a way as to, hopefully, be aware of and control risk and return. It attempts to quantify the relationship between risk and return. Rather than analyzing only the individual instruments within a portfolio, MPT attempts to determine the statistical relationships among the members of the portfolio and their relationships to the market. The processes involved in MPT analysis are as follows (1) portfolio valuation, or describing the portfolio in terms of expected risk and expected return; (2) asset allocation, determining how capital is to be allocated among the classes of instruments (bonds, stocks, and so on); (3) optimization, or finding the trade-offs between risk and return in selecting the components of the portfolio; and (4) performance measurement, or the division of each stock's risk into systemic and security-related classes. How important is this for the general investor? Not very and there is a large question among pragmatic analysts, such as the editor, as to its pragmatic usefulness for professionals, although they cling to it as to a life ring in a shipwreck. Mandelbrot observed in articles (“A Multifractal Walk Down Wall Street”) and letters in the Scientific American (February 1999 and June 1999) that MPT discards about 5% of statistical experience as if it did not exist (although it [the experience] does). He also observed the ignored experience includes 10-sigma market storms that are blamed for portfolio failures as though it were the fault of the data instead of the fault of the process. The wonders and joys of investment technology Are there any other innovations in finance and investment theory of which the general investor should be aware? (See Chapter 42 for discussion of Value at Risk and Pragmatic Portfolio Theory.) Well, it never hurts to know everything, and the very best professionals not only are aware of everything, but also are in the constant process of finding new wrinkles and glitches and anomalies. Though, as Magee would ask, what is necessary and sufficient to know (see Winning the Mental Game on Wall Street)? Absolute certainty is the hallmark of religious extremists and the naive, who do not know what they do not know. So I will remark that probably this book contains either what is necessary and sufficient for the investor to know about these matters or guides the reader to further study. Not to mention, nota bene, any number of little old ladies with a chart, a pencil, a ruler, and previous editions of this book have beaten the pants off professional stock pickers with supercomputers and MPT and Nobel Laureates and who knows what other resources. I personally know investment groups that have thrown enormous resources into the development of real-time systems that, in research, were 100% successful in beating the market. The only real glitch was the systems required so much computer power they could not be run quickly enough in real time to actually trade in the markets. Philosopher's stone redux. Advancements in investment technology, part 2: futures and options on futures on the Dow-Jones Industrial Index at the CBOT (EN9: The general investor must be aware that the methods and techniques described in this chapter are for advanced practitioners. Careless use of the described instruments can be extremely damaging to a portfolio.) Investment and hedging strategies using the CBOT® DJIASM futures contract A futures contract is the obligation to buy or sell a specific commodity on or by some specified date in the future. For example, if one went long corn futures, he would be obligated to accept delivery of corn on the delivery date, unless he sold the contract before the settlement date. Shorting the contract would obligate the seller to deliver corn unless he offset (by repurchase) the contract. The “commodity” in our present case is the basket of stocks represented by the DJIA futures index. All futures contracts specify the date by which the transaction must conclude, known as the “settlement date,” and how the transaction will be implemented, known as “delivery.” The DJIA futures contract price closely tracks the price of the Dow-Jones Industrials as computed from stock market values. The value of the future is found by multiplying the index price of the futures contract by $10.00. For example, if the futures index price is 10,000, the value of the contract is 10,000 x $10.00 = $100,000. So the buyer or seller of the futures contract is trading approximately $100,000 worth of stocks at that Dow futures level. The value may be higher or lower owing to several factors, for example, cost of carry, which will be discussed below. Settlement of futures contracts All futures contracts must be “settled.” Some futures are settled by delivery, the famous nightmare of finding 5,000 bushels of soybeans delivered on your front lawn. Dow Index futures “settle” (are delivered) in cash. The short does not dump a basket of Dow stocks on the yard of the long. Thus, on the settlement date of the contract, the settlement price is $10.00 times a figure called the “Special Opening Quotation,” a value calculated from the opening prices of the member stocks of the Dow Future following the last day of trading in the futures contract. This value is compared with the price paid for the contract when the trade initiated. For example, if the Dow Future is 10,000 at expiration, a long who bought the contract at 9,000 receives $10,000 ($10.00 x 1000) from the short. Marking-to-market This $10,000, however, is paid daily over the life of the contract, rather than in one payment upon expiration of the contract. It is paid as successive daily “margin” payments. These payments are not really margin but are in effect “earnest money” or a performance bond. The practice of squaring up accounts at the end of every day's trading is called “marking-to-market.” These daily payments are determined based on the difference between the previous day's settlement price and the contract settlement price at the close of trading each day. As a practical example, if the settlement price of June Dow Index futures increases from 9,800 to 9,840 from May 17 to May 18, the short pays $400 ($10.00 x 40) and the long's account is credited $400. If the futures settlement price decreases 10 points the following day, the long pays $100 to the short's account—and so on each day until expiration of the contract, when the futures price and the index price achieve parity. At any time, the trader can close his position by offsetting the contract, that is, by selling to close an open long, or buying to close an open short. At the expiration date, open contracts are settled in cash at the final settlement price. Fungibility One of the great contributions of the great established exchanges like the CBOT® and the Chicago Mercantile Exchange is their institutionalization of contract terms and relationships is known as “fungibility.” Any one futures contract for corn, or an index, or any other commodity is substitutable for another of the same commodity. Similarly, the Exchange has negated counterparty risk by placing a Clearing Corporation between all parties to trades. Thus, even if the other party to a trade went broke, the Clearing Corporation would assume his liability and, using the mechanism of daily settlement, whereby losers pay winners daily, the danger of major default is avoided. Futures “margins” (or “earnest money”) are deposited with the broker on opening a trade. The leverage obtainable is quite extreme for a stock trader. The initial margin is usually 3%-5% of the total value of the contract. Each day thereafter, margins vary according to the process described above of marking-to-market. As the reader can see, the purchase or sale of a Dow Future is the equivalent of a fairly large portfolio transaction, with the understanding it is a transaction that will be closed in the future, unlike a stock purchase, which may be held indefinitely. Differences between cash and futures The main two differences between the cash and the futures transactions are as follows: 1. In cash, the value of the portfolio must be paid up front or financed in a stock margin account. 2. The owner of the cash portfolio receives cash dividends. These are not the only differences. The leverage employed in the futures transaction is a two-edged sword. If the trader has no reserves, a minor move in the index wipes him out. Such a minor move would be barely noticed by the owner of a cash portfolio. Dow Index futures The price of the future and the price of the index are closely linked. Any price anomaly is quickly corrected by arbitragers. On any significant price difference, arbitragers will buy the underpriced and sell the overpriced, bringing the relationship back in line. Their prices are not exactly the same because the futures contract value must reflect the costs of short-term financing of stocks and the dividends paid by index stocks until futures expiration, known as the “cost of carry.” The “theoretical value” of the future should equal the price of the index plus the carrying cost, what is called the “fair” or “theoretical” value. Using stock index futures to control exposure to the market The owner of a cash portfolio in the Dow, or of DIAMONDS, can control his exposure, his risk, by using futures to hedge. If, for example, he is pessimistic about the market, or more to the point, a lot of uptrend lines have been broken and the technical situation seems to be deteriorating, he can sell a futures contract equivalent to his portfolio and be flat the market. Readers will immediately recognize the advantages of this strategy. Tax consequences on the cash portfolio are avoided, as are the other negative consequences of trading— slippage, errors, and so on. Long-term positions are better left alone. By flattening his position, the investor has now insured the future value of his portfolio, and the capital involved is now earning the money market rate of return. What happens if the forecast market decline occurs? The portfolio is protected from loss and the capital earns the market rate of return; however, the investor should monitor his hedge closely, lifting it when he calculates the correction has run its course. Taxes will then be due on the profits on the hedge. In monitoring the hedge, the possibility the market rises instead of falls must be considered. In planning the hedge in the first place, the investor must plan for this eventuality and determine at which point he will lift the hedge on the losing side. At worst, the investor has surrendered portfolio appreciation. Not considering cash flow implications. It is worth emphasizing, in fact strongly emphasizing, that these techniques require knowledge, expertise, and study. Careless use of techniques of this nature can bloody the amateur investor. Hence, it is probably best to have a professional guide for the first several of these expeditions and to execute first a number of paper transactions. The canny investor can increase his exposure to the market and the risk to his capital by buying index futures. But the canny investor must be careful not to turn into a burned speculator. Futures trading, because of the extreme leverage, is an area for dedicated and experienced speculators. A Dow futures transaction costs less than if you had to buy or sell a whole basket of stocks. Professional fund managers—as well as other professionals—regularly use futures for asset allocation and reallocation. In all likelihood, they are not using the extreme leverage afforded by futures. In other words, if they have a $1 million cash portfolio, they do not buy $10 million worth of futures. It is not the leverage in which they are interested, but rather it is the extreme convenience and agility offered by doing short- term allocations in futures. The ability to almost instantaneously move in and out of the market without disturbing the underlying portfolio is a powerful feature of these “proxy markets.” Figure 17.3 Diamonds and Futures. The 2% plus break at the arrow of an 11-month trendline is an unmistakable invitation to hedge the DIAMONDS by shorting the futures. Profits on the short would have offset losses in the DIAMONDS. This convenient drill would have preserved liquidity, postponed capital gains taxes, and avoided loss of equity. Notice the return to the trendline after the break. More of the foolish virgin syndrome? Investment uses of Dow Index futures The following examples describe the basic mechanics of using Dow futures contracts. These can be used to adjust equity exposure in anticipation of volatile market cycles and to rebalance portfolios among different asset classes. The futures also may be used for other purposes not illustrated here. The following examples are not intended to be absolutely precise, but only to illustrate the mechanics involved. For the sake of simplicity, mark-to- market payments and cost of carry have been eliminated from the examples. Situation 1: Portfolio protection You are a long-term Magee-type investor and you have old and profitable positions with which you are satisfied. Yet, you have seen the broadening top of the Dow Jones (ca. 2000) and it is almost October, so you would not be surprised to see a little bloodshed. You have $400,000 in the Dow and $100,000 in money market instruments. You decide to reverse this ratio, but you do not want to liquidate the Dow portfolio, as there is no sign of a confirmed downtrend, only that of consolidation. You sell $300,000 of index futures, leaving yourself with a $100,000 kicker in case you are wrong about the market's declining. At the time, the market is 10,000 and the futures are 10,500, meaning the cost of carry is approximately 0.5% (10,500/10,000 - 1). You sell three futures contracts [$300,000/($10 x 10,000)]. You now have reversed your position and are long $100,000 Dow stocks and long $400,000 money market equivalents. Validating your technical analysis, the market has begun to swing in broad undulations and, at the expiration of the futures, the Dow is at 10,000. On your stocks, you have a return of -0.5%, and the money market position has a rate of return of 0.5%. What would have been the situation had you not hedged? Stock Portfolio $400,000 x 0.95$380,000 Money Market + 100,000 x 1.005$100,500 Total $480,500 How the futures position affects the portfolio: Short three futures 3 x $10.00 x (10,000-9,500)+$15,000 Total $495,000 Value of portfolio with reallocation of assets in cash market: Stocks $100,000 x 0.95 $95,000 Money market + $400,000 x 1.005$402,000 Total $497,000 By hedging in the futures market, you now have the equivalent of a $100,000 investment in Dow futures stocks and a $400,000 investment in the money market instrument. The stock market decline now affects only $100,000 of your stock portfolio rather than $400,000; in addition, you earn a money market rate of return of 0.5% on the $300,000 difference. Without the futures transaction, the portfolio is worth $480,500. The $15,000 profit on the short futures position offsets the loss on the $300,000 of the portfolio that was moved out of equities by the short futures position. In brief, by selling futures, you are able to protect $300,000 of your initial portfolio value from a stock price decline, nearly breaking even, an achievement given these market conditions. Had you been more confident of the market decline, you might have completely neutralized the equity risk on the portfolio by selling more futures contracts. This would have converted the entire stock position to a $400,000 investment in the money market. The amount of protection you should obtain depends on your assessment of the market and your tolerance for risk. Situation 2: Increasing exposure with futures Now let us look at the other side of the coin. The market has come off its highs in a predictable and controlled secondary reaction and your technical analysis is that the Bull Market will continue. At 10,000, it appears headed for 11,000, and you want to increase your commitment. Your portfolio is as previously described, split 80/20 between Dow stocks and money markets. It is time to go whole hog, you decide. You are acutely aware of the market maxim (bulls make money and bears make money and hogs wind up slaughtered), but there is also a market maxim that no market maxim is true 100% of the time, which is also true of this maxim. Rather than liquidate your money market holdings, you buy one futures contract, which puts you long another $100,000 of stocks. The rate of return on the money markets in your portfolio is 0.5%. To get a $500,000 exposure in blue chips, you buy the following number of contracts: $100,000/($10 x 10,000) = 1 contract. Results: Your technical analysis of the direction of the market is correct, and the Dow future rises to 11,000 at the September expiration, or by 10%. Value of portfolio with passive management: Stocks $400,000 x 1.10$440,000 Money market+$100,000 x 1.005$100,500 Total $540,500 Value of portfolio with futures position: Long DJIA futures 1 x $10.00 x (11,000 - 10,000)$10,000 Total $550,500 Value of portfolio with reallocation of assets in cash market: Stocks $500,000 x 1.10$550,000 Money market $0 Total $550,000 In buying Dow Index futures, you are able to “equitize” $100,000 of your money market investment, effectively increasing your return from the money market rate of 0.5%-10%. If you had not bought futures, the total value of your portfolio at the September expiration would have been $540,500 instead of $550,500. Not only do you have a $10,000 extra gain in your portfolio, but also you have taken advantage of the market's continuing upward climb without having to adjust your portfolio. Situation 3: Using bond and index futures for asset allocation Speculation in bonds can be quite profitable, notwithstanding David Dreman's assertion that long-term investments in bonds are net losers. (EN9: An oversimplification of a sophisticated thesis by an important figure.) Subsequently, it is not unusual for an investor to have both bonds and stocks in his portfolio. In this event, the portfolio can be managed with facility by using both Index futures and Treasury bond futures. Many investors consider it prudent to reallocate their capital commitments based on inflation rates, interest rates, and the reported expression on Alan Greenspan's (or Bernanke's) face before congressional testimony. An efficient and inexpensive way to reallocate assets between stocks and bonds is to put on spreads of Treasury bond futures and Dow Index futures. Analysis of recent long- and medium-term trends in the market, however, has led you to consider increasing your equity portfolio and decreasing your bond portfolio. You have $200,000 invested in Dow stocks and $200,000 invested in Treasury bonds. You would like to take advantage of the sustained market rally by increasing your equities exposure to 75% and decreasing your bond holdings to 25%. As for tactics, you can reallocate both sides of your portfolio—buying $100,000 of stocks and selling $100,000 of bonds—with the sale of Treasury bond futures and the purchase of Dow Index futures. The Treasury bonds in your portfolio have a market price of 103-20. The price of September Treasury bond futures is 102-20 per $100 of face value, and $100,000 of face value must be delivered against each contract. The value of the Dow futures is 10,000, and the price of the Dow Index futures contract is 10,000 (ignoring the cost of carry). The number of T-bond futures to sell is: short T-bond futures: $100,000/ (102 - 20 x $1,000) = 1 (number of futures is rounded to the nearest whole number). The number of stock index futures to buy is as follows: long stock index futures: $100,000/ ($10.00 x 10,000) = 1 (number of futures is rounded to the nearest whole number). Results: at the September futures expiration, the value of the Dow future is 11,000, a rate of return of 10%, and the market value of the bonds is 101- 08, a rate of return of -1%. Portfolio value with no market action taken: Stocks $200,000 x 1.10$220,000 Money market$200,000 x 0.99$198,000 Total $418,000 Value of futures positions: Long Dow futures$10 x 1 x (11,000 - 10,000)$10,000 Short bond futures+$1000 x 1 x (102-20 - 101-08)$1375 Total $11,375 Grand total $429,375 Value of portfolio had transaction been done in cash market: Stocks$300,000 x 1.10$330,000 Bonds+$100,000 x 0.99$99,000 Total $429,000 By this simple maneuver, you have quickly and easily changed your market posture to add an additional $100,000 exposure to stocks and subtract $100,000 exposure to bonds. Figure 17.4 Dow-Jones Futures and Options. A put purchased at the arrow on the break would have protected patiently won gains over the previous 11 months. The increase in the value of the put can be seen as futures track declining Dow cash. A theoretical drill, but theoretical drills precede actual tactics in the market. Having correctly analyzed market trends, your action results in an increase in portfolio value from $418,000 to $429,375. You could have accomplished the same result by buying and selling bonds and stocks, but not without tax consequences and the attendant transaction headaches. The use of futures to accomplish your goals allowed you to implement your Perspective Although there can be no argument about the importance of CBOT® DJIASM Index futures— they are markets of enormous usefulness and importance—there can also be no doubt the futures novice should thoroughly prepare himself before venturing into these pits. In such a highly leveraged environment, mistakes will be punished much more severely than an error in the stock market. By the same token, ignorance of this vital tool is the mark of an investor who is not serious about his portfolio, or who is less intense in his investment goals. “They” (the infamous “they”) use all the weapons at their disposal; so should “we.” Options on Dow Index futures The buyer of this instrument has the choice, or the right, to assume a position. It is his option to do so—unlike a futures contract in which he has an obligation once entered. There are two kinds of options: calls (the right to buy the underlying instrument) and puts (the right to sell). Also, options can be bought (long) or sold (short) like futures contracts. A long call option on Dow Index futures gives the buyer the right to buy one futures contract at a specified price which is called the “exercise” or “strike” price. A long put option on Dow Index futures gives the buyer the right to sell one futures contract at the strike price. For example, a call at a strike price of 10,000 entitles the buyer to be long one futures contract at a price of 10,000 when he exercises the option. A put at the same strike price entitles the buyer to be short one futures contract at 10,000. The strike prices of Dow Index futures options are listed in increments of 100 index points, giving the trader the flexibility to express his opinions about upward or downward movement of the market. The seller, or writer, of a call or put is short the option. Effectively selling a call makes the writer short the market, just as selling a put makes the writer long the market. As in a futures contract, the seller is obligated to fulfill the terms of the option if the buyer exercises. If you are short a call, and the long exercises, you become short one futures contract at 10,000. If you are short one put and the long exercises, you become long one futures contract at 10,000. Buyers of options enjoy fixed risk. They can lose no more than the premium they pay to go long an option. On the other hand, sellers of options have potentially unlimited risk. Catastrophic moves in the markets often bankrupt imprudent option sellers. Option premiums The purchase price of the option is called the option premium. The option premium is quoted in points, each point being worth $100. The premium for a Dow Index option is paid by the buyer at initiation of the transaction. The underlying instrument for one CBOT® futures option is one CBOT® DJIASM futures contract; so the option contract and the futures contract are essentially different expressions of the same instrument, and both are based on the Dow-Jones Index. Options premiums consist of two elements: intrinsic value and time value. The difference between the futures price and strike price is the intrinsic value of the option. If the futures price is greater than the strike price of a call, the call is said to be “in-the-money.” In fact, you can be long the futures contract at less than its current price. For example, if the futures price is 10,020 and the strike price is 10,000, the call is in-the-money and immediate exercise of the call pays $10.00 times the difference between the futures and strike price, or $10 x 20 = $200. If the futures price is less than the strike price, the call is “out-of-the-money.” If the two are equal, the call is “at-the-money.” A put is in-the-money if the futures price is less than the strike price and out-of-the-money if the futures price is greater than the strike price. It is at-the-money when these two prices are equal. Since a Dow Index futures option can be exercised at any date until expiration, and exercise results in a cash payment equal to the intrinsic value, the value of the option must be at least as great as its intrinsic value. The difference between the option price and the intrinsic value represents the time value of the option. The time value reflects the possibility that exercise will become more profitable if the futures price moves farther away from the strike price. Generally, the more time until expiration, the greater the time value of the option because the likelihood of the option becoming profitable to exercise is greater. At expiration, the time value is zero and the option price equals the intrinsic value. Volatility The degree of fluctuation in the price of the underlying futures contract is known as “volatility” (see Appendix B, Resources, for the formula). The greater the volatility of the futures, the higher the option premium. The price of a futures option is a function of the futures price, the strike price, the time left to expiration, the money market rate, and the volatility of the futures price. Of these variables, volatility is the only one that cannot be observed directly. Considering all the other variables are known, however, it is possible to infer from option prices an estimate of how the market is gauging volatility. This estimate is called the “implied volatility” of the option. It measures the market's average expectation of what the volatility of the underlying futures return will be until the expiration of the option. Implied volatility is usually expressed in annualized terms. The significance and use of implied volatility is potentially complex and confusing for the general investor, professionals having a decided edge in this area. Their edge can be removed by serious study. Exercising the option At expiration, the rules of optimal exercise are clear. The call owner should exercise the option if the strike price is less than the underlying futures price. The value of the exercised call is the difference between the futures price and the strike price. Conversely, the put owner should exercise the option if the strike price is greater than the futures price. The value of the exercised put is the difference between the strike price and the futures price. To illustrate, if the price of the expiring futures contract is 7,600, a call struck at 7,500 should be exercised, but a put at the same or lower strike price should not. The value of the exercised call is $1,000. The value of the unexercised put is $0.00. If the price of the expiring futures contract is 7,500, a 7,600 put should be exercised but not a call at 7,600 or a higher strike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00. The profit on long options is the difference between the expiration value and the option premium. The profit on short options is the expiration value plus the option premium. The expiration values and profits on call and put options can often be an important tool in an investment strategy. Their payoff patterns and risk parameters make options quite different from futures. Their versatility makes them good instruments to adjust a portfolio to changing expectations about stock market conditions. Moreover, these expectations can range from general to specific predictions about the future direction and volatility of stock prices. Effectively, there is an option strategy suited to virtually every set of market conditions. Using futures options to participate in market movements Traders must often react to rapid and surprising events in the market. The transaction costs and price impact of buying or selling a portfolio's stocks on short notice inhibit many investors from reacting to short-term market developments. Shorting stocks is an even less palatable option for average investors because of the margin and risks involved and semantical prejudices. The flexibility that options provide can allow one to take advantage of the profits from market cycles quickly and conveniently. A long call option on Dow Index futures profits at all levels above its strike price. A long put option similarly profits at all levels below its strike price. Let us examine both strategies. Profits in rising markets In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You expect the current Bull Market to continue, and you would like to take advantage of the trend without tying up too much capital and also undertake only limited risk. You buy a September call option on Dow Index futures. These options will expire simultaneously with September futures, and the futures price will be the same as the cash index at expiration. Your analysis is bullish, so the 10,500 call (out-of-the-money strike price) is a reasonable alternative at a quoted premium of 10.10. You pay $1,010 for the call ($100 x 10.10). The payoff: at the September expiration, the value of the Dow Future is 10,610. Now, your call is in-the-money, and you exercise it and garner the exercise value less the premium, or $90.00 = $10.00 x (10,610 - 10,500) - $100 x (10.10) = $1,100 - $1,010. If the Dow future stays at or below 10,500, you let the call expire worthless and simply lose the premium. This is the maximum possible loss on the call. If the Dow future increases by 101 points above the strike price, you break even. Instead of buying the call option, the trader could have invested $100,500 directly in the Dow stocks. Given a value of the Dow future of 10,110 in September, he would have had a gain of $3,030. If he had invested directly in the stocks, however, an unexpected market decline would have led to a loss. Exploiting market reversals The trader expects a reversal of the Bull Market now at 7,800 and would like some downside protection. He buys a put with a strike price of 7,700 (out-of-the-money). The put premium is 9.80, for a total cost of $980 = $100 x 9.80. If the Index decreases to 7,600, with a corresponding decrease in the futures contract in September, the put is worth $1,000. The maximum loss is the premium cost, which is lost if the Dow future is above 7,700 at expiration. The trader breaks even if the Dow future decreases by 98 points below the strike price. Using puts to protect profits in an appreciated portfolio During a sustained Bull Market, investors often search for ways to protect their paper profits from a possible market break. Even when fundamental economic factors tend to support a continued market upside, investors have to guard against unpredictable “technical market corrections” and market over-reactions to news. Selling stocks to reduce downside risk is costly in fees and taxes and sacrifices potential price gains. What is desirable in a sideways market environment is an instrument that protects the value of a portfolio against a market drop but does not constrain upside participation. This is precisely what put options are designed to do. Situation 1 The market is in an uptrend in August, which is when the market lives with the anxiety the Federal Reserve will tighten short-term interest rates further in the coming months. The trader has $78,000 invested in the Dow portfolio, and the Dow Future is at 7,800. To hedge his portfolio, he purchases a put option on September futures against a possible market downturn. He buys a 7,600 put at a premium of 6.60, cost $100 x 6.60 = $660. Buying the put places a floor on the value of the portfolio at the strike price. Buying a put with a strike price of 7600 effectively locks in the value of the portfolio at $76,000. Above its strike price, a put is not exercised and the portfolio value is unconstrained. If the trader is wrong, and the market goes up, he loses the premium paid for the put. Depending on which strike price he chooses, he increases or decreases downside risk. He breaks even when the Dow future reaches a value of 7,534 = 7,600 - 66, the strike price less the put premium. At this level, the unprotected and put-protected portfolios are equally profitable. The similarity to life insurance is striking. If you do not die, the premium is wasted. But if you do... Improving portfolio yields Situation 2 All markets, as the reader is perhaps aware, are not trending. Days, weeks, months, sometimes years can pass while the markets grind up and down in what are euphemistically known as trading range markets. When the astute technician identifies one of these market doldrums and judges that it will continue, he can reap other returns on his portfolio by selling puts and calls on Dow Index futures. For example, when the Dow Index is 10,000 and the trader calculates it will not break out for the next month above 10,200, he sells calls at a strike price of 10,200. The quoted premium of the 10,200 call is, say, 10.10; selling a 10,200 call generates $1010 income. The trader pockets the entire premium as a profit if the index remains below 10,200 at the September expiration. The downside of this trade is that the trader gives up price appreciation above 10,200. Above 10,200, the combined value of the portfolio and short call premium is $101,010. The break-even point is 10,301, where the Dow Future is equal to the sum of the strike price and call premium. Above this point the covered call portfolio becomes less profitable than the original portfolio. Since the short call is covered by the portfolio, this strategy is not exposed to the risk represented by a naked call. The main risk is the trader giving up the profit potential above the strike price of the call. As is obvious to the technician, this is a bad strategy in trending markets. Only in clearly range-bound markets would an enlightened trader want to write covered calls. The call premium collected is some compensation for this risk, but cold comfort when the trader has misanalyzed the market. The best strike price of the call depends on the probabilities you have assigned to future increases and behavior of the Dow. Using option spreads in high- or low-volatility markets Long and short stock positions reflect definite market opinions or analyses. The market will go up or the market will go down and the moderately competent technician should be right about this more often than the unwashed general public. In markets of coiling volatility (i.e., lower than average volatility and declining), it is sometimes possible to exploit uncertainty by putting on a long straddle. The long straddle combines a long put and a long call at the same strike price. This spread generates a return over two ranges of market values: values below the strike price of the put and values above the strike price of the call. It is a profitable strategy given sufficient volatility; the editor's company used such a strategy immediately before the crash of 1987 for managed accounts and collected disproportionate profits on a very low-risk position. Experienced speculators and traders generally sell high-volatility markets and try to backspread (go long) in chosen less-volatile markets, expecting volatility to return to the mean. Sometimes they do this by writing a short straddle, a position with a short put and a short call at the same strike price. Situation 3 In August, a technical analysis predicts that volatility will increase, and the market is in a coiling process. The direction of prices is uncertain but potentially explosive. The trader buys a straddle of a long put at 7,800 and a long call at 7,800. The quoted call premium is 18.90 and the quoted put premium is 13.90. The total cost of the straddle is $3280 = $100 x 32.80. This is the maximum loss if the Dow Future stalls at 7,800. The straddle makes a profit when the Dow Future moves enough to recover the cost of the straddle, either below 7,472 = 7,800 - 328 or above 8,128 = 7,800 + 328. The potential upside profit is unlimited. The maximum profit on the downside is $10.00 x (7,800 - 328), or $74,720, if the Dow future goes to zero (somewhat unlikely, but one never knows what Chicken Little the investor will do if he thinks the sky is falling). Situation 4 In August, the investor calculates options are overvalued and volatility will be lower than implied volatility. He expects a dormant market to continue through the end of the summer. He decides to sell the September put and call at 7,800, collecting $3,280. The return on this short straddle will turn negative if the Dow future in September goes below 7,472 or above 8,128. The maximum loss on the downside is $10.00 x (7,800 - 328), or $74,720, and the loss on the upside is unlimited. The investor, however, perceives the risk as limited because he believes the Dow future will neither increase nor decrease to these levels within the next month when the options expire. In these cases, the trader must also consider catastrophic risk—as, for example, the editor's client who was short puts in the crash of 1987 and lost $57 million. Perspective (EN9: Once again, do not practice the methods and techniques described in this chapter without complete confidence in their use. A course in futures and options is recommended, or professional consultation.) I like to tell these stories so prospective options traders and general investors are made dramatically aware of the potential dangers, as well as the potential profits. As stated elsewhere in this book, the novice should work to achieve competence and experience before attempting advanced tricks in futures and options. On the other hand, the investment use of these instruments for prudent hedging and insurance is recommended to the investor willing to do his homework, acquire competence, and grow in investment skills. Dow Index futures and futures options present new techniques of portfolio protection and profit-making for the general investor. Numerous strategies can be practiced by the moderately competent investor using these instruments. Keep in mind always that all the methods of analytical investing espoused in this book are the base discipline—that is, knowledge of the instruments and their use, prudent trade management, stop-loss discipline, and close attention to the dynamics of the situation. Above all, the existence of these instruments allows the most conservative of investors insurance and hedging techniques not previously available. In summation, knowledge of the DJIA futures and options on futures is absolutely essential for the competent technical investor and trader. Recommended further study In view of the importance of this chapter, noted here are references to advanced material, which are also found in Appendix B, Resources. The CBOE has a website explaining the math behind hedging. To hedge a portfolio of $500,000 tracking the S&P 500, you need four puts. The address for the calculation of the hedging ratio is available at http://www.cboe.com/portfoliohedge. For further study, see the following: • Options as a Strategic Investment by Lawrence Macmillan, http://www.optionstrategist. com • Chicago Board Options Exchange, http://www.cboe.com • Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341- 3168 (fax); http:// www.cbot.com part two Trading tactics Midword As a kind of foreword to Section II of this book, we might mention a commentary, “On Understanding Science: An Historical Approach,” by James Bryant Conant, president emeritus of Harvard. Dr. Conant points out that, in school, we learn science is a systematic collection of facts that are classified in orderly array, broken down, analyzed, examined, synthesized, and pondered; and then lo! a Great Principle emerges—pat, perfect, and ready for use in industry, medicine, or what-have-you. He further points out that all of this is a mistaken point of view held by most laymen. Discovery takes form little by little, shrouded in questioning, and only gradually assumes the substance of a clear, precise, well-supported theory. The neat tabulation of basic data, forming a series of proofs and checks, does not come at the start but much later. In fact, it may be the work of other men entirely, men who, being furnished with the conclusions, are then able to construct a complete, integrated body of evidence. Theories of market action are not conceived in a flash of inspiration; they are built, step by step, out of the experience of traders and students, to explain the typical phenomena that appear over and over again through the years. In market operations, the practical trader is not concerned with theory as such. The neophyte's question, “What is the method?” probably means, actually, “What can I buy to make a lot of money easily and quickly?” If such a trader reads this book, he may feel there is “something in it.” He may feel “It's worth a try” (a statement, incidentally, that reflects little credit on his own previous tries). He may also start out quite optimistically, without any understanding of theory or any experience in these methods, and without any basis for real confidence in the method. In such cases, the chances are great he will not immediately enjoy the easy success he hopes for. His very inexperience in a new approach will result in mistakes and failures. Yet, even with the most careful application of these methods, in correctly entered commitments, he may encounter a series of difficult market moves that may give him a succession of losses. Whereupon, having no solid confidence in what he is doing, he may sigh, put the book back on the shelf, and say, “Just as I thought. It's no damn good.” Now, if you were about to go into farming for the first time, you might be told (and it would be true) the shade tobacco business offers spectacular profits. But you would not expect to gain these profits without investing capital, without studying how shade tobacco is grown and in what kinds of soils and what localities, nor without some experience with the crop. Furthermore, you would need confidence—faith in the opportunity and also in the methods you were using. If your first season's crop were blighted (and these things do happen), you would naturally be disappointed. If it should happen that your second year's crop were destroyed by a hailstorm, you would be hurt and understandably despondent. Moreover, if your third season's crop were to be a total loss because of drought, you would probably be very gloomy indeed (and who could blame you?). But you would not say, “There's nothing to it. It's no damn good.” You would know (if you had studied the industry and the approved cultivation methods) that you were right, regardless of any combination of unfavorable circumstances, and you would know the ultimate rewards would justify your continuation, no matter how hard the road, rather than turn to some easier but less potentially profitable crop. So it is with technical methods in the stock market; anyone may encounter bad seasons. The Major Turns inevitably will produce a succession of losses to Minor Trend operators using the methods suggested in this book. There will also be times when a man who has no understanding of basic theory will be tempted to give up the method entirely and look for a “system” that will fit into the pattern of recent market action nicely, so he can say, “If I had only averaged my trades ... . If I had followed the Dream Book ... . If I had taken Charlie's tip on XYZ ... . If I had done it this way or that way, I would have come out with a neat profit.” It would be better, and safer, to understand at the start that no method ever devised will unfailingly protect you against a loss, or sometimes even a painful succession of losses. You should realize what we are looking for is the probability inherent in any situation. Likewise, just as you would be justified in expecting to draw a white bean from a bag which you knew contained 700 white beans and 300 black beans (even though you had just drawn out 10 black beans in succession!), so too you are justified in continuing to follow the methods that, over long periods, seem most surely and most frequently to coincide with the mechanism of the market. Thus, this book should not be given a quick “once-over” and adopted straightaway as a sure and easy road to riches. It should be read over and over, a number of times, and it should be consulted as a reference work. Furthermore, and most importantly, you will need the experience of your own successes and failures so you will know what you are doing is the only logical thing you can do under a given set of circumstances. In such a frame of mind, you will have your portion of successes and your failures, which you can take in stride, as part of the business, will not ruin either your pocketbook or your morale. In short, the problem stated and analyzed through this whole volume is not so much a matter of “systems” as it is a matter of philosophy. The end result of your work in technical analysis is a deep understanding of what is going on in the competitive free auction, what is the mechanism of this auction, and what is the meaning of it all. Be mindful this philosophy does not grow on trees; it does not spring full-bodied from the sea foam either. It comes gradually from experience and from sincere, intelligent, hard work. Section II of this book, which follows, is concerned with tactics. Up to this point, we have been studying the technical formations and their consequences. We should have a good general understanding of what is likely to happen after certain manifestations on the charts. Knowing that, however, we will still need a more definite set of guides as to when and how it is best to execute this or that sale. These chapters are based on one man's experience and his analysis of thousands of specific cases. It takes up questions of method, of detail, and of application, and should provide you with a workable basis for your actual market operations. As time goes on, you will very likely adopt refinements of your own or modify some of the suggested methods according to your own experience. However, the authors feel the suggestions made here will enable you to use technical analysis in an intelligent and orderly way that should help to protect you from losses and increase your profits. John Magee Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter eighteen The tactical problem (EN: In this chapter, Magee addresses the question of tactics for the “speculator” who follows short and medium-term trends. The later sections of the chapter address the question of strategy and tactics for the long-term investor and provide a discussion of the term “speculator.”) It is possible (as many traders have discovered) to lose money in a Bull Market—and, likewise, to lose money trading short in a Bear Market. You may be perfectly correct in judging the Major Trend; your long-term strategy, let us say, may be 100% right. Except, without tactics, without the ability to shape the details of the campaign on the field, it is not possible to put your knowledge to work to your best advantage. There are several reasons why traders, especially inexperienced traders, so often do so poorly. At the time of buying a stock, if it should go up, they have no objectives and no idea of what policy to use in deciding when to sell and take a profit. If it should go down, they have no way of deciding when to sell and take a loss. Result: they often lose their profits; and their losses, instead of being nipped off quickly, run heavily against them. Also, there is this psychological handicap: the moment a stock is bought (or sold short), commissions and costs are charged against the transaction. The trader knows the moment he closes the trade there will be another set of charges. Also, since he is not likely to catch the extreme top of a rally or the extreme bottom of a reaction, he is bound, in most cases, to see the stock running perhaps several points against him after he has made his commitment. Even on a perfectly sound, wise trade, he may see a 10% or more paper loss before the expected favorable move gets under way (see Figure 18.1). Obviously, if he weakens and runs for cover without sufficient reason before the stock has made the profitable move he looked for, he is taking an unnecessary loss and forfeiting entirely his chance to register a gain. The long-term investor who buys in near the bottom and remains in the market to a point near the top, to later liquidate and remain in cash or bonds until (perhaps several years later) there is another opportunity to buy in at the bottom, does not face the continual problem of when to buy and when to sell. This assumes one can tell precisely when such a bottom has been reached and when the trend has reached its ultimate top (and those are very broad assumptions indeed). The long-term investment problem for large gains over the Major Trends is by no means as simple as it sounds when you say, “Buy them when they're low, and sell them near the top.” However, such large gains have been made over the long pull, and they are very impressive. (EN: Note the record of the Dow Theory in Chapters 4 and 5.) This section of the book is concerned more particularly with the speculative purchase and sale of securities. There are some basic differences between the “investment” point of view and the “speculative.” It is a good thing to know these differences and make sure you know exactly where you stand (see Figure 18.2). Either viewpoint is tenable and workable, but you can create serious problems for yourself, and sustain heavy losses, if you confuse them. One difference is a speculator deals with stocks as such. A stock, to be sure, represents ownership in a company, but the stock is not the same thing as the company. The securities 76 72 68 64 60 Sales 100's 125 100 75 50 25 CUX CUDAHY PACKING JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER I 7 114 I 211 28> 4 i 111181 251 1 1 8 115122 ■ 29 I 6 113 120 127 1 3 110117 >241 1 * 8 11^ 22 • 29 • Figure 18.1 It is possible to lose money owning stocks in a Bull Market. Notice this Major Top Formation did not occur in 1929, but in the summer of 1928. For more than a year after this, a majority of stocks and the Averages continued the Bull Market Advance. But Cudahy declined steadily, reaching a price below 50 well before the 1929 Panic, and continued in its Bearish course for more than four years, ultimately selling at 20. Except for the somewhat unusual volume on the head on August 21, this is a typical Head-and-Shoulders Pattern with a perfect Pullback Rally in mid-November. It underscores what we have mentioned before—a Head- and-Shoulders Top in a stock, even when other stocks look strong, cannot safely be disregarded. The Head-and-Shoulders Pattern, either in its simple form or with multiple heads or shoulders, is likely to occur at Major and Intermediate Tops, and in reverse position at Major and Intermediate Bottoms. It has the same general characteristics as volume, duration, and breakout as the Rectangles and the Ascending and Descending Triangles. In conservative stocks, it tends to resemble the Rounding Turns. of a strong company are often weak, and sometimes the securities of a very weak concern are exceedingly strong. It is important to realize the company and the stock are not precisely identical. The technical method is concerned only with the value of the stock as perceived by those who buy, sell, or own it. A second difference is in the matter of dividends. The “pure investor,” who, by the way, is a very rare person, is supposed to consider only the “income” or potential income from stocks—the return on his investment in cash dividends. (EN: This rara avis is largely extinct now.) Nevertheless, there are many cases of stocks that have maintained a steady dividend while losing as much as 75% or more of their capital value. There are other cases in which stocks have made huge capital gains while paying only nominal dividends or none at all. If the dividend rate were as important as some investors consider it, the only research tool one would need would be a calculator to determine the percentage yields of the various issues; hence, their “value,” which, on this basis, stocks paying no dividends would have no value at all. From the technical standpoint, “income,” as separate from capital gains and losses, ceases to have any meaning. The amount realized in the sale of a stock, less the price paid and plus total dividends received, is the total gain. Whether the gain is made entirely in capital increase, entirely in dividends, or in some combination of these, makes no difference. In the case of short sales, the short seller must pay the dividends. Although, here again, this is simply one factor to be lumped with the capital gain or loss in determining the net result of the transaction. Figure 18.2 What would you have done with Hudson Motors? The great Panic Move of October-November 1929 carried the Dow-Jones Industrial Average down from its September all-time high of 386.10 to a November low of 198.69. A rally, bringing the Average back to 294.07 in April 1930, recovered 95 points, or 51% of the ground lost, a perfectly normal correction. Suppose you had bought HT after the decline from its 1929 high of 93 1/2, say at 56, in the belief that the 37-point drop had brought it into a “bargain” range. On your daily chart, you would have seen the pattern shown above (which you will now recognize as a Descending Triangle) taking shape in the early months of 1930. Would you have had a protective stop at 51? Would you have sold at the market the day after HT broke and closed below 54? Or would you have hoped for a rally, perhaps even bought more “bargains” at 50, at 48, at 40? Would you still have been holding onto your “good long-term investment” when HT reached 25 1/2 in June? Would you still have been holding HT when it reached its ultimate 1932 bottom at less than 3 (see Figure 8.22)? (EN: See Figure 18.4 for a recapitulation of the lesson from the 2000s.) There is a third source of confusion; very often, the “pure investor” will insist he has no loss in the stock he paid $30.00 for, which is now selling at $22.00, because he has not sold it. Usually he will tell you he has confidence in the company and he will hold the stock until it recovers. Sometimes he will state emphatically that he never takes losses. How such an investor would justify his position if he had bought Studebaker at more than $40.00 in 1953 and still held Studebaker Packard at around $5.00 in 1956 (EN: Or Osborne at $25.00 and $0.00 in the 1980s or Visacalc at similar prices in the same decade. EN9: Or Enron and WorldCom in the 2000s. Or Bear Stearns, or Lehman, or ... ) is hard to say; however, for him, the loss does not exist until it becomes a “realized” loss. Actually, his faith the stock will eventually be worth what he paid for it may be no more than a speculative hope—and a forlorn one at that. Furthermore, one may question whether his reasoning is always consistent. For example, suppose another stock this investor had bought at $30.00 was now selling at $45.00. Would he tell you he did not consider a profit or loss until the stock was sold? Or would he be tempted to speak of the “profit” he had in this purchase? It is all right to consider gains or losses either on the basis of “realized” or completed transactions, or on the basis of the market values “accrued” at a particular time? Yet, it is not being honest with yourself to use one method to conceal your mistakes and the other method to accentuate your successes. The confusion of these concepts is responsible for many financial tragedies. (EN: One might almost say, in the modern context, such confusion amounts to willful or neurotic behavior. Given the easy availability of portfolio software that marks-to-market positions, avoidance of this knowledge can only be regarded as self-defeating.) As a trader using technical methods, you will probably find the most realistic view is to consider your gains and losses “as accrued.” In other words, your gain or loss at a given time will be measured with reference to the closing pricing of the stock on that day. Recapitulating, it is important (1) to avoid regarding a stock and the company it represents as identical or equivalent; (2) to avoid the conscious or unconscious attribution of “value” to a stock on the basis of dividend yield, without regard to market prices; and (3) to avoid confusing “realized” and “accrued” gains or losses. The technical trader is not committed to a buy-and-hold policy. There are times when it is clearly advantageous to retain a position for many months or for years, but there are also times when it will pay to get out of a stock, either with a profit or with a loss. The successful technician will never, for emotional causes, remain in a situation that, on the evidence at hand, is no longer tenable. An experienced trader using technical methods can take advantage of the shorter Intermediate Trends, and it can be shown that the possible net gains are larger than the entire net gains on the Major Trend, even after allowing for the greater costs in commissions and allowing for the greater income tax liability on short-term operations. It should be understood that any such additional profits are not easily won. They can be obtained only by continual alertness and adherence to systematic tactical methods. For the market, regarded as a gambling machine, compares very poorly with stud poker or roulette, and it is not possible to “beat the market” by the application of any simple mathematical system. If you doubt this, it would be best to stop at this point and make a careful study of any such “system” that may appeal to you, checking it against a long record of actual market moves. Ask yourself whether you have ever known anyone who followed such a system alone, as a guide to market operations, and was successful. (EN: After Magee wrote this, many successful traders, aided by computer technology and advances in finance theory, have created algorithmic systems that have been successful in the financial markets. However, the markets usually become aware of the success of these systems and develop counterstrategies to defeat them. So there is a tendency for the performance of mechanical systems to degenerate or totally fail over time. It is the happy combination of the system with markets hospitable to it that makes mechanical systems successful over defined periods of time.) The practice of technical analysis, on the other hand, is not a mathematical process, although it does involve mathematics. It is intended to search out the significance of market moves in the light of past experience in similar cases, by means of charts, with a full recognition of the fact that the market is a sensitive mechanism by which all of the opinions of all interested persons are reduced by a competitive democratic auction to a single figure, representing the price of the security at any particular moment. The various formations and patterns we have studied are not meaningless or arbitrary. They signify changes in real values, the expectations, hopes, fears, developments in the industry, and all other factors that are known to anyone. It is not necessary to know, in each case, what particular hopes, fears, or developments are represented by a certain pattern. It is important to recognize the pattern and understand what results may be expected to emerge from it. The short-term profits are, you might say, payment for service in the “smoothing out” of inequalities of trends, and for providing liquidity in the market. As compared with the long-term investor, you will be quicker to make commitments and quicker to take either profits or (if necessary) losses. You will not concern yourself with maintaining “position” in a market on any particular stocks (although, as you will see, we will try to maintain a certain “total Composite Leverage” [or risk and profit exposure] according to the state of the market, which accomplishes the same result). You will have smaller gains on each transaction than the long-term investor, but you will have the advantage of being able to frequently step aside and review the entire situation before making a new commitment. Most particularly, you will be protected against Panic Markets. There are times (and 1929 was by no means the only time) (EN: 1987 and 1989 also come to mind. EN9: Add 20012002, if you please: May 2, 2001, Dow 11,350; September 17, 2001, 8,062; March 18, 2002, 10,673; and July 22, 2002, 7,532), when the long-term investor stands to see a large part of his slowly accumulated gains wiped out in a few days. The short-term trader, in such catastrophes, will be taken out by his stop-loss orders, or his market orders, with only moderate losses, and will still have his capital largely intact to use in the new trend as it develops. (EN: The best technical analysts' opinion in “modern times” is that even long-term investors should not grin and bear a Bear Market. This is a necessity only for bank trust departments and believers in Burton Malkiel.) Finally, before we get on with the subject of tactics, the operations we are speaking of are those of the small and midsize trader. The methods suggested here, either for getting into a market or getting out of it, will apply to the purchase or sale of odd lots, 100 shares, 200 shares, and sometimes up to lots of thousands of shares or more of a stock, depending on the activity and the market for the particular issue. The same methods would not work for the trader who was dealing in 10,000-share blocks (except in the largest issues) because, in such cases, his own purchases or sales would seriously affect the price of the stock. Such large-scale operations are in a special field governed by the same basic trends and strategy, but that requires a different type of market tactics (see Figure 18.3). (EN: Or, put another way, as Magee said to me one time, a mouse can go where an elephant cannot.) Strategy and tactics for the long-term investor— What's a speculator? What's an investor? In the years since Magee wrote the original Chapter 18, some different connotations have attached themselves to the terms “speculator” and “investor.” A great cultural shift has also occurred. The days when the New Haven (New York, New Haven, and Hartford Railroad) was a beacon of respectability (and lent luster to its investor) and paid “good dividends” are gone forever; as is the New Haven. In fact, after the turn of the century, corporations saw a change in investor sentiment about dividends. Investors wanted capital appreciation Figure 18.3 If an investor only learned one thing from this book, it would be that one thing might be the salvation of his portfolio or his retirement plan (if all his assets in the investment plan were shares of Enron). Instead, the employees of Enron made a major mistake in not having a diversified retirement portfolio—they had all their eggs in one basket, their income and savings came from one source. But diversification is not even the crucial lesson here; the lesson is get out of the stock when it reverses. The corollary of that lesson is never buy a stock in a downtrend. However, the more important lesson is never buy a stock when it is in a swan dive. So obvious you say, but not so obvious at the time for portfolio managers for the University of Miami who continued to accumulate Enron stock even as it neared earth at 100 miles an hour. Of course, they had a sophisticated (?) company; the Motley Fools had a death grip on the stock all the way to the bottom. and cared less for dividends. In fact, it has lately been considered the mark of a “growth stock” not to pay dividends. Evidently, the days of the New Haven are gone forever, when an “investor” was one who bought, held, and collected dividends, and “speculators” were slightly suspect men like Magee who played the medium-term trends and bought “unchic, speculative” stocks. It all has a sepia tone to it. Yesterday's Magee speculator might be called a medium-term investor today. Although the term “speculator” could still be applied to anyone who “trades” the market, today that old-time speculator and his kind would more likely be called traders than speculators. Commodity traders who have no business interest in the contracts they exchange are always referred to as speculators, as opposed to commercials, who are hedgers and users of the commodities they trade. Now “day traders” might be considered the equivalent of the old-time speculators—except that day trading veers dangerously close to gambling. And only the passive, in the opinion of this editor, never trade at all and sit on their holdings during Bear Markets. On the spectrum of investors, from investor to gambler, the old “New Haven Investor” who “wants his dividends” is pretty rare these days, and, again, may be one of those trust departments that does not want to get sued and so stays out of stocks that go up. After all, prudent men do not “trade in volatile stocks” but “invest in safe issues, like bonds,” which only lose about 1.5%-2.0% of their purchasing value per year but preserve the illusion of having “preserved principal.” One definition of the long-term investor Let us take as a long-term investor now one who expects to at least track market returns, for it has been demonstrated over a relatively long period of time that this can be done by passive indexing. At the turn of the century, as this is written, it would seem neither longterm, medium-term, nor short- term investors think about the risks involved in matching the market because, entering the third millennium, it has been so many years since we have had a really vicious Bear Market. Dow 36,000? This is a passing phase. As each Bull Market reaches higher and higher, the odds are lower and lower that it will continue— historic Bull Markets of the 1990s notwithstanding. What then are the strategy and tactics for the long-term investor to achieve a goal of matching the market? (EN9: Is it necessary to remind the reader of Chapter 4 and the Dow Theory?) Let us remark immediately that the tactics Magee described for the speculator—or trader if you will—are not at all in conflict with the short- term tactics used occasionally by the long-term investor. As buying or selling time approaches the stops of the long-term investor, that investor becomes a trader who can and should adopt the trader's tactics. Sooner or later, the focus even narrows to real time at the moment of trade execution. Interestingly, the charting techniques we have described here work on tick- by-tick data in real time also. Hence, if the trader wants to enter into the real-time environment, he can attempt to time his trade right down to the real-time chart formations. Only the really active and skilled long-term investor will be concerned with squeezing the last half point or points out of his position. This illustration of the time focus is addressed to any investor or trader or speculator to demonstrate the fractal nature of both price data and the applicability of Magee-type technical analysis to it. The strategy of the long-term investor The strategy of the long-term investor is to catch the long trends—to participate in trades that lasts months and years. However, this strategy does not intend to be sucked into long Bear Markets. Rather, portfolios are liquidated or hedged when Bear Market signals are received. As has been previously seen in examples of the performance of (more or less) mechanical Dow Theory (see Chapter 4), this kind of performance can be quite satisfactory—better indeed than buy-and-hold strategies that have come much into vogue because of the Clinton-Gore Bull Markets of the 1990s. If the goal is to beat not only the markets but also the mutual funds (only 20% of which outperform the market over the long term anyway—and sometimes none of them make money), then passive indexing is the most likely strategy. This may be done in a number of ways—index funds, buying the basket, buying the futures, and so on. Nevertheless, the most attractive method might be the use of the Standard & Poor's Depositary Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and the like. The tactics may be calibrated to the risk tolerance and character of the investor. He might hedge or sell on Dow Theory signals, or on breaks of the 200-day moving average, or on breaks of the long-term or intermediate trendlines with a filter (Magee recommended 2%, and this might be calibrated to the character of the markets and increased to 3% or a factor relevant to actual market volatility). Basing Points (see Chapter 28) is also a powerful method. Instruments we have previously discussed— SPDRs, DIAMONDS, index futures, and options—can be used to execute these tactics. Suffice it to say that every strategy must provide for the plan gone wrong, in other words, the dreaded Bear Market. Bear Markets would not be so fearsome if the average investor did not insist on seeing only the long side of the market. Long-term strategies go out the window quickly when blood runs on the floor of the New York Stock Exchange. The well-prepared technical investor has a plan that provides for the liquidation of positions gone bad and presumably the discipline to execute it. This involves the regular recomputation of stops as markets go in the planned direction, and ruthless liquidation of losers that do not perform. One may think of a portfolio as a fruit tree. Weak branches must be pruned to improve the yield. Stop computation is treated in a number of places in this book (see Chapters 27 and 28). For the investor trading long term, this may be, as an example only and not as a recommendation, the breaking of the 200-day moving average or the breaking of a long-term trendline. The 200-day moving average is widely believed to be the long-term trend indicator, for which believing will sometimes make it come true. (EN9: Let me emphasize here that “200” is a parameter and an example. Personal research may fit a better parameter to the actual market.) In reality, more than just the 200-day moving average or a manually drawn trendline should be looked at. The chart patterns comprising the portfolio should be considered also, as well as charts of major indexes and averages. Also, consider the condition of the averages and their components—their technical state—whether they are topping, consolidating, or trending as indicated by their charts. Moreover, it would be impossible not to mention Magee's Basing Points Procedure (see Chapter 28). Possibly the most powerful trailing stop method in existence. Rhythmic investing In addition, if Chapter 31 on “Not All in One Basket” is weighed seriously, one might be rolling a portfolio from long to short gradually in natural rhythm with the markets and in harmony with the Magee Evaluative Index described there. That is the preferred strategy of the authors and editor of this book. These things all depend on the goals, temperament, and character of the investor. If he is going to spend full time on the markets, he is probably not a long-term investor. Such men eat well and sleep soundly at night. The trader is lean and hungry—not necessarily for money, but for activity. It behooves one to know his type as a trader or investor. Knowing one's type or character is best established before finding it out in the markets, as the markets can be an expensive place to search for self-knowledge. There is no inherent conflict in holding long-term positions and also attempting to profit from intermediate trends, depending on the amount of capital in hand and how much time, energy, and capital the investor wants to put into trading. A long-term strategy can be implemented with a modicum of time and energy, as follows: pay attention to the major indexes and averages and buy on breakouts, at the bottoms of consolidations and on pullbacks; sell or hedge on the breaking of trendlines, calculated on Basing Points (see Chapter 28) and the penetration of support zones. The long-term investor will accept greater swings against his position than the intermediate-term trader or speculator. As an example with the method of using Basing Points in Chapter 28, the speculator is using a three-days- away rule, whereas a long-term investor might be using a three-week Basing Point or some such analogy. Plus, if interested, when he suspects or analyzes a long Bull Market is approaching a climax, he might adopt the three-days rule also, or even begin following his stock with a daily stop just under the market. Beware though, as professionals look for stops just under the close of the previous day in situations such as these. It would be wise not to confuse long-term investing with “buy and hold,” or as it was expressed in one investment fad in the 1970s, “one-decision investing.” As an example of this misguided thinking, in 1972, the “best and brightest” investment analysts (fundamental) on the Street picked a portfolio of stocks for the generation, or 20 years. The companies would be difficult to argue with as the creme de la creme of American business. After all, who could kvetch at Avon, Eastman Kodak, IBM, Polaroid (unless he happened to look at Figure 37.27), Sears Roebuck, and Xerox? Even today, if you did not have a close eye on the market, you would immediately respond, “blue chips.” Consider the following table showing the stocks and the results achieved over the long term. Price Price Percent Stock 4/14/7212/31/92Change Avon Products61.00 27.69 (54.6)% Eastman Kodak42.47 32.26 (24.0)% IBM 39.50 25.19 (36.2)% Polaroid 65.75 31.13 (52.7)% Sears Roebuck21.67 17.13 (21.0)% Xerox 47.37 26.42 (44.2)% In 2017, the vagaries of unsupervised portfolios is again seen: Avon 2.50; Kodak 7.75; IBM 141; Polaroid unlisted; Sears 7.21; Xerox 32.64. Beware of pundits and mindless investing. Charts (Figures 18.4 and 18.5) showing activity for IBM and Xerox appear on the following pages. Figure 18.4 The questionable—even bizarre—results of “one-decision investing” (i.e., buy and hold) are amply illustrated by this chart. First of all, the “best and brightest” recommended IBM at a decade high to see it decline by more than 50%. It subsequently recovered to double from their original recommendation. Ah, sweet justification! Only, unfortunately, at the end of 20 years to see it rest approximately 40% beneath the recommendation. The analytical lines give some hint of how a technician might have traded the issue. I like to say that there are bulls, bears, and ostriches, and anyone who followed this one-decision investment proves my case. Figure 18.5 Like IBM in the previous figure, Xerox was recommended at a place at which it should have been sold instead of bought. The comments there might apply to the chart here. The foolishness of “buy and hold” or “one-decision investing” is amply illustrated by observing the long-term swings of the stock and thus of the investor's equity. Technical analysis is intended to be an antidote to such foolishness. Summary The long-term investor attempts to catch major market moves—those lasting hundreds, if not thousands, of Dow points and stay in trades for many months if not years. Within this time frame, he expects to take secondary trends against his position. Depending on his temperament and inclination, he may attempt to hedge his portfolio upon recognizing secondary market moves against his primary direction. His preference for stocks and portfolio will be for market leaders, for baskets that reproduce the major indexes (or Index Shares) as the ballast for his portfolio, and he may choose some speculative stocks to add spice to his portfolio. In spite of his penchant for long-lasting trades he will not tolerate weak, losing, or underperforming stocks. They are the shortest of his trades. He will cut losses and let profits run, the truest of the market maxims and the least understood by unsuccessful investors. The other maxim least understood by investors is “buy strength, sell weakness.” Truly sophisticated investors attempt to participate in Bear Market trends also. This is the greatest difference between professional and general investors—professionals have no bias against the short side. For the convenience of day traders, the URL of Gamblers Anonymous is noted: http:// www.gamblersanonymous.org. chapter nineteen The all-important details In this chapter and the one following, we take up a number of elementary suggestions intended largely for the benefit of those who have never kept charts before. Much of this will seem obvious and repetitive to the advanced student, although even he may find some thoughts that will simplify his work. The beginner should read these chapters carefully and use them for later reference. The details of how and when you keep the charts will not guarantee you profits, but if you fail to work out these details in such a way as to make your work easy, as part of a regular systematic routine, you cannot expect to keep up your charts properly or make any profits. Charting and analyzing your charts is not a difficult process, nor will it take too much of your time if you have determined a reasonable number of charts and have arranged for doing the work regularly, meaning every day without fail. You will need a source of data—the day's market prices and volume. If you live in a big city, your evening paper will carry the complete list, and you can plan to set aside a certain period before dinner, or after dinner, or during the evening. If you cannot allot such a period and keep it sacred against all other social or business obligations, then plan to do the charting in the morning. The key is to set a definite time and let nothing interfere, ever, or you are lost. (EN: This process is radically simplified by automated computer downloading procedures and access to data sources and internet sites, but the principle is the same.) You should have a suitable place to work and keep your charts. If it is at home, in the dining room or living room, other members of the family should understand that what you are doing is important. You should be able to shut the door and work without interruption. The light should be bright and as free from shadows as possible. (It makes a big difference, especially if you are keeping a large number of charts.) The ordinary desk lamp throws a reflected glare directly across the paper and into the eyes. It can be a strain if you are doing much of this close work. Better to have an overhead light, placed just a few inches in front of your head and a convenient distance above; and if this light can be a fluorescent fixture using two 40- watt lamps, you will get almost perfect shadowless lighting. These suggestions apply in case you are not working by daylight. Additionally, have plenty of room. A big desk top or a dining room table with a large clear space for chart books, extra sheets, pencils, scratch paper, ruler, calculator, computer equipment, and anything else you need. If your working surface is fairly low, say 28 or 29 inches from the floor, it will be less tiring than the usual 30-inch desk height. Whether you are working in ink or in pencil, pick out the writing tool that is easiest for you to use. If you are using pencils, try several different makes and degrees of hardness. Find one that is hard enough not to smudge too easily, and yet is not so hard you have to bear down to make a clean black mark. The wrong kind of pencil can tire you and irritate you more than you realize. Also, have plenty of pencils, a dozen at least, well-sharpened, so as soon as one becomes a trifle dull and you are not getting a clean, fine line, you can simply lay it aside and continue at once with another freshly- sharpened pencil. Keep your charts in loose leaf books with big enough rings to make turning the pages easy. Do not overcrowd the books; get new books if a volume is too crowded. Finished charts may be kept in file folders. The only ones that need to be in the books are the current sheets and the sheets for the immediately preceding period. If possible, use a seven-ring binder. Pages are easily torn loose from two- and three-ring binders, but seven rings will hold the pages safely and you will seldom have one tear out. The charts you keep will become increasingly valuable to you as the chart history builds up. The old chart sheets will be very helpful to you for reference. Provide a file or space where they can be indexed and kept in chronological order, and also have file folders for brokers' slips, dividend notices, corporate reports, clippings and articles, notes on your own methods, and analyses and special studies of the work you are doing. In this connection you will, of course, keep a simple but complete record of each purchase, sale, dividend, and so on, on stocks you have bought or sold. This record will make your work much easier when the time comes to figure out income taxes. It will also give you all the statistical information you need to judge the results of your trading operations. (EN: At the beginning of my investment career, and often in the middle of it, I thought the above was cracker-barrel wisdom. The longer I last the more I think that homespun wisdom might be the best kind to have in investing— somewhat like Mark Twain, who was astounded at how much his father increased in wisdom the older Twain himself got. We may restate the modest homilies above: Be serious. Be methodical. Be disciplined. Be businesslike. Anyone who succeeds in investing without these qualities is the recipient of blind luck and will be fortunate not to fall into a hole before his career is over. These thoughts occur when one is wondering how Magee would have viewed the advent of the microcomputer and its impact on technical analysis and investing. Might he have said, “What hath this tool wrought?! Wonders and abominations!!” Given the possibilities for complicating analysis and operations when confronted with all the bells and whistles of the average computer software package, the investor must maintain perspective. What, then, are the all- important details in practicing technical analysis with the aid of a computer?) The simplest and most direct way to use a computer for charting analysis In reality, the computer can be used as a simple tool to do a simple job. There is nothing inherently complicated about keeping a chart on a computer. All computer software packages enable bar charting and many, if not most, enable many other kinds of charting, from candlesticks to oscillator charting. The process, in almost all commercially available packages, is so simple that explaining it here would be superfluous (see Appendix B, Resources, for demonstrations), except to generally say it consists of retrieving data, updating the program's price database, and clicking an icon to run a chart. The software packages themselves explain their features better than can be done here. What is important here is to give perspective. Even simpler when the whole process takes place on the internet, as at http://www.stockcharts.com or http://www.bigcharts.com, or http://www. tradestation.com. In this respect, charting can be done with quite expensive programs and also on publicly available free programs or freeware. Charting can also be done with interactive charting programs on many internet sites. The basic bar chart can be enhanced with an unending number of technical studies— moving averages, oscillators, and so on. Therein lies the danger. Chart analysis in itself is a qualitative process. Decorating graphic charts with number-driven information and studies can lead the general investor astray —and into confusion and indecision. Thus, the first preference of this analyst is to keep the process as simple as possible. Get the data, draw a chart, analyze the patterns, consider the volume, and draw the appropriate analytical lines—this can usually be done by the program on the screen. Often a better graphic picture may be obtained by printing the chart and hand-drawing the analytical lines. This brings to the fore one of the main problems of almost all the software packages—screen graphics are poor and, at least to old chartists, disorienting. They are especially befuddling to analysts who are accustomed to working on TEKNIPLAT™ chart paper. With passing editions of Resources, this problem will be dealt with. (EN9: In the intervening years since the eighth edition, two things have occurred: the editor adjusted to modern technology and the technology achieved a level of excellence acceptable to a carping analyst. Internet technical analysis sites such as http://www.stockcharts.com and http://www.thinkorswim.com improved to be surprisingly valuable resources at unbelievably low prices— even free.) The question of graphic representation of the facts is worth noting as a persistent one. To a certain extent, the individual analyst will solve this conundrum by adapting his eye and mind to a graphic environment, using one graphic method consistently and seeing how it relates to the facts in the market. John Magee-oriented solutions to this problem will be available on the website http:// www.edwards-magee.com. In Appendix B, Resources, the reader may see some examples of simple and inexpensive software packages and internet sites that are quite adequate to the required tasks of charting technical analysis, as well as more complex number-driven analysis. Summary The computer is an invaluable tool for analysis. Use of it will enable the following: • Data may be acquired automatically via internet or dial-up sites at little or no cost. Some of these even offer real-time data, which is a way for the unsophisticated trader to go broke in real time, but which the general investor may desire on the day of executing a trade. Many of these sites offer every kind of analysis from respectable technical analysis (usually too complicated) to extraterrestrial channeling. • A computer package and internet portfolio sites will give the analyst virtually effortless portfolio accounting and mark-to-market prices—a valuable device to have to keep the investor from mixing his cash and accrual accounting, as Magee says. • The computer will enable processing of a hitherto unimaginable degree. An unlimited number of stocks may be analyzed. Choosing those to trade with a computer will be dealt with in Chapters 20 and 21. • Appendix B, Resources, contains information on software packages that the reader may try and purchase at quite reasonable prices. In all likelihood, the least expensive of these will be adequate to the needs of most general investors. In addition, I present a brief discussion of internet sites and resources. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter twenty The kind of stocks we want: the speculator's viewpoint The specifications of the kind of stock we want to chart are fairly simple and few. We want a stock that will enable us to make a profit through trading operations, meaning a stock whose price will move over a wide enough range to make trading worthwhile. There are those who are concerned mainly with safety of principal and the assurance of income from a stock. For them, there are (EN9: or were) stocks that afford a considerable degree of stability. You may (and probably will) want to keep a substantial part of your total capital in stocks of this type. They move in a narrow price range; are extremely resistant to downside breaks in the market; are also (and necessarily) unresponsive to fast upside moves in the market as a whole, and are highly desirable for the conservative investor. They are not, however, the most suitable issues for trading operations, because their swings are small, and commissions would tend to diminish the narrow trading profits that could be taken. Also, they do not make the sharp, clear chart patterns of the more speculative issues, but move in rounding, sluggish undulations. (EN9: These remarks reflect a bygone time. The described stocks by and large went the way of the Dodo. When T can disappear from the market as a factor, there is no place to hide, except in bonds, which, when stagnant, only lose real value at the rate of inflation and loss of purchasing power of the dollar. Even bonds should be subject to frequent reevaluation using the tools described in this book.) (For illustrations in this chapter, see Figures 20.1 through 20.4.) To amplify this comment and explain a bit about what underlies what we are doing, let us assume a certain company has two issues of stock, a preferred and a common. We will assume the concern has a certain steady minimum profit it has earned for years, sufficient to pay the preferred dividend, the continuance of these dividends seems practically assured. The dividends on the preferred are fixed at, let us say, 6%. Now the common stock gets all that is left. In one year, there may be $0.50 a share for the common stockholders. The next year, there may be $2.00 a share or four times as much. In a case like this, if there are no other factors, you would expect the preferred stock to sell at a fairly steady price without much change, whereas the common stock is subject to a “leverage” and might shoot up to four times its former value. The more speculative issues represent either a business that is, by its nature, uncertain as to net profit from year to year, where the volume of business or the profit margin fluctuates widely, or one in which the majority of the “sure” net profit has been sheared off for the benefit of senior obligations. There are also other factors that affect the speculative swing of a stock, and, as a result, one issue may be very sensitive and another extremely conservative, and between them there would be all shades and degrees of sensitivity or risk. It is enough here to note briefly the nature of the business itself does not always account for the habits of the stock because the other factors may be very important. Most stocks have a fairly well-defined “swing” power, which can usually be determined by past performance of 76 72 68 64 --------------------------------1-------------------------------- _ GOODYEAR TIJ COMMON RE ”ti 60 56 52 48 44 40 36 32 28 J1L J Ji1 1 I pnpr 1 ir I 1943 1944 194519461947 120 112 104 96 88 80 ---------------------------------1-------------------------- ------- “GOODYEAR T 1 ST PREFERR] IRE RD II ill l.lll, ■■•I,,..."1 ...........nil.I .Hl1' r 1943 1944 1945 1946 1947 Figure 20.1 Opportunity vs. Security. Here (at left) is Goodyear Common, representing the residual interest in all profits after senior obligations have been met, compared (at right) with the Goodyear $5.00 Preferred, which carries a high degree of assurance that the $5.00 dividend will be met, but no promise of further participation in profits. Monthly range of each stock for the same 54-month period is shown on a ratio scale. As the Common makes an advance of more than 300%, the Preferred advances about 25%, leveling off at a point that represents the maximum price investors are willing to pay for the sure $5.00 dividend. 88 89 90 99 00 92 93 97 500 400 300 1500 1400 1300 1200 1100 1000 900 800 700 600 SPX LAST-Monthly-— 94 Figure 20.2 S&P. Here the benefits of relaxed long-term investing may be seen, buttressed, of course, by the longest and handsomest Bull Market in American history in the Clinton-Gore years. At the end of this record, the effects of public enthusiasm (or as Chairman Greenspan of the Fed said, “irrational exuberance” vide tulipomania) can be seen in the wide undisciplined swings (best seen in Figure 20.3). The dotted line represents 150-day (approximately) Moving Average. Just using the Moving Average as a signal (or the Basing Points Procedure) would have beaten the market and 99% (the 99%) of other investors. II'. Zj I I’ 2000000 1600000 1200000 8000000 4000000 '5/19986/19r987/i99887i998,9/1998’' 2/19993/199 >4/1999 5/1999 6/1999 7/1999 8/1999 9/1999 10/1999 11/1999 12/199 '10/1998'11/1998 12/1998 99 129.999 ).999 114.999 • 104.999 .. 9 4.999 ■ • • 109.999 SPY LAST-Daily J ; ; Created with TiadeStation www.Tai i +-■ T i i..... Figure 20.3 SPY. For illustration, here is a chart of the AMEX Index Share, the SPY, or ETF based on the S&P 500. After the crash of 1998 (the Asian Economic Flu crash), the fan lines tell a story, as does the last phase of the chart where the market whips in what appears a Broadening Top. (EN9: Note this Broadening Top was identified in 1999-2000 before the crash as documented in the http://www. edwards-magee.com archives. See Figure 20.4.) Figure 20.4 The S&P 500 in all its glory and tragedy. An especially good portrait by Holbein, the younger. The Broadening Top pointed out in Figure 20.3 in 2000 foretold the decline of the S&P to below 790—not quite 50% but close enough to catch the eye. Particularly fine lessons here, besides the Broadening Top lesson. All of them screaming for action. The broken trendline at A, the broken trendline at B, the broken “neckline” or horizontal line at C. Notice the close correspondence of the break at B and C. The next lesson is not to buy downtrends until a clear bottom is made in a major bear market. Clearly no bottom is made until the Kilroy Bottom at 1-2-3. Even then, the least risky trade for the long-term investor is when the Kilroy Fenceline (Neckline) is broken at D. All of this was knowable at the time. how a stock will behave in the future as to the extent of its swing. (EN9: Or we might say, short-term volatility and long-term range.) Incidentally, for short-term trading (EN9: amusing in the modern context; by short-term trading Magee means trading of trends of shorter length than Dow Waves), we are thinking about the habits of the stock that are only partly determined by the business it represents. Purchase of stock in one company that has a somewhat uncertain or fluctuating profit record may be more conservative than purchase of a highly leveraged stock of another company whose basic business is steadier and more conservative. We will take up the matter of determining these risk constants a little later. One should also understand the short sale of a stock does not imply any feeling that the country is going to the dogs or even that the concern represented is going to the dogs. Such a sale merely indicates your belief the stock may be temporarily overpriced; that earnings or dividends may have been abnormal in recent years and are likely to be reduced; or that for one reason or another, the stock of the company may be worth a bit less than it has been worth. For technical trading, we want a fairly speculative stock, one that will make sizable swings up in a Bullish Trend and down in a Bearish Trend. The very factors that tend to make a stock safe and desirable to the investor may make it entirely unsuitable for trading. Also, with certain reservations that will be taken up later on, the more speculative the stock the better it is for our purposes. (EN: Entering the third millennium (since we Anglo-Saxons started counting—the fourth or fifth by other measures), the distinctions between “speculative” stocks and every other kind of stock has grown increasingly blurry. Rather than apply a perhaps pejorative (in the minds of some readers) term like “speculative” to otherwise-innocent stocks, we would do better to describe stocks as wide ranging or narrow ranging, as volatile or nonvolatile. Stocks may then be evaluated one against another by their betas and historical volatilities, statistical data easy to obtain. “Betas” and “volatilities” are dealt with in Chapters 24 and 42.) In line with this more current thinking, there is another question for readers of this book—the choice of trading (or investment) instruments for the long- term investor. The kind of stocks we want: the long-term investor's viewpoint Changing opinions about conservative investing Virtually no one invests like the conservative investor described above in Chapter 20— except perhaps trust departments of antediluvian banks. There may be some investors still out there who are so risk averse they still follow the method described. Bank trust departments may be still doing it; they used to do it so the trust beneficiaries could not sue them. This is the reason trust departments exist, to give legal cover (the so-called prudent man rule) to trustees in case of suit by beneficiaries. Most enlightened trust departments and trustees now probably follow indexing or other more productive strategies to cater to new understandings of the prudent man rule. “Indexing” refers to the practice of constructing a portfolio to replicate or closely reproduce the behavior of a widely followed index such as the Standard & Poor's (S&P) 500 or the Dow-Jones Industrials. These portfolios never track the Indexes exactly because the advisors and funds who manage them take management fees and expenses. These fees are generally less than fees and expenses on actively managed funds, but in fact are not necessary for the private investor to pay because even the tyro investor can now use “Index Shares” (e.g., DIAMONDS™ [DIA], S&P Depositary Receipts [SPDR; SPY, QQQ,] and so on) or other proxy instruments to do what the funds and professionals do. Essentially what indexing does is track the Averages, a strategy that was impossible or difficult (expensive) when Magee examined it, as in Chapter 15. (EN9: In the opinion of this editor, hiring a management company to run an indexing strategy is a waste of capital. Much better for the investor to invest directly in ETFs and to exit the market when uptrends end and reverse. This is a much better strategy than “passive indexing,” which cleverly manages to capture both losses and profits in the Averages.) The kinds of stocks long-term investors want: the long-term investor's viewpoint Perhaps one of the most important actualizations of recent editions is to bring current this book's treatment of the Averages, noting that it is now possible to trade the Averages in stock-like instruments. This fact deserves to be marked as a vitally important development in modern markets. This chapter will confine itself to describing facilities for trading and investing in the Averages and Indexes. In 1993, the American Stock Exchange (AMEX) introduced trading in SPDRs™, an Exchange-traded unit investment trust based on the S&P 500 Composite Stock Price Index. The AMEX calls these securities Index Shares™, a name they also use for other similar instruments. As noted above, large investors and funds have long traded “baskets” of stocks representing the S&P 500, obviously an activity requiring large capital. In fact, a certain class of investment managers and funds have practiced “passive investing” meaning indexing, primarily for large clients. The purchase and liquidation of these and other “baskets” is one form of “program trading.” Recognizing the utility of this investment practice, the AMEX created the SPDR as a proxy instrument to allow the smaller investor to practice the same strategy. The effectiveness of this product introduction may be measured by public participation in the trading of the SPDR (SPY). By 2000, almost $15 billion was invested in SPDRs with more than 100,000,000 shares outstanding. These units allow the investor to buy or sell the entire portfolio or basket of the S&P 500 stocks just as he would an individual stock, but the capital required to do so is radically reduced. In 1998, the AMEX introduced DIA, Index Shares on the Dow-Jones Industrial Average™ (DJIA), which is analogous in every way to the SPDRs. Thus, an investor may “buy the DJIA.” So in current financial markets, it is possible to “buy the market,” unlike those conditions under which Edwards and Magee operated. Construction of the Index Shares and similar instruments The AMEX unit investment trusts are constructed to replicate the composition of their base instrument. The SPDR, for example, is an instrument that represents one-tenth of the full value of a basket of the S&P stocks and trades on the AMEX, just like a stock (SPY). Other characteristics of stocks are also reproduced such as long life (the SPDR Trust lasts into the twenty-second century) and quarterly dividends (cash paid on the SPDRs reproducing dividends accumulated on the stocks of the S&P 500). Even dividend reinvestment is possible, and the units may be traded on the AMEX during regular trading hours. Under normal conditions, there should be little variance in the price of the SPY relative to the S&P 500. (In 2008, the AMEX merged with the New York Stock Exchange. Trading and instruments remain as described.) These elements, as discussed for SPDRs, are common to all the Index Shares— DIAMONDS, World Equity Benchmarks (WEBs), and others. There are, of course, some expenses and costs to using the Index Shares—a small price to pay for the use of the instrument and generally less than the costs of a fund. Index Shares are also much more flexible for the independent investor. Among other advantages, the private investor can control the tax consequences of his investment, which is not possible in funds. Other Exchanges have created similar security instruments or derivatives or futures to replicate or track the well-known averages and indexes. Among these are tracking shares or index shares or futures (let us call them “instruments”) on other indexes (Russell, Nikkei, and so on) or options on the futures or indexes until there is a bewildering array of instruments available for trading, investing, and hedging. Among the more important exchanges and instruments traded are the Chicago Board of Trade (futures and options on futures on the Dow); the Chicago Mercantile Exchange (futures on the S&P, Nikkei 225, Mini S&P 500, S&P Midcap 400, Russell 2000, and NASDAQ 100); and the Chicago Board Options Exchange (S&P 100 and 500 options). This, by no means, is an exhaustive list. All the futures and options that matter will be found listed in the Wall Street Journal under Futures Prices or Futures Options Prices. This book does not deal in comprehensive detail with futures and options, but it is worth mentioning these exchanges and their futures and options products because of the facility they offer the investor and trader for hedging portfolios in Index Shares and Average trading, not to mention opportunities for speculating. Briefly, hedging is the practice of being neutral in the market. That is, one might be long the DIAMONDS and buy a put option on the DJIA at the Chicago Board of Trade, meaning that advances in the DJIA would result in profits in the DIAMONDS, and a loss of premium in the put. Conversely, a decline in the Dow would result in profits in the put and losses in the DIAMONDS. As this area is not the province of this book, this is a highly simplified description of a hedge. Nevertheless, the reader should see and understand that hedging can be an important strategy. Hedging can take the place of liquidation of a portfolio when the analyst recognizes a change of trend or unstable conditions but does not wish to incur taxes or wishes to defer them. An outline of instruments available for trading and investing It would be herculean to attempt to list the entire panoply of averages, indexes, futures, and options available for trading—herculean due to the fact new trading instruments are constantly in creation and due to the fact, now operating at internet speed, we may expect the rate of change to accelerate. In addition to those listed above, there are WEBS (meaning that exposure to world markets may be arranged). In all, approximately 30 or more Index Share units or instruments were available for trading on the AMEX at the turn of the century, in addition to DIAMONDS and SPDRs. Similar instruments exist on the Philadelphia and in Chicago, and others are being created daily. To reduce the confusion, the general investor will probably find the major indices of the most importance. The more instruments one deals with the more complicated the strategy and tactics become. Therefore, the Dow, the S&P 500, and the NASDAQ composite (DIA, SPY, QQQ) are probably sufficient for the purposes of the gentleman (or lady) investor. The Mid-Caps, the Nikkei, and others begin to come into play when the trader begins to try to catch sector rotation, fads, short-term cycles, and so on. The importance of these instruments: diversification, dampened risks, tax, and technical regularity It would be difficult to underestimate the importance of these new trading instruments. First of all, they afford the private investor what was previously reserved for the large capital trader—the ultimate in market diversification. The S&P 500 represents stocks comprising 69% of the value of stocks on the New York Stock Exchange. Buying it is buying the American economy. The 30 Dow Industrial stocks represent the most important symbol in the American economy—and perhaps in the world. Investors are well advised to pay attention to both Averages if they would fare well in the markets (Note the plural: markets). These two Averages now have the influence or clout that once the Dow alone had to express the state of the markets and stocks in general. Buying the SPY or DIA then represents the immediate acquisition of a diversified portfolio. And buying the NASDAQ or QQQ gives one immediate exposure to the more speculative and volatile sector of the American economy. Given the long-term bullish bias of the averages and the American economy, it is difficult to argue with this as both strategy and tactics for the long-term investor. This does not mean positions should be taken blindly without thought or not monitored. On the contrary, recall if you will the record of the Dow Theory; even for the long-term investor, bear markets should not be allowed to destroy liquidity and equity value. These questions are discussed at greater length in Chapter 18. Although we believe these instruments are good vehicles, it is wise to remember Magee's frequent admonition (less important now than when spoken) that it is a market of stocks, not a stock market. Meaning when the tide is flowing down with the Dow and S&P, prudence and care must be used in taking long positions in stocks that are in doubt as to direction. Additionally, it is worth noting investments in these instruments will be less profitable than an astutely chosen individual stock. For example, Qualcomm appreciated approximately 240% (temporarily) in 1999-2000 compared with about 24% in the S&P over the same period. Those who bought Qualcomm at its top and sold it at the bottom of its reaction lost about 75% or about $148 a share. Traders in Qualcomm tended to obsess and pay hyper attention to the stock, whereas investors in the SPY reviewed it once a week or less or told their computers or their brokers to give them a call if it broke the trendline or entered stops. Then they slept at night and had eupeptic digestion. Other advantages accrue to the trading of the SPDRs. Ownership of a fund can result in tax liabilities as managers adjust portfolios to reflect changing membership in the fund or withdrawals in capital by irate stockholders. Since Index Shares last into the twenty-second century, the long-term investor has no need to realize gains and pay taxes. Bear markets may be dealt with by hedging with other instruments—futures, options, or proxy baskets of stock, or individual stocks, and accepting the tax consequences of these trades. John Magee aptly observed before the direct trading of the Averages was possible that the Dow-Jones Industrials were very regular and dependable from the technical point of view. This observation is annotated at some length in comments on Dow Theory in Chapter 36. Therefore, the investor in the Index Shares may have a smoother time technically than a trader of an individual stock. Summary The long-term investor and mid-term speculator attempt to capture long secular (as well as cyclical) trends in the markets. They shun frequent trading and capital-eroding transactions. They recognize that risk fluctuates with time and trend, and they know that frequent turnover benefits mainly the broker. The strategy of the long-term investor may be to match the market by using funds or SPDRs or baskets, but he does not like to participate in Bear trends. He hedges or liquidates his positions on major trend shifts. In fact, he may even short the indexes if his analysis indicates major bear markets. If he desires to outperform the market (which will happen automatically if he follows the methods of this work), he finds some individual speculative stocks to trade in addition to his foundation portfolio. Depending on his risk tolerance, he may always be somewhat hedged. When long the indexes, he finds some stocks in downtrends to short. When he is short the indexes, he finds some strong stocks to hold long. There is no excuse for a moderately skilled and reasonably capitalized investor to lose money over the long term in the market. As a reminder, Chapters 5 and 28 describe powerful methods for the long- term investor using Magee's Basing Points Procedure. chapter twenty-one Selection of stocks to chart The trader who operates on the “fundamental” basis, making his commitments on his analysis of earnings, dividends, corporate management, prospects for the industry, and so on, will usually (of necessity) confine himself to a few stocks or a single group of stocks in the same field. To the contrary, the technical trader, using daily charts, should have a large portfolio of issues. Since he is primarily interested in the technical chart patterns, he will not try to make an exhaustive study of the background of each company. In fact, the characteristics of the stocks themselves, as they act in the market, are more important to him than what these companies make or what they are earning. This is because, although the stocks represent ownership in the company, the capital structure, “leverage,” and floating supply of the stock may (and very often does) mean fluctuations in the stock price that are not directly in proportion to changes in the affairs of the business. You will also find many cases in which the stock of a well-regarded, well- managed, long-established concern, whose latest earnings report shows increased profits, and with a long record of dividends paid, would not be a good buy at the market price. It may be overpriced and due for a serious depreciation. You will find other cases in which a stock, which apparently represents no great promise of either earnings or dividends, suddenly starts a series of spectacular moves upward, and is indicated clearly as a buy. Of course, the answer, in each case, is the records available apply to the past, not the future; and very often, chart action will indicate the inside knowledge of those who are in possession of facts the public has not yet received. To change our example to something more easily visualized, let's assume there are two houses for sale. One is a fine, well-built, modern home in an attractive part of town at, say, $200,000—and the other property, a somewhat shabby six-family tenement in a less attractive section, at the same price of $200,000. There is no question which is the “better” house, but in a case like this, the market for well-built single homes at this price may be poor, whereas the demand for apartments may be good. The six- family house may be the better investment. Then again, we have the question of what is conservative and what is highly speculative. It is not always enough to judge from the type of business of the company itself. You may have a highly conservative concern, carrying on a stable volume of business, with a long record of successful operation. Yet, if there are bonds, debentures, preferred stocks, and other senior obligations, the common stock may be subject to wide fluctuations. Also, if the issue is small, or if a large part of it is closely held, you will have a “leverage” effect that results in wide swings in the stock. Therefore, in choosing your stock to chart, you will want to consider the kind of stock and its character and habits in the market, rather than the business of the concern it represents. We will come back to this point and show you how you can shape up a list that will give you the kind of stocks you want for trading. Meanwhile, the question “How many charts?” has been left hanging. One answer to this is that the more stocks you chart, the more good opportunities you will have. Many stocks, even of active issues, will go through long periods when, indeed, there is nothing much to tell. In a period of stability, the chart simply indicates it is a period of stability, and the only possible trading activity would be purchases and sales at the Bottoms and Tops of its undulations. The charts are more informative when a change in the situation occurs; they will signal a change of trend as soon as (and usually before) the news of the changed conditions has come out. If you have enough charts, you will always have some stocks making decisive and clear-cut moves either up or down, at any time. You should, therefore, keep as many charts as you can. Do not bite off more than you can chew, however. A man with only 15 minutes to half an hour a day for this work might have to confine himself to 20 or 30 charts. It would be much better if he could have 100. If he is in a position to give a major part of his time to the work, he could very well run as many as 300 charts. A most important word of caution is indicated here: Do not start anything you cannot finish. It is better to have too few at the beginning than too many. Then, if you find you can add others, you will be in a better position, from your experience, to pick out the ones you want to include. However, if you start with too many charts or begin to run behind with your analyses, you will not be getting the best use from your portfolio and it would be better to cut down at once. (EN: Magee's admonitions are still in effect for the manual chartist. The modern computer-equipped investor has a different problem. He can chart every issue in the market every day. The question becomes how many can he effectively study and analyze? There is even a computer answer to this question. Namely, the cyber trader can program the computer to report stocks on an exception basis. For example, “Computer, show me all the stocks which are above their 50-day moving average and which have unusual volume.”) From what we have already been over, you know it is possible to chart anything that is sold in identical units in a free competitive market. This includes all kinds of commodities, bonds, debentures, when-issued contracts, and so on, as well as stocks. You may have some special interest that will call for charting something outside the field of stocks—well and good. In general, however, you will want to chart active, listed stocks of well- established corporations. There is no reason an unlisted stock cannot be charted, but ordinarily, the only figures you can obtain on it are the bid and offer prices. On these stocks, you do not have a published statement of the volume of sales each day or any record of prices at which sales actually took place, and those are essential to the charting of daily technical action. Therefore, you will usually be charting stocks listed on some exchange. This is also an advantage because concerns listed on the larger exchanges are required to meet certain conditions, publish certain information, and comply with definite rules and practices. In this book, most of the examples have been taken from stocks listed on the New York Stock Exchange (NYSE). There are thousands of issues traded on the NYSE, and these stocks represent every type of security, from the most conservative to the most speculative, from the cheapest to the most expensive, and they include every principal type of industry and business. There is no reason, however, that stocks should not be chosen from the American Stock Exchange, the NASDAQ, or from any other exchange in this country, or for that matter, in some other country. (EN: So far as the chart action is concerned, the patterns and their meanings will be the same). (EN9: In general the stocks to watch, or chart, will tend to leap out of the haystack of stocks. For stock pickers Investor's Business Daily is in the constant process of sifting the markets for nuggets with its CANSLIM system. (Not a recommendation to use that system, only a recommendation to examine every tool that might be of use.) Stocks that appear suddenly on the most active lists of http://www.stockcharts.com might bear examination by the chart analyst. These include optionable stocks that suddenly show a radical change in implied volatility,; stocks that pop up with suspicious Chapter twenty-one: Selection of stocks to chart 317 volume spikes compared with average volume, and those with internet and software packages one might construct a filter to be informed by the computer of stocks breaking their 14-, 44-, 150-, and 200-day moving averages: 14 because some professionals think the public thinks in this time frame; 44 because some think funds think in 44-day time frames. The others because everyone thinks they are important. In reality, if the investor aim is to beat the market, he may choose just to confine his activities to the ETFs that represent the indices—DIAMONDS™ (DIA), Standard & Poor's Depository Receipts (SPY), and QQQ. ETFs are inherently less risky than any individual stock.) Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter twenty-two Selection of stocks to chart: continued In choosing your stocks, you will probably look for the greatest diversity in the kind of industry. As you are not specializing in the detailed study of a single group, you will try to get stocks from as many different groups as possible. You will want to include mines and oils, rails and chemicals, liquors and amusements, airlines, utilities, techs, internets, biotechs, ad infinitum. The reason for this is simply that, very often, many stocks in a particular industrial group will show the same or similar patterns, as the entire industry is affected by certain Major conditions. You will often find, for instance, when Allis-Chalmers (EN: or Dell) makes a Triangle or other Area Pattern, followed by a sharp upward move, Deere (EN: or Compaq), Minneapolis-Moline, Harvester, and Case will make similar Triangles, or possibly Rectangles or some other Consolidation Pattern, followed by a similar upward move. When Schenley is moving in a long downtrend, you will very likely find that Distillers—Seagram's, National Distillers, Publicker, and American Distilling—are also moving in a long downtrend. (EN: Metaphorical names, like the names of Greek gods or Ulysses and Leopold Bloom. The present-day reader may read Intel, Fairchild, and National Semiconductor or 3COM. The idea is the same.) (For an illustration in this chapter, see Figure 22.1.) Therefore, unless you plan to keep enough charts to include several stocks of each important group, it is best to pick your stocks to make up as widely diversified a list as possible. In this way, during times when certain groups are moving indecisively, or are inactive, you will have some representation in other groups that may be active. (Do not infer from this that all stocks of a group move together at all times. Individual concerns will frequently move according to special influences that bear on a single company. Where the Major influence is some industry-wide condition, the group will move more or less as a unit.) We, therefore, choose stocks representing a wide variety of groups or basic industries. Nevertheless, suppose we are limited as to the number of charts and we must choose one stock from a group; which stock to choose? For instance, we must choose one stock from the transportation group (EN: or Biotech, or internets.) As a matter of fact, you would probably want more than one because this particular group is so important and so large, but for the moment, let us choose just one. (EN9: Or, even better, why not one of the indexes—for example, an ETF—for the desired group. An example of betting on all the horses rather than trying to pick the winner, and there is no conflict between making both bets.) Should it be a high-priced stock or a low-priced stock? Let us examine that point first. If you examine the past records of stocks, you will generally find the lower priced issues make much larger percentage moves than the higher priced stocks. It is not unusual for a stock selling around 5 to make a rise of 100%, moving up to 10 sometimes within a few weeks. On the other hand, you do not find 100% moves in days or weeks among the stocks selling at 100 or 200. The same industry-wide move that carries your $5.00 stock from 5 to 10 might carry your $100 stock from 100 to 140. Obviously, if you had put $1,000 into outright purchase of the stock at 5, the move would have increased the value of your stock 100% or $1,000. In the other case, if you had put the same amount into a stock at 100, 136 128 120 112 104 96 88 80 Figure 22.1 Low-priced stocks move faster than high-priced stocks. Here are weekly charts of two rail stocks, charted on ratio scale over the same six-month period. Baltimore and Ohio during this time advanced from 12 3/8 to 28 7/8, a gain of 16 1/2 points, while Union Pacific moved up from 109 to 137, a gain of 28 points. The advance in “UP,” however, compared with its price, is much less than the advance in “BO.” A thousand dollars used for outright purchase of “UP” would show you a capital increase of 25%. On the other hand, if you had put a thousand dollars into outright purchase of “BO,” your increase would have been 133%, or more than five times as much. Bear in mind low-priced stocks not only go up much faster, but also come down much faster than high-priced stocks. When you own a low-priced stock, you cannot safely “put it away in the box and forget it.” For security and stability, you would do better to buy a few shares of a high-priced, gilt- edge security. For trading purposes, you will want to strike a compromise between the rather sluggish “blue chips” and the extremely erratic “cats and dogs” in the lowest price bracket. the move to 140 (although many more points) would have increased your capital to only $1,400. The gain in the lower priced stock would be about two and one-half times as great. The authors have worked out and tabulated the percentage moves of large groups of stocks over long periods of time (see Appendix A, ninth edition) and have set up a table that shows the relative average sensitivity of stocks at different price levels. This table pertains only to the price level of stocks; thus, the same stock that today sells at 5 and makes wide percentage swings will not swing so widely when it has moved up to a price level of 20-30. (EN10: These concepts replaced by beta and volatility.) Several questions may come to your mind at this point. Do not the costs of trading low-priced stocks relative to high-priced issues have to be taken into account? (EN: Yes, they do. Given the extreme changeability in these costs in the internet economy, calculation of those costs here would be tantamount to wasting trees. This cost question may be researched quickly and easily given the availability of search engines such as Google and access to the internet.) In selecting the price level of the stocks you prefer to trade in, you cannot set too arbitrary a limit because there are other factors to consider and you may have to make some compromises on one score to get what you want in some other direction. Stocks from 20 to 30 are in a good trading price range. Very often, you will find stocks in the 10-20 range that are so interesting you will want to chart and trade in them. You will find good situations in stocks selling at 30-40. Furthermore, you will understand, of course, the stocks that are now selling at 10 may be selling next year at 40, or vice versa. Considering you cannot be changing your portfolio of charts all the time, you must not be too “choosy” in picking the price range of your stocks. You would not ordinarily pick out a stock that was selling far above the price range of most stocks of its group, say at 150, when several others in the same industry were selling at 15, 28, or 37. For the high-priced stock, as we have said, is likely to be sluggish as a trading medium. On the other hand, you would not take the very lowest priced issues of the group, selling at, say, 4 or 2 when others were in the 10-30 bracket. You would not only be faced with erratic and tricky chart action, and much higher percentage costs for commissions, but also you might not be able to operate on margin at all. There are, from time to time, limitations on the amount of margin on stocks at all levels. In the lower priced issues, these limits are often more stringent. Plus, in the lowest priced stocks, you are sometimes not permitted to trade on margin. (EN: As these requirements are subject to the vagaries of the Federal Reserve Board, the investor must inform himself at his personal broker or ECN. For quite some years, the general margin requirement has been 50%. The Fed came in for some sharp criticism for not dampening speculation in the fin de siecle bubble by raising margin rates to 100%, and its lack of action exacerbated the blow off of 2000. A change in margin rates should get the immediate attention of the technical analyst. Something will be up.) Ordinarily, you will get the greatest effective leverage at some point in the 20s, considering all these factors, and your trading can run down through the teens and up through the 40s. Above 40 and below 10, you will have to have strong reasons for trading, which might be, of course, ample capital. It would therefore be best for the moderately financed investor to choose a majority of his stocks from the middle price range (10-40), plus only those special situations you are particularly interested in watching among the very low and very high brackets. If, however, you will go back to the long-time past record of any group of stocks, you will find that even among stocks moving at nearly the same price levels today, there are widely different behavior patterns. You will find some stocks respond to a severe market setback by reacting, let us say, 20% —that is, if they were selling at 30, they would move down to around 24. Others will respond to the same setback in the general market by a reaction of 50%—that is, if they were selling at 30, they would end up at around 15. Additionally, if you examine the records, the same stocks that make these relatively different reactions in one setback will make about the same moves, relative to each other, in other setbacks. Furthermore, the same ones that make only moderate corrections on declines will make only moderate advances on rises. The ones that go down sharply on setbacks will also skyrocket in a Bullish Market. This has nothing to do with the phenomenon we discussed earlier, by which we saw that cheap stocks move faster than expensive stocks. This is due to the habits of particular stocks, and these habits seem to be quite stable over periods of many years. We will find, for instance, volatile and speculative issues that make larger percentage swings than most other stocks at their price level. On the other hand, we will find a stock, selling for much less, that has smaller percentage swings than most stocks at its price level. This fact may be obscured, as the comparatively low-priced stock may actually make larger swings than the higher priced. It is only when we have taken the price level into account that we can see the individual habit of the stock. Knowing this, we can project that habit to other price levels. We are not too interested, as we have said before, in stocks that do not ordinarily make substantial moves. We are very much interested in those that make the wider moves. We can compute the basic swing power of a stock, which we call the Sensitivity Index, and will outline the method for doing this in Appendix A, ninth edition. (EN: The procedure Magee speaks of here, of computing a “Sensitivity Index,” may be regarded as the historical predecessor of what are now called “betas.” The beta of a stock compares its relative volatility with that of the market as a whole, so if the beta of the market is 1.00 and the beta of the stock in question is 1.50, a move of 1.00 in the market will probably be matched by a move of 1.50 in the higher beta stock. The formula for beta will be found in Appendix B, Resources, and calculated betas at finance.yahoo.com.) Therefore, you will have eliminated from your list stocks at the wrong price level and stocks without enough swing power (for you want to chart only those stocks in which you can trade profitably). Of the ones left, you will eliminate others and find that some stocks, which make wide price moves and apparently offer large opportunities for profit, may be very “thin.” The charts will be spotty, filled with gaps, days of “no sale,” and moves of several points on only a few hundred shares of business. These stocks are thin because of a small issue, because of ownership of a large block of shares by some corporation or by insiders, or for other reasons. They are difficult to trade in because they are hard to buy and hard to sell; you stand to lose heavily on the “spread” between bid and offer. It might be hard to liquidate even 500 shares without driving the price down badly, to your loss, and sometimes you will see changes of 1 or 2 full points between sales of single hundreds. These you will want to eliminate, and if you do not know the habits before you choose your portfolio, you will probably find it worthwhile to drop any stocks that prove too thin, substituting new and more dependable choices. After you have culled the list from all these angles you will find you have left a choice of a number of stocks, all of them selling in a price range that is attractive, all of them sufficiently active and responsive to market trends, and all of them available in sufficient supply to provide a good trading medium. The final choice of any one (or several) of these stocks is then a matter of personal preference. After you pick out your stocks from one group, study the other groups—the motors group, the amusements, the computers (EN: the internets) and so forth, until you have finally made up your selection of stocks to follow. Try to get as complete and balanced a representation of groups as the number of your charts will allow. (EN: In this context, the process described here is made infinitely simpler by available software and by the proliferation of group indexes, ETFs, and indicators. In fact, if the investor desires, rather than trading an individual stock in an industry group, he may often choose to trade the average or index itself and cushion his risks. This will almost never be as profitable as a well-chosen individual issue but will always be better than a badly chosen individual issue. And ETFs never go broke (so far).) In this connection, if you are not planning to represent all groups, there are some groups more likely to provide good trading stocks than others. Foods and tobaccos, for example, are generally less responsive to market swings than the rails, liquors, and airlines, which are very responsive. Do not worry too much, however, about exactly which stocks to choose for even if you took the first 50 or 100 stocks in the listed issues, you would have among them at least 25 good trading stocks. You can start with almost any list, and, as time goes on, you will drop some and add others, improving your portfolio and tailoring it to your own needs. (EN: As additional commentary here it is worth noting that “techs,” “biotechs” (or whatever the mania of the moment is—probably space hotels and intergalactic travel in this millennium) will present areas of risk and reward sufficient to excite the seventeenth-century tulip trader. The centered investor and trader will consider vogues and manias as he chooses his active portfolio and choose to participate (or not) depending on his appetite for risk and excitement. Or, as the popular maxim has it, one man's champagne is another man's poison. This question is pursued in greater detail in Chapter 23.) By way of further simplification, the investor may choose to follow only one or two issues— Standard & Poor's Depositary Receipts (SPY) or DIAMONDS™ (DIA). If it were not only bought, but also sold or hedged, the market would be outperformed. This would be a simple investor's life indeed. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter twenty-three Choosing and managing high-risk stocks: tulip stocks, Internet sector, and speculative frenzies Nothing could more vividly illustrate the timeless nature of chart patterns and situations than the internet stocks that bloomed at the turn of the century. These stocks repeated that eternal pattern—the Tulipomania, the Gold Rush, the can't-fail-opportunity-to-get-rich-quick. (For illustrations in this chapter, see Figures 23.1 through 23.17.) It is almost impossible to resist comparing the speculative frenzy that took place in the internet and technology issues to the famous seventeenth- century mania that Holland experienced in the famous Tulipomania. In MacKay's undying classic account (Extraordinary Popular Delusions and the Madness of Crowds), the trading of tulip bulbs replaced sober commerce and business as the occupation of the country, and enormous fortunes were made trading the tubers. Blocks of real estate, breweries, assets of real and large value were traded for one tulip bulb. MacKay produced my favorite paragraph in the literature of finance: “A golden bait hung temptingly out before the people, and one after the other, they rushed to tulip-marts, like flies around a honey pot. Every one imagined that the passion for tulips would last forever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them.” That mania ended in ruin. A better long-term prospect may be in store for the internet, as there is a basis of technology and economic substance to the sector. You could not, after all, use your tulip to check the market for prices. In fact, there were those, admittedly a small number, who struck it rich in the California Gold Rush of 1849. It is an ill wind, etc. As an exercise in rueful perspective, the seventh edition of this book remarked, in the words of Richard McDermott, Companies like Lotus or Microsoft went public and grew into business giants in a short period of time... A significant theme stock for the 1990s has been Internet stocks. Names like America Online, CompuServe, and Netscape have provided important products and services that allow individuals to “surf the net” for information around the world. Young students of the market will search in vain for Lotus, CompuServe, and Netscape in the lists of stock symbols. The giant Lotus was swallowed by IBM, in part because Microsoft, a ruthless competitor, disemboweled it. CompuServe and Netscape disappeared into the belly of a larger fish, AOL, with some of the same factors involved. Later Microsoft got its comeuppance—halving in value as the U.S. Justice Department brought successful antitrust action against it. There are those who fault the great Wall Street investment banks for having brought half-baked potatoes (or unblooming tulips) to market. The Street firms, cashing in on the mania, were willing to sell the public every immature profitless idea and company named Figure 23.1 Multitudinous lessons in Microsoft. However, short-lived joy. The top rounds over, price makes another attempt, and then the momentum is clearly, if puzzlingly, down. The cancellation of the runaway day in January definitely marked this move as a bull trap, and the short-term trendline from October would also have taken the trader out of the trap. Use of the Basing Points technique (see Chapter 28) would also have allowed escape from the trap. Failed signals, as this one, often are excellent signals for a trade in the other direction. “dot.com Inc.” that venture capitalists floated on a sea of seed money. Mining engineers will recognize the phenomenon of “salting the mine.” It was the finest moment for the great old firms of the Street since the investment trusts of the 1920s. The reader is most recommended to look into The Great Crash, 1929 by John Kenneth Galbraith to compare the Street firms' behavior from one mania to the next. It will be found most edifying. At the pinnacle of great manias, no one can be trusted. Managing tulipomanias and Internet frenzies and.. .Bitcoin In a time of excess, the centered investor maintains his composure and focus. Probably easier said than done. Nonetheless, many investors and traders profited from the internet boom or were not severely damaged. Many managers and traders watched with envy from the sidelines, and with schadenfreude when the bubble burst. For technical analysts speculating and trading according to the principles of this book, important opportunities arise in speculative frenzies and buying panics—namely, important profits may be made by remaining calm and methodical while the uninformed and naive cause speculative blow-offs, which have some things in common with the ends of great bull trends in substantive issues. The question becomes that of realizing some of the profits to be made in these exciting times. Of course, the first thing to do is not get excited. These manias come and go— sometimes they are called biotechs, sometimes computers, sometimes internets, and probably, at some point, human genome miracle drugs or Martian real estate. It should be emphasized these profits are made on both sides, long and short. The crowd will only Figure 23.2 MSFT monthly. It is easy to lose perspective when looking at a daily chart of a bull trap in which one has lost a leg. A monthly long-term look at Microsoft can help restore perspective. Unfortunately, the Dow- Jones Company was looking at this chart, not the nearby, when they added Microsoft to the Dow 30 in 2000. Expert timing? At the time, the John Magee Newsletter observed it was a negative indicator of a major top in the Industrials. think of the riches to be made long. Professionals and skilled technicians, professional or not, will take the profits on the short side. Here is the most important concept in trading these runaway issues: all of the techniques and methods described in this book remain valid for dealing with these kinds of stocks. In addition, here are some other points that should be taken into consideration. The best way to control risk in the Bitcoin market is by trading a position so small (like a roulette bet) that a 100% loss will cause no distress or discomfort. The sector in question, tech- tech, web-tech, biotech, internet, space travel, whatever, will be a market unto itself, and special technical factors will apply to it. The phases of market lives, accumulation, attraction, markup, mania, and blow-off will occur in compressed time spans—much shorter than the cyclical life of an issue with fundamental data to attach it to reality (see Figure 23.4 of Palm Computing). By the time the IPO occurs, the insiders are already prepared to begin the distribution phase. For example, when Palm Computing was spun off from 3Com in 2000, only 3% of the shares were sold—creating an artificial scarcity and propelling it to absurd heights—Palm attained an instant market value greater than that of 3Com, which owned most of its stock. (EN9: We have, since The Fall, learned of “laddering.” To let their inside clients in on the IPO, some of the underwriters required the clients to buy more of the stock in the open market after the IPO at higher prices. A clever way to throw gasoline on a raging bonfire. Whether Palm was laddered or not is not known.) Figure 23.3 The editor learns a lesson. Never leave a chart unanalyzed, even if the implications are obvious. Also, never be afraid to belabor the obvious. Obviously, this figure should have had a longterm trendline drawn on it. No monumental bull market should be ignored. Why give the market its money back? It should have been obvious from this figure that the Microsoft party was over and not just the fat lady but the entire chorus was beating on anvils. Plus, the protective line must be drawn. Here the broken line at A is the most important and saves a bit of capital rather than waiting for the plaintive signal at C. Given the robust Bull Market in Microsoft, the long-term investor might have been justified in waiting until the C trendline was broken. A matter of investing style and philosophy. There appears to be some long-term support at 18. The five-year sideways market appears to be resolving itself into a macro triangle that might break out one way or the other in 2005. This is a case in which an investor might make a fundamental analysis to guide his position (always confirming with the chart analysis). Microsoft is beset with howling wolves on all sides. Linux, Unix, sales of only one copy of Windows in China, hackers playing hob with security holes in its software. Can it rise again? Only the chart knows for sure, and it is silent at this recording. In 2011, MSFT was in an 11-year sidewave. These issues must be traded with the utmost care and attention. For example, it is the height of foolishness to enter a market order to buy on the issue of the IPO. An issue going public at 12 might trade on the opening at 50 in these frenzies—a sign to the savvy technician the sheep are headed for the shearing shed. Certain factors must be kept in mind. Some IPOs collapse shortly after going public. Others rocket off before distribution is complete. So stops must be carefully computed. Once it is clear the rocket is taking off, as indicated by price and volume, some discreet pyramiding might be possible for the experienced and skilled speculator. Detailed techniques for management of the runaway issues The technique described in Chapter 28 for tight progressive stops is certainly one way of dealing with these stocks. There, the method for finding Basing Points and raising stops based on the three-days-away rule is detailed. Also, especially in the case of these rocket stocks, the practice of raising stops based on new percentage highs should be 170 - 160 - PALM Created with MetaStock www.equis.com 150 - 140 - 130 - 120 - 110 - 20 - 10 - 35000 - 30000 - 25000 - 20000 - 15000 : 10000 - 5000 - X10 40 • 30 • April May June July August J. 4 11 September Figure 23.4 PALM. Fool's gold. Fool's gold with naivete writ large on it. Here is a spike reversal day on the initial day of trading. The accumulation, markup, and most of the distribution occurred behind closed doors before this trick was perpetrated. After the matanza, the continuation takes on Figure 23.5 Dealers palmed all the missing capital in PALM? Somebody made the money disappear up a shirtsleeve. What makes you think the deck was stacked? Or that the initial public offering (IPO) was laddered? Maybe it was just fools chasing tulips. Those investors (gamblers) playing the shell game with PALM found themselves playing with six shells instead of three as like an insidious amoeba PALM divided into two tulips, PLMO and PSRC. Keep your eye on the magician closely. For the analyst, all the smoke and mirrors could not hide the fact gravity took PALM in all its manifestations down. The downtrend lines are broken in 2003 and 2004 and a respectable Kilroy Bottom is made. Nevertheless, the implications of the bottom may have already been carried out. A continuing story for speculators or astute (very astute) investors who know something fundamental and have very long-term vision. Figure 23.6 PSRC in its amoeba-like glory. The failure of what might have been a rounding bottom, especially with the breakdown gap in October and the failure to rally back to the neckline left no doubt as to the fate of PALM by any other symbol. Broken trendlines are also indicative. Remember that any large pattern can be broken down into smaller patterns susceptible to short trendline analysis, as in this case. Sooner or later a palm-size computer, PDA, widget device is going to be the wave of the future. (EN10: A visionary prediction of the iPhone.) The canny investor will not mistake the company for the stock and will also not venture capital until there is a better chart story. implemented. Since these are “game” situations, and irrational, one may employ tactics he might not ordinarily use with his serious capital—some light pyramiding and some scaling out of the position based on continuous new highs. Additionally, in the blow-off phase when close monitoring is necessary, one might want to exit on a long reversal day, or on a key reversal pattern, and then go to the beach; or, if from Texas, one might want to short the issue. Essentially, I view these stocks as interesting aberrations in the early part of their lives. So I would not look for long-term investment-type trades. Take the money and run. In all likelihood, these stocks will explode like fireworks and then expire. There will be the companies like Microsoft and —it remains to be seen—Yahoo!. After the fireworks show, the patient technician may return to the scene of the crime to see whether there are any burning embers. Once they have blown off, crashed, and made reasonable bottoms, then one begins to look for investment possibilities, which there definitely will be. There is too much potential in the technology of the internet—and biotech and the human genome—for some phoenix not to rise from the ashes. In the beginning it behooves the trader to regard them as speculative instruments of exceptional risk and opportunity. Several caveats are in order: • The prudent speculator does not commit too much of his capital to such enterprises. Probably no more than 5%-10%. 3com Corporation-(Nasdaq NM) 3.71 0.10 2.77% Apr Jul Oct 97 Apr Jul Oct 98 Apr Jul Oct99 Apr Jul Oct 00 AprJul Oct 01 Apr Jul Oct 24 22 20 18 16 14 12 10 2 540 480 420 360 300 240 180 120 60 0 Figure 23.7 COMS. Underwriters cleverly doled out only 3% of 3Com- owned Palm stock onto the market at the IPO. Palm wound up “worth” more than 3Com for a short time. Here the lesson of tulipomania is vivid. The contrast in before and after volume. The necessity of analysis to deal with tulips in bloom. The fatal lesson of heeding (or not heeding) gaps across horizontal trendlines. Impossible to manage for the buy-and-hold investor. • When selling them short, one should not be early. A definite top should be seen because there might be a second stage of the rocket. • Emotional involvement with tulips and internet stocks—or stocks of any kind actually—can lead to a broken heart. In the charts, note the success in a number of cases of trading the key reversal day. (EN9: Reviewing charts from the apocalypse is a sobering experience. So many rash and mad adventures. So much capital sucked into the black hole of underwriters and 21-year-old huckster CEO wallets. Better than the South Seas Bubble. And, as definite proof that man is directly descended from geese and sees no farther ahead than the next feeding bowl, the ghost of the mania oozes from the closet in 2005, reborn as Google mania. Man (or goose if you will) never learns. That is why he is so much fun to watch.) Google—what a creature is man! What a game is the market! Google, a wonderful company, and a great concept goes public in 2004 after world- class hype (world class? intergalactic class!). Floated as a red herring at 135, it eventually goes IPO at 85 in an innovative public offering. Then the fun starts. Future readers of this book may observe the markup made as of the date of this writing (November 2004) and judge whether the method worked. A company on roller blades, impossible to dislike as a company. Remember, unless you are Warren Buffet, you are buying the stock, not the company. 45 39 36 33 30 27 24 21 18 15 12 Figure 23.8 ORCL. True to the character of stocks during the Tulipomania, Oracle was difficult to handle without careful analysis. Stock splits preceded a number of the sell-offs (note gaps post splits). Bullish gaps are also frequent here, and the tulip top is obvious, and was at the time. An excellent trading vehicle though a wreck for the casual investor. Hope springs eternal and there is one born every second One might have thought the age of the tulip was over as we moved into the second decade of the new millennium—but what naivete! Not over at all. Investors rushed into the LinkedIn and Groupon IPOs and stood quivering on the sideline begging for Facebook to go public. But Facebook, the ultimate practitioner of chutzpah, satisfied itself by feeding on the venture capital community, demanding ever higher valuations from venture capitalists desperate to own a sliver of the deal at whatever cost. The public will have to wait to be shorn. But have faith, it will be. Remember Palm. You can buy these things, but you have to remain glued to the screen and the ride will be rough. Unless you have your professional speculator's license and have lost money on these deals before, watch the snake pit from the sidelines—and do not buy any snake oil. 260 220 180 160 140 120 100 80 60 40 20 2 Figure 23.9 INKT. The pleasures and delights (and disappointments) of internet stocks. The last trendline, in conjunction with the second horizontal trendline, clearly marks the end of the party (AND WILL FOR ANY STOCK WHATSOEVER). The break of the long-term trendline is the last exit signal, as if the previous signals were not clear enough. Is it not obvious that this issue was (and is) manageable with technical analysis? Figure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing, and precipitous at that, would have been lost on the non-technician. Those who continued to ride the roller coaster relearned a lesson some technicians know—stocks often repeat the same behavior (or misbehavior). The lesson of monster breakaway gaps (or air gaps) may have needed relearning also. Oh well, after such a gap the damage is done, the unenlightened investor says, only to see the damage continue down to 10 (from 110!). These are signals of such magnitude that disaster awaits the trader who denies its significance. The air gap here nicely complements those of Figures 12.9 and 37.43. 10 120 100 80 60 50 40 30 20 1 120 100 80 60 40 20 0 Figure 23.11 Amazon weekly. Amazing Amazon dances in the internet follies. The breathtaking plunges are the direct result of the breathtaking speculative excess. See the daily chart (Figure 23.12) for a closer look at the details of the blow-off. AMZN (Amazon.com, Inc.) Figure 23.12 Amazon daily. In cases of speculative blow-off, trendlines are of little use. A dozing trader (presumably it was obvious this was not an investment issue) would have been mauled in the plunge. An alert trader, knowing that in blow-offs the procedure is to sell strength, might have avoided it. Other techniques include recognition of the second exhaustion gap and exit. Also, a trader using the techniques described in Chapter 28, setting progressively tight stops, might have avoided the fall. Figure 23.13 The wild frontier of the internet and of the gunslinger speculators (gamblers?). Amazon bucks on. Give us a slug of rotgut whiskey and get out the ruler. A clear top for the rational analyst with clear broken trendlines and broken horizontal lines and then a clear Bear Market with a clear bottom resembling a Kilroy Bottom and then a clear breakout and another Bull Market and then another downtrend. Talk about your fearless bull riders down at the rodeo. But this Bull-Bear is ridable with a little technical analysis. Without technical analysis it is like being the target in a shooting gallery—a sitting duck. Figure 23.14 CISCO (CSCO). Although the first long-term trendline beautifully intercepts the downtrend in progress at a gap (a coincidence of indicators that occurs too often to be a coincidence), the trendlines drawn later are of such strength that even the novice analyst should know how to exit. In fact, one of my students, an employee of Cisco, did just that, saving himself thousands of paper dollars in this very case. Created with TradeStation 2000i by Omega Research '.s'-1999 Figure 23.15 Is there any way the trader (investors keep away) could avoid stepping off this cliff? Extreme paranoia is one way. Another way is by being acutely conscious of the pattern of behavior manifested by Cisco in Figure 23.14. Figure 23.16 You thought all the tulips and Bulls had been exhausted in the Tulipomania in 2000? Silly you. There is an inexhaustible supply. All you need is a company and a story and an underwriter to peddle it. Sometimes there are even earnings. Sometimes the earnings are even real. Sometimes the earnings are skating uphill on roller blades. Then sometimes the characters are so appealing that you are almost willing to buy the IPO at face value, but not if you are a cynic, as are all technical analysts. Google was rumored at $200 or more on the IPO. The editor offered to sell all of it at that price and throw in the Brooklyn Bridge for free. This offer (well, there may have been other factors also) knocked the IPO down to $85 (still an errant speculation), but only insane, not unreasonable. The oversubscription in an innovative offering revealed that the tulip virus was not dead, but very much alive and infecting not just the same old suspects, but many new ones. We love a horse race, and this is a great one. Notice the obvious defensive lines and support and resistance. How long Google can defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent gamblers will have a stop identified. On this chart, for the long-term gambler, it might be in the 182 area. For the more agile gambler, it might be failure of the support around 204, or closing of the breakaway gap there. No opprobrium is attached to the term gambler. In fact, bolder investors (competent readers of this book) should take a flyer from time to time with about 5% of their capital. This is the flyer that should have been taken. The breakaway gaps in October and April, operating against disbelief, were signals of enormous technical strength. And Google went to 475! The lesson here, which must be learned and relearned and ... ad infinitum ... is this: trust the chart. Ignore the story. In 2008, GOOG went to 700, halved in the Bush Bear Market, recovered to 600, and entered a two-year sidewave. Figure 23.17 Google, 2011. Google turned out to be the real thing and had a herd of cash cows that produced and produced and produced. Mother's milk? Or America's love affair with advertising? Whatever, the reader can see the simple-minded management of the issue with trendlines. Using trendlines would have avoided bungee-like equity, which is never pleasant. Basing Points might have been used the same way with the same effect. GOOG has essentially been in a large sidewave (very large) since 2010. The exit from this sidewave should have dramatic consequences—up or down. chapter twenty-four The probable moves of your stocks At first glance, all stocks appear to move helter-skelter without rhyme or reason, all over the lot. All stocks go up at times, and all go down at times —and not always at the same time. We already have seen in these rises and falls stocks do follow trends, make various typical patterns, and behave in a not completely disorderly manner. (For illustrations in this chapter, see Figures 24.1 and 24.2.) It is also true that each stock has its own habits and characteristics, which are more or less stable from year to year. Certain stocks normally respond to a Bullish Phase of the market with a very large upsurge, whereas others, perhaps in the same price class, will make only moderate moves. You will find that the same stocks that make wide upward swings are also the ones that make large declines in Bear Markets, whereas the ones that make less spectacular up-moves are more resistant to downside breaks in the market. There are stocks that ordinarily move many, many times faster than others. We do not know, for example, whether a year from now Glenn Martin (EN: read, Microsoft, eBay) will be moving up or down, but we do know, and it is one of the most dependable things we know, whichever way it is going, it will be covering ground much faster than American Telephone and Telegraph. (EN9: Even T accelerated into hyperspace after its unfortunate divestment of local Bells. And, unlike the leopard, completely changed its spots.) These differences of habit, of course, are due to the size of issue, floating supply, nature of business, and leverage in the capital structure, matters we have touched on briefly before. As a matter of fact, we are not especially concerned with why the differences exist. We are interested mainly in what the differences are, and how we can determine them. This is important: stocks that habitually move in a narrow range, although excellent for investment purposes in cases in which stability and income (dividends) are the chief desiderata, are not good trading stocks. A fairly high degree of sensitivity (EN: volatility), with wide percentage moves, is necessary to make possible profitable commitments that will cover costs and leave a net gain. To be in a position to make a profit, you should see the probability of at least a 15% move in your stock. How then are you going to tell which stocks are most sensitive and potentially most profitable? By examining the record of a certain stock for a number of years back, and comparing the percentage moves it has made with the percentage moves of the market as a whole, you can obtain a fair picture of that stock's habits. You will not be able to say, at any particular moment, “This stock is now going to move up 25%,” but you can say, with a good deal of confidence, “If the market as a whole makes an advance of 10%, this stock will probably advance about 25%.” Or, conversely, “If the market goes down 10%, this stock will very likely go down at least 25%.” (EN10: The concept of beta.) Many methods have been used for measuring and checking these percentage-move habits, differing only in detail. (EN10: With the ready availability of desktop and internet software, the investor may call up a two- or five-year chart and see the potential range of the stock at hand.) Indexes on several hundred important stocks listed on the New York Stock Exchange have been computed by the authors and are presented in Appendix A, ninth edition. 44 46 40 36 32 28 72 68 64 60 56 52 Figure 24.1 Some stocks move faster than others. We have already noticed that low-priced stocks have much larger percentage moves than high-priced issues. Yet, even between two stocks that may, at a particular time, be selling at the same price, there are enormous differences in their habits. Furthermore, these habits change very little from year to year. Here we have a weekly chart of Corn Products Refining Company (left), covering an 18-month period in the years 1945 and 1946. We also have a chart of Schenley Distillers (right) for the same period. The average price between the high and low on these charts is about 64 1/2, the same for both stocks. However, during this period, we see “CFG” moving between a low of 58 1/2 and a high of 71, a range of 12 1/2 points, while at the same time, “SH” has moved between 28 1/2 and 100, a range of 71 1/2. A thousand dollars put into an outright purchase of “CFG” at its extreme low would have grown to $1,210 at its extreme high, whereas the same amount used for outright purchase of “SH” at its low would have grown to $3,510. Your gain of $2,510 in “SH” would be more than 10 times the gain of $210 in “CFG,” and this without using margin. It is not likely you would actually purchase either stock at the extreme low, nor sell at the extreme high. The point we are bringing out here is there are enormous differences in the swing habits of stocks. (EN10: Magee's concept of “sensitivity” appears to combine some aspects of our modern concept of beta and modern computation of volatility. The replacement for Magee's Sensitivity Index is readily available at finance.yahoo.com and http://www.abg-analytics.com as well as any number of other sites findable by Google.) Individual stocks have their characteristic habits, as do some entire industries. In general, the food stocks, of which “CFG” is one, are stable and slow-moving. On the other hand, liquor stocks make wide moves on any general advance or decline of the market. At this time “CFG” had a Sensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley's was 2.05. (EN: Current-day betas or volatilities may be compared with these and/or substituted for them in other computations suggested in this book, for example, in Composite Leverage formulas. The reader CUBAN - AMERICANSUGAR CSU 36 34 32 30 28 X MJI 24 Pftirww r • 22 20 4. UL J L I d 1 18 164 --------------r 141945 1946 4 llliiil "TO Figure 24.2 Another example of the difference in swings between stocks. In this case also, the stocks show the same average price between the high and low of the period, and both stocks are plotted for the same 18 months in 1945 and 1946. Although in a lower price range and even though the disparity in their Sensitivity Indexes is less, there is a considerable difference in their actions. Cuban-American Sugar (left), a food stock, shows a range of 76% from its low of 16 1/2 to its high of 29, whereas Electric Boat (right), a shipbuilding concern, advances more than 140%. may read in the following text “beta” for “Sensitivity Index” and avoid the annoyance of excessive notation by the editor.) The Indexes are relative. They show stocks with a high Sensitivity Index (EN: beta) will move much faster in either Bull Markets or Bear Markets than stocks with low Indexes, and about how much faster, relative to the other stocks. (EN: As is obvious to the experienced reader, and new to the inexperienced, Magee's method predates the modern compilation of betas and volatilities. Beta measures the systematic risk of a stock, or for those who are not into financial industry jargon, the sensitivity of a stock to the market. Volatility measures the dispersion of returns in the stock itself. Thus, if the market moves 1 point, a stock with beta of 1.5 will move 1.5 points. A stock with a beta of 0.5 will move 0.5 points, approximately or more or less. Not surprisingly, high beta stocks are volatile. For readers who like to roll their own, I offer here the formula for computing the beta of a stock, which is somewhat more sophisticated than Magee's method: ((N)(Sum of XY)) - ((Sum of X)(Sum of Y)) where N = the number of observations, X = rate of return for the S&P 500 Index, Y = rate of return for stock or fund. The general investor may not be avidly interested in this calculation, especially when the beta is readily available at Value Line and finance.yahoo.com and is published regularly by Merrill Lynch. Betas litter the internet, found by searching Google; seekingalpha.com has lists; and finance.yahoo. com displays the stock beta in “Key Statistics” for each stock covered. Of equal or greater importance is the individual risk of a stock that professionals like to determine by computing its volatility. Somewhat akin to Magee's “normal range for price,” volatility measures the variability of a stock's returns (price movement). The general investor should be informed the study of volatility is an extremely sophisticated subject, and professionals expend enormous resources dealing with the question. Numerous methods are used to derive volatilities, but these mainly come into play in options arbitrage and professional trading on exchange floors. For the private investor, it is sufficient to know of the dangers of this arcane area. Before venturing into “volatility plays,” the newcomer should take a postgraduate course. For the general investor who wants to know enough to calculate his own volatilities (not recommended or necessary), I note the formula here: To calculate volatility, first find the difference between each return and the average. Then square each difference and add them together. Divide the sum by the number of returns minus one. This result is known as the variance. Finally, take the square root of the variance to get the volatility. Combining these steps into a formula: ^(Ri -|i)2 • Step 1: Calculate the average return. • Step 2: Calculate the deviation of each return. • Step 3: Square each period's deviation. • Step 4: Add them together. • Step 5: Divide the sum by the number of periods - 1. This is the variance. • Step 6: Take the square root. The less punctilious (or more practical) investor may find volatilities at ht tp://www . optionstrategist.com, ht tp: // www .cboe.com, and finance.yahoo.com, as well as other locations that can be located by searching on Google.) chapter twenty-five Two touchy questions This chapter is directed largely to the new trader, to the investor who has followed other analytical methods, and to the investor type who is now, for the first time, taking up the technical trading of stocks for the shorter term. The use of margin The first question here is the use of margin. There are many people who, knowing of the disastrous margin calls of 1929 and the staggering way losses can be multiplied against one in a margined account during a sharp break in the market, take the attitude that the use of margin is intrinsically bad, dangerous, foolish, and unsound. They will tell you they are willing to risk their own money, but they never speculate on borrowed funds. They will tell you that by buying securities outright, they are safe against any kind of break in the market. There is something to this line of argument, although very often you will find the arguer has not really thought the case through all the way. If he had, he might realize that, in buying outright stocks that are sensitive or highly leveraged, he is accomplishing almost exactly the same thing as someone else who buys more conservative stocks on a margin basis. Very often, despite his feeling that outright purchase is more conservative than margin buying, he is a speculator at heart. He is not really interested in dividends and a stable investment. Rather, he is looking for “something with appreciation opportunity.” Considering he is not facing the issue squarely, he may fall into expensive errors. To be thoroughly consistent here, a man who shuns the risks inherent in margin trading should shun the risks of leverage and volatility. He should avoid risk, forget “opportunity for appreciation,” and confine himself to sound, income-producing stocks of a sort that will not fluctuate widely. If we are looking for stability, we do not want excessive fluctuation and there are securities that provide stability. In this work, however, we are looking for “swing power.” We want the highest degree of fluctuation we can handle safely. We can secure this by buying outright a stock that is normally subject to fairly broad swings—that is, a stock with a high Sensitivity Index (EN: beta). We can get the same effect by trading in a stock of more conservative habits but increasing the Composite Leverage (EN: or simply leverage) by using margin. (The method of computing and comparing Composite Leverages in various situations is covered in Appendix A, ninth edition and may be studied in Chapter 42.) Let us assume, for example, we will buy 100 shares of a rather speculative stock, which we will call UVW, on an outright basis. It has a Sensitivity Index of 1.50, and now sells (let us say) at 20. At the same time, we buy a somewhat less speculative stock, XYZ, also selling at 20; but in this case, we buy on 70% margin, putting up only three-quarters of the value of the stock. In a general advance affecting both of these stocks, the probabilities would favor a somewhat greater percentage move in UVW than in XYZ. If such a general rise should bring UVW to 30, we might expect XYZ to rise to a lesser degree, say to 28. Now the advance of 10 points on the $2,000 invested in outright purchase of UVW will represent a gain of $1,000 or 50%. The advance of XYZ to 28 on the $1,400 invested at 70% margin will mean a gain of $800 or 57%. In other words, we have, by the use of margin, increased the effective leverage of XYZ; we have made it, in fact, slightly more speculative than UVW. The effect of margin use is simply to accentuate or increase the sensitivity of a situation. It is a mechanism for assuming more risks and, therefore, more opportunities for faster gains. Assuming you are willing to assume risk (as you must be if you intend to make speculative commitments), it is simply a matter of knowing approximately what risks you are taking and whether you can afford to take them. The danger in margin lies in cases in which the customer grossly overextends himself, taking on a risk far beyond his ability to protect himself. This will not happen if he sets a reasonable limit to his total leverage (EN: put another way, his portfolio risk). The margin transaction is simply a matter of buying (or selling short) more stock than you have money to pay for in full. The purchase of a home on a mortgage is essentially a margin transaction. The financing of business operations, using borrowed money for part of the capital, is the same. The buying of anything for which the purchaser puts up part of the capital and borrows the rest, using the value of the purchased property as security for the loan, is exactly similar to the trading of stocks on margin. In each case, any change in the value of the property will cause a larger net change in the value of the margin capital. Thus, if a man buys a home for $100,000, paying $50,000 cash, and later sells it for $150,000 (an increase of 50% in the value of his property), he will benefit to the extent of $50,000 profit, or 100% on his invested capital. The question of margin calls, being “wiped out” on margin transactions, will seldom, if ever, come up if you protect yourself properly by maintaining stops at all times or by closing out the transaction when it has violated certain predetermined danger points. Needless to say, if you have allowed a trade to go so bad it reaches the minimum margin maintenance range, the best thing is to take your loss and forget it; not try to meet the margin call. Yet again—this need not ever happen. As we will see in discussions of sensitivity and leverage, stop levels, and so on, there are certain limits that can be fairly well defined, beyond which you cannot safely venture. If you could buy stock on a 10% margin, as you could at one time, you might have visions of highballing $1,000 up to $1 million in one Bull Market; that is not a reasonable hope and it is not safe to risk your capital on a 10% margin because, in many cases, your perfectly logical purchase would sag enough to wipe you out entirely before going ahead to the normal advance you expected. (EN: In a nutshell, the risk of trading commodities and futures.) In judging how much margin you can or should use within the limits of margin trading laid down by law, you must take into account the method of trading you are using, the amount of adverse fluctuation you must expect in the normal operation of your method, and the nature of the stock you are dealing with, that is, its Sensitivity Index and Normal Range-for-Price (EN: at the risk of being repetitive, beta and volatility), at the time you make the original commitment. Short selling The other touchy question is that of short sales. A majority of traders avoid the short side of the market. Six out of seven investors you meet, who have bought or sold stocks, will tell you they would never sell a stock short under any conditions, at any time. In fact, short selling is limited, very largely, to skilled professionals. (EN: The private investor, because of his fears and prejudices, voluntarily grants this “edge” or advantage to professionals. Magee dealt with this subject at length in Winning the Mental Game on Wall Street, which I wholeheartedly recommend to the reader. EN9: The widespread proliferation of hedge funds in the new century attests to the frustration of professional managers with mutual fund rules requiring them to maintain only long positions. Even with this development, short selling by the general investor remains a limited technique—to the disadvantage of the nonprofessional.) Now, if you have studied long-term charts (weekly and monthly), and the daily charts in this book, you will recognize several facts about the action of markets. Most stocks go up most of the time. There are almost always more advances than declines in the list of the most active stocks published each day. Stocks, in general, advance about two-thirds of the time, and go down only about one-third of the time. (EN9: Probably a truth over the long term, but in the modern context, ample short opportunities exist.) Furthermore, most of the news releases, rumors, and comments in the press related to stocks and corporate affairs have to do with the brighter side of industry. It is only natural that executives, public relations people, and the reporters themselves should be interested in forward-looking developments, new processes, expansion of facilities, increased earnings, and the like, and that such items should prove more newsworthy than less optimistic reports. These various factors may explain why “the public” is always Bullish. The public is always hoping and expecting stocks to go up all the time. If stocks are rising and in a Bullish Phase, the public expects them to still go higher. If stocks have declined sharply, the public will argue they are now better buys than before and must surely go up soon. It is up, up, UP, always up, in the mind of the public. Yet, examination of the long-term charts covering the action of the Averages over many years will show you that, through these long periods, the levels rise and fall about the same amount. This being the case, it must follow that stocks come down as far as they go up and because they go up about two-thirds of the time, they must come down much faster than they go up. This you will find is true. The angles of decline in the Averages and also in individual stocks are usually steeper in Bear Market Moves than the advances are in Bull Market Moves. A corollary to that is that profits can be made faster on the downside of the market than on the upside. Such profits are made by selling short. It is important if you are a trader to understand the meaning of a short sale. When you sell a stock short, you borrow that stock from someone who owns it, and then you turn around and sell it to someone else, agreeing with the original owner to replace his shares at some unspecified time in the future. All of the details of this transaction is handled by your broker. Shares of most stocks of large outstanding issue are available for loan at all times in the hands of brokers, and your broker has access to them. The mechanics of this borrowing and sale are interesting; you may wish to get from your broker the whole story of how these operations are carried out. For all practical purposes, however, all you need to do is tell your broker what you wish to sell and leave the rest to him. He will advise you if, by any chance, the stock you have selected for short sale is not available for loan. Another practical point, although of minor consequence, is that a slight additional tax is assessed against short sales. (EN: In that gains on short sales are not eligible for long-term capital gains tax.) It is important also, if you are a trader, to accept opportunities to sell short as readily as you go long stock. Unfortunately, there are psychological barriers to short selling. There are, for example, the unintelligent and entirely irrelevant slogans about “selling America short.” There is the feeling on the part of many who are poorly informed that short selling is the somewhat unethical trick of the manipulator. Others have the impression that, in selling short, one is hoping to profit by the misfortunes of others at times of disaster and Panic. It is not the purpose of this book to persuade anyone to sell stocks short, any more than it is our purpose to advise anyone who should not to speculate on the long side of the market. Nevertheless, so many questions are constantly raised, even by fairly sophisticated investors, about the ethics, as well as the practical procedure of short selling, that we may perhaps be pardoned for saying a few more words in its defense. All of the popular ideas about short selling mentioned in the preceding paragraph may be branded as so much nonsense. There is nothing more reprehensible about selling short than buying long. Each is a speculation in relative values. The truth is money is a commodity, just as much as a share of stock. There is no moral or practical difference between borrowing money to buy stock because you believe the latter will go up in value in terms of the former and borrowing stock to “buy” money because you believe the latter is going to go up in value in terms of the former. In each case, you are obligated eventually to repay the loan whether it be money or stock. In each case, you are taking a risk on the basis of your considered forecast as to the future trend of relative values. There are, in fact, many common business practices that are more or less analogous to selling stocks short. For example, every time the publisher of a magazine accepts cash in advance for a subscription, he is making something like a short sale. His ultimate profit or loss will depend on what the magazines he will eventually supply have cost him by the time the subscription runs out. When you sell stocks short, you (or rather your broker) receive the proceeds of the sale at once but you are obligated to turn back an equal number of the same shares at some future date to the man from whom the stock certificates were borrowed. (EN: One of the advantages or edges that professionals enjoy over private investors is the credit of short sales to their accounts and the payment of interest thereon. Although the proceeds are credited to the private investor, no interest is generally paid on it, unless the investor has influence with the broker. A favorable situation is created, however, if a short sale of $100,000 were made on, say, 50% margin, a credit of $150,000 would be made to his account, and no interest would be charged. Any dividends the trader paid on the transaction would be expensable.) Consequently, sooner or later, you have to go into the market again and buy those shares. When you buy them, you (or rather your broker) return the shares to the original lender, thus discharging your obligation. If the cost of your purchase was less than the proceeds of the earlier sale, the difference is your profit. If it costs you more to buy in the shares—or as it is termed, cover your short—the difference represents a loss. You do not enter into a short-side transaction unless you expect the price of the stock to go down; hence, showing you a profit. One of the little-appreciated results of a large volume of short selling is actually to strengthen the market. Every short seller is a potential buyer. Most short sellers are glad to cover and take their profits on a relatively Minor Decline. Consequently, if there is a big short interest at any given time in a particular issue, it means there are many people waiting to buy that stock when it goes down. This situation tends to “cushion” bad breaks. Some astute operators will actually buy a stock when they learn there is a very large short interest in it, meaning a great many shares of it have been sold short and not yet covered, because they realize competition among the short sellers to buy the stock whenever it has a small decline may result in a very fast and profitable Short-Covering Rally. Any stock is stronger, technically, if there is a good-size short interest in it. There is one further objection raised against short selling. It will be pointed out when you buy stock that your loss, if worse comes to worst, can be no more than the total amount you paid for it. In the case of a short sale, the price of your stock could, theoretically, rise against you to $50.00, $100, $1,000, $10,000 a share; in other words, it could rise without limit. This argument sounds much more alarming than it really is. Certainly there is no occasion to lose sleep over it. Stocks do not go up without limit all of a sudden. It is just as easy to set a stop on the loss you are willing to take on a short-side transaction as it is on a long purchase. Such situations as the famous 1901 corner in Northern Pacific are not likely ever to occur again under present regulations. (EN: The famous “short squeeze.” Short squeezes still occur but are extremely rare in big liquid issues. A famous short squeeze occurred in the silver markets of the 1980s when the Hunt brothers trapped Exchange members and almost bankrupted them. The members, being in control, retaliated by quintupling margin requirements and bankrupted the Hunts.) The authors realize nothing said, and probably no amount of cold-blooded analysis on the part of the reader himself, will remove entirely the trepidation that most nonprofessional traders experience when they sell short. The mental hazards will always be slightly greater than in buying long. Nevertheless, from every practical angle, a short sale is exactly the same thing (although in a reverse direction) as a long purchase, with no greater risk, with actually somewhat greater chance of quick profit, and differing only in details of execution. A commitment in commodity futures contracts, whether long or short, although quite different in theory, has some similarities to a short sale of stock. In making a contract, no actual sale takes place, and no loan of either cash or the commodity is involved. Such a contract is simply a binding legal agreement to accept delivery or to deliver a certain commodity at a certain price at a certain time. In this respect, it is different from a short sale of stock. It is also different in that it must be closed out on or before a definite date. Although, the purchase or sale of a commodity contract is similar to a stock short sale in that (1) it is necessarily a margin transaction, and (2) it creates an “open” or incomplete transaction that eventually must be liquidated. A short sale of stock must always and necessarily be a margin transaction. Thus, if you buy 100 shares of stock outright at 20, it can sink to 15 and you cannot be called for more margin. You have lost $500, but the stock is still yours. If you sell, you get back $1,500, disregarding commissions. On the other hand, if you sell a stock short at 20, putting up a margin of 100%, and the stock rises to 25, you will also have lost $500. The broker, under certain conditions, such as the 100% margin requirements in effect at one time, might call on you for $500 additional margin. Or, if the transaction were to be closed out at that point, you would receive back $1,500 less commissions, the same as in the long transaction. In the case of this short sale, had the price dropped to 15, your profit would have been $500. On short-term moves, the effect of short selling is exactly the same as the buying of long stock, but in the opposite direction. You simply apply the same methods here in reverse, during a Bear Market, that you would use in a Bull Market. As we have already seen, the various technical indications that point to upward moves in a Bullish Phase have their counterparts in downside signals during a Bearish Phase. Execution of short sales cannot be made at any time and at any price you wish. A short sale must be made in a rising market. You are not permitted to sell a stock short on the New York Stock Exchange during a market break when each regular sale is at a lower price than the one before it (EN9: the uptick rule). However, this need not bother you much because, ordinarily, you would make such a sale on the rally as it reached your price, and this would naturally fill the requirement of a rising market. Your broker can give you, in detail, the special rules and regulations that apply to short sales. It will pay for you to study these so you can place your orders correctly when the proper time comes to make such sales. (EN9: At the AMEX, short sales on ETFs and some HOLDRS are exempt from the uptick rule as are futures contracts on the futures exchanges. EN10: In 2007, the uptick rule was removed in an ill-considered bow by the Securities and Exchange Commission to large speculative interests. The reader may judge for himself whether subsequent markets have been more volatile on the downside. It is our observation that the loss of this rule results in accelerating slides in fast downside markets. Since 2009, there has been wide debate about reinstatement of the uptick rule, so far to no avail. In the current context, short selling has been institutionalized. The public may buy ETFs, which take the short side of almost any instrument, as, for instance, QID for the Qs is a short bet, as is DOG for the DIAMONDS™ (DIA). There are even leveraged [two times, three times] ETFs [long and short].) chapter twenty-six Round lots or odd lots? (EN: Or, put another way, size?) One of the minor tactical questions bound to plague you is whether to trade in round lots of 100 shares or odd lots (less than 100 shares in active stocks). (EN: In Internet-age markets, this question has virtually lost its relevancy. In Magee's time, there was a distinct disadvantage to trading odd lots, and one traded odd lots only if hampered by limited capital. Now that an investor can achieve full diversification in an odd lot position by buying odd lots of Standard & Poor's Depositary Receipts (SPYs) and DIAMONDs™ (DIA), there seems little point in discussing it. There is, of course, always the question of broker commission—if the broker has a fixed commission rate, regardless of the size of the trade, then the small investor gets nicked. It would seem this follows the old adage that the rich get richer. Nevertheless, now the small investor can strike back by finding a broker who does not charge commissions. At first I thought commission-free brokers were making up their profit on volume; in fact, there are other ways to make a profit on trades than charging a commission—for example, directing the execution of the orders to a trader who needs “order flow.” In the Internet age, the question of what size a trade or investment should be is different from the question that confronted traders of, as it were, ancient times. Now, it is not so much a matter of cost disadvantage in trading odd lots as it is a much deeper question—that of risk and portfolio management. So how does the aware investor determine the size of any individual trade? I am indebted to a longtime friend, colleague, broker, and fellow trader, William Scott, for articulating the common-sense procedure here for calculating trade size and controlling risk. First, we determine the percentage of our capital we want to risk on any given trade. Among many professional traders of our acquaintance, this figure is often 2% or 3%. For the sake of illustration, using round numbers, if we have $100,000 capital this means we will be risking $3,000 on a trade. Let us say we are going to buy a $20.00 stock and defend our position with a stop-loss order $5.00 away. Our formula for computing position size is as follows: 3,000/5 = n number of shares (600 shares) If we were going to accept a $10.00 risk, our trade size would be 3,000/10 = 300 shares. Thus, we adjust our trade size to fit our risk parameters. This is a simple, practical, and elegant way to implement risk control at the individual trade level. Trade size is, without doubt, one of the most crucial factors in success for the general investor. Ignorance, or denial, of its importance is a major reason for the failure of many traders. In short, overtrading. Other perspectives on risk and trade size are found in Chapter 42 and in Appendix B, where the Leverage Space Model is explained.) Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter twenty-seven Stop orders We are going to take up two kinds of stop orders, or, rather, two entirely different uses of the mechanism of stop orders. First, let us look at the protective stop order. At best, it is not a happy subject. Stop orders of this type are like fire extinguishers; the occasions when they are put into operation are not times of rejoicing. Stop orders are used for emergency rescue when things get so bad there seems no reasonable hope for a situation. Wherever you set your protective stop, it is likely to be touched off at what seems to be the worst possible moment. You will set it at a safe distance under a certain bottom; the stock will break through, catch your stop, and then proceed to build a new bottom at this level for the next rise, or to rally at once and make new highs. No matter, you had your reasons for setting the stop. The stock did not act the way it should have. The situation is not working out according to Hoyle and certainly not the way you hoped it would. Better to be out of it, even at a loss, rather than face a period of uncertainty and worry. If the stock has started to act badly, you cannot tell how much worse it is going to behave. If you fail to set a stop, you may go on day after day hoping for a rally that never comes while your stock sinks lower and lower until, eventually, you find (as millions have found) that what started to be a small reaction, and an annoying but trivial loss, has turned out to be a ruinous catastrophe. Stop orders cannot always be placed; in certain cases in active stocks, the exchanges may even restrict the use of stop orders. The question is where and when to set the stop, realizing there is no perfect and absolutely satisfactory rule. If the stop is too close, you will take unnecessary losses; you will lose your holdings of stocks that eventually forge ahead and complete the profitable rise you hoped for. If stops are too wide (too far away), you will take larger losses than necessary in those cases in which your stock definitely has broken out of pattern. Now, it will be obvious, as the setting of stop orders depends on the price of the stock and its habits. You would not place your stop level at the same percentage distance under a Bottom in a conservative, high-priced stock when it is selling at 80 that you would to protect a speculative issue at a time when it is selling at 8. The higher priced stocks, as we have already seen, make smaller percentage moves. Conversely, the lower-priced stocks make wider percentage moves. Therefore, the lower-priced stocks should have more leeway for their gyrations. We will need a wider stop for them than we will for the less volatile “blue chips.” Similarly, we can take our Sensitivity Indexes (EN: betas in considering a stock relative to the market, and volatilities for absolute measure of one stock against another) to give us a picture of the individual habits of the stock. Although two stocks may be selling at the same price at a given moment, you would expect a high-beta, high-volatility stock to make wider swings than a low-beta, low-volatility stock; therefore, you will set your stops wider on the higher volatility stock. We must take these factors into account and work out some sort of simple rule of thumb to follow. Let us arbitrarily assume an imaginary stock of “average” habits and a price of 25 and further assume we will be satisfied, in this particular case, with stop protection 5% below the last established Minor Bottom. For a stock of the same sensitivity selling at 5, we would need about half again as much stop leeway (on a percentage basis). That is, the stop would be placed 7.5% below the last Bottom (EN9: significant low). (EN10: Here Magee gave an account of how, using his Sensitivity Index and his normal range for price, he computed stop positions. The process is too convoluted for modern investors—and unnecessary because Magee boiled the procedure down to a table I have modernized below. The Procedure is intact in the eighth and ninth editions for the scholarly (or obsessed) investor or academic.) For most ordinary purposes, a simplified table of stop distances will be sufficient. Table 27.1 gives you the approximate stop distance you would get by the method outlined above, for stocks in various price classifications and of various degrees of sensitivity (volatility). (EN10: Magee originally constructed this table based on his Sensitivity Index. The informed reader may consider an alternative to Magee's Sensitivity Index, which I have conjectured here for the modern context— that is, basing the stop distance on volatility, which would present a dynamic method of adjustment.) The stop level should be marked on your chart as a horizontal line as soon as an actual or theoretical transaction has been entered into, and it should be maintained until the transaction is closed, or until progressive stops (which we will explain in a moment) have been started to close it out. In the case of purchases, the stop level ordinarily will be at the indicated distance below the last previous Minor Bottom. In the case of short sales, it ordinarily would be at the indicated distance above the last Minor Top. To determine the position of this stop level, simply figure what the percentage distance would amount to at the price of the stock. If you are dealing with a stock selling at 30 and the stop distance comes out 10%, then allow 3 points under your last Minor Bottom. In no case would we ever set a protective stop level at less than a 5% interval, even for the most conservative, high-priced stocks. These questions remain: What constitutes a Minor Bottom? What makes an established Minor Top? How do we know how to choose the Basing Point (EN9: see Chapter 28) from which to measure off our stop level interval? The constitution of a Bottom or a Top (EN10: wave high, wave low) will be taken up in the next chapter. For the present, let us accept the proposition we will determine the correct Basing Point and will always, always set our stop level at the moment we make the commitment. Table 27.1 Table of stop distances (expressed in percent of the price of the stock) Price Conservative sensitivity Median sensitivity Speculative sensitivity Volatility under 0.40 Volatility 0.41-0.79 Volatility over 0.79 Over 100 5% 5% 5% 40-1005% 5% 6% 20-40 5% 5% 8% 10-20 5% 6% 10% 5-10 5%a 7% 12% Under 55%a 10% 15% a Ordinarily, stocks in these price ranges would not be in the conservative group. It is understood protective stops under long stock are never moved down, nor are protective stops over shorts ever moved up. As soon as the stock has moved in the right direction far enough to establish a new Basing Point, the stop level is moved up (on longs) or down (on shorts), using the same rules for determining the new stop level as were used in fixing the original level. The progressive stop There is another use of a stop that is properly considered here. This is the progressive stop, which is used to close out a stock that has made a profitable move, or in some cases, where a stock has given a danger signal before either completing a profitable move or violating a previous Minor Bottom. You will find on many moves, the stock will progress in the primary direction for several days and then may develop exceptional volume. Often, this occurs just as the stock reaches an important trendline or pattern border or Resistance Area. This heavy volume means one of two things: usually, that the Minor Move has come to an end, being this is the top of the rise for the moment; occasionally, the volume may signal the start of a breakaway move that may run up several (and perhaps many) points, almost vertically. (The reverse situation may develop on downside moves.) If, noticing the heavy volume following a good rise, and assuming this day marks the end of the move, you sell the stock at the market or at a limit, you are going to be dreadfully disappointed if this should be one of those rare cases in which the stock opens the next day on an upside gap and continues 3, 5, or 20 points up in the following days. On the other hand, experience will have shown you it will not pay to expect that sort of move very often. You will know that, 9 times out of 10, you will be better off out of the stock. After such a day when volume is exceptionally high (provided this is not the first day of breakout into new high ground beyond the last previous Minor Top), cancel your protective stop and set a stop order, for the day only, just 1/8 (0.125) point under the closing price. For example, you have bought a stock at 21; it goes up on moderate volume, smashes through the old Minor Top one day at 23 on very heavy volume, the next day continues to 23 3/4 on moderate volume, the third day advances on moderate volume to 24 1/4, and, finally, the fourth day makes a rise to 25 on much heavier volume than it has shown on any day of the rise except the day it broke through 23. The morning after this close at 25, you will notice the volume signal. You will cancel your protective stop, which may be at 18, and you will place a stop order, for the day only, to sell on stop at 24 7/8. In most cases, this will mean your stock will be stopped out on the first sale of the day. Plus, you may get a slightly lower price than you would get with a straight market order. On the other hand, after a day of high volume activity, you are not likely to be left in a thin market; there should be bids enough, near the top, to get you out at or near your stop price. Meanwhile, you are protected against losing the stock if there should be a continued move in the right direction. Suppose the opening the morning after you set your stop at 24 7/8 should be a gap at 25 1/4, and that prices then move up further, closing at 26. (On “runaway” moves of this sort, the closing for the day during the move is likely to be at the top.) You will then set your stop, again for a single day only, at 25 7/8. If the stock then opens at 26 3/8 and moves up to 28, you will set another day stop at 27 7/8, which, let us assume, is caught at the opening the following day at 27 5/8. In this example, you risked only 1/8 point on the first day, and eventually netted an extra gain of 2 5/8 points. This, it should be pointed out, is all net gain because your commissions are approximately the same in either case. A progressive stop of this sort can be indicated on the chart by any mark you choose to use—for example, a band of short diagonal lines. When a stock moves for several days in a runaway move, you may repeat this mark each day, indicating a tight stop 1/8 point under the close for each successive day, until finally, one of these stops is caught. In the case of short sales, a buy stop is used in precisely the same way as the selling stop, by following the stock down on a sharp runaway dive. This use of tight progressive stop orders is indicated wherever a stock has reached its reasonable objective on high volume, or where it has exceeded its objective and is moving out of the Trend Channel in free air, so to speak, and in some cases, where the stock has failed to reach its objective. If your stock, for instance, is rising in a Trend Channel, and, about halfway between the lower and upper trendlines, suddenly develops great volume, then a progressive tight stop will protect you against the threatened failure of the move. Extreme volume in such a case, before there has been a breakout to a new high above the last Minor High, is definitely a warning and a threat. This would be especially true if there were also a gap or a One- Day Reversal at this point. The one day on which a tight stop would not be applied after heavy volume had appeared would be the day the stock made a new high, running entirely through the previous Minor Top and closing above it. This action generally means the move is not yet completed. Should the move continue higher and again show heavy volume, even if it is the very next day, we would then protect with a progressive stop. In this chapter, as throughout the book, the expression “heavy volume” means heavy only with respect to the recent volume of sale in the stock you are watching. A thousand shares may be significantly heavy volume in some thin issues, whereas 10,000 shares would be no more than a normal turnover in more actively traded stocks. The volume chart itself will show, by a market peak, when a day of abnormally heavy volume occurs. It should be understood the progressive stops we have been discussing are intended to take short-term gains, or to close out an exceptionally profitable runaway move terminating in an Intermediate Climax. Although the extreme conditions that call for this type of operation are by no means rare, they are not the usual, everyday action of the market. In the case of ordinary Minor Tops, even when they are fairly apparent on the basis of Trend Channels, volume peak, and other indications, many traders and investors will prefer to wait out the expected reaction rather than pay additional commissions and lose a position that is still presumably in a favorable Major Trend. In short, the progressive stop is a device that may be very useful on occasion, but it is intended to cope with a special and somewhat unusual move. The protective stops, on the other hand, offer the average trader, the man who is not able to spend his entire time studying the market, or who has not had long experience, a device by which he can limit his possible loss. He will be protected from his own reluctance to close out the bad holding, and he will avoid the ruinous condition of becoming frozen into a hopeless situation. Since he will be taken out automatically, regardless of whether he has an ultimate gain or loss, he will have the capital to use in better-looking issues and will not have to worry about the prospects of recovery in his stock after it has gone many points against him. If one has sufficient knowledge and sufficient determination to get out as soon as the trend has shown convincing evidence on a turn, there is less need for the stop orders. (EN: This editor believes that only the proven trader-investor should trade without a stop in the market. The reader may determine whether he meets this criterion by examining his portfolio to see whether he has ever let a loss run or allowed a significant profit to slip away. If so he, or she, or they, or it, is not proven.) It is possible for such a person to operate successfully without them; and there are some advantages in doing this because a stop order will occasionally be caught by a false move or an extended dull reaction. There are also advantages in not using stop orders for the experienced technician who is looking toward a possible long-term gain and who is willing to wait out a Secondary Reaction. Yet it is a thousand times better for the person who is not sure of his methods to be stopped out early, than to be left holding a stock bought at, say 60, when it has declined to 29—or to 5! Stop systems and methods The two most important concepts in investing and trading are trends and stops. Being right, the trend immeasurably diminishes risk and increases our probability of profit. However, without skillful setting of stops, all our work and study can easily result in nothing as the markets dodge and weave, deceive, and throw off false signals. If our analysis has not resulted in skillful stop setting, we will be no better off than that unfortunate fellow who is acting on a tip from his brother-in-law—or his bootblack. Consequently, let us first attack this question from the viewpoint of the trend-following investor and deal with trading stops thereafter. In Magee's systems for the trend follower, there are two basic stop methods. One is based on trendlines (sloped and horizontal), and the other is rooted in Basing Points. Chart patterns interact with these two methods. This entire book treats the former at length in too many chapters to mention here. The second, Basing Points, is discussed exhaustively in Chapter 28. The breaking of trendlines is always significant. Magee tested the validity of the break by requiring that prices penetrate the line by 2%-3%. This may not be perfect, but it serves for the majority of situations. The longer the trendline the more important the break, as illustrated in the market breaks of 2008 and 2011 (a trendline of more than 700 days). The downwaves (crashes?) resulting from these trendline breaks were recognized and commented on at the time at http://www/edwards-magee.com. Figure 5.1 illustrates the serendipitous convergence of all three methods combining to exit longs and short the market in 2008. Trendline analysis, pattern analysis, and Basing Points analysis by their very nature are complementary and lead to similar conclusions, as, for example, in August 2011 when the long-term trendline from March 2009 was broken, a Head-and-Shoulders Top was identified, and the Basing Point stops were taken out. Therefore, we have three ways of setting stops in extended trends— trendlines, patterns, and Basing Points. Are there other stop methods for trend following? Indeed. A multitude. A plethora. A cornucopia. An excess. First, let us remark on the crucial question of stop setting in trends. Stops set too close to the market result in the trader losing his position. The stop must be set to give the market room to move against his position, thus (crocodile tears) apparently surrendering precious profits. As the market advances in waves (truism)—wave up, wave down—stops must be, as in the Basing Points Procedure, set sufficiently below wave-low points to avoid being exercised. In an interview in Market Wizards, Jack Schwager asked a major trader, Bruce Kovner, where he set his stops. “Where they're hard to get to,” replied Kovner. This is the principle at work in Basing Point stops. Knowing that locals and market mischief-makers probe for stops at wave lows and support zones, the stop is set with a filter, thus some distance below the wave low (or wave high). This stop is hard to access. The same thing is true if using a moving average. Magee used a 2% or 3% stop for trendlines and a stop of this type is probably good for a moving average, too. At the same time, if volatility and excitement are running high, the trader must adjust the size of his filter. In a rising market tracked with a moving average, the trailing stop would be moving every day the dotted line moved up. Naturally, with a filter that might be enlarged if market volatility became excessive. A brief survey of stop methods Here we are going to deal primarily in exit stops. (EN: My book Signals [available on Amazon's Kindle platform] analyzes at length methods for entering trades and trends.) Many traders use stops to enter positions, but that is not our interest at this moment. We want to know how to protect our initial entry and how to advance our stops so as to lock in our profits when the trade has gone our direction. The initial stop may be set as with Basing Points (as described in Chapter 28), or it may be set above or below a Support-Resistance zone, or as a percentage (William O'Neil says a stop should be set 8% below the entry), or even as a percentage of capital—for example, 2% risk per trade—a $2,000 stop ($100,000 capital) is a common money management system. If the market moves against our trade, the protective stop limits the loss. If the market moves with us and begins to accumulate profits for us, we have a different, and happy, problem. It is only a matter of time until the market throws us a downwave to test our mettle—or to dislodge us altogether. We are trend followers, so we buy strength and sell weakness, but our antagonists are contrarians—they do the opposite. Thus, after a reasonable upwave, contrarians will be taking profits and driving prices down. Swing traders will be doing the same thing. We want to stick to the trend until it changes, even taking these “corrective” waves against our position. Basing Point stops will do this, and the inevitable result is fluctuation in equity. Long experience has shown that fleeing from downwaves and exiting invariably results in smaller long-range profits. Accepting downwaves and fluctuations in profit leads to greater long-range profits. Look at the tables of Dow and Basing Points performance. It is not unusual to see downwaves of 10%-30% without a change of trend occurring. We have seen how we can stop these trends with trend analysis and Basing Points analysis—and there are other philosophies and other methods. Some other stop methods Average True Range Average True Range (ATR) is an interesting concept and tool. It is a measure of volatility, in actuality, and tracking it gives us some interesting information. True Range is defined as the largest of the following: Today's high minus today's low. Today's high minus yesterday's close. Today's low minus yesterday's close. ATR is the average of True Range over some defined period. Twenty days is a not uncommon parameter, as is 14. Five days is very sensitive, which has advantages and disadvantages. ATR may be used to set stops. For example, we might set our initial protective stop 2 (or x) ATRs below our entry. We might set our trailing profit protection stop in the same way: x ATRs below the recent high—or the low of the recent high. Stops set this close are typical of trading situations. There is at least one practitioner of my knowledge (Eric Crittenden, http://www.blackstarfunds.com) who judges if prices take out the stop 10 ATRs below the most recent high, the trend has changed. This is sometimes called a Chandelier Exit. This kind of concept can be examined using trendlines and reversal formations. ATR is a natural way of measuring market volatility and it rhythmically adjusts to market behavior. This makes a system more flexible than fixed percentages or fixed dollar amounts. An interesting paper on Crittenden's method is found at http://www. trendfollowing.com/whitepaper/Does_trendfollowing_work_on_stocks.pdf. Feature this, relevant to my point, that the market must be given room to work: Crittenden found that a 10-ATR filter averaged a space of 27%. So what we have here is an inherent stop system that posits a 27% reversal to indicate a change of trend. Parabolic stop and reverse Welles Wilder's (1978) parabolic stop and reverse (SAR) technique uses an “acceleration factor.” Consequently, the stop rises parabolically, which has its strengths and weaknesses as the reader can imagine. Chuck LeBeau has conjectured a Modified Parabolic Exit, which tweaks the acceleration factor at http://lcchong.files.wordpress.com/2011/05/precise-exits-entries- manual.pdf. This presentation includes other interesting comments on stop methods. Target stops I am not a great proponent of target stops, but many traders analyze a formation or market situation and compute a possible target and exit the market when their target is reached. Other target criteria may be used—a dollar or point amount, or as in Bill Scott's method, five days down causes liquidation of half the position, six days the other half. Similar to the target method, the trailing stop is raised when x% of profits are achieved and raised again as prices advance. An old Japanese saying has it as follows: “Sell half at 8 new prices, half again at 10 new prices, and the rest at 12 new prices.” Of a similar nature, some traders will close the trade when an extreme move occurs in their direction. A natural method used by the Turtles The Turtles used the breakdown from a 10-day channel to exit their long trades. This can be modified to as little as three days, in which case the trader would set a very tight stop based on the three-day low if a market were running away. Such a situation might also be managed with Magee's tight progressive stops—raising the stop each day to just under the low of the day to be in effect for the next day. In the end, as the reader can see, there are as many stop methods as there are traders. For our purposes, the more natural and less algorithmic the method, the better—so it comes back down to trendlines, formations, and Basing Points, which can be tweaked to the individual taste. If there is a truism about the markets it is this: a trader without stops will soon be a trader without capital. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter twenty-eight What is a Bottom and what is a Top? (EN9: In this extremely important chapter, I have left intact Magee's usage of “Tops and Bottoms.” It will be less potentially confusing for the reader to think of “highs and lows” as that terminology is commonly used in the business in the modern era. Also, thinking in terms of highs and lows is an important concept in itself. Thus, for a Bull trend, higher highs, higher lows. When this pattern is broken in an important way, the trader should be alert for a trend change. Also, as the use of eighths is of the essence in Figure 28.1, I have left the discussion in eighths, although the reader knows decimals are now used in the markets.) In this chapter, we are not talking about what makes a Major Top or Bottom or what makes an Intermediate Top or Bottom. We are speaking of the Minor Tops and Bottoms that give us important hooks on which to hang our technical operations. Stop-order levels, trendlines, objectives, and Supports and Resistances are determined by these Minor Tops and Bottoms. They are of prime importance to us as traders. (For illustrations in this chapter, see Figures 28.1 through 28.4.) Usually, these Minor Tops and Bottoms are well marked and perfectly clear, though often they are not. Sometimes, it is not possible to say definitely that this or that place is or is not a Top or Bottom, but it is possible to set certain standards and practical working rules that will help us in making these points, and these rules will not fail us too often. A good rule for setting stop levels is to consider a Bottom has been made when the stock has moved “three days away” from the day marking the suspected low of the Bottom. If a stock reacts for some days and finally makes a low at 24, with a high for that day at 25, then we will not have an established Bottom until we have had three days in which the stock sells at no lower than 25 1/8. The entire price range for three full days must be entirely above the top price for the day making the low. This is the three- days-away rule, and it would apply in reverse in declining markets, in which the range for three days must be entirely below the entire range of the day making the high. This gives a rule for setting an original stop order. It also gives a rule for changing the stop order. As soon as the stock has moved three days away from a new Bottom, we move the stop order to a position below that Bottom. (We have already explained in Chapter 27 how we determine the distance this stop level should be below the Bottom.) Protective stops for long stocks can move only up. A stop level, once established, is never to be moved down except when the stock goes ex- dividend or ex-rights; then, the stop may be dropped the amount of the dividend or rights. Similarly, protective stops for short sales are to be moved only down and may not be raised. (In the case of ex-dividends and ex-rights, the short-sale stop would be dropped the amount of the dividend or rights.) There are certain situations in which it is difficult to determine Bottoms and Tops; where, indeed, it seems as though a Consolidation or Correction had been made without any significant move in the Secondary Direction. In such cases (as contrasted to the obvious situation in which the stock moves up or down in series of well-marked steps and reactions, like a staircase), you will need all your judgment and experience to determine the point at which the Minor Basing Points actually occur. 17 16 15 14 JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER 7 14 21 28 4 11 18 25 1'8 15 22 29 6 13 20 29 3 :10 17:24' 1 8 15 22 29 5 ’ Figure 28.1 Advance of a protective stop order in a long commitment. The daily chart of American Cable and Radio in the summer of 1945 made a Rounded Bottom, part of a long period of Consolidation following the advance that ended in July 1944. A breakout on heavy volume occurred September 12, and purchases were then possible on any Minor Reactions. 13 12 11 10 Sales 100's 250 200 150 100 50 The first protective stop would immediately be placed 6% below the previous Minor Bottom of August 21, using Table 27.1 in Chapter 27. This would put the stop level at 9 7/8. On September 19 and 20, we would have two days of market action entirely “away” from the September 17 Minor Bottom, and, on September 28, a third day. We would then move the stop up to 6% under the September 17 Bottom, or to 10 5/8. The next move would come after the new high closing of October 11, which is more than 3% higher than the October 1 Minor Peak. The stop would now be placed at 11 7/8. On November 2, a new high close was registered more than 3% over the October 15 Minor Peak; the stop would be raised to 12 3/4. On November 15, another high closing topped by more than 3% the Minor Peak made on November 7. The stop would be moved up again, this time to 13 1/2. November 29 made the third day the entire range was “three days away” from the November 26 Bottom, and the stop was upped to 13 3/4. The closing on December 5 gave us a 3% advance over the November 17 high, and again we moved the stop, raising it to 14 7/8. Finally, on January 3, 1946, this stop was caught as shown on the chart. In a Bear Market, protective stops would be moved down in exactly the same manner to protect a short sale. (EN9: A number of inconsistencies exist in this figure and caption that are clarified later in the text.) Basing Points Let us call the levels that determine where stops should be placed Basing Points. In a Bull Market Move, we will consider the Bottom of each Minor Reaction as a Basing Point, from which we will figure our stop-order level as soon as the stock has moved up to “three days away.” We will also use each Minor Top as a Basing Point in a Bull Move. In a Bear Market, we will consider the Tops of each rally and also each Minor Bottom as Basing Points for the protective stops in the same way. Where a stock makes a substantial move in the Primary Direction, say a move of 15% or more, and then moves back at least 40% of the distance covered from the previous Basing Point to the end of the Primary Move, that surely gives us a Basing Point as soon as the stock again starts off in the Primary Direction. If the stock reacts less than 40%, however, perhaps even marks time at the same level for a week or more, that should also be considered a Basing Point as soon as the move in the Primary Direction is continued (provided the volume indications are right). The daily volume, as we have seen, is like the trained nurse's clinical thermometer; it tells a great deal about what is happening in a stock, more than the superficial symptoms of price alone. There are three times at which you may look for exceptionally heavy volume: (1) on the day of breakout from a pattern or a period of inaction, especially if the breakout is on the upside; (2) on the day on which the stock goes into new ground in the Primary or Intermediate Direction, that is, goes above the last Minor Top in a Bull Market or below the last Minor Bottom in a Bear Market; and (3) on the day on which the Minor Move is completed or nearly completed, that is, the new Minor Top in a Bull Market and the Minor Bottom in a Bear Market. To this we might add that extra heavy volume on any other day during a move in the Primary Direction is likely to indicate the move is at an end and will not complete the hoped-for advance or decline. Now, after a Minor Top has occurred, the stock now being in new high ground, and the Top having been made on very heavy volume, we may look for the corrective move. Ordinarily, that would be a decline of several days, a week, sometimes longer. Occasionally, the correction, as we said a few paragraphs back, will take the form of a horizontal hesitation lasting a week or more without any particular corrective move in the downward direction. Where there is a downward correction, it is likely to come down to or near the Top of the last previous Minor High (support). Also, and often at the same time, the corrective move will carry down to the Basic Trendline drawn through two or more previous Minor Bottoms; or to the “parallel”; or to a trendline drawn through the last two or more previous Minor Tops. If the corrective move is horizontal, it is likely to run out until it meets one of these lines. In any case, the thing to watch for is the decline of volume. If the trading shrinks, perhaps irregularly, but on the whole, steadily, for some days after a new Top has been made, during which time the stock either reacts or, at any rate, makes no progress in the Primary Direction, then you are justified in considering this as a Minor Correction. If the stock now continues the Primary Move and gets to a point that is “three days away,” you can consider the Bottom (i.e., the point you draw your trendline through, not necessarily the extreme low point in the case of horizontal moves) as a new Basing Point. Where a stock is starting what appears to be a new move or a breakout from a period of vacillating moves, it is sometimes hard to say precisely what point should be considered the Bottom. There may be several small and indecisive moves on low volume preceding the real breakout. In such a case, we would consider the appearance of high volume as the breakout signal and set our Basing Point at the low point immediately preceding this signal. There usually will be such a point on one of the low-volume days in the three or four days just before the breakout. All that has been said about Basing Points in a Bull Market would also be true, in reverse, in a Bear Market, except that heavy volume does not always accompany a downside breakout. Now comes the difficult and distressing situation in which the stock, having made a long runaway move (let us assume it is an upward move), starts out to make a Flag; is bought after a sufficient correction of 40% with a decline of volume; and then continues to go down steadily, without any rallies and without any clear volume indications. This is an unusual situation, but it does happen on both the upside and the downside, from time to time. In the case we have just mentioned, we would look for Support Levels (Consolidation Patterns, Multiple Tops, and so on) formed on the way down in the previous trend and lying below the level at which we purchased the stock. We would use these supports as Basing Points rather than hold a stop under the extreme Bottom of the vertical move. In many cases of this type, you will not be able to find adequate Basing Points. Therefore, it seems unwise to try to get in on corrections after long runaway moves except in the following cases: (1) the stock has risen well above good Support that can serve as a Basing Point, or (2) the stock is completely above all prices for several years and is moving “in the clear.” (And the reverse: in Bear Markets, the stock should have fallen below a strong Resistance Area or must be in new low ground for the past several months before you consider a short sale.) In any case of this sort in which you are thinking of a trade in a stock that appears to be making a Consolidation after a fast, long, vertical move, you must have pronounced and conspicuous drying up of volume throughout the formation of the Flag or Pennant Correction. There is one more word of caution needed here regarding trading in an Intermediate Trend. A series of moves in a trend will often take place in very regular form. There may be a good trendline, and the reactions may be about 40%-50% and may come back to the previous Minor Tops. The volume on the Corrections may shrink with increasing volume on the new Tops. It is easy to start trading on such a “staircase” in the expectation the moves will continue to be regular and consistent, but trends do not go on forever. Any Minor Top may be the last. The importance of finding your Basing Points is to enable you to get out, at best, on any closing violation of one of these points, and at worst, on your protective stop order. The volume may again come to your aid in this question of when to stop trading on a trend. Although you look for high volume on the Tops, you will be exceedingly suspicious of volume that is much higher than on any of the preceding Minor Tops (or Bottoms in a Bear Market). The final, or the next- to-final, “blow-off” of a trend usually will show more volume than any of the Minor blow-offs along the way. When you see such climactic volume, you should prepare to retire into your shell and wait for a full Correction of the entire series of moves making up your Intermediate Trend. Later, weeks later, or perhaps months later, you may find the stock has corrected 40% or more of the whole Intermediate Move and is resting quietly with very little activity. Then is the time to watch it for new opportunities and a new trend in the Primary Direction. (EN9: In a book composed of nothing but important chapters, this Chapter 28 might not get the emphasis it deserves from the unwary reader. In fact, the procedure outlined here is of absolutely basic importance in analyzing and trading trends. I have added to this chapter material that has been of great importance to my trading and to the trading of my students.) Basing Points: a case analyzed The longer one thinks about the chart so casually tossed off in Figure 28.1, the more he realizes it embodies a profound and natural understanding of trends and the market. Consider—wave up, wave recedes, wave up, wave recedes, and so on. As long as the trader or investor is not chased from his position by the corrective wave, he will, under normal circumstances, ride the trend to its natural end. Nevertheless, locals and hedge funds and those who profit from volatility know the previous low is where investors and traders set their stops. So in the ordinary flow of trading, if they see an opportunity to take out an important low, they will do it—if possible. Indeed, it is sometimes possible and the low sometimes falls from the natural flow of trading. Bruce Kovner, on being interviewed by Jack Schwager (Market Wizards), was asked where he set his stops. “Where they're hard to get to,” he said. A twice told tale for its importance a stop set on a Basing Point with a prudently calculated filter is hard to get to unless the market has truly reversed direction. In fact, what is a long-term moving average but a lagging stop with a filter built in? Basing Points are merely the marking of highs and lows in full realization that a pattern of higher highs and higher lows is a Bull trend, and when that pattern changes to one of lower highs and lower lows the trend is changing or has changed. This is the principle behind Dow Theory, and it is the principle behind trading trends of lesser duration than Dow trends. Moreover, as is quickly realized, a pattern of lower highs and lower lows means inevitably the trendline has been broken. As for Figure 28.1, Mark Twain had some cogent comments on it. He said anyone trying to make sense of it would go crazy, and anyone trying to justify the prices with the chart would be shot. Figure 28.1 preserves unexplainable conundrums and conflicts carefully preserved since the earliest editions. The reader is urged to take it as a concept rather than using it as a lesson (See Figure 28.2). Let me codify the rules implicitly presented in the figure: • A high is made, being recognized by no higher prices occurring for the moment. • Prices recede and a low is made. This low is found by watching each day after the previous high until no lower prices are made. As prices begin to rise again, we note each day on which prices are completely outside the range of our low day candidate. • When three such days are observed (three days away) before a new low is made, we mark the candidate day as a Basing Point and raise our stop to 6% (or x%) under the low of the Basing Point day (see Chapter 27). • If a new high is 3% greater than the previous high, a new Basing Point is found at the low of the new high day. The Basing Points paradigm By no means will every issue be amenable to this kind of analysis. However, the method is so paradigmatic, it is worth examining at greater length. Similar to virtually every other method of classical chart analysis, it must be used with caution and good, thoughtful judgment. Sometimes some stocks will seem to work as smooth as silicon lubricant, while other issues will appear to be useless. Even on recalcitrant issues, however, the principles underlying the method will be of use, if not the actual method itself. With this in mind, Figure 28.2 is presented; the careful reader will see the chart in this example uses only bottoms or lows in stop setting and does not advance stops on the making of new highs as in Figure 28.1. This is done for instructional purposes and to keep the example simple for the general investor. More advanced traders will want to study and perhaps utilize the new high techniques in Figure 28.1. Figure 28.2 actually serves more than one instructional purpose. It illustrates a pictureperfect case of the use of Basing Points, as well as a complete analysis of a Bull Market from entry to exit with keys marking events in the life of the market. Thus, the observation of Basing Points, the setting of the stops, the tracking of potentially false turns are all noted. The chart is accompanied by the keys. Originally the marked and keyed chart was used in graduate seminars at Golden Gate University for instructional purposes. Shortly, it became obvious that marking the chart in this manner was extremely useful in trading. Thus, it is suggested to the reader as a way of making his charts more communicative and more useful. Key to Figure 28.2 analysis 1. A rounding bottom, or perhaps a scallop. 2. Resistance or breakout line. 3. Wake-up call on volume. 4. Run day, big volume. Breakout through line 2. Sure entry signal. 5. First Basing Point (BP). Notice prior volume fall-off in consolidation and surge on run day. A stop was entered before this BP using the low of the formation before the entry. 6. BP. 7. A weak BP (because of shallowness of retracement). 8. BP. 9. Test of BP at 8. 10. A trendline drawn after point 9. 11. BP. 12. BP candidate that fails the three-day-away rule. 13. BP. 14. A potential BP, but not a very good one because a new high has not been made from 13. 15. A Support-Resistance line. 16. A test of 16 BP. 17. BP. 18. A Resistance-Support line. Figure 28.2 Apple Computer, Bull Market of 1987. A near-perfect example of the use of Basing Points for trading of a reasonably regular and smooth Bull Market. Only wave-low Basing Points are illustrated. 19. Flag that becomes BP. 20. Trendline, but too steep to last. 21. Trendline. 22. BP. 23. Trendline. 24. BP. 25. BP. 26. Horizontal trendline. 27. BP at 26.75 (stop 25.41). Stopped out at 25.41. A narrative of the events in the chart 1-3. Had we been asleep, the event at number 3 should have awakened us; a volume day like this should catch our attention. We begin paying attention to the stock and note the pattern that has been developing—the rounding bottom, or scallop. 4. At number 4 we see a run day on heavy volume. A good signal for entry with the breaking of the horizontal line at number 2. When we enter, we set our stop 5% under the recent low. After entering on strength, there is every possibility that some profit-taking will occur as well as probing by locals to chase out arrivistes. 5. We watch with interest for the first reaction. Each day we observe as a candidate for a possible Basing Point. This occurs at 5, and we now begin to count “days away” from the Basing Point—days whose range is entirely outside the range of the candidate day and occur before a lower low is made. When the Basing Point at 5 is confirmed, we raise our stop to 5% under the low of 5. 6. A higher high is made after 5 with a subsequent reaction to 6, which proves to be another Basing Point. Therefore, we raise our stop to 5% under 6. 7. Prices continue to climb and another Basing Point is made at 7. The procedure is becoming clear: find a Basing Point and establish a stop a prudent distance under it. If a new Basing Point is made, raise the stop. Watch with interest the reactions against the trend. Either they allow you to establish a new higher Basing Point, or they end your trade. 8-10. We find a new Basing Point at 9, raise our stop and draw the trendline at 10. At 9 we have a lower low than 8, but our “filter,” our 5% padding, keeps our position intact. We do not lower our stops using 9 as a new Basing Point. One of the inviolable rules is stops are never lowered. The filter is important because traders try to take out nearby lows and exacerbate volatility. It is called the running of the sheep. 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high. 12. At 12 we have a candidate for a Basing Point that fails the three- day-away rule. 13. At 13 we find the Basing Point that is good and raise our stop. 14. At 14 we are confronted with a marginal situation. It is a potential Basing Point, but a marginal one because a higher high was not made after 13. 15. At 15 we are able to draw a line defining resistance—a line that will become a support line. 16. At 16 we have a new Basing Point that would have tested a point at 14. 17-21. At 17 we find a new Basing Point, and at 18, we can identify a resistance line. The spurt across this line is both gratifying and a warning because it becomes a flagpole from which the flag at 19 flies. Flags and flagpoles are messages the market has heated up and now wants close watching. A flag can serve as a Basing Point, so we move our stop again, fully aware the end may be approaching. The trendline at 20 is further confirmation of this environment because of its steepness, but we see two good anchor points in 16 and 17 and draw trendline 21—a better line to defend. 22, 23. A good reaction finally occurs at 22, giving a strong Basing Point and good rationale for raising the stop. Notice the interesting fact that points 22 and 24 have come back to rest on the trendline we drew at 10. 24. As the tempo has increased and the volatility 24 furnishes us another valid Basing Point. 25, 26. Even 25 is a valid point, and we can now see the clear support line at 26. 27. When this line is pierced at 27 upon extraordinary volume, and in the process takes out our Basing Point stop from 25, it is clearly time to exit the train. The Basing Points concept is even more thoroughly explored in the book entitled, StairStops, which is available on the John Magee Technical Analysis website at http://www.edwards-magee.com and on http://www.amazon.com, including Kindle edition. The complete Basing Points Procedure: taking into consideration the setting of Basing Points on both wave lows and new highs As previously discussed by Magee, the Basing Points Procedure may set Basing Points on both wave lows and on new highs. We find the wave-low Basing Point by the three-days-away rule; we find the new high Basing Point, by marking wave highs and subsequent new highs so when price exceeds by 3% the old wave high, or recent high, whether or not an intervening wave low has occurred, we may set the new Basing Point at the low of the new high day. If a new high were made subsequent to this new high, we would reset the Basing Point again if we were using this variant of the procedure, which I call Variant 2. Once again, the one-armed economist rules. On the one hand, raising the stops like this on new highs may easily result in being ejected from the position by a price dip; then you watch the train leaving the station on the way to incredible new highs amid much teeth gnashing and irritation. (Incidentally, if emotional distress occurs in this or other like situations it is a message to you are too emotionally attached to the market. Complete market maturity is not achieved until such situations can be viewed with relative equanimity so the event is viewed with detached interest and a plan to set things right.) On the other hand, after having accumulated large paper profits, the issue collapses and snatches back from you a third (or more) of your hard-earned profits. (If you had only advanced stops based on new highs!) Remember, the problem with Dow Theory (and trend following) is you give up the first third of the move and the last third of the move and sometimes there is not a middle third, as conventional market wisdom has it. What essentially occurs when using Variant 2 of the procedure is as follows: when blow-off or runaway conditions occur, the procedure changes from selling weakness to selling strength. I believe very strongly in the variation of tactics, generally. Also, I am intimately familiar with the pitfalls of varying tactics, but I like the procedure in general and also think knowing when to use it and when not to use it can require a great deal of experience and emotional coolness in potentially high-stress conditions. If the entire (Variant 2) procedure is executed and also combined with a scale-in/scale- out plan, the user may succeed in shooting the moon. The phlegmatic Marc Antony (who sleeps well of night and is sleek and well fed) follows the conservative wave-low method (Variant 1) and probably wins in the long run. The Variant 1 procedure is simpler and naturally expands to accommodate the high-volatility market that ejects the trader attempting to escape the inevitable collapse before going on to new completely unexpected heights. As it goes, damned if you do, damned if you don't, unless you are charmed or kissed by the market fairy—or lucky. The complete Basing Points procedure 1. A wave high is made, recognized by no higher prices coming for the moment. If this high is 3% (Magee's number, but could be a parameter) higher than the previous wave high (or the recent high in a run or blow off), the Basing Point is raised to the low of the new high day. Obviously, this comes into effect for the next trading day. 2. Prices recede and a low is made. This low is found by watching each day after the previous high until no lower prices are made (a potential wave low or Basing Points candidate). As prices begin to rise again, we note each day on which prices are completely out of the range of (away from) our low-day candidate, or a “day away.” 3. When three such days are observed (the three-days-away rule) before a new low is made, we mark the candidate day as a Basing Point and raise our stop to 6% (or x% as this is a parameter) under the low of the Basing Point day. Obviously, the new stop is established the day after the three days away have occurred. 4. If a new high is made without an intervening wave low Basing Point, the process starts over from the new high. 5. If the new high is 3% (or x%) higher than the previous high (whether made from a wave low or wave high), or from surging prices continually making new highs, a new Basing Point is found at the low of the new high day. Thus, a price move that went from 10 to 10.3 to 10.61 to 10.93 would create new Basing Points at the low of each new high day. 11 14 13.5 13 12.5 12 11.5 Figure 28.3 Basing Points candlestick version. This chart is a candlestick version of Figure 28.2. It illustrates the complete procedure, showing establishment of Basing Points made by wave lows and by higher highs. This is a blow up of the period in the chart during which higher high conditions exist. As might be obvious, the higher high rules begin to come into play late in the life of a trend, in the runaway and blow-off stages. 10.5 10 Figure 28.4 Apple Variant 2 of the Basing Points Procedure. This chart shows the trend from beginning to end as in Figure 28.2, with the addition of dotted lines to show where stops fell when computed from higher highs. The previous candlestick chart is used for the close-up analysis. This chart puts into broad perspective the relative level of stops using the Variant 2 method. As can be seen, setting stops from new higher highs results in stops closer to the market prices. This can be good or bad, depending on what the market does to you. Two charts giving a long-view perspective on the complete (Variant 2) procedure There is another method Magee advocated for surging and blow-off markets. He called this alternative method “progressive stops,” which is explained in the ninth edition. Strictly speaking, although there is a variation in tactics involved in using new highs for stop calculation, this method is a twist on selling on strength. Variant 2 is still lagging stops behind prices. A pure strength selling method would attempt to time exit on a blow-off day, or a key reversal day or a one-day reversal, or even on a strong long running day up. This is perhaps a little easier to visualize on the downside. A panic selling day (which tends to finish at the lows) would provoke an exit on the close. The representative case fully analyzed using wave lows and new highs The case will not be unfamiliar to readers, and its use will fully highlight the differences found in the procedure. The same materials will be used, and the differences will be boldfaced in the text. 1. A rounding bottom, or perhaps a scallop. 2. Resistance or breakout line. 3. Wake-up call on volume. 4. Run day, big volume; breakout through line 2; sure entry signal. 5. First Basing Point (BP). Notice prior volume fall-off in consolidation, and surge on run day. 6. BP. 7. A weak BP (because of shallow retracement). 8. BP. 9. Test of BP at 8. 10. A trendline drawn after point 9. 11. BP. 12. BP candidate that fails the three-day-away rule. 13. BP. 14. A potential BP but not a very good one because new high has not been made from 13. 15. A Support-Resistance line. 16. BP. 16A. New High: 10.35. 17. BP. 17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13); Stop 9.30. 17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49); Stop 10.49. 17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96); Stop 10.55. 18. A Resistance-Support line. 19. Flag that becomes BP. High 11.62. 19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19. 20. Trendline, but too steep to last. 21. Trendline. 22. BP. 23. Trendline. 24. BP. 24A. New Higher High 12.93; Low BP 12.43 (+3% 13.34); Stop 11.68. 24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29. 25. BP. 25A. New Higher High 13.82; Low BP 13.36 (+3% 14.23); Stop 12.56. 25B. Stopped out at 12.56. 26. Horizontal trendline. 27. BP at 25 (stop 11.80); Stopped out at 11.80. A narrative of the events in the chart 1-3. Had we been asleep, the event at number 3 should have awakened us; a volume day like this (Cf. chart 28.2) should catch the attention. We begin paying attention to the stock and note the pattern that has been developing —the rounding bottom, or scallop. 4. At number 4 we see a run day on heavy volume. A good signal for entry with the breaking of the horizontal line at 2. When we enter, we set our stop 6% under the recent low. After entering on strength, there is every possibility that some profittaking will occur as well as probing by locals to chase out arrivistes. 5. We watch with interest for the first reaction. Each day we observe as a candidate for a possible Basing Point. This occurs at 5 and we now begin to count “days away” from the Basing Point, that is, days whose range is entirely outside the range of the candidate day, and that occur before a lower low is made. When the Basing Point at 5 is confirmed, we raise our stop to 6% under 5. 6. A higher high is made after 5 with a subsequent reaction to 6, which proves to be another Basing Point, so we raise our stop to 6% under 6. 7. Prices continue to climb and another Basing Point is made at 7. The procedure is becoming clear: find a Basing Point and establish a stop a prudent distance under it. If a new Basing Point is made, raise the stop. Watch with interest the reactions against the trend. Either they allow you to establish a new higher Basing Point, or they end your trade. 8-10. We find a new Basing Point at 8, raise our stop, and draw the trendline at 10. At 9 we have a lower low than 8, but our “filter,” our 6% padding, keeps our position intact. We do not lower our stops using 9 as a new Basing Point. One of the inviolable rules is that stops are never lowered. The filter is important, because traders try to take out nearby lows and exacerbate volatility. It is called the running of the lambs. 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high. 12. At 12 we have a candidate for a Basing Point that fails the three- day-away rule. 13. At 13 we find the Basing Point that is good and raise our stop. 14. At 14 we are confronted with a marginal situation. It is potential Basing Point, but a marginal one because a higher high was not made after 13. 15. At 15 we are able to draw a line defining resistance—a line that will become a support line. 16. At 16 we get a Basing Point. 16A. New High: 10.35 (a benchmark). 17. At 17 we find a new Basing Point and at 18 we can identify a resistance line. The spurt across this line is both gratifying and a warning because it becomes a flagpole from which the flag at 19 flies. Flags and flagpoles are messages that the market has heated up and now wants close watching. A flag can serve as a Basing Point, so we move our stop again, fully aware the end may be approaching. The trendline at 20 is further confirmation of this environment due to its steepness. However, we see two good trendline anchor points in 16 and 17 and draw trendline 21—a better line to defend. 17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13). 17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49). 17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96). 18. Support-resistance line. 19. Flag that becomes BP. High 11.62. 19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19. 22-24. A good reaction finally occurs at 22 giving a strong Basing Point and good rationale for raising the stop. Notice the interesting fact that points 22 and 24 have come back to rest on the trendline we drew at 10. As the tempo has increased, and the volatility, 24 furnishes us another valid Basing Point. 24A. New Higher High 12.93; Low BP 12.43 (+3% 13.34); Stop 11.68. 24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29. 25. Even 25 is a valid point and we can now see the clear support line at 26. 25A. New Higher High 13.82; Low BP 13.36 (+3% 14.23); Stop 12.56. 25B. Stopped out at 12.56. 26. Support-resistance line. 27. When this line is pierced at 27 upon extraordinary volume, and in the process takes out our Basing Point stop from 25, it is clearly time to exit the train. chapter twenty-nine Trendlines in action From what has already been said in Section I of this book, you will be familiar with the characteristic single-line trends of stocks and the numerous exceptions and deviations that come into the picture from time to time. We know stocks often move in parallel trends, sometimes for months, occasionally even for years. We also know they may, and do, break out of trend or change the direction of their trends without notice. Most of the pattern formations we have studied can be considered as manifestations of trend action, or Continuations or Reversals of a trend. Thus, a Symmetrical Triangle is simply the meeting of two trends. During the formation of the Triangle, the stock is following both trends in a narrowing pattern until, finally, the dominant trend asserts itself. An Ascending Triangle is following an upward trend but has encountered a Resistance Level at the Top. A Head-and-Shoulders Formation shows the end of an upward trend and the beginning of a downward trend. A Rectangle is a Parallel Trend Channel running in a horizontal direction, and so on. We can project a Parallel Trend and, in the case of stocks continuing to move in that trend, we can buy and sell at almost the precise points of contact with the trendline. Unfortunately, long and perfect straight-line trends of this sort are the exception rather than the rule. For actual trading purposes, we will project our trends more or less continuously on the basis of the most recently established data. From the standpoint of tactics, let us consider the trends as they are indicated by the successive Minor Tops and Minor Bottoms. For illustration of this, and as a guide to what we are leading up to, we will consider simplified, ideal situations (see the examples in Diagrams 29.1 through 29.6). To avoid confusion, mark the top trendline in blue pencil and the bottom trendline in red pencil. We will refer to the upper trendline as the Blue Trend, and the lower trendline as the Red Trend. From time to time, we will also want to draw a line parallel to a Blue Trend across the Bottom of the trend so as to include a segment of the Trend Channel between two Tops within parallel lines. This we will call the Blue Parallel, and we will mark it with a dotted or broken blue line. Conversely, we may wish to draw a parallel to the Red Trend so as to include the segment of the Trend Channel between two Bottoms, and this dotted red line we will call the Red Parallel. Ordinarily, a Top (wave high) will be formed after a Bottom (wave low) and a Bottom after a Top; thus, we will expect to draw, alternately, a Blue Trendline and a Red Trendline with these lines being drawn as soon as the new Top or Bottom is established. (In some cases, a light pencil line may be drawn to indicate suspected Tops or Bottoms, until developments confirm their validity.) We have already taken up the important and rather difficult question of determining the Minor Tops and Bottoms. Very often, these points will be clear and obvious. Sometimes they will be obscure, and you will be able to draw trendlines with confidence, in such cases, only after considerable experience covering many types of actions. The most difficult times to determine Minor Trends are during Reversals, especially in cases in which these are of Diagram 29.1 Here is a rising trend showing the Basic Trendline across two Bottoms, which we call the Red Trendline, and its parallel (indicated by a broken line) through the Top of the intervening peak. The parallel suggests the approximate objective of the next move if the stock continues in trend. Diagram 29.2 The same rising trend with the Return Line, which we call the Blue Trendline, drawn through two Tops. The broken line represents its parallel through the intervening Bottom. This Blue Parallel is useful in determining a buying point, especially in trends of rapidly changing form when the stock may not react to its Basic Trendline. Diagram 29.3 This is a declining trend showing the Basic Trendline across two Tops, which we call the Blue Trendline, and its parallel (indicated by a broken line) through the Bottom of the intervening decline. The parallel suggests the approximate objective of the next move if the stock continues in trend. the rounded and irregular types. In these cases (of Reversal), however, we will not depend much on the trendlines to determine buying and selling points. As long as a stock persists in a Parallel Trend Channel, it is perfectly clear to buy near the Bottom of the channel and sell near the Top. From the geometry of the situation (see examples), you will see at a glance it is not likely to be profitable to sell short in an Diagram 29.4 The same declining trend with the Return Line, which we call the Red Trendline, drawn through two Bottoms. The broken line represents its parallel through the intervening Top. This Red Parallel is useful in determining a point at which to make short sales, especially in trends of rapidly changing form when the stock may not rally to its Basic Trendline. Diagram 29.5 Simplified diagram of a stock chart showing trend action. Basic Trendlines are marked with heavy lines; Return Lines are marked lightly. upward-moving trend (because the reactions are necessarily smaller than the advances), or to buy stock in a downward-moving trend. Therefore, a trend must show it is presumably an uptrend before you are justified in buying stock. Plus, you must have what is presumably a downtrend to justify a short sale. You will notice from the simplified examples shown here that pattern formations indicate trends. The breaking of a Rectangle on the upside results in an upward slope of the Blue Trend. The move up out of an Ascending Triangle confirms the rising Red Trend and creates a rising Blue Trend. The downside breaking of a Head-and-Shoulders neckline confirms a descending Blue Trend and sets up a descending Red Trend, and so on. From studies of these patterns and various trend actions, we arrive at a compact set of trading rules based on these Red and Blue trendlines. These rules are summarized below. Buying stock, “going long” • Preparatory buying signals (indicating a buying opportunity may be in the making). Penetration of Blue Trend to a new high closing (in most cases). The simple breaking of a descending Blue Trendline, in cases in which no other pattern or indication is present, is not sufficiently conclusive evidence of Reversal to justify commitments. b g h Diagram 29.6 Preparatory buying signals shown by trend action. a. Penetration of an ascending Blue Trendline. b. Penetration of a horizontal Blue Trendline. c. The penetration of a descending Blue Trendline without other technical indications is not conclusive evidence of a change in trend and does not justify long commitments. d. Contact with the Blue Trendline of an Ascending Parallel Trend Pattern. e. Contact with the Blue Trendline of an Ascending Divergent Trend Pattern. f. In this case, contact with the Blue Trendline does not suggest a buy on the next reaction, because the trend appears to be converging; a possible Wedge in the making, with Bearish implications. g. Contact with the Blue Trendline of a Rectangle at its fifth point of Reversal. h. Contact with the Blue Trendline of an Ascending Triangle. i. Penetration on volume of descending Blue Trendline when Red Trendline is ascending (Symmetrical Triangle). • Contact with the ascending Blue Trend if the Red Trend is also ascending, provided the trends do not converge (Parallel or Divergent Trend Channel). • Contact with the horizontal Blue Trend if the Red Trend is also horizontal or ascending (Rectangle, Ascending Triangle). • Penetration of the descending Blue Trend on volume if the Red Trend is ascending (Symmetrical Triangle). • Execution of buys (after preparatory buying signal). • In case the previous Blue Trend has been ascending, draw the Blue Parallel and buy at or near this line. Diagram 29.6 (Continued) Preparatory signals for short sales shown by trend action. j. Penetration of a descending Red Trendline. k. Penetration of a horizontal Red Trendline. l. The penetration of an ascending Red Trendline without other technical indications is not conclusive evidence of a change in trend and does not justify short commitments. m. Line of a Descending Parallel Trend Channel. n. Contact with the Red Trendline of a Descending Divergent Trend Pattern. o. In this case, contact with the Red Trendline does not suggest a short sale on the next rally, because the trend appears to be converging; a possible Wedge in the making, with Bullish implications. p. Contact with the Red Trendline of a Rectangle at its fifth point of Reversal. q. Contact with the Red Trendline of a Descending Triangle. r. Penetration of ascending Red Trendline (with or without volume) when Blue Trendline is descending (Symmetrical Triangle). In descending trends, the Red Trendline is a return Line, and short sales will be made on rallies to a line parallel to the new Red Trendline established at the Bottom of the signal move and drawn through the intervening peak. Note in the case of decisive breakouts from patterns such as Rectangles and Triangles, a short sale might also be made on the basis of a computed 40%-50% correction of the breakout move, or on a return to Resistance. • In case the previous Blue Trend has been horizontal or descending (that is to say, emerging from Rectangles, Triangles, and various Reversal Patterns), buy on a reaction of 40%-45% of the distance from the last previous Minor Bottom to the extreme Top of the most recent move. Liquidating, or selling a long position Immediately on execution of the buy order, determine the stop level (see Chapter 27, Stop Orders) and place your protective stop. Penetration of this stop level will automatically close out your transaction. The stop level may be moved up according to the “three-days-away” rule but may never be moved down (except to adjust for ex-dividend or ex-rights). If the stock closes below a previous Minor Bottom (thus setting up a descending Red Trend), sell on tight (EN: or hair-trigger) progressive stops. At the start, the stock declines in a Parallel Trend Channel. The Blue Trendline is basic here. A short sale on a rally to the Red Parallel at point A will find its objective on the Blue Parallel at B. Another short sale on the Red Parallel at C would be followed by failure to reach the objective. Chances are good, however, that increased volume would develop at the Double Bottom and give warning to get out of short commitments. The upside penetration of the basic Blue Trendline at E, alone, is not sufficient reason to reverse position and go long. Trendlines set up during formation of the Rectangle would be marked in the regular way, but they are indicated here by broken lines to emphasize the pattern. Another short sale, if tried on the sixth point of contact with the Rectangle at F, would be stopped out on the breakout. The trend is now rising, although we cannot yet draw a Basic (Red) Trendline. The first buy would be made on a 40%-50% correction of the breakout move from the Rectangle, or on a return to the Top (Support) level at H. A trendline would be drawn to the first Bottom established in the Triangle. This is not shown, as it would ultimately be replaced by the line shown through the outermost point in the Triangle. We have indicated by broken lines the trendlines set up during the formation of the pattern. The objective of the breakout move from the Triangle would be the Red Parallel to our now rising Basic Trendline; this objective is reached at J. A Return Line (Blue) would be drawn from the first Reversal Top of the Triangle at G through the Top of the breakout move at J, and the parallel to this through point I would indicate about where to make the next purchase. As a matter of fact, the stock does not actually get back to that point; in practice, the purchase would probably be made at K on the basis of a 40%-50% correction, or on a reaction to the Support Level G. The subsequent upward move would not carry through to the Red Parallel marked W; however, the alarm would probably be sounded clearly by a day of heavy volume, a One-Day Reversal, or a gap. Since the trend is now obviously convergent, no further purchases would be considered. The next move fails to make such headway and falls far short of the objective set by the Red Parallel marked Y. Soon after, the Wedge breaks out downside. If the stock advances on moderate volume and then develops unusually high volume on any day during the advance before either the Blue Trend is broken (with a close above that trendline) or before the stock has made a new high closing over the last Minor Top, close out the transaction on tight progressive stops. If the stock develops high volume on the day on which it either tops and closes above the Blue Trend or makes a new high closing over the previous Minor Top, hold it. If heavy volume again occurs on the following day or any subsequent day, however, sell on tight progressive stops. In rising trends, the Blue Trendline is a Return Line, and purchases will be made on reactions to a line parallel to the new Blue Trendline established at the Top of the signal move and drawn through the intervening Bottom. Note in the case of decisive breakouts from patterns such as Rectangles and Triangles, a purchase may also be made on the basis of a computed 40%-50% correction of the breakout move, or on a return to Support. You will find in many cases the heavy volume signal will develop (sometimes with also a One-Day Reversal or an Exhaustion Gap) on or near the Red Parallel; watch especially for this volume indication as a sign of a good profit-taking point. If the volume signal does not show up, your selling objective is this Red Parallel, at a limit or on tight progressive stops. In case there is no such volume signal at the top of the move and the move does not reach the Blue Trend or make a new high, you are very likely running into a Triangle situation. In that case, you will have to wait for a breakout one way or another. Meanwhile, maintain your stop protection underneath. Selling stock short • Preparatory selling signals (indicating an opportunity for short sales may be in the making). • Penetration of Red Trend to a new low closing (in most cases). The simple breaking of an ascending Red Trendline where no other pattern or indication is present is not sufficiently conclusive evidence of Reversal to justify commitments. • Contact with descending Red Trend if Blue Trend is also descending, provided the trends do not converge (Parallel or Divergent Trend Channel). • Contact with horizontal Red Trend if Blue Trend is also horizontal or descending (Rectangle, Descending Triangle). • Penetration of ascending Red Trend (with or without volume increase) if Blue Trend is descending (Symmetrical Triangle). • Execution of short sales (after preparatory selling signal). • In case the previous Red Trend has been descending, draw the Red Parallel and sell at or near this line. • In case the previous Red Trend has been horizontal or ascending (that is to say, emerging from Rectangles, Triangles, and various Reversal Patterns), sell on a rally of 40%-45% of the distance from the last previous Minor Top to the extreme Bottom of the most recent move. Covering short sales Immediately on execution of the short sale, determine the stop level (see Chapter 27, Stop Orders) and place your protective stop. Penetration of this stop level will automatically close out your transaction. The stop level may be moved down according to the three-days-away rule, but it may never be moved up. If the stock closes above a previous Minor Top (thus setting up an ascending Blue Trend), buy to cover on tight progressive stops. If the stock declines on moderate volume and then develops unusually high volume on any day during the decline before either the Red Trend is broken (with a close below that trendline), or before the stock has made a new low closing under the last Minor Bottom, close out the transaction on tight progressive stops. If the stock develops high volume on the day on which it either breaks and closes below the Red Trend or makes a new low closing under the previous Minor Bottom, hold it short. If heavy volume again occurs on the following day or any subsequent day, however, buy to cover on tight progressive stops. You will find in many cases the heavy volume signal will develop (sometimes with also a One-Day Reversal or an Exhaustion Gap) on or near the Blue Parallel; watch especially for this volume indication as a sign of a good profit-taking point. If the volume signal does not show up, your buying objective is the Blue Parallel, at a limit or on tight progressive stops. In case there is no such volume signal at the bottom of the move and the move does not reach the Red Trend or make a new low, you are very likely running into a Triangle situation. In that case, you will have to wait for a breakout one way or another, meanwhile maintaining your stop protection overhead. Additional suggestions When a level is reached that appears to be either a Minor Bottom on a reaction or a Minor Top on a rally, and when the stock continues to stall and remain at this point, moving in a very narrow range for three weeks or more without giving any signal either by way of price change or volume action as to its next move, it is wise to assume this congestion is definitely a key area and should be considered a Minor Top or Bottom; protective stops should be adjusted to it as a Basing Point, instead of the previously established Top or Bottom, as against the possibility that the move out of this area, when it comes, may be in the wrong direction. After a series of moves in a trend, with each move in the Primary Direction marked by heavier volume than the retreats or Corrective Moves against the trend, you are likely to have a move in the Primary Direction, which is marked by extraordinary volume (much larger volume than the normal increase for a Primary Move). On such a move, after taking your profits on previous commitments, you would ordinarily begin to plan the next commitment on the Correction. In this particular case, noting the extreme volume, you would cancel any immediate plans for further commitments in the Primary Direction. The reason for this is such climactic volume normally indicates the final “blow-off” of the Intermediate Trend, to be followed either by a Reversal, or at least by a period of stagnation, or by formation of Consolidation Patterns, or by Intermediate Correction. In such a case, it is not safe to make any further commitments on this trend pending further developments and the positive reassertion of the trend. If you examine daily charts of various stocks, covering long and important trends, you will find the series of Minor Moves making up the Intermediate Trend is likely to culminate in a Minor Move marked by tremendous volume. This is truer of Tops than Bottoms, although at the end of the Panic Phase of a Bear Market, we very often see climactic volume. The climax indicates, on the other hand, the sale of large amounts of stock by strong investors to weak traders, near the top; on the other hand, the liquidation of holdings by weak traders occurs near the bottom, into the hands of strong investors who will hold them for the next Major Move. One of the most common errors, and easiest to fall into, is to mistake a Climactic Top or Bottom for a normal confirmation or preparatory signal for a new commitment in line with the preceding trend. It is similar in nature to the error often made by novices in the market of buying on the Minor Tops (becoming dazzled with the rapid price advance and the great volume of activity). However, in the case of these final “blow- off” moves, the volume is greater and the adverse portent far more serious. General outline of policy for trading in the Major Trend A. Always trade in the direction of the Major or Primary Dow Trend (EN: see the editor's comments in Chapter 3) as it is indicated at the time. B. If the two component Averages of the Dow Theory (Industrials and Rails; EN9: Transportations) are not in agreement, trade in the direction of the last established Primary Trend but only in the component that is still following that trend. C. Examine charts of group Averages covering groups of businesses in the same or related lines; trade in the Primary Direction when the trend of the group corresponds. D. Trade in any particular stock when its own individual chart indicates a trend in the same direction as the Primary Trend, and when the technical picture has indicated a probable move in that direction. Make all new commitments on the reactions or rallies following the signaling move in the Primary direction, except in the case of Primary Reversals from Bull Market to Bear Market, when short sales may be made at the market immediately following the Reversal. Exception: after an extended move or a series of moves in the Primary Direction, when signs of exhaustion and Reversal appear in individual charts, commitments in the opposite direction may be made with objectives limited to a correction of the preceding Intermediate Move in the Primary Direction. (EN9: Now the reader's head is spinning and the color blind are completely confused. As this book is unfortunately printed in black and white, the reader without colored pencils will be at sea. This is what I recommend: take out your colored pencils and color the lines yourself. The principles articulated here by Magee are of great value to a trader and are worth studying.) Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter thirty Use of Support and Resistance We know that after many breakouts from well-defined Reversal and Consolidation Patterns, we get ashort countermove back to the edge of the pattern and the checking of this move at that point is anexample of Support or Resistance, as the case may be. Also, we should be familiar by now with thetendency of stocks to move up or down in a series of zigzag steps (EN10: i.e., waves and wavelets). If themove is upward, the reaction after each advance tends to stop at the level of the preceding peak. If themove is downward, the rally after each decline tends to stop at the level of the preceding bottom. This isagain a matter of Support and Resistance and provides the basis for buying on reactions or selling onrallies. It has also been pointed out Intermediate Secondary Moves will frequently stop at or close to theprevious Intermediate Top or Bottom. It is necessary to evaluate the importance of these phenomena of Support and Resistance and apply themin market practice, for they are among the most important tools we have. Unfortunately, it is not easy toreduce this particular subject to a neat formula or body of rules. (EN9: And the effort will be made. Seeendnote of this chapter for an interesting effort to do just that.) Here you will depend very largely onexperience and observation. You will have to be alert in spotting the levels at which Resistance or Supportis likely to be encountered, and some judgment is needed in balancing the various factors that will affectthe situation. For example, there is a stock that has broken up out of a well-defined Rectangle of considerable duration.Should the heavy volume of the breakout move give way to a dull reaction, you will look for anopportunity to buy this stock at a point a little above the top level of the Rectangle. It will probably notpenetrate very far below that level and, indeed, will often fail to react all the way to the Support. If thestock should then advance to a new high, and once more decline on low volume, you may look foranother buying point at about the level of the peak reached on the original breakout. Another advancemay be followed by reaction to the second peak, and this process may be repeated a number of times,each reaction carrying back to the level of the preceding high. Now we all know this sort of thing does not continue indefinitely. When the stock first breaks out,moving from, say, 15 to 19, we may buy rather confidently on the reaction to 17, if that is the SupportLevel. If we did not buy on this move, we may buy with considerable assurance on the reaction toSupport after the next advance. This advance might have carried the price to 21 and our buying pointwould be at the previous peak of 19. As the stock moves up to 25, 30, 40, it must be clear we areapproaching a real Top; although we cannot say where that Top will be reached, we can be sure it isbecoming increasingly tempting to long-time holders of this stock to sell and take their substantial gains.The series of steps is bound to come to an end. To be sure, the Major course of the stock and of themarket may continue up for months or years, but after a series of sharp rises, we may reasonably expect aReversal and a rather substantial Intermediate Decline before the upward move is continued. Therefore, we must regard each successive step of advance with increasing suspicion; after a stock hasmade three such moves in the Primary Direction, it is time to look for an Intermediate Correction or atleast for an important period of Consolidation. Thus, we have the rough shape of a rule. Buy on thereaction to Support after the first breakout; buy on the reaction to the first Minor Peak after the nextmove, but do not buy on the reaction to the second Minor Peak. Let us say, then, we have been successful in two short-term moves, buying on the reaction to Support andselling on the climax after a new Top has been made. Nevertheless, we have decided not to attempt a thirdsuch trade. What, then, may we expect next? We may see a period of Consolidation, we may see thebeginning of an Intermediate Decline, or we may see the stock actually go right on moving up. No matter—we will wait for the Intermediate Reaction. We will wait until the stock makes a very substantial decline, and this may take many weeks. Then, if the Major Trend has not reversed itself, we will againlook for a buying opportunity at (or somewhat above) the Intermediate Support, which will usually be thetop level of the advance preceding the one just completed, for this is the level from which the nextPrimary Advance is likely to proceed and is a good buying point. We find the same situation in Bear Markets. A breakout is likely to be followed by one, two, three, ormore steps of decline, with intervening rallies to Minor Resistance. Sooner or later (and we would counton no more than three such steps in a series), we will get a turn and an Intermediate Recovery. We willthen wait for this rally, which may itself be made up of several Minor steps, to reach or approach closelythe preceding Intermediate Bottom, at which point we may look for substantial Resistance. Here is theplace again to put out shorts. Questions will come to your mind. One of them, and one of the most important: how do we decide whenan expected Support or Resistance has failed us, and at what point do we then abandon our position? It will be clear this question can be a very painful one. Let us suppose you have seen a stock rise to 25and have placed an order to buy it at 23 1/2 on the basis of expected Support at 23, the level of a previousMinor Peak. The order is executed during a dull reaction. The next day, the stock slips down to 22 1/2, onperhaps only two or three sales. The next day, it continues down to 21 1/2, still on low volume. Plus,during the next week, it goes down steadily, without much volume, nearly every sale being at a lowerprice, as though no new bids were being received, and as though no substantial number of bids werestanding on the book at any point. A decline of this sort can eventually assume the magnitude of anIntermediate Reaction. The move may carry down to 15 before it turns. Obviously, this was not what youexpected, and you should be out of the stock. The painful part of these drifting moves is you do not want to sell your stock (which you bought at 231/2) on just a slight move down, say to 22 3/4, because the probability is strong it will shoot up at anymoment to new high levels. Yet, at some point during a continued decline, you must decide, “This hasgone through the Support; I should sell and take a small loss now, rather than risk a more serious loss.”The most painful part of all is, sometimes, the moment you have sold and taken your loss, the stock willcome to life and complete what would have been an extremely profitable move. You might just as well prepare yourself for this sort of disappointment, for it will happen to you. To avoidnights of pacing the floor and days of worry, you should decide, at the time you make the originalcommitment, just how much leeway you are prepared to give the stock. Then you will not be tempted toput off a decision from day to day if things are not going the way you hoped. In the case of purchases or short sales made against Minor Peaks or Bottoms, as the case may be, youmight set up the following rule. Measuring from the extreme high of the previous (Supporting) MinorTop, or the extreme low of the previous (resisting) Minor Bottom, set a stop using the method we haveoutlined in Chapter 27. (EN9: See also Chapter 28 and consider the risk limitation procedures in Chapter42.) This often would be the intraday high or low, not necessarily the closing price. Penetration to thatextent should be presumptive evidence that your expected Support or Resistance is not going to function. Where you are buying against Major or Intermediate Support, or selling short against Major orIntermediate Resistance, you can allow a little more leeway for penetration. In such cases, examine theSupport or Resistance Area, and estimate visually its core or axis; in other words, try to gauge the “centerof gravity” of this area, the point is most nearly the mean price of sales occurring there, taking intoaccount the volume, because the important thing is to determine the approximate price level at which agreat many shares changed hands. Having determined this point, set your stop beyond it, according to themethods specified in Chapter 27. Up to this point we have concerned ourselves (reversing the usual order) with how to get out of situationsthat have gone bad. We have said nothing about where, precisely, to get in, nor where, precisely, to takeprofits. In the matter of getting in, that is, making the original commitment, you might feel there is a conflictbetween acting on Support or Resistance and acting on either trendline action or a computed reaction of40% to 50% after a previous move. At times, these conflicts might arise and it is not possible to state anyexact rule that will reconcile these three different trading indications. In a great number of cases,however, you will be delighted to observe a reaction of about 45% will bring your stock to the trendlineand will also bring it near to the Support or Resistance Level. After a move to a new Minor Top, a stockmay be expected to react (1) about 40% to 50% of that move, (2) to the Basic Trendline, and (3) to theprevious supporting Minor Top. Your purchase, then, will be based on a consideration of all three factors.If you have bought “early,” on the basis of one factor alone, you may expect the stock to react a bitfurther without spoiling the triple indications to the extent of catching your stop. It would be best to makeyour purchases on the basis of whichever factor indicates the smallest reaction and to place your stopbeyond the greatest reaction indicated by any of the three. Ordinarily, there will not be too muchdifference between these three factors. As usual, the method applies in reverse to short sales. In cases in which you are buying after an Intermediate Decline or selling after an Intermediate Rally, youwill lean somewhat more heavily on Support and Resistance than on either a computed percentage for theSecondary Move or a trendline. You will examine the history of the stock, preferably on weekly ormonthly charts first, to see its Major Trend, to locate important Support or Resistance Areas, and toestimate roughly the extent of the Corrective Move, the termination of which you are trying to gauge. Youwill then check these data in the more detailed picture you can get from your daily charts. As theIntermediate Corrective Move approaches within 4% or 5% of the Support or Resistance Level, you maycome to a day of extremely heavy volume, and this day may also be a One-Day Reversal. If so, yourcommitment should be made at once and protected by a stop. Otherwise, you may make yourcommitment whenever the chart begins to hesitate or flatten out, or, lacking other indications, when it hascome to within 3% of the Support or Resistance. In this case, your problem in taking profits is a bit more difficult than in the case of Minor Moves. Youare expecting a Reversal of the Intermediate Corrective Move and the establishment of a newIntermediate Trend in the Primary Direction. You are at a point at which the course of the market isuncertain. You must realize prices may stay at the Support (or Resistance) Level, forming a Line orRectangle, and finally penetrate that level, establishing Reversal of the Major Trend. However, they maybe stopped and turned at the Support or Resistance Level, only to make a small move away and thenreturn for another, and possibly successful, attempt at penetration. Then again (and this is what you hope),a continuation of the Major Trend may develop with a sharp move on increased volume in the favorabledirection, to be followed by a Minor Corrective Move and another thrust in the Primary direction—perhaps a new series of Minor Moves carrying the entire Primary Trend into new ground. Taking these cases one by one, if the stock remains at the Support or Resistance Level for many days orseveral weeks and then penetrates that level, closing at a price that is clearly through it, get out at once. Ifthe stock makes a small move in the right direction and returns to the Support or Resistance, prepare toget out if there is a definite penetration. If, however, the move is in the right direction, watch for volumeindications, and prepare to set tight stops to take your profits as soon as heavy volume appears (except ona day of breakout). Once such a signal has appeared, you are then justified in continuing to make newcommitments on the following Minor Correction, and the one following that, for you are again moving inthe Major Trend. One other situation should be mentioned; up to this point, we have assumed all of your commitmentshave been made to take advantage of a move in the direction of the Major Trend. Let us suppose a move that has carried a stock up to new high levels in a series of Minor steps proceeds to form and then breaksout of a Reversal Pattern. We must now look for a Secondary Move of Intermediate extent. We may sellshort on the rally to the Minor Resistance, and, if the move continues down, we may make a second andeven (more cautiously) a third commitment against successive Minor Bottoms. In this case, we will belooking for the decline to end somewhere in the vicinity of the last previous Intermediate Top, which isnow a Support Level. Similarly, following a recognized Reversal Pattern and upward breakout on volumeduring a Bear Market, we may expect an Intermediate Rally that can be used for trading up to theprevious Intermediate Bottom where strong Resistance is likely to show up. A skillful trader can turnthese Secondary Moves into profits during periods when it is not possible to trade along the indicatedPrimary Trend; however, it should be remembered, ordinarily, such moves cannot be expected to go as faras will those in the Primary Direction. We might close this chapter by reminding you again that, although Support and Resistance action in theMinor Trend is shown clearly in daily charts, the Intermediate and Major Supports and Resistances aremost easily recognized on weekly or monthly charts. (EN9: It seems to this editor that Magee's discussion here of the use of Support and Resistance is reallymost pertinent to position building and pyramiding. Alternatively, the method applies to an issue that hasjust caught the analyst's attention, and he has missed the breakout, which is usually obvious (at least inhindsight). I feel strongly that the serious trader should not miss the original breakout. Chasing movingtrains is never a healthy activity. Does this appear an impossible occupation, to watch thousands ofstocks? Impossible for your average analyst, but not for your average computer. For example, thecomputer may be programmed to alert you when a stock is gapping on volume or trading at volumes thatare suspiciously large. And given the plethora of services and user groups, the trader stands a goodchance of spotting an issue to put on his watch list before it takes off. Investors should, in theory, never miss a breakout, because they should be watching a much more limitedgroup of issues. In my opinion, these are primarily indexes and iShares. An investor's portfolio mightinclude a few well-chosen individual issues, but these would be of obvious visibility to the individual, forexample, biotechs for an investor with some knowledge of the area, or Internets for an engineer, and soon. The unending effort to remove ambiguity from market interpretation extends to identifying areas ofSupport and Resistance. Metastock (http://www.metastock.com), an excellent software package, has anumber of value-added packages. One of the more interesting of these, Powerstrike™ by John Slauson ofAdaptick, Inc. (http://www.adaptick.com) attempts to mathematically define Support and Resistancezones. Slauson's package is interesting, and the reasoning and observation behind it are interesting aswell. Market analysis is rooted in one thing: the intelligent observation of the operation of the market.Dow watched the markets for years and came to the understanding of waves that led to Dow Theory.Schabacker and Edwards, equipped with these observations and comments, collated and observed moredata and recognized the persistent patterns that occurred over and over in the markets, and added Mageefor his practical engineer's approach to solving the tactical and strategic questions. In the 1980s, one ofmy friends, a Chicago market maker in the options pit, noticed that there was a 90-second delay on datacoming out of the futures pits to the options pit. He set up a “human ticker” with a direct phoneconnection to his pit and enjoyed a 90-second advantage over other market makers until the glitch wasnoticed and corrected. Slauson (among others) noticed that important trading and Support and Resistance in optionable stockstended to cluster around important option strike price levels. In fact, these levels influence stock pricesand may be said to determine where “important” buying and selling occur. Obviously, Support andResistance Levels are set by concentrated face-offs between buyers and sellers. A battleground metaphoris appropriate: since the time of the Greeks, battles have occurred time and again in the same physical locations. The reason is obvious. You need physical space to deploy an army. So commanders will beattracted to the plain or open ground for face-offs and to the high ground for defensive purposes. Optionstrike prices have the same attractiveness for traders that a good battleground has for a militarycommander. A good place to test the enemy. Powerstrike™ analyzes the instrument price and volume around the nearby option strike prices anddetermines whether Support or Resistance is stronger. All in all, this is a clever application of number-driven analysis to the Support and Resistance question. The chart analyst may supplement his analysiswith a routine like this.) Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter thirty-one Not all in one basket (EN: As diversification for the general investor is nowadays infinitely easier, an important endnotefollows Magee's text.) Diversification is important because technical patterns do not always carry out their original promise. Ifall your capital is tied up in one stock, or in a few stocks of the same group or line of business, you maybe hurt by a false move affecting only your holdings, even though the rest of the market may continue tohold firm or even to move farther along the Primary Trend. By diversifying, you are protected by the lawof averages against all of your holdings going the wrong way, except in the case of some Reversalaffecting the entire market or a large segment of it. Intelligent diversification calls for study of the costs of buying and selling stocks, especially in smallquantities. You might wish to have a portfolio of stocks representing the entire Dow-Jones Averages, or aselection that includes at least one stock of every major group. However, if your capital is limited, thismight mean buying only a half-dozen shares of each stock, and the minimum commission charges wouldmake this an expensive operation, entirely too costly for short-term trading. The short-term trader mustalways think of these costs. They are more important to him than to the long-term investor who mayintend to hold the same stock for many months or years. To you as a trader, a quarter point or a half pointmay amount to serious proportions when it is multiplied through a number of transactions. Your broker can give you a schedule showing commission and tax costs, and in case there are anyimportant changes in the rates, which you should study to see what effect they will have on your costs oftrading in stocks at various prices. (EN: You may also evaluate these charges at http://www.gomez.comand by checking websites of http://www.scottrade.com, http:// www.etrade.com, and http://www.tdameritrade.com. Google is, as ever, an important price-checking resource, and Barron'spublishes a yearly edition evaluating brokerage houses. In general, this editor believes the investor whodoes it the “old-fashioned way,” that is, by phone and human broker, operates at a disadvantage unlessthe broker's value added can be quantified and proven.) You will find your round-trip costs are a higher percentage of the capital invested in low-priced stocksthan in high-priced stocks. Also, the percentage costs will be higher on a smaller number of shares thanon a round lot and increasing as the number of shares decreases. Additionally, the percentage costs rise asthe total amount of capital used is less. If your capital is, say $1,000 or $2,000, you might do well to divide it into units of about $500 each andconfine your trading to odd lots of stocks selling at 40 or higher. With larger capital, you could use largertrading units and extend the range of trading into somewhat lower priced stock. In any case, it isimportant to diversify your holdings. By dividing your capital and using it in such a way as to avoidunnecessary penalties in high costs, you will have greater protection against freak moves and suddenchanges that might affect a single stock very seriously. On the other hand, if you have sufficient capital to secure plenty of diversification (8 or 10 stocks shouldbe a maximum for an active trading account), you can increase the size of the trading units. The wholequestion here is as to the minimum amounts to be invested in a single commitment and, if these amountswere doubled or tripled, it would not increase costs, but would, in many cases, reduce them. EN: diversification and costs In this original chapter, Magee discussed the necessity for considering costs while striving fordiversification. In present-day markets, diversification may be achieved through the use of Standard &Poor's Depository Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and similar instruments (ETFs) atcomparatively reasonable costs. Index funds and mutual funds also represent diversification and costcontrol for the general investor. Mutual funds will not control costs and expenses as efficiently as theIndex Shares and ETFs. This is because mutual funds create costs that the Index Shares do not:management fees and expenses, slippage, the spread, turnover, and taxes resulting from realized gains.These costs may be avoided by the careful independent investor. An internationally prominent trader has told me, on more than one occasion, his considerable tradingfortune amounts to what brokers and specialists would have made off of him if he had been a member ofthe general public instead of a member of the Exchanges. The most important weapons in his quiver wereseats in Chicago, New York, and San Francisco. The message is extremely clear. The general investor must control his costs. The more frequently hetrades, the greater his chances of having his capital ground to hamburger meat by brokers, specialists,floor traders, market makers, tax authorities, Exchanges, etc., etc., because there is undoubtedly anotherparty out there taking a chunk as the capital changes hands. The phone company maybe. Trading costs are the last item brokerage firms want to focus on (see the book Where Are the Customers'Yachts?). For years, the Street firms and Exchanges controlled commission costs, keeping them high, butentering the Internet age a different ethos rules—cutthroat (and cut fees) competition, reluctantly broughtto the old-line exchanges and brokers by upstart competitors, and not suppressed by the Securities andExchange Commission (SEC) and the Commodities Futures Trading Commission. It would be misleading to attempt to analyze costs in this book because of the mercurial nature of costfigures as firms compete in the Internet age. The SEC runs a mutual fund calculator for computing costs of mutual funds. Mutual funds are amongthose that manage somehow to not be overly punctilious in estimating (read, disclosing) their costs toinvestors. Another good resource for researching mutual funds is http://www.morningstar. com. But let me emphasize once again that iShares and ETFs have really made mutual funds obsolete if theinvestor uses the simple procedures outlined in this book. chapter thirty-two Measuring implications in technical chart patterns If you show one of your charts to a friend and tell him it looks Bullish, he will reply immediately, “Howfar do you think it will go?” This is an automatic response; you can count on it. The question is a good one. How far is this expected move likely to go? You do not know, nor doesanyone. Very often you can say, with a fair degree of assurance, “This stock, which has just made such-and-such an advance, is likely to react to around such-and-such a price.” That you can estimate fairlyclosely 7 or 8 times out of 10, by referring to the Basic Trendline, the parallel projection of the toptrendline, or the Support Level. These rules work out fairly well as applied to reactions in the Bull Trend, and similarly, we can estimaterallies in a Bear Trend. Not so with the move in the direction of the trend itself. A Bullish Move may, andoften does, overrun the upper trendline by running up as far again as the move to the trendline. A BearishMove may exceed the downtrend, dropping apparently without limit. (That is one reason we haveprotective stops—to prevent disaster in case the trend suddenly reverses itself.) Additionally, it is why weprefer the use of nearby progressive stops as a method of taking profits, rather than using limit ordersplaced at a trendline, Resistance Level, or at some other definite point. Very often, to be sure, a stock willcheck its advance at one of these indicated points, but the cases in which a move carries beyond itsobjectives are fairly common, and in such cases, no one can make even a reasonable guess as to whatlimit the stock will reach on the move. This follows because the move itself is an unreasonable one. It is an example of public participation, thesurge of uncontrolled speculation (and, very often, it is the final surge of that particular trend). In exactly the same way, and often more violently, the uncontrolled falling out of trend in a downwardmove is an example of Panic, and being completely beyond reason, it follows no rule and knows nopredetermined limits. There are, however, certain patterns and certain situations in which we can make some estimate of theprobable extent of a move in the Primary Direction—usually an estimate of its minimum extent. In thesecases, we have a guide to help us in making the decision as to whether the situation offers enoughpotential gain to be worth the risks involved. Also, the indicated measurement gives us at least a hint ofabout where we might reasonably begin to look for the volume that will indicate the Top. For example, a decisive breakout from a Symmetrical Triangle is likely to carry at least as far as theheight of the Triangle measured along its first reaction. This is a conservative measurement. The movemay go much farther. In fact, the trend implications of the Triangle would suggest a continuation equal tothe move preceding the Triangle and leading into it, for if the trend continues valid, the move should runup to the upper limit of the channel. In the case of a Reversal, we would also use the height of the firstreaction as a minimum measure. With Right-Angle Triangles, we also can take the long side (formed bythe first reaction) as a rough measure of the minimum expected move. What is more, with Rectangles the minimum we may reasonably expect after a breakout is a distanceequal to the height of the Rectangle. The Head-and-Shoulders Pattern carries a good measuring stick. Theheight of the formation from the extreme Top of the head down to the point directly beneath where theneckline crosses represents the minimum probable move from the neckline down. Again, this is a matterof Trend Channels, and most emphatically, this is only a minimum move. Some Head-and-ShouldersPatterns, representing an implied move of no more than 3 or 4 points, have marked the start of a declineeventually running to hundreds of points. The rather unusual breakout that takes the form of an almost vertical “mast” running up (or down) manypoints before arriving at a stopping point, where some Consolidation Pattern is made, carries with it amost explicit measuring rule, and one that works out with amazing accuracy. The Flag or PennantConsolidation will occur at the halfway point—“the Flag flies at half-mast.” The speculation moveleading up to the Flag very likely will be duplicated by another rise, at least equal to the first, in the nearfuture. Following this rise, there may be another Consolidation and other rises, or there may not. Aftertwo surges of this sort, it is best to stand back and let someone else carry the ball. If you keep enoughcharts, and for a long enough time, you will see many perfect examples of this beautiful formation. Youwill also see some imperfect examples and some failures. And because the move is so spectacularlyprofitable when it works out, you will be tempted to buy on every Consolidation Pattern formed after asharp rise. It would be best to wait until the example is clear—a nearly vertical, almost unbelievable rise,followed by several days of congestion with practically no volume. If the congestion continues or sags offfor more than about three weeks, sell the stock; it is probably not the real thing. Needless to say, this same pattern appears in reverse in downtrends and can be traded on accordingly. The questions relating to the measuring attributes of gaps have been reviewed in detail in Chapter 12. Theonly type of gap that carries substantial implications as to the extent of the move to follow is theRunaway or Continuation Gap. The appearance of such a gap during a rapid price move is likely to markapproximately the halfway point; two or more such gaps can be weighed, in connection with volume andtotal extent of the move, to estimate the probable midpoint of the move and thus to predict a probableultimate objective. Measuring properties have been ascribed to other patterns and occasionally work out according to plan. Ingeneral, the best measuring devices are your trendlines, Support-and-Resistance Levels, and the all-important signals of increased volume. Other tools exist for measuring moves. Arthur Sklarew (see Bibliography) describes the-rule-of-seven,which I have often found effective. In addition, Wyckoff used PnF charts to measure moves and I haveseen some impressive analyses produced by Professor Hank Pruden using PnF charts. (EN9: I have always been extremely chary of measuring moves. If the measurement does not lead thetrader to indulge in expectations that distract him from the crucial nature of the moment at hand, it mightbe quite all right. So, as an off-hand casual tool, it might serve some use. Always better to observe closelywhat the situation is when the price arrives at the measured point. Decisions should always be made inthe here and now, and not in the “I measured it then.”) chapter thirty-three Tactical review of chart action The Dow Theory (EN: In this chapter, multiple references are made to the tight stop - 1/8 point which decimalizes to .125.Readers should read this as decimal.13 to.25, depending on the habits of the issue. Issues greater than adollar are quoted at two decimal places. Penny stocks can go to 4 decimal places.) The record shows an investor who had bought a representative group of stocks on every Major BullMarket signal according to the Dow Theory, as outlined in Chapters 3 through 5, and sold all his stockson every Major Bear Market signal, since the start of the Dow Averages, would have come out very wellindeed over the years. (EN: see tables in Chapter 4.) Although this tabulation does not take short salesinto account (EN9: now taken into account in the ninth edition), it would be perfectly consistent to add arepresentative group of stocks might be sold short on every Major Bear Market signal and covered at thenext Bull Market signal. Additionally, if the figures for such short sales, based on the level of theIndustrial Average, were included, the total profits on these theoretical transactions, both long and short,would be enormous. (EN9: Buy and Hold to 2018: $55,411.83. Dow Theory, long only: $795,592.01.Dow Theory, long and short: $5,757,390.17.) (For illustrations in this chapter, see Figures 33.1 through33.16.) We believe this record carries some weighty implications that have a bearing on the operations of everytrader and investor. We will comment on these shortly, but before doing so, it should be pointed out thatfew, if any, investors have actually followed the long-time Dow signals, buying or selling 100% on everyMajor signal. In the first place, to do so would require a long market lifetime and would presuppose the investor hadaccepted the Dow Theory in its classic form in toto from the start and he had never wavered, never alteredthe definitions nor his method of trading, and never withdrew any of his capital during the entire period. In the second place, we would have to assume our ideal investor had an extraordinary degree of courageto stand firm in periods during which the Major Trend appeared to be making dangerous threats againsthis position and an extraordinary degree of patience to wait out the many months of stagnation when thetrend seemed to be getting nowhere at all. Finally, we would have to make the assumption the group of stocks actually bought or sold reallyrepresented a fair cross-section of the Averages in that they would make about the same moves as theAverage itself. As a matter of fact, if the group were well diversified, the chances are good its movesmight approximate those of the Averages. However, it is taking a lot for granted to suppose an investor could meet all of these conditions over aperiod of years, which he would have to do to operate strictly as a “Dow Theory” trader. It is not seriouslysuggested anyone try to follow any such plan literally. (EN: Well, in retrospect, why not? Given, in theInternet age, the availability of trading instruments and markets [DIAMOND™—DIA, Standard &Poor's Depositary Receipts—SPY] it might not Figure 33.1 Head-and-Shoulders Top. The Bull Market that carried Southern Pacific from 8 to 70 in theyears 1941 through 1946 culminated in June 1946 with this formation. Notice the heavy volume on theleft shoulder, lower volume on the head, and small volume on the right shoulder. The breakout signal,which was decisive on July 15, served notice on holders of long commitments to sell at the market thenext day (at about 63) instead of waiting for the protective stop, which would have been set at 61, to becaught. Volume eventually developed at the Bottom of the breakout move at about 58 1/2, which move,incidentally, carried out the minimum measure of the Head-and-Shoulders prediction. From this point, however, a weak rally on low volume started and continued up for four weeks. Theweakness of this picture would justify a short sale on a rally of 40% to 50% of the move from the leftshoulder to the bottom or on a return to the neckline, say, at 63. The rally actually extended to theneckline at 64, broke away on a gap with volume, and continued down in a move that led, in the nextthree months, to prices below 40, and later even lower. An extraordinary feature of Head-and-Shoulders Tops is the frequency with which a comparatively smallformation, such as the one shown here, will herald a Major Move, changing the course of the stock formonths or even years to come. Not all patterns of this type will lead to such big moves as this, but noHead-and-Shoulders should be regarded lightly, ever. be such a bad idea. The implementation of such a plan in Magee's time would have been extremelycumbersome and expensive, but it is eminently practicable in modern markets.) The important implications of which we spoke are these: if the record of the Averages shows on theseMajor Signals it is possible to take substantial theoretical profits over the long term, and if the Averagesare composed of the prices of individual stocks, then the probabilities favor buying or selling a majorityof stocks in line with the Major Trend of the Averages. The evidence shows Major Trends normallycontinue for months or years. The line of “most probable gain,” therefore, is the line of the Major Trend. On this basis, we would be on safe ground to say when a trend of sufficient importance gives a MajorSignal, the Averages are under way and there will be a greater likelihood of finding profitable situationsamong individual stocks moving in that trend than among those moving in the reverse trend. Figure 33.2 Head-and-Shoulders (or Kilroy) Bottom in Braniff Airways, 1945. Strictly speaking, aContinuation Head-and-Shoulders after a Secondary Correction in the Bull Market. A Major Bottom,reversing a long Bear Market, would normally take much longer to form. Here we see heavy volume on the left shoulder, somewhat less on the head, and very little on the rightshoulder, with a sharp increase, as required, on the breakout move of September 21. The breakout wasfollowed by a Throwback to the neckline on diminishing volume, providing a good opportunity forpurchases at 23. The upward move was resumed, and again there was a reaction to the neckline Support.A second reaction of this sort is not unusual. The closing at 22 3/4 on October 19, below the previousMinor Bottom, and on increased volume, was mildly disturbing. But in view of the strength of the patternand breakout, we would not have sold the stock, and the protective stop at 21 7/8 was not eventhreatened. On October 25, the advance was resumed with a Breakaway Gap and continued up to 29 1/2,where the move was signed off with a One-Day Reversal and Exhaustion Gap. Notice on reaching 29 1/2, “BNF” went into a Consolidation Pattern for more than three weeks, makingan Ascending Triangle, before leaping to 37 1/2. Notice also (we might as well get all we can out of theseexamples) the Ascending Triangle takes shape at approximately the halfway point of the whole advance.We are already familiar with this tendency of stocks in fast moves to form “halfway” patterns. It is suggested you read this preceding paragraph again, carefully. It means we do not try to sell stocks “atthe Top” in a Bull Market. We do not try to “pick up bargains at the Bottom” in a Bear Market. We do notdeliberately buck the kind of trend that history shows is likely to continue for an undetermined andpossibly long time. What we have said here is stated with a little different emphasis than in previous editions of this book.You will notice we have not said you will never sell a stock short during a Major Bull Market or buy astock in a Bear Market. There will be, and often are, cases of stocks moving against the Major Trend and,on the basis of their individual technical behavior, may justify a commitment against the trend of theAverages. ASSOCIATED DRY GOODS DG ••••••••••• 44 Sales 100's 50 40 30 20 10 JANUARY FEBRUARY MARCH APRIL 5 12 19 26 2 9 16 23 2 9 16'23 30'6 13 20 : 13'20 27 4 MAY 11 18 25 1 8 15 22 Figure 33.3 Associated Dry Goods winds up its Bull Market Trend with a Rounding Top. This is a dailychart for the first six months of 1946. The advance in “DG” from 4 to above 72 in just 3 1/2 years, when seen on monthly charts, is a smooth,accelerating curve that emerged from a long Bottom Formation that had lasted five years from 1938through 1942. As we enter the final six months leading up to the ultimate peak, note first the action during January andFebruary. “DG” had just completed a fast run-up in the last quarter of 1945 and was about due for aConsolidation or a Secondary Correction. On reaching 48, it turned back to 45, advanced to 50 1/2, to 51,and finally to 52, and then reacted to 44 at the end of February. Had the move on January 22 gone a littlelower and closed below the January 3 low, followed by an even lower closing on February 26, we wouldhave had to consider this January-February pattern a completed Broadening Top, a definite Reversalsignal. However, the pattern was not perfect, and, therefore, not valid, but the erratic price action showsincipient weakness. It is not unusual in these last stages, when public participation is running high, for the climactic advancesto be spectacular and fast; that is what we see here. A five-point Breakaway Gap occurred on March 25,followed by an advance that petered off at 63 1/2 reacted, and then ran up to more than 68. From here on the move advanced slowly with suggestions of a Convergent Trend and a succession of“heads” and “shoulders,” and volume dropped off as the Top was reached. The drop on June 4 to belowthe May 7 Minor Bottom on increased volume would complete the Rounding Top and call for immediatesale if we were still long; and the penetration of the “neckline” on June 18 was a conclusive break. We feel such trades should be made cautiously and with a full realization the majority of stocks aremoving in a contrary manner. Such trades might be made, for example, in particular cases as indicated bythe charts of the stocks involved, as partial hedges to reduce overall risk. For example, if a Bull Markethad persisted for several years and was still presumably in effect, but certain stocks had broken badly andshowed individual weakness, a trader might continue to hold three-quarters of his capital in good longpositions but might make a limited number of short sales in the weaker stocks. If, then, the 34 32 30 28 26 24 22 Sales 100's 125 100 75 50 25 Figure 33.4 Greyhound: a Rounding Bottom in 1945. A Continuation Pattern after the May run-up tomore than 29 and reaction to Support at 24, the 1944 high. In July, volume ran fairly high on downside days, drying up as we entered August. August 10 showed aspurt of volume on the upside, and then more dullness. The various small moves through August and September would not give us any basis for tradingoperations. The move to a new high in the pattern on August 31 suggested an upturn, and again onSeptember 19-20, we see another little push up to the 26 level—still not conclusive, however. The move that got under way in the week ending October 13 is more definite. This decisive move withgood volume carries right out of the “Bowl” in an almost vertical ascent; not a big move, but a clearindication of the probable trend. We would look for a point to buy “G” on a correction of 40-50% of theentire move up from the Bottom, or on a return to near the Support Level around 26. The purchase wouldprobably be made around 26 1/2. Notice the drying up of volume on this reaction. The advance from here to 30, marking an entirely new Bull Market high, came almost immediately. OnNovember 3, with very heavy volume for a Saturday, “G” closed at 30; since this volume was not on theday of breakout, we would have closed out the transaction on a tight stop at 29 7/8 on Monday (unless wehad elected to wait out the next Minor Reaction for a further advance). Two weeks later, on the basis of the reaction to good Support, we would have bought “G” again at about29 (you cannot figure on getting the extreme low price on any reaction). The following advance carriedup to 34 1/4 in two days. At that point, profits could have been taken or the stock held for the longer term.“G,” it might be noted, continued up eventually to 54. Bull Market continued, he might eventually have to close out the shorts for losses, which could beregarded as the reasonable cost of “insurance.” On the other hand, if the general weakness became greaterand eventually reversed the Major Trend, then the short sales would cushion the depreciation of the longsup to the time of the Reversal signal. (EN9: An extremely wise observation the present editor hasdeveloped at greater length in the theory of “natural hedging.” Given the complexity of modern markets,profits may be made on both sides of the hedge, and this should be the objective.) By using an Evaluative Index (see Chapter 38) instead of, or in addition to, the Averages, it is possible tosay, “The market appears to be about 60% Bullish,” or “55% Bullish,” instead of merely Bullish orBearish. This takes account of the fact that some markets are more 52 48 44 40 38 36 34 32 Sales 100's 125 100 75 50 25 Figure 33.5 Symmetrical Triangle in Allied Stores, a Consolidation in the 1946 decline. Notice heavyvolume as “LS” crashed to the first Reversal point of the pattern on September 10, and the drying up ofvolume during the successive swings of the Triangle. In Point-and-Figure charts, this type of pattern isknown as a Pendulum Swing because it does seem to come to rest like a pendulum. Often, volume willpick up somewhat at each Reversal point, but a valid Triangle must show some overall decrease ofvolume. If, by some unhappy chance, you were then long “LS,” you should have had your protective stop at 331/8, 8% below the Bottom reached at 36. However, the move down out of the Triangle on Friday andSaturday, October 4 and 5, although on slight volume, was a true breakout (remember that downsidebreakouts do not require volume confirmation), and you would have been justified in selling your longcommitment at the market on Monday. You would have received about 38 1/2. To justify a short sale,however, the breakout would have had to close at least 3% outside the Triangle. The return to the borderof the pattern at 40 was interesting, and you will notice volume increased characteristically as the declinereally got under way on October 9 and 10. No question about the validity of this breakout. Short sales were in order on a return to the border of theTriangle, or a 40-50% Correction of the breakout move, say, at 38 1/2 to 39. The rally carried to the apexof the Triangle and then broke away fast for the decline to 33, where, on October 30, a Selling Climaxand One-Day Reversal occurred—a signal to take profits. Notice the small Head-and-Shoulders in August. This was a Continuation Pattern marking the top of therally before the September-November crack-up. Bullish or more Bearish than others, and it enables the investor to “roll with the punch” instead of havingto take an all-out position one way or the other. (EN9: I have called this “Rhythmic Trading.”) It should be noted, however, while he may take such a partial position against the (presumed) MajorTrend, he will continue to use the bulk of his capital in situations that accord with the main trend. He willnever risk the larger part of his assets in opposition to the trend, and he will make any countermoves witha clear understanding they are of the nature of insurance and serve this purpose even though theyultimately may be closed out as small losses. Summarizing all these implications of the Dow Theory: do not make a majority of your commitmentsagainst the Major Trend. During periods of potential Reversal, gradually reduce your long holdings, andmake short sales to a limited amount in weak stocks; but do not attempt to anticipate either a Major Topor Major Bottom in the Averages by making an all-out commitment counter to the main trend. 19 18 17 16 15 14 13 12 11 Figure 33.6 An Ascending Triangle. “CMR,” after emerging from the doldrums in 1943, forged up toabout 12 early in 1945. The first eight months of the year on a monthly chart showed an AscendingTriangle with Top at 12 1/4. On daily charts, however, we see the more detailed aspects of this largepattern. For instance, the final reaction of the whole (monthly) formation in August became here aSymmetrical Triangle. The breakout from this pattern carried out the minimum measuring requirements,bringing the price again to the 12 1/4 Top, from which point there was a reaction that was stopped cold at11, the apex of the Triangle. A purchase on the reaction after the powerful breakout from the Triangle, sayaround 11 1/2, would have been closed out on progressive stops, starting September 28 when “CMR”reached 14, the sale being consummated October 2 at 14 1/2, a highly profitable move. Profit-taking of this sort would largely explain the stopping of the rise and the formation of aConsolidation Pattern that turned out to be the Ascending Triangle with Top at 16 1/4, lasting eightweeks. Notice the November 7 volume when price went through the 16 1/4 level, but failed to closeoutside the pattern, and the volume on November 30 when a clean, decisive breakout move closed at 17.This move ran to 20, and purchases would have been made at 18 or less on the reaction. The next wavetook “CMR” to its ultimate Bull Market Top at 24 in January. On the ratio scale, the Top of the AscendingTriangle was exactly halfway between the September Bottom at 11, and the extreme high of 24. This typeof halfway consolidation is typical of Flags and Pennants, and this is a very similar case. Head-and-Shoulders Top A. If you are long a stock, should a breakout down through the neckline occur, with a closing at least 3%below the neckline, next morning place a stop 1/8 point below the last close. Continue to place such“tight stops” if not caught the first day, 1/8 point under each day's close until one is caught. B. Short sales may be made after a breakout, on a recovery of 40% of the distance from the top of theright shoulder to the bottom of the breakout move, or on a recovery to a line drawn down across the topof the head and right shoulder, or on a Pullback to 26 24 22 20 19 18 17 Figure 33.7 A Broadening Top. This somewhat rare but beautiful and highly dependable formationdeveloped as CertainTeed made its Bull Market Peak in 1946. A quick glance at the volume scale in thisdaily chart shows the high volume on the final stages of the advance, the dullness during the developmentof the Top Pattern, and the increased volume after the breakout. As we all know by now (or go back to Chapter 10 and review the specifications), a Broadening Top is aFive-Point Reversal, differing from the Head-and-Shoulders, Triangles, Rectangles, and so on, in thateach Reversal must be at a new high or low for the pattern. It is, if you wish, a sort of reversed Trianglewith its apex to the left, the swings becoming continually wider. In the second week of May, “CT” (the symbol has since been changed to “CRT”) made a new BullMarket high at 25 1/4 (marked “1”). The reaction carried back to Support at the previous Minor Peak(point “2”) and the following week, “CT” advanced to another new high at 3, closing 1/8 point above theprevious Top. Another week had brought “CT” down to point “4” with a closing at 22 1/2, three-quarters of a pointbelow point “2.” This, in itself, is not sufficient reason for making short commitments. Three weeks later,“CT” closed at 25 5/8, another new high, at point “5.” Finally, the stock dropped to 21 1/2 on July 23, andat this point (marked “B”), the pattern was completed. Notice the tendency of volume to rise at eachReversal point of the pattern. Long holdings would be sold at the market the day after the breakout, but short sellers should wait for acorrection of 40-50% of the move from point "5" to point "B." If shorts were put out at 23, we would notworry if the stock advanced for a time, as it did, without making a new high. The downside move in "CT"went quickly to 15 1/2, and within 12 months to 11 1/2. 26 22 24 Figure 33.8 Rectangles in Remington Rand. This is part of a long Bull Market rise that carried “RR”from under 10 to above 50 in the period from 1942 to 1946. The last three years of this advance werealmost continuous, as seen on monthly charts, without any extensive reactions. When we put the chart ona daily basis, such as this section covering the end of 1944 and the early months of 1945, right in themiddle of the advance, we see that the rise was not actually continuous but rather was built up of steps inan ascending “staircase” of Accumulation Patterns. Each sharp advance on increased volume is followedby a period of dullness and slight recession. A picture of this type suggests the methodical campaign of buyers who intended to purchase large blocksof the stock for large long-term advances without creating a “skyrocket” market by their own buyingoperations. Presumably, each advance was checked by the temporary distribution of part of the stock heldby such buyers, and accumulation restarted on reactions. In October and November, there is a well-marked Rectangle between 20 3/4 and 22. A purchase couldhave been made at or near the bottom limit, say at 21, on the fifth Reversal on November 14. The moveout of pattern in the week of December 2 did not carry 3% out of pattern, but about two weeks later, amove got under way that qualified as a valid breakout, with volume confirmation as required on upsidemoves. Notice the volume increase and One-Day Reversal on December 20 as this move neared its Top.Purchases would have been made at about 22 1/2 on the basis of a normal correction, and you would have expected Support at the 22 level. This Support was respected, but the move did not advance beyond 233/4 (made this same Top three times in a period of two weeks) and returned again to 22 1/4. There was no question about the breakout on January 25. Extent and volume were decisive. Notice thegap and One-Day Reversal on the following day as this Minor Move reached its end. In mid-March, as you will see, “RR” plunged down from its high of 27, but the decline was stopped in itstracks at the top level of the January Rectangle, a good Support shelf. Never again during the Bull Marketdid “RR” even threaten this level because it moved up in April and continued its long march to the 1946Top. the neckline, whichever point is reached first. If the breakout move continues down another day, or forseveral days, the 40% recovery would be based on the entire move from the top of the right shoulder tothe lowest point reached. Head-and-Shoulders Bottom (EN: The editor, long distressed by the paradox of the term “Head-and-Shoulders Bottom,” proposes thisformation be renamed in technician's nomenclature to “the Kilroy Bottom” [see Figure 7.4.]) A. If you are short a stock, should a breakout on increased volume occur, penetrating the neckline andclosing at least 3% above it, place a stop next morning to cover at 1/8 point higher than the close. If sucha stop is not caught, continue each day to place a stop 1/8 point higher than the previous day's close untilone is caught. B. New purchases may be made after a breakout, on a reaction of 40% of the distance from the bottom ofthe right shoulder to the top of the breakout move (which reaction must be on decreasing volume), or on areaction to a line drawn across the bottom of the head and the right shoulder, or on a Throwback to theneckline, whichever is reached first. As in the case of the Top Formation, this 40% reaction is figured onthe entire distance of the breakout move if it should continue up for several days. 22 20 19 18 17 16 15 14 13 12 Sales 100's 50 40 30 20 10 Figure 33.9 A Double Bottom in Paramount Pictures. Double Tops and Double Bottoms are not ascommon as many traders like to think. They require considerable time to develop and must conform tospecifications as to price range and time, and also (on upside breakouts from Double Bottoms) as tovolume. They are easier to spot on weekly charts than on dailies. This is a weekly chart of “PX” from September 1941 through March 1943. A Bottom was made onclimactic volume at 11 3/4 during the “Pearl Harbor Panic” Move. Then came a rise lasting eight weeksthat brought “PX” back to 15 5/8—a rise, incidentally, on feeble volume, strongly suggesting thepossibility of another crack-up to even lower levels. This rise, you will notice, was a considerable one,amounting to 35% of the price at the December low. The downward move, however, which lasted to mid-April, was on low volume and ended precisely at theDecember low of 11 3/4. (Note: it is not necessary moves of this sort end at exactly the same level; thesecond Bottom could have been a bit higher or lower without spoiling the pattern.) The second week in July shows the first sign of a possible Reversal when the price advanced on increasedvolume, but it did not close above 15 5/8 and, therefore, was not a breakout. Two weeks later, on heavyvolume, “PX” had moved up to 16 1/2, closing the week at 16. This is a true breakout and purchaseswould have been in order on reactions from this point on. The move continued up for three years to an ultimate Top at 85. Figure 33.10 A Right-Angled Broadening Formation in Associated Dry Goods. A beautiful example of abreakout through Multiple Tops, followed by an important move. This is, however, a pattern that is morefun to observe in retrospect than to follow as an active trader. The stock had moved up from an importantBottom around 4, established in 1938, 1940, and 1942. At the time of this chart in 1945, “DG” wasstarting the accelerating climb that eventually ended with the 1946 Rounding Top at more than 70 (seeFigure 33.3). If you had been holding the stock, you would have been watching for a substantial corrective move afterthe advance from 12 to 20. In late February and the first week of March, “DG” went into a new BullMarket high-ground, reacted to Support around 19 to 19 1/2, and then advanced again in the week ofMarch 17, failing in this move to make a new high. Ten days later, “DG” had reacted to 18 1/2, closingbelow the previous Minor Bottom. An inexperienced observer, at this point, might have commented“Double Top” and planned to sell “DG” at once or even to make a short sale. The pattern, however, wasnot large enough in duration or extent of price movement to qualify as a Double Top, nor did it conformto any other recognizable pattern of Reversal. Nor was the volume as high as one would expect on animportant Top. The rally in early April carried through to a decisive breakout of more than 3% in the move that reached22 7/8 on April 18. This move was a near penetration of the middle Top and confirmed the uptrend. If youstill held your long stock, you would not rest easier, and in any case, you would have looked for a chanceto buy on a reaction after the breakout. If you had tried to buy at the 21 1/2 Support Level, you wouldhave been left behind, but if you had put your order in a little higher, say at 22, you would have had a niceprofit on the advance to 25 7/8, where you would have sold on a tight stop at 25 3/4. Complex or multiple Head-and-Shoulders The same tactical suggestions apply to these as to the simple Head-and-Shoulders. Definitions and specialfeatures of these formations are covered in Chapter 7. Rounding Tops and Bottoms It is difficult to set precise rules for trading on these gradual changes of trend. In the case of RoundingTops, if one is long the stock, the general appearance of a Rounding Formation, extending over a periodof several weeks, leveling off from the rise and then turning down, very likely with a tapering off ofvolume nearing the top of the rise and a pick-up of volume as the turn starts down, would suggest gettingout of the stock at the market as soon as the picture looks more or less definite. A short sale of a RoundingTop could be very profitable; but no exact rule could be stated except, in the absence of fixed BasingPoints, one would want to be very certain the formation was unmistakably a Rounding Top. It would needto be well formed and following a long rise and extending over a period of some weeks in its formation. Itwould also need to be protected with a stop above the Top of the curve, as explained in the chapter onstops. 104 96 88 Sales 100's 50 40 30 20 10 ::::::..................................»>•••••«!• — ::::::::::....■T? MOM AMERICANCANA C ! II j 1946-1947tiffFffl 91 H H w:- ■8 111 :::J n r|l| iffltS iniiini 11 ii iiin .......Il J }•- ■+wII ,iLji :fl + ■ ffff tit w fl•• J t: •|Aff+ 1-. ifflll1 ttt**+ff: ■ ff1#r ::: iist"}+■■th: iff! mi ;;f Q X1 I limt3‘+ TT1 ::cff: H::xff • iiilfiEi a I ■ in II ,11 ........T ii 1111 nnAlldjLiuIi i 1luliiiuu ........1 iLiiliimill' : FEBRUARY MARCH APRIL MAY DECEMBER JANUARY 7 14 21 28 4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 : 10 17 24 31 Figure 33.11 A Diamond Pattern in American Can. The daily chart covers the period from December 3,1946, through May 1947, inclusive. For background on this situation, keep in mind that “AC” made itsBull Market Peak in October 1945 when it reached 112. The tendency of high-grade, high-priced stocksto top out early at the end of a Bull Market has already been noted. The first decline carried nearly to 90and was followed by a rally to 106. The stock then dropped to below 80 and a second rally brought us tothe situation we see here. You will notice at once the moves have a gradual “rounding” appearance, due to the fact, at this price,conservative stocks do not make large percentage moves. If charted on a scale having larger verticalintervals, the patterns would look very much like those in more speculative stocks. The first part of the pattern is similar to a Broadening Top. The first Minor Peak at 96 is followed by areaction to 92. The second peak carries even higher, to 98; and the reaction this time goes down to 91 1/4.A third rally takes “AC” to 99. So far, we have the five Reversal points of a Broadening Top, needingonly a close below 91 1/4 to confirm the Bearish indications. The next decline fails to break out of thepattern, however, and for several weeks, we have a narrowing picture like a Symmetrical Triangle. Eventually, the stock makes a clean breakout to 89, which is the signal to get out of longs and to considershort sales on the next rally. As a matter of fact, the three-week rally that started never made an upsidepenetration of the Resistance Level at 94, the level of the apex of the converging lines bounding the latterpart of the Diamond. American Can did not make a spectacular move down from this point, which is not surprising consideringthe markdown that had already taken place in “AC,” the habits and price of the stock, and the generalcondition of the market. It did not, however, again rise to the level shown here and, in fact, retreated tothe 80 level. To review the nature of the Diamond—it is not a common pattern. It is somewhat like a Complex Head-and-Shoulders with a bent neckline. It resembles, at the start, a Broadening Top, and its latter phasenarrows like a Symmetrical Triangle. 30 28 26 24 22 20 19 18 17 16 15 Sales 100's 250 200 150 100 50 GULF MOBILE & OHIO RR. FEBRUARY illli.ill.lili.-i MARCH 741 . n APRIL MAY : 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 42 19 26 2 9 16 23 30 Figure 33.12 Gulf, Mobile, and Ohio builds a beautiful Wedge, as shown on this daily chart for the firsthalf of 1945. This was the move that terminated the spectacular rise of “GFO,” its final Bull Market Top. Immediately after the downside breakdown from the Wedge, “GFO” came down to 18 3/4, and from thisIntermediate low, which was reached in August, rallied into a long Rectangle between 23 3/4 and 26 3/4from which it eventually broke down in a series of crashes that found it, in May 1947, selling for 6 1/8! It is rather hard, with a formation of this sort, to say at what precise point the convergence of the trends isestablished. The breakout move late in April was normal; the stock was a buy on the next reaction. Thefollowing advance in May, which reached 23 1/2, did not carry out a Parallel Trend Channel, and we sawa tendency to converge as prices retreated on the reaction. The next three advances all repeated andconfirmed the Wedge picture, and at the top, we see a sort of “bunching up” as prices make little or noheadway. The chances are at 11 an alert trader would have taken profits on long commitments after thehigh volume appeared at the top of the Minor Move ending June 4 and 5. In any case, he would havemaintained a protective stop at all times to take him out if and when a downside breakout occurred. You would not be likely to be short a stock on a Rounding Bottom. The long and gradual roundingappearance with dull volume, followed by a sudden revival on greatly increased volume, would be signalenough to cover if you should find yourself in this uncomfortable position. Purchases would be justifiedin a stock whose chart showed a Rounded Bottom or Saucer, after the first spasm of activity following along, dull period of dormancy. You would buy, according to the rules we have given for purchases onreactions, not on the breakout, but on the reaction following it, which would almost surely come. 24 22 20 19 18 17 16 15 14 13 12 11 Sales 100's 125 100 75 50 25 I it it H tint titpp" wHTg.LL.J »::i III II II* It li**1 m n Hi it ill (1 ...... Illi II ■ IH 1 . 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Ji : •1Iffii;li I if [■ I flP S.-J • alltt Ifrili rm f ■ nut fl.;jf; if-£ ■[ fl|| ■ Hl MAPTTXT-PAPPY MPT £Hil ’ iL -ill fl f fl■fl|H MMMA AlxTIX N X.AXxXxl .. i L1T HIT . .ft Jtt ff fff Iffffj I..:::: . 1 tt TT TT :±:: SH I i ■ ■■ 1it 4 1 ■ ■ y nil ■ flihi 1 1 iflfl.|n ■ • l• II11 X u :: : .....I .1.. flfl I ^fl: : : : ;; •:::::• m H HH fl-fl t flHI fi H " E 1 1 t Hit... .r :: T - MM ™ . 1: ’: E ‘: 1:: ' L: If M! it’ ■ i HI 5 * :: ::::::: 1 1 Mill......: 1 Ilill .uJl uLi uliJlulljiMiunkuUi-uhaxI. APRIL _ MAY IUNE JULY AUGUST SEPTEMBER 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 Figure 33.13 A Pennant in Martin-Parry. This type of pattern is fairly common in fast-moving markets.The extraordinary point about Flags and Pennants (and sometimes other Consolidation Patterns in fastmoves) is their tendency to form almost exactly halfway between Bottom and Top. Just before this move, “MRT” had built a Rectangle between 10 and 12 lasting seven months, whichfollowed the 1944 rise from around 4 to 12. The May breakout on heavy volume carried “MRT” right tothe top of the Pennant without any adequate reaction. Note the increase of volume at the top of that rise.For three weeks prices drifted off with a drying up of volume that is clearly shown in the chart. Thepattern did not correct the entire first phase but found Support at the Minor Peak at 14 1/2. Suddenly, on high volume, the move was resumed and this time went right up to 24 3/4. The chances aretraders who were still long their original stock or who had bought in around 15 on the Pennant wouldhave sold after the high volume of June 6 when “MRT” reached 19 7/8. Symmetrical Triangles A. If you already have a position in the stock. During the formation of a Symmetrical Triangle, you may be unable to make any change in your holdings. Let us say you have bought the stock on a reaction after a Bullish Move. The next upsurge fails to make a new high and gives no sufficient volume signal to cause you to sell out. The next reaction fails to carry below the previous one. You are “locked” into the Triangle, and you cannot safely sell, because the Triangle that has formed may eventually break out in the original direction and show you a good profit (in fact, the odds favor that it will break out in that direction). In case of a breakout move (which must be on increased volume on the upside), you can close it out for a profit (according to the rules for trading we have already given) and immediately mark it as a rebuy on the next reaction. If the breakout is down (whether or not on increased volume), with a closing outside the Triangle, you should protect yourself with a tight (1/8 point) stop the next day and continue to set such tight progressive stops under each day's close until it is sold. If you are short the stock, the same rules would apply in reverse, except the breakout in the right direction (down) would require no volume confirmation while the adverse breakout (up) would need such increased volume. Figure 33.14 This daily chart of Lehigh Valley R.R. through late 1945 and early 1946 shows a variety of gaps. At this particular time, “LV” was completing a Secondary Corrective Move before making one more (and as it turned out, final) effort to exceed the 1945 Top just above 17. This long- term situation could be used for a discussion of Double Tops because the Bottom of the intervening move was violated in the summer of 1946 and the stock continued a downward course to below the 5 level. Not all gaps are significant, as displayed in the first gap on October 3, when the stock was moving in a narrow range on low volume. The gap on Saturday, November 3, however, is important because the Saturday volume (when doubled) is high. The move failed to qualify by a 3% new high closing as a true breakout, but the implications of the move were Bullish and might well have justified purchases on Minor Reactions. The low- volume gaps on these reactions were of no particular interest. It is not until the third week of January that we see another gap that looks like a real breakaway. On January 14, with high volume, “LV” moved up and out in a rush that took it to 15 7/8 on January 16, closing at 15 1/2. The second appearance of volume here would have suggested application of progressive stops, and long trades would have been closed out at 15 3/8. New purchases could have been made on the reaction at 14 1/2. A second advance accompanied by a Breakaway Gap developed on January 23. If we consider the second gap (of January 24) a Runaway or Measuring Gap, we would estimate the probable top of this move at around 17 3/4. When a third gap appeared on January 28 with a One-Day Reversal and climactic volume, it would be clear this move was about finished and progressive stops would be used to clear out longs at 16 3/4. Note the attempt to rally after the sharp drop and the One-Day Island formed by two gaps as “LV” fails to hold at the 15 level. B. If you do not have a position in the stock. Stay away from any stocks making Symmetrical Triangles until a clear and definite breakout close has been made. After such a breakout, if on the upside, buy on the next reaction if the Major Trend is up; on the downside, sell short on the next rally if the Major Trend is down. Rules for making such commitments have already been given. Note: Avoid breakouts from Symmetrical Triangles of the type that have continued to narrow until the breakout point comes far out toward the apex. The most reliable breakouts occur about two-thirds along the Triangle. Right-Angle Triangles The same rules would apply to Right-Angle Triangles as to Symmetrical Triangles (see Chapter 8, Important reversal patterns: the triangles). Early breakouts are more dependable here, as in the case of Symmetrical Triangles. Volume confirmation is more important on upside breakouts from Ascending Triangles and is not strictly required on downside breakouts from Descending Triangles. Commitments already made are retained until the breakout and then closed out in the same way as any transaction that shows a gain. As the Ascending and Descending Triangles carry a directional forecasting implication that the Symmetrical Triangles do not have, it is possible to make new commitments on reactions within an Ascending Triangle or rallies within a Descending one. Since the flat horizontal side of one of these Triangles represents a supply or demand area of unknown magnitude, and because such a Triangle can be (and sometimes is) turned back before the horizontal line has been decisively penetrated, it might be better policy to note such formations in the making and wait until the decisive breakout before making the new commitment. Broadening Tops Presumably, you would not be long a Broadening Top. The early Reversals in the pattern would have taken you out of the stock, if you follow the tactical rules based on trendlines, as previously outlined, long before completion of the pattern. Neither would you be tempted to buy into such a pattern because the trend indications would be clearly against a move. On the other hand, a Broadening Top, after its completion, offers excellent opportunities for a short sale. After downside penetration and a close below the fourth point of Reversal in the pattern, you are justified in selling short on a rally of about 40% of the distance covered from the extreme top (fifth point of Reversal) and the lowest point reached on the breakout move. The stop would be placed at the proper distance above the fifth Reversal, that is, the extreme top of the pattern. Rectangles A. If you already have a commitment in the stock. The early moves of a Rectangle may provide no volume signals to permit you to get out. There will be no “breakout” moves during the formation of a Rectangle that will allow you to take a profit. However, as soon as the character of the Rectangle is well established (which requires at least four Reversals to set up a clear Top and Bottom), you may trade on the Tops and Bottoms— that is, sell at or near the Top, or buy at or near the bottom. For, as in the case of Symmetrical Triangles, there is a definite presumption in such formations that they are more likely to lead to continuous moves than to Reversals, this would mean you would probably pass up your first opportunity to get out (on the fifth Reversal) and would indeed probably decide to “ride along” in the expectation of a continuation of the original move, which will be in the “right” direction for your commitment. In the case of a breakout in the right direction, you would dispose of your commitment according to the rules for trading already stated. If in the wrong direction, use the tight (1/8 point) progressive stops, the same as with the Triangles. B. If you are not committed in the stock. Trades can be made within the Rectangle on the fifth and subsequent Reversals. Due to the slight probability, the move will eventually continue in the same direction as the preceding move leading up or down to the Rectangle; thus, it might be best to wait until the sixth Reversal for new commitments, which would set your interests in the same direction as a continuation. Also, short sales can be made after any downside breakout close from a Rectangle or purchases after an upside breakout close with increased volume. Both the short sales and the long purchases would be made on the Corrective Move following the breakout. Double Tops and Bottoms Double and Multiple Tops or Bottoms are not valid unless they conform to the requirements for such formations. Chapter 9 on these patterns should be read carefully in this context. A. If you are long a stock. On penetration and close at a price lower than the extreme Bottom of the pattern between the Multiple Tops, dispose of the stock on tight (1/8 point) progressive stops. B. If you are short a stock. On penetration of the highest point of the Inverted Bowl or rise between the Bottoms, with a close above that point, close out the short sale on tight stops. C. If you are not committed in the stock. Consider a penetration and close beyond the limit of the correction between the Tops (or Bottoms) as a signal of Reversal and make new commitments on rallies or reactions. Right-Angled Broadening Formations The handling of these on breakouts through the horizontal side would be similar to what has been said about Multiple Tops and Bottoms, and Right- Angle Triangles. The Diamond If you are sure what you have is a valid Diamond Pattern, the rules for trading will be the same as those we have already covered in connection with breakouts from Symmetrical Triangles. As in the case of such Triangles, new commitments should wait for a definite breakout. Commitments already in force would have to remain until such a breakout had occurred, either declaring a Reversal or indicating a probable continuation of the original trend. Wedges There is no need to set forth detailed rules for policy within a Wedge and during its formation because the general principles taken up in connection with trendlines and Support and Resistance would take you out of such a situation at the first opportunity after the convergent nature of the pattern became clear. At the very worst, your stops (which we hope you maintain faithfully in all situations) will take you out before the consequences become serious. Regarding new purchases (from a Falling Wedge breakout) or short sales (from a Rising Wedge), the same volume characteristics would be expected: notably increased volume on an upside breakout from a Falling Wedge and less pronounced volume action on the first stages of breakout from a Rising Wedge. New commitments, in line with the implications of the breakout, may be placed on rallies or reactions after a clear breakout closing occurs, carrying beyond the trendlines forming the Wedge. One-Day Reversals One-Day Reversals are not technical patterns suitable for trading in the same sense as the important Reversal and Consolidation pictures we have examined. They are mainly useful as a gauge in helping to find the precise Top or Bottom of a Minor Move to protect profits on commitments previously made. The One-Day Reversal, the Exhaustion Gap, and the day of exceptionally heavy volume following several days of movement in a Minor Trend are strong indications that the move may have run out. Any of these three signals is worth watching for; any two of them together carry more weight than one alone; and the appearance of all three carries very strong implications of a Minor (EN: or even a Major) Top or Bottom. Regarding trading on movements signaled by One-Day Reversals, this type of trading would lie almost in the field of gambling, or at least trading for quick, small profits on short moves. It would not be the same kind of trading at all that we have been studying in the greater part of this book. The indications and some suggestions for trading on those one-day moves are covered in their discussion in Chapter 10. Flags and Pennants In many cases, the total decline from a Flag in an uptrend will bring the price back to a point at which the stock may be bought according to our regular trading tactics, namely, the decline may carry down to the Basic (Red) Trendline, to the Blue Parallel, or make a 40% to 50% correction of the rising “mast” preceding the Flag. If the “mast” move is the first such move out of a level or only moderately rising trend, and if the Major Trend of the market is Bullish, we would be justified in buying at the first opportunity, which would be on the Blue Parallel. In such a case we would expect, and ordinarily get, some further reaction, but it is important to get in early because sometimes the reaction is very brief and does not meet either of the other requirements for the correction. It is most important in a situation like this that the volume drop off sharply. Volume must decrease and remain slight; any increase of volume during the formation of the Flag should be reviewed as casting suspicion on the entire pattern, except the increasing volume that characteristically attends the start of the breakout drive. This drive is usually so virile that we would be safe in placing a tight (1/8 point) stop under the close of any day during formation of a Flag or Pennant that showed notably increased volume. Hence, if the volume indicated failure of the pattern, we would be taken out at once; but if the breakout was under way, we would probably be left in because the stock would ordinarily move up then without a reaction, very often making a Breakaway Gap. In downward movements, when the Major Trend of the market is Bearish, the same suggestions would apply, with one difference. The final high day of the Flag type of rally may be on high volume and also may show the Exhaustion Gap or One-Day Reversal. If a short sale has been made into such a day showing high volume, gap, or One-Day Reversal, a stop order placed above the peak of the Flag will protect you should the advance be resumed unexpectedly. In either the up-moving or down-moving manifestations of this type of action, there may be Flags having horizontal Tops and Bottoms, which are Rectangles. If the drying-up of volume and other aspects of the picture, including the sharp upward or downward move preceding it, suggest a Flag- type Consolidation, you would be justified in making a commitment on the sixth Reversal point, or for that matter, at almost any point in the pattern (because you cannot expect this pattern to continue very long). Flags and Pennants continuing too long (more than three weeks) are open to question. Stops should then be set at the usual computed distance above or below their extreme Tops or Bottoms (as the case may be). The fairly frequent appearance of Flag-like Formations that eventually fail is unfortunate because it is particularly hard to give up hoping with this kind of pattern, and it is necessary to set the three-week time limit to prevent the stock from drifting all the way back to previously established stop levels. On the other hand, breakout moves from these patterns, when completed normally, are among the fastest and most profitable forms of market action. The question remains what to do in the case of stocks you may be holding as they go into Flag or Pennant Formation. Obviously, they should be held if you are long and the move leading to the Flag is up; or short positions should be retained if the move is down. This would not happen ordinarily, however, if you had followed the trading rules strictly. In most cases, your signals calling for tight (1/8 point) progressive stops would have appeared during the formation of the “mast.” You would have been taken out of the picture somewhere along the way, possibly at the extreme top of the mast (although ordinarily, you could not count on being so fortunate). If no signal should appear and you still are holding a position as the Flag starts to make its appearance, by all means hold your position. The odds favor a continuation of the original move. Now, if you have been holding the stock long (in a Bull Market) and have seen it break out and start leaping to new highs, say from 20 to 32, and you have been stopped out at 30, and then you see the price advance, halt, and during the next several days retreat, with the rather high previous volume drying up to practically nothing (it must be a drastic drying-up, and no mistake about it), then you are justified in buying right back in again, even at a higher price than you received only a few days before. Gaps If you are long a stock that is in a well-marked pattern formation, or in an area of dull movement within fairly narrow limits, and the stock suddenly breaks out on the upside with high volume and a gap, that is a Bullish indication. You will hold the stock until signs of exhaustion appear as the rise continues, or reappearance of high volume, or another gap or One-Day Reversal. Then, particularly if two or all three of these indications show up at the same time, you can protect your commitment with tight progressive stops. You will have to consider whether a second gap should be considered an exhaustion gap or a continuation gap, depending on the volume and the speed of the rise, as discussed in the chapters on gaps and their measuring implications. 19 18 16 15 14 17 Figure 33.15 This daily chart in Northern Pacific, covering six months during 1944, shows several examples of Support and Resistance. The entire chart covers only part of the series of Consolidations that took place in 1943 and 1944 preceding the 1945-1946 advance that carried beyond 38. Support and Resistance phenomena appear on many, in fact, on most of the charts in this book, and you will find them on the charts you set up for yourself. There is nothing unique or even unusual about the Support- Resistance action in “NP.” Starting at the left in April, after the downside move on volume to 14 1/4, notice the recovery to 15 5/8 where the move stops at the Resistance Level of the preceding two weeks. After the formation of the Symmetrical Triangle, there is a breakaway move with a gap that runs right on up to above 17, where a small Rectangle is built during the next three weeks. The stock ultimately breaks down from this pattern on considerable volume. It is doubtful whether one would want to trade on this as a normal reaction after the breakout from the Triangle because of the downside volume and the implications of the Rectangle. Note, however, how the reaction stops cold at the 15 line, the apex level of the Triangle, and then moves right on up. Rather surprisingly, there is only a three-day hesitation at the Bottom of the Rectangle, but a little setback occurs at the Top of that pattern. The July Top might be classed as a Head-and-Shoulders or Complex or Rounding Top; in fact, it is almost a Rectangle, and after the downside breakout, prices hesitate at the level of the Top of the May Rectangle, continue down, find temporary Support again at the April Support Shelf around 16, and ultimately wind up a bit under 15. Although “NP” actually did penetrate and close slightly below the apex of the Triangle, the violation was barely 3%, and it is interesting to note this September Bottom was the lowest point reached. From here, the stock started its climb to the 38 level, which was reached in December 1945. Ordinarily, after a Breakaway Gap, regardless of whether you sell on the next Minor Top, you would consider the move Bullish and would prepare to make a purchase on the next reaction. Now if you are long a stock and during the course of a sharp rise it develops a gap after several days of the move, you must make your decision as to whether or not it is a Continuation (Runaway) Gap. If so, you would prepare to hold the stock for a further rise approximately equal to the rise up to the gap. You would watch the approach to the ultimate objective indicated very closely; on the appearance then of Reversal signals, you could protect your holding with tight stops. If you are satisfied a gap following a good rise is actually an Exhaustion Gap, then you should protect your stock with a tight progressive stop at once. In Bear Markets, you would apply these same rules in reverse to your short sales, remembering a downside breakaway is not necessarily accompanied by the high volume you expect on an upside breakaway. Where you are long or short a stock that is moving in a Pattern Formation and the stock then makes a Breakaway Gap in the adverse direction, the commitment should be closed out immediately at the market, or on tight progressive stops. 38 36 34 30 28 26 32 Figure 33.16 Trendlines in American Steel Foundries. This daily chart shows the tendency of trendlines to develop along straight channels. We have already pointed out that these channels are frequently easier to see in retrospect than during their formation, that stocks move in perfect channels only occasionally, and that all channels come to an end, frequently without warning. In this case, the long trend channel does give a warning of Reversal. In 1946, “FJ” had declined from 48 to a Support Level of 30. From here it rallied for three months in a Trend Channel that brought us to the February Top at 37. The next decline broke the previous trend, and volume developed at the bottom of this break. If you will follow the entire chart, you will notice volume nearly always shows an increase at the points of Reversal, which are also usually points of contact with the Trend Channel. Notice also the way the Corrective Rallies tend to stop at or near the previous Minor Bottoms in the downward trend, and how reactions tend to stop at the previous Minor Tops in the upward trend. Trading on this situation would have been profitable. The Secondary Intermediate Rally up to February approached the Resistance Level marked by a 1946 Bottom around 40, and a correction of the drop from 48 to 30 would indicate short sales around 37 (which objective was just barely reached). Such sales, if made, would have been covered after the first drop (week of March 1) around 33 1/4. New shorts at 34 1/2 would have been closed in the week of March 15 at about 31 1/2. Shorts made on the rally of the March 22 week around 33 would be covered in the week of April 19 at 30. If shorted again, the same week at 31, the sale would have been covered after the Climactic Bottom in the week of May 24. The combination, here, of great volume and a One-Day Reversal would have warned against further shorts. The Rising Channel, being a Secondary, presumably of limited extent, would not offer any great inducement to long-side trading in the absence of other good reasons. Support and Resistance When you are long a stock, you do not want to see it violate any Minor Bottoms previously made. Neither do you want to see it violate any of the preceding Minor Tops that it has surpassed. Therefore, your stop orders will be placed at a computed distance, as explained in Chapter 27 on stop orders, using both the Minor Bottoms and the Minor Tops as Basing Points. Normally, the Minor Bottom most recently formed will be at the approximate level of the preceding Minor Top, so that these Basing Points often will coincide. Ordinarily, therefore, in a rising trend, we look to the most recently formed Minor Bottom. When the stock has, for three days, made a price range that is entirely above the entire range of the day marking this Bottom, you may move up your stop protection to a place indicated by this new Basing Point. The same procedure will apply in Bear Markets; the “three-days-away” rule being used to confirm Basing Points established by Minor Peaks and also by the preceding Minor Bottoms. Ordinarily, it will be sufficient to use the Minor Peaks as Basing Points. Intermediate Tops and Bottoms are used in determining the probable objectives of Intermediate Moves because previous Tops constitute Support under Intermediate Reactions, and previous Bottoms indicate Resistance over Intermediate Rallies. Multiple Tops are Support Levels. Multiple Bottoms are Resistance Levels. The neckline of a Head-and-Shoulders Pattern is a Support or Resistance Level, as the case may be. The apex of a Symmetrical Triangle is a strong Support and Resistance point that may show its effect again on a subsequent move. Any congestion or area at a certain price level or within narrow price limits may provide Support or Resistance when a stock moves again to that price or range. Trendlines We have already gone into the methods of following trends in stocks, and the use of the Top and Bottom Trendlines (Basic and Return Lines) as indicators of Bullish and Bearish opportunities, and as price determinants for executing purchases or short sales. There remains the tactical problem of the stock in which you are committed, which is acting badly, but which has neither broken out of a recognized pattern nor violated an established Minor Peak. This is not a common situation, but it can present a very difficult problem when it does come up. Let us say the Major Trend is Bullish, and a certain stock that has been moving up irregularly in a Parallel Trend Channel confirms its uptrend by a long, more or less continuous advance and calls for repurchase on the next reaction. You buy on the reaction, and the stock continues down; namely, the reaction continues with prices sagging for days and weeks, without any rallies, Consolidations, or Corrections that are sufficiently well- defined to serve as Basing Points for stop orders. In the absence of clear indications during the reaction, and also during the preceding large upward move, your stop would be placed at a computed distance below the top of the preceding rise. Plus, if the reaction continues down until that level is reached, you will have sustained an abnormally large loss. In a case like this, you should examine the trendlines making up the long advance in the Trend Channel. The points of contact with the Basic Trendline can serve as a fair emergency substitute for Minor Bottoms. Your stop level, therefore (in the absence of more definite Basing Points), should be placed at the computed distance below the last point at which the stock made contact with the bottom trendline and moved decisively up away from it. If a penetration and close below this point occurs without catching the stop, sell on tight progressive stops. (EN: The editor feels that such situations should occur only in positionbuilding or pyramiding cases. Every effort should be made to join trends on breakout or origination, whatever the source. There is no excuse for “chasing stocks” in the modern environment in which literally monitoring all stocks and instructing the system to alert one to the conditions attending breakouts is possible with a computer. EN9: On the other hand, human frailty being what it is, we will all find ourselves chasing a train at some time or other.) The reverse of this rule would apply to the same type of situation in a Bear Market, where stops for short sales would be placed at the computed distance above the point at which the stock made contact with and fell away from the upper trendline. The changes of angularity and direction in Intermediate trendlines are helpful in showing the gradual turning of a Major Trend. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter thirty-four A quick summation of tactical methods There are three types of tactical operations: (1) getting into new commitments; (2) getting out of commitments that have moved as expected and show a profit; and (3) getting out of commitments that have not moved as expected, whether the transaction shows a profit or a loss. The principles of taking profits based on trends, Resistance and Support Levels, measuring implications of patterns, and most especially, on the daily technical and volume action of the stock, already have been covered. These profit-taking operations seldom present very difficult problems because the picture has developed normally and in the way you hoped and expected it would. The “stepping off” point is usually easy to determine. The more difficult problems arise in making new commitments correctly, and in the very important defensive operations of getting out of losing commitments with the least possible loss. It should be emphasized that a stock ceasing to act in a Bullish manner should, therefore, be sold and is not necessarily a short sale on the next rally. In other words, the signal that shows weakness or failure of a move in one trend is not always a signal to make new commitments on the opposite side of the market. More often than not, in fact, it is nothing of the kind. We know certain moves, such as adverse breakouts from Symmetrical Triangles or Rectangles, advise us simultaneously to get out of commitments in what is now clearly the “wrong” direction and to make new commitments in the “right” direction. The simple failure of a trendline, however, where the stock merely penetrates an old Minor Bottom without completing a Head-and-Shoulders or other Reversal Pattern, although reason enough to get out of commitments that are showing losses, is not sufficiently conclusive by itself to justify reversing policy and making new commitments in the opposite direction. Therefore we separate the two types of signals as follows: Get out of present commitments • On adverse breakout from Head-and-Shoulders Formation. • On adverse breakout from Symmetrical Triangle. • On adverse breakout from Rectangle. • On establishment of new Minor low or new Minor high in adverse direction. • On adverse breakout from Diamond. • On adverse breakout from Wedge. • On One-Day Reversal if marked by heavy volume or a gap. • On adverse breakout from Flag or Pennant. • On clear penetration of any Resistance or Support Level in the adverse direction. • On an adverse Breakaway Gap. • On the appearance of an Island after a move in the favorable direction. • On penetration of basic trendline in the absence of pattern or other favorable criteria. Note: It is understood all breakouts must close in the breakout area. A closing 3% beyond the Support, trend, or pattern is sufficient to give the danger signal. All takeouts are performed by the use of 1/8-point progressive stops. Make new commitments • In line with the Major Dow Trend, or to a limited extent in countertrend, moves as insurance to reduce overall risk. • On breakout from Head-and-Shoulders Pattern. • On breakout from Symmetrical Triangle, provided it is not working into the final third of its length toward the apex. • On breakout from Right-Angle Triangle. • On breakout from Rectangle, or (possibly) on points of contact, beginning with the sixth Reversal. • On breakout from a Broadening Top. • On breakout from Double or Multiple Top or Bottom. (Namely breakout through the Bottom of the valley between Tops, or upside penetration of the “dome” between Bottoms.) • On breakout from Wedge, or (possibly) commitments within the Wedge in the last third of its length as it approaches its apex. • On Flags and Pennants, after sufficient Secondary or Corrective Move by the pattern, or (possibly) within the pattern, provided volume and all other indications tend strongly to confirm the pattern. • On clear penetration of a well-defined Support or Resistance Area. • On Breakaway Gap (possibly). • After formation of an important and well-defined Island following a considerable move. • On contact with, or penetration of, the “favorable” trendline if both trendlines are moving in the Major Trend direction. (Blue Top Trendline in a Bull Market, Red Bottom Trendline in a Bear Market.) Note: Breakouts and penetrations must show a closing in the breakout area and must conform to volume requirements. Breakout closings should conform to the 3% rule. New commitments (marked “possibly”) may be made in certain cases within some patterns: Rectangles, Wedges, Flags, and Pennants. Exceptional care should be used in such cases. It is extremely difficult to catch Breakaway Gaps; we would not recommend this as a general practice. (EN: This is not so difficult as it was in Magee's time thanks to modern communications, computers, and access to the internet.) All commitments, except those just noted, are made on the next following reaction or rally, to rules previously stated. All commitments are protected by stops from the moment they are made. Stops are moved, as conditions justify moving them, but always in the favorable direction, never in the adverse direction. chapter thirty-five Effect of technical trading on market action The question often is asked whether the very fact that traders are studying methods and patterns tends to create those very patterns and trends—in other words, whether the technical method sets up, to some extent, an artificial market in which the market action is merely the reflection of chart action instead of the reverse. This does not seem to be true. The charts we make today seem to follow the old patterns; the presumption is very strong that markets have followed these patterns long before there were any technicians to chart them. The differences mentioned briefly in Section I, due to changed margin requirements, restraining of manipulative practices, and so on, seem to have changed these habits, if at all, only in degree and not in their fundamental nature. The market is big, too big for any person, corporation, or combine to control as a speculative unit. (EN9: And even beyond big in the twenty-first century. Gargantuan.) Its operation is extremely free and extremely democratic in the sense it represents the integration of the hopes and fears of many kinds of buyers and sellers. Not all are shortterm traders; there are investors, industrialists, employees of corporations, those who buy to keep, those who buy to sell years later—all grades and types of buyers and sellers. What is more, not all short-term traders are technicians by any manner of means. There are those who trade on fundamentals for the short term, and those who rely on tips, hunches, on reading the stars, or on personal knowledge of the company. They are all part of the competitive market and all use methods different from yours—and sometimes they will be right and you will be wrong. The technician using the various tools of technical analysis, Dow Theory, Point-and-Figure charts, oscillators, scale order systems, and monthly, weekly, and daily charts is in the minority. The cold attempt to analyze a situation on the basis of the market record alone does not appeal to many people. Technical analysis leaves out the warmth and human interest of the boardroom, the trading room, the fascinating rumors of fat extra dividends to come, the whispered information on new patents, and the thrilling study of the quarterly earnings reports. (EN9: Unless I am mistaken the only appearance of irony in Magee's work.) It is the influence of all these rumors, facts, and statistics that causes people to buy and sell their stocks. It is their actions that build the familiar chart patterns. You are not interested in why they are doing what they are doing. So far as your trading is concerned, you are interested only in the results of their actions. The habits and evaluative methods of people are deeply ingrained. The same kinds of events produce the same kinds of emotional responses, hence, the same kinds of market action. These characteristic approaches are extremely durable. It is not quite true that “you can't change human nature,” but it is true it is very difficult to change the perceptive habits of a lifetime. Considering the “orthodox” investors greatly outnumber the technicians, we may confidently assume technical trading will have little or no effect on the typical behavior of free markets. (EN: This statement by Magee is still true in principle and it should be noted in modern markets professional investors attempt to learn (or perhaps it is “the mysterious and anomalous market”) what makes systems and other investors successful. They then take action to frustrate those methods, which are inimical to their self-interest. For example, locals and professionals will search for stops above a congestion zone in an attempt to cause the market to break away. This might be in an attempt to create a trend or it might be in an attempt to create a Bull trap. The proliferation of systems trend traders in the futures markets has, some of those traders feel, created conditions hostile to systems traders as a group. The moral of the story is the trader-investor must be ever alert for the false move and the changing rhythm of the markets. No one has been able to quantify chart analysis or to disguise his own activities from the x-ray of the charts. Nor has anyone changed human nature to eliminate treachery and perfidy and truculent defense of self- interest.) (EN9: And—dramatic drum roll—in 2005, Smith-Barney fires its entire technical analysis staff. What to make of this is left to the imagination of the reader. Some commentators attribute it to the Bearish outlook of the technical staff as opposed to the need of the firm to sell long positions to its customers. In my view, an unintended validation of the craft. When you have to shoot the messenger, it says something about the state of the market, as well as something about the industry. Also, in conversation at a meeting of the Technical Securities Analysts Association of San Francisco (http://www.tsaasf.org), Larry Williams said, “I hate technical analysis.” I am reasonably certain the “technical analysis” referred to is number-driven analysis.) chapter thirty-six Automated trendline: the Moving Average In 1941, we were still filled with starry-eyed ignorance and felt if only we worked hard enough and lookedshrewdly enough, we would discover the sure, unbeatable formula or system that would solve all our problems inthe stock market, and all we would have to do for the rest of life was apply the magic and telegraph our brokerperiodically from Nassau, or Tahiti, or Switzerland, or wherever we happened to be enjoying life at the time. We have learned (we hope) quite a bit since then. We have learned most particularly a number of things not to doand by not repeating the same errors over and over, we have been able to improve our performance substantially.We have also learned (to date) (EN: still true in the twenty-first century) there are no sure, unbeatable formulas orsystems in the market, even the most useful and generally dependable forecasting methods must be regarded asstatements of probability only, subject to revision and vulnerable to failure at all times. One of the useful tools, and one of the first many students of market action adopt, is the trendline. Whether a stockis moving generally up or down or sideways, there seems to be a tendency for the Major Trend to persist. It is trueevery trend is broken sooner or later, and the fact that it has been broken is often significant. But given a well-established trend, the probabilities certainly appear to favor its continuance rather than its Reversal. As with all other market studies, however, there are times and conditions in which the simple trendline actionseems “not quite good enough.” One feels there should be some mechanical or mathematical way of determiningthe trend that might avoid some of the perplexities of choosing the right point through which to draw a trendline. Itwas back in 1941 when we delightedly made the discovery (although many others had made it before) that byaveraging the data for a stated number of days, weeks, or months, one could derive a sort of Automated Trendlinethat would definitely interpret the changes of trend over the past 30 days, or 200 days, or 12 months, or whateverperiod was chosen. It seemed almost too good to be true. As a matter of fact, it was too good to be true. The Moving Average is a fascinating tool and has real value in showing the trend of an irregular series of figures(like a fluctuating market) more clearly. It also has value in the fact it can be used to cancel out the effect of anyregular cyclical variation, such as a normal seasonal range of temperatures, to get a better picture of the truesecular trend. The trouble with a Moving Average (which we discovered long since but keep bumping into from time to time) isit cannot entirely escape from its past. The smoother the curve (longer cycle) one has, the more “inhibited” it is inresponding to recent important changes of trend. Plus, there is a very bad fault of Moving Averages in that “the tailtends to wag the dog”; the figures back to the first date of the current tabulation, perhaps six months ago, or a yearago, if they are large, may unduly affect the present average, and may conceal or mask some important feature bydistorting the curve. We feel the Moving Averages trendlines are useful, but they should be understood and usedwith discretion and with a full perception of their limitations. After going through some of the caveats of Moving Averages, let us give you some of the ways to construct them.Moving Averages can be classified as Simple Moving Averages, Weighted or Exponential Moving Averages, andLinear Moving Averages. We have found over the years, and prefer, the simple methods that work just as well andsometimes better than the more complicated Moving Averages, while the others are more useful when usingcomputers. For this reason, we will concentrate on Simple Moving Averages. The most common are the 50-day and the 200-day Moving Averages. If you want to increase the sensitivity of a Moving Average, shorten the Moving Average byusing 10 or 20 days. Another way is to increase the lead time by starting on the third day for the 10-day MovingAverage, or on the 20th day for a 50-day Moving Average, and so on. To construct a Simple Moving Average, whether it is 5 days, 10 days, 50 days, or 200 days, add the price of 5 daysand divide by 5, or the 10 days and divide by 10, or the 50 days and divide by 50, or 200 days and divide by 200. Asimple way of doing the five-day Moving Average, instead of adding all five prices each time, is to drop day one and add day six. A similar method can be used in calculating the 50-day Moving Average or the 200-day MovingAverage. Instead of adding the 50-day Moving Average each time, just drop the first day of the previous averageand add the 51st day. The same with the 200-day Moving Average; drop the first day of the previous 200 and addthe 201st day. Another way of calculating the 200-day Moving Average is to take one day of the week of 30 weeks,such as Wednesday or Thursday, add them, and divide by 30. This will give you the same Moving Averages as youwould have doing 200. Another way to put it is, on the second day, take the total, add the new day's price, andsubtract the oldest day's price from your 5-day, 10-day, 50-day, or 200-day Moving Average, whichever way youare doing it. Repeat the process on a daily basis and divide by the representative day—for the 5 day, you woulddivide by 5; for the 10 day, you would divide by 10; for the 50 day, divide by 50; and for the 200 day, you woulddivide by 200. Sensitizing Moving Averages The shorter the time period, the greater the sensitivity you will develop in your Moving Average. The 5-dayMoving Average will be much more sensitive than a 10-day. The problem with short-term Moving Averages is youcan have a greater number of false moves. Shorter Moving Averages are more suitable for commodities. Oncommodities, we would even advise using a 30-hour, a three-day, and a six-day Moving Average. It is often better to use two Moving Averages, one of shorter duration and one of longer duration. In addition, youcan use channels, a Moving Average of lows and a Moving Average of highs. (EN10: In the markets of the 2000s,the most watched Moving Averages are the 50-day and the 200-day. In fact, these two have gained almost iconicstatus.) Crossovers and penetrations As a general rule, consider the crossing of two lines (EN10: as 50 and 200) by the price line as a sell or buy signalin the direction of the crossover or penetration. 1. Uptrends—Long positions are retained as long as the price trend remains above the Moving Average Line. a. When the price line intersects or penetrates the Moving Average Line on the upside, it activates a buysignal. b. When the price line goes above the 200-day Moving Average, but falls sharply toward it withoutpenetration, it is a possible buy signal. Additionally, conditions at the time must be closely observed. c. When the price line falls below the Moving Average Line while the line is still rising, it could be a buysignal. d. When the price line spikes down too fast and far below a declining Moving Average Line, a short-termrebound toward the line may be expected: a possible whipsaw trap. 2. Downtrends—Short positions are held as long as the price trend remains below the Moving Average. Whenthe price trend reaches a bottom and turns upward, a penetration of the Moving Average is a possible buysignal. a. When the price line moves above the average line while the average line is still falling, it is a sell signal. b. When the stock price line moves below the average line and rises toward it, but fails to penetrate andbreaks down again, it is a possible sell signal. c. If the price line rises too fast above the rising average line, a short-term reaction may be expected: could bea whipsaw. d. Occasionally, penetration of the Moving Average Line will occur in close conjunction with the penetrationof a trendline, and then according to its direction, it is a buy or sell signal. 3. Horizontal, Diagonal, or Sideways Movements—If the fluctuations are broad in comparison to the lengthof the Moving Averages being used, the price trend will fluctuate back and forth as the Moving Average, trueto its character or purpose, moves horizontally. The trader must be alert to the need to change tactics. 4. Gaps—Moving Averages, depending on their length, may have a tendency to be penetrated in proximity toa Breakaway Gap, particularly at the beginning of a Major Phase of an Intermediate cycle, and also in suchcases in which Breakaway Gaps occur at the beginning of correction phases. Area Patterns can be a pitfall for the Moving Averages. Normally, the Moving Average oscillates through thecenter of these areas, producing buy and sell signals in rapid succession. In Area Patterns, the Moving Average is aheadache to the trader because he never knows which penetration is the one preceding either the renewal of thetrend or the Confirmation of a Reversal. When trading areas develop in the form of Triangles—Descending, Declining, or Symmetrical—the MovingAverage will trend through the center of the Triangle. The technician has some small advantage in judging whichof the series of penetrations of a Moving Average is the important one. When the Triangle reaches its apex and thestock breaks out in one direction or another and penetrates the Moving Average, the penetration is likely to be themost important one during the sideways movement of the Triangle's development. Penetrations occur many timesin close conjunction with the penetration of a trendline. As a price derivative product, the Moving Average can be a trend indicator by the way it fits a trendline.Nevertheless, it should be considered an adjunctive tool to everything else you have learned in relation to technicalanalysis. (EN10: Magee had, and I have, an instinctive aversion to mechanical systems. We want to see and feel the analysisand the moment and consider the context and the subtle variables. A mechanical system of any type—and aMoving Average system is not bad in broadly trending markets—is blind. It will throw your capital in front of anon-rushing train and merrily hum along while the Figure 36.1 150-day Moving Average (dotted line). Up to the 1980s (the period during which Ronald Reagantripled the national debt) trading the 150-day Moving Average (buying on an up crossover and selling on a downcrossover) gave a trader somewhat the same advantage that trading the Dow Theory afforded. In the 1980s, thesystem stopped working. Here in 1929 it would have been a lifesaver, as can be seen. Not illustrated here is whatthe Moving Average does in a Dow Line, or rectangle or congestion pattern. If taking signals on crossovers onecould find his capital ground to hamburger meat. market is eating your lunch. I have called these “unnatural” systems—they interpose an algorithm between thetrader and the facts. This reduces decision-making stress but can go badly awry in some types of markets.) A 150-day Moving Average is charted in Figure 36.1. The PENTAD Moving Average system from Formula Research One of the solid and prestigious technical research firms in the country is Ned Davis Research, Inc. (NDR). NelsonFreeburg of Formula Research has taken one of NDR's systems and tweaked it to yield what may be an effectivelong-range approach to the market. It is presented here because Magee was interested in Moving Average systems,as well as investors who are graphically challenged, meaning they can relate to numbers but not to pictures. Freeburg took an NDR Moving Average system and a 20-week Moving Average, added a filter, and produced asystem that reportedly has an 80% profitability on signals and generated returns in the 15% range going back to1942. Since 1980, returns averaged 19%. We all know (or the reader can quickly demonstrate to himself with asoftware package) that a Moving Average tends to create whipsaws in a sideways market. As the market movessideways, the Moving Average moves through the pattern creating buy and sell 490-i S&P 600 and 20-Week MA: / r490 485 -iS&P 500 Close Unfiltered Signals / v 4 485 480 -i 475-; 470 -i \rA / k‘ A* I » 1 \ A / • / vA K / • ■480 ■475 ■470 465 - 460 455 - • • . • \ ./X 4 A J X \ A*/ \ —. J • * F Vt \ / * *• • •* V\ / ■465 •460 -455 450- ■450 445 ■ t = Buy, S&P 500 Crosses Above 20-Wk MA■445 440 + = Sell, S&P 500 Crosses Below 20-Wk MA■440 490"t Buy, S&P 500 Crosses 1% Above 20-Wk MA Filtered Signals . / ■490 485* Sell, S&P 500 Crosses 1% Below 20-Wk MA ■485 480- ■480 475 -475 470- 20-Wk MA+1% [ V\ j y -470 465 • r 465 460-i 7\ I* j-460 455 r 450- 20-Wk MA-1% 1 -455 - 450 445 -i j-445 440- ■-440 1 1 ' 1 (Nov| Dec | 94 [Feb |Mar|Apr |May| Jun | Ju. ’Aug | Sep (Oct ]Nov| Dec ] 95 | Feb ] Mar Figure 36.2 Looking at the top chart, we can see the deleterious effects of using a Moving Average system in asideways market. Of course, at the end in January 1995, the system gets ready to cash in big time. You will nevermiss a big market with a Moving Average system—if you have any capital left after the whipsaws. Yet when a 1%filter is added, the number of trades is dramatically reduced and the accuracy improved. Something systems tradersnever think of is a qualitative filter—looking at the context when price crosses the average. What is the volumeand what is the price action? Also, the trader can experiment with different-size filters and filtering conditions. signals as price oscillates about it. In a common-sense move, Freeburg added a filter to the system thatimmeasurably improved it. Readers should be aware we include this method because experience tells us this kindof system can be effective, but we have not validated the research. Also, any system including the 1990s isguaranteed to have good, if not spectacular, results. Diagrams illustrating the idea are shown in Figure 36.2. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter thirty-seven The same old patterns To the newcomer, the market appears filled with wonders and mysteries as the landscape of Mars will appear to thefirst space travelers to land there. There are strange rumblings, apparently unexplainable upheavals, weird growths.An unknown stock will suddenly emerge from a morass of debt and deficit and proceed to soar to great heights. Anold and trusted issue will paradoxically sag and droop, although apparently rooted in the soil of economic stability.All will seem peaceful and secure, and, suddenly, the ground opens up and swallows values in a sensational marketbreak. (For illustrations in this chapter, see Figures 37.1 through 37.54.) Such a newcomer, perhaps not realizing what appears unusual and alarming is only the normal fluctuation andadjustment that goes on continually in the market according to the changing evaluations of millions of investors,will feel frightened, insecure, and indecisive. He may scurry from boardroom to boardroom, personally or on thetelephone, scan the financial pages, talk with friends, accumulate a mass of conflicting information, and end upshutting his eyes and making a blind stab in the hope he may come up with the right answer. Some never, even after years of contact with the market, achieve a tranquil and assured approach. However, it is possible to learn something about the basic nature of stock trends. It is possible to know, withinreasonable limits, about what might be expected in certain situations. It is also possible to find ways of coping withthese situations, including the exceptional cases that persist in doing the unexpected. To repeat: it is possible todeal successfully with the unexpected and with what cannot be precisely predicted. To put it another way, it is possible to be wrong part of the time and still to be successful on the balance. To dothis, it is only necessary to have a background of experience sufficient to know what will usually happen underparticular conditions, about how often the unexpected will occur, and how to deal with the unexpected when itdoes happen. These are the same general problems that would confront the space traveler, the chemist, thephysician, or almost anyone else in his daily affairs. There are men who have observed the market long enough and carefully enough to discover there are not quite somany unexpected events as the newcomer might be led to believe. The charts in this book are, in the main, the same as those used for examples in the first edition in 1947. Some ofthem show situations from 1928 and 1929, others from the 1930s and 1940s. (EN: And still others from the 1980s,1990s, and 2000s.) The reader can hardly overlook the similarities that occur in various stocks at different timesduring corresponding phases of their trends or turning points. We have said that these same patterns, trends, and Support/Resistance phenomena repeat themselves over and overagain, and that they may be observed by anyone in his own current charts for any period of time, in any normallyactive stocks, and on any exchange or market. By way of demonstration, there were included in this chapter of the fifth edition a number of typical technicalexamples, similar to those already discussed, but taken from Figure 37.1 A 1952 Major Head-and-Shoulders Top in U.S. Smelting, Refining and Mining. This stock had movedup from a bottom at 33 in 1950 to the peak at nearly 88 shown here. The decline carried down to 37. This chartshows the typical high volume on the left shoulder. The volume at the head is a little higher than in the “ideal”pattern. Light volume on the right shoulder is a definite warning. Notice the Pullback Rally to the neckline in thelast week of August. Also, the Secondary Recovery in November and December. There also appears, at the left sideof this chart in 1951, a beautiful example of an Ascending Triangle, indicating the resumption of the previousinterrupted advance. the period 1947-1966. (EN: The eighth edition includes examples taken up through the turn of the millennium.) Itwould be possible to include ten times the number of good examples, for almost every situation that has beenpreviously illustrated has appeared again and again in recent years. Not all the same Although a majority of stocks will participate in a big market trend, they will not all move at the same time or tothe same degree. Some will move quite independently and contrary to the Averages. There was a “boom” in the1920s and there was a Panic in October 1929, but these are inadequate statements, half-truths if you will, and canbe very misleading if they are swallowed whole. A technician, following the individual behavior of stocks, wouldhave been able, through a balanced and diversified portfolio, to protect himself against irreparable loss. The facts are that of 676 stocks we have studied through the period 1924-1935, only 184 made a Bull Market Topin August-September-October 1929 and suffered Major Declines in October and November of that year. Therewere 262 stocks actually in Major Downtrends before the year 1929. Another 181 stocks made their Bull MarketTops in the first nine months of the year and were already moving down before the end of the summer. Five stocksdid not start their decline until after 1929 and 44 stocks continued to make new highs after 1929. In Figures 37.9through 37.11, there are three stocks showing very different trends during the years 1927-1930. Figure 37.2 Downtrends seldom show the perfect and regular trendlines we often see in uptrends, but in spite ofthe irregular, ragged rallies and spotty volume action, the basic principles are about the same as for advances.Notice in this six-month period, Inspiration Copper had no rally that carried above the Top of a preceding rally. Awell-marked downtrend of this sort must be presumed to continue until there is a marked change in the pattern andvolume action. Notice the volume on the day “IC” broke the historically important 52 level, and subsequent action. Figure 37.3 Part of the Major Advance in Granite City Steel. Here we see the familiar phenomenon of Support andResistance in almost every move through the period shown. The August-September Rectangle held for six weeks between the top limit of 47, which was reached on threeoccasions, and the bottom at 44. Like most Rectangles, it was marked by heavy volume at the start on July 19, andgradually declining volume as the pattern progressed. The breakout move on August 29 was on enormous volume. After this breakout, there was a typical Flag-like reaction on sharply diminished volume, and although this movepenetrated the top border of the Rectangle, the penetration was not decisive or significant, and the lower borderwas never violated. Now, see how volume appears on October 15 as the old high is reached, and again at the top ofthe move on November 14. The decline returns to the level of the September high on a low-volume reaction. It isinteresting how, on five occasions in this chart, the 52 level served as a Support or Resistance point: twice asResistance on the way up, and three times after the new October high, as Support. On the next rise, we see almost the same type of advance. In this case, the Support-Resistance Level is about 57.Notice the approach to the critical level, the backing away, the aggressive move into new high ground (in mid-December), and the recession to the Support at 57. Advances of this sort seem to represent the ebb and flow of the Minor Moves during a Major Trend when there areno great “news developments” to change the normal progress of the trend. Where there are frequent and importantchanges in the market or in news affecting the industry, we may see long Consolidations or Secondary Reactions,but the Major Trend is durable. We must not assume a Major Reversal prematurely. 48 44 40 38 36 34 32 30 28 Sales 100's 125 100 75 50 25 JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER TT ■ ■ ■ 1!! ; : TH ;48 i fH ••■•Itill! ::::: tainlllll :::::: ::::: 7 :w B Tim .. ■ ■ ■f tt 3 :: r* ::Hill i m w nrn O mi i T jji t tr 1 ffffff H ' *tTirt .f;:: : Iff "•ffi • t ■ .... y :: 111 if yHt ®i° W Q iND 50inr.r;lND4%STOCKtarn* .....i SEE HWuul *’J1 :: 11 llllllllll !!iljiijiiii.i : :• i:::: : ::: : :::iiniiii i: 1: mi mi ■ inIIIXI4 EEEE WE H H ::: 1 1 1 1 • ■ 5 E : E min ...... ••MM EEEEEE ::: j S: : : EEE:: ::::: ::: : SI? ii|*H • ::::::: 5 ::::: wl- w 4ltn - H-l mi■Ffll: Hn5?fl HHi :::: | .H::-' r Ift :,;g| I s ii :I4iIn :1i wiffi :::: ::m & Hr SS J im i :::: ml B r :nn JlHiiii t t i k KA ASON ..... < HTE M vINC :: 4 L956 Hl ►int : :: , ,■ •«•■< i ii ....... :■ ■a 1 T r 1 II 1 1 1 1mil III11111111111 . hi I L i kill1 JillLI LUJ111LklinkUlLuiiiiiiiii Figure 37.4 During the same period that Granite City Steel was making the series of steps upward, as shown inFigure 37.3, Masonite was doing almost the same thing in reverse. To have continued to hope for a change in trend with a stock that was acting as “MNC” did through the latter partof 1956 would have required an unusual amount of optimism or innocence about the habits of stocks. Actually,there would be good reason for optimism if the stock had been sold short early in the trend. This is almost a perfect counterpart to the “GRC” chart. We have not only a series of declines with rallies that failto establish even Minor highs above the previous Tops, but we are also able to draw a trendline with a number ofpoints of contact on the way down, which is somewhat unusual in a downtrending situation. Notice the tendency ofthe rallies to stop short at the level of previous bottoms in a series of Support-Resistance Levels. We see suchaction at 44, at 41, at 38, and at 36. We would certainly not consider the breaking of the trendline on the upside in late December as evidence of aReversal. Such a break after a trend of this sort probably means no more than a Secondary Recovery. To be ofgreater significance, it would certainly call for some volume showing, which was utterly lacking here, and beforewe would consider the stock again strong enough to buy, there would have to be some sort of Reversal Pattern. Afaltering rally back to around 40 would, in fact, suggest the advisability of further short sales. DELAWARE, LACKAWANNA AND WESTERN 11 Sales 100's 125 100 75 50 25 SEPTEMBER OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY Figure 37.5 Very often you will hear the question, “But how can you tell whether a technical formation or abreakout is valid?” In many cases, and in a great majority of upside patterns, the volume gives such a decisiveanswer that all doubts are removed. Not always is the volume confirmation as clear as in this chart of Delaware, Lackawanna and Western, but this is typical of a good many breakouts in uptrends. You will see the volume wasgenerally light during the Rectangle, in which we see five plainly marked Tops and Bottoms. On Thursday, November 4, the volume increased sharply as the price moved up to the top of the Rectangle andclosed at that point. The following day, Friday, we see good volume again with a close beyond the top border.From this point on, the move is obviously upward. There was no indication of Reversal at any time after the breakout. A Top was reached in March at 25 1/2. This was an especially vigorous move as it came out of the Rectangle. Normally, we would look for MinorSetbacks such as the series of reactions in “GRC,” Figure 37.3. If these had occurred, it would in no way haveweakened the Bullish Pattern. 22 20 19 18 17 16 15 14 13 12 11 Sales 100's 250 200 150 100 50 Figure 37.6 The situation, somewhat similar to “DL” in Figure 37.5, presents a little complication. The problemwould have been whether to sell or continue to hold “LA” after the late October break down through the Bottom ofthe Rectangle. There was no important volume on this drift move, and on only one day did the price close barely3% below the bottom of the pattern. A holder of the stock might well have sold it, might even have executed ashort sale. Suppose now, you had actually sold the stock short; observe the volume and the price action on Thursday,November 4, and Friday, November 5. Notice the volume and the price on the following Monday and Tuesday as itreacted slightly. Then see the quick pick up in volume as the price advanced on Wednesday, the week and a half ofdull Consolidation, and the larger volume on the move up on Friday. Surely by the middle of the first week ofDecember, if not before, you would have seen the danger signals and closed out your short. Such a turnabout does not need to be a tragedy nor even a discouragement. Some easily discouraged traders wouldbe so concerned about the small loss realized on their unsuccessful short sale they would not be ready to seize theopportunity to reverse position and buy the stock after the strong up signals. This move carried to 26 3/4 in March1955. 52 48 44 40 38 36 34 32 30 28 26 24 22 Sales 100's 250 200 150 100 50 si 1 ftftt ::::: :iff BBintFii liil iff ■ ■ II § : :: ••••iff ii ttft t ft f fttftft ni 1 ii ittHtiftftgftfftt: 11 :: ::Hh H• W- T A MCTTCTA/FTTA T T T TDAZTr’A T LNTTft Lt fit f 11 ft ft tftft tftt .. .iff FAN S TEEL M META ALLURGI AL F 1NLff:: JfffffftfffS .. ..lift :: !!!!! IIlllll II Illi* ...... ::::: I : :: : |: i i n;::::innnnin g: -tffffOff 5:it Iff ' *1 II Kit* IIllltl iiiiiiiiiinliniliiiiii 1:1: I' i 111 tffiigLA g:::::}ggggtg{g• ii mu IInut II lllll■I lllll iiinn IM.11 linn iiitn■ffl 1 ........ u tt U 1I :: ;::::: ...... tttjSt lilt ft ft 1ft' T ft ■ ■ ftIt t B: II.....Illi H MH MM m :nu I::::::::::::::::::::: 'Hii JR 1R IRHIM:::Illi : :: : ft : 0 nd::::: H-n;-: -- - - S 4 H ♦tmt; ::::::::::: H::| Ii ::::! : ••1 im lu:: u j:. mi HI is :::: :::L -■* 11- - • ■ 1 ft ft : ::ft : 4; u.: Ji ii * j 1 4ft .■:: I g! Hi ii ' ■ '|i|H iiilliiljft i’HiiiS&i4; iiSShtti ll L W R::: si ii ii;:::::::: :::: Hffg iggae Iff Iffi ;; •; j ! J ■K fS •r :: B-fr-n ttmW ;; 1 smHSffls ..... ::: ■........ ■ iiiiitPw 4$inniii mfrffl It lllll 1L1 nt 11+41 IUL1+11+ 4h iB•••••4-4 :::::::: 1 <(l 1 III 1 III 1 III :|i ::::: 3mfftfeIffiff 1955 - 19561 III 1 III1 III 1 III iittt HHHfftflffft* ft I* tttft ftrr tftftftp t fttftffttfftfttft ft fttftft tt tftfttuti •tftft III 1 III 1 III 1 III 1 III 1 III 1 III 1 ■ 1 1 1 mill:::::: ■■■IIImin 1Illi min :: :: :: m 11 Iff : :::::U L H ftift.ttft, L 4ft ft + ■ ttt ■ ■ftftt iftft jffiW + :: | : '■■■: III 1 III 1 III 1 III I IMtt nt i tttft ft*ititii t 1 w ffl : 4- ITT . .. ........ ffjggslSmi ::::: T s r 1 1 if iimini lilllll[ TJ IBS i■'liii u II HI lilllll mffi It .111 F ' M ‘ A ’ M ' J ’A ' S 1 O ' N ‘ D 1 J 1 F 1 M 1 “A“'TM-' J L Figure 37.7 Bottoms normally take longer to complete than Tops. That is one reason we have this chart of Fansteelon a weekly basis, so that a year and a half of the action can be shown. The pattern shown at the left is aConsolidation formed after a rise from the 1953-1954 Multiple Bottoms around 21. The top of the AscendingTriangle corresponds roughly with the April 1953 peak. At the time this Triangle started, in early 1955, it was not possible to identify it as such—particularly since theFebruary high ran a little higher than the horizontal Tops that eventually formed. However, during the sevenmonths preceding the first breakout move, it became increasingly clear each rally to the neighborhood of 32 1/2was followed by a reaction on low volume, and these reactions were forming a series of Rising Bottoms. In the first week of September we see a clean penetration upside, and from here on, the advances and declines fitinto the typical pattern of a Major Advance. Notice the Breakaway Gap in November and the low volumethroughout the December-January-February reaction. 14 Sales 100's 125 100 75 50 25 :::::|| || $ BHHH2ma::::: ..... :;:!: ::::: ::::::::: ■| W Esffi i kii ...» TnttHft+1 +i+ 4+ :HH Hr r*4 0 • ■>] HIH InjS: O*Htt ii 1:tin* Lrt*14■ B ; iV P- — ilS — ::::: I ■ •(III: :s:: . MillI rr4 ftft ■ 30 Libi > n ill HPtill n it! !:::::::::::::ai:::s B jtt H?ra ffl •ran “4* H>:1*II Mir ' :n ™ iilB T p nt S' Soli innb Si ■ iiiiii ::::::::::::: s#;1HHi s HH: m iiiiii li :HTr W SI rfeiS :-l i it« f :: ':': : uwO ijrsf*ffiH£T iSi: T X:::::::::!:::: fflgggmgsxiiiulHRx stiff Hl £ |Pl T ::::::iniinn4ftt ini s n t|fn Si ...syas :: : ii :::::u i :::::::::::::::::: ®£fe aa :::::xHttI T : iil IO TEXTRONTXT ||i 1956-1957 1 : if ::::::::::::::::: w i :::::fttr : T F K R lira ama S H F ffe: I......ORI ni .11 II 1 " J iiulLlliiilLlilJiLill111 jl lift Llilt1111 11 Hill111 T 2 1 AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER JANUARY 11 18 25 1 8 15 ’22 ’2^ 6 13 20 27' 3 10-17 24 1 '8 15 22 29 5 ' 12 19 Figure 37.8 Here, in a daily chart, we see once again the dramatic sequel to a Descending Triangle. Here is thetypical series of declining Tops on rather low volume with retreats between the rallies to a horizontal line. Notice the important Support here was violated with heavy volume on Friday, January 25. Although the degree ofpenetration was not great, in view of the generally Bearish reaction to this point we would sell at once. ADescending Triangle has Bearish implications even before the breakout. There was no substantial Pullback afterthe breakout. Since it is not possible to count on such a recovery after a break through Support, it is safest to selllong holdings immediately or to place a very near stop on them as soon as a close outside pattern occurs (in thiscase, outside the pattern as adjusted for ex-dividend). Notice the pickup of volume as the price drops into a tailspin at the end of January. Heavy volume is notnecessarily a feature of important downside moves, but it may, and often does, accompany them, and when it does,it simply underscores the significance of the move. Question: does Textron look like a “bargain” to you at the end of January on this chart? Would you be tempted tobuy this stock because “it can't go down any more,” or because it is “due for a rally,” or because it is “sellingbelow its true value”? Suppose “TXT” did have a technical rally, which seems quite likely after the move shown. How far would youlook for it to go? Would you expect it to penetrate the 20 level in the near future? Would you call this a BullishSituation at the end of January 1957? LIBBY, McNEILL AND LIBBY 1927 1928 1929 1930 Figure 37.9 (a) Libby, McNeill and Libby showed no serious effects at the time of the October 1929 panic, andwent on to new highs in March and April 1930. (b) Chrysler, one of the great market leaders, made its Bull MarketTop in 1928, more than a year before the Panic, and had already lost 60% of its value before October 1929. (c)Eagle-Picher Lead never enjoyed any Bull Market at all. Aside from an unimpressive rally in 1928, it was in adowntrend all the way. The examples given are not rare exceptions; there are many others involving important stocks that did not followthe pattern set by the Averages. This variety of behavior is typical of the market. It is to be seen today. They are not“all the same,” and each stock must be studied individually. In Figure 37.10, there are a few examples showingdisparate action during the years 1953-1956. There are hundreds of others that would illustrate the point equallywell. (a) 50 40 30 20 750 500 250 Sales 100's Figure 37.10 (a) West Indies Sugar broke out of its “Scalloping” Pattern in late 1956 to make its own Bull Marketat a time when action in the Averages was apathetic and generally weak. (b) Although the Averages continued tomake new highs through the spring of 1956, Westinghouse Electric made its top and went into a Major Declinemore than a year earlier. (c) Here is a companion piece to Eagle-Picher's chart of more than 25 years ago, shownabove it. Kresge, like a number of other “blue chips,” did not participate in the Bull Market Moves of 1953-1956. These six charts were adapted from “Graphic Stocks” (F.W. Stephens, New York). The 1927-1930 charts are froma Special Edition covering nearly 700 stocks through the period 1924-1935. The 1953-1956 charts are from a lateredition of “Graphic Stocks.” 38 36 34 32 30 28 26 24 22 20 19 18 Sales 100's 250 200 150 100 50 NORTHROP AIRCRAFT NOC DECEMBER ' 4 ;11 18 25 J ANUARY FEB R UARY MAR CH 4 41 18 2^ 1 8 45 22 2^ 5 12 19 26 5 12 19 26 2 9 16 23 30 7 14 21 28 ’ Figure 37.11 A beautiful Top Formation in Northrop Aircraft, 1954-1955. The move, which ended here at 39 3/4 inJanuary 1955, emerged from a Bottom in 1953 at 6 1/4. The Descending Triangle is marked by rather unusual volume at the peaks of rallies in February and March.Otherwise it is typical of this sort of Reversal Pattern. As so frequently happens, there was a Pullback effort afterthe March 14 breakout, but this rally lasted only two days. You will notice the volume on the breakout and throughout the downside move was not so spectacularly heavy, notnearly as heavy, in fact, as on the Minor Rallies within the Triangle. As pointed out previously, however, we do notneed or expect so much volume on a decline as we look for in an advance. Volume did not develop until the end of the first stage of the decline. It is quite usual for heavy volume to show upat the end of a Minor Move whether on the upside or the downside. Notice the Flag formed on the subsequent rally in mid-April. The measuring implications of this Flag wereapproximately carried out a month later. During the following year and a half, “NOC” never reached 31 again. 20 19 18 28 26 22 24 Figure 37.12 Bearing in mind the 1954-1955 chart of Northrop in Figure 37.11, we now turn to the action in thissame stock in the latter part of 1956 and the beginning of 1957. The question is whether the Major Downtrend isstill in effect or whether an important upturn has taken place. As usual, it is the volume that must be watched and studied. Notice the Minor Peak on August 14, then the veryheavy volume on August 24. See how the activity dries up during September but resumes briskly as a new MinorTop is established in October. Observe the drying-up of volume on declines and the activity on rallies to the 25 1/2level, which, by the middle of December, has become the horizontal Top of an Ascending Triangle. There was no question about the validity of the breakout move on December 10, and the subsequent reaction in thenext two weeks confirmed this by the lack of activity on the decline. Again, in early February, we see volume pickup notably as a new high is registered. At the time this is written (EN: 1957), it is not possible to say whether or not “NOC” will continue this upwardcourse and eventually smash the “31 barrier.” We feel there will be no doubt in the reader's mind at the beginning of February, Northrop was presumably moving in an uptrend and must be presumed to be in that trend until adefinite change in its market action has taken place. It seems quite probable if “NOC” should advance to the 30-31level, there is likely to be a period of Consolidation with the formation of an Area Pattern before a successfuladvance above 31 is accomplished. As a sidelight on this chart, it might be mentioned that during the period of advance shown above, many aircraftstocks were moving lower. 38 36 34 32 30 28 26 24 22 20 19 18 17 16 15 14 13 12 11 Sales 100's ’EMBER OCTOBER. APRIL AUGUST S CHICAGO, MILWAUKIE, ST PAUL AND PACIFIC ST JOVEMBER DECEMBER JANUARY FEBRUARY MARCH B.; 100 50 Figure 37.13 The 1954-1955 advance in Chicago, Milwaukee, St. Paul and Pacific is an object lesson in BullMarket techniques. Where would such a trend (of which there are many similar cases) leave the man who sells just“because he has a good profit,” say at 15, or who feels “17 is too high a price”? Here is a chart worth considerable study because it exemplifies a great many features of the “ideal” uptrend. In thisfull year of advance, there is no point at which even a tyro technician could find reasonable cause for anxiety orjustification for selling the stock. What is more, we should not overlook the tax advantages of long-term gains. In August and September, we have a perfect example of the Symmetrical Triangle as a Consolidation. The volumeis typically heavy at the start of the pattern and shrinks to almost nothing as it progresses. The breakout volume isdecisive. The reaction after the breakout, also on lower volume, as it should be, runs right back to the apex, the“cradle point” that is nearly always a strong Support on such a reaction. Now follow the action from here; the two days of higher volume in the early November rally represent thepenetration of the previous Minor Top, and the end of the rally, respectively. The reaction comes back to theprevious top. The December rally is marked by heavier volume when the November top is exceeded, and again, to a lesserdegree, at the end of the move. Once more there is a reaction, this time to the November top. A fast move near the end of December repeats the same price and volume action, and it is followed by a typicallow-volume reaction to the early December top. (This is becoming monotonous, but it is important. You are seeinghere a long-term demonstration of Bullish technical action.) Next, we have the January breakout. How far would you expect its Minor Reaction to go? Would you be surprisedif it found Support at the level of the three little Tops formed early in the month at 17 1/2? The following advance drives through the 20 level, and, in a series of small fluctuations, forms an AscendingTriangle. By the end of February, another new high has been established. Can you estimate where to look forsupport on the reaction? Figure 37.13 (Continued) Now we see the formation of the second Ascending Triangle (notice the relatively lowvolume), which is broken on the upside in a burst of trading activity toward the end of April. The next reactioncomes back to the support of the former Tops as you would expect. Once again, an Ascending Triangle is formed,and you will see how the volume dries up throughout this pattern, coming to life emphatically on the breakout onWednesday, June 8. Many students, on first seeing this chart, remark, “Well, the trend wasn't broken until Tuesday, June 21.” Actually,no break occurred on that day. The stock simply went ex-dividend $1.50, which, as you will see if you adjust theprice by that amount, merely brings it back to the Support at the top level of the April-May Ascending Triangle. It is inconceivable that any such regular series of Bullish Patterns could appear throughout a full year of trading ina stock “by accident.” This is part of the normal mechanism of the market, representing the judgments, opinions,fears, hopes, and trading tactics of thousands of traders and investors. It should be added, however, that it is notoften that one sees such a long and “perfect” Major Advance as this. Normally, there are interruptions, distortions,or Secondary Reactions from time to time. 80 76 72 68 64 60 56 52 48 44 Sales 100's 250 200 150 100 50 WESTINGHOUSE ELECTRIC AND MANUFACTURING CO. 1955 FEBRUARY MARCH i . ApR1^ , , MAY . , JUNE JULY. , 5 12 19 26 5 12 19 26 2 9 16'23 30 7 14 21 28 4 11 18 25 29 16 23 30' Figure 37.14 Does it require second sight to perceive this is a Bearish stock? If you were keeping a chart onWestinghouse Electric and Manufacturing, wouldn't you have recognized, long before the end of the period shownabove, that the trend was down, not up? It is one of the great delusions of the market that the stock we own must be “good.” As prices decline, the price-dividend ratio, based on past history, will improve. Additionally, the priceearnings ratio likewise will lookcontinually better. Investors will begin to speak of “averaging their cost” by putting more money into a tumblingstock (instead of looking for something going their way). They will talk endlessly about improved outlook, newproducts, and a forward-looking management; they will prove to you it is selling “below its true value,” whateverthat may mean. They will bend every effort to establish what is going on before their eyes is not true; that the veryweak-looking stock is actually strong; that the American public is making a great mistake and is misjudging thisstock; that the tape is wrong because they must be right. Nevertheless, values in the market are determined democratically and, by and large, probably represent the bestcomposite appraisal you can find. A move like this is not meaningless, and it is not possible today to attribute it tothe machinations of a few manipulators. In the chart, we are seeing the reflection of a collective evaluation thatcannot be lightly disregarded. Westinghouse reached 50 7/8 in November 1956. o o o o o o o Chapter thirty-seven: The same old patterns Figure 37.15 A typical stock chart on TEKNIPLAT™ charting paper. Allowing for ex-dividends, "OT" neversignificantly violated the apex of the Triangle. The advance ultimately added 60% to the value of the stock. Thischart, in its long, mostly sideways movement, is a good example of the importance of making allowance for theex-dividend drop in the price. During the first five months shown, we see an almost perfect Symmetrical Triangle.The first critical point would be on the slight breakdown in the middle of May. The lower border of the Trianglewas violated just a trifle, even if we had allowed for the 62 1/2(2 March dividend. If one had sold the stock here,who could blame him? No great or immediate harm would have been done. However, an experienced technicianmight have taken into account the insignificant volume at this point and waited a bit, with a stop at, say, 60. (Seethe somewhatsimilar situation in the chart of "LA," Figure 37.6.) If "OT" had been held, the volume pickup on therally would have shown the trend had not yet reversed itself. The second critical point came in late September andearly October, at the time of President Eisenhower's illness. However, if we allow for the two dividends that wentex in July and October, the break did not violate the May Bottom. Furthermore, it was on relatively light volume.If the stock was still held, there was no valid reason for selling on this decline. From here on, breaking upwardsharply from the October-November Island, "OT" resumed the Major Advance interrupted by this long period ofConsolidation, and advanced to the equivalent of over 100 (adjusted for two-for-one split) in 1956. 550 540 530 520 500 490 480 470 460 450 440 430 420 510 Figure 37.16 The Broadening Top in the Dow-Jones Industrial Average that formed in May, June, July, and August1957. Although Broadening Tops have appeared many times in individual stocks, and, as a rule, have carried outtheir Bearish implications, such a chart pattern has never before been completed in the Industrial Average. In 1929,on two occasions, there were patterns that began to show Broadening tendencies, but because these wereinterrupted by continuation moves, about all one can say of them is they may have indicated a growing technicalweakness in the market. The 1957 situation, on the other hand, was very definite and was fully completed. During the early stages of thepattern, several of our friends wrote, calling attention to the possible Broadening Top, among them Charles E.Carden of Fort Worth, TX, who has handled Dow Theory comment and analysis for the Fort Worth Star Telegram.The chart shown in Figure 37.16 is adapted from one of Mr. Carden's charts and is reproduced with his permission. The first significant point after the February 12 Bottom was the Minor Peak of Tuesday May 21, marked (1). TheMinor Decline from this point on Tuesday, May 28 (2), was quite normal, as was the renewed advance to Monday,June 17 (3). The first sign of a broadening tendency was when the Average closed on Monday, June 24 (4), below the May 28bottom. However, this by itself did not indicate a Reversal. The advance was resumed, and surmounted the May 21and June 17 Minor Tops, reaching a high closing figure of 520.77 on Friday, July 12 (5). The Broadening picturewas now quite evident, and the completion of a Broadening Top required only a close below the June 24 Bottom. On Tuesday, August 6, the Industrial Average closed decisively below the June 24 Bottom, signaling thecompletion of the Broadening Top. This was an indication of Major weakness, a warning not to be taken lightly. The Broadening Top, as we have pointed out previously, is an indication of a wildly gyrating market, a marketwithout leadership or definite trend. The presumption is that heavy distribution is going on under cover of therallies and the breakout move is seldom a false one. Figure 37.16 (Continued) Since we are dealing with an Average rather than a single stock, we would consider anyclosing below point (4) after the peak at (5), regardless of how slight the margin might be, would constitute a validbreakout, because Averages are less sensitive than individual stocks, and it is customary to consider even slightpenetrations at signal points (as in Dow Theory) as perfectly satisfactory. You will notice also that, although itwould be possible to draw the Broadening Top through the extreme ranges of the price, as we have done with thewide-dashed line, we have used the closing prices as marked by the narrow-dashed line. This, too, is in line withDow Theory practice, where only closing prices are considered. The implication of the pattern here was Bearish for the “market-as-a-whole.” As might be expected, a majority ofstocks showed weak patterns of trends at this time. As always, however, it was necessary to examine each stockseparately on its merits, because, as we will show in the following pages, not all stocks behaved alike even in thisextremely weak market situation. Compare the broadening top from 1999 to 2000 (Figure 37.17). Figure 37.17 The Broadening Top in the Dow in 1999-2000. If repetition is the heart of pedagogy, the reader maydie of heart disease with looking at the Dow Broadening Top, especially if he was long at the time and eitherdisregarded the signs or was not educated as to their significance. The lesson is always the same: bad news is on the way. The numerous technical aspects of this historic market top are discussed at length in other views of theDow taken at this time. Remember, this time it is different. The market paradigm has changed, and so on and soon. ... Those who listen to fools will be fooled. Figure 37.18 1957 Bearish Trend in Industrial Rayon. At no time did this stock show significant strength. Averages do not tell the whole story. Each stock has to be considered on its own merits. Long before the formationof the 1957 Broadening Top in the Industrial Average, Industrial Rayon was moving down in a Major Decline. Youwill find many cases in which it is difficult to "see" what a stock is doing or to determine its Major Trend, but insuch a situation as this (and this is not a rare case), it is perfectly obvious that the trend is down. Although therewere a number of Minor Rallies and Consolidations during the decline, the entire pattern was so obviously part andparcel of the same big decline that no one who was even slightly familiar with typical stock behavior would havebeen tempted to buy the stock, even to cover shorts. On Monday, July 29, there was a sharp downward break with a gap on climactic volume. This would havesuggested the probability of a Minor Bottom, and for three and a half weeks, the stock did stabilize at around 24.But even during this Consolidation, the continuing weakness showed up on the small Descending Triangle that wasformed, and ultimately on Wednesday, August 21, the price broke sharply to continue the Major Decline. 446 Technical Analysis of Stock Trends Figure 37.19 1957 Bullish Trend in Lorillard. Although most stocks declined in 1957, there were a number ofstrong issues like this one that appeared to be totally unaffected by the general pessimism. Averages do not tell the whole story. It will come as a shock to many readers, who rightly regard the latter half of1957 as a Major Bear Market, to see Lorillard making a typical Bull Market Advance. Lorillard moved up from15L to 34 during the year—and reached 54J during the first three months of 1958. It is hard to believe this chartand the Industrial Rayon chart we just looked at cover the same period, the year 1957. The majority of stocks did suffer severe depreciation, but there were a good many issues, like Lorillard, whichenjoyed a generally Bullish Trend all year. Among the important stocks that moved up consistently in 1957 wereAmerican Chicle, Anchor Hocking Glass, Colgate-Palmolive, General Foods, General Cigar, Grand Union,National Biscuit, Parke Davis, Penick and Ford, Plough, Inc., Proctor and Gamble, Ruberoid, Vick Chemical,Winn-Dixie Stores, and Zenith Radio. Whatever theories we may have as to the condition of the "market-as-a-whole," we must always realize we arebuying and selling individual stocks. (EN: Unless we are trading Index Shares.) We may get a picture of extremeBullishness or extreme Bearishness in the "general market," but if this picture conflicts with the clear evidence in aparticular stock, we must recognize it is the stock, not the Average, with which we have to deal. We cannot assumea stock "must" follow the Average. Often, it is possible to obtain greater stability and safety by buying a few strongstocks in a Bear Market or by selling short a few weak stocks in a Bull Market, than by attempting to maximizeprofits with an "all-out" position one way or the other. Chapter thirty-seven: The same old patterns 447 448 Technical Analysis of Stock Trends 68 64 60 56 52 48 44 40 38 36 34 32 30 28 26 24 22 Figure 37.20 During the latter nine months of 1961, some well-known market Averages continued to show newall-time highs. However, the Evaluative Index (see Chapter 38), in this period did not indicate any such overallstrength; many stocks were in almost continuous decline for the nine months. These included such important issuesas Air Reduction, Allied Chemical, Allis-Chalmers, Aluminum, Ltd., Fansteel Metallurgical, Flintkote, HeydenNewport Chemical, Sperry Rand, Texas Instruments, Trans World Airlines, Universal Match, and many others. Atsuch times, it is best to choose stocks selectively and maintain adequate liquid reserves. 40 38 36 34 32 30 28 26 24 Sales 100's 50 40 30 20 10 HOTigttfg o - l■l■■ll■■l■ mill millIII laiiaiuiiilamiiiiiaiHi r^Jrtrr:l*illrffilti i i rmOWtr5 iiatuiiiii laaiimaaaitai :s:::ss: isaniHsiss • •1...... nil; mil. 11 44- U 1 11»i ■ fi- • ■ -tit-• ‘ 8BH n(HlifIBiHIf? ifi BiWiSnt r.;i. nni tupfh IL •jtiMM ::::::: : ::: :::::: B y- g.g h* 1 1 iiii i lOii Hfflgl§3 Qr Iffl BU■RND' s?s f C ORPORAT 11 4()\ E >DC H isy ,1J 4 | || • • ■ ■ : :: : :: !••••ss 5 :: w i: 4:4 : ::: :: " :¥’s?:S#1 i..HI. 1H?US ri IB4 H 444U T j .m iii II i ii ■WfMW i ■■ • Ml .■ : :: 1} TT I TT 4 •:::::: H u <. ••it :: :::: :: ■ ■y o ::::::::: ii SI IMi H i i imp J ffit J I-::::::::::::::::::::::::::mi ■ ■ ■■” ■■•••■•a rti 1961 ' TT T ''11 P+ff'ff-Tw 111 ...... :4t 4 tf III w io 7TT T H :1Wi±L . ti, IHlii.11 :::::! S S□ m’ 'tg rirl mt II : : 4: I IIIffi 4 i S -HU iHffl ::::::: T I ttTT........... :jh:,‘Ut |' |H|h{-: t J..... jffl • i " i : III; ill 1 1 titutffi i# Hi: ■..... 1......J mj • . W 1.111ii 1- nnn irnnmn n. 1 1 11.1Lini rr . :ii .iili 1: im . A.11 ZZUZZ-------------------------0 iuiiiliii^iiiii,uiiiiiuuiiiiuuuu.uuiaiii»iiiii^iiuniiiuuiiiiiiiiuiu^ui»'ui»uiijuuiuiuiiuiiiiuiiiiuiiiu^iu.imii APRIL MAY JUNE JULY AUGUST 125 1 I 8 15 22 29 6 43 20 47 3 40 47 24 1 . 8 15 22 ■ 25 5 '12-19 25 2 '9 46? Figure 37.21 A familiar Top Pattern. From the end of 1957 to the spring of 1961, Burndy Corporation moved frombelow 10 to 37 in a generally Bullish Trend. The advance accelerated sharply on the postelection rally of late 1960and early 1961. However, with Burndy, as with many other stocks, the rally ended in the early months of 1961.Here, we have not only a perfect example of the Head-and-Shoulders Top in the price action, but we also have thetypical volume confirmation. The early April rally was on heavy volume. The rally in the last week of April was onsomewhat-disappointing volume, although a new high was made at that time. We have a definite increase ofvolume on the retreat from this peak, and practically no enthusiasm in the final rally of the first week of June. Thebreakdown on Monday, June 19, accompanied by heavier volume and a definite gap in the price track, confirmedthe Top Formation. Although Burndy held around the 30 level for a time, and after a further drop recovered to 31,the Major Trend had definitely been reversed. By June 1962, Burndy was selling at 11 3/4. Figure 37.22 Weekly chart of Brunswick Corporation showing the final stages of the long Bull Market in "BC,"the Climactic Top in March 1961, the distributive phase through December 1961, and the ultimate breakdown. For five years, from 1956 into early 1961, Brunswick advanced in a great Bull Market surge. During this period,the stock was split four times. In the first week of March 1961, terminating the postelection rally, "BC" made anew high on extraordinary volume, but closed the week nearly at the bottom of the weekly range. The One-WeekReversal might well have served as a warning to the market trader. Assuming, however, the owner of shares in Brunswick was not a trader and was interested in the stock from along-term point of view, he might have held the stock through the breakdown from the Symmetrical Triangle formed in March and early April. He might have continued to keep his shares through the summer and fall of 1961and the rally of September and October. If so, and if he had been watching the action of the stock, he would realizethe 50-52 level was a critical area. A break through this previous Bottom would represent a serious failure ofSupport and, certainly, the decisive violation of the 50 level in the first week of January 1962 (with heavy volume)could be recognized as a very dangerous Reversal Signal, calling for immediate sale of the stock regardless ofcapital gains tax or anything else. Although this move preceded the general collapse of the market by severalmonths, it was a clear technical indication of extreme weakness and extreme danger in Brunswick, regardless ofthe action of other stocks at that time. If an investor had noted the break but decided to "wait for a rally" to sell hisstock, he would have had no chance to get out. Brunswick never recovered, never rallied, and by October 1962 itwas selling at 17. Technical Analysis of Stock Trends 240 224 208 192 160 152 144 136 128 120 112 104 Sales 100's 1100 1000 900 800 700 600 500 400 300 200 100 ::::: ::: :::: i 4.....— 22 :::: ipjmmHtm:4 •:::: : m ::i :::: :::: SgwM r St I J ftmm26663££ jl 0 E H : ffl 3t 4..»±[EHr m ............ mt rrm timnmmt T/ii rtttttxi. 1 Hriti |i mt 4mm? Qu Sf mfr •tiintitr iM 1 : R :: 1 3 s gH|:: sii ■ H 1 ii :::::- T : gig— E3 1 ...J6T: - 1 P OL ARC mns? )ID C nmf OR ..... PC :: )i HCATIOIN PR EED w tmti r! Hig mm it t it it:::::..... ..." WtIraira t • i ::::tmgII i tte.....i:;; - ■ 111).ill <111 ■"T llll 1 IIIm 1 11 tt I ttii uw .... ii i.il. 61.. .1 **t-T • • • 1 ......f'f ml .. . ... w ±..111k 1 Ill 1 iinn jjll. ulIllillll11.1lilk..in Hill Mui■ nilinnlulililill. .Ilillli.l.III 3 JANUARY FEBRUARY Figure 37.23 A beautiful example of a Rectangle in Polaroid. Notice the low-volume fluctuations between(approximately) 178 and 202. On Thursday, May 10, on the highest volume of that year to date, Polaroid brokeSupport and plunged to 168. This was a clearly Bearish Move. It would have been fatal to “hold for a rally,” forthere was no rally. It can be very expensive to hold onto a stock wishfully when the situation has changed radically,no matter how good it may have looked previously. Note this break came more than two weeks before the “near-panic” of May 28. By that time, “PRD” had dropped 50 points and was headed for still lower levels. 17 16 15 14 13 26 24 22 20 19 18 Figure 37.24 At a time when a majority of stocks were already showing signs of serious weakness, early in 1962,Copper Range was making vigorous new highs. Actually, the move did not get far; it never substantially brokeabove the 1961 Top. The evidence of weakness in “CPX” did not become apparent until, after the relatively weak April rally, the stockbroke through 19 on Monday, April 30, and closed at 17. This was the completion of a well-marked Head-and-Shoulders Top. In this case, there were three days of rally before the downward move really got under way, but itmight have been dangerous to count on a rally after the clearly Bearish signal. Incidentally, this Top Formation was completed well before the precipitous drop of May and June. 40 26 24 22 38 36 34 32 30 28 Sales Figure 37.25 Like practically all stocks, “UV” went into a tailspin in the spring of 1962. After the “bad day,” May28, it continued to slide throughout the month of June. At this point, there started what could be considered nomore than a technical rally in a Bear Market. This rally stopped at 29 and was followed by a dull decline lastingabout two weeks. The next move, in the second week of August, was marked by considerable volume, and although there was noobvious, clear-cut pattern, it seemed significant that the 29 level, briefly touched on May 23, May 28, and July 12,was penetrated on August 6. Whether to regard this August 6 closing as an immediate buy signal, or to wait for the completion of the breakoutmove and look for an opportunity to buy on a reaction, would be a problem. In this case, it would have paid towait. Notice the late August reaction came back to the 29 level, where it found Support, and then continued itsupward move. Considering the weakness of most stocks in this period, the action of “UV” is remarkable. The important thing torecognize is individual stocks do not necessarily follow “the main trend” of the Averages. Figure 37.26 Weekly, July 1961 through June 1962. This chart shows the Head-and-Shoulders Top Formation inthe Industrial Average that preceded the collapse of April, May, and June 1962. Normally, especially in the chartsof individual stocks, there would tend to be heavier volume on the left shoulder. The price pattern alone issufficient to mark the pattern as a dangerously toppy situation. During the entire period in which this formationtook shape, many individual stocks representing important companies were showing Top Reversal symptoms, asmight be expected. Note, so far as this Head-and-Shoulders Pattern is concerned, the Reversal Signal is notdefinite until the neckline has been penetrated. Figure 37.27 Daily, April through September 1961. Here is a rather confusing and complicated chart, but one thatcontains several points of interest worth a bit of analysis. Notice the beautiful little Head-and-Shoulders Top inApril and May, especially the volume weakness on the final rally before the downside breakout. Notice also thisstock was split two-for-one in June, but such a split does not materially affect the technical action of the stock,except because there are now two shares of stock (at half the market value) for each share of old stock, there maybe some increase in the average number of shares traded per day. Notice also that once the downtrend wasestablished, the rallies (especially the mid-July rally) do not penetrate the trendline drawn through the April andMay peaks. This trend continued down for more than a year after this, reaching a low of 11 1/4 in October 1962. Figure 37.28 Daily, January through June 1963. Here is a good example of a Symmetrical Triangle as aContinuation Pattern. Triangles of this (Symmetrical) type may mark Consolidations in a Major Trend, or they mayconstitute a Reversal Formation. The characteristics in either case are an active move to the first turning point ofthe Triangle, and then, generally diminishing volume as the price fluctuates in a narrowing pattern. During thisperiod, it could be said the stock was in both an uptrend, marked by the lower boundary of the formation, and adowntrend, indicated by the upper boundary. Notice the increase of volume on the breakout, which, in this case,was on the upside. Also, notice the reaction to the “cradle point” defined by the intersection of the two boundarytrends of the Triangle. The advance of the stock from April to June measures just a little more than the height ofthe open side of the Triangle. The attainment of this “objective” does not necessarily mean the termination of theMajor Trend, however, and by August 1963, Cerro had reached 33 1/4. M CRUCIBLE STEEL CO. OF AME m i 11 111 11111 i iii ii Ji! III I Illi 1 ' ■ 1 1 1 11 H::::::::: :::::::::::::::::::::::::::::::::::: :::: ::::::::::::::::: an - A- 1 >• ^iHiiiii i iii iiiiiai ii iiii iiiieiiiii 1 uiati nai 1 nBaMaiiaaBtiiBiaBtittaaiBioaaia aaa aaaaanvaaa laaaaaaaaaaaaai 11 it*'itiaatatiaatinataiittaaai(aaaa«*taaa aaaaataaaaaai; *« n laaaiaaam (UlUllill...... I 1 (It ............... «( 1 ............ .......................... • 1 11a ........... mm 11 » itnat ai aia • iisnaiiaai.....liiiiituiii t i tia temnaaa ta aaiaaa 11 » aami 11 tn i w—ac~*"ii’"**jaa—nrrnwr • t x:n:N: ::wa iiitmlatiniaai n mitiiimi ttu it iiiiuh it tairii i iimiii at at i anna«iaaHiMiiiiiaii>iitaaa«i •laM'ittiiMiNHi, taaaaaaiaaattaait at 1 h ■: 1 in: 1n»w 1 mr; ji 1• t m n umiNNii u nti u HNNNNN*iK±;uNN imKint•i"ihi nnnn:m •• •••* • ••••• ■ >■■■ aaa a......a aaa aaaaaa ( ■ ■ ■■ a a in 1 >1 aaa a aaaaa ........Si : —:S 111 11111111111 min min 11111111 i iiuiiiim urn 111111111111 mu 11111 H 111 mil i iminim 1111111111 ni mi mu mu mu i imnnii mu 111111111 in mu mu mm u iiuiiiin IIIII 1 ru 1111111 mu 1 min 1111 gu miimiiii 1111 mi MARCH APRIL. , ’.MAY/ . JUNE JULY . AUGUST 1 9 16 23 37'6 13 20 27 4"11’18 25’ 1 1 8 ’15 22 47 6 43 20 27 3 ' 10 1724 31 Figure 37.29 XA. Daily, March through August 1963. Here is a good example of an Ascending Triangle, in whichthe rallies advance repeatedly to a given level; the reactions find Support at gradually higher points. Such a patternnormally indicates a potentially Bullish situation in the making, just as the reverse (Descending Triangle) implies aBearish tendency. Notice the higher volume on the various peaks near 22, and the very high volume on thebreakout move in August. If any further evidence of the strength of this move was needed, the Breakaway Gap atthe opening, Monday, August 12, would supply it. After a breakout of this sort, it would be quite normal for thestock to suffer some profit-taking reaction, usually on light volume, and such a reaction might run back to 22 oreven a little below this without altering the essentially Bullish nature of this picture. 1408 1280 1216 1152 1088 1024 960 896 832 768 704 Sales 100's 5 4 3 2 1 JUNE JULY AUGUST SIPIIMBI^ OCTOBER NOVEMBER ' 2 ' 9 '16 23 30 7 '14 21 28 4 ■11 18 25 1 8 15 22 29 6 13 20 27 3 1017 24 Figure 37.30 SOC. Daily, June through November 1962. Before commenting on the November breakout here, weshould call attention to the fact “SOC” was one of the stocks that held up fairly well during the Cuban crisis inOctober 1961 and did not make a new low under the June bottoms. This chart picture is an excellent example of aDouble Bottom. It is not necessary for the two Bottoms to be at exactly the same level if they are reasonably close.The important thing is the stock has found Support once, has rallied, then declined again, and has found Support atnearly the same point. The Bottoms should be some distance apart; there should be at least six weeks betweenthem, preferably more. Also, the rally between them should be definite and should amount to at least a 15% gain atits peak. The formation does not acquire significance as a Major Bottom Pattern until the level of the top of therally is penetrated on substantial volume. This penetration took place on Tuesday, November 13, and from thattime continued in a Major Bullish Trend, reaching 1559 in May 1963, an advance of more than 500 points from theclose on the day of breakout. Double Tops have an opposite significance; they are similar to the Double Bottoms, but they consist of two tops atapproximately the same level, separated by some weeks or months, and with a decline between them, which mustbe penetrated to validate the Top Formation. 64 60 56 52 48 44 40 38 36 34 32 30 Sales 100's 50 40 30 20 10 Figure 37.31 Daily, November 1962 to April 1963. To the average person unfamiliar with the usual behavior ofstocks in the market, the price fluctuations appear meaningless and entirely fortuitous. If they are aware of generaltrends lasting months or years, they are often inclined to consider only the trend of “the Averages,” and are notconscious of the fact many stocks may be making large advances at the very same time that others are slidinglower and lower. It is not always possible to lay a straight-edge ruler along the trend and show \ it makes a perfectstraight line (although this does sometimes happen); however, as in the case of General Steel Industries, there is noquestion the advance is fairly consistent over a long period of time, barring the relatively unimportant reactions,Consolidations, and so on, along the way. You will notice, too, the two-for-one split in early March did notmaterially affect the upward trend except to show somewhat more volume, as might be expected with a greaternumber of (new) shares. For a contrasting (downside) trend, see the chart of Avnet Electronics, Figure 37.20. 32 30 28 26 24 22 20 19 Sales 100's 250 200 150 100 50 Figure 37.32 Daily, February to August 1963. This is an interesting study of Support and Resistance phenomena.Incidentally, it is also an example of a Bearish Stock (and not the only one by any means) in what was generallyconsidered a Bullish Market, during the spring and summer of 1963. We would point out several rallies to 31 inMarch and April, and the breakdown in early May. In May and June, the stock rallied, but it stalled at about the level of the March low. Then there was another drop, and in the rally, this time came back to the late April low. Thenext drop, in July, was followed by a little rally to the June Bottom at 25. This is fairly typical Support-Resistancebehavior. The price level that has been a Support tends to become a Resistance once the Support has beensubstantially broken. Vice versa, as regards overhead Resistance; after it has been broken, it tends to serve as aSupport level. 19 18 17 16 15 14 13 12 11 10 9 Sales 100's 125 100 75 50 25 Figure 37.33 January through June 1963. Sometimes a move happens all of a sudden and does not result in acontinuing long trend. In this case, it is not possible to say whether the long-term trend will be up or not. Thepurpose of showing this chart is to point up the remarkable action that can follow a break through an importantSupport or Resistance Level. You will notice that the entire period from mid-January to Tuesday, May 14, can beregarded as a Rectangle on the chart with Bottoms at about 10 1/8 or 10 1/4, and Tops at about 11 3/4. Notice theincrease of activity on the several rallies during the formation. The move, which was a “situational” thing insugars, affected all sugars in May, and turned out to be somewhat of a flash in the pan. Nevertheless, it was aspectacular one, and a trader with courage and acuity might have picked up this stock as a speculation after theclose of Tuesday, May 14. The next five trading days advanced the price from Wednesday's opening at 12 to theTuesday, May 21, close at 17 1/2, an advance of 46%. This is a type of market trading we would not recommendgenerally; it calls for courage, experience, and the willingness to take a number of small losses to secure onesubstantial gain. However, the in-and-out trader who observed the action on May 21 and noticed the One-DayReversal with abnormal volume and a gap could have secured maximum quick profits either by selling his stock atthe opening of the next day or by placing a stoploss order just under the close, say, at 17 3/8. 64 60 56 52 48 44 40 38 36 34 32 30 28 26 24 22 Sales 100's 500 400 300 200 100 ii( ii urn Iii 11 mu CONTROL DATA CORP’ CDA :::::::::::::: FEBRUARY MARCH APRIL MAY JUNE . JULY ' 13 20 27 6 :13 20 27 3 10 17 24 1'8 15 22 29 5 12 19 26 3 10 17 24 31' 7 7 Figure 37.34 There are some warning signs in “CDA” in the Minor Breakdowns of late March and early May.What seems especially significant, however, is the nature of the recovery move in May and early June 1965. Thetwo convergent boundaries of the Recovery Trend form an up-sloping Wedge, which has rather definite Bearishimplications. If the Wedge had been pointed down, it would strongly suggest the possibility of a decisive upwardbreakout. Notice on the two days during which the highest prices were attained during this Wedge Pattern, thestock closed near the Bottom of the day's range. The subsequent history here, the collapse on heavy volume, showsclearly how dramatic a break from this not-too-common formation can be. 256 240 224 208 192 176 160 152 144 136 128 120 112 104 96 88 Sales 100's 500 400 300 200 100 ::: iii ::: :::: HS-:::: :::::: :::::::::::: ::::::: :: ::: :: ::::::::::::::: :::::::: :::::::: :::::: ::::: nils :::::::: 11 II 1 :: :: :: ::: :: Is : :::::0 ss II w tmti ::m ;60 lit ::::::::: :::::::::Hi: F it.;-!Hti?ni ♦ m Ii w1 ::ii: I ttmfII si •56 :: :::: ■ p«I <:■ !!! a ffii 1 : : n Mtt n 3tH J ii :::: • ■U.S. SMELTING, REFINING ANDa 52 ‘B :*++ 4I NINIG CO . U V IHirTTT 148-i 1 III lllll ■ mi 111:: ::::HU 1 mil ■iii> ' H T IIIIIIII MUM ftn | tth :ti: i TTl 1 III 11111111 II1 ::::::multiin.....St-- 41 tlliu TTTTT4 SDT IT ffMtf tffr TtTTTT nr f ff ff 111111 Uf:jj I IT i: i i :::::::::B :« SI -40. fill 1965 Itltt H I:;:;:::S0t HH 4 ::::::: •Hu itr.ri? :• HHE: ::: 4' 4:::: iiiiiiii S :::::::u :::EHH Ii Bttt:1 -- ■HiHu 1! |L MII 134 # Eld ii k 1: a IS g ; ■:: :: g Im tgg4 •4» :: :: r: >28: lip ill :: :: It H H BL ■ ftltl •• ■■• 4 ■■■•II ...... :::::: ■■•••I MMMi :::::: ih . ::: : r::: •• ?:1 i ni ;!?■■-I II :: ii • l*U :: ••••* a “it IiMM :::::: mi iiMR ■ ilijl Rail m * ■■■■■■■ ::::::: 11 ■ ■ 1■ 1 ... :::: inin 1114 • • ■ 22- 1 i ITT 22 i 11 11 41 I 4 i 4 i 1 1 1 U11 : d t JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER 10 17 24 31 7 14 21 28 4 11 28 25 2 9 :16 23 30 6 13 20 27’4 11-18 25’ ■3 Figure 37.35 Here is a chart that shows several interesting technical features. In July, August, and most ofSeptember, “W” was in a period of dormancy. The breakout of September 27 was followed by a week of inactionand then a strong continuation of the move on big volume. Notice the October-November Consolidation, whichtook the form of a large Symmetrical Triangle. If we draw the upper boundary of this Triangle, and the lower, wesee the breakout signaling a continuation of the move, on Wednesday, December 1, was decisive both in price andvolume action. At no time during the advance from 28 1/2 to more than 62 was there any indication of potentialweakness. 16 15 14 13 12 11 10 9 8 7 6 Sales 100's 500 400 300 200 100 2|g Hi:r itlri ::u: :::|ii!iiiiiiiiiii!ito«i Snb~ilwSHwtttt* ........::::: :::: •HHHir ::::: gm ::::: :::: 1 ::::: ::::: i: . ....... :::u Hie fix 5 1 sL sail in IS! l|ti~ Bfi glffi aliift«...■fwf 1 ttttmittTtttt xttts {flftfe 4l|f ''*****■***'''4tT*»* mil 1141k4 •t..» r m *m it tit.TtFtr irIt I 4 miS HIH S 3f: :&t E t Iff Inf ftfft 1 :: |Si :: :O;H wBwW ±g;;£t nrrttm :: ::: [rlr j-’r-f-::: ’SSrrSTiPtffl:::::::zilllllitffitll r ?ntl Iff! 4 ft ttnirt i:nr J lllJll ttM 1min in i mtnin t min tn imm mu ....... T nt IT ilg 1 H+ttH ::::: : : Tffff ..... min in i ......ill I mill IM •I j II1*IIIIIIIIIIIIIIIIIIIIII II l> IIII IIiimuiiiiiwiffS :::::ffi ::::: 03 fsxssi ■’■ '1 :::::::: ::::::::::::::xs 4 ! :::::: ::::::::::::fiH m* ,n;:;:;r: ;;;;;;;■•;;;•••■ tts text ig:t:::■ 8§Ss ■ •■'iiili:::: . :::: :::tin: ts4yalHini itsH nk ms xst IftS trft ks; I Xtr 1 mftIk: mH : :::s tttt:m7 ' I f(Igig •• II ftm ::::: :s it tt siitiUft:41U4W tff nfn: nff:ftr: xitttth ji ip ::::::::: :: ::::::: tffff :t|. . .. TTA7'TXT/~,CrTV'\XT Figure 37.39 A complete collapse in one day, Astrodata in January 1970. Not the sort of action you see every day,or even every month, but it is “normal” in the sense it is a phenomenon we have seen many times in the past andundoubtedly will be seen many times in years to come. When it does happen, it should be heeded—it meanstrouble. “ADA” was doing well in what appeared to be a typical and perfectly healthy uptrend. After a one-daysuspension on January 15, it reopened many points lower and never recovered. Trading was halted in lateSeptember. Some readers may remember other downside moves of this nature in the past. In Mack Trucks, in FifthAvenue Coach, and some may even recall, many years ago, a break like this in American Woolen. Such a break isdue to some sudden development or change in company affairs, but it is not necessary “to know the reasons”: thechart speaks for itself. As Lady Macbeth put it (in another connection), “Stand not upon the order of your going,but go at once.” There was a good example of this type of a “Gap Move” in Villager Industries on April 30, 1971,when the stock dropped 42%, from 7 3/8 to 4 1/4 in one day. Such moves as we are discussing here are nearlyalways on the downside; we do not often see comparable upside gap moves. After this type of break, althoughthere may be brief rallies, the stock nearly always resumes the downtrend, and in many cases, is delisted from theExchange. Anyone caught holding such a stock should not feel he had made a mistake in buying it, nor should helook for evidence of weakness before the big breakdown, for ordinarily, there is none, however, he should get outimmediately to avoid further loss. By way of reassurance, it can be repeated though this kind of collapse is a ratherrare occurrence. Figure 37.40 Oracle Corporation. Lest one think the air pocket gap does not still exist, here is an example from theturn of the century (third millennium). These gaps, caused by disappointing earnings, were so prevalent at the endof the century at the top of that Bull Market that one could short vulnerable stocks before earnings reports withlittle upside risk and often collect nice scalps like this one. EARN. DIV. . SHARE S PUBLIC SERVICE ELECTRIC AND G A S PE G THOUSANDS OF , 1 ElLJ Figure 37.41 A typical electric and gas utility stock. There are a great many stocks in this group, serving variousmunicipalities or regions. They tend to show similar market behavior because they are basically similar in nature. There is a relation between the earnings of a company and the dividends paid, and the market price of the shares.Neither earnings nor dividends alone, however, are sufficient to constitute a complete determination of “value”because there are many other factors that can affect the “value” considered from different angles, such asdependability of earnings, future prospects, taxability, research and development investment by the company, andso forth. The electric and gas companies, enjoying a regulated monopoly position in most communities, have a sure andsteady income. They are also in a definite “growth” situation because of the constantly increasing demands forpower by users. Most utilities will show a record and pattern of trading over a period of years very similar to thatof “PEG.” You will notice reported earnings have been larger each year from 1959 through 1970. Also, thedividend rate has been increased each year except in 1970, when it was unchanged from the year before. Anyonebasing his estimate of “value” on a simple index such as “price-earnings ratio” would conclude the stock was 2 1/2times as good a buy in 1970 as it had been in early 1965. Obviously, there is more to it; the big funds and other large holders of stock are not giving up “bargains” of thatsort lightly and for no reason. The depressed chart is undoubtedly reflecting the whole thorny outlook facing theutility industry, including costly new facilities, anti-pollution devices, and other problems including deregulation. 176 160 152 144 136 128 120 112 104 48 Sales 100's 2000 1600 1200 800 400 JANUARY AUGUST [ARCH APRIL MAY MEMOREX CORP. MRX SEPTEMBER OCTOBER NOVEMBER DECEMB FEBRUARY Figure 37.42 Although 1969 was Bearish for most stocks, “MRX” was enjoying the final fling of a dramatic four-year advance. Notice the Island-like Top in November, December, and January, and the low volume all throughthis period. The Breakaway Gap in early February speaks for itself. See also Figure 37.39. 44 40 38 36 34 32 30 28 26 24 22 20 19 18 17 16 15 14 13 12 11 250 200 150 100 50 FLY FLYING TIGER CORP 1969, 1970, 1971 TTi I • • • • •' M T A T M ^L J A T S J P T N J-. D J J J F Figure 37.43 From a 1967 high of 48 1/2, “FLY” started a downtrend that lasted two years and took the stockdown to 11 1/4; but during the spring and summer of 1970, the stock found bottom, made a Head-and-ShouldersReversal, and took off in a skyrocket move that, by February 1971, had recovered nearly all of the two-year drop. 44 42 40 38 36 34 32 30 28 26 24 22 20 19 18 17 16 15 14 13 12 11 Sales 100's 250 200 150 100 50 Htt::: 8" SSO1I ...........1............fit " i i T' T H m ■ IILilt SOS Sim® -H T ■*frIftt ttt+ WStTTTT :> [Et *H* ....... ........... ::::: •lllflltltllllnmiiiiiiiii :::::::::::::: ••lll•■ mimi in H T i i iHtti n r r t H*Hin iff i i HHtr it f f f rHHJI .... .11. fU :::::mHJ fit:: S IS® ‘Mft’ :fi{ 44:444rrr :: IIS 4 4Hfin ft:' Tn " ” <■■■■w —.. ......... 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APML 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 5 12 19 26 4 11 18 25 1 8 15 Figure 37.44 Here is a familiar pattern you have seen many times before in the pages of this book or in your owncharts—a large Ascending Triangle in the daily chart of Action Industries, formed in December of 1971 andJanuary of 1972. Notice the typical breakout and reaction moves and the continued uptrend into April of 1972. Figure 37.45 Two things are remarkable here: (1) the amazing story of a business emerging from a college dormroom—a computer business, of course—and (2) the regular occurrence of air pockets, which will be seen better onthe next chart. Not a stock for those who dislike carnival rides and surprises. One should fit his portfolio to hisdigestion. Dell broke its long-term trendline, which the reader may easily draw here with a ruler, and after setting abull trap, went to 20, displaying several major warning downside gaps (see next chart). The out-of-proportionvolume at the chart end is a forewarning. Figure 37.46 DELL. The breakaway or air pocket gap continues to astound, so frequently choosing to occur athorizontal lines. An exceptionally alert trader might have avoided the air pocket, observing the broken trendlines. The average technician would have got out and shorted the breakaway gap. Seen one tulip, seen them all. Figure 37.47 The benefits of the “Wintel” partnership are reflected in Intel's chart. The trader might have been inand out of Intel several times based on tightening trendlines, whereas the long-term investor would have patientlywaited out the—call it a “rectangular wedge”—that never was violated on the downside. The steeper the trendlinethe more likely—even the more certainly—it will be broken. Figure 37.48 NOKIA (NOK). Not enough is made of the marking of zones of Support and Resistance (highs andlows) with horizontal trendlines. These benchmarks help the technician to mark the running of the tide, just likeDow's stakes on the beach. Notice how the high of 1999 influences the high of 2004. The breaking of horizontallines here after the breaking of the steepest trendline once again tells the tale for the technician. Figure 37.49 AMD. Reflecting the vagaries of the semiconductor business, including the felicity (or infelicity) ofbeing a competitor of Intel, AMD shows trading opportunities both up and down. Here the intermediate-termtrader would respond to the vigorous breaking of short-term downtrend lines to get long. JulOct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr Jul Oct 00 Apr JulOct 01 Apr Figure 37.50 Yahoo! (YHOO). A superb trendline that should have kept the technician long until April of 2000—and then got him out, especially when combined with the top horizontal trendline. The extravagant volume at the very top is the exclamation point on the warning. Figure 37.51 Any resemblance between this chart and Amazon (see Figure 23.13) is not strictly coincidental.Readers will remember Magee's principle that birds of a feather flock together. Internet goony birds certainly do—or did. Yahoo! looks in this guise somewhat stronger than Amazon, but then selling books and mortar is a harderrow to hoe than selling electronic images (best business in the world). Again, such an attractive fundamental story.Gooks (or geeks) on skates helping revolutionize the wild frontier—we love these stories, but not enough to stopdrawing lines on the chart and selling them when they violate our lines. Even love must obey the rule of the ruler. Figure 37.52 Apple (APPL). Apple is a remarkable delight because it illustrates vividly one of the centralprinciples of technical analysis: ignore (or take with a cellar of salt) the news. Any time the media swarms on acompany, be skeptical. If we believed the media, Apple would have more lives than a cat, considering how manytimes the media has written it off as dead. It is also a chartist's delight as illustrated in my Basing Point studies(Chapter 28), and here, by trendlines (horizontal and sloped) and a large fan. Readers years from now will want toobserve how the trendlines here forecast Apple's future. Figure 37.53 vividly illustrates the technical signal thatkicked off Apple's run, complete with Triangle and run day, and wake up volume. We constantly deprecated thepress disrespect of Apple—hounds of the press are appropriate—and they paid the price for their disrespect asApple went to 425 in 2011. It is satisfying to see the know-nothings of the financial press exposed for how littlethey know. Figure 37.53 The file of press clippings predicting the death of Apple weighs as much as the daily output of theAugean Stables, and it is worth as much. One wonders why the press likes to beat on Apple so, especially when thewizard was up to his never-ending tricks; the wizard (Steve Jobs) had millions of fanatics ready to support his nexttrick. Although the Beatles are mad at Jobs and Apple, Apple is now a music company as well as a computercompany. The smooth-as-silicon lubricant iPod made music to investor's ears and Apple took off on another run.The start of the latest trick is pictured here. The volume in April is the wake-up call. Of course, what is thatvolume? A shakeout. The breakout across the Descending Triangle line after the false signal (Remember? Thosefalse signals are often followed by valid signals), the volume, and the surging run days—all good grist for theanalyst's mill. Furthermore, the surge across the downtrend line on big volume should be recognized as animportant technical pattern regardless of what proceeds it. Figure 37.54 $NDX, THE NASDAQ 100. Following the Basing Points Procedure in Chapter 28, an almostcompletely objective procedure may be devised for the very long-term investor to replace or augment Dow Theory.In this chart, the Basing Points Procedure is applied to weekly bars. Thus, instead of three days away, we look forthree bars away. The result is a trade that lasts around 10 years! The method gets long in 1991 at the arrow, holdsthe trade until about 2001, and reverses. Observes the bottom of 2002 and reverses again and is long into the BullMarkets of 2006. Arrows show the signals; numbers mark the Basing Points, and Stops, which would be about 5%under the Basing Points, are not illustrated. chapter thirty-eight Balanced and diversified The average investor wants a clear-cut, simple, easy answer to his question, “What do you think of the market?” To him, it must be at all times either a Bull Market or a Bear Market. If, in answer to his insistent demand, you reply with the question, “What particular stocks are you interested in?” he will avoid that issue and say, “Oh, I mean in general.” (For illustrations in this chapter see Diagrams 38.1 and 38.2.) If you will examine the pages of any magazine or newspaper carrying a great deal of financial advertising, you will find many advisers and advisory services make a great point of giving unhedged opinions as to the future course of the market, and these opinions are most frequently couched in terms of what the market as a whole is going to do. Now, there is just enough truth in the common belief that they all move together to make this an exceedingly dangerous assumption. It is true, for example, we can set up definitions of what we feel constitutes a Bull Market or a Bear Market, such as the Dow Theory, and if a given set of conditions meets the rules we have laid down (i.e., our definitions), then we can say accurately, “according to my premises this is now a Bull Market” (or a Bear Market, as the case may be). It is also true that over the years, if we had treated the Dow Industrial Average (DIA) as if it were a stock and had theoretically bought it and sold it according to classic Dow Theory, we would have done very well. (EN: As is vividly illustrated in Chapter 4, where buying and selling by the Theory netted one $795,592.01 as opposed to $55,411.83 [as of December 29, 201]) through buying and holding. Of course, now it is the same as a stock [ETF], DIA.) It is also true in the great inflationary and deflationary movements, which reflect the changes in the relative values of dollars to equities, there is a tendency for the majority of stocks to move with the tide. Furthermore, it is true in the day-to-day movement of stock prices that most stocks move up or move down together. We should never lose sight of the fact the Averages themselves are abstractions, not railroads, manufacturing companies, airlines, and so on. If the Averages move, it is because the individual stocks making up the Averages have moved; although, it is true during a time when the Averages are advancing, a majority of stocks are also advancing, it is not quite possible to reverse this and make it absolute by saying because the Averages are advancing, therefore, all stocks must advance. If we carried this to its logical conclusion, we would arrive at the point (that some have arrived at) at which the fact that a stock has not advanced, but rather has declined in a Bull Market, is considered sufficient reason to make the stock attractive for purchase on the basis it must catch up with the others. If we examine the facts, namely, the long-term records of what stocks have actually done, we find there are periods when most stocks go up in value and other times when most of them go down. We find, sometimes, laggard stocks eventually will join the procession in an upward trend. However, this does not always happen and it can be extremely uncomfortable to have bought stocks in a presumably Bullish Market because they are behind the market or they are all going to go up, and then wait for months as we watch other stocks climbing to new highs, whereas our own securities continue to languish or decline further. From what you already know of the market, you will surely agree it is not a wise policy to put all your capital into buying stocks in what is clearly a Bear Market in the Averages and in most stocks. You will agree, too, it is not a safe thing to sell stocks short to the limit of your resources in a skyrocketing Bull Market. If you have to be 100% on one side or the other, it is much better to go with the trend. In that way, you will be in line with the probabilities as shown by a majority of stocks and by the Averages. Nevertheless, you should realize going with the trend is not always as easy as it sounds. We can set up definitions, as we have, of what constitutes the Major Trend. Then the question is whether you have the patience and the courage to maintain a position in line with these definitions through months of uncertainty and possible adverse moves. During turning periods, it is often hard to make the decision whether to buy or sell. Most especially, there is the difficulty of knowing what to buy or what to sell and when. The simple patterns and signals of the Averages do not tell the whole story. There is a certain usefulness in regarding the market as a whole in studying Dow Theory, just so long as we keep in mind the Averages we are studying are generalities (high-order abstractions) and the rules for determining their trend apply to these generalities and not necessarily to each and every stock listed on the Stock Exchange. In many cases, for example, a group of stocks will top out and start an important Bearish Trend, whereas other groups of stocks are continuing to make new highs. This occurred in 1946, when we saw a large number of stocks topping out in January and February, and others continuing strong until the end of May. We think of 1929 as the year the market made its great peak and crashed in October to start the series of breaks that continued into 1932. There is some truth in this, but it is not the whole truth. There were some important stocks that made their highs long before the 1929 Top. Chrysler, for example, made its high in October 1928, and had dropped from 140 to 60 before the Panic of 1929. There were stocks that never enjoyed a Bull Market at all in the whole period from 1924 to 1929. By actual count of nearly 700 listed stocks, 262 issues made their Bull Market highs before 1929, and 181 topped in 1929, but before August of that year. There were several stocks that did not have their first downside break until after 1929. Forty-four stocks went into new Bull Market high ground after 1929 and before mid- 1932. Only 184 of the 676 stocks studied made their Bull Market highs in August, September, or October of 1929 and crashed in October and November. In other words, only 27% of the stocks acted the way everybody knows all stocks acted. (EN: As the Dow and S&P 500 made all-time highs in 1999 and were near those highs in 2000, the same condition held true again. Many stocks had topped and were in long downtrends. EN9: And as stocks crashed after the top of March 2000, Dow stocks held up well compared with NASDAQ stocks and Standard & Poor's (S&P) 500, which saw declines of around 50% [see Figure 20.3].) It is all right to accept the general trend as a useful device, as long as we know it is a device only, and not a picture of the detailed reality. We have to face the problem that continually confronts every student of the market: how to protect ourselves from uncertainties in interpretation of the Averages, and how to protect ourselves against stocks that are not moving with the majority. The problem can be met, first of all, by not taking an unreasonable amount of risk at any time (see Chapter 41). It can also be met by using an Evaluative Index instead of switching from all-out Bullish to all-out Bearish. By this we mean using an indicator that will show not merely whether it is a Bull Market or a Bear Market, but how Bullish or how Bearish it seems to be at a given time. 10 20 Diagram 38.1 The Evaluative Index shows the percentage of stocks that appear in Bullish or Bearish Major Trends. In 1961, this Index conflicted with “stock Averages,” suggesting a possible Major Turn. 30 40 50 60 70 80 90 At first glance, this may seem not too different a conception from that of the classic Dow Theory; the same technical methods apply. Also, during a strongly Bullish Market, an Evaluative Index will also indicate approximately the degree of strength. As the market begins to develop weak spots, as did the market in 1928 and 1929, the degree of Bullishness will gradually decline. Before considering the use of this Index, let us outline what it is and how it may be constructed. You will understand it is not a precise tool; it gives only an approximate picture of the state of the market; it gives no positive signals; and, in the final analysis, it is a reflection of the judgment and opinion of the person who is maintaining it. Suppose you are keeping daily charts of 100 stocks; at the end of each week, you can mark these along the bottom of the chart with a small plus or minus, indicating your opinion as to whether each particular stock is moving in a Bullish Major Trend or is Bearish. In some cases, you will find it hard to make a decision. This is not too important, however, because these cases will not be numerous, and in the majority of stocks, you normally will be able to mark them plus or minus on the basis of their obvious action. If you now total the plus stocks and also the minus stocks, including those in which you have had to make a tentative decision, you will have two figures totaling the number of your charts. If 75 of these are plus, you can say the market looks 75% Bullish to you. If next week the percentage is higher, say 80%, it indicates a stronger or more Bullish condition. If it is lower, say 70%, it shows that, on balance, fewer of your stocks look strong; hence, the market is presumably weaker. (EN10: A quick way to construct an Index of this sort is to run Moving Average studies on the market, examining how many stocks are above their 50-day Moving Average, how many above and below their 200-day Moving Average, and so on. Obviously, you can also do it as Magee did, by examining each chart of the Dow to see whether it looks strong or not.) As we have said before, if the Averages are making new highs, you will expect (and find) the Evaluative Index will range well above 50%. In an obvious Bear Market, the Index will stand considerably lower than 50%. However, notice we do not speak, here, of signals. There is no point at which we need to say, “Sell everything.” Neither is there a point at which we can say, “Buy now,” in an all-out sense. The Index will float and adjust itself continually to the shifting conditions. It must be clear that a market in which only 53% of a large group of representative stocks are moving Bullishly is not as strong as one in which 80% of these stocks are acting Bullish. Therefore, you would be justified in making larger commitments on the long side in this second case. You would still have the problem of selection of the individual stocks to buy, but you would be justified in making larger total commitments or in assuming total greater risk (see again Chapter 41), than in a market that was barely qualifying as a Bull Market. By bringing the total of one's investment program in line with this Index, it is possible to roll with the punches, and one would almost automatically be withdrawn from a deteriorating market before things became too dangerous. Furthermore, this would be accomplished without the need for torturing decisions as to whether to sell now or wait a while. There is a further extension of this method. If an investor were to follow the Evaluative Index only by increasing or decreasing his long commitments with the rise and fall of the Index, he might be better off than if he had only the two alternatives of complete optimism or complete pessimism. In this case, he would still be pointed always in one direction and would stand to lose to some degree on his long commitments if the market did eventually reverse and go into a Panic Move. The extension of the method is to proportion capital, or a certain portion of capital, between the long side and the short side of the market. Assuming your interpretation of your own charts is reasonably correct in a majority of cases, you can, at any particular time, select several stronger-than-average stocks, and similarly, several weaker-than-average issues. With the Index standing in the vicinity of 50% (as it did for a number of months in mid-1956), you can then select several strong stocks to buy, and several candidates for short sale, making commitments that will approximately balance your total risk. In the case of an upward surge that sweeps all before it, you will accrue losses on the short sales and eventually may have to reverse your classification of them from minus to plus, closing them out for a loss. In such a case, the gains on your good long positions will more than offset the loss, assuming your choices were well made, and the loss realized can be absorbed as insurance, namely, the price you have paid to be in a protected position. On the other hand, should the market collapse suddenly (as it did, for example, at the time of President Eisenhower's illness in 1955) (EN: and as it did on rumors of Reagan's incompetence in October 1987, and the Asian Flu of 1998, and so on and so on), the accrual of loss in the long positions will be offset by accrual of gains in the short positions. If the decline should continue to a point calling for sale of the long stock, the losses here could be considered the price of the insurance protection to the shorts provided by the longs. (EN: In the tradition of the Texas Hedge, I take a somewhat different view of shorts. Although they would be viewed in Pragmatic Portfolio Theory as reducing risk, I like to view shorts as another profit opportunity with the added benefit of reducing total risk. Being short a stock in a confirmed Uptrend is simply feckless, and vice versa.) It is also quite possible, in a more normal market, for both the long positions and the short positions to show gains. What we are proposing is a systematic and continuous arbitrage or hedge. As the Evaluative Index advances, the proportion of short positions would gradually be reduced, and the long positions increased. As the Index declines, the reverse would happen. (EN9: I have suggested the method outlined here be called a “Natural Hedge,” and the implementation of the hedge be called “Rhythmic Trading.” A Natural Hedge of the Dow would consist of a long commitment to, for example, the DIA in a Bull Market and short positions in Bear stocks within the Dow. Or, even better, short positions in stocks positively correlated to the weak Dow stocks. This last because even weak members of the Dow will tend to be cushioned by the large holdings of passive indexers.) This method is essentially conservative. Those who have always feared the short sale as a purely speculative gamble might well reexamine short selling from the standpoint of using the short sale as a regular part of their investment program as counterbalance to the long holdings. The result to be looked for in this conservative balanced and diversified program is primarily protection of capital. By its very nature, it eliminates the possibility of plunging for spectacular profits, but it also provides the mechanism by which the technical method can stand on its merits, largely independent of the changes and chances of the market. It makes it possible to eliminate a large part of the anxiety and uncertainty so many traders and investors carry every day and often late into the night. (EN: Many modern readers are probably unaware that John Magee wrote a weekly advisory letter for four decades. These wise and practical letters comprise the John Magee Market Letter Diagram 38.2 From Collected Market Letters, September 28, 1985. Magee Evaluative Index computed on the Dow-Jones Industrials illustrating the use of the Index to identify Tops and Bottoms in the market. A sort of “oversold-overbought” indicator. Archive. From this Archive, I append here the letter of September 28, 1985, relative to the Magee Evaluative Index (MEI). It speaks very strongly for itself.) September 28, 1985: an oversold market This week, the MEI fell to 9% Strong, its deepest penetration into the oversold quadrant this year. Not since June of 1984 has this index been lower (see Diagram 38.1). Shortly after its June low of 8% Strong, the MEI headed steadily higher, giving an Aggressive Buy signal throughout late June and July. The June 1984 MEI low of 8% Strong, together with the 8% level reached on February 25, 1984, constituted a Double Bottom oversold reading for this index. It corresponded to the 1,079 Bottom recorded by the Dow-Jones Industrial Average (DJIA) on June 18, 1984, after which that Index advanced steadily to its recent July peak of 1,372. For more than 20 years, all major stock market Bottoms have corresponded with extremely low MEI readings. During the “turbulent period” when the stock market oscillated violently but showed no gain at all, MEI readings of 5% Strong or less corresponded with all Major DJIA Bottoms until the June 1982 low of 9% Strong, which immediately preceded the stock market's upward explosion. That slightly higher than “5% Strong or less” Bottom was an important clue that a reinvigorated stock market was at hand; the straight-line DJIA advance from 770 to nearly 1,300 ended a 17-year “do-nothing” period for stock prices and ushered in the “renewed upswing” period shown on the chart. In this context, the “8% Strong Bottom” of June 1984, and the current MEI reading of 9% Strong, take on added meaning. If, in fact, we are in a period of Renewed (or major secular) Upswing, stock market Bottoms will tend to be less severe and Tops more extremely overbought than would otherwise be the case. Both the June 1982 DJIA low and that of June 1984 fit this model. Because secular stock market waves tend to last for many years, even decades, the likelihood is that the current MEI reading of 9% Strong will also define a Major DJIA low. chapter thirty-nine Trial and error You will not expect to turn in a perfect record from the start. You may indeed do poorly, which is one of the reasons we have suggested using only a safe amount of your capital, allowing enough leeway so if you should misread and misdirect your campaigns, or if you should encounter an Intermediate Setback in the trend of a Major Turn, you will be able to get back on course, undismayed, and richer in experience. Your records of actual transactions (and notes on theoretical transactions) will help you. As time goes on, you will discover new trading refinements. Try these methods against your previous chart records. See whether your improvements work out consistently to your advantage. In that way, you can test new details of method without risking actual capital until you have checked the operation thoroughly. In one actual case, a trader who had shown a rather poor record of performance through a fast-moving Bear Phase of the market, rechecked 30 of his actual trades made during that period in light of new methods he had subsequently developed. Where the original record showed a loss at the rate of about 40% per year on the capital for the time it was tied up, the changes he introduced, applied to the same situations, would have resulted in a profit at the annual rate of 156%. Such a result, although not conclusive, would strongly suggest trying out the new method in all similar situations in the future, and if the performance continued to show this advantage, to adopt it as a permanent policy. It is only by continual checking and testing that you can learn to pick up more of the profitable opportunities and protect yourself better against the unexpected Reversals. If you follow the suggestions of this book, those already given, and those in the following chapters, you will proceed slowly and cautiously, not risking all your capital on a single move in a single stock; subsequently, errors and plain bad luck, when they hurt you, will not hurt you too seriously. You will be prepared for false moves, wrong interpretations, and complete Reversals of expected developments. If you have worked thoughtfully and serenely, without permitting your emotions to rule your judgment, the law of averages will bring you continually greater success. You are not gambling blindly in this work; you are intelligently using past experience as a guide— and it is a dependable guide. Your operations are part of the competitive workings of a free market; your purchases and sales are part of the process of interpreting the trend, checking runaway inflation and crashes, and determining the value of the American industrial plant. The market will continue to go up and down in the future as it has in the past. Your technical knowledge will save you from “buying at the Top” in the final Climactic Blowoff, and it will save you from selling everything in a fit of depression and disgust when the Bottom is being established. In your studies of past market action, you have a strong shield against the sudden thrusts that surprise and often defeat the novice trader. (EN9: I have often told my students if their knowledge of this material does nothing more than keep them from making stupid mistakes like buying a Top or buying a downtrend or buying before a Bottom has completed forming, then their time will have been well spent. The elimination of amateur blunders such as these can immeasurably improve investment performance.) Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com chapter forty How much capital to use in trading Up to this point, we have been talking mostly in terms of points and percentages. Little has been said about dollars. From here on we are going to turn the spotlight on the questions revolving around money, capital, and the dollars you will actually be using in your operations; just as an understanding of the technical signals and patterns alone will not guarantee your profits without a tactical method of applications, so too your tactics alone will not ensure you profits until you have tailored your method to fit your pocketbook, and until you have a systematic control of your trading in terms of dollars and cents. At the start of your charting operations, you will be using no capital. You will be making no trades either actual or theoretical. Any commitment you might make during the first four or five weeks on a new chart would be no more than gambling on a hunch. It will take about two months of thankless charting before you have any clear picture of how any of your stocks are acting technically. From then on, your chart history will become more valuable each week. Your first trades probably will be theoretical ones. You will want to get the feel of the charts and learn to apply the methods you have studied. Eventually, you will want to make an actual transaction. (EN: The prudence of this approach can hardly be disputed. Just as markets have changed, stock market mentality and awareness have changed. The mere existence of this book and of the general atmosphere enable the modern investor to progress more rapidly than the old pencil-and-paper and slide-rule chap. The availability of computers and databases and tutorial tools, not to mention online and offline courses in the subject, are unparalleled resources.) Then the question will come up, “How much of my capital shall I use for trading purposes?” (EN: In a certain sense, this question begs the question. It presupposes the reader has capital. If the reader does not have capital but is gambling with the milk money or the mortgage payment, his failure is virtually assured. Do not speculate with money whose loss will occasion you more than passing discomfort.) The amount will depend on your circumstances and how much of your time and effort you plan to put into stock trading, as well as your experience in the market. If you have been buying and selling stocks for a number of years, you will naturally continue along the same lines, simply applying the new techniques to your operations. On the other hand, if stock trading is entirely a new field for you, or if it is only a minor hobby or sideline, it would pay to make haste slowly. Some writers have pointed out it usually takes about two years to gain enough practical experience to operate safely in the market; during the two-year apprenticeship period, many traders come in, gradually lose their capital, and retire permanently from the field, leaving their money behind them. Therefore, no matter how confident you may be or how anxious to get in and start pitching, it would be safest to do most of your experimenting on the theoretical basis and to use only a small amount of your actual capital, so that after, say, two years, if you have shown some actual profits, consistently and regularly, even though small, you will be much better prepared to use more of your capital wisely and safely. Conversely, if during that time you have made repeated mistakes and have registered many unnecessary losses, you will be able to correct your methods and continue on a sounder basis, without having lost your main capital reserve. In no case do you want to risk everything you can scrape together on the theory that here is the quick way to make easy money. That simply is not true and the chances are overwhelmingly against you if you go ahead under any such plan. It is better to figure out how much you can spare, how much you could afford to spend for experience, considering the amount you start with is in the same category as money you might use for taking a special course of instruction, or for improving property you hope to sell. Or, to take another example, it would be similar to the salary you might lose in accepting a lower paid position in a new kind of work that eventually should be worth more than your present job. In other words, you will not depend, from the start, on any returns from the capital you use in trading. You will plan your own budget outside of these funds, even if that calls for trimming your budget to make that possible. Then you can go ahead and follow your trading method free from any pressure to take unnecessary risks, free from the need to sell stock prematurely to meet obligations, and free from heckling fears and worries. You can start operations with as little as $500. (EN: This is especially true in the Internet age. Free commissions in many sites and the availability of low-cost diversified trading instruments like index ETFs [(the SPY (S&P 500), DIA (Dow Jones Industrials), and QQQ (NASDAQ 100)] offer the small investor more opportunity than ever before in financial market history.) Better to have $1,000 or several thousand, but it makes little difference, so long as you have worked out what you can afford to use during the apprenticeship period, and as long as you are sure you will have capital to continue your operation as you develop ability. The important thing at the start is not how many dollars you can make, but what percentage of increase per year you can average with the capital you are using. If you approach the serious business of trading in this frame of mind, you will not be afraid to take losses when it is necessary (and there are times when that is the only wise course to adopt). You will not be straining to make an unreasonable or impossible profit (with the usual disastrous results). Additionally, you will be able calmly to build your trading policy in the sure conviction the market will still be there next year, that opportunities will still be waiting for you, and that the basic procedures you are developing are more valuable than any “lucky break” you might pull out of thin air or a boardroom rumor. chapter forty-one Application of capital in practice (EN: Today we would refer to this as “asset allocation,” about which many learned books and articles have been written (see Appendix B, Resources). The modest suggestions in this chapter are, like Magee, very pragmatic and simple—and quite possibly more effective for the general investor than those complicated procedures spun out by supercomputers for complicated Street portfolios.) Let us now restate a number of ideas we have already investigated and on which (let's hope) we are thoroughly agreed. 1. Major Trends ordinarily run for long periods of time, covering a tremendous number of points in total advance or decline—15733.05, 2009 to 2017. 2. Almost unbelievable profits could be made by one who could buy stocks at the extreme Bottom of a Bear Market and sell at the extreme Top of the following Bull Market; or sell short at the extreme peak of a Bull Market and cover at the extreme Bottom of the following Bear Market. 3. It is not possible to accomplish either of these desirable results. 4. It is possible to avoid becoming trapped in purchases made at or near the extreme Bull Market Top so that losses become dangerous or ruinous in a Major Reversal. It is also possible, of course, to avoid such losses through ill-advised short sales near the extreme Bottom of a Bear Market. 5. It is possible to make profits by trading in line with the Major Trend, and in some cases, by trading on the Intermediate Corrections to the Major Trend, or, occasionally, on the individual behavior of a stock moving contrary to the Major Trend. 6. The greatest and most dependable profits may be made along the Major Trend during the principal period of advance (or decline, in the case of short sales), but not during the earliest phases when the movement first gets under way or during the rounding off or Reversal phenomena near the end of the movement. Therefore, to get the greatest benefits from following the Major Trends, one would want to have a relatively small equity in the market at the very start of the move and very little at or near the termination of the move, but a very substantial interest during the mid-portion when the advance or decline was making the greatest headway. The writers have felt it should be possible to express this relation between the amount of capital tied up and the state of the Major Trend in a neat and definite equation. Yet, inasmuch as the idea of a Major Trend is, itself, a matter of definition, and because the trend is an abstraction from the individual movements of many stocks, it does not seem possible to arrive at any such easy solution to the problem of how much capital to use at a given time. Nor is it necessary to have a definite and exact answer. As we have already stated, it is possible to set up an Evaluative Index that will give an approximate answer good enough for all practical purposes so far as weighing the “strength” of the trend at a particular time. (EN: To clarify and make more explicit the concept here, I would point out the Asset Allocation implications of the Magee Evaluative Index. If the analyst's evaluation of the market indicated 30% of stocks were Bullish, 30% Bearish, and 40% neutral, he might so commit his capital—30% long, 30% short, and 40% cash. This would also assume his assessment of risk also indicated the risks of the long and short positions were balanced, or approximately equal since infinite precision is achievable only by the writers of academic treatises working with perfect hindsight.) There are, however, some other questions. Most important is the question of how much total “risk” you are assuming because some stocks are very conservative and others are very speculative, it is not enough to determine what part of your capital should be applied in a market trend. The proportion of your total capital used is not necessarily the whole measure of your participation. The price level of a stock will affect its habits (low- priced stocks make bigger percentage moves than high-priced stocks). The amount of margin you are using will have an effect on the degree of risk. There is some substance to this plan (otherwise we would not be taking the time to discuss it here at all), but there is a serious question whether the decision as to the amount of capital to be used at any specified time can ever be reduced to a simple mathematical operation. (EN: Still true although there are those who attempt it.) Let us suppose you are convinced this is a Bull Market, in a phase of such potency that you would be justified in using 80% of your capital. However, you will immediately realize, from what has been said in earlier chapters, if this money is put into a high-priced (EN: and low-beta) stock, it will not give you as much likelihood of either profit (if you are right) or loss (if you are wrong), as it would if put into a lower priced (EN: and high-beta) stock. In the same way, your money put into a stock having a low Sensitivity Index, that is, a conservative stock like a Utility stock, will not give you as much likelihood for either profit or loss as a stock of a high Sensitivity Index (EN: volatility), namely, a speculative stock such as an internet issue. These factors, quite as much as the amount of actual dollars, affect your status, and are factors in answering the question, “Am I out on a limb and, if so, how far out?” To make this perfectly clear, we could take 80% of our capital, say $8,000 out of $10,000, and put this amount into the market by purchasing a conservative preferred stock, outright. A great rise in the general market might bring us an increase in value of a few points, perhaps 4% or 5%. Conversely, a great decline might depress the issue by about the same amount. An example of going to the other extreme might be to purchase $8,000 worth of options on a low-priced, extremely speculative stock, in which the probable result within 90 days would be either a profit of several hundred percent, or a total loss of $8,000. Obviously, we could vary our status during the progress of the market either by increasing or decreasing the amount of the total commitment, or by changing the nature of the account, switching part of the total into more or less speculative stocks, higher or lower priced stocks, and also by varying the amount of margin used. In Appendix A, ninth edition, and Chapter 42, we will show how the principal factors affecting a given sum of capital used (sensitivity, price, and margin) can be combined into one figure, which we are going to call the Composite Leverage Index. (EN: Once again, Magee demonstrates a practical vision and intuitive understanding both of the markets and of the basic character of investing far ahead of investment theory and understanding of his time. What we have in this concept is nothing less than the original glimmerings of VAR, or Value at Risk. The concepts and practices of VAR are succinctly summarized in Chapter 42. Composite Leverage is a complex subject and based on manual charting. For that reason, it has been left in the ninth edition, where the truly dedicated scholar may study it at leisure.) It is perfectly true you must vary your Composite Leverage (EN: risk exposure) to take advantage of the fast-moving central portions of important moves, using a lower Composite Leverage at the beginning of such moves and during the tapering-off or turning periods near the end. It is one thing to express the Composite Leverage accurately, however, another thing to write a formula for applying specific degrees of leverage at particular times. The method suggested at the very beginning of this chapter has some value but owing to the Secondary Reactions and the difficulty of determining Major Trends in individual stocks, it is not possible to make this into the neat, pat rule we are looking for. It must be a matter of experience, or intuition based on experience. You will not permit your Composite Leverage factor (i.e., your Portfolio Risk Factor; see Chapter 42, Portfolio Risk Management) to run out to a dangerous point on the limb. Neither will you allow it to become so low during times of good market opportunity that you are not getting full benefits from the move. We can keep the general shape of a Major Swing in our minds as we consider this. Bull Markets normally rise through a series of irregular advances and declines, starting with a moderate upward trend, and gradually accelerating as the market approaches its ultimate top. Bear Markets are likely to move fastest at the start and to taper off gradually toward the end. Bear Markets are steeper than Bull Markets. These considerations will help us to judge the times when the market will offer the best opportunities, the times when our Composite Leverage should be increased. There are other factors, even harder to pin down in simple figures. We would, at times, make switches of our holdings for reasons indirectly related to the factors making up the Composite Leverage Index of the stocks. We know, for example, high-grade issues, the active market leaders, and perhaps some stocks of a more conservative nature will tend to start their moves in a Bull Market fairly early and to continue their advance at a fairly steady pace. Eventually, they will reach their tops and make a Reversal Pattern. They will decline from this point, probably at a steeper average angle than the ascent. Low-priced and low-grade issues, on the other hand, tend to be slow in getting started, will remain dormant during the early phases of a Bull Market, and will then suddenly and spectacularly skyrocket in a series of moves that brings them to their ultimate Top. This Top, however, is likely to be reached at a later point (perhaps months later) than the point at which many of the more conservative stocks topped out. The speculative group will then drop very fast and will return to the dead levels of inaction before the conservative group has finished its more leisurely Major Decline. This means you will do well to concentrate your Bull Market trading in the early stages, in the higher grade stocks, and in the later stages, in the lower grade stocks. In a Bear Market, you would perhaps be able to make short sales unsuccessfully in high-grade stocks even while some of the “cats and dogs” were still completing their final run-up; however, you would be watching for the opportunity to cover those shorts and go short the low- grade stocks as soon as their Reversal was signaled. Appendix A, ninth edition, will go into the Composite Leverage Index. It should be a useful gauge for you in your market operations, and a protection against overtrading. Except, do not expect to use it mechanically as an index against the market to answer all your questions involving the nature and size of your commitments. For in gauging the condition of the Major Trend at any time, your personal experience and judgment must be the final arbiters. Put and call options Options of various sorts have a long history in commercial markets. Nearly 2,000 years ago, the merchants who operated in the Mediterranean region used “to arrive” at agreements that amounted to option contracts, as insurance to reduce the risks of storm and piracy. Modern commodity futures contracts resemble stock options in their dual nature of serving either as trading media or as insurance devices. Options are also widely used in real estate transactions and in various other applications. For many years, stock options were traded only on the basis of individual agreement between a buyer or a writer, and an opposite number, directly or through a broker or dealer. The customer and the writer were free to decide what stock (any stock) would be optioned, at what exercise or striking price, for what period of time, and at what premium. In 1973, a new method of handling option contracts was inaugurated by the Chicago Board Options Exchange and later the American Stock Exchange, and then to other Exchanges across the country in which call options on a selected list of actively traded stocks are offered with standard expiration dates (like commodity contracts) and at definite exercise prices, the premium depending on the bids and offers of buyers and writers. An excellent guide to this rapidly expanding market is (EN) Options as a Strategic Investment by Lawrence G. McMillan. (EN: In the Internet age, options and derivatives markets have attained an astounding economic importance. One amusing way of measuring this importance is by listing some of the great debacles that have occurred to major traders of derivatives. Bank Negara, Malaysia's central bank, lost $5 billion in 1992-1993 through bad bets on exchange rates. Showa Shell Sekiyu, Japan, lost $1.58 billion in 1993; Metallgesellschaft, Germany, lost $1.34 billion in the same period. Barings Bank lost $1.33 billion on stock index futures. From 1987-1995, known losses like this totaled $16.7 billion. As Magee would say, etc., etc., which is appropriate considering in 2012 JP Morgan Chase lost 2 to 5 billion trading derivatives. Of course, compared with the estimated total market in 1995 of $25 trillion, this is a mere bagatelle. Perhaps this is sufficient to warn the general investor that the field is strewn with financial mines even for the sophisticated. EN9: If the investor considers stocks a complex or difficult area [although it is hoped this book will make it less so for him] options are exponentially more difficult. Professionals beat amateurs at that game so thoroughly and so often as to consider it easy money. So, the general investor should be sternly warned that much training and study should be undertaken before becoming fodder for the pros. EN9: Tradestation, the superlatively fine trading system and brokerage operation, distributed at one time an intelligent little book by Charlie Wright, Trading for a Living, which among its other fine points offered a plan for the ongoing allocation of capital to trading.) chapter forty-two Portfolio risk management As we suggested in the preceding chapter, there is some relation between the state or stage of a Major Market and its potentialities for profit. There are many mechanical plans and systems for coping with the problem, but we do not believe it can be fully solved by mechanical means alone. We mentioned one plan by which the commitments were governed according to the consensus of trends in an entire portfolio of charts. (EN: The Magee Evaluative Index, or MEI.) There are other plans dependent on pyramiding the commitment as the trend proceeds, and still others based on averaging costs by increasing the commitment working against the trend, namely, by buying on a scale-down at progressively lower levels in a Bear Market and selling on a scale-up in Bull Markets. (EN9: Invitations to disaster, the first, and demanding adroit skill, the second. Avoid such methods unless you are an expert position trader.) None of the plans, taken by themselves, are adequate to answer the questions of when to buy and when to sell. The primary purpose of this book is to study the technical phenomena of individual stocks. If we can learn from the charts at what points to buy and under what conditions to sell, we have acquired the basic machinery for successful trading. On the other hand, if buying and selling at points that more often than not result in net losses, then it makes no difference how you divide up your capital or apply it in the market, for it will be bound to shrink until, eventually, it has all disappeared. (EN: An investor who finds himself in this situation should set a benchmark. He should decide if he loses 50% of his capital he will quit trading and put his money in index or mutual funds or in the hands of an advisor. Generally speaking, an advisor is preferable to a mutual fund, yet both are preferable to an investor with two left feet. They can certainly do no worse than a consistently losing performer. EN10: On second thought, from the vantage point of 2011, maybe they can.) The first problem, then, is to learn to use the technical tools, patterns, trends, Supports, Resistances, and so on. Then we can consider how much money we will risk and in what way. We have already grasped it makes a difference, sometimes a great difference, how we apply our capital. The various factors of price level, sensitivity, and margin enter into the concept we are going to call the Portfolio Risk. Meanwhile, we have said enough so you will understand what we are driving at if we use the term in connection with your market commitments. You realize, of course, you do not want to be so conservative to rule out practically all opportunities for making gains. If you decide never to oppose the Primary Trend, you will have to be inactive during long Secondary Trends and may be left waiting, sometimes for weeks on end, for a continuation of the Primary Move. Naturally, you will pass up all weak signals and convergent trends and shun new commitments after very active blow-offs or Panic Climaxes. You could, no doubt, carry your refinement of caution so far that your percentage of success, instead of being a mere 60%, 70%, or 80%, might approach 90%; you might actually be right 95% of the time in your decisions, but this extreme conservatism would also mean you would trade only in the very finest possible situations, when every factor was clean-cut and favorable. You would not have such opportunities very often. The result might be a profit, but too small a profit to justify all the work and study you would be putting into your charts, for you can obtain nominally respectable returns on your capital without very much study and without much risk, and you must expect a much higher rate of return if your efforts are to be worthwhile. (EN: These “nominally respectable returns” are obtained by investing in T Bonds and similar instruments. Bond traders and investors traditionally consider these investments “risk free,” which is another form of the denial of reality. In reality, as David Dreman has demonstrated (Contrarian Investment Strategy, Simon & Schuster), bonds are a kind of deteriorating asset because of the unarrestable depreciation in the commodity- denominated value of currency.) To put your charts to work, you have to avail yourself of the higher leveraged stocks that carry more opportunity for gain, hence, more risk of loss. You have to accept, deliberately, a greater risk than the man who is content to buy a “safe” security, put it in the box, and forget it. By maintaining your Portfolio Risk at or near some constant level that your experience and judgment tells you is safe for the particular state of the market, you will be protected against overcaution and irrational exuberance. More important, if you maintain this risk posture in your operations, you will be protected against unconsciously overtrading. This is a fault more common than extreme caution and can be a dangerous enemy even when your percentage of theoretical trading gains is high. When you select a definite Portfolio Risk Strategy and adhere to it in your trading commitments, changing it as necessary to meet changed conditions, you will be forced to restrain your enthusiasm within safe limits, and you will be continually aware of the risks you are taking. Overtrading: a paradox A series of identical percentage gains and losses on your capital does not give you a series of equal gains and losses in dollars and cents. This is a serious problem, worth understanding, for a trader who is greatly overextended is intensifying this problem (which exists in any case, but which does not need to cause him too much worry if he has planned his program). You can understand the paradoxical statement that percentage gains and losses are not equal if you take the extreme case, first, of a man, who, in every business venture he enters, risks his entire capital with the expectation of either a 100% gain or a 100% loss. If this first venture is a loss, he loses 100%. He is finished, because he cannot gain by making 100% on nothing. However, if the first venture is successful and he then uses his entire capital, including the new profits, again on the same terms, and the second venture is a failure, he will be wiped out completely. No matter how many successes he may have, he stands to lose everything on his first failure. In a lesser degree, this is the situation in which we speak; you would not risk all of your capital on the basis of doubling your money or losing all. Though, suppose you were extended, continually, to a point at which you were taking the risk of a 40% net loss on each transaction, with the hope of a 40% net gain. Should you start with $1,000 and have a succession of 10 losses, you would wind up with about $6.00. Now suppose the very next 10 transactions were all successful. You would finally come out, after 10 losses and 10 gains, each of 40%, with capital of less than $100. It would not be necessary either that these 10 losses and 10 gains come in the order given. You might have the 10 gains first, or three gains, four losses, seven gains, and then six losses. The result would be the same. After 10 gains and losses, in any order, you would have lost more than 90% of your capital. On the other hand, if you risked your entire capital each time on 20 ventures, in 10 of which you took an 8% net gain and in 10 an 8% net loss, your $1,000 after the 10 gains and losses would be reduced only to $937. You would still have about 94% of your original capital. Therefore, in this case (and 8% is a fair average figure for short-term transactions resulting in a loss, in fact, a rather liberal figure according to extensive tabulations of actual transactions), you would have a handicap due to this paradox of only about one-third of 1% on each trade. Now it is conceivable that 10 successive trades might go wrong, although that would be an unusual condition. There was one period of 10 months between the actual turn of the market and the Dow Signal for a Reversal of the Primary Trend. True, the resulting new trend, once established, ran far and long, and it would have made up all losses and produced fine profits; however, during the 10 hard months, allowing the fair average time of 30 days per transaction, it is possible that 10 successive wrong-way trades might have been stopped out for losses, reducing the original $1,000 to $434. The important thing is that the next 10 successful trades would have brought this $434 back to $937; in other words, you could have righted the boat and sailed right on if you were working on the 8% basis, whereas if you had been following the 40% basis we gave previously as an example, you would have been sunk without a trace, a victim of overtrading. Therefore, by maintaining a sane Portfolio Risk Strategy and letting the law of averages work for you and with you, you will be on solid mathematical ground. Your technical studies will have every opportunity to make you a profit. Otherwise, you can, simply by unwise overextension of your trading, prevent even the best technical analysis from producing a net profit. EN: John Magee could easily be called the father of modern investment theory but modern investment theory is so unenlightened as to technical analysis that academics largely have not recognized his contributions—and many probably have not read his work. If they had, he would be recognized as having identified what theorists now call systematic risk, and what is now called the beta (Greek letter 3) with his concept of the Sensitivity Index. Similarly, his work on Composite Leverage precedes (and may be more practical than) modern Portfolio Risk analysis, if cumbersome in the modern context. Systematic risk, simply put, is market risk in aggregate; beta relates the individual instrument risk to the market. Thus, Magee's Sensitivity Index did what beta calculations do—relate instrument behavior to market behavior. A stock with a beta of 1 will move up or down 1 point for each 1 point of market move. A 1.5 will move 1.5 for each 1 point of market move, and a 0.5 will move 0.5 for each 1 point of market move. This number tells us immediately which stocks are more volatile and sensitive to aggregate market behavior. Composite Leverage was Magee's method of determining how much risk the investor was assuming in a stock or portfolio. The formula was (is) as follows: CL = SNT 15.5 x C where S = the Sensitivity Index, N = Normal Range-for-Price (an attempt to quantify volatility), T = Total Paid, C = Capital dedicated to this commitment, 15.5 a constant Magee called a Market Reciprocal, a sort of proxy for market volatility. The same formula, using sums, was used for Portfolio Composite Leverage. The number that falls out of this formula quantifies risk for Magee and uses concepts that are extremely modern. In his original exposition of Composite Leverage in this chapter, Magee made use of some cumbersome manual chart procedures and tables that I have relegated to Appendix A in the eighth and ninth editions, and deleted in this edition. There is nothing invalid about them, even now, I feel, but there might be simpler and more convenient ways for the present-day trader to assess his leverage, risk, and profit exposure. One of these is certainly utilizing Value at Risk (VAR) technology. However, there might be simpler more pragmatic (and even more effective) ways of extracting this information from our trading portfolios. In short, Pragmatic Portfolio Theory and practice, which we will explore shortly. Volatility, for example, tells us something about the risk of a stock insofar as the dispersion of returns. Portfolio volatility gives us a way of measuring the riskiness of a group of stocks. In researching our systems and methods, we should be able to get some handle on “drawdown,” or the average and largest negative swings against our equity in an account. Simple conclusions follow: if we are willing to accept larger risks, we pick a portfolio of volatile stocks—a portfolio of Internet (or whatever the current frenzy is) stocks rather than a portfolio of utility stocks. It is indispensable to maintain a regular periodic review of portfolio statistics to assure oneself that excessive risks are not being undertaken heedlessly. These important numbers include the following: • Original risk per trade • Actual realized loss • Average (and ranges) loss and profit per trade and their relationship (average profit divided by average loss) • Number of winning and losing trades and their ratio • Time in winning and losing trades (long-time trades combined with oversize losses is an ominous sign) • Equity swings: average drawdown, maximum drawdown • Costs and expenses, summation, and per trade • Daily risk, yearly risk, and catastrophic risk, as computed by Pragmatic Portfolio Theory (as discussed below) Risk of a single stock The beginning of conventional, or academic, analysis of risk is the examination of volatility. The formula for calculating the volatility of a stock (or downloading it) was discussed in Chapter 24. As a theoretical exercise, the formula and the theory make certain assumptions that are not necessarily of interest to the pragmatic practitioner. One of the assumptions is the holder chooses to accept the inherent volatility of the stock at hand. Except the point of technical analysis is to limit the risk accepted while attempting to realize profit opportunities. Thus, the volatility of a stock, its (academic) risk, is 0.30% or 30%, but when we trade it, we put a stop loss on it and only risk a move of (say arbitrarily) 5%-8% against our position (where the 5%-8% sums to 2%-3%, or x% of total capital.) Thus, our method of risk control is basically more dynamic than the theory. Nonetheless, volatility will give us a measure of the stocks that make interesting trading vehicles. It is perfectly possible to take our own experience with a stock or our system's experience with a stock and calculate its volatility to ourselves, using the method described in Chapter 24. If the dispersion of its returns (in our trading) was greater than our appetite, we could then eliminate it from our watch list. To my knowledge, the literature does not mention this method for customizing our analysis of risk. Use of a customizing procedure like this would give us an idea of the reliability of our methods in a particular case. Stocks that did not behave would be banished to the portfolios of mutual fund managers. We subscribe to a much more pragmatic and practical concept of risk. Risk is, to us, drawdown, or the probability of loss. Volatility qua risk is static and non-descriptive of the “risks” we take in trading and investing. We will choose a volatile stock or instrument because that is where the profit opportunity is—in movement. Less risk-oriented investors will choose utility stocks. As some carnival goers choose the Ferris wheel and others the roller coaster. The probability of an exciting ride will be in the volatile instruments. Our skills as traders give us the confidence to manage the probabilities of the more “dangerous” instrument. By measuring the drawdowns, we empirically measure the risks of trading. Risk of a portfolio If you have sufficient experience with a portfolio, you can calculate its volatility the same way you calculate the volatility of a stock using the method in Chapter 24. Note Modern Portfolio Theory (MPT) has a complex procedure for computing portfolio volatility. (The value of MPT may be computed by examining MPT portfolios after a market collapse.) You may also dramatize the volatility of your portfolio by preparing a frequency distribution. The dispersion of the returns would certainly highlight characteristics of your trading system or style. Academicians and investment managers use a measure called the Sharpe Ratio to compare the performance of two systems or competing money managers. It is discussed in Appendix B, Resources, and has deficiencies in analyzing Portfolio Risk. I will address this question later in this chapter after looking at some of the ways professionals treat risk. The reader may judge for himself in the use of Composite Leverage as presented in Appendix A of the ninth Edition by Magee, or he may consider the following brief presentation of modern portfolio management and risk analysis. The purpose of Magee's Composite Leverage is to measure and control risk and profit exposure in a more or less quantitative manner. Present-day portfolio managers might use VAR technology or do this as follows. The editor offers this exposition only for perspective. His own preferred method, Pragmatic Portfolio Theory, follows thereafter. EN9: Risk and trend Risk of a portfolio and risk of a stock are affected by being the right way in the trend. It seems intuitive and it is observable that losses (thus risk) expand in an Enron case in which the trader remains long while the stock dies. The converse is also true; Risk is diminished to a portfolio and a stock when it is with the trend. In a paper submitted to the Market Technicians Association (http://www.mta.org), “Dissecting Dow Theory,” Bassetti and Brooker argue (with some success in the opinion of this editor) that risk can be proved to diminish in the Industrials when the portfolio (of Industrials) is with the trend as identified by Dow Theory. This paper is available at the Magee website, http://www.edwardsmagee. com. The paper was subsequently expanded into the book, Sacred Chickens, the Holy Grail and Dow Theory. Value-at-Risk procedure (EN: VAR is a method of assessing and controlling risk. Particularly, VAR measures the worst expected loss over a given time interval under normal market conditions at a given confidence level. This rather complex statistical process is in use in numerous banks, American and European regulators in Basel and at the Federal Reserve have largely accepted it as an acceptable risk control procedure. The hole in the procedure is in the words “normal market conditions.” The procedure is based in MPT. As Mandelbrot has remarked, MPT ignores 5% of market data, treating market collapse as if it did not exist. VAR and MPT both ignore trend risk, as though it does not exist. As a brief description of the VAR procedure, I offer the following: returns of the individual securities are determined and, from these, returns of the portfolio are calculated. This is done based on some time period for which the portfolio is held. Thus, from day to day the returns, or changes in value, of the portfolio will vary—some positive and some negative. Taking a totality of returns, an average return will be determined. A frequency distribution of returns may be constructed. The width of this frequency distribution measures the riskiness of the portfolio. Thus, a portfolio with a minimum return of 1% and a maximum return of 8% is inherently less risky (according to investment theory) than one with returns varying from -1% to 20%. Although a frequency distribution is illustrative, it does not give us a common measure for two different portfolios. That is done by determining the volatility of the portfolio.) Volatility measures the deviation of returns from the mean, known as the standard deviation and is indicated by the Greek letter sigma (o). (EN: The higher the volatility of a portfolio the greater its risk, according to the academic theory. This would seem to be intuitive, in that a commodity portfolio might range from -30% to 100% returns because of leverage, whereas a bond portfolio would vary only by the market price of the bonds and would return face value at maturity. In calculating bond risks, managers ignore the deterioration of money—but that is a little secret among us pragmatic analysts and we need not bother academicians and bond traders with that information, as they would not want to know it anyway. As pointed out, portfolio volatility can be easily obtained if we have sufficient experience with the portfolio. If we have to calculate the volatility, the procedure gets quite complicated and the entire procedure for determining our VAR requires some statistical sophistication as well as a gamut of data. We must weigh the components of our portfolio, determine their correlations, compute correlation coefficients, and on and on. As Mandelbrot notes in Scientific American, at the end of all this, we would still be wondering what to do in the Perfect Storm. A crystal-clear procedure for computing VAR is presented in Philippe Jorion's excellent book Value at Risk. Pragmatic Portfolio Theory (and practice) Perhaps, rather than giving ourselves headaches trying to remember college statistics, we should look for something simpler and more pragmatic—something just as serviceable for the general investor: Pragmatic Portfolio Theory. The academic world, and the world of rarefied Wall Street, strives madly to quantify everything in the world except the risks and liabilities that they themselves create for their customers. Let us seek simpler methods to quantify the risks of individual stocks and the portfolios they reside in, knowing all the time that absolute precision is impossible (namely, professional portfolio managers' performance in the Great Panics—1929,1957,1987,1989,2008-2009; Long-Term Capital Management, which almost brought down the world financial system in 1998; and Leland O'Brien Rubinstein Portfolio Insurance, which contributed significantly to the Reagan Crash in 1987). Pragmatic portfolio risk measurement Determining the risk of one stock The theoretical risk of a stock is commonly agreed to be its volatility, which is determined as detailed in Chapter 24. Subsequently, we might say the theoretical risk of our stock, Microsoft, for example, equals on 100 shares, our position, at the market price of 120 and annualized volatility of 0.44: Theoretical Risk = Volatility x Position x Price V x Po x Pr = T$Risk .44 x 100 x 120 = $5,200 where T$Risk = Theoretical Risk (dollar) V = Volatility Po = Position (number of shares) Pr = Price Theoretically speaking, the annual risk for Microsoft should be Volatility x Price or (in 2000) 0.44 x 120 or $52.00. In fact, those non-chart analysts who bought Microsoft at 120 (there were some), and who did not have the technician's ability to set a stop and discipline to stick to it, saw a risk of 50% from its top of 120 in February 2000 to its (presumed) bottom of 60 in June 2000. There is another measurement that might be more meaningful to us, Operational Risk. Operational Risk refers to the specific instance of the particular trade. For example, we have taken an initial position in Microsoft of 100 shares. Our analysis has identified a stop point at which we put our stop, which is 5% away from the market price. Our Operational Risk is as follows: Operational Risk = Market Price — Stop Price x Position (MP — S) x Po = O$Risk (120 — 114) x 100 = 600 where O$Risk = Operational Risk (dollar) MP = Market Price Po = Position S = Stop Price Determining the risk for a portfolio Computing the theoretical risk for a portfolio is quite a complex process. It involves, in essence, finding the volatility for the portfolio as a whole, and multiplying the portfolio market value by the portfolio volatility. This does not sound so complex, but volatility is not determined by simply adding together volatilities of individual securities. Rather, correlations between instrument returns must be computed, and variance and covariance of securities must be determined as steps along the way. This by no means presumes to be a complete description of the process, further study of which may be guided by entries in Appendix B, Resources. The theoretical risk for a portfolio is, for a simple case, as follows: Volatility x Market Value TP$Risk = MV x V where TP$Risk = Portfolio Theoretical Risk (dollar) MV = Market Value V = Volatility Under normal market conditions, the Operational Risk of a simple Portfolio, PO$Risk, may be calculated by first taking the sum of the Operational Risk figures, O$Risk, for each stock held long. Then the sum of O$Risk for short positions is subtracted from the first figure. PO$Risk = (sum of O$Risk longs) - (sum of O$Risk shorts) In the situation of perfect negative correlation, the two factors would be summed. Measuring maximum drawdown (maximum retracement) In the designing and testing of a system, or in actual trading experience, we care little about standard deviations and cold statistics. What bothers us is the flow of blood—the worst run of “luck” or experience we have. What is the greatest sustained loss we suffer before our system or trading method rights itself, stanches the flow of blood, and begins to accumulate profits again? Constructing a wave chart is one way to look at this experience. Measuring from the top of the wave to the bottom gives us our maximum drawdown, and an idea of what amount of capital we need and how much reserves to maintain. It also gives us a vivid depiction of our results. A chart with many tsunamis (in the wrong direction) probably means we need to modify our methods—unless we genuinely enjoy riding roller coasters (with the full understanding that dreadful accidents do sometimes happen on thrill rides). If constructing a system without actual market experience, one should multiply maximum drawdown by 3 or 4 to get a reasonable amount of capital with which to back the system. Pragmatic portfolio analysis: measuring the risk In analyzing a portfolio, we must first know what is important to measure. To be able to control risk, we must be able to measure it. Theoreticians identify risk with volatility. There are some real-life problems with this concept, but we will use it for the moment anyway. In a portfolio, we want to be able to separate our various types and weights of risk. In terms of volatility, bonds are obviously less volatile than stocks, and unleveraged commitments are less volatile than, say, futures. Similarly, if the portfolio is not risk balanced, that is, if one issue represents a large proportion of the whole, then it represents a larger portion of the risk. But, if a portfolio consisted of only the Standard & Poor's 500, that would obviously be a different case, because a commitment like this would be by definition diversified. Thus, we must know what is important to measure (see Philippe Jorion's Value at Risk. In addition, there is a piece of tutorial software called Risk Management 101, Zoologic Corp., which is excellent in presenting these concepts). In operational or pragmatic terms, a trader wants to know what his operational risk is, rather than his theoretical risk, and does not consider upside equity volatility a negative. A trader may choose to measure risk by the pragmatic method outlined here. In doing so, he will want to know for his Portfolio Ordinary or Normal Risk, POR, his Risk Over Time, PRT, and his Extraordinary or Catastrophic Risk, PCR. Portfolio Ordinary or Operational Risk “Ordinary” and “Operational” may be used interchangeably when discussing daily risk. First consider we want to measure our risk today. Our Ordinary Risk today is easily computed by taking the stop price from the market price on each position and summing the differences, as above. Dividing this figure by the allocated capital (Total Capital, TC) will give us a Portfolio Risk Factor (PRF), which is the risk factor the trader is willing to assume for one day. POR = sum of differences PRF = PO$Risk/TC Portfolio risk over time The Daily Operational Risk number can be annualized to give us a number for risk over time—or it can be computed for a week or a month, and so on. Or, this factor may be collected from operations. It may be collected by taking each day's Ordinary Risk, summing and dividing for the desired time period (and plotted). It also may be computed by taking the average return and the variances therefrom and calculating the standard deviation. This is Risk Over Time. Annualized risk, for example: DR x (square root 365) where DR = Daily Risk Portfolio extraordinary or catastrophic risk Extraordinary Risk is the risk of market collapse or panic on any given day. The way to look at this risk is, first of all, to assume normal behavior of the markets, or your everyday panic. In this case, if all of one's positions cratered, one would take his worst-case, one-day loss and be out of the market. To extend this analysis, assume the market makes a two, then four, then six standard deviation move. What will be the effect on your position in this event, when stops will not be honored by specialists and market makers and the market will be stampeding like spooked cattle for the exits? That is, meltdown. This is Extraordinary or Catastrophic Risk. If you have no capital reserve you are out of business. Controlling the Risk The most danger in these meltdown events is in the greatest leverage—so the greatest risk is in short options—and usually short puts. You will remember my story of my customer at Options Research Inc. who lost $57 million during the Reagan Crash of 1987; he was short puts. Some market makers have been destroyed by shorting calls, but the case is rare and specifically results in the case of takeovers and unwise concentration of commitments in one issue only. The least risk lies in being hedged. To oversimplify, long the stock, long the put. The profit of one makes up for the loss on the other. Also, if one were long some stocks and short others, that also is a kind of hedge. Or long the Dow and short futures on the Dow, or some of its components. Now, let us be pragmatic; if during the management of our portfolios we consistently measured the market with the MEI and balanced our portfolio accordingly, we will be at less risk, both from the Ordinary and the Extraordinary viewpoint. In fact, we may profit from an event that disemploys many professional money managers. If you have been religiously raising your stops, following the market with progressive stops, and in fact raising them on the basis of new highs as described in Chapter 28 (the three-days-away rule), it is quite possible that while the market is storming, you will be sailing to Byzantium in your customer yacht. Summary of Risk and Money Management Procedures The procedures described above are easily reducible to simple formulas, even for the math phobic. Trade size is the basic unit for controlling risk. Regardless of volatility, 500 shares of anything is riskier than 100 shares. To determine trade size, take the difference between the entry price and the stop price, giving Dollar Risk 1 ($R1). Take the Risk Control Factor, the percentage of total capital to be ventured on the trade, and multiply times Total Capital—for example, 3% times TC of $100,000, giving Risk-per- Trade. Divide Risk-per-Trade by Dollar Risk 1 to determine Trade Size. EP - SP = $R1 RCF x TC = RpT RpT/$R1 = TS where TS = Trade Size EP = Entry Price SP = Stop Price $R1 = Dollar Risk 1 RCF = Risk Control Factor TC = Total Capital RpT = Risk-per Trade Measure daily Operational Risk as described above. Divide Operational Risk by Total Capital to determine Portfolio Operational Risk Factor. If this factor is too high, look for hedges or positions to eliminate, starting with those that are underwater. Recompute stops frequently (daily for a trader), raising them according to the Basing Points Procedure, Support and Resistance, or Trendlines. Additionally, a money management stop may be employed, where the trader says, for instance, no more than 8% from the market price will be risked and this 8% must represent no more than x% of total capital. Money management stops, it should be noted, are inherently less dynamic than technically placed stops. As the markets proceed inevitably through their phases, track their internal composition with the MEI, and as positions are naturally terminated, put on new positions in accord with the general long and short strength readings of the MEI. Remember that exceptionally high MEI readings coincide with broad market tops, and exceptionally low MEI readings coincide with broad market bottoms. Professional risk managers compute daily the Extraordinary Risk potential in the markets using the procedure described in this chapter to constrain traders under their authority from overexposure. In fact, panics and crashes rarely occur out of the blue. There is almost always a pre-panic phase the truly alert trader can identify, especially with the aid of a computer; these are marked by insider and professional selling that creates increasing volume with Reversal Days occurring in many stocks and Gaps and Runaway down days. Almost always, these conditions will be preceded by many top formations among key stocks—Double and Triple Tops and Heads-and-Shoulders and V-Tops. Eternal vigilance is the cost of freedom. It is also the cost of investing success. Infinitely more sophisticated risk and money management procedures—Ralph Vince and optimal f Undoubtedly, one of the most sophisticated analysts now practicing is Ralph Vince, author of The Handbook of Portfolio Mathematics and progenitor of the Leverage Space Model. He defines risk as we do, as drawdown, not as the variance of returns. His procedure for determining trade size is extremely sophisticated—more so than the procedures I have outlined here. Although I feel these procedures meet the needs of the general investor, Vince's procedure is must reading for the more sophisticated investor and trader. He has described the Leverage Space Model in a short article found in Section 8 of Appendix B, Resources. chapter forty-three Stick to your guns It has often been pointed out that any of several different plans of operation, if followed consistently over a period of years, would have produced consistently a net gain on market operations. The methods we have discussed in this book (representing the technical approach) are a case in point. The fact is, however, that many traders, not having set up a basic strategy and having no sound philosophy of what the market is doing and why, are at the mercy of every Panic, boom, rumor, tip, in fact, of every wind that blows. Since the market, by its very nature, is a meeting place of conflicting and competing forces, they are constantly torn by worry, uncertainty, and doubt. As a result, they often drop their good holdings for a loss on a sudden dip or shakeout; they can be scared out of their short commitments by a wave of optimistic news; they spend their days picking up gossip, passing on rumors, trying to confirm their beliefs or alleviate their fears; and they spend their nights weighing and balancing, checking, and questioning, in a welter of bright hopes and dark fears. Furthermore, a trader of this type is in continual danger of getting caught in a situation that might be truly ruinous. Since he has no fixed guides or danger points to tell him when a commitment has gone bad and it is time to get out with a small loss, he is prone to let stocks run entirely past the red light, hoping the adverse move will soon be over, and there will be a “chance to get out even,” a chance that often never comes. What is more, even should stocks be moving in the right direction and showing him a profit, he is not in a much happier position because he has no guide as to the point at which to take these profits. The result is he is likely to get out too soon and lose most of his possible gain or overstay the market and lose part or all of the expected profits. If you have followed the preceding chapters carefully, you will have realized none of the technical formations and signals is certain and unfailing. The chart action of a stock discounts and records all presently known information about that stock (which includes all matters of dividends declared or expected, split-ups, and mergers that are known to be planned, political angles as they affect the market, world affairs, management, earning records, and so on). The chart does not and cannot forecast unforeseeable events, matters that are completely unknown to anybody. In a majority of cases, the charts are dependable. If you are not satisfied this is true, you should study further, or else plan not to use charts at all. On the other hand, if you are satisfied the charts are, for you, the most dependable indication of the probable future course of stock prices, then you should follow explicitly the signals given on your charts, either according to the rules we suggest here or according to such other rules and modifications as your experience dictates. Nevertheless, while you are following any set of rules and policies, follow them to the letter. It is the only way they can help you. If you do this, you will have certain large advantages, right at the start: (1) you will never be caught in a situation in which a single stock commitment can wipe out your entire capital and ruin you; (2) you will not find yourself frozen in a market that has turned against you badly, with a large accumulated loss and your capital tied up, so that you cannot use it in the reversed trend to make new and potentially profitable commitments; and (3) you can make your decisions calmly, knowing exactly what you will be looking for as a signal to take profits, and knowing also that your losses, at the very worst, will be limited to a certain definite amount. All of this means you will have peace of mind. You will take losses and you will make gains. In neither case will you have to take your notebooks home and lie awake worrying. You will have made certain decisions. If developments prove you were right, you will, at the proper point, take your profit. And if it turns out that you were wrong, then you can take your comparatively small loss, and start looking for a better situation, with your capital still largely intact, liquid, and available. Your job, as a speculator, is to provide liquidity in the market and to counteract the irrational excesses of market-in-motion. Part of that job is to keep yourself free to become liquid whenever it is necessary to reverse your position. It is part of your job to keep yourself free from irrational and excessive emotional actions. If you do this intelligently and consistently, you will be performing a useful and necessary service to the general economic welfare, and you will find the market offers as good or better returns for your efforts as any other line of endeavor. (EN9: With the ninth edition, I expect the reader will have some powerful new guns to stick to: new lessons in Basing Points that show what a powerful procedure it can be; new analyses of Dow Theory that refresh and reinforce the validity and persuasiveness not just of the Theory, but also of long-term investing as such. EN10: And a host of new stop systems to work with. Good trading and stick to all your guns!) Appendix A: The Dow Theory in practice EN10: This appendix appears as Chapter 4 in the ninth edition. EN9: The casual and careless reader will shake his head at this chapter and ask why on earth theeditor has not excised it from the book. The editor has not deleted the chapter because, like old-fashioned cod liver oil, it is good medicine. It will appeal mainly to the serious student of not justDow Theory but also of long-term investing. If the reader has absolutely no interest in DowTheory or long-term investing, he may skip over this chapter and return to it in his old age, whenhe is wiser. At this point, the reader, if he has little previous knowledge of the stock market, may be sufferinga mild attack of mental indigestion. The Dow Theory is a pretty big dose to swallow at onesitting. We departed deliberately in the foregoing chapter from the order in which its principlesare usually stated in an effort to make it a little easier to follow and understand. Actually, not allof the 12 tenets we named are of equal import. The essential rules are contained in 2, 3, 4, 5, 8,10, and 11. Number 1 is, of course, the basic assumption, the philosophical justification for theserules. The other points (6, 7, 9, and 12) furnish “background material,” as the news reportersmight put it, which aid in interpretation. Theoretically, one should, by strict adherence to theessential rules alone, accomplish just as much as he could with the added collateral evidence. (Forillustrations in this appendix, see Figures A.1 through A.9.) However, the utilization of Dow Theory is, after all, a matter of interpretation. You may memorizeits principles verbatim and yet be confounded when you attempt to apply them to an actual marketsituation. We can better organize our knowledge of the theory and acquire some understanding ofits interpretation by following through a few years of market action and seeing how it looked atthe time through the eyes of a Dow theorist. For this purpose, we may well take the period fromlate 1941 to the beginning of 1947 because this covers the end of one Bear Market, an entire longBull Market, and part of another Bear Market, and includes examples of most of the marketphenomena with which the Dow Theory has to deal. Five years of Dow interpretation Figure A.2 is a condensed chart of the course of the two Dow-Jones Averages from January 1,1941, to December 31, 1946, on which most of the Minor Trends have been disregarded but allthe recognized Intermediate Swings (Primary and Secondary) have been indicated. Certainportions of this history will be supplemented by complete daily charts in connection with ourdetailed discussion that follows. The year 1941 opened with the stock market in a Minor Rally. A Primary Bear Market had beensignaled when prices collapsed in the spring of 1940 and that Bear Market was Figure A.1 “Swing” (EN: or Wave) chart showing all the Intermediate and some of the moreextensive Minor Trends of the Dow-Jones Industrial and Rail Averages, January 1941 to December 1946.Industrial price scale left, Rails right. still in effect. After the May Panic had ended, a Secondary Recovery swing, which lasted for morethan five months, had regained more than half of the ground previously lost by the Averages,carrying the Industrials from their closing price of 111.84 on June 10 to 138.12 on November 9and the Rails from 22.14 on May 21 to 30.29 on November 14. (During this long Bear MarketSecondary, incidentally, volume tended to increase on rallies, which encouraged many who didnot hold strictly to first principles to believe that this rise was the beginning of a new Bull Trend,illustrating the point we cited under “Volume” in Chapter 3.) From the November highs, however,the trend turned down again. Then a Minor Rally developed, as stated, at the end of the year,reaching its peak on January 10 at 133.59 in the Industrials and 29.73 in the Rails. From there,prices fell again to 117.66 and 26.54, respectively, on February 14. The first severe test The next few months will be particularly interesting for us to trace because they put the DowTheory to a real test. Figure A.3 shows the daily ranges and closing prices of the two Averagesand total daily market volume for the seven months from February 1 to 130 128 126 124 122 120 118 116 H -IS i * Jmm$ Bl •mi Mmp: ft ml |I NDUSTRIALS® (Hi iffn Wi - : Pi.i ........ “V 1 / mHII •|m ■ iri? ■ pi Mf 1,A » l ■Hrm£ -m■:is iii i Vr~!H IIm:t 1941 / HI r ■sg-j pi ig R flY lifeA; 1 RAILS :P*f lll» j; HH H w1 A, rflJ 1 f* J Kit lOy' h *» tin* lift::t L t*ii,r~J : •Hi l§|l g !L- itIIPH n Hffl lilt; i Si $ ffi K TH Hill TTTTIlli ' n 'i |I — n 1 . LiIII llyi jilili lilll 1II II11 31 30 29 28 27 26 FEBRUARY MARCH-------APRIL-------MAY---- JUNE JULY' AUGUST “ 845 22'1 8 151122 29 5 121926'3'1017'2431 7 14"21'28 5'12'19 ' 26 2 9 16 23 "30' FigureA.2 Closing price levels of the Dow-Jones Industrial and Rail Averages, February 1 toAugust 31, 1941, and total daily market volume. Vertical lines show net daily change from oneclosing level to next. August 31, 1941. Before we examine it in detail, however, let us first review the situation onFebruary 14. The Bear Market lows to date had been registered in May-June, 1940. Thereafter, anextended Intermediate Recovery had advanced the Industrial Average 26.28 points and the RailAverage 8.15 points. This had been followed by a three-month decline of 20.46 and 3.75 points,respectively, and this decline, incidentally, had consisted of three well-defined Minor Waves. Induration, and in extent of price change with respect to the previous swing—46% in the Rails andnearly 78% in the Industrials—this downswing qualified as an Intermediate Trend, and nowprices were turning up again. Dow theorists were on the alert. If both Averages could continuetheir rise to levels above their high closes of the previous November (138.12 and 30.29), thataction would constitute a signal of a new Primary Bull Market, and reinvestment of fundswithdrawn from stocks in May 1940 would be at once in order. Also, it would then be necessaryto go back and label the May-June lows of 1940 as the end of a Bear Market, the advance toNovember as the first Primary Swing in the new Bull Market, and the decline to February as itsfirst Secondary Reaction. Note Rule 12 of our preceding chapter (EN11: Chapter 3) applied here;the presumption was it was still a Bear Market until a definite signal to the contrary appeared. Let us now turn again to Figure A.3 and see what actually did happen. The Industrials rallied forsix weeks, reaching 124.65 on April 3. The Rails got up to 29.75 on the same date, registeringdouble the percentage gain of the Industrials, but both Averages were still below their November highs. Then the Industrials slipped off within two weeks and had broken down below theirFebruary low and drifted down to close at 115.30 on May 1. This Average was, therefore, still inan Intermediate Downtrend. The Rails, meanwhile, were staging a different sort of performance;they dropped back from their April 3 high for two weeks, but held at 27.72, rallied smartly andthen sold off again to 27.43 on May 31. The picture became at once even more 116 114 112 110 108 106 104 102 100 98 96 94 92 INDUSTRIALS 1942 RAILS OCTOBER 30 29 28 27 26 25 24 23 ; MBER T ■ APRIL i 1 i AUGUST----SEPT ;■ "r /r i rr':”1 - I MARCH r'„ i i i Figure A.3 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from March2 to October 31, 1942, and total daily market volume. This period saw the beginning of a 4-yearmajor bull market. interesting. Here was a Divergence between the two Averages, a failure to confirm; the Rails,after two opportunities, were refusing to confirm the Industrials in the latter's downtrend. Failure to confirm When prices began to work upward in June, many commentators seized on this “failure toconfirm” as a Bullish omen and the wishful thinkers again talked Bull Market. There is anunfortunate tendency in the Street to overstress any such divergence, particularly when it can betwisted into a favorable sign. The fact is Dow Theory's refusal of one Average to confirm theother can never produce a positive signal of any sort. It has only negative connotations.Divergences sometimes occur at Reversals in the Major Trend—there have been several instancesin market history, in which, perhaps, the most remarkable occurred way back in 1901 and 1902,and we shall soon inspect another—but they also occur with equal frequency at times when noMajor Reversal is developing, and the instance we are discussing here was one of the latter. The situation at the end of May in 1941 was precisely the same to the Dow theorist, insofar as theMajor Trend was concerned, as it had been on February 14. The June-July rally topped out in theRails at 30.88 on August 1, and in the Industrials at 130.06 on July 28 (compare these figures withtheir 1940 November highs) and prices then declined at an accelerating pace, temporarilyculminating in the Pearl Harbor Panic. This took the Industrial Average below its previous BearMarket low (111.84 on June 10, 1940), although the Rails, again, did not follow. They had,however, by this time, broken below their previous (February 14) Intermediate Bottom by aliberal margin. The next period of importance began in April 1942. We can skip any detailed chart of the monthsbetween December and April because they posed no Dow Theory problems. Figure A.4 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume. After a Minor Rally in the Rails in January, prices simply drifted lower and lower, but it wasincreasingly evident that trading volume did not expand on the dips (Minor Declines). Liquidationwas drying up; the boardrooms were void of customers; the atmosphere was typical of the laststages of a Bear Market. The daily action of the Averages from March 2 to October 31, 1942 is shown in Figure A.4. Newlows (since 1940) were registered both in late April, at 23.72 on April 24 in the Rails and at 92.92on April 28 in the Industrials. Shortly thereafter, a notable Divergence developed, when, afterrallying for only seven days, the Railroad Index began to slip off while the other Average keptright on going up. Trading activity remained at a low ebb (there was no sustained volumeincrease, in fact, until late September). On June 1, the Rails dropped to another new low and onthe 2nd closed at 23.31. On June 22, it looked as though the Industrials were going to be pulleddown again, but only a few days later, the best rally in months got started, taking the Industrials tonew highs and more than recovering all of the April-May loss in the Rails. Activity also speededup briefly, with one day registering a greater turnover than the market had enjoyed in any sessionsince early January. (EN9: Note this warning sign. The ringing of an alarm clock.) Signs of Major Turn Again, the Dow theorists were very much on the alert. An advance of Intermediate proportionswas obviously under way. Until proved otherwise, it had to be labeled a Secondary within theBear Market, which was still presumably in effect, but that Major Downtrend had by now run fornearly three years—nearly as long as any on record—and its last decline had shown no sellingpressure whatever, simply a dull drift. This presumed Secondary might turn out to be a newPrimary; hopes for such a denouement had been blighted 12 months earlier under somewhat-similar circumstances, but this time prices were lower and there was a different “feel” to themarket. The general news offered little encouragement, but the Dow Theory does not concernitself with any news other than the market itself (which discounts all other kinds of news). In anyevent, there was nothing to do but wait and see—let the market, in its own time and way, state itsown case. In early July, the Industrials started to “mark time”; for 11 weeks, they fluctuated within a 5-pointrange, building a typical Dow Line from which they emerged on the upside in late September.The Rails pushed up to a new high for the move at the same time, and by November 2, bothAverages had surpassed their Rally Tops of the preceding January. At this stage, some Dowtheorists were willing to announce a Bull Market had been signaled. Their arguments, aside frompoints of a nontechnical nature or having nothing to do with Dow Theory, were as follows: 1. The conspicuously low level of volume at the April-June Bottom, typical of the end of aBear Swing. (True and cogent.) 2. The Rail Average had refused to follow the Industrials into new Major low ground at thattime. It had held above its closing level of May 1940. (Also true, but of questionablesignificance. More about this later.) 3. The Industrials had constructed a Line and gone up out of it. (Again true, but the Line wassomewhat short to have, beyond a doubt, major import.) 37 36 35 34 33 32 30 Figure A.5 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume. This chart follows andshould be compared with Figure A.4. The decline in the Rail Average during November andearly December produced the first test of the Major Trend since the preceding June. Whenthis Index recovered and, on February 1, 1943, closed above its November 2 high, a PrimaryBull Market was thereby signaled according to Dow Theory. 4. The Rail Average had produced successively higher Minor Tops and Bottoms for fourmonths. (This also was true but did not permit positive differentiation from a Bear MarketSecondary.) The more conservative Dow theorists were not yet convinced. They maintained this uptrend hadyet to undergo the test, bound to occur sooner or later, of an Intermediate Reaction. They admittedthat the picture was most encouraging, but they called attention to the fact that, except for Point 1,it was no better than that of November 1940. Let's follow along through the next five months.Figure A.5 shows the daily market action from November 1, 1942, to June 30, 1943. The Bull signal After reaching 29.28 at their close on November 2, the Rails declined in almost a straight line forsix weeks to 26.03 on December 14. This move indubitably rated as an Intermediate in durationand it had “given up” more than half of that Average's entire advance from the June 2 low point.The Industrial Index, however, held stoutly in another narrow Line throughout November,December, and January. From December 14, the Rails turned up, and finally, on February 1, 1943,closed at 29.55, out above their previous Intermediate Top of 29.28 recorded the previousNovember. By then, the Industrials had also moved up into new high ground. This development atlast satisfied every strictest requirement of Dow Theory; a new Primary Bull Market was in force.Trading volume had also been expanding on each Minor Advance during the fall and wintermonths, but its evidence was not needed; the price action alone was conclusive. The Rails hadproduced the necessary sequence of higher Intermediate Tops and Bottoms. In the Industrials,Lines had served the purposes of the theory as substitutes for Intermediate Reactions. It was necessary now to relabel the up-move from April-June to November of 1942 as the firstPrimary Swing in a Bull Market. The decline of the Rails from November 2 to December 14 wasnow recognized as the first Secondary within that Major Trend. We may turn back for a moment at this point to comment on the performance of the Rail Index inJune 1942. Since it held above its low of May 1940, some commentators have maintained theBull Market should really have been dated from that former year as representing the last“confirmed” lows. This strikes us as rather impractical hair-splitting. Regardless of the 1.17higher level in the Rail Average in June 1942, a genuine Bull Move did not start until that time.We suspect, before many years have passed, Dow theorists will have occasion greatly to regret theimportance that has since been assigned to the Rails' “failure to confirm” in the spring of 1942.Remember, such a Divergence does not and cannot produce a positive signal; at the time of itsoccurrence, it can serve merely to negate or cast in doubt the implications of the other Average;only subsequent action in the opposite direction can establish the existence of a change in trend. Ifthe Rails' decline in May 1942 had carried them below 22.14, but their subsequent action hadfollowed the course it actually did, point for point at a lower level, a Bull Market Signal wouldnevertheless have been given at the very same time, not one day later and not one day sooner. Moreover, a Divergence does not necessarily imply a move of consequence in the oppositedirection will ensue. We have already examined one comparable instance (in the spring of 1941)that resulted otherwise. Logically, if a failure to confirm such as occurred in 1942 is to be taken asan indication of a turn in trend, then its opposite, (confirmation or reaffirmation by both Averages)should argue with equal force against a turn in trend. Yet the simple truth is that many more MajorReversals have come when the Averages were in 66 64 62 60 58 56 54 52 50 FigureA.6 Daily closing prices of Dow-Jones Industrial and Rail Averages, and total marketvolume, July 1, 1943, to January 31, 1944. agreement than when they were divergent. We have no wish to belabor the point or waste thereader's time, but we do feel he should be warned against the wishful thinking that every “failureto confirm” seems to inspire when the market is in a Bear Trend. To return to our history, the Averages closed at 125.88 and 29.51, respectively, on the dayfollowing our conclusive Bull Market Signal in February 1943. Theoretically, that is where aninvestor who strictly followed the Dow Theory would have bought his stocks. (Those who weresatisfied the Primary Trend was up in November 1942 bought with Averages around 114.60 and29.20.) It was reasonable to assume this Bull Market, which as yet showed few of the usualcharacteristics of the second phase and none whatever of the third phase, would continue for sometime to come. The next four months produced no market developments that required interpretativeattention, and we can move on to the events of July. Figure A.6 charts the action from July 1,1943, to January 31, 1944. The first correction After closing at 145.82 on July 14, 1943, the Industrial Average drifted off. The Rails pushed upto a new high (38.30) 10 days later, but the Industrials refused to join in the rally and then bothindexes cracked down sharply for seven sessions. Turnover increased and the decline was thegreatest occurring in the Bull Market up to that date. However, everyone realized the market, afterseveral months of quite persistent advance, was “entitled to a correction.” In neither duration norextent could this down move be qualified as more than a Minor Trend. Next ensued three monthsof desultory fluctuation with little net progress in either Average. The Industrials pulled up to141.75 on September 20 and then drifted off again, whereas the Rails struggled back to 35.53 onOctober 27. Another quick break developed in early November, culminating in a high-volumeshakeout that cut the value of the Industrials by 3.56 points and the Rails by 1.75 on November 8.Prices rallied a little and sold off again, reaching new lows (since early spring) on November 30—Industrials 129.57 and Rails 31.50. There was no question now that a full-fledged Secondary Reaction had developed. The problemfor Dow interpreters was whether there was more involved. If the first drop in July could beconstrued as an Intermediate Trend in itself, and the August- October action as anotherIntermediate Swing, then the November break would signal a Bear Market. As a matter of fact, noDow theorist, so far as we know, gave very serious consideration to any such interpretation. The July break, as aforesaid, did not rate as an Intermediate in either duration or points retraced; thewhole move from July to November 1943 had to be regarded as all-of-a-piece, all one SecondaryReaction. The real Major Trend test would come on the next advance, whenever that shoulddevelop; if that failed to top the July peaks, and prices thereafter declined to new lows, a BearMarket would indeed be in effect. The decision was long deferred. Prices began again to move up, but the advance in the Industrialswas slow and grudging. The Rails forged ahead more rapidly and pushed through their July Topon February 17, 1944, going on to a Minor Peak at 40.48 on March 21. The Industrial Averageattained 141 on March 13, but still nearly 5 points below its “signal” level, faltered and fell back.Here was another striking case of “failure to confirm.” For those who chose to assign gravesignificance to such developments, it could have only a very Bearish meaning. All it did mean, infact, was continuation of the Primary Bull Move had not as yet been confirmed. Only if bothAverages now declined and closed below their respective November 30 Bottoms would the newhigh registered by the Rails alone in February have to be disregarded and a Primary Bear Marketannounced. In brief, the situation at the end of March was no different, so far as its Major Trendimplications were concerned, from what it had been in early January before the Rails pushedthrough. Bull Trend reaffirmed The situation remained in doubt (but subject always to that basic presumption of the Dow Theorythat we named as Rule 12 in the preceding chapter [EN10: Chapter 3]) until June 15, 1944, whenthe Industrials finally came through to close at 145.86. It had taken them four months to confirmthe Rails, almost a full year to reaffirm the Primary Uptrend. The effect of this “signal” on traderswas electric; trading volume increased by 650,000 shares on the following day as prices jumpedanother full point. The following 12 months need no detailed discussion as they produced nothing in the way ofmarket action to give a Dow theorist any concern. Prices drifted off irregularly for nine weeksafter mid-July, but their net loss was of minor proportions, and they then climbed with only briefinterruptions to 169.08 in the Industrial Index on May 29, 1945, and 63.06 in the Rail Index onJune 26, 1945. We should take a brief look at the period following, not because it illustratesanything new in our study, but because it takes in the surrender of Japan and the end of fighting inWorld War II. The seven months from May 1 to November 30, 1945 are covered in Figure A.7. The Industrialsheld steady for four weeks while the Rails were making the spurt to their June 26 Top. On June28, with nothing in the newspaper headlines to account for such a radical trend change, pricesbroke sharply and turnover climbed to nearly 3 million shares, the highest day's total for the BullMarket up to that time. Nevertheless, the Industrial Average gave ground reluctantly thereafter,and by June 26, at 160.91 had given up less than 5% of its top price. The Rails shook downrapidly, however. The Hiroshima bomb was dropped on August 5, and Japan surrendered on the14th. The Industrials were now rallying up from 216 212 208 204 200 196 192 188 184 2.0 1.5 1.0 .5 70 68 66 64 62 60 Figure A.7 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 1to November 30, 1945, and total daily market volume. This period, which saw the end of WorldWar II, produced only a moderate Secondary Correction in the Primary Bull Market, which hadalready run for three years from its beginnings in April/June, 1942. INDUSTRIALS RAILS MARCH FEBRUARY iigii - JANUARY In I 1 n T 6 APRIL 1 £ I i Q I on MAY l"l I 1 O I QK 111 DECEMBER I o I i K Inn I on I their July 26 low, but the Rails could not hold and plunged again, hitting bottom finally (for thismove) on August 20 at 51.48, for a loss of more than 18% of their June peak value. The Rails falter Before we go on with our examination of the market action here, it is interesting to note up to thispoint the Rail Average had been the “hero” of our story. Starting with its refusal to go down to anew Bear Market low in June of 1942, it was the spearhead of each important advance, had stagedthe most spectacular rallies, had gained 170% in value as compared with the Industrials' 82%. Inretrospect, the explanation is obvious: the railroads were the chief business beneficiaries of thewar. They were rolling up profits, paying off indebtedness, and reducing their fixed charges at arate unheard of in this generation (and probably never to be seen again). Although the “public's”eye was on the traditional and better publicized “war industries,” the market began, as far back asPearl Harbor, to shrewdly appraise and discount this unprecedented harvest for the Rails. Butfrom here on, the picture changes and the Rails become the laggards. As we look back now, it isjust as obvious that, with equal shrewdness, the market began in July of 1945 to discount achange in their fortunes. An illuminating demonstration of the basic assumption (Tenet Number 1)in Dow Theory! Turning back to our chart, prices began to push up again with renewed vigor after August 20.Both Averages had experienced a Secondary Reaction and now Dow theorists had to watchclosely to see whether the Primary Uptrend would again be reaffirmed by their going to newhighs. The Industrials “made the grade” when they closed at 169.89 on August 24, but the Railshad much more ground to recover and were running into offerings as they came up in successionto each of the Minor Bottom levels of their June-August downtrend (a phenomenon to which weshall devote some attention later on in the chapter on Support and Resistance). Not until earlyNovember 1945 were they able to confirm the signal of the Industrials by closing above 63.06. Atthis point, the Averages had, once again, announced that the Primary Bull Market was still inforce. It had now lasted for three and a half years—longer than most Bull Markets, and “thirdphase” signs were rapidly appearing. The public was buying, the boardrooms were crowded,stock market news was making the front pages of even small city newspapers, the “cats and dogs”were being whooped up, business was booming. With both Averages in new high ground and the Bull Market reaffirmed, all previous low pointscould now be disregarded. For example, the 160.91 Bottom of July 26 in the Industrials and the51.48 of August 20 in the Rails had no further significance in Dow Theory. This is a point wehave not stressed heretofore, but it is important. It might, indeed, be added to our set of rules in the preceding chapter (EN11: Chapter 3) were it not implicit in the basic tenets. Once a PrimaryTrend has been confirmed or reconfirmed, the past is forgotten and everything hinges on futureaction. At the end of 1945, with “third phase” symptoms rife, the action of the market had to befollowed with redoubled vigilance. The third phase could last for two more years (as it did in1927 to 1929) or be concluded at any moment. Our next chart (Figure A.8) carries us throughMay 1946. The spring of 1946 The market went through a Minor Setback in late December, a development has come to beexpected as the normal pattern for that month and is usually attributed to “tax selling”— andstormed ahead again in January 1946. Daily volume on January 18 exceeded 3 million shares forthe first time in more than five years. During the first week of February, prices “churned” withlittle net change. Extreme high closes were registered during this period by the Rail Average at68.23 on February 5, and by the Industrial Average at 206.97 on February 2. On February 9, bothstarted to slide off, pulled back sharply from the 13th to the 16th, and then broke in a selling wavethat ran to a climax on February 26 with closings at 60.53 and 186.02, respectively. The loss inthe Industrials was the greatest in points (20.95) they had suffered during the entire Bull Market;in the Rails, it was exceeded only by their July-August decline of the previous year. It amountedto a little more than 10% in the former and 11% in the latter and gave up a little less than half oftheir advances from the 1945 summer lows. The decline was three weeks old on February 26. Itwas an unqualified Intermediate—in Dow Theory a Secondary Reaction presumptively within thestill existing Major Uptrend. Labor troubles were dogging the steel and motor industries in 1946 from early January on, with acoal strike looming. The February break was attributed to those news developments, but theruling cause was more likely the discontinuance of margin trading. In January, the FederalReserve Board announced after February 1 stocks could be bought only for full 100% cash. Thelate January up-fling was featured by the “little fellow” seizing his last chance to buy on margin.(Those who participated in this scramble will doubtless regret it for a long time yet to come.)Professionals seized the opportunity to unload their trading commitments, but the “little fellow”was now temporarily out of funds; his brokerage account was quickly “frozen.” Under thecircumstances, as we look back, it is amazing that a more extensive Panic did not then eventuate. 216 212 208 204 200 196 192 188 184 180 176 172 168 164 160 RAILS INDUSTRIALS ' AUGUST SEPTEMBER OCTOBER’- 1 1 3 1 2 90 2 97 2 3 2 10 2 1 7 2 9A 2 31 L 7 2 1A ^Tl2 9 32 3 219 IQ Final Up-Thrust The late February Bottoms were now the critical points on the downside; if both Averages shoulddecline below the Intermediate Low closes then recorded, before the Rails could make a new highabove 68.23 (in which event the Bullish Signal of the Industrials would be canceled), a BearMarket would thereby be signaled. Despite a miner's strike and an imminent rail workers' strike,the market turned firm again in mid-May and put forth a surprising rally that swept the IndustrialIndex up to 212.50 on May 29, 1946—a new Bull high by nearly 6 points. The Rails failed inMay by only 0.17 to equal their February high close, slid back a trifle, and then pushed through atlast on June 13 to close at 68.31, thereby confirming the Industrials in their announcement that (asof that date) the Primary Trend was still up. The February lows (186.02 and 60.53) now ceased tosignify in Dow Theory, but keep those figures in mind because they are involved in an argumentthat raged among Dow students for months thereafter. The preceding picture is overlapped by Figure A.9, taking up the market's action on May 4 andcarrying it forward to October 19, 1946. Trading volume, it may be noted, in late May and earlyJune did not come up to the levels of either the late January to early February Top or the lateFebruary Bottom; the market appeared to be losing vitality, an ominous, although by no means,decisive manifestation. Prices began to fall off rapidly immediately after the Rail Confirmation onJune 13. The Industrials rallied for two weeks in early July, but the Rails continued to decline; theIndustrials broke again on July 15 and the two Averages continued their slide until they stood at195.22 and 60.41 at the close on July 23. There, as it subsequently developed, was the end of that particular Intermediate Swing—one inaccord with our Rule 12 had to be labeled a Secondary Reaction in a Bull Market until provedotherwise. The market swung up again. It climbed slowly and steadily, but with turnover runningwell under a million shares, until exactly three weeks later, the Industrials at 204.52 (August 13)had regained a little more than half of their June-July loss and the Rails at 63.12 (August 14) alittle more than a third of theirs. This advance, therefore, had met the minimum requirements ofan Intermediate Trend. If prices could continue to rise and eventually push through their May-June Tops, the Major Bull Trend once again would be reaffirmed. Although, if they should turndown and fall below the July 23 closing levels, it would signal a Reversal of the Primary Trend. The Bear Market signal The situation was critical, as evident in the volume chart. Ever since the end of May, turnover hadtended not only to increase on the declines, but also, and more importantly, dried up on the rallies.Compare Figure A.9 with Figures A.7 and A.8, and you can see how conspicuous thisphenomenon had become by mid-August. Prices did turn down, with activity increasing on thebreaks, and on August 27, the closing prices, 191.04 for the Industrials and 58.04 for the Rails,told a sad story. The Averages had spoken: a four-year Bull Market had ended, and a Bear Marketwas under way. A Dow investor should have sold all his stocks on the following day (atapproximately 190 and 58 in terms of the two Averages). To clear the record, it was necessary for the Dow theorist now to go back and mark the May 29and June 13 highs in the Industrials and Rails, respectively, as the end of the Bull Market. TheJune-July decline then became the first Primary Swing in the new Bear Trend, and the July 23 toAugust 14 advance became the first Secondary Recovery within the Major Downtrend. A secondPrimary Swing was now in the process of development. 216 212 208 204 200 196 192 188 184 180 176 172 168 164 160 2.0 21..05 1.0 .5 RAILS INDUSTRIALS ' AUGUST SEPTEMBER OCTOBER’- 1 1 3 1 90 1 97 1 3 1 10 1 1 7 1 9A 1 31 L 7 1 1A ^Tl1 9 31 3 119 IQ Figure A.9 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 4to October 19, 1946, and total daily market volume. This chart overlaps Figure A.8. Compare theclosing price of the Rail Average on June 13 with its February 5 high close. This June actionnullified the previous Dow Theory importance of the February lows. Note significant change involume pattern after May, especially during the August rally. You will have noted in the foregoing, a Bear Market was signaled as soon as both Averagespenetrated their July 23 lows. Let us return now and take up that argument we mentioned on thepreceding page. Some students of Dow Theory refused to recognize the new high of June 13 inthe Rail Average as a decisive reaffirmation of the Bull Trend. The previous close should bebettered by at least a full point (1.00), many argued, to confirm the signal previously given by theIndustrials; the margin of only 0.08 was inconclusive. Nevertheless, this opinion, if accepted, hadlogical consequences that later proved embarrassing. For, if the Bull Market had not beenreaffirmed in June, then the critical levels on the downside remained at 186.02 in the Industrialsand 60.53 in the Rails, the February 26 Bottoms. Therefore, a Bear Market could not be “called”until those prices had been penetrated downside by both Averages. This view acquired a largefollowing, especially among those who were not interested in “hair splitting” theory but wanted“to give the market every chance in view of the still improving fundamentals.” The market did, of course, proceed to break its February lows, and by that time, the Panic (secondphase) was on. Obviously, in this case, the orthodox “any-penetration-whatever” school had allthe best of it; they had sold out at least 13 points higher up in terms of the Industrial Index (atleast 6 in the Rails). Six weeks later, on October 9, 1946, this second Primary Intermediate Swingended at Industrials 163.12, Rails 44.69, and another Intermediate Recovery Move started. Before closing this history of six years of Dow Theory interpretation, we might note the June 13high in the Rail Average furnished a perfect illustration of the rule stating a trend can change anytime after it has been confirmed or reaffirmed, also of the diminishing odds in favor ofcontinuance with each successive reaffirmation of the Primary Trend. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com 1 2.0 21..05 1.0 .5 FigureA.8 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromDecember 2 1945, to May 31, 1946, and total daily market volume. Noteworthy features of this periodincluded the extremely high volume that prevailed during January and February as compared withlower turnover in April and May, and the laggard performance of the Rails when the IndustrialAverage pushed up to a new high in April and again at the end of May. At the latter date, theFebruary lows were still the critical downside “signal” levels according to the Dow Theory. Yet the Dow theorist was not concerned with causes. The Bull Market had been reaffirmed byboth Averages in early February, canceling all previous “signal” levels. Bullish Forces were stillevidently in effect because the February 26 lows held and prices began to recover. The Industrialscame back quickly and by April 9 had closed in new high ground at 208.03. The Rails dragged;when the market showed signs of weakening at the end of April, the Rail Average was still nearly5 points below its early February high. Was this another “failure to confirm” to worry about? Appendix B: Resources • Section 1: Important and indispensable sites • Section 2: References for further study • Section 3: Investment-oriented sites • Section 4: The Sharpe Ratio • Section 5: Calculating volatility and examples of professional risk analysis • Section 6: The essence of fundamental analysis • Section 7: Software packages and Internet technical analysis sites • Section 8: The Leverage Space Portfolio Model of Ralph Vince Section 1: Important and indispensable sites Contact information for John Magee: John Magee technical analysis::Delphic options research ltd (jmta::dor) E-mail bassetti@edwards-magee.com bassetti@att.net Edwards-Magee website SEC Enforcement http://www.www.edwards-magee.com http://www.enforcement@sec.gov (Whenever I receive touts or investment spam, I immediately forward it to this important branch ofthe SEC. All responsible investors should do the same.) Volatilities and options:http://www.optionstrategist.com Portfolio hedge computationhttp://www.cboe.com/portfoliohedge http://www.cboe.comhttp://www.abg-analytics.com Software reviews andinformation Software demonstrations andpackages http://www.traders.com http://www.omegaresearch.comhttp://www.comstar.com http://www.aiqsystems.comhttp://www.tradestation.com http://www.equis.com Web chart analysis site Morningstar Industry evaluations Mutualfund cost calculator Internetanalysis http://www.stockcharts.com http://www.morningstar.nethttp://www.gomez.com http://www.sec.gov/mfcc-int.htmhttp://www.stockcharts.com Section 2: References for further study On Volatilities and Options:http://www.optionstrategist.com (and futures) http://www.cboe.com DOW futures and optionshttp://www.cbot.com AMEX iShares (DIA, QQQ, etc.)http://www.amex.com On betas http://www.finance.yahoo.com On risk Value at Risk, Phillipe Jorion, New York: John Wiley & Sons, 1996 Against the Gods, Peter Bernstein,New York: John Wiley & Sons, 1996 Risk Management 101 (software), Zoologic, Inc., 1997. See also Chapter 42 On candlesticks Japanese Candlestick Charting Techniques, Steve Nison, New York: NYIF, 1991 Beyond Candlesticks,Steve Nison, New York: John Wiley & Sons, 1994 On futures Schwager on Futures, Technical Analysis, Jack Schwager, New York: John Wiley & Sons, 1996 (andother titles by Schwager in References). On portfolio management The Journal of Portfolio Management Risk Management 101 (software), Zoologic, Inc., 1997 Chapter 42 Section 5, this appendix Section 8, this appendix Section 3: Investment-oriented sites AARP Investment Program Accutrade ADR.com American Association of Individual Investors American Century American Express Financial Services American Stock Exchange Ameritrade (has little-advertised free trade site) Annual Report Gallery Barron's BigCharts Bloomberg Financial Bonds Online http://www.aarp.scudder.com http://www.accutrade.com http://www.adr.com http://www.aaii.comhttp://www.americancentury.com http://www.americanexpress.com/directa http://www.amex.comhttp://www.tdameritrade.com http://www.reportgallery.com http://www.barrons.comhttp://www.bigcharts.com http://www.bloomberg.com http://www.bondsonline.com Briefing.com Brill's Mutual Funds Interactive Business Week CBS MarketWatch Chicago Board of Options Exchange CNNFN DailyStocks Excite Federal Deposit Insurance Corporation Federal Trade Commission Fidelity Investments Financial Times Forrester Research FundFocus Fund Spot Gomez Advisers H&R Block Hoover's StockScreener IPO Central Lombard Marketplayer Market Technician's Association Microsoft MoneyCentral Morningstar National Association of Securities Dealers National Discount Brokers Net Investor New York Stock Exchange Online Investor Philadelphia Stock Exchange Quick & Reilly Quicken Quicken Financial Network Realty Stocks Reuters Schwab, Charles Securities and Exchange Commission Securities and Exchange Commission Enforcement Securities Industry Association Securities Investor Protection Corporation SmartMoney Social Security Online Standard & Poor's Fund Analyst Standard & Poor's Ratings Services Stock Guide Stockpoint Suretrade http://www.briefing.com http://www.fundsinteractive.com http://www.businessweek.comhttp://www.marketwatch.com http://www.cboe.com http://www.cnnfn.com http://www.dailystocks.comhttp://www.excite.com http://www.fdic.gov http://www.ftc.gov http://www.fidelity.comhttp://www.ft.com http://www.forrester.com http://www.fundfocus.com http://www.fundspot.comhttp://www.gomez.com http://www.hrblock.com http://www.stockscreener.comhttp://www.ipocentral.com http://www.lombard.com http://www.marketplayer.com http://www.mta.orghttp://www.moneycentral.com http://www.morningstar.net http://www.nasd.com http://www.ndb.comhttp://www.netinvestor.com http://www.nyse.com http://www.onlineinvestor.com http://www.phlx.comhttp://www.quickwaynet.com http://www.quicken.com http://www.qfn.com http://www.realtystocks.comhttp://www.reuters.com http://www.schwab.com http://www.sec.gov http://enforcement@sec.govhttp://www.sia.com http://www.sipc.org http://www.smartmoney.com http://www.ssa.govhttp://www.micropal.com http://www.ratingsdirect.com http://www.stockguide.comhttp://www.stockpoint.com http://www.suretrade.com 1040.com http://www.1040.com The Motley Fool http://www.fool.com TheStreet.com http://www.thestreet.com Technical Securities Analysis Association of San Francisco http://www.tsaasf.org T. Rowe Price http://www.troweprice.com Treasury Direct http://www.publicdebt.treas.gov Vanguard Brokerage Serviceshttp://www.vanguard.com Wall Street Access http://www.wsaccess.com Wall Street Journal Interactive Edhttp://www.wsj.com Yahoo! Finance http://www.finance.yahoo.com Zacks Investment Researchhttp://www.zacks.com ZD Interactive Investor http://www.zdii.com a American Express now advertises free trades for some accounts. Brokerage houses Waterhouse Securitieshttp://www.tdameritrade.com 800-934-4134 A. B. Watley http://www.abwatley.com 888-229-2853 Web Street Securitieshttp://www.webstreetsecurities.com 800-932-0438 Jack White http://www.jackwhiteco.com 800-753-1700 WitCapital http://www.witcapital.com 888-494-8227 Net Investor http://www.netinvestor.com 800-638-4250 Quick & Reilly http://www.quickwaynet.com 800-672-7220 Charles Schwab http://www.schwab.com 800-435-4000 Suretrade http://www.suretrade.com 401-642-6900 Vanguard Brokerage Serviceshttp://www.vanguard.com 800-992-8327 Wall Street Access http://www.wsaccess.com 888-925-5782 Empire Financial Group, Inc.http://www.lowfees.com 800-900-8101 E*TRADE http://www.etrade.com 800-786-2575 Lombard http://www.lombard.com National Discount Brokershttp://www.ndb.com 800-888-3999 Accutrade Ameritrade See also Discover Brokerage DLJ Direct Datek Online DLJ Direct Dow Jones Markets DRIP Central Empire Financial Group http://www.accutrade.com 800-494-8939 http://www.tdameritrade.com 800-326-7507 http://www.freetrade.com http://www.discoverbrokerage.com 800-688-3462 http://www.dljdirect.com 800-825-5723 http://www.datek.com http://www.dljdirect.com http://www.djmarkets.com http://www.dripcentral.com http://www.lowfees.com Section 4: The Sharpe Ratio Although this formula is flawed, it will not hinder the reader to know about it and understand it. Believingin it would be quite a different matter, however. The Sharpe Ratio itself is as follows: SR = (E - I)/sd where E is the expected return, I is the risk-free interest rate, Sd is the standard deviation of returns. The effect of this inflexible formula is to stick the trader with a measuring tool of little use to the practicaltrader. It assumes volatility of returns as measured by sd equals risk (the common academic problem). Inthe inflexibility of the sd calculation, it fails to measure the most important fact in trading, the maximumdrawdown, or, the inevitable fluctuations in gains and losses. Specifically, the greatest expected orexperienced loss, the retracement from greatest high to greatest low, and the sequences of theseexperiences. Section 5: Calculating volatility To calculate the volatility of a portfolio or of an individual instrument, first find the difference betweeneach return and the average. Then square each difference and add them together. Divide the sum by the number of returns minus one. This result is known as the variance. Finally, take the square root of thevariance to get the volatility. Combining these steps into a formula (see Diagram B.1): Step 1: Calculate the average return. Step 2: Calculate the deviation of each return. Step 3: Square each period's deviation. Step 4: Add them together. Step 5: Divide the sum by the number of periods minus 1. Step 6: Take the square root. a = £ (Ri - M )2 i=1 n-1 Diagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate theaverage return; (2) calculate the deviation of each return; (3) square each period's deviation; (4) add themtogether; (5) divide the sum by the number of periods minus 1 to get the variance; and (6) take the squareroot. Note this is the formula to use when you have experience with the portfolio. There is quite a morecomplex procedure in Modern Portfolio Theory. Section 6: The essence of fundamental analysis From the John Magee Market Letters, December 15, 1984 by Richard McDermott The Elliott Wave Theory: perspective and comments We had the pleasure of attending the December meeting of the Market Technicians Association of NewYork. Long-term subscribers will remember the MTANY as the organization that honored John Magee with its“Man of the Year” award in 1978. The speaker was Robert Prechter, publisher of “The Elliott WaveTheorist,” an investment advisory which bases its forecasts on interpretations of R. N. Elliott's work onthe stock market. Of primary interest to SAS subscribers are Prechter's comments on technical analysis itself. The ElliottWave Theory, it must be remembered, is really no more than a “catalog” of stock market price movements, laid one on top of the other, so to speak, until a grand, underlying, and enduring pattern isobserved; in short, pure technical analysis. Among Prechter's definitions and observations regardingfundamental analysis are the following: 1. “First let's define ‘technical' versus ‘fundamental' data .. technical data is that which is generatedby the action of the market under study.” 2. “The main problem with fundamental analysis is that its indicators are removed from the marketitself. The analyst assumes causality between external events and market movements, a conceptwhich is almost certainly false. But, just as important, and less recognized, is that fundamentalanalysis almost always requires a forecast of the fundamental data itself before conclusions about themarket are drawn. The analyst is then forced to take a second step in coming to a conclusion abouthow those forecasted events will affect the markets! Technicians only have one step to take, whichgives them an edge right off the bat. Their main advantage is that they don't have to forecast theirindicators.” 3. “What's worse, even the fundamentalists' second step is probably a process built on quicksand....The most common application of fundamental analysis is estimating companies' earnings for boththe current year and next year and recommending stocks on that basis.. And the record on that basisalone is very poor, as Barron's pointed out in a June 4 article, which showed that earnings estimatesaveraged 18% error in the thirty DJIA stocks for any year already completed and 54% error for theyear ahead. The weakest link, however, is the assumption that correct earnings estimates are a basisfor choosing stock market winners. According to a table in the same Barron's article, a purchase ofthe ten DJIA stocks with the best earnings estimates would have produced a ten-year cumulative gainof 40.5%, while choosing the ten DJIA with the worst earnings estimates would have produced awhopping 142.5% gain.” We enjoyed Prechter's polished exposition of a technical approach, which differed from our own. As forhis observations about fundamental analysis, we simply could not agree more. Key: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profit, and severalmeasures of risk for a portfolio of user-specified stocks and options. The screen displays: STOCK SYM = The stock symbol; STOCK POS = The stock position, or number of shares owned; DELTAS TOTAL = The sum of the stock deltas and option deltas; BETA = The stock beta for each stock (implementation pending); $BETA = $The dollar risk due to movement of the general market: $Beta = (Delta x Stock Price) x Beta; $DELT = An annualized risk figure based on Position imbalance: $Delta = (Total Delta x Stock Price) xVolatility; Portfolio Analysis Screens Diagrams B.2 and B.3 deal with portfolio risk and profit analysis. Illustrated are the sophisticatedquantitative portfolio Profit and Risk reports of Delphic Options Research as implemented forStandard & Poor's trading systems and Prudential Securities to give the reader an appreciation of the depth and complexity of professional thinking about risk and portfolio analysis. The originals ofthese reports were designed by Blair Hull and Lester Loops for their own use in market making. PORTFOLIO RISK ANALYSIS (.30 Filename) *TOT -6900 -559 -7459 47,165 -63,9444 -141,969 93,000 166 24,7470 100.0 OMS+ .30 PORTFOLIO RISK ANALYSIS 3/24/87 10:55:28 --STOCK-- ----DELTAS SYMPOSOPTIONTOTALPROFITBETA$BETA $DELTA $GAMMA$THETA$RISK%RISK FDX2800-3063-26316,7341.60-32,081-7017158,136-121 18,0757.3 GE3200-3089110 12,632.95 11,3742993120,104-16 13,0005.3 HWP-62005682 -51782701.20-45,959-13,404-522,208734 56,61722.9 LIT-67000 -67000 1.40-56,9834-122,1070 0 122,10749.3 NSM3600-4080-48010,411 1.45-21,076-7267150,464-169 17,4367.0 XRX-36003991 391 -882 1.0518,1324835186,506-260 20,2328.2 AVERAGE VOLATILITY: .338 EQUIVALENT MARKET EQUITY: -419613.40 PORTFOLIO PROFIT RATIO: .191 PORTFOLIO PROFIT GAMMA RATIO: 4.815 Diagram B.2 Risk analysis. $GAM = An annualized risk figure based on curvature of the position. A positive $Gamma indicates abackspread, and a negative $Gamma indicates a vertical position: $Gamma = Total Gamma x (Stock Price x Volatility); $THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remainsunchanged; $RISK = The annualized standard deviation of the position based upon a composite of $Delta and$Gamma; %RISK = Percent of portfolio risk in each position; TOT = Totals for each of the above categories; AVERAGE VOLATILITY = Average volatility for the stocks; EQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas;PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk; PORTFOLIOPROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gamma squared. Key: portfolio profit report. The Portfolio Profit Analysis screen summarizes delta, profit, and severalmeasures of profit for a portfolio of user-specified stocks and options. The screen displays: STOCK SYM = The stock symbol; STOCK POS = Stock position, or number of shares owned; DELTAS OPTION = Total delta of the option position; DELTAS TOTAL = Sum of the stock deltas and option deltas; M TO M = Mark to market: Total value of stock and options positions based upon market prices; PROFIT TOTAL = Total theoretical profit for each position; PROFIT/DAY = Theoretical profit divided by the number of days to expiration; PROFIT/RISK = Ratio oftheoretical profit to risk; PROFIT/DY/RISK = Ratio of theoretical profit per day to risk; PORTFOLIO PROFIT ANALYSIS (.31 Filename ) OMS+.31 PORTFOLIO PROFIT ANALYSIS 3/24/87 10:55:28 --STOCK— ----DELTAS ---------PROFIT--------- $ $ % SYMPOSOPTIONTOTALM TO MTOTAL/DAY/RISK/DY/RISKTHETARISKRISK FDX2800-3063-26342,316216,734213.93 4.31 -12118,0757.3 GE 3200-3089110 704,00612,632107.97 3.01 .16 13,0005.3 HWP-62005682 -51753,7878270150.15 .97 734 56,61722.9 LIT-67000 -6700-407,0250 0 .00 .00 0 122,10749.3 NSM3600-4080-480157,29310,411 105.60 2.21 -169174367.0 XRX-36003991 391 -4431-882-18-.04-.34 -26020,2328.2 *TOT-6900-559 -7459926,79247,165557.19 .00 166 247,470100.0 AVERAGE VOLATILITY: .338 EQUIVALENT MARKET EQUITY: -419613.40 PORTFOLIO PROFIT RATIO: .191 PORTFOLIO PROFIT GAMMA RATIO: 4.815 Diagram B.3 Profit analysis. $THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remainsunchanged; $RISK = The annualized standard deviation of the position based upon a composite of $Delta and$Gamma; %RISK = Percent of portfolio risk in each position; TOT = Totals for each of the above categories; AVERAGE VOLATILITY = Average volatility for the stocks; EQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas; PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk; PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gammasquared. Section 7: Software packages and internet technical analysis sites The first cavemen, fighting over resources, used teeth and claws. The nature of warfare was changedforever when one of the smarter ones picked up a tree branch. Then another smart one discovered theprinciple of artillery and picked up a rock. Naive and arrogant traders laughed at Wyckoff's charts. Marketmakers on the Pacific Coast Options Exchange sniggered at Blair Hull when he started appearing on thefloor with printouts. In the days of the wooden racquet, squash players hated the arrivistes who appearedwith metal and then composite racquets. No longer—the last to adopt the new weapons is a dead man. Charts showed their power and so did Hull'swonky printouts made with the Black Scholes Model. The losers figured out pretty quickly they needednew weapons. With that dissertation on the epistemology of warfare, I present some of my favoriteweapons in the following software and internet sites. No attempt whatsoever is made to be comprehensiveor encyclopedic. On the contrary, idiosyncrasy is my operating method and no disfavor is implied to thosenot included here. For myself, three desktop software packages are powerful and sufficient for all the needs of a technicalanalyst: AIQ Trading Expert Pro (http://www.aiqsystems.com), Metastock 9.0 (http://www.equis.com),and TradeStation 2000i and later versions (http:// www.tradestation.com). The reader will find examplesof charts sprinkled throughout this book, supplementing the beautiful hand-drawn charts of Magee. Allthese packages have the basic requirements necessary for technical chart analysis, basic charting onreadily available data and portfolio. I have said before that all the chart analyst really needs is the abilityto draw lines on a chart ... and then perhaps to see the chart as a line chart, or a candlestick chart or ... andso on and so on. The analyst is soon seduced by the dazzling features, and the analysis is enriched andmade more powerful. Even if one says (as I do), when he looks at an oversold tool, “What do I need thatfor? I saw it on the bar chart.” The analyst finds himself wanting to know more about %R. If it worked forLarry Williams, there must be something in it. AIQ: TRADING EXPERT PRO AIQ's package includes an on-screen control panel and scrolling indicator boxes that are color-coded, andthis information is synthesized in an indicator barometer. Data management is smooth and easy, and theuser may use a system module to create and test his own trading ideas. A panoply of reports is available toaid the investor. For the trader, real-time alerts are a feature. A portfolio manager module aids the investorin managing not just the portfolio, but also his positions by making stop management facile. An ExpertGuru lurks behind the curtain to aid the user in analyzing situations. METASTOCK 9.0 Metastock 9.0 boasts an impressive array of tools and indicators. “System Experts” pop up on demandand can also guide the user through systems tests and explorations. The Experts can also suggest buys andsells. A point and figure toolbox is a valuable feature. The ability to create and test trading systems, withexhaustive and critical data analysis, is a powerful tool. Metastock adapts easily to add-ons, of whichSlauson's Powerstrike (the quantitative tool for finding critical Support-Resistance zones) is a goodexample. Tradestation 2000i and Tradestation 8 Tradestation 2000i is the standalone version of Tradestation 8. Tradestation 8 is a real-time onlinepackage that allows for trading through the Tradestation brokerage affiliate. The package is so powerfulthat online professional and semiprofessional users probably benefit by combining their softwarearrangement with a brokerage arrangement. 2000i requires the user to maintain his local database,whereas Tradestation 8 always has the data on demand. For the creatively lazy (among them the editor)this is an attractive feature. Systems building and testing has always been and remains a powerful featureof Tradestation. With “EasyLanguage,” the user may specify virtually any system and then chat about itwith the Tradestation community of traders. This community has contributed to a large database oftrading systems and ideas. The Internet: prophet (http://www.thinkorswim.com) For the even lazier and more casual investor, there is http://www.prophet.net (now at thinkorswim.com),an internet technical analysis site whose free features will fulfill the needs of the general charting investor. With powerful interactive charts and portfolio reporting, the penurious investor will save many pennies athttp://www.prophet.net. As Mark Twain said, a penny saved is a penny earned. Actually, what did BenFranklin mean by a penny saved is capital when put to work? A user community and sharing are otherattractions. And no local data maintenance is necessary. Among its most valuable features,http://www.prophet.net occasionally distributes market commentary and analysis by this editor. All in all,http://www.prophet.net appears to deserve the continuing awards it has received from Barron's andForbes, as well as Technical Analysis magazine. Prophet charting is now available to customers ofhttp://www.tdameritrade.com. The Internet: http://www.stockcharts.com Of similar quality, and similarly honored by Forbes and Technical Analysis magazine, http://www.stockcharts.com has an additional valuable feature: point and figure (P&F) charting. I have notremarked on P&F charting here, but it is an important technical method, especially for the patientinvestor. All the other features are available at http://www.stockcharts.com, including candlesticks, barcharts, and others. Also, the distinguished analyst John Murphy makes his electronic home there. There isalso a “Voyeur” feature that allows the user to see what other traders are doing. A brief summary Knowledge is power. Knowing where to find knowledge is even more powerful. The inquiring investorcan keep himself up to date on these sites through the yearly evaluations in Barron's and Forbes, and thefinancial press regularly updates its evaluations of Internet resources. Section 8: The Leverage Space Portfolio Model No less than John Bollinger called Ralph Vince's Handbook of Portfolio Mathematics, the most importantwork on the subject. Mr. Vince has done the readers of this book, and me, the very great favor ofdescribing his work in a short article I present here verbatim. In 1884, Charles H. Dow began his compilation of what would become known as the Dow Jones Indexes.Theories pertaining to non-confirmation of these indices, known as “Dow Theory,” would become thecornerstone of modern Technical Analysis. It is fitting then, with Dow Jones Indexes having embraced the concepts expressed herein with thecommercial offerings of The Dow Jones LSP indexes in 2011, this explanation of Optimal f and theresultant Leverage Space Portfolio Model be included in this the foundational text on modern TechnicalAnalysis. Let us consider a case of a simple trade with two possible outcomes. In one of the outcomes, we win 2units, and in the alternative outcome, we lose 1 unit. We can construct a spectrum ranging between avalue 0, where we risk nothing, and 1, where we risk our entire equity. We will consider this valuebetween 0 and 1 as the fraction (f) of our stake at risk, and we will refer to this interchangeably as ourleverage. Thus, on any given trade or over any given period, we are risking some fraction of our stake,and thus for any given trade or over any given period, we have a value, f, assigned to us whether we areaware of it or not. If we consider over this hypothetical, simplistic 2-outcome, 2-1 trading situation (similar to if it were thetwo outcomes of a coin toss) we could plot what we would expect to make on our trading equity(expressed as a multiple of our initial equity) over one play at various values for f as depicted in DiagramB.4. Diagram B.4 Expected Multiple of Starting Stake in a Single 2:1 Coin Toss. Diagram B.5 Expected Multiple of Starting Stake after Forty Tosses in a 2:1 Coin Toss. When there is more than 1 trade or period and what we have left to invest in the immediate play or periodis a function of what we have made or lost up to this period, the straight line becomes curved, and thepeak of the curve settles into a fixed point, migrating in from 1.0 off to the right where a positiveexpectation trade or period is growth-maximized over 1 trade or period. Thus, after many trades orperiods, it settles in to a given location, and for the simplistic case of a coin toss that pays 2-1, that peakwill settle in at .25 as depicted in Diagram B.5. The height of the curve for any given value for f is given by the formula for Optimal f, determined as: t1 multiple = 1 + f *| py | '( P) * * \( Pn )' number_of_expected_plays_or_trades Thus, for n trades or periods, for a given value of f, we can determine the multiple made on our stake withsimply the outcome of each trade or period (t), probability of that outcome (p), and the worst-caseoutcome (w), the lowest of all the values for t. We raise the resultant product to the power of howevermany plays we want to determine our expected growth, obtaining the multiple on our initial tradableequity at that many trades or periods. This represents what you would expect to make as a multiple on your starting stake for risking a givenfraction, f, of your stake. Notice this is not the same as what is known as The Kelly Criterion, which gives a peak as a “leveragefactor,” a value between 0 and infinity representing how much to lever up one's account, rather than a fraction (a value between 0 and 1) of an account to risk as expressed by the Optimal f formula. Undercertain conditions the two will give an equivalent value for the peak, for example, the leverage factor willequal the optimal fraction to risk, as in the 2:1 coin toss example herein, but often not, and it can be aperilous mistake to assume that the answer given by The Kelly Criterion is an optimal fraction of accountequity to risk to be expected growth optimal. The Kelly Criterion never yields a peak whose value is theexpected growth optimal fraction of an account to risk, but rather always yields the expected growthoptimal leverage factor. The two can be translated between one another, but the real benefit of theOptimal f formula is it gives us the height to this curve, expressed as an expected multiple made (or lost)on our initial equity (which is not provided by the Kelly Criterion), from which we can derive a field ofstudy. For example, there is a point left of the peak where the curve goes from concave up to concave down.Given the vertical axis is the expected growth multiple and the horizontal axis is the risk, we can state thispoint of inflection represents that point where marginal increase in growth is occurring faster thanmarginal increases in risk, and this flips at the point of inflection. Consider the height of the curve at both f = .l and f = .4 as equivalent yet the latter is risking four times asmuch! Clearly, there is never any reason to be beyond the peak of the curve to the right. We have spoken that you are on this curve, somewhere, whenever you have a position in the markets,whether you acknowledge this or not. Note the point in Figure 2 where f = .5, where the multiple = 1.0. Torisk any more than this is to see a multiple less than 1.0, and therefore the more one continues to trade atthis level, multiplying his initial equity by a number less than 1, the more one insures he will go broke. Most importantly, this is a situation created without borrowing anything at all—it occurs in a cashaccount! This is a situation created wherein one would have on one unit risked for every 2 units in equity,a situation that clearly requires no borrowing whatsoever, and yet, to continue at that level of “leverage”under these (very favorable) conditions, one will go broke with certainty as he continues to trade. When more than one trade or play occurs simultaneously in various markets or approaches, the curvedisplayed in Figure 2 (which is a curve in 2D space since we are looking at one component), manifests inN + 1 dimensional space for N components traded simultaneously. If we consider a case of trading two ofthese issues simultaneously, of wagering on two 2:1 coin toss games simultaneously, we find ourselves inan N + 1 dimensional manifold (in this case, 2 + 1 = 3 dimensional manifold) space as depicted inDiagram B.6. This N + 1 dimensional space is referred to as “Leverage Space,” and portfolios derived therefrom as“Leverage Space Portfolios” (“LSP” portfolios). LSP-style portfolio construction grants us insights unavailable by more conventional portfolio constructs. For example, in Figure 3, we find the peak of thecurve at the f coordinates for both f C o in 2 .50 f C o in 1 Diagram B.6 Expected Multiple of Starting Stake after Twenty Tosses in Two Simultaneously Played 2:1Coin Toss Games. games at.23, .23. Yet, notice what happens if we are off on only one axis; we can be at, say .23, .6, and wefind our multiple, the height of the graph at these coordinates, to be less than 1. Thus, even though we areoff on only one component in the portfolio (and still not borrowing money to assume any positions) weinsure we will go broke as we continue to trade. The notion of diversification as one of meliorating risk isclearly challenged in an LSP-style portfolio, and this is not at all evident by more traditional perspectiveson portfolio construction. Not only are we ineluctably in leverage space when we put on one or more positions in the markets, butwe are also very likely moving through leverage space with changes in our equity and the markets, payingthe price and reaping the consequences for the various points we traverse through the surface of leveragespace. Thus, various paths can be constructed algorithmically through leverage space to achieve different criteriathan the conventional criterion of maximizing expected return to expected variance, or even that ofmaximizing expected growth (which would be to reside at the peak in the surface). With a path throughleverage space in an LSP-style portfolio, a path through the surface of expected growth as a multiple ofour starting stake, we are now able to seek solutions to any investment criteria. Appendix C: Technical Analysis beyond Edwards& Magee • Section 1: A brief general survey of number driven tools • Section 2: The creative technician—the work of Richard Arms • Section 3: The Point and Figure method by an eminent analyst, Mike Moody • Section 4: One of the most famous of technical routines—Bollinger Bands Section 1: A brief general survey of number driven tools Here is something to contemplate: A listing of technical analysis tools. Technical Overlays 1. Bollinger Bands: A chart overlay showing the upper and lower limits of “normal” price movementsbased on the Standard Deviation of prices 2. Chandelier Exit: An indicator used to set trailing stop-lossesfor both long and short position 3. Ichimoku Cloud: A comprehensive indicator defining support andresistance, identifies trend direction, gauges momentum and provides trading signals 4. Kaufman's Adaptive Moving Average (KAMA): A unique moving average that accounts forvolatility and automatically adjusts to price behavior 5. Keltner Channels: A chart overlay showing upper and lower limits for price movements based on theAverage True Range of prices 6. Moving Averages: Chart overlays showing the “average” value overtime. Both Simple Moving Averages (SMAs) and Exponential Moving Averages (EMAs) are explained 7.Moving Average Envelopes: A chart overlay consisting of a channel formed from simple movingaverages 8. Parabolic SAR: A chart overlay showing reversal points below prices in an uptrend andabove prices in a downtrend 9. Pivot Points: A chart overlay showing reversal points below prices in anuptrend and above prices in a downtrend 10. Price Channels: A chart overlay showing a channel madefrom the highest high and lowest low for a given period of time 11. Volume by Price: A chart overlaywith a horizontal histogram showing the amount of activity at various price levels 12. Volume-Weighted Average Price (VWAP): An intraday indicator based on total dollar value ofall trades for the current day divided by the total trading volume for the current day 13. ZigZag: A chart overlay showing filtered price movements greater than a given percentage Technical Indicators 1. Accumulation/Distribution Line: Combines price and volume to show how money may beflowing into or out of a stock 2. Aroon: Uses Aroon Up and Aroon Down to determine whether a stock is trending or not 3. Aroon Oscillator: Measures the difference between Aroon Up and Aroon Down 4. AverageDirectional Index (ADX): Shows whether a stock is trending or oscillating 5. Average True Range (ATR): Measures a stock's volatility 6. Bandwidth: Shows the percentage difference between the upper and lower Bollinger Band 7. %B Indicator: Shows the relationship between price and standard deviation Bollinger Bands 8.Chaikin Money Flow (CMF): Combines price and volume to show how money may be flowing into orout of a stock Alternative to Accumulation/Distribution Line 9. Chaikin Oscillator: Combines price andvolume to show how money may be flowing into or out of a stock. Based on Accumulation/DistributionLine 10. Chande Trend Meter (CTM): Scores the strength of a stock's trend, based on several technicalindicators over six different timeframes 11. Commodity Channel Index (CCI): Shows a stock's variationfrom its “typical” price 12. Coppock Curve: An oscillator using rate-of-change and a weighted movingaverage to measure momentum 13. Correlation Coefficient: Shows the degree of correlation betweentwo securities over a given timeframe 14. DecisionPoint Price Momentum Oscillator (PMO): An advanced momentum indicator trackinga stock's rate of change 15. Detrended Price Oscillator (DPO): A price oscillator using a displaced moving average toidentify cycles 16. Ease of Movement (EMV): An indicator comparing volume and price to identify significantmoves 17. Force Index: A simple price-and-volume oscillator 18. Mass Index: An indicator identifying reversals when the price range widens 19. MACD (MovingAverage Convergence/Divergence Oscillator): A momentum oscillator based on the difference betweentwo EMAs 20. MACD Histogram: A momentum oscillator showing the difference between MACD andits signal line 21. Money Flow Index (MFI): A volume-weighted version of RSI showing shifts is buyingand selling pressure 22. Negative Volume Index (NVI): A cumulative volume-based indicator used toidentify trend reversals 23. On Balance Volume (OBV): Combines price and volume in a very simpleway to show how money may be flowing into or out of a stock 24. Percentage Price Oscillator (PPO): A percentage-based version of the MACD indicator 25. Percentage Volume Oscillator (PVO): The PPO indicator applied to volume instead of price 26. Price Relative/Relative Strength: Technical indicator comparing the performance of two stocksto each other by dividing their price data 27. Pring's Know Sure Thing (KST): A momentum oscillator from Martin Pring based on the smoothed rate-of-change for four different timeframes 28. Pring's Special K: Amomentum indicator from Martin Pring combining short-term, intermediate and long-term velocity 29.Rate of Change (ROC) and Momentum: Shows the speed at which a stock's price is changing 30.Relative Strength Index (RSI): Shows how strongly a stock is moving in its current direction 31. RRGRelative Strength: Uses RS-Ratio to measure relative performance and RS-Momentum to measure themomentum of relative performance 32. StockCharts Technical Rank (SCTR): Our relative ranking system based on a stock's technicalstrength 33. Slope: Measures the rise-over-run for a linear regression 34. Standard Deviation (Volatility): A statistical measure of a stock's volatility 35. Stochastic Oscillator (Fast, Slow, and Full): Shows how a stock's price is doing relative to pastmovements. Fast, Slow and Full Stochastics are explained 36. StochRSI: Combines Stochastics with the RSI indicator to help you see RSI changes moreclearly 37. TRIX: A triple-smoothed moving average of price movements 38. True Strength Index: An indicator measuring trend direction and identifying overbought/oversoldlevels 39. Ulcer Index: An indicator designed to measure market risk or volatility 40. UltimateOscillator: Combines long-term, mid-term and short-term moving averages into one number 41. VortexIndicator: An indicator designed to identify the start of a new trend and define the current trend 42.Williams %R: Uses Stochastics to determine overbought and oversold levels Outline This is a list of tools and indicators available at stockcharts.com. Most if not all of these tools are alsoavailable either through software packages (Tradestation, AIQ, Metastock) or online (thinkorswim andothers). I display the list so newcomers to technical analysis get an idea of the plethora of tools available.Also, I display the list so that students see the philosopher's stone nature of building systems to beat themarket. To briefly review, the philosopher's stone is a stone which allows the owner to convert lead togold. In the Middle Ages, it was the subject of much dedicated research. At present, to my knowledge,only George Soros has a philosopher's stone, but it is entirely possible for the dedicated student to find inthe list a tool or method which will allow him to reap rich rewards. Displaying the list also prompts me to repeat what we have frequently told our graduate students over theyears: You can drive a nail with a screwdriver; so if it works for you it doesn't matter what it looks like. Tothis end I will comment on some, but not all, of the tools listed here—in some cases revealing tools andsystems which, in research, have been fiendishly effective. Moving averages Technical Analysis of Stock Trends is often the first book investors read when they become interested inthe technical approach to the market. This is as it should be and also new analysts need to be informed ofthe amazingly varied field of technical analysis. Chart analysis is the cornerstone of technical analysis anda required field of knowledge. If the analyst is more statistically oriented or is looking for an algorithmicmethod he must search through the numerous alternatives in the technical toolbox. This appendix is intended not to teach the reader the details of operating a moving average or stochasticsroutine, but to place the various technical tools and systems (or methods) in context and in perspective.The first of these tools is the moving average. We personally can testify to the power of these systems,having reaped outsize profits using moving average systems. Note these profits were gained in roaring bullmarkets. In sideways markets trading a moving average can be the equivalent of producing sausage with ameat grinder. Thus, having confidence in the state of the market is an absolute necessity. The effect of amoving average is to smooth raw price behavior and clarify the trend of the market. The bells and whistlesyou can hang on a moving average are like a Christmas tree. You can use the moving average as input to asignal —buying when the price penetrates above the MA line. Using the MA line as a stop, selling whenprices fall below the MA line. Or you can construct a filter—buying or selling when prices pierce the lineby x%. The possible variations are infinite. As is probably obvious, MA systems are in the main trend following systems. As are virtually all Edwards& Magee methods and systems. The reason for attempting to employ trending systems is, withoutexception, long-term trend following results in larger profits than any other trading method. In general, the market makes something of a shibboleth of two moving averages—the 50-day and the 200-day. The 50-day is thought by the media and public to be a warning crack in the market and the 200-daypenetration is thought to be a bear market phenomenon. In our trading, we watch the 50 and the 200--daybut we don't use them as signals. We are usually more concerned with patterns and the character of themarket rather than using these moving averages as signals. Rather, we use them as alerts as to what thepublic is thinking and depend on Basing Point analysis for stops. Magee's consideration of moving averages is contained in Chapter 36. It is amusing to quote a remark ofhis upon discovering moving averages: "...one could derive a sort of Automated Trendline that woulddefinitely interpret the change of trend. It seemed almost too good to be true. As a matter of fact, it was toogood to be true.” Personally, we have experienced excellent profitability with moving average systems. While we originallythought this was a sign of genius, with time we realized that the market was the genius and my companywas trading in a roaring bull market—and indeed we were—the monstrous commodity bull markets of the‘70s—the Russian wheat market, the Hunt silver market.. Almost anything, including bonobo monkeysthrowing darts, works in a tidal market. Nevertheless, a long moving average can keep the investor fully invested for months— if not years. In thecase of the great Bull Market of 2009-2017, it took years, as evident by the chart with a 200-period simplemoving average. (Figure C.1) A number of different types of moving averages are used by technicians:simple, exponential, triangular, variable, and weighted. The distinguishing difference amongst thesemethods is the simple method weights all prices equally. Weighted and exponential routines place a highervalue on the most recent data, enabling more sensitive and rapid reaction. Triangular averages put moreweight in the middle of the time period and variable averages adjust the weighting according to thevolatility of prices. Does this smack of the philosopher's stone? One thing it should tell the newcomer—and grizzled veteran—is the search for a market beating method is incessant and indefatigable— it never ceases. Figure C.1 A 200 period moving average on a weekly chart. The investor would never (virtually never)have felt the least anxiety for his position. His confidence in the trend would have been buttressed by theMA line. Contemplating an exponential versus a simple moving average the difference is probably not worth thetrouble. Trading decisions might be moderately accelerated on trading length systems (-5-15 days for veryshort term; 15-23 days for short term; and 24-50 days for intermediate term; and 100 days and up for longterm. With recent thinking we might add super long term—that is 200 days or even longer weekly basedsystems.) The conventional way to use a moving average system is to go long when price breaks above themoving average and sell when price falls below the moving average. Probably the most usual modificationto these systems is to put a filter on them, for example requiring the penetration of the moving average lineby 1 (or x) % to assure validity. (Cf. Chapter 36, the Pentad system) We think, based on experience, thismay be the most effective way to employ this tool. Sometimes two moving averages are used. Signals arecreated by the interplay of the moving average lines, one moving above or below the other. This is acharacteristic of MACD, which will be discussed later. Stochastics The first thing to do when studying stochastics is stop trying to figure what “stochastics” means. Ofcourse, it has a dictionary meaning to be discussed later. Right now, the reader should put aside thequestion of actual meaning and consider what it means in the discipline of technical analysis. Markets have two basic theoretical (and actual) states: trending or mean reverting. If the market is non-trending, swinging back and forth, up and down, traders need tools to deal with it. If they want to tradeunder these conditions they turn to oscillators. The purpose of the oscillator is to aid in identifying wavebottoms and wave tops. The stochastic algorithm is one of the more popular of these oscillators. Stochastics establishes a “window” on the market for the analysis of prices. The default value for thiswindow is 14 bars, but different practitioners customize the value for their own use. The price highs andlows within this window are integral to the analysis. The routine establishes a line (called %K) as theessential benchmark or guide of the analysis. A second line is calculated (%D) using a simple movingaverage of %K. This moving average is quite short (3 periods default value) and thus creates a line ofgreat sensitivity. Conventionally these lines are displayed on a scale from 1 to 100. Signals are generatedby values of 20 and 80. The routine buys when the low value is 20 and sells upon a high value of 80. Inshort, selling strength and buying weakness. 20 and 80 refer to where the closing price is relative to thewindow trading range, thus placing price position at 20% or 80% of the range. Other means of generatingsignals are available, to wit the interaction of the two lines, as for example, the %K line falling below orrising above the %D line. (Figure C.2) As with most tools, the technician can modify the routine to suit his whim. MACD (Moving Average Convergence/Divergence) MACD is a trend following momentum indicator that shows the relationship between two movingaverages of price. It is calculated as the difference between a 26 and a 12-day exponential moving average.Gerald Appel, who is reported to be the creator of the routine, placed a 9-day exponential moving averageon top of the MACD as a means of identifying trading signals. Generally, a sell signal occurs whenMACD falls below the signal line and a buy signal when it rises above the signal line. Trading also occursas MACD goes above and below zero. (Figure C.3) As one can well imagine with 55 indicators (andcounting), there is a tool for every occasion. One must always remember the rule of tools: To a man with ahammer everything looks like a nail. Rather than attempting to explicate every tool, I will restrict myselfto the obvious, after reminding the reader that careless and uneducated use of any tool can seriouslyendanger his capital. Some other chosen indicators to consider: ADX, a tool which shows whether an issue is trending oroscillating. This tool is easily replaced with a ruler and the naked eye. This is the case with many of theindicators; they have been developed by their inventors to attempt to remove ambiguity from the market—a desire the experienced chart analyst doesn't possess. The chart analyst looks at a chart and most of time itis obvious. If not, it becomes obvious the moment a ruler is laid on it. Another tool which does more orless the same is the Aroon which uses Aroon Up and Aroon Down to determine whether an issue istrending or not. Once again, a question which is painfully obvious at first glance to the chart analyst. Weshould make clear that some intelligent analyst has used each of these tools to wring a profit from the market. Accumulation /Distribution Line showing how money flows in and out Figure C.2 Stochastic routine on a gold chart. Obviously interpreting the indicator requires someexperience and discrimination, but this is true of all number driven indicators. of an issue may be useful to some practitioners, as may Volume by price which shows the amount ofactivity at various price levels. Pivot points—a relatively simple mechanism evidently popular with manytraders can at least give the trader unambiguous trading points. Which brings us to a central technical and philosophical point: Almost any system is better than nomethod (or system) at all. The problem for the inexperienced trader— or investor—is what system. Thisbook answers that question for most investors and is a good method while the investor refines his ownmethods. We continue to say the trader who invents a system without thorough knowledge of this book isputting life limb and capital at risk. This statement may be a little less true now than in years past—simplybecause so much of this book's material has leaked via osmosis into general investor knowledge—usuallyunconsciously, but often through outright imitation or worse. Not a practice which outrages us, though,sometimes amuses us—but no tears. Also, as we have been in education for many years, we observe thespread of knowledge as something the enlightened and educated do as a responsibility to the communityand humanity. Point and Figure analysis Bar chart analysis has so dominated investor usage for so long (partly because of this book) that evenmany experienced analysts have ignored an interesting and valuable method which we will explore brieflyhere. That method is Point and Figure analysis. $SPX S3P 500 Large Cap Index INOX © StockCharts com Figure C.3 MACD on a gold chart. MACD is a popular tool and deemed effective by many traders.Readers can see why from the chart. 544 Appendix C Said by some to be an invention of Charles Dow, and by others to be created by the Russians, PnF chartinghas shown itself to be surprisingly effective in our experience. When we examine some of itscharacteristics we get an idea why. Bar charts represent price action (open high low close) with a verticalbar with cross hatches for open and close. The x axis represents time, the y, price. PnF ignores time for themost part, though there is a nod to it as we will see. Several basic decisions are made in the construction of the chart. Since the chart is made up of boxes, thesize of the box must be determined. The analyst chooses a box style appropriate to the duration of thechart. Obviously, if one is dealing with years of data in the INDU the box must be large—50, 100 points.At shorter durations wave analysis would suggest a good size; and at any rate online routines presentreasonably sized charts. In general, one might say larger boxes furnish perspective and smaller boxesfurnish detail. The other choice the analyst must make is reversal size. The traditional choice here is a three box reversal.Thus, if the box size is 4 and we are in an x column, 12 points down must occur to change to a column of0s and three 0s would be drawn in the next column. And although time is usually ignored, a box is markedwith a month indicator as a column rolls over to a new month. All these options are subject to change and adjustment by the individual technician. What is more, thereare other varieties of PnF charts—one box reversal, for example, but the basic idea is the same. Using a variety of methods, one may make forecasts from the chart. Let me emphasize: Treat this method and anyother algorithmic method with caution until you have thoroughly examined it (Figure C.4). Next for comparison, a bar (Candlestick) chart shows the traditional picture of this period (Figure C.5). As the reader can see, PnF charting is a fascinating and valuable method. Many investors rely on thismethod alone for their analyses. As with all of the tools surveyed here no attempt is made to give a definitive exploration of the tool or todescribe the mechanics of its creation. Those details about PnF charts are ably discharged by the booksPoint & Figure Charting by Thomas Dorsey and The Definitive Guide to Point and Figure by Jeremy duPlessis. Later in this appendix Mike Moody will discuss the method in a much more sophisticated way. Section 2: The creative technician—the work of Richard Arms The Arms Index (TRIN) by Richard Arms In 1967, when I was still an unknown in Technical Analysis and was working as a stockbroker for a majorNYSE firm, we moved into new modernized offices. Among the improvements were new quote machines,which actually had a tiny screen to display the information. Moreover, the data included some fascinatingnumbers. It was possible to see the number of stocks that were up and the number of stocks that weredown at any time, and even a total of the volume traded on the up stocks and a total of the volume tradedon the down stocks. Looking at this, I began to wonder if it could serve as an indicator, telling us if theratio of up to downs was the same as the ratio of up volume to down volume. If not, deviations fromnormality might show when the buyers or the sellers were more in control. In seconds, the Arms Index, orTRIN, came into being in my mind and then in my research. An article in Barron's was all that was neededand it took on a life of its own. SSPX S«P 500 Large Cap Index NDX 02-Nov-2015.16:00 ET. da4y, 0 2.08076, H 2,106 20. L 2.080.76. C 2.104 05. Chg *24 69 (1 19%) P&FPattern Long Tai Up on 28-Oct-2015 Trad ton al scaling 3 box reversal Buksh Price Objective (Tentative) 2549 0 (<) StockChirtrcom n I 2140.00 2140.00 2130.00 X X 2130.00 2120.00 X X Xo X Xo 2120.00 2110.00 X X X XoXoXoX XoXoX 2110.00 2100.00 X3Xo XoXoXoXoXoXoXoX8X\ X B <<2104.05 2090.00X XOXo XoXo5oX6XoXoXoXoXoXo X 2090.00 2080.00Xo XoXoX Xo o oXo/ o oXoXoXoXo X 2080.00 2070.00Xo XoXoX4X o / oXo o oXo X 2070.00 2060.00c XoX X XoXoXOX oX o o X 2060.00 2050.00° X1Xo Xo XoXo O 7 o X 2050.00 2040.00P XoXo Xo Xo o X _2040.00 2030.00 2020.00 2010.00 2030.00 2020.00 2010.00 1990.00 °X oooo o X Xo X 1990.00 1980.00 ° o X9 X Xo X 1980.00 1970.00 o XOX XoXo X 1970.00 1960.00 o XOXoXoXo X 1960.00 1950.00 o XOXoXoXoX X 1950.00 1940.00 oX XOXoXo oXoX 1940.00 1930.00 oXoXOXoX oXoA 1930.00 1920.00 oXoXoXo oXoX 1920.00 1910.00 oXoXo o oX 1910.00 1900.00 oXoX / oX 1900.00 1890.00 oXoX oX 1890.00 1880.00 oXo/ O/ 1880.00 1870.00 o / 1870.00 1860.00 1860.00 Figure C.4 Here from the edwards-magee.com website is a PnF chart from November 2015 which looksfor a target of 2549—this when the S&P was around 2000. $ S P X S&P 500 Large Cap Index INDX ® StockCharts.com Appendix C 547 The calculation With so many sources, such as newspapers, television stations and every quotation service, providing thecalculated index most users will never need to make the calculation themselves. However, in order toappreciate the significance of the index one should be familiar with its derivation. The Formula is:(ADVANCES/DECLINES) 2---------------------- = ArmsIndex (ADV.VOL./DECL.VOL.) At any time, we can retrieve the numbers showing how many stocks are up for the day, how many stocksare down for the day, the volume on the advancing stocks and the volume on the declining stocks.Plugging them into the above formula we end up with a single number, the Arms Index for that instant.The above example* (footnote) has produced a somewhat bearish index. An index of 1.00 is a standoff,indicating both the advancing stocks and the declining stock received their fair share of the volume. Avalue over 1.00 is Bearish, indicating the declining stocks are receiving more than their share of thevolume. An index lower than 1.00 is Bullish since the up stocks are receiving more than their fair share ofthe volume. Normally, the index will fluctuate closely around 1.00. We have seen days end with an indexas low as .19 and other days with an index over 10.00, but these were rare occurrences, where the traderswere reacting to extremes in euphoria or fear. Normally, the index will be somewhere between .65 and1.75. EXAMPLE THE ARMS INDEX: ADVANCES 1024 DECLINES 2030 ADVANCING VOLUME 299,790,000DECLINING VOLUME 786,830,000 1024/2030 =.504 1024/2030 =.504 299790/786830 =.381 .504/.381 = 1.32 .504/.381 = 1.32 (ADVANCES / DECLINES) (ADV. VOL. / DECL. VOL.) (ADV. VOL. / DECL.VOL.) = THE ARMS INDEX (TRIN) EXAMPLE The reasoning At any time, the Arms Index is telling us whether the up stocks are getting their share of the volume ornot. If the index is over 1.00 the down stocks are overpowering the up stocks. (Remember, under 1.00 forthe raw number is good, and over 1.00 is bad. It is counter-intuitive, but it is the way the index was firstcalculated, and it's late to try to change it now. If that really bothers you, invert the calculation and it willbe more intuitive, but you will be out of step with everyone else using the index. You will see the index isdealing with comparing two ratios, so it is commonplace to have a market that appears to be Bullishbecause of there being more stocks up than down, but is actually under pressure, in that those up stocksare not getting their share of the volume, and the index is Bearish. Similarly, we can have more stocksdown than up, but have a Bullish index, because the up stocks are getting more than their fair share of thevolume. The Arms Index is measuring the internal dynamics of the market—dynamics that may not beotherwise readily apparent. A Bullish Arms Index in a slumping market may be telling us there isaccumulation going on, under the guise of a down market. Using the index The index was originally developed as an intraday timing tool, and it still is valuable in that role. There aretwo things to look at: the actual reading and the way it is changing during the day. The actual level istending to reflect the current condition; sometimes a Bullish reading in a declining market or a Bearishreading in a rising market makes the move suspect. More often, the value will be in line with the currentmarket activity, but watch for the big extremes. Not always, of course, but often, the index will go too farin one direction, and suggest the move is overdone. It is reflecting those times when reason is beingabandoned and a blind panic or a feeding frenzy is dominating the trading. A very high or a very low indexcan be a sign it is time to be a contrarian. The other intraday use is watching for change, rather than justthe actual value of the index. Often the index will change direction before a reversal becomes apparent inthe averages. A Bearish index in a Bearish market that suddenly starts to move toward lower (less Bearish)levels may be a warning the market is about to turn up. The same is true bullish numbers that start to gethigher; suggesting a downturn may be developing. Most often, though, the index is now used on a longer-term basis. The most common use is a simple 10-day moving average of the closing daily numbers. Thistends to be a good indicator for market moves lasting a few weeks. For short-term trading, I like the 5-daymoving average. In order to get a feel for longer-term trends, I use a 21-day and a 55-day. The big marketmoves can be recognized by using very big moving averages, such as the 233-day. On each of thefollowing charts, we are looking at simple moving averages of the Arms Index on an inverted scale. Thered line is the index and the black line is the market. Since the scale has been inverted for the index, thelows on the indicator line tend to coincide with low points in the market. Similarly, peaks in the indexcoincide with the market tops. I have chosen different time intervals on each of the charts below since thelonger-term moving averages are used for longer-term predictions. I have not given any hard-and-fastnumerical levels as buy and sell signals because we need to look at the index in the context of the currentmarket. Buy signals in a Bear Market are at more oversold levels than they are in a Bull Market. Extremepeaks and troughs, compared to what has been seen recently, tell when it is time to become a buyer or aseller. These are only a few applications and examples. Not shown are Arms Indices, now available, forNASDAQ and also for a number of foreign markets, in which the index is equally effective. Immenseamounts of work, using many different methods, has been done over the years since the index was firstmade public. Anyone wishing to know more is referred to the various books by Richard W. Arms, Jr.Figure C.6 illustrates the index and shows Equivolume chart for context. Figure C.6 Notice how on the Equivolume chart the breakaway is accentuated by the wide bars. Thetechnician is constantly in need of accents and alerts like this (cf. also Figure C.7). Equivolume charting Introduction In 1971, with the Arms Index a part of Wall Street methodology, I had become more fascinated by the roleof Volume in the marketplace. I had been spending great deal of time studying an early edition of the bookyou now hold but had also been learning the ideas of Richard Wyckoff; both placed a great deal ofemphasis upon the importance of Volume in evaluating stock movements. As I was driving home fromwork one afternoon, I was thinking about stock charts and volume and suddenly realized there might be abetter way of depicting trading action. What if we could substitute volume for time on our charts? Wecould depict each day as a rectangle rather than the traditional line on a bar chart. The width of the boxwould represent the volume for that day. Unbeknownst to me, I was reinventing a method suggesteddecades earlier, but not widely popularized. I decided to call my new approach Equivolume (cf. FiguresC.7 and C.11). Figure C.7 Once again the wide volume indicating bars alert the technician to an important surge in themarket. The technique In the days before the proliferation of computers, implementing the concept of Equivolume was far fromeasy. In order to lift the volume from the bottom of the chart and insert it in the posting, a scale for eachstock had to be devised based upon its normal trading. That scale could change if the stocks went into aphase of much heavier or lighter trading. I will not go into the calculations I used at the beginning, but itseemed to work. I hired a lady to draw dozens of charts for me and proceeded to learn to read what theysaid; this led to my first book. Later, each new advancement justified another book. Once people a lotsmarter than me figured out how to let a computer do the work, it became a lot easier. Now, one can getEquivolume charts on most major charting services, so there is really no need to wonder about the scaling.Suffice it to say, the rectangles on any chart are proportional to one another in reflecting the volume. The result An Equivolume chart does not in any way change the high and low on each entry, but when combinedwith the volume it becomes a box, the shape and size of which reflects supply and demand for that tradingperiod. All the techniques popularized by the masters who first published this book are valid when usedwith Equivolume charts. However, for example, trendlines tend to be broken earlier if volume becomes heavier, and breakouts aremore noticeable if volume increases, thereby legitimizing them, as are levels of support and resistance.Equivolume uses all the same data, but just gives us a different picture, which includes all the data in asingle entry. Below are two charts: a bar chart and an Equivolume chart of the same stock over the sametime period. This is three months of trading in General Electric (Figure C.8). The chart below is posted on a weekly basis (Figure C.9). Conclusion Equivolume represented a far better way of looking at market action because each entry told a morecomprehensive story. The shape of the box indicated how easy or hard it was for prices to move while thesize of each box showed the interest intensity. It was a method that could be used for any investmentproduct, as long as both price movement and volume numbers were available. It has become a completemethodology and is readily available on a plethora of data services. Arms CandleVolume charting After the introduction and wide adoption of Equivolume, the next logical step was to combine theEquivolume concept with the Japanese method known as Candlesticks. Yet, I was slow to do this becauseone or more of the major charting services had already included a partial joining of the two techniques,calling it CandleVolume, but doing it in such a way some of the visual advantages of Equivolume werelost in the process. Yet, if I did the combination of the methods in my way, completely merging the twotechniques, I found it could be another great advance in the way we looked at charts. Clumsily doubleprinting of charts, I was able to work on it and found the results to be very helpful, and since the nameCandleVolume was already taken, I started calling it Arms CandleVolume. Then, after my first speech onthe approach, to the International Federation of Technical Analysts in San Francisco a few years ago, theproblem was solved. Within minutes of completing the speech the President of Stockcharts.com, who hadbeen in the audience, showed me he had quickly adapted their software for the new technique and, withmy approval, would immediately include it in their service, which they did. The illustrations in this articleare from that source. 200 180 214 210 8 10 12 17 Od 14 15 17 21 27 28 1 5 7 11 14 18 20 22 28 2 Oec 201 GE General Eiectnc Co. NYSE ‘Bats •StoclCtarfsrom SJin-20181:27pm Open 1880 High 18 88 Low18.51 Last 1840 Volume 48 1U Chg »0 02 (•013%) • ¥« (Dally) 18.56 104 175 200M 100M 20 2011 M GE (Oaily) 18.57 •hiiunu GE General Electric Co. hyse ♦ bats 5.J1O-2018 128pm 8 A Volume 48,359,892 300M OltockClurtKom g <003 (*0.19%) - 243 240 235 23.0 225 22.0 213 210 205 20.0 y l. 38.75 aa M W1V 3800 37.75 37 60 37 26 37 00 3076 36 60 36 26 3600 3575 36 60 35 25 0 10 23 XNov e 13 20 27 Dec 11 10 20 2010 NEM Mrmg Corp NYSE 5-J aft-2018 M NEM (Daily) 38.40 • $to< kChart i com Open 38 18 High 38 43 Low 3802 Close 38 40 Volume 2 OM Chg *0 14 («O37M) - NEM Newmort MnngCorp NYSE 5 Jan-2016 MNEM Daily) 38.40 • StocKKarttcora Open 38 18 High 38 43 Low 38 02 Close 38 40 Volume 2 0M Chg «0 14 (*037M) - 370 370 365 360 355 VNEM (Oatlv) 38.40 I W I n, . tt] LI, d 3500 3475 3450 3425 Figure C.10 Notice the increasing analysis of information that occurs from one method to the nextmoving from conventional bar chart through Equivolume to Candlevolume. Figure C.11 Notice the increase in information as we move to the newer technique. Candlevolumecombines virtues of Equivolume and Candlestick charts. Point & Figure technical analysis by Mike Moody Like most technical analysts, my exposure to charts came initially from bar charts. I started as a naivestockbroker, hoping to understand markets to help my clients make money. I soon learned the “accountexecutive” position was—from the faulty point of view of the brokerage firm—primarily a sales job. I quickly learned to use bar charts as a form of selfdefense from the firm's research department. The chartscould be used to examine the position of any security the firm's research department was recommending,in the often vain hope the recommendation and the chart were in synch. I found the bar charts most commonly in use had a limited perspective, usually only about a year of pricedata. Soon I was taking an additional charting service that used weekly bar charts—including a relativestrength line as well. My quest for perspective ended when I was introduced to the Point and Figure chart. I think it is anextraordinarily flexible and useful complement to bar charts because of the perspective it can supply.Analysts like Richard Wyckoff used both bar charts and Point and Figure charts in tandem because of theirdifferent features and strengths. Point and Figure charts are now fairly rare, which is unfortunate. Novices often do not understand whatthey are looking at or how a Point and Figure chart is constructed. I've included a simple example chart below (Figure C.12). This chart is an example of a traditionally scaled 3-box reversal Point and Figure chart. The chart stylewas popularized by Abe Cohen of Chartcraft. The price scale is on the left. (You can see that price boxesbelow $20 are smaller than price boxes from $21 to $100. This is a clever, pre-computer attempt to adjustto a more logarithmic scale.) Columns of Xs denote rising prices and columns of Os indicate fallingprices. The small numbers embedded in the chart indicate the month a security first printed that price. (1-9for January through September, and A-C for October through December—another elegant early solution tofit a time identifier in a single-width box.) The perspective is obvious, as this chart covers well over adecade. However, for a technical analyst used to bar charts, two things stick out. First, there is no timescale; years where a lot happened are wide because many reversals occurred. Years where the stock wasquiet are represented by far fewer columns. Second, it is not immediately obvious how a 3-box reversalchart is constructed; it's simple but requires a short explanation. A 3-box reversal chart is designed to filter out any price movements less than 3 boxes, whatever that maybe on the chart. With a 3-box reversal chart, there will never be a column that consists of less than 3 boxes.The general rule will hold—the minimum column depth will be a function of the reversal value used. Let's pick up the chart in 2012, as it first reversed upward to $34 in September. There is a simple flowchart logic to plotting a Point and Figure chart. 1. If you are rising in a column of Xs, first look to see if a new price high was made. If yes, put a newX in the column. 2. If no new high was made, check to see if a 3-box reversal down occurred. If yes, put in a newcolumn of 3 Os. 3. If no new price high was made or no reversal down was made, do nothing. It's the “do nothing” that is different because time can pass with no adjustment made to the chart. Thechart is a record of pure price movement. By November 2012, General Mills had printed $35—without ever reversing down 3 boxes or more. InJanuary 2013, the price hit $36. February 2013 was a good month—the Scaling: Traditional [Reversal: 3] (c) StockCharts.com xoxix 7OXOX XOXO2 OXOXOX OSO9OX 1 SAX AX 7 A X2X040C9 X9 XO XO XO XO XO X xox 4 xoxoxo XOXO5A2O XO5O XO 3 > OX OXOX AXoxox 5XO6OXOX 3OXO I OX X COX 5 7 BOX 4OXOX s xoxox XOX X9XO XOX2XA 45XOAO3 XO79 O 30 X SOX BA 70X09 05 OX °n4 O J. 14 15 IS 3 7X0 XOA 1400 OB 3 13 50 ~O 13.00 _ 03 04 05 OS 10 11 II 13 TTTT 4SXO t XO9 5 . C1X XOX 902 3X 4 OX OX 30 Figure C.12 Years of data for GIS. price hit $37 and continued to $40. $41 was reached in March, and $42 and $43 in April. May 2013 sawthe first 3-box reversal, from a peak price of $44 to the minimum reversal level of $41. Key to the value of Point and Figure charts is their flexibility. Many early practitioners of Point and Figureused single-box reversal charts calculated with intraday data. This style of chart looks more similar to abar chart, but actually captures volatility particularly well because of the use of intraday data. With a barchart, each day might be a single bar, but during a particularly volatile period for the market or for anindividual stock, a single-box reversal chart can put in many, many columns. Like a bar chart, price targets with a Point and Figure chart are usually estimated from the width of thebase—and during a particularly volatile period like 1987 or 2008 many, many reversals can occur in asingle day! Alan Shaw, formerly the chief market technician at Smith Barney, believed that intraday,single-box reversal point & figure charts were the premier way to estimate price moves from a base. As aguide to this type of chart, Alan always recommended Alexander Wheelan's Study Helps in Point andFigure Technique. On more than one occasion, this knowledge allowed Alan to estimate large price moveswhen the base on a bar chart was narrow. The computer age has improved Point and Figure charting immeasurably. The computer has no troublecreating true logarithmic charts. Here is the same chart of General Mills, this time using a 2% box and a 3-box reversal. Also shown is the traditional 45-degree trendline, drawn from prominent highs or lows.(Figure C.13) Percentage charts are, I think, significantly clearer. There is no reason not to use them nowsince they can be so easily generated. (All of the charts here are courtesy of StockCharts.com.) Detail canbe added by shrinking the box size; greater perspective can be achieved with a larger box size. It seems simple but changing the box size or reversal value allows the Point and Figure chart to be adaptedto any time frame, from scalping to swing trading to infinity. The chart below, using a 1% box size with a 3-box reversal shows a clear breakout from a downtrend thatis not visible at the same price on a chart with a larger scale. (Figure C.14) Moving averages can also be helpful on Point and Figure charts to help determine trend. The differencewith a Point and Figure chart is that the moving average is a moving average of the center point of acertain number of columns. The chart below simply replaces the 45-degree trendline with a 10-column moving average. (Figure C.15)Trend is critically important, but as my career developed into money management, it became importantalso to measure the power and durability of the trend. The Chartcraft service had, for years, calculated arelative strength ratio (stock price divided by index price), adjusted the decimal points to make itchartable, and then plotted it on a traditional 3-box reversal chart. At Dorsey Wright, we changed theserelative strength charts to percentage charts and gained vast additional perspective. The chart below, of Danaher Corp., is a relative strength chart using a 6% scale with a 3-box reversalvalue. The price of Danaher is divided by the price of an S&P 500 ETF and plotted on a log scale.Suddenly, it becomes apparent—in broad terms—Danaher has been outperforming the market for morethan 15 years. (Figure C.16) The final strength of Point and Figure charts is their objectivity. A skilledpractitioner with a bar chart can be very effective, but one analyst might discern a continuation pattern where another sees a different pattern in a larger or smaller time frame. Two analysts Scaling: Percentage(Reversal: 3, Box Size:2.0%] (c) StockChartscom 69 87 69 87 68 50 7 68 50 6715 X 9 6715 65 84 XO 65 84 64 55 xo 64.55 63 38 xo 63 38 63 04 6OX 63 04 60 83 4 xoxo 60 83 59 63 XOX A 3O X <<60 18 58 46 xo 50 ox X X 58 46 57 33 7 0 0X0X0 c 57 32 56 19 X 4XO6OXX 56 19 55 09 7 X 5 O OXOX55 09 54 01 XOXIX O8OX54 01 52 95 7OXOX OX 52 95 51 91 XOXO 2 9X 51 91 50 89 X XOXO OX 50 89 49 90 1 2XOX 5 49 90 48 92 Xco 3OX 48 92 47 96 57 80ox 47 96 47 03 40X ox 47 03 46 10 5 xox ox 46 10 45 19 XOB39X ox 45 19 44 31 xox CXA 0 44 31 43 44 X7 oxox 43 44 43 59 45XOAOX 43 59 41 75 xox 93 41 75 40 93 XOX 40 93 40 13 86 40 13 39 34 X 39 34 38 57 X 38 57 37 82 X 37 82 3707 7 37 07 36 35 1 36 35 35 63 c 35 63 34 94 34 94 34 25 1 p 34 25 33 58 c 77 33 58 32 92 A OX 33 93 33 38 XXOX 33 38 31 64 56 907 31 64 31 03 Xox6 31 03 30 41 X 4ox 30.41 39 83 604X xox 39 83 39 33 5098Xox8X 39 33 38 66 30X01030 28 66 28 10 1OX0 0 28 10 27.55 X7X 27 55 2701 cox 2701 26 48 9 8 26 48 25 96XX X 25 96 25 45X8XO A 25 45 24 95 ’xox ox X 24 95 24 46 OXOXOXOX\X 24 46 23 98 OXOoxoxo X 23 98 23 51 OOXOXO9 23 51 23 05 ' 0 cox X 23 05 23.60 OX3 ‘22 60 33 15 /01 OX ‘22 15 31 73 0 0 7 ‘21 72 31 39 0 X 21 29 30 88 0 6 ‘20 88 20 47 oxX 20 47 20 07 ~ OXO5 ‘20 07 19 67 ~ 3X04 19 67 19 39 OX OX 19 29 18 91 ~ OOX 18 91 18 54 OX 18 54 1817 " ox/ 18 17 17 82 ’ 0/ 17 82 1747 ‘ 17 47 09 10 11 12 13 14 IS It 17 Figure C.13 An alternative view of General Mills. 70 15 69 45 68.77 68 09 Scaling: Percentage [Reversal: 3, Box Sized.0%) (c) StockCharts com XOXO CX OX OX O OXOXO OXOXO 7X0X0 O 0 90 OX OXO XX OX ox ox O9OXOXOXOX3 \ 0 o/o 0 oxox \ / oxoxox \ / O OXOXO \ / 4X0X0 X \ oxoxox xo \ 5XOXOXO 8OX OXO6OXOXOXO OXO2 X 0 ox ox OX OX/ 0X0/ ox/ 0/ / / xoxox X 2 XO! O X \ 7 8X\ XOX 9 XOXO XO O X X X X X X X XXX X XOX XOX xo OX X X X / OXAXOX9X / oxoxoxox / oxo o ox/ 0 o/ 4 OX OX XOXO6 XOXO X XOX XOXO5 XOXO 30 70 15 69 45 68 77 68 09 6741 66.74 66 08 65 43 64 78 64.14 63 50 62 88 62 25 61 64 61 03 60 42 <<60 18 59 23 58 65 58 06 5749 56 92 56 36 55 80 55 25 54 70 5416 53 62 53 09 52 57 52 04 51 53 51 02 50 51 50 01 '49 52 16 17 Figure C.14 Clarifying the issue with percentage boxes. looking at the same Point and Figure chart, on the other hand, will always be in agreement about whether thechart is on a buy signal or a sell signal. The criterion is incredibly simple and unambiguous. If the price exceeds the immediately previous column ofXs, it is on a buy signal. If the price declines below the immediately previous column of Os, it is on a sellsignal. On the Danaher relative strength chart, for example, there is a buy signal at 10.88 in October 2000. (Itexceeded the previous rising column, which topped out at 10.27.) There is no subsequent sell signal, as nocolumn of Os ever falls below the previous column of Os. A security, by definition, is always on either a buyor sell signal. The objective nature of Point and Figure can be useful in other realms as well. Market indicators or diffusionindexes can be plotted on a Point and Figure chart and objectively graded as a buy or sell, for example. Perspective, flexibility, and objectivity, then, are the cardinal virtues of the Point and Figure charting method.They give a perspective, unlike a bar chart, abstracting pure price and giving deep insight into volatility. Theyhave almost unlimited flexibility to be Scaling: Percentage [Reversal: 3, Box Size:1.0%) (c) StockChartscom 70 15 ~r 70.15 69 45 X 69 45 68 77 76X 68 77 68 09 xox 68 09 67.41 xoxo 67.41 66 74 xo 2 66.74 66 08 X 2 66.08 65 43 X 2 65 43 64 78 X 2 64.78 64 14 X 2 64.14 63 50 X 2 63.50 62 88 X 2 62 88 62 25 X 2 62 25 61 64 XXX X 61 64 61 03 xox ox 2X0 xo11 61 03 60 42 4 ox ox4XOX xoxc I X 60 42 59 82 xoxo6 OXOX ex ox X <<6018 59 23 xoxoJ 2 BOX OX OX OX? X 59 23 58 65 x xoX 2 00 0 7XOX X 58 65 58 06 XOXO5 7XOXOX XX 58 06 5749 xoxo O 0X0X0 cox 5749 56 92 30 4X0X0 xox 56 92 56 36 X oxoxox xox 56 36 55 80 X _L_ 5XOXOXOS xo 55 80 55 25CX X X “T OXO 6OXOXOX X 55 25 54 70 9xoxoX1 X 0 000X0X0 X 54 70 5416 OX OX OXO/ 0X0X0 XX 54 16 53 62OXO 7xoxo xox 53 62 53 09 OX0 ox ox 0 090 xox 53 09 52 57 0 ox ox 00 xo 52 57 52 04 ' oxo oxX X 52 04 5! 53 ox OXAXOXBX 51 53 51 02 0 oxoxoxox 51 02 50 51 0X00 ox 50 51 50 01 0 0 50 01 49 52 - 49 52 Figure C.15 Overlaying the PnF with a moving average. adapted to different scales, time frames, and purposes. Finally, their objectivity can become a powerful tool inthe hands of any analyst. For further investigation, some of the best-known resources are: Alexander Wheelan, Study Helps in Point &Figure Technique A.W. Cohen, How to Use the Three-Point Reversal Method of Point & Figure Stock MarketTrading: A Technical Approach to Stock Market Trading Thomas J. Dorsey, Point and Figure Charting: TheEssential Application for Forecasting and Tracking Market Prices Jeremy du Plessis, twenty-first CenturyPoint and Figure: New and Advanced Techniques for Using Point and Figure Charts Bollinger Bands The creation of John Bollinger, Bollinger Bands is an inventive solution to the question of measuring anddisplaying price volatility. Technicians had previously developed channels DHR:SPY DsnjhefCo Yesterday's Close, then OBV = Yesterday's OBV + Today's Volume • If Today's Close < Yesterday's Close, then OBV = Yesterday's OBV - Today's Volume • If Today's Close = Yesterday's Close, then OBV = Yesterday's OBV ONE-DAY REVERSAL—See Island Reversal. OPTION—The right granted to one investor by another to buy (called a call option) or sell (called a put option) 100 shares of stock, or one contract of a commodity, at a fixed price for a fixed period of time. The investor granting the right (the seller of the option) is paid a nonrefundable premium by the buyer of the option. OPTIONS RESEARCH, INC.—Founded by Blair Hull, later of Hull Trading Co. The first company to computerize the Black-Scholes Model. ORDER—See Limit Order, Market Order, and Stop Order. OSCILLATOR—A form of momentum or rate-of-change indicator usually valued from +1 to -1 or from 0% to 100%. OVERBOUGHT—Market prices that have risen too steeply and too quickly. OVERBOUGHT/OVERSOLD INDICATOR—An indicator that attempts to define when prices have moved too far and too quickly in either direction, and thus are liable to a reaction. OVERSOLD—Market prices that have declined too steeply and too quickly. PANIC—The second stage of a Bear Market when buyers thin out and sellers sell at any price. The downward trend of prices suddenly accelerates into an almost vertical drop, whereas volume rises to climactic proportions. (See also Bear Market.) PANIC BOTTOM—See Selling Climax. PASSIVE INDEXER—Investor who invests in a major index and holds it through up and down waves. PATTERN—See Area Pattern. PEAK—See Top. PENETRATION—The breaking of a pattern boundary line, trendline, or Support and Resistance Level. PENNANT—A Pennant is a Flag with converging, rather than parallel, boundary lines. (See also Flag.) POINT AND FIGURE CHART—A method of charting believed to have been created by Charles Dow. Each day the price moves by a specific amount (the arbitrary box size), an X (if up) or O (if down) is placed on a vertical column of squared paper. As long as prices do not change direction by a specified amount (the Reversal), the trend is considered to be in force and no new column is made. If a Reversal takes place, another vertical column is started immediately to the right of the first, but in the opposite direction. There is no provision for time on a Point and Figure Chart. PREMATURE BREAKOUT—A breakout of an Area Pattern, and then a retreat back into the pattern. Eventually, the trend will break out again and proceed in the same direction. At the time they occur, false breakouts and premature breakouts are indistinguishable from each other or from a genuine breakout. PRICE/EARNINGS RATIO—Price of stock divided by earnings (which may or may not be real) to give the P/E ratio. Sometimes an unnatural, or imaginary, number. PRIMARY TREND—See Major Trend. PROGRAM TRADING—Trades based on signals from various computer programs, usually entered directly from the trader's computer to the market's computer system. EN: Usually indicates large volume transactions on large baskets of stocks by professional traders. PROGRESSIVE STOP—A stop order that follows the market up or down. (See also Stop.) PROTECTIVE STOP—A stop order used to protect gains or limit losses in an existing position. (See also Stop.) PULLBACK—Return of prices to the boundary line of the pattern after a breakout to the downside. Return after an upside breakout is called a Throwback. PUT—An option to sell a specified amount of a stock or commodity at an agreed time at the stated exercise price. RAIL AVERAGE—See Dow-Jones Transportation Average. RALLY—An increase in price that retraces part of the previous price decline. RALLY TOPS—A price level that finishes a short-term rally in an ongoing trend. RANGE—The difference between the high and low during a specific time period. REACTION—A decline in price that retraces part of the previous price advance. RECIPROCAL, MARKET—See Market Reciprocal. RECOVERY—See Rally. RECTANGLE—A trading area bounded on the Top and the Bottom with horizontal, or near horizontal, lines. A Rectangle can be either a Reversal or Continuation Pattern depending on the direction of the breakout. Minimum Measuring Formula: add the width (difference between Top and Bottom) of the Rectangle to the breakout point. RED PARALLEL—A line drawn parallel to the trendline (Red Trendline) that connects at least two Bottoms. The Red Parallel (basically a Return Line) is started off a high and used to estimate the next high point. RED TRENDLINE—A straight line connecting two or more Bottoms together. To avoid confusion, Edwards and Magee use a red line for Bottom Trendlines and a blue line for Top Trendlines. RELATIVE STRENGTH (RS or RS INDEX)—A stock's price movement over the past year as compared with a market index (most often the Standard & Poor's 500 Index). Value below 1 means the stock shows relative weakness in price movement (underperformed the market); a value above 1 means the stock shows relative strength over the one-year period. Equation for Relative Strength: Current Stock Price/Year-Ago Stock Price Current S&P 500/Year-Ago S&P 500 (See also Wilder Relative Strength Index.) RESISTANCE LEVEL—A price level at which a sufficient supply of stock is forthcoming to stop, and possibly turn back for a time, an uptrend. RETRACEMENT—A price movement in the opposite direction of the previous trend. RETURN LINE—See Ascending or Descending Trend Channels. REVERSAL GAP—A chart formation where the low of the last day is above the previous day's range with the close above midrange and above the open. REVERSAL PATTERN—An Area Pattern that breaks out in a direction opposite to the previous trend. (See also Ascending Triangle, Broadening Formation, Broadening Top, Descending Triangle, Diamond, Dormant Bottom, Double Bottom or Top, Head-and-Shoulders Pattern, Rectangle, Rising or Falling Wedge, Rounding Bottom or Top, Saucer, Symmetrical Triangle, and Triple Bottom or Top.) RIGHT-ANGLED BROADENING TRIANGLE—Area Pattern with one boundary line horizontal and the other at an angle that, when extended, will converge with the horizontal line at some point to the left of the pattern. Similar in shape to Ascending and Descending Triangles, except they are inverted and look like Flat-Topped or Bottomed Megaphones. Right-Angled Broadening Formations generally carry Bearish implications regardless of which side is flat. But any decisive breakout (3% or more) through the horizontal boundary line has the same forceful significance as does a breakout in an Ascending or Descending Triangle. RIGHT-ANGLE TRIANGLES—See Ascending and Descending Triangles. RISING WEDGE—An Area Pattern with two upward-slanting, converging trendlines. Normally, it takes more than three weeks to complete and volume will diminish as prices move toward the apex of the pattern. The anticipated direction of the breakout in a Rising Wedge is down. Minimum Measuring Formula: a retracement of all the ground gained within the wedge. ROUND LOT—A block of stock consisting of 100 shares of stock. ROUND TRIP—The cost of one complete stock or commodity transaction, that is, the entry cost and the offset cost combined. ROUNDING BOTTOM—An Area Pattern that pictures a gradual, progressive, and fairly symmetrical change in the trend from down to up. Both the Price Pattern (along its lows) and the Volume Pattern show a concave shape often called a Bowl or Saucer. There is no minimum measuring formula associated with this Reversal Pattern. ROUNDING TOP—An Area Pattern that pictures a gradual, progressive, and fairly symmetrical change in the trend from up to down. The Price Pattern, along its highs, shows a convex shape sometimes called an Inverted Bowl. The Volume Pattern is concave shaped (a bowl) as trading activity declines into the peak of the Price Pattern and increases when prices begin to fall. There is no measuring formula associated with this Reversal Pattern. RUNAWAY GAP—A relatively wide gap in prices that occurs in an advance or decline gathering momentum. Also called a “Measuring Gap” because it frequently occurs at just about the halfway point between the breakout that started the move and the Reversal Day that calls an end to it. Minimum Measuring Formula: take the distance from the original breakout point to the start of the gap and add it to the other side of the gap. RUNNING MARKET—A market wherein prices are moving rapidly in one direction with very few or no price changes in the opposite direction. SAUCER—See Rounding Bottom and Scallop. SCALLOPS—A series of Rounding Bottom (Saucer) Patterns where the rising end always carries prices a little higher than the preceding Top at the beginning of the pattern. Net gains will vary from stock to stock, but there is a strong tendency for it to amount to 10%-15% of the price. The total reaction, from the left-hand Top of each Saucer to its Bottom, is usually in the 20%-30% area. Individual Saucers in a Scallop series are normally five to seven weeks long, and rarely less than three weeks. The volume will show a convex or Bowl Pattern. SECONDARY TREND—See Intermediate Trend. SECULAR TREND—A major long-lived trend based in solid economic conditions, as opposed to cyclic or technical. SELLING CLIMAX—A period of extraordinary volume that comes at the end of a rapid and comprehensive decline that exhausts the margin reserves of many speculators or patience of investors. Total volume turnover may exceed any single day's volume during the previous upswing as Panic Selling sweeps through the stock or commodity. Also called a Clean-Out Day, a Selling Climax reverses the technical conditions of the market. Although it is a form of a One-Day Reversal, it can take more than one day to complete. SEMILOGARITHMIC SCALE—Price or volume scale in which the distance on the vertical axis (i.e., space between horizontal lines) represents equal percentage changes. SENSITIVITY—An index used by Edwards and Magee to measure the probable percentage movement (sensitivity) of a stock during a specified percentage move in the stock market as a whole. EN: More or less equivalent, or with the same intent as beta. SHAKEOUT—A corrective move large enough to “shake out” nervous investors before the Primary Trend resumes. SHORT INTEREST—The number of shares that have been sold short and not yet repurchased. This information is published monthly by the New York Stock Exchange. SHORT SALE—A transaction in which the entry position is to sell a stock or commodity first and to repurchase it (hopefully at a lower price) at a later date. In the stock market, shares you do not own can be sold by borrowing shares from the broker and replacing them when the offsetting repurchase takes place. In the commodity market, contracts are created when a buyer and seller get together through a floor broker. As a result, the procedure to sell in the commodity market is the same as it is to buy. SHOULDER—See Head-and-Shoulders Pattern. SMOOTHING—A mathematical approach that removes excess data variability while maintaining a correct appraisal of the underlying trend. SPIKE—A sharp rise in price in a single day or two. STOCHASTIC—Random. STOCHASTICS—The Stochastic Oscillator, developed by George Lane, compares a security's price closing level to its price range over a specific period of time. This indicator shows, Lane theorized, in an upward-trending market, prices tend to close near their high; and during a downward- trending market, prices tend to close near their low. As an upward trend matures, prices tend to close further away from their high; as a downward trend matures, prices tend to close away from their low. The Stochastic Indicator attempts to determine when prices start to cluster around their low of the day in an uptrending market, and cluster around their high in a downtrend. Lane theorizes these conditions indicate a Trend Reversal is beginning to occur. The Stochastic Indicator is plotted as two lines, the %D Line and %K Line. The %D Line is more important than the %K Line. The Stochastic is plotted on a chart with values ranging from 0 to 100. The value can never fall below 0 or above 100. Readings above 80 are considered strong and indicate a price is closing near its high. Readings below 20 are strong and indicate a price is closing near its low. Ordinarily, the %K Line will change direction before the %D Line. However, when the %D Line changes direction prior to the %K Line, a slow and steady Reversal is often indicated. When both %K and %D Lines change direction, and the faster %K Line changes direction to retest a crossing of the %D Line, though does not cross it, the incident confirms stability of the prior Reversal. A powerful move is under way when the Indicator reaches its extremes around 0 and 100. Following a Pullback in price, if the Indicator retests extremes, a good entry point is indicated. Many times, when the %K or %D Lines begin to flatten out, the action becomes an indication the trend will reverse during the next trading range. STOCK SPLIT—A procedure used by management to establish a different market price for its shares by changing the common stock structure of the company. Usually a lower price is desired and established by canceling the outstanding shares and reissuing a larger number of new certificates to current shareholders. The most common ratios are 2-to-1, 3-to-1, and 3-to- 2. Occasionally, a higher price is desired and a reverse split takes place where one new share is issued for some multiple number of old shares. STOP—A contingency order placed above the current market price if it is to buy, or below the current market price if it is to sell. A stop order becomes a market order only when the stock or commodity moves up to the price of the buy stop, or down to the price of a sell stop. A stop can be used to enter a new position or exit an old position. (See also Protective or Progressive Stop.) STOP LOSS—See Protective Stop. SUPPLY—Amount of stock available at a given price. SUPPLY LINE—See Resistance. SUPPORT LEVEL—The price level at which a sufficient amount of demand is forthcoming to stop, and possibly turn higher for a time, a downtrend. SYMMETRICAL TRIANGLE—Also called a Coil. Can be a Reversal or Continuation Pattern. A sideways congestion in which each Minor Top fails to attain the height of the previous rally and each Minor Bottom stops above the level of the previous low. The result is upper and lower boundary lines that converge, if extended, to a point on the right. The upper boundary line must slant down and the lower boundary line must slant up, or it would be a variety of a Wedge. Volume tends to diminish during formation. Minimum Formula: add the widest distance within the Triangle to its breakout point. TANGENT—See Trendline. TAPE READER—One who makes trading decisions by watching the flow of New York Stock Exchange and American Stock Exchange price and volume data coming across the electronic ticker tape. TEKNIPLAT™ PAPER—A specially formatted, two-cycle, semilogarithmic graph paper, with sixth-line vertical accents, used to chart stock or commodity prices. Check http:// www.edwards-magee.com. TEST—A term used to describe the activity of a stock or commodity when it returns to, or “tests,” the validity of a previous trendline, or Support or Resistance Level. THIN ISSUE—A stock with a low number of floating shares and is lightly traded. THREE-DAYS-AWAY RULE—An arbitrary time period used by Edwards and Magee in marking suspected Minor Tops or Bottoms. THROWBACK—Return of prices to the boundary line of the pattern after a breakout to the upside. Return after a downside breakout is called a Pullback. TOP—See Broadening Top, Descending Triangle, Double Top, Head-and- Shoulders Top, Rounding Top, and Triple Top. TREND—The movement of prices in the same general direction, or the tendency or proclivity to move in a straight line. (See also Ascending, Descending, and Horizontal Parallel Trend Channels, Convergent Trend, Divergent Trend, Intermediate Trend, Major Trend, and Minor Trend.) TREND CHANNEL—A parallel probable price range centered about the most likely price line. TRENDING MARKET—Price continues to move in a single direction, usually closing strongly for the day. TRENDLINE—If we actually apply a ruler to a number of charted price trends, we quickly discover the line most often really straight in an uptrend trend is a line connecting the lower extremes of the Minor Recessions within these lines. In other words, an advancing wave in the stock market is composed of a series of ripples, and the bottoms of each of these ripples tend to form on, or very close to, an upward-slanting straight line. The tops of the ripples are usually less even; sometimes they also can be defined by a straight line, but more often, they vary slightly in amplitude, and so any line connecting their upper tips would be more or less crooked. On a descending price trend, the line most likely to be straight is the one that connects the tops of the Minor Rallies within it, while the Minor Bottoms may or may not fall along a straight edge. These two lines—the one that slants up along the successive wave bottoms within a broad up-move and the one that slants down across successive wave tops within a broad down-move—are the Basic Trendlines. You draw an Up Trendline by drawing the line on the inner side. You draw a Down Trendline by drawing it on the outside. You draw a Sideways Trendline on the bottom. TRIANGLE—See Ascending Triangle, Descending Triangle, Right-Angled Broadening Triangle, and Symmetrical Triangle. TRIPLE BOTTOM—Similar to a flat Head-and-Shoulders Bottom, or Rectangle, the three Bottoms in a Triple Bottom. TRIPLE TOP—An Area Pattern with three Tops widely spaced and with quite deep, and usually rounding, reactions between them. Less volume occurs on the second peak than the first peak, and still less on the third peak. Sometimes called a “W” Pattern, particularly if the second peak is below the first and third. The Triple Top is confirmed when the decline from the third Top penetrates the Bottom of the lowest valley between the three peaks. 200-DAY MOVING AVERAGE LINE—Determined by taking the closing price over the past 200 trading days and dividing by 200, then repeating the process each succeeding day, always dropping off the earliest day. UPTICK—A securities transaction made at a price higher than the preceding transaction. UPTREND—See Ascending Trendline and Trend. UTILITY AVERAGE—See Dow-Jones Utility Average. V/D VOLUME—Is the ratio between the daily up-volume to the daily down-volume. It is a 50-day ratio determined by dividing the total volume on those days when the stock closed up from the prior day by the total volume on days when the stock closed down. VALIDITY OF TRENDLINE PENETRATION—The application of the following three tests when a trendline is broken to determine whether the break is valid or whether the trendline is still basically intact: (1) the extent of the penetration, (2) the volume of trading on the penetration, and (3) the trading action after the penetration. VALLEY—The V-shaped price action that occurs between two peaks. (See also Double Top and Triple Top.) VINCE, RALPH—Author of Handbook of Portfolio Mathematics where optimal f is described as a quantitative way to achieve optimal allocation and leverage of a portfolio. The Leverage Space Model achieves optimal bet sizing for maximizing gains while minimizing risk. VOLATILITY—A measure of a stock's tendency to move up and down in price, based on its daily price history over the latest 12-month period. (See Appendix B, Resources, for the formula.) VOLUME—The number of shares in stocks or contracts in commodities traded over a specified period of time. “W” FORMATION—See Triple Top. WEDGE—A chart formation in which the price fluctuations are confined within converging straight (or practically straight) lines. WILDER RELATIVE STRENGTH INDICATOR (RSI)—Although relative strength, comparing a security price to a benchmark index price, has been around for some time, this indicator was developed by J. Welles Wilder, as explained in his 1978 book, New Concepts in Technical Trading. Relative Strength is often used to identify price Tops and Bottoms by keying on specific levels (usually “30” and “70”) on the RSI chart, which is scaled from 0 to 100. The RSI can also be useful to show the following: 1. Movement that might not be as readily apparent on the bar chart. 2. Failure Swings above 70 or below 30, warning of coming Reversals. 3. Support and Resistance Levels appear with greater clarity. 4. Divergence between the RSI and price can often be a useful Reversal indicator. The RSI requires a certain amount of lead-up time to operate successfully. Taylor & Francis Taylor & Francis Group http://taylorandfrancis.com Bibliography Allen, R.C., How to Use the 4 Day, 9 Day and 18 Day Moving Averages to Earn Larger Profits from Commodities, Best Books, Chicago, 1974. Arms, R.W., Volume Cycles in the Stock Market. Market Timing Through Equivolume Charting, Dow Jones-Irwin, Homewood, IL, 1983. Arms, R.W., Jr., The Arms Index, TRlN, Dow Jones-Irwin, Homewood, IL, 1989. Bassetti, W.H.C., StairStops, MaoMao Press, San Geronimo, CA, 2009. Bassetti, W.H.C., Zen Simple Beat the Market with a Ruler, MaoMao Press, San Geronimo, CA, 2009. Bassetti, W.H.C., Sacred Chickens, the Holy Grail and Dow Theory, MaoMao Press, San Geronimo, CA, 2010. Bassetti, W.H.C., Ten Trading Lessons, MaoMao Press, San Geronimo, CA, 2010. Bassetti, W.H.C., Signals, MaoMao Press, San Geronimo, CA, 2011. Belveal, L.D., Charting Commodity Market Price Behavior, 2nd ed., Dow Jones-Irwin, Homewood, IL, 1985. Bernstein, J., The Handbook of Commodity Cycles. A Window on Time, John Wiley & Sons, New York, 1982. Bernstein, P., Against the Gods, John Wiley & Sons, New York, 1996. Blumenthal, E., Chart for Profit Point & Figure Trading, Investors Intelligence, Larchmont, NY, 1975. Bolton, A.H., The Elliott Wave Principle. A Critical Appraisal, Monetary Research, Hamilton, Bermuda, 1960. Bressert, W.J., and J.H. Jones, The HAL Blue Book. How to Use Cycles with an Over-Bought/Oversold and Momentum Index for More Consistent Profits, HAL Market Cycles, Tucson, AZ, 1984. Chicago Board of Trade, CBOT Dow Jones Industrial Average and Futures Options, Chicago, 1997. Cohen, A.W., How to Use the Three-Point Reversal Method of Point & Figure Stock Market Trading, 8th rev. ed., Chartcraft, Larchmont, NY, 1982. Cootner, P.H., Ed., The Random Character of Stock Market Prices, MIT Press, Cambridge, 1964. de Villiers, V., The Point and Figure Method of Anticipating Stock Price Movements. Complete Theory and Practice, Windsor Books, Brightwaters, NY, orig. 1933, reprinted in 1975. Dewey, E.R., and O. Mandino, Cycles, the Mysterious Forces That Trigger Events, Manor Books, New York, 1973. Dobson, E.D., Understanding Fibonacci Numbers, Trader Press, Greenville, SC, 1984. Dorsey, T.J., Point & Figure Charting, John Wiley & Sons, New York, 2001. Dreman, D., Contrarian Investment Strategy, Simon & Schuster, New York, 1974. Dunn, and Hargitt, Trader's Notebook. Trading Methods Checked by Computer, Dunn & Hargitt, Lafayette, IN, 1970. Dunn, and Hargitt, Point and Figure Commodity Trading. A Computer Evaluation, Dunn & Hargitt, Lafayette, IN, 1971. Du Plessis, J., The Definitive Guide to Point and Figure, Harriman House Ltd., Hampshire Great Britain, 2005. Elliott, R.N., The Major Works of R.N. Elliott, R. Prechter, Ed., New Classics Library, Chappaqua, NY, 1980. Emery, W.L., Ed., Commodity Year Book, Commodity Research Bureau, Jersey City, NJ, annually. Frost, A.J., and R.R. Prechter, Elliott Wave Principle, Key to Stock Market Profits, New Classics Library, Chappaqua, NY, 1978. Galbraith, J.K., The Great Crash 1929, Houghton Mifflin, Boston, 1961. Gann, W.D., How to Make Profits in Commodities, rev. ed., Lambert-Gann Publishing, Pomeroy, WA, orig. 1942, reprinted in 1976. Granville, J.E., New Strategy of Daily Stork Market Timing for Maximum Profits, Prentice-Hall, Englewood Cliffs, NJ, 1976. Hadady, R.E., Contrary Opinion. 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Index A ABC Vending Corp., 455, 576, 579 Absolute certainty, 275 Accelerating Downward Trend, 68 Accumulation, 14, 17, 43, 44, 107, 157, 159, 168, 184, 241, 245, 265, 32, 538, 542, 595 Pattern, 73, 401 Action Industries, 472, 576, 579 Activity, see Volume Acts of God, 12, 248 Acute Triangle, 79-80 Advisors, 252, 268, 310 ADXR Indicator, 595 Agricultural commodity, 247-248 AIQ Trading Expert Pro, 531-532 Amazon, 2 , 335-336, 358, 47 , 563, 573, 579 AMD, 475, 57 , 579 American Locomotive, 63, 163, 433, 566, 570, 575, 580 American Stock Exchange (AMEX), 271, 309, 311, 312, 316, 349, 494, 524, 616 Apex, 80, 83, 84, 8 , 88, 94, 9 , 99-100, 122, 128, 142, 145, 153, 201, 203-205, 209, 398-400, 404, 408, 412, 423, 440, 443, 596 Apex of Symmetrical Triangle, 414 Appel, Gerald, 542 Apple Computer Inc (APPL), 135, 366, 478-479, 577 Appreciated portfolio, protecting profits in, 285-286 Arbitrage, 344, 596 Area Gap, see Common Gap Area Pattern, 8, 90, 145, 176, 184, 186, 198, 202, 221, 261, 264, 319, 423, 439, 596, 601, 604, 605, 611-614, 617-618 Area Reversal Pattern, 599 Arithmetic paper, 8, 229 Arithmetic scale, 8, 58, 69, 143, 211-216, 596 Arms CandleVolume charting, 551-553 Arms Index, 545, 548-549 Aroon, 538, 542 Aroon Down, 538, 542 Aroon Oscillator, 538 Aroon Up, 538, 542 Ascending Channel, 596 Ascending Formation, 99 Ascending Pattern, 98-99 Ascending Trend Channels, 596, 599, 613 Ascending Trendline, 596, 618 Ascending Triangle, 84-89, 94-95, 97-98, 114-115, 122, 135-136, 141, 147, 161, 166, 177-178, 189, 204, 294, 373-375, 395, 399, 408, 428, 434, 439-441, 465, 472, 596, 613-614 Asset allocation, 275, 278, 280-282, 491 Astrodata Inc. (ADA), 46, 576, 581 At-the-money, 283, 596 Automated trendline, 421-425, 540 Average(s), 4, 17, 19, 26, 41, 50, 99, 106, 112, 135, 145, 151, 181, 313, 34 , 393-394, 428, 436, 445, 459, 481, 482, 596, 600 discount, 12 Dow, see Dow averages gaps in, 187 investor, 192 moving, see Moving averages support and resistance in, 206 trendlines in, 243 Average Directional Index (ADX), 538, 542, 595 Average True Range (ATR), 358-359, 538 Averaging Cost, 442, 485, 596-597 Avnet Electronics Corp., 448, 459, 575, 581 Axis, 196, 205, 597 B Balanced program, 481-486, 597 Bandwidth, 538, 598 Bar Chart, 31, 266, 304, 531, 532, 545, 550, 552, 554, 558, 597 Baruch, Bernard, 265 Basic Trendlines, see Trendlines Basing Points (BP), 31-40, 198, 239, 256, 258, 260, 299-300, 308, 314, 326, 328, 340, 357-359, 362-366, 368-370, 404, 414, 480, 504, 506, 574, 581, 597 Basket Trades, 389-390, 597 Bearish Move, 391, 451 Bearish Trend, 310, 482 in Industrial Rayon, 446 in Lorillard, 447 Bear Market, 13, 15, 225, 242, 264, 293, 299, 386, 413, 481, 509, 511-512, 597,602, 611 signal, 519-521 Bear Market Bottom in Socony-Vacuum, 89, 109 Bear Market Rallies, 61, 63 rising wedges in, 144 Bear Market Selling Climax, 608 Bear Raiding, 168 Bent Neckline, see Neckline (NL) Bent neckline, 138, 444, 597 Beta, 310, 321, 322, 342-343, 346, 597 coefficient, 597 Bitcoin, 326-328 Black Scholes model, 266, 273, 531 Block Trades, 97-99, 105, 597 Blow-Off, see Climactic Top Blue Chips, 41, 280, 301, 320, 353, 43 , 598 Blue Parallel, 373-374, 378-380, 410, 598 Blue Trend, 373, 375-379 Blue Trendline, 373-378, 578, 598 Bollinger Bands (BB), 266, 267, 53 , 561-563, 598 Bollinger, John, 533, 561 Bona fide breakout, 600 Bond futures for asset allocation, 280-282 traders and investors, 496 Book value, 4, 5, 175, 599 Bottom, 599 Kilroy, see Head-and-Shoulders Bottom Patterns, 5 , 58, 117, 161, 458 Trendlines, 224, 273, 414 Boundary, 54, 78, 599 Bowl Pattern, see Rounding Bottoms Bracketing, 599 Breakaway gaps, 4 , 63, 91, 142, 162, 173-174, 177-182, 186, 202, 254, 258, 410, 412, 417, 423, 470, 599, 607 Breaking neckline, 47-49 Breakout failure, 603 Breakout Gap, 126, 175, 184 signals, 185 “Breakout of dormancy,” 73 Breakouts, 88, 108, 161, 418, 551, 599 decisive, 221, 37 , 378 downside, 95, 99, 398, 408 premature, 85, 108 pullbacks, 224 from Right-Angle Triangles, 100 upside, 89, 99, 402, 408 Broadening Bottoms, 135 Broadening Formations, 121-122, 599, 608-609 volume during, 122-128 Broadening Pattern, 604 Broadening Price Formation, 130-131 Broadening Price Patterns, 121, 122, 126, 131, 136 Broadening Tops, 122, 124, 125, 129, 133, 309, 400, 404, 408, 617 in Dow-Jones Industrial Average, 444-445 Orthodox, see Orthodox Broadening Top Broad market, 243 Broad market background, 264 Broad Market Trend, 243 Brokerage firms, 270 Brokerage houses, 526-527 Brokers, 145, 146, 268, 269, 313, 347 Brooker, Brian, 27 Brunswick Corporation, 450, 575, 581 Bullish Market, 321, 460, 481, 483 Bullish Move, 391, 406 Bull Market, 13-19, 23, 70, 226, 241, 264, 293, 299, 396-39 , 481, 492, 493, 514, 518, 595, 599, 602 in commodities, 260 dynamic phase of, 157 Primary, see Primary Bull Market Publicker, 116 Bull Market Advance, 159, 225, 294 Bull Market Concomitants, 159 Bull Market High, 52 Bull Market Peaks, 114 Bull Market Reaction, 219 Bull Market Top, 53, 86, 240 of Head-and-Shoulders Form, 50 Symmetrical Triangle Bottom, 80 Symmetrical Triangle Reversal, 78 in U.S. Steel, 127 in Westinghouse, 96 of Westinghouse Electric, 47 Bull Market Trend, 237 of General Motors, 230 Bull Market Trendlines, 229 Bull signal, 513-514 Bull trap, 139, 148, 326, 32 , 420, 473 Bull Trend reaffirmation, 515-516 Burndy Corporation, 449, 575, 582 Buy-and-Hold investor, 26, 27 Buying at the top, 487 C Call option, 599, 611 Candlestick charts, , 8, 182, 266, 267, 553 Candlesticks, 551, 599 Canny investor, 278 CANSLIM system, 316 Capital, 489 application in practice, 491-494 to use in trading, 489-490 Cash, differences with future transactions, 277 Catastrophic Risk, 503 “Cats and dogs,” 15, 320, 493, 517, 599 Caveats, 330-331 of Moving Averages, 422 CBOT® DJIASM Index futures, 276, 282 Cerro Corporation, 456, 576, 582 Chaff, 270 Chaikin Money Flow (CMF), 538 Chaikin Oscillator, 538 Chandelier Exit, 359, 537 Chande Trend Meter (CTM), 538 Channel, 599 Chart(s), 15, 19, 261, 267, 269, 304, 505, 599, 605 Ascending Triangle, 399 associated dry goods winds up, 396 Broadening Tops, 400, 408 candlestick, , 8, 182, 266, 26, 553 Complex or multiple Head-and-Shoulders, 403 daily chart in Northern Pacific, 412 daily chart of Lehigh Valley R. R, 407 decorating graphic charts, 304 Diamond, 409 Diamond Pattern in American Can, 404 Double Tops and Bottoms, 409 Dow Theory, 393-399 Flags and Pennants, 410-411 Gaps, 411-413 Gulf, Mobile, and Ohio builds beautiful Wedge, 405 Head-and-Shoulders Bottom, 401-403 Head-and-Shoulders Top, 400-401 of New York Central, 175 One-Day Reversals, 410 Pennant in Martin-Parry, 406 Rectangles, 408-409 Rectangles in Remington Rand, 401 Right-Angled Broadening Formations, 409 Right-Angle Triangles, 408 rounding Bottom in 1945, 397 Rounding Tops and Bottoms, 403-406 Spiegel's Bear Market, 262 of stocks, 163 Support and Resistance, 414 Symmetrical Triangle in allied stores, 398 Symmetrical Triangles, 406-408 Trendlines, 414 trendlines in American steel foundries, 413 types of scales, 8-9 Wedges, 409-410 wide Descending Triangle of, 262 Chart analysis, 304, 539-540 computer for, 304-305 Chart analysts, 259, 266 Commodity Research Bureau Index, 254 trading futures, 259-260 Chicago Board of Trade (CBOT®), 271 Chicago Board Options Exchange (CBOE), 273, 494 Chicago Mercantile Exchange, 276-27 , 312 Chicago, Milwaukee, St. Paul and Pacific, 440 Chrysler, 436 Classical technical analysis, 4 Clean-cut Triangle, 82 Clean-Out Day, see Selling Climax Climactic Top, 59 , 600 Climax Day, see One-Day Reversal Climax, Selling, see Selling Climax Close-only charts, 267 Closing gap, 171-173 Closing prices, 18, 600 Closing the gap, 600, 601 Cloud, 269 Coil, see Symmetrical Triangle Colby, Robert, 21 Commission, 600 Commitments, 417-418 Commodity, 276 agricultural, 247-248 market, 615 traders, 298 Commodity Channel Index (CCI), 538 Commodity charts, technical analysis of application of Edwards and Magee's methods, 252-259 chart analyst trading futures, 259-260 rocket scientists, 249-250 Turtles, 250-252 21st-century perspective, 249 variety of methods, 259 Common Gap, 175-17, 184, 596, 600 Comparative relative strength, 600 Complete Basing Points Procedure, 368-370 Complex Formations, 59 Complex Head-and-Shoulders Pattern, 59, 403, 600, 602, 610 EN, 60 ragged Kilroy Bottom, 61 strong movement toward lower interest rates evident, 60 Composite Average, 600 Composite Leverage, 498, 600 Composite Leverage Index, 492, 493 Compound Annual Growth Rates (CAGR), 32 Computer, 265 for charting analysis, 304-305 technology, 267-268 Computer software packages, 267 Conant, James Bryant, 289 Confirmation, 16-19, 600-601 Congestion, 151, 601 Congestion Formations, 115, 175-176 Conservative investing, 310-311 Consolidating, 151 Consolidation Formation, 110, 151 a, 156 Bull Flag in February and Bear Flag in April 1936 compact type of price “Congestion,” 158 Consolidation Pattern, 167 down-sloping, converging price formation, 157 flag pictures on weekly and monthly charts, 158-159 Flags and Pennants, 151-153 Flag seemed for several weeks, 163 “Half-Mast” Pattern, 161 Head-and-Shoulders Consolidations, 160-162, 164 measuring formula, 154- 156 modern vs. old-style markets, 168-169 rectangular Consolidations, 159 reliability of Flags and Pennants, 156-157 Consolidation Formation (Continued) scallops, 162-167 series of Flag-type Consolidations, 159 stock make long series of small Consolidation Patterns, 155 Consolidation Head-and-Shoulders, see Head-And-Shoulders Pattern Consolidation Pattern, 79, 94-9 , 156, 161, 167, 190, 392, 600, 601, 604 Consolidations of Rectangle, 159 Construction of index shares and similar instruments, 311-312 Continuation Formation, see Consolidation Formation Continuation Gap, see Runaway Gap Continuation-of-Trend Pattern, 137 Continuation Pattern, see Consolidation Pattern Control Data Corp (CDA), 462, 576, 583 Controlling risk, 351, 499, 503 Convergent Pattern (Trend), 601 Copper Range Co., 452, 576, 583 Coppock Curve, 538 Correction, 601 Corrective trends, 226-227 Correlation Coefficient, 500, 538 “Cost of carry,” 276-279 Costs, 390 Covering the gap, see Closing the gap “Cradle,” 205, 601 “Cradle point,” 440, 456 Crossovers, 422-424 Crucible Steel Co. of America, 45 , 576, 583 Cyber trader, 316 Cyclical approach, 3 D Daily Range, 148, 173, 508, 601 Dampened risks, 313 Danaher Corp., 558 Day-to-day chart analysis, 196 “Day traders,” 31, 166, 168, 298, 302 Day trading, 168, 298 DecisionPoint Price Momentum Oscillator (PMO), 538 Definite warning, 428 Degree of fluctuation, 283, 345 Delaware, Lackawanna And Western, 432 “Delivery,” 276 Dell, 473-474 Delphic Options Research, 523, 529 Demand, 70, 86, 98, 112, 117, 601 Demand Line, 98, 104, 176, 202 Descending Channel, 601 Descending Trend, 603 Descending Trend Channel, 374-375, 599, 601, 613, 619 Descending Trendline, 601, 603 Descending Triangle, 92, 97-99, 122, 136, 175, 294, 408, 601-602, 613-614, 617 Detrended Price Oscillator (DPO), 538 Diagonal Movements, 423 Diamond, 74, 12 , 129, 130, 137-139, 602 Pattern, 610 Reversal Formation, 128, 137-138, 409 DIAMONDS™ (DIA), 271, 274, 299, 312, 317, 323, 350, 351, 390 Directional tendency, 110 Discipline, 260, 28 , 501, 542 Dissecting Dow Theory, 499 “Distance away” criteria, 194, 203 Distribution, 43, 44, 117, 136, 168, 602 frequency, 500 Line, 538, 542 Pattern, 90 planned, 98 Distribution period, 15, 17 Divergence, 4, 99, 212, 510, 511, 513, 600-602 definite, 166 negative, 610 Divergent Pattern, 206, 602 Divergent Trend, 617 Divergent Trend Channel, 376, 377, 379 Diverging boundary lines, 100 Diversification, 41, 298, 313, 319, 389, 390, 481-486, 602 Dividends, 23, 194, 27 , 294, 297-298, 30 , 310-311, 315, 341, 345, 348, 361, 419, 469, 602 Donchian system, 251 Dormant Bottom, 72-74, 602 Double Bottoms, 113-115, 118, 409, 602 Double Top, 103-105, 113-115, 118, 409, 602, 617 at Primary Trend Reversals, 118 Double trendlines, 222-223, 603 Dow averages, 12 basic tenets, 12-14 major trend phases, 14-16 principle of confirmation, 16- 19 tide, wave, and ripple, 14 Dow Index futures, 27 , 287 Dow Industrial Average (DIA), 481 Dow interpretation, 507-508 Dow-Jones Industrial Average (DJIA), 6, 41, 146, 311, 444-445, 454, 486, 600, 603, 606 Dow-Jones Industrial Index differences between cash and futures, 277 Dow Index futures, 277 exercising option, 284 exploiting market reversals, 285 fungibility, 276-277 futures and options, 275, 284 investment and hedging strategies, 276 investment uses of Dow Index futures, 279-282 marking-to-market trading, 276 option premiums, 283 options on Dow Index futures, 282-283 option spreads in high-or low-volatility markets, 286-287 perspective, 287 portfolio yields improvement, 286 profits in rising markets, 284-285 protecting profits in appreciated portfolio, 285-286 settlement of futures contracts, 276 stock index futures to control exposure to market, 277-278 volatility, 283-284 Dow-Jones Stock Composite, 12 Dow-Jones Transportation Average, 603, 612 Dow-Jones Utility Average, 600, 603, 618 Down Channel, see Descending Channel Down-slanting boundary line, 79- 80 Downtick, 603 Downtrends, 143, 202, 242, 423, 429 Intermediate, see Intermediate downtrends Major, see Major downtrends Primary, see Primary downtrends Dow principles, 16, 17, 23-24 Dow Theory, 3, 11, 18, 21-23, 28-29, 31, 41, 7, 207, 259, 264, 313, 365, 381, 393-399, 50 , 533, 600, 601 in 20th and 21st centuries, 26-27 Bear Market signal, 519-521 bull signal, 513-514 Bull Trend reaffirmation, 515-516 closing price levels of Dow-Jones Industrial and Rail averages, 509, 510, 511, 512, 514 failure to confirm, 510-511 final up-thrust, 519 first correction, 514-515 first severe test, 508- 510 five years of Dow interpretation, 507-508 intermediate trend investor, 23-26 leaving investor in doubt, 23 Rails falter, 516-517 signs of major turn, 511-513 spring of 1946, 517-518 utilization, 507 Dow Theory Line, 151 Dow Theory replacement with John Magee's Basing Points Procedure Dow-Jones Industrials (1924-1934), 39-40 fractal nature of market, 31 interesting charts ever made of Dow-Jones Industrials, 40 trades made by Magee Basing Points Procedure, 33-37 2008 top in industrials, 38 Drawdown, 498-499, 603 Dreman, David, 280, 496 Dunn and Hargitt, 251 E Eagle-Picher Lead, 436 “Earnest money,” see Futures “margins” Ease of Movement (EMV), 538 Economic tide, 264 Edwards and Magee's methods, 252-258 stops, 258-259 Electronic marketplaces, 269 Electronic portfolio, 270 Elliott Wave Theory, 6, 528-531 Emotion-driven markets, 266 End Run, 83, 204, 205, 603 Equilibrium Line, 609 Equilibrium Market, 603 Equivolume charting, 550 result, 551-553 technique, 551 Evaluative Index, 39 , 448, 482-483 Ex-Dividend, 90, 173, 175, 361, 443, 603 Ex-dividend gaps, 174, 603 breakaway gaps, 177-182 common or area gap, 175-177 continuation or runaway gaps and measuring rule, 182-184 exhaustion gaps, 185-186 two or more runaway gaps, 184-185 Exaggerated leverage, 272 Exception, 381 Exchange-traded fund (ETF), 271, 317, 322, 603 Exchange Traded Notes (ECNs), 268, 321 Execution of buys, 376-377 Exercise, 283, 325, 603 exercising option, 284 price, 272, 282, 494 Exhaustion Gap, 184, 185-186, 258, 410, 603-604, 607 Experimental lines, 224 Expiration, 271, 284, 604 Exponential Moving Average (EMAs), 422, 53 , 542, 609 Exponential Smoothing, 604 “Extent of decline” criterion, 193 Extent of penetration, 221 Extraordinary Risk, 503 F Facebook, 332 Fact chart analysis, 266 Failure to confirm, 510-511, 513-514, 515 Faith, Curtis, 251 Falling Wedge, 132, 139, 142-143, 410, 604 False Breakout, 604, 612 False moves, 48, 66, 81, 89, 108, 179, 487 False Signal, 66, 88, 129, 149, 266, 479, 604 Fan lines, 217, 218, 220, 22, 309, 604 Fan principle, 226-227 Fansteel Metallurgical, 434, 448, 585 Filling the gap, see Closing the gap Final up-thrust, 519 Finance theory and practice developments in, 271 futures on indexes, 273- 274 MPT, 275 options, 271-272 options on futures and indexes, 274 options pricing models and importance, 273 Finance theory and practice (Continued) quantitative analysis, 272-273 wonders and joys of investment technology, 275 Fin de siecle, 139 First correction, 514-515 First severe test, 508-510 Five-Point Reversal, see Broadening Pattern Flag-type Consolidation, 411 Flag, 151-159, 258, 410-411, 604 Flag Consolidation, 15 , 179, 392, 465 Flag of mid-April, 175 Flat-Topped Broadening Formation, 136-137, 163 Flat-Topped Broadening Pattern, 151 Flat-Topped Price Formation, 177 Floating Supply, 73, 107, 117, 145, 315, 341, 604 Flying Tiger Corp, 471, 586 Force Index, 538 Forecasting methods, 11, 176, 421, 604 Formation, see Area Pattern Formula measurement, 154-156, 160, 164, 596, 608 Fractal nature of market, 31 Dow-Jones Industrials (1924-1934), 39 interesting charts ever made of Dow-Jones Industrials, 40 trades made by Magee Basing Points Procedure, 33-37 2008 top in industrials, 38 Front-Month, 605 Fundamental analysis, 3, 6, 91, 266, 328, 605 essence of, 528-531 Funds tracking indexes, 603 Fungibility, 276-277 Futures “margins,” 277 Futures contract, 274, 276-27 , 282, 283, 349, 494 Futures options, 283, 28 , 313 to participate in market movements, 284 price of, 283 Future transactions, differences between cash and, 277 G Gains and losses, percentage, 496 Galbraith, John Kenneth, 326 Gamblers Anonymous, 302 Gaps, 171, 411-413, 423, 605 April-June Rectangle on 1945 chart of “AW,” 172 in averages, 187 closing gap, 171-173 daily chart of Blaw-Knox, 176 ex-dividend gaps, 174-186 Island “shakeouts, 181 Island in “PA,” 183 Island Reversal, 186-187 monthly chart of Zenith Radio, 175 Panic Declines produce large Runaway Gaps, 178 small Island in right shoulder of Head-and- Shoulders Top, 180 SMC, 180 TLT, 183 Gates, Bill, 244 General Motors, 41, 99, 229, 230, 586, 598 straight-line Bull Market Trend, 230 General Semantics of Wall Street, The, 269 General Steel Industries, Inc. (GSI), 459, 586 Gilt-edged securities, 598 Gimlet-eyed investor, 270 Google, 321, 331, 339, 340, 343, 389, 586 Granite City Steel, 430-431, 586 Graph, see Chart “Graphic Stocks,” 437 Great Crash, The (1929), 326 Greenspan, Alan, 248, 281 H “Hair splitting” theory, 521 “Half-Mast” patterns, 154, 161, 604, 608 Handbook of Portfolio Mathematics (Vince), 618 Head-and-Shoulders Bottom, 55, 57-59, 61-63, 161, 336, 395, 401-403, 58 , 605, 60 , 608 Head-and-Shoulders Consolidation, 160-162, 164, 605 Head-and-Shoulders Formation, 48, 88, 373 Head-and-Shoulders formula, 100, 162 Head-and-Shoulders Pattern, 4 , 13 , 241, 392, 414, 454, 605-606, 608, 610, 615 Head-and-Shoulders Reversal Pattern, 211 Head-and-shoulders to Dow Theory, 55 Head-and-Shoulders Top, 44, 45, 46, 48, 54, 57-59, 63, 75, 7 , 103, 108, 118, 160, 161, 180, 198, 202, 241, 24 , 294, 35 , 394, 400-401, 449, 454, 455, 466, 602, 605, 606, 608, 617 Daily chart of Chicago, 46 hypothetical daily stock chart, 45 starting in March, “HUM,” 46 variations in, 49-52 Heavy Volume, 355, 356, 363, 398, 402, 435, 605, 606 Hedging, 137, 240, 246, 276, 279, 28 , 312, 606 Hedging strategies using CBOT® DJIASM futures contract, 276 High-risk stocks hope springs eternal, 332-340 managing tulipomanias and internet frenzies and Bitcoin, 326-328 multitudinous lessons in Microsoft, 326 techniques for management of runaway issues, 328-332 High-volatility markets, option spreads in, 286-287 Higher priced stocks, 353 Historical Data, 606 Hook Day, 606 Horizontal Channel, 213, 606 Horizontal Congestion Pattern, 178, 189 Horizontal Line Formations, 103, 207 Horizontal Movements, 423 Horizontal pattern boundary, 177 Horizontal Trendline, 256, 333, 606 Hull, Blair, 26 , 531, 611 Hybrid Head-And-Shoulders, 606 I Ichimoku Cloud, 537 I C Industries (ICX), 49 “Ideal” trend, 197 “Implied volatility,” 284 In-the-money, 283 Indexes, , 19, 243, 261, 271, 310, 312, 314, 341, 343 funds tracking, 603 futures on, 273-274 options on futures and, 274 Index funds, 299, 390 Index futures for asset allocation, 280-282 “Indexing,” 310-311 Index Shares, 302, 310-312, 313, 390, 447 Individual stocks, 26, 41, 55, 112, 145, 146, 206, 243, 342, 44 , 454, 484, 493, 495 Industrial Average, 11, 12, 13, 16, 18, 20, 23, 393, 444, 446, 454, 514, 515, 518, 600, 603 Industrial Rayon Corporation, 446, 587 Inflationary and deflationary movements, 481, 587 Information revolution, 265-266, 268, 270-271 Initial public offering share (IPO share), 327-328, 607 Inside Day, 606 Insiders, 41-42, 168, 322, 32 , 606 Inspiration Copper, 429 Intel, 319, 474, 475, 587 Intermediate Bottom, 64, 8 , 193, 202, 294, 384, 386, 414 Intermediate downtrends, 225-226 Intermediate Reversals, 59, 200, 206 Intermediate Support, 197, 198, 226, 384, 385 Intermediate Support Range, 198 Intermediate Swing, 13, 50 , 508 Intermediate Tops, 200, 211, 294, 361, 386, 414, 513 Intermediate Trend, 14, 41, 216, 224, 296, 380, 515, 519, 590, 606, 614 investor, 23-26 Intermediate Trendlines, 208, 226, 229 Intermediate Uptrend, 194, 212, 213, 219, 222, 225 Intermediate Up Trendline (IUT), 52, 176, 211, 212, 21 , 220-221, 224 Internet-age markets, 351 Internet, 265, 268-269, 532 Internet Age, 269, 351, 393, 494 Internet frenzies and Bitcoin, 326-328 Internet technical analysis sites, 305, 531-533 Intraday gaps, 173 Inverted Bowl, see Rounding Top Inverted Triangles, 100, 121, 135-136 Investment advancements in investment technology, 271 bond and index futures for asset allocation, 280-282 developments in finance theory and practice, 271-275 finance theory and practice, 271-275 futures and options on Dow-Jones Industrial Index, 275-287 increasing exposure with futures, 280 investment-oriented sites, 524-527 investment/information revolution tools, 265 portfolio protection, 279-280 strategies using CBOT® DJIASM futures contract, 276 uses of Dow index futures, 279 Investor, 297-298, 332, 351 cyber, 270 experienced, 268 gimlet-eyed, 270 long-term, 310-311 modern, 244 private, 312 sophisticated, 302 iPod, 479 Island Congestion, 186 Island Pattern, 147, 186, 187 Island Reversal, 182, 186-187, 60 , 611 J Johns-Manville's Primary Trend Reversal, 79 Jorion, Philippe, 500, 502, 524 July-August Flag, 158-159 K Kaufman's Adaptive Moving Average (KAMA), 537 Kelly Criterion, 534, 535 Keltner Channels, 537 Key Reversal Days, 147-149 Kilroy bottom, 57-59, 63, 309, 336, 401, 58 , 607 Kovner, Bruce, 35 , 365 Kresge (S.S.) Co., 196, 43 , 588, 591 L Laddering, 607 Lane, George, 615 Lane theorizes, 615 Leisurely pattern, 65-66 Leverage, 258, 315, 607 Leverage factor, 534-535 Leverage Space Model, 351, 504, 618 Leverage Space Portfolios (LSP), 533-536, 607 Libby, McNeill And Libby, 436 Limit Move, 258, 607 Limit Order, 391, 60 , 611 Limit Up, Limit Down, 607 Linear Moving Averages, 422 Line Chart, see Bar Chart Line in Dow Theory, 17-18, 607 Liquidating, 378-379 Livingston Oil Company (LVO), 464, 588 Logarithmic scale, 211-216, 229, 607 Long-term charts, 9 Long-term investment problem, 293 Long-term investor, 293, 29 , 299, 313, 314, 389 strategy and tactics for, 297-298 Long-term investor (Continued) strategy of, 299-300 viewpoint, 310-311 “Long side” of market, 41 Lorillard, 44 , 588 Low-volatility markets, option spreads in, 286-287 Lower-priced stocks, 353 “Lunatic fringe,” 3 M MacKay, Charles, 325 “M” Formation, 119, 602 Magee-type technical analysts, 266 Magee analyst, 267, 268, 270 Magee chart analysis, 266, 270, 595 Magee Evaluative Index (MEI), 19, 300, 485-486, 491, 495, 503-504 Magee methodology, 260 Magee's admonitions, 316 Magee's Composite Leverage, 499 Magee's concept of “sensitivity,” 342 Magee's method, 252-259, 343, 497 Magee's Sensitivity Index, 342, 354, 497 Magee's simple-as-pie method, 32 Major Bear Market signal, 393 Major Bear Moves, 159 Major Bear Trend, 15 , 226 Major Bull Market, 225 Major Bull trendlines, 241 Major charts, 9 Major Double Tops, 114 Major Downtrend, 242, 428-429, 439, 511-512, 519, 576, 579, 592 Major Market Turn, 60 Major Reversal, 106, 114, 123, 132-133, 139, 158, 180, 491, 510, 513-514, 604-605 Major Reversal Formation, 66, 114, 123, 186 Major Reversal Patterns, 44, 605 Major Signals, 394 Major Trend, 17-18, 22, 9 , 198-199, 212, 225, 229, 242, 296, 314, 356, 380-381, 384, 386, 393, 398, 430, 446, 449, 456, 482, 491, 493, 510, 512, 515, 60 , 612 general outline of policy for trading in, 380-381 of market, 410-411 Major Trend Channels, 242-243 Major trendlines, 227 accelerating uptrend of common stock, 231 Bull Market tops, 240 conservative investment-type utility stock, 232 decurving Major Bull Trend of high-grade preferred stock, 231 high-grade food issues, 236 low-priced building stock, 235 Major Bull Trend, 234 Major Downtrends, 242 Major Trend Channels, 242-243 primary Bear Market, 238 S&P long-term perspective, 239 S&P Reagan Crash, 239 speculative oil stock, 233 steel stocks, 234 straight- line uptrends in investment oil, 233 tobacco stocks, 236 trading Averages in 21st century, 244 trendlines in averages, 243 up-curving trend of speculative motors stock, 230 Major Turn, 121, 167, 226, 242, 290, 483, 487 signs, 511-513 Margin, 88, 108, 145, 147, 221, 223, 274, 276, 342, 345, 367, 445, 492, 495, 535, 607-608 decisive, 48, 57-58, 118, 128 transaction, 346, 349 use, 345-346 Market, 3, 6, 11, 19, 2, 31, 42, 7, 82, 104-105, 121, 139, 143, 147, 192, 20 , 256, 259, 264, 270, 274, 280, 285, 289, 29, 299, 312, 315, 32, 383, 42, 48, 493, 505, 507 Dow-Jones Industrials (1924-1934), 39 exploiting market reversals, 285 fractal nature, 31 indicator, 609 interesting charts ever made of Dow-Jones Industrials, 40 marking-to-market, 269-270 marking-to-market trading, 276 technical trading effect on market action, 419-420 trades made by Magee Basing Points Procedure, 33-37 2008 top in industrials, 38 Market on Close, 608 Market Order, 29 , 328, 608, 611, 616 Market Reciprocal, 49 , 608, 612 Market Technicians Association, 499 Market Technicians Association of New York (MTANY), 6 Masonite, 431, 575, 588 Mass Index, 538 Mast, 152, 217, 392, 411, 604, 608 move, 410 Maximum drawdown, 2 , 32, 502, 52 , 603 Maximum retracement, 502 McClellan Oscillator, 608 McDermott, The Redoubtable Richard, 325, 528 Measuring Formulae, 608 Measuring Gap, see Runaway Gap Measuring or Half-Mast Patterns, see Flag Measuring rule, 55, 65, 100, 154-155, 182-184, 392 Mechanical Dow Theory, 299 Mechanical systems, 250, 252, 260, 296, 423 Megaphones, 608, 613 Melon, 194, 609 Memorex Corp. (MRX), 470 Metastock 9.0, 531-532 Mike Moody, 545, 556-561 Mining engineers, 326 Minor Bottom, 88, 91-92, 122-123, 193, 198, 208, 210, 222, 354, 362-363, 373, 378-379, 386, 403, 413, 414, 41 , 517, 608-609, 616-617 Minor Bottoms, 123, 208, 222, 361, 363, 373, 386, 413-414, 617 Basing Points, 362-365 Basing Points paradigm, 365-366 complete Basing Points Procedure, 368- 370 narrative of events in chart, 367-368, 371-372 representative case fully analyzed using wave lows and new highs, 370-371 Variant 2 procedure, 370 Minor Correction, 209, 363, 386 Minor Fluctuations, 13, 74, 7 , 99, 129-130, 138, 151, 186, 190 process, 153 Minor phenomena, 202 Minor Reaction, 95-96, 115, 172, 181, 186, 362, 39 , 40 , 440, 605 Minor Reversal, 122-123, 155-156 Minor Reversal Areas, 157 Minor Setback, 17, 216, 432, 517 Minor Swings, 186 Minor Top, 79-80, 122, 198, 206, 354-355, 361, 363, 373-374, 378, 385, 414, 439, 444, 513, 616 Basing Points, 362-365 Basing Points paradigm, 365-366 complete Basing Points Procedure, 368- 370 narrative of events in chart, 367-368, 371-372 representative case fully analyzed using wave lows and new highs, 370-371 Variant 2 procedure, 370 Minor Trend, 13-14, 82, 144, 229, 290, 386, 410, 50 , 609 Minor Wave Pattern, 197 Minor Waves, 13, 223, 509 Misconceptions, 198-200 Model-driven market, 266, 272 “Models,” 266-26 , 273 Modern-style markets, 168-169 Modern era development, 271 Modern Portfolio Theory (MPT), 275, 499 Momentum, 43, 49, 184, 326, 539, 611, 614 Momentum Indicator, 538, 542, 609 Money, 41, 249, 253, 265-266, 270, 272, 283, 299, 332, 348, 489-490, 608 management procedures, 503-504 management rules, 258 Money Flow Index (MFI), 538 sophisticated risk and, 504 Monthly chart gaps, 171 Moving Average, 421, 424, 53 , 539, 609, 610 150-Day Moving Average, 424 200-Day Moving Average Line, 31, 267, 299, 300, 31 , 422, 423, 484, 618 50-Day Moving Average Line, 316, 422, 484, 604 crossovers and penetrations, 422-424 PENTAD Moving Average system from formula research, 424-425 Sensitizing Moving Averages, 422 Moving Average Convergence/Divergence (MACD), 538, 542-544, 609, 610 Histogram, 538 Moving Average Crossovers, 609 Moving Average Envelopes, 537 Moving Average Line, 422-423, 541, 598, 604, 609, 618 Multicolincarity, 598, 610 Multiple Bottoms, 414, 434 Multiple Formations, 66, 68 Multiple Head-And-Shoulders Pattern, see Complex Head-and-Shoulders Pattern Multiple Tops, 364, 403, 409, 414 Mutual funds, 43, 268, 390, 495 N Narrow Range Day, 610 NASA, 249 National Association of Securities Dealers Automated Quotations (NASDAQ), 19, 316 NASDAQ 100, 312, 480 Natural Hedge, 485, 610 Natural mechanical systems, 260 Natural method, 359, 610 NDX, 480, 577 Near progressive stops, 139 Neckline (NL), 47-49, 57, 59, 610 on multiple head-and-shoulders formations, 61 Ned Davis Research, Inc. (NDR), 424 Negative divergence, 610 Negative Volume Index (NVI), 538 Nelson Freeburg of Formula Research, 424 New commitments, 418 New Concepts in Technical Trading (Wilder), 618 “New Haven Investor,” 298 New York Stock Exchange (NYSE), 4, 269, 300, 311, 313, 316, 341, 349, 615, 616 NOKIA (NOK), 475 Normal Range for Price, 344, 346, 354, 49 , 610 Normal Uptrend Channel, 141-142 Northrop Aircraft, 438-439 Number-driven systems, 259-260 Number-driven technical analysis, 4, 26 , 610 Number-driven technical analysts, 266 O Odd lots, 351, 610 Old-style markets, 168-169 Old-time “plunger,” 168 On Balance Volume (OBV), 538, 610-611 One-Day Island Reversal, 607 One-Day Reversal, 42, 144-145, 410, 600, 615 One-Week Reversal, 147, 450, 589 Operational Risk, 501-504 Opportunity vs. Security, 308 Optimal formula, 534, 535 Optimization, 275 Options, 271-272, 611 on Dow index futures, 282-283 exercising, 284 on futures and indexes, 274 pricing models and importance, 273 spreads in high-or low-volatility markets, 286-287 as strategic investment, 273 traders, 272 trading, 272 Options Research, Inc, 611 Oracle Corporation, 332, 468, 573, 576, 579 Order, see Limit Order; Market Order; Stop Order Orthodox Broadening Top, 123, 130-135 “Orthodox” investors, 419 Oscillator, 4, , 304, 419, 600, 611 Aroon, see Aroon Oscillator Chaikin, see Chaikin Oscillator Out-and-out boardroom gamblers, 168 Out-of-the-money, 283 strike price, 285 Overbought, 611 Oversold market, 486, 611 “Oversold-overbought” indicator, 485, 611 Overtrading, 351, 493, 496-498 P Pacific Coast Options Exchange, 531 Packard-Bell Electronics Corp (PKB), 465 Palm Computing, 327 Panic, 611 decline, 145, 157, 159, 171, 178, 192, 201 phase, 15, 147, 380 Panic Bottom, see Selling Climax Parabolic SAR, 359, 537 Paradigm-setting model, 271 Paradox, 496-498 Parallel Trend Channel, see Descending Trend Channel Parke, Davis and Company (PDC), 466 Passive Indexer, 611 Patience, 265 Pattern analysis, 357 boundary, 203 gaps, 176, 184 resistance, 202-205 Peak, see Top Penetration(s), 422-424, 611 validity, 220-222 Pennant(s), 151-154, 410-411, 611 consolidations, 157 and flags, 608 reliability, 156-157 Pennant Consolidation, 392 PENTAD Moving Average system from formula research, 424-425 %B Indicator, 538 Percentage Price Oscillator (PPO), 538 Percentage Volume Oscillator (PVO), 538 Performance measurement, 275 Personal body digital assistants (PBDAs), 268 Philosopher's Stone, 249, 265, 275, 539 Pivot Points, 53 , 543 Plain scale, 8 Planned distribution, 98 Point and figure (P&F), 392, 532, 545 analysis, 543 charting, 26 , 532, 545, 612 technical analysis by Mike Moody, 556-561 Polaroid Corporation, 451 Polymath, 31 Pool operations, 105-112 Portfolio ordinary or operational risk, 502-503 Portfolio protection, 279- 280 Portfolio Risk Analysis screen, 529, 530 Portfolio Risk Factor (PRF), 502 Portfolio risk management controlling risk, 503 measuring maximum drawdown, 502 overtrading, 496-498 risk and money management procedures, 503-504 risk and trend, 499 risk of portfolio, 499 risk of single stock, 498-499 sophisticated risk and money management procedures, 504 VAR, 499-500 Portfolio Risk Strategy, 496, 497 Portfolio valuation, 275 Portfolio yields improvement, 286 Pragmatic analysts, 275 Pragmatic portfolio analysis, 502 portfolio extraordinary or catastrophic risk, 503 portfolio ordinary or operational risk, 502-503 portfolio risk over time, 503 Pragmatic portfolio risk measurement, 500 determining risk for portfolio, 501-502 risk of one stock, 500-501 Pragmatic portfolio theory, 500 Premature breakouts, 108, 612 Preparatory buying signals, 375-376 Preparatory selling signals, 379 Price Congestion Formation, 177 “Price-earnings ratio” index, 469, 612 Price Relative/Relative Strength, 538 Price(s), 196 channels, 537 fluctuation, 261 of futures option, 283 line, 423 pattern, 52, 5 , 70, 12 , 135, 138, 614 Primary Bear Market, 238, 242, 243, 507-508 Primary Bull Market, 21, 22, 41, 86, 122, 242 Primary Direction, 13, 355, 363, 380, 381, 383, 385, 386, 391 Primary Downswing, 202, 242 Primary Downtrends, 15 Primary Market Trend, 26 Primary Reversal phenomenon, 118 Primary trends, 12-14, 16 Pring's Know Sure Thing (KST), 538-539 Pring's Special K, 539 Probable moves of stocks, 341-344 Profit-taking patterns, 168 Profit analysis, 530 Profits in rising markets, 284-285 Program Trading, 311, 612 Progressive stop, 328, 355-357, 359, 370, 379, 612 Protective stop(s), 295, 353, 355, 356, 358, 361, 612, 616 Proxy markets, 278 Psychological grounds, 117 Psychological handicap, 293 Public Service Electric and Gas (PEG), 469 Pullback(s), 110, 202, 205, 224, 612, 617 Pullback Rallies, 58 “Pure investor,” 294-295 Put option, 272, 284, 285, 312, 611, 612 Q QID, 350 QQQ, 244, 271, 312, 313, 490 Quantitative analysis, 272-273 Quantitative analysts, 266 R Rail Average, 513, 603 Rails falter, 516-517 Rally, 612 Rally Tops, 612 Range, 612 Rate of Change (ROC), 539 Reaction, 612 Reciprocal, Market, see Market Reciprocal Recovery, see Rally Recovery Trends, 202 Rectangle(s), 18, 151, 159, 173, 189, 373, 408-409, 606, 608, 613 to Dow Line, 112-113 patterns, 378 from Right-Angle Triangles, 113 in Socony-Vacuum, 106 tops, 103-105 Rectangular Consolidations, 159 Red Parallel, 373, 378, 379, 613 Red Trend, 373, 375, 376, 379, 380 Red Trendline, 373, 376, 37 , 613 Relative Strength, 619 Relative Strength Index (RSI), 539, 598, 613, 618-619 Relative Strength Indicator, see Relative Strength Index (RSI) Reliability of flags and pennants, 156-157 Repeated saucers, 162-167 Resistance, 189, 603, 616 Level, 155, 184, 189, 194, 198, 202, 206, 226, 246, 613 Lines, 99, 196 Range, 189, 193, 196, 197 Zones, 192, 194, 19 , 200, 206 Resources, 523 essence of fundamental analysis, 528-531 important and indispensable sites, 523 investment-oriented sites, 524-527 leverage space portfolio model, 533-536 references for further study, 524 Sharpe Ratio, 527 software packages and internet technical analysis sites, 531-533 volatility calculation, 527-528 Retracement, 118, 172, 603, 613 Return Line, 223, 225, 596, 601 Reversal Broadening Bottoms, 135 Broadening Formations, 121-122 The Diamond, 137-139 Falling Wedge, 142-143 Key Reversal Days, 148-149 One-Day Reversal, 144-145 Orthodox Broadening Top, 130-135 Right-Angled Broadening Formations, 135-137 Rising Wedges common in Bear Market Rallies, 144 Runaway Days, 148 Selling Climax, 145-147 short-term phenomena of potential importance, 147-148 Spikes, 147-148 typical example, 128-130 volume during broadening formations, 122-128 wedge formations, 139-142 wedges on weekly and monthly charts, 143-144 Reversal Area, 42, 55, 158 Reversal Days, see Key Reversal Days Reversal Formation, 42, 50, 155, 168, 198 Reversal Gap, 613 Reversal Levels, 190 Reversal Pattern(s), 41, 42, 7 , 132-133, 493, 602, 613 ADM turned sharply lower, 64 breaking neckline, 47-49 Descending Triangles, 98-99 distinguishing characteristics, 115-118 Dormant Bottom variation, 73-74 Double and Triple Tops and Bottoms, 113-115 Double Bottoms, 118 Dow Theory, 41 fine Symmetrical Triangle Reversal Formation, 78 Head-and-Shoulders Bottoms, 57-59 Head-and-Shoulders to Dow Theory, 55 Head-and- Shoulders Top, 44, 45, 46, 63 “ideal” multiple top made by Budd in (1946), 62 intermediate bottom of complex class, 64 Johns-Manville's Primary Trend Reversal (1942), 79 leisurely pattern, 65-66 long multiple head-and-shoulders top, 63 Reversal Pattern(s) (Continued) MCA enjoyed 62excellent advance from (1980-1986), 62 measuring implications of Triangles, 100 multiple head-and-shoulders patterns, 59-61 planned distribution, 98 pool operations, 105-112 price action confirmation, 52-55 prices break out of Symmetrical Triangle, 88-90 Rectangles, double and triple tops, 103-105 Rectangles from Right-Angle Triangles, 113 relation of Rectangle to Dow Line, 112-113 reversal or consolidation, 94-97 Right-Angle Triangles, 97-98 Rounding Tops and Bottoms, 66-70 Rounding Turns affect trading activity, 70-73 Sears Roebuck made Symmetrical Triangle Reversal, 78 slide in Amdahl occupied Bears, 65 Symmetrical Triangles, 79-88 tendency to symmetry, 61 time to reverse trend, 42-44 Triangles on weekly and monthly charts, 100 Triangular formations, 100-101 Triple Tops and Bottoms, 118-120 typical Triangle development, 90-94 variations in head- and-shoulders tops, 49-52 volume, 44-45, 4 , 74-75, 99-100 Rhythmic investing, 300-302 Rhythmic Trading, 485 Richard Arms work, 545 Arms CandleVolume charting, 551-553 Arms Index, 545-548 calculation, 548 Equivolume charting, 550-551 using index, 548-549 reasoning, 548 Right-Angled Broadening Formations, 135-137, 409 Right-Angled Broadening Triangle, 606, 613 Right-Angle Triangle(s), 97-98, 103, 139, 173, 408, 596, 601 chart, 99 rectangles from, 113 Ripple, 14 Rising Channel, 413 Rising Wedge(s), 139, 141, 143, 614 common in Bear Market Rallies, 144 Risk analysis, 529 management, 495-504 measurement, 502-503 and money management procedures, 503-504 sophisticated, 504 “Risk-free” interest rate, 273 Rocket scientists, 249-250 Round-trip costs, 389 Rounding Bottom(s), 66-70, 403-406, 599, 614 Rounding Top(s), 66-70, 403-406, 606, 614, 617 Rounding Turn(s), 66, 68 affecting trading activity, 70-73 picture, 70 Round lots, 351, 614 RRG Relative Strength, 539 Runaway Days, 147, 148 Runaway Gap, 17 , 182-186, 202, 258, 601, 608, 614 Runaway issues, 327 techniques for management of, 328-332 Runaway or Continuation Gap, 392 Running Market, 614 S Saucer-Like Reaction Pattern, 99 Saucer Pattern, see Rounding Bottoms Scales, types of, 8-9 Scallops, 162-167, 614 Schadenfreude, 326 Schannep, Jack, 21, 26 Scholes, Myron, 271 Schwager, Jack Secondary Reaction, 13, 18, 35 , 493, 515, 516, 517, 519 Secondary Recovery swing, 508 Secondary Trend, see Intermediate Trend Secondary trends, 12, 13, 17 Secular Trend, 614 “Self-correction,” 197 Selling Climax (SC), 138, 145-147, 190, 201, 600, 611, 615 Selling Climax Day, 615 Selling stock short, 379 Semilogarithmic paper, 8 Semilogarithmic Scale, 8, 144, 220, 242, 60 , 615 Sensitivity, 341, 342, 346, 354, 422, 495, 600, 615 Sensitivity Index, 322, 342, 345, 346, 353, 492, 497 Sensitizing Moving Averages, 422 Settlement of futures contracts, 276 price, 276, 600 “Settlement date,” 276 Shakeout, 89, 145, 181, 221, 264, 505, 615 Sharpe Ratio, 499, 527 Short-term phenomena of potential importance, 147-148 Short-term profits, 297 Short-term trader, 190, 29 , 389, 419 Shorting stocks, 284 Short Interest, , 348, 615 Short sale(s), 379-380, 400, 409, 615 Short selling, 145, 346-350, 485 “Short side” of market, 41 Shoulder, see Head-and-Shoulders Pattern “Sideways” chart pattern, 151 Sideways Movements, 423 Simple Moving Averages (SMAs), 422, 537, 549 Single stock risk, 498-499 Sites, important and indispensable, 523 “Skullduggery,” 168, 169 Skyrocket, 184, 185, 196, 321, 401, 493 effect, 71 run-up of Willys-Overland, 179 Slauson, John, 387 Slope, 539 “Smart money,” 265 Smoothing, 615 Software packages, 305, 531-533 “Special Opening Quotation,” 276 Speculative aims, 245 Speculative blow-offs, 326 Speculative stock, 345, 492 Speculator(s), 3, 145, 149, 274, 286, 293, 297-298, 300 agile, 148 commodity, 246 psychology, 245 Spiegel's Bear Market, 262 Spike(s), 147-148, 615 Spring of 1946, 517-518 SPY, see Standard & Poor's Depositary Receipts (SPDRs) Standard & Poor (S&P), 274, 310-311, 482 Standard & Poor's Depositary Receipts (SPDRs), 271, 274, 299, 317, 323, 351, 390 Standard Deviation, 539 Statistical approach, 3 Statistical driven technical analysts, 266 Statistics fundamentalists, 4 “Stepping off” point, 417 Stick to guns, 505-506 Stochastic(s), 542, 615-616 Stochastic Indicator, 615 Stochastic Oscillator, 539, 615 StochRSI, 539 Stock(s), 12, 30 , 353, 356, 414, 41 , 482 alphabetic index of stock charts, 579-593 averages, 483 chart, 7 construction of index shares and similar instruments, 311-312 at different times, 427-479 index futures to control exposure, 277-278 instruments, 313s kinds of stocks long-term investors want, 311 long-term investor's viewpoint, 310-311 Major Downtrends, 428-429, 439 NDX, 480 opportunity vs. security, 308 options, 494 prices, 42, 266, 505 probable moves, 341-344 S&P, 308 S&P 500 in glory and tragedy, 309 selection of stocks to chart, 315-323 SPY. for illustration, 309 trends, 218 StockCharts Technical Rank (SCTR), 539 Stock Exchange vigilance, 168 Stock market(s), 3, 189, 266 fundamentalist, 3 to newcomer, 427 Support- Resistance Level, 430 Stock Split, 616 Stop, 616 Stop Loss, see Protective Stop Stop orders, 353, 611 ATR, 358-359 natural method using by Turtles, 359 progressive stop, 355- 357 SAR, 359 stop distances, 354 stop systems and methods, 357-358 survey of stop methods, 358 target stops, 359 Street, 3 Street firms, 325 “Strike” price, 282 Superior Oil Co (SOC), 458 Supply, 616 Supply and demand, 77 balance, 245 equation, 42 relation, 175 Supply Line, see Resistance Support, 189, 603 significance of support failure, 197-198 Support and Resistance, 383-38 , 410, 414 in averages, 206 estimating support-resistance potential, 194-196 explanation, 191-193 levels, 198, 200, 264 locating precise levels, 196-197 normal trend development, 190 pattern resistance, 202-205 popular misconceptions, 198-200 predictions, 189-190 principle, 189 repeating historical levels, 200-202 round figures, 200 significance of support failure, 197-198 theory, 202 volume on breaks through support, 205-206 Support Level, 151, 189, 192, 198, 206, 210, 364, 383, 386, 391, 414, 41 , 616 Support Line, 598 Support Range, 189, 192 Support-Resistance Level, 266, 430 Support- Resistance Theory, 224 “Swing” power, 30 , 345 Symmetrical Triangle, 80, 600 Symmetrical Triangles, 79-88, 103, 121, 151, 168, 203-205, 406-408, 609, 616 pattern, 603 prices break out, 88-90 T Tactical methods making new commitments, 418 Tactical methods (Continued) present commitments, 417-418 quick summation, 417 Tactical problem Hudson Motors, 295 long-term investor, 299 rhythmic investing, 300-302 strategy and tactics for long-term investor, 297-298 strategy of long-term investor, 299-300 “Tangents,” 208 Tape Reader, 9, 166, 616 “Tape watchers,” 163, 166 Target stops, 359 Tax, 313 consequences, 277 selling, 517 Technical analysis, 4-6, 419, 478, 537 Bollinger Bands, 561-563 number driven tools, 537-545 Point & Figure technical analysis by Mike Moody, 556-561 Richard Arms work, 545-553 and technology, 265-266 Technical chart patterns, measuring implications in, 391-392 Technical data, 6, 22 , 528 Technical indicators, 538-539 Technical Magee analyst and investors, 268 chaff, 270 information revolution, 270-271 internet, 268-269 marking-to-market, 269-270 separating wheat from chaff, 270 Technical overlays, 537-538 Technical regularity, 313 Technical trading effect on market action, 419-420 “Teenie,” 272 TEKNIPLAT chart paper, 305, 443, 616 semilogarithmic chart sheet, 219-220 Tenets, 12-14, 20 , 50 , 517 Test(s), 617 of authority, 216-220 Text diagrams, 565-578 Textron, 435, 575, 592 “Theoretical value” of future, 277 Thin Issue, 174, 356, 617 3COM, 319, 32 , 331, 579 “Three-days-away” rule, 300, 328, 361, 369, 414, 617 Throwback(s), 99, 110, 181, 202, 203, 221, 224-225, 612, 617 Tide, 14 Time requiring to reverse trend, 42-44 scale, 8, 31 TLT chart, 258 Top, 611, 617 Broadening, see Broadening Top Double, see Double Top Head-and-Shoulders, see Head-and-Shoulders Top Rounding, see Rounding Top Triple, see Triple Top Top of Ascending Triangle, 177 Top Price Chart Formation, 598 Top Trendlines, 414, 598, 613 Total Capital (TC), 30 , 492, 498, 502, 503, 504 Total Composite Leverage, 297 Trader(s), 251, 284, 293, 296, 300, 315, 505 Traders, 358 Trades, 33-3 , 409 Tradestation 2000i, 532 Tradestation 8, 532 Trading, 4 activity, 17, 44-45, 80, 91, 122, 163, 185, 221, 316, 441, 511, 614 area, 103, 121, 151, 175, 423, 613 averages in 21st century, 244 costs, 390 opportunities, 42, 163, 266, 475 range, 73, 79, 149, 186, 286, 599, 60 , 609, 616 Transportation Average, 596, 600, 603 Treasury bonds, 253, 281 Trend(s), 12, 13, 14, 223, 229, 617 consolidation, 151 ranges, 222-223 and trendline studies, 264 Trend Channels, 214, 215, 223, 242-243, 356, 392, 617 in Bethlehem Steel, 213 Parallel Trend Channel, 373-375, 378 Rising Trend Channel, 225 Trending Market, 252, 253, 286, 423, 595, 617 Trendline(s), 207-209, 209- 211, 414, 429, 59 , 616, 617 in action, 375 additional suggestions, 380 amendment of trendlines, 222 analysis, 357 arithmetic vs. logarithmic scale, 211-216 buying stock, 375-377 consequences of Trendline penetration, 224- 225 corrective trends, 226-227 covering short sales, 379-380 double trendlines and trend ranges, 222-223 experimental lines, 224 intermediate downtrends, 225-226 liquidating, or selling long position, 378-379 policy for trading in Major Trend, 380-381 selling stock short, 379 tests of authority, 216-220 validity of penetration, 220-222 Triangular Price Formations, 103 Triangular/Triangle(s), 79-80, 423, 608, 617 development, 90-94, 98 formations, 100-101 measuring implications, 100 patterns, 378 on weekly and monthly charts, 100 Triple Bottom(s), 113-115, 118-120, 617 Triple Top, 103-105, 113-115, 118-120, 504, 568, 617-618 TRIX, 539 True Range, 358, 595 True Strength Index, 539 Tulipomania, 61, 308, 325, 331, 332, 339, 57 , 593, 607 managing, 326-328 PALM, 329 Tulips, 241, 325, 329, 331, 339 “Turbulent period,” 485, 486 Twain, Mark, 26-2 , 304, 365, 532 Turtle(s), 250-252, 259 natural method using by, 359 system, 258-260 U Ulcer Index, 539 Ultimate Oscillator, 539 United Artist Corporation (UNA), 460 Unnatural method, 610 Up-slanting bottom boundary, 92-93 line, 79-80, 91 Up Channel, 596 Uptick, 349, 350, 618 Up trendline, 208, 209, 210, 211, 216-217, 221, 596, 617 Uptrends, 14, 104, 153, 158, 208, 212, 219, 225, 233, 422-423, 429, 432 U.S. Securities and Exchange Commission (SEC), 105, 145, 168, 390 U.S. Smelting, Refining and Mining Co, 453, 463 a, 428 Head-and-Shoulders Top in (1952) U.S. Steel, 4, 5, 79, 105, 12, 131, 147, 200, 201, 569 Utah-Idaho Sugar Co. (UIS), 461, 576, 593 Utility Average, see Dow-Jones Utility Average V Validity of Trendline Penetration, 618 Valley, 116, 118, 119, 176, 618 Value-at-risk procedure (VAR procedure), 499-500 Variance, 212, 311, 344, 501, 527, 536 Variant 2 procedure, 368, 370 Variations in head-and-shoulders tops, 49-52 V/D volume, 618 “Vertical” Panic Declines, 157 “Vested interest,” 186, 199, 200, 201, 202 Vigor, 95, 144, 197, 516 Vince, Ralph, 504, 533, 60 , 618 Volatility, 283-284, 343, 354, 498, 500, 501, 528, 539, 618 calculation, 527- 528 Volume-Weighted Average Price (VWAP), 538 Volume, 44-45, 4 , 108, 193, 194, 264, 595, 616, 618 on breaks through support, 205-206 during broadening formations, 122-128 characteristics same as symmetrical type, 99-100 confirmation, 398, 401, 40 , 408, 432, 449 pattern, 46, 4 , 5 , 59, 63, 64, 6 , 74-75, 13 , 161, 196, 20 , 216, 605, 614 by Price, 537-538, 543 of trading, 67, 193, 197, 221, 618 Vortex Indicator, 539 “Voyeur” feature, 532 W Wall Street investment banks, 325 Wall Street Journal, 11, 12, 243, 312 “Wash sales,” 107 Wave, 14 Wave analysis methods, 260 Wedge(s), 139, 409-410, 618 formations, 139-142 on weekly and monthly charts, 143-144 Weighted Moving Averages, 422 West Indies Sugar, 43 , 575, 593 Westinghouse Electric, 4 , 237, 437, 442, 566, 568, 572, 575, 593 “W” Formation, see Triple Top Wide-Ranging Days, see Runaway Days Widening Channel effect, 243 Wilder Relative Strength Index (Wilder RSI), 595, 610, 618-619 Wieckowicz, R.T., 307 Williams, Larry, 420, 531 Williams %R, 539 World Equity Benchmarks (WEBs), 312 World War II, end of, 515, 516 “W” Pattern, see Triple Top Wright, Charlie, 494 Wyckoff, Richard, 259, 392, 550 Wyckoff's charts, 531 Y Yahoo! (YHOO), 330, 476, 47, 526, 577, 593 Z Zen, 269 ZigZag, 197, 383, 538 Zone, Resistance, 189, 192-194, 196, 197, 199-200, 202, 206, 387 ©Taylor & Francis Group an informa business Taylor & Francis eBooks www.taylorfrancis.com A single destination for eBooks from Taylor & Francis with increased functionality and an improved user experience to meet the needs of our customers. 90,000+ eBooks of award-winning academic content in Humanities, Social Science, Science, Technology, Engineering, and Medical written by a global network of editors and authors. TAYLOR & FRANCIS EBOOKS OFFERS: REQUEST A FREE TRIAL support@taylorfrancis.com 3 Routledge „oC CRC Press Taylor & Francis Croup Taylor & Francis Croup ================================================================================ SOURCE: eBooks\Tom Hougaard - Best Loser Wins.pdf ================================================================================ BEST LOSER WINS BEST LOSER WINS Why Normal Thinking Never Wins the Trading Game Tom Hougaard HARRIMAN HOUSE LTD 3 Viceroy Court Bedford Road Petersfield Hampshire GU32 3LJ GREAT BRITAIN Tel: +44 (0)1730 233870 Email: enquiries@harriman-house.com Website: harriman.house First published in 2022. Copyright © Tom Hougaard The right of Tom Hougaard to be identified as the Author has been asserted in accordance with the Copyright, Design and Patents Act 1988. Paperback ISBN: 978-0-85719-822-8 eBook ISBN: 978-0-85719-823-5 British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library. All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publisher. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published without the prior written consent of the Publisher. Whilst every effort has been made to ensure that information in this book is accurate, no liability can be accepted for any loss incurred in any way whatsoever by any person relying solely on the information contained herein. No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading material in this book can be accepted by the Publisher, by the Author, or by the employers of the Author. The Publisher does not have any control over or any responsibility for any Author’s or third-party websites referred to in or on this book. To the girl at the Bloomberg terminal CONTENTS Dear Markets Preface Introduction Liar’s Poker The Trading Floor Everyone Is a Chart Expert The Curse of Patterns Fighting My Humanness Disgust The Drifter Mind Trading Through a Slump Embracing Failure Best Loser Wins The Ideal Mindset About the Author DEAR MARKETS FROM THE MOMENT I first came across you, I have been fascinated by you. I probably even fell in love with you. I was too young to know what that meant, no more than ten years old. You were featured in a national newspaper – a competition of sorts. I was too young to play with you, so I observed. Time was not on my side. I was born a few decades too soon to participate in trading like it is possible today. I had to go and live my early life and you went about yours. When you went through the devastating bear market of 1973, I was just learning to walk. When you roared with anger during the crash of 1987, I was just finishing school. When you took the first steps towards the epic 1990s bull market I was almost ready. But not quite there yet. So, you sent me a message that would change my life, and I took you up on the invitation, leaving everything behind me to pursue you. I studied you at university, two degrees in fact. I toiled for hours and hours, trying to understand you through the eyes of the conventional economic thinkers, through the eyes of Nobel Prize recipients, and through the eyes of well- meaning journalists and experts. I wish you could have told me back then not to bother. You are not an equation to be solved. You are far more complex than a model could ever capture. Over and over, you prove yourself to be the elusive mistress that no one every truly understands. You are everywhere and you are nowhere. Universal laws do not apply to you. My love for you was deep. You gave me so much joy. I gave you my all. You were there when I woke up, and you were there when I went to sleep. You have elevated me when I was fluid, rewarded me beyond my wildest dreams when I was flexible. You have punished me when I was rigid and stubborn, taking all your gifts back – with interest. And boy did I pursue you. I pursued you like a lovestruck teenager. I approached you from all angles, from Fibonacci ratios to Keltner Channels, to Bollinger Bands, to Trident strategies, as well as mythical vibrations of Gann and Murry Math. I developed models of the tide swell in the Hudson River to see if you responded to that. I printed out thousands and thousands of charts, applying lines and circles, trying to find a way to dance with you so that my feet didn’t get stamped on so much. I had sore toes, my love. Sometimes my toes were so sore that I had to go to the beach and just throw stones in the water for hours on end, angry that you didn’t want to do the tango with me. You gave me sleepless nights. You gave me tears in my eyes, anger in my body, hurt in my soul, and yet I couldn’t let you go. I knew there was more to it, and I knew I had to keep looking. I gave you everything because you made me feel alive. You gave me a purpose. You gave me challenges so hard even a drill sergeant would have to give you a nod of respect. And I will always love you for it. You kept me on my toes, like a parent wanting only the best for their child. But you made the lessons obscure. You designed it to look easy. But it was never easy. You made everyone believe that you could be danced with through models, through equations, through indicators, through conventional thinking and through logic. But often there is little logic to you. And I struggled to dance with you for years, until one day by chance you told me your secret. You told me to stop trying to understand you. You told me to understand myself. I stopped trading. I took the time to understand myself, and I came back. And when I returned to the dance floor, you welcomed me with open arms, smiled, and said, “Welcome back, I see you get it now. Did you bring the band-aids?” And I did. Best loser wins. PREFACE HOW YOU FEEL about failure will to a very large degree define your growth and your life trajectory, in virtually every aspect of your life. You may want to close this book and think about that for a while. It is quite frightening how deep that sentence is. What 99% of traders do not realise is that they are looking for answers in the wrong places. Knowledge of technicals, fundamentals, indicators, ratios, patterns and trend lines… well, everyone knows about them – and everyone loses, except the 1%. What do the 1% do that the 99% is not doing? What am I doing, enabling me to have the success in trading that I have, which the others are not doing? The answer is as simple as it is complex. I am an outstanding loser. The best loser wins. I have conditioned my mind to lose without anxiety, without loss of mental equilibrium, without emotional attachment, and without fostering feelings of resentment or desire to get even. It is because of how my mind works that I am able to trade in the way that I do. My knowledge of technical analysis is average at best. My knowledge of myself is what sets me apart. The true measure of your growth as a human being is not what you know, but rather what you do with what you know. I wrote this book to describe how I transformed myself into the trader I am today, and how I was able to bridge the gap between what I knew I was capable of, and what I actually achieved. INTRODUCTION MY NAME IS Tom Hougaard. I am 52 years old. Thirty years ago, I left my native Denmark. I wanted to trade the financial markets and I wanted to do it in London. I had an idea of what I needed to do to become a trader. I got a BSc in Economics and MSc in Money, Banking and Finance. I thought I had everything I needed to become a trader: the right kind of education; a good work ethic; and passion for the markets. I was wrong. On paper, I was qualified to navigate the financial markets. In reality, educational qualifications mean little in the dog-eat-dog world of trading. This book describes the journey I went through to get to where I am today. Where am I today? As I type this, I have not had a losing day in 39 trading days. I run a Telegram trading channel, where my followers witnessed me make £325,000 in the last month alone – in real time, with real-time entries, money management, position sizing, and ultimately the exit of the position. No time delays. No lag. All done before their eyes – time stamped. This book dispels the myths of what it takes to be a home trader, or any trader for that matter. It has been a journey that saw me initially pursue the path that everyone else takes – a lot of books about a lot of indicators, patterns and ratios – before finally realising that the real answer to the elusive quest for trading profits was right inside of me all along. It truly was the last place I ever thought of looking. A PROMISING BEGINNING After completing my university degrees, I started working for JPMorgan Chase. It wasn’t a trading job, but it was close enough. Then in 2000 I became a home trader for a year and a half. It only lasted 18 months because I ran out of money. I had befriended the staff at the broker I traded with. They hired me as a financial analyst. I say analyst, but I was a glorified media whore. My mandate was to get the brokerage seen on TV and my credentials were an understanding of technical analysis. I started that job in the summer of 2001. My first customer-facing experience was when the CEO brought me to Royal Ascot – a significant event in the social calendar of the rich and famous. It is a horse racing event, mixed with champagne, funny-looking hats and big cigars. Only the best and most lucrative clients were invited to this VIP event. On board the executive coach taking the prestigious clients to Ascot, I was introduced as the new financial analyst. “Ask him anything,” declared the CEO. One client asked me what I thought of Marconi. Marconi was a member of the FTSE 100. It had seen better days. It had declined from 1,200 pence to 450 pence over the preceding 12 months. “Do you think Marconi is cheap?” asked a pharmacist from Luton. I didn’t know it at the time, but my answer – and a similar one on TV a few months later – would eventually get me fired from my job. Even if I had known, I would not have changed my answer: Marconi is garbage, gentlemen. Why are you chasing stocks that have fallen in price? The stock market is not like a supermarket, where it makes sense to buy toilet paper when there is a sale on. Sure, it makes sense to buy toilet paper at a 50% discount, but it makes no sense to buy a stock that has fallen more than 50%. Concepts like ‘cheap’ and ‘expensive’ may work in the world of Saturday grocery shopping, but not in the financial markets. My answer hung in the air like a morbid joke at a funeral. I had barely finished my verdict before I noticed the death stare from my boss. All these clients were long Marconi and they would go on to lose fortunes. Later that year I was on CNBC and I was asked to do a chart analysis of Marconi. By that point Marconi had fallen to 32 pence – from 1,200 pence. And still people were buying it. I suggested that on the basis of the chart pattern, Marconi would go to zero. A few newspaper outlets picked up on the story and a few days later I was called to the offices of Sporting Index. The CEO wanted to ask me if it was possible to get these Marconi comments deleted from “that internet”. Marconi went to zero and I was asked to find another job. Fortunately, City Index hired me the same day I left Financial Spreads. I spent seven years on the trading floor at City Index. In 2009 I was made redundant and I have been a private trader ever since. I have spent the last 12 years of my life perfecting my craft. I am what brokers call a high-stake trader. The average stake size amongst retail traders is about £10 per point risk. I risk anywhere from £100 per point to £3,500 per point. On volatile days I have traded in excess of £250 million in notional value. I once made a little more than £17,000 in less than seven seconds. One time I lost £29,000 in eight seconds. That kind of stake size sharpens the senses. Yes, it is a great life when it goes well, but a very challenging one when adversity sets in. This book describes my journey from an unemployed financial broker in February 2009 to the high-stake trader that I am today. But it is not a conventional trading book. JUST ANOTHER TRADING BOOK? The world does not need more trading books. So, I decided not to write one. I know enough about technical analysis to write a few books. I also know that technical analysis does not make you a rich trader. It doesn’t even make you a good trader. I had no ambitions of wanting to write a book, but one day, while I was watching a documentary on YouTube, an advert appeared on my monitor. I recognised the face immediately. It was a guy who once attended a few speeches I gave on technical analysis, while I was working as a trader at City Index in London. Now he appeared in an advert, promising to reveal the secrets to the financial markets through his courses. The advert proudly declared that if you wanted to learn to trade like a pro, then this course was what you needed. As it happened, a friend of mine had attended the course. It took place over a weekend in some plush offices in London. The place was packed and the hopefuls hung on every word of this self-proclaimed guru as he took them through one chart after another. There was no critical thinking present. No one questioned his claims. Everyone left that office building on Sunday night thinking they would make a small fortune by the coming Friday. I saw the course notes. It was hundreds of pages of regurgitated material from a standard textbook on technical analysis. There was no original thought behind it. There were no new contributions to the field of technical analysis. Anyone with half an afternoon at their disposal could find the same material free of charge on the internet. More importantly, my friend told me, the guru never missed an opportunity over the weekend to pitch additional products such as personal mentoring and the advanced course. THOSE WHO CAN, DO There is a saying that those who can, do. And those who can’t, teach. I don’t agree with that. There are many people who “can” and who also “do”. One is not exclusive of the other. Many great “do’ers” see it as part of their life mission to pass on knowledge to those around them. When I worked at City Index, I might not have been an oracle of technical analysis, but I certainly knew more than most of our clients. For that reason I gave technical analysis lessons most evenings to our clients and the many white label clients that City Index had, such as Barclays Bank, Hargreaves Lansdown and TD Waterhouse. I truly enjoy passing on knowledge and I did the best I could with the knowledge I had. However, what I didn’t realise back then was that technical analysis is rather pointless unless it is combined with behavioural response training. My main beef with the many gurus teaching outrageously expensive weekend courses is their outcome focus. They are driving their agenda by the use of external stimuli, such as portraying themselves in a helicopter or on a private jet, and they portray trading as an easy profession to master, or one where there is a secret to be learned, and once in possession of this coveted secret you become your own ATM. Rarely if EVER will these gurus risk their reputation by disclosing their trades in real time. It is always after the fact. We never hear about their losing trades. This gives the illusion that losing is a mere inconvenience you experience from time to time when trading. It is only when you sit down in front of the screen on Monday morning, after your overpriced weekend course on trading, and the market is moving in front of you, and you don’t have the after the fact chart in front of you, that you realise this game is not as easy as the guru told you during the weekend course. I have written a book that is an antidote to all the rubbish that is being peddled in the trading arena by charlatans who are 99% marketing and 1% trading. They preach their message to unsuspecting people – who sadly believe them – with neither the teacher nor the student realising that they only got 10% of the story. More importantly, I have written a book which is all about the aspect of trading they never teach you, and how to get to the top of the trading pyramid. While writing this book, I saw an advert for a technical analysis course in my home country, Denmark. Only the year before, the person running the course had lost 35% of their trading capital on a copy trader account for their followers, before closing the account. That is the problem with technical analysis. It is very easy to learn, but it should not be touted as the path to untold riches in the financial markets. The gurus appear on adverts suggesting that all you need to make money from the market is to learn technical analysis. I wish it was that easy, but it isn’t. IF NOT TECHNICAL ANALYSIS, THEN WHAT? There is a law in Europe that states that brokers offering trading services to retail clients must disclose what percentage of their clients lose money. I looked up the major players in the industry. According to their websites, around 80% of their clients lose money. I called one broker to ask how this number was calculated. The number is adjusted quarterly. The broker compares the account balances of its clients from the prior quarter and simply takes the percentage of accounts that have a lower balance than three months earlier. If the answer to the trading quest was to study technical analysis, then you would not have default rates of 80%. Incidentally, the guru who gave a weekend course to my friend happens to also own a brokerage that he refers all his attendees to. I looked up its default rate. More than 80%! So, either his clients are just awful traders, or he is an awful teacher. I will come to the rescue of both camps and state that to become a profitable trader, you need much more than just technical analysis under your belt. That is why I wrote this book – to describe the path I have taken to get where I am today. Over the last 20 years I have read many books on technical analysis and trading techniques. I personally find most of them boring and pointless. All I see in these trading books is one perfect chart example after another. It creates an illusion in the mind of the reader. They absorb these conceited tales, written by traders who espouse the same material as everyone else – material that bears little resemblance to the real trading world. It leaves the reader blindsided to the reality of the trading arena. Of course, there are exceptions. There are some good books written on techniques and strategies, but most of them are garbage because the author suffers under the illusion that he or she should only show perfect trading examples. They perpetuate the illusion that trading is an easy endeavour. I think it is fair to say that with a failure rate around 80%, there is absolutely nothing easy about trading. I dare say that if technical analysis as a subject was comparable to something like dentistry, the vocation would be terminated on account of the 80% failure rate. You don’t have a 80% failure rate amongst dentists. THE MILLION VIEWS YOUTUBE TALK I was invited by one of the biggest brokers in the world to give a talk about the life of a home trader. They filmed the event, which lasted a few hours. I gave the speech a provocative title: Normal Does Not Make Money The broker emailed me last year to say that my video had received five times more views than their second-best video, and that it had now surpassed one million views on YouTube. This gave me the confidence to push ahead with the book project, because I could see that my message resonated with an audience that wanted to move beyond the conventional teachings in trading. Although this is not a book about trading techniques, I am not arguing that you can do without technical analysis, or some form of analysis. There must be some rhyme or reason to your entries and exits, and your stop-loss placement. However, I am also arguing that techniques alone will not make you rich. Analysis alone will not get you to where you want to be. I imagine you want trading to give you a meaningful side income or perhaps even be your main income. I am arguing that a normal human being, displaying normal thinking patterns and traits, will never stand a chance of making money trading. In other words, normal won’t cut it. One of the best books ever written on trading is Reminiscences of a Stock Operator. There is not a single mention of trading techniques in that book. Let’s face it, we can all learn to walk a tightrope suspended one foot off the ground. However, can you walk across that same tightrope when it is suspended 100 feet off the ground? In the same vein, we can all trade bravely and aggressively when we are trading one lot, but can you trade with absolute clarity and emotional detachment when you are trading a 10-lot or a 100-lot? I can’t guarantee you will trade 100-lots, but I will describe the process that got me to trade that kind of size. I am leaving no stone unturned. I have described every facet of life as a trader, from the mundaneness to the excitement, and I have described the exact steps I take every day, week, month and year, to ensure that I am up to the job. And let me immediately make an important declaration: I am not going to sugar-coat my message. It is an insanely difficult profession, one that is beyond the apparent mental abilities of almost everybody, yet at the same time a profession that will reward you with wealth beyond your imagination, once you understand how this game really should be played. This book describes how to play the game of trading. Now you know the end destination. If you don’t like the sound of it, now is a good time to put down the book and go to the YouTube and TikTok videos and watch the Ferrari-driving 20-year-old trading coaches tell you how it is all done. If, however, you want lasting change – not only in your trading, but in how you live your life – then stay with me. Your transformation into a consistent trader will permeate other parts of your life. It will give you a deep understanding of who you are and what you can do to better yourself. The end result is not just more money on your trading account, but a more harmonious and exciting life journey. LIAR’S POKER MY JOURNEY AS a trader started when I came across a book called Liar’s Poker. I was home from school with flu and my dad brought me some books from the library. Liar’s Poker was one of them. It is a period piece, written by Michael Lewis, the man behind the book The Big Short, which was made into a Hollywood blockbuster. In Liar’s Poker, Lewis describes life as a bond trader during the excesses of the 1980s. In his own words it was meant to serve as a warning to future generations about the gluttony of the finance industry, as well as a warning to young people wanting to work in the financial industry. I think it had the opposite effect. I suspect thousands of young men and women like me read the book and thought to themselves that Wall Street was the place to be. The book describes a young man travelling from America to Britain to study at a London university and subsequently being hired to work for an American investment bank. It describes what it was like to work on a trading floor and observe some of the big traders there. I was hooked, and I knew trading would be my vocation. I have since read many other trading books that are perhaps more specific about trading than Liar’s Poker, but as a starter book, I could not have asked for anything better. My life changed after reading that book. It was a wake-up call. I went from being a skateboard-loving football fanatic, to being a focused and driven individual. I had found my calling. I started applying to university degree courses around Europe. I already had a job at a pension fund as an office trainee. After reading the book, I knew that would not be my end destination. I got accepted to a university in Britain for the following year, but I had a problem. There was no funding. I had to pay my own way. I worked all hours, day and night. During the day I would work at the pension fund, then in the evening I would skate five miles to an amusement park to work there until 1 am. I absorbed as much information as I could from the Danish finance pages. I would read English books to improve my language skills. My family was less than supportive. On the big day of departure, I had to make my own way to the airport. They eventually came around and shared my trials and tribulations throughout the years. My sister once told me she chewed her nails the first time she saw me on TV. She was so nervous I would freeze on air. MY FIRST BIG TRADE There is a saying in the financial markets that perfectly sums up my first brush with speculation. Don’t confuse talent with luck. I was blind to the ways of the financial markets, but I got incredibly lucky. It was September 1992. I had just been accepted to my university. I had worked hard to earn enough money to finance the tuition fees and living expenses for three years, although I was a little short. I figured I would work through the holidays to make up for the shortfall. As I was packing up my home and preparing myself to journey to the United Kingdom for my first year as a university student, there was a proverbial hurricane blowing through the currency markets. The UK was a member of the European Exchange Rate Mechanism (ERM). This was a system introduced by the European Economic Community to reduce exchange rate variability and achieve monetary stability in Europe. The UK joined the ERM in 1990, but by 1992 the UK was in a recession. The Bank of England found it more and more difficult to honour their commitment to maintain the British pound within a tight band against other currencies in Europe. Speculators were actively betting against the pound, thinking that it was heavily overvalued. As I was walking to my local bank in Denmark with my savings, looking to exchange my Danish kroner for British pounds, a major drama was unfolding in the financial markets. It was called Black Wednesday. On 16 September 1992 the British government was forced to withdraw the pound from the ERM after a failed attempt to keep the pound above the lower currency exchange limit mandated by the ERM. I found the following information about Black Wednesday on Wikipedia. It sets the tone well for what I was about to experience, and what caused a massive windfall for a 22-year-old aspiring trader: Soros’ Quantum Fund began a massive sell-off of pounds on Tuesday, 15 September 1992. The Exchange Rate Mechanism stated that the Bank of England was required to accept any offers to sell pounds. However, the Bank of England only accepted orders during the trading day. When the markets opened in London the next morning, the Bank of England began their attempt to prop up their currency as per the decision made by Norman Lamont and Robin Leigh-Pemberton, the then Chancellor of the Exchequer and Governor of the Bank of England respectively. They began buying orders to the amount of 300 million pounds twice before 8:30 am to little effect. The Bank of England’s intervention was ineffective because Soros’ Quantum Fund was dumping pounds far faster. The Bank of England continued to buy, and Quantum continued to sell until Lamont told Prime Minister John Major that their pound purchasing was failing to produce results. At 10:30 am on 16 September, the British government announced a rise in the base interest rate from an already high 10%, to 12% to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15%, dealers kept selling pounds, convinced that the government would not stick with its promise. By 7:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12%; however, on the next day the interest rate was back on 10%. This was of course all unbeknownst to me, yet it had a material impact on my studies. Had I walked down to the bank just a few days earlier I would have had to pay close to 12 Danish kroner for one pound. By sheer luck I walked straight into, and benefited from, one of the biggest modern-day currency crashes, and I was able to convert my Danish kroner at an exchange rate of about 9 kroner to the pound. I made an extra £4,000 from my savings. My annual budget with tuition and lodging was £2,500. ‘Uncle George’ made my university education debt free. Although the day was called Black Wednesday, many historians argue it was a Golden Wednesday, because the cheaper pound attracted investment. It set the stage for an economic growth spurt in the United Kingdom. THE PRICE OF A HOTDOG IN PARIS I wasn’t the only one who made a life-changing amount of money that day. George Soros made a billion dollars. It cemented his name as one of the greatest speculators of all time. And he wasn’t the only one who had noticed stark value differences between the European currencies before that fatal day in September 1992. Another trader had too. Actually he wasn’t a trader at all. He owned a printing company in East London. We shall call him the Englishman. When I started working in the City of London, I heard the story of a client who had been holidaying in France. During a visit to Paris, he found himself buying a hotdog at a corner stand, down by the Eiffel Tower. When it came to pay for the goods, the price for the hotdog was so shocking to our Englishman that he was thinking the hotdog stand owner was trying to cheat him. He was assured that this was the prevailing price for a hotdog in Paris. He decided to buy another hotdog somewhere else, just to make sure he had not been cheated the first time around. The outcome was the same. Our Englishman was laying the foundation for one of the greatest single- man bets in the history of the retail trading industry. He walked into a supermarket in Paris and started making a note of the prices for food, drink and other household items. Back in London our Englishman compared the French prices to the prices for the same goods in his local supermarket, and he concluded that the French franc was hugely overvalued. He called his financial trading house, and spoke to a young broker, who was later to become my boss. My boss loved to tell the story of how his client managed to turn a £5,000 account deposit into an £8m (that is eight million pounds!) profit. He relentlessly pursued the idea that the French franc was hopelessly overvalued, and he profited hugely from it. The reason for sharing this anecdote is not merely to tell you a good story, but also to prepare you for what this book is all about. You see, this might have been a great story, had it not been for the fact that the client later went on to lose all of that money, and then some. Isn’t successful trading all about making the money and holding on to it as well? What 99% of people do not realise is that when you win, there are things happening in your brain chemistry, which – if left unnoticed and unchecked – will have a detrimental effect on your decision making. ECONOMIC THEORY AND ECONOMIC HISTORY Studying at university taught me what there was to learn about economic theory. It taught me how the financial markets were put together and how current economic theory tried to make sense of the world around us. However, it didn’t teach me how to trade. It didn’t teach me how momentum, psychology and sentiment have a major influence on the financial markets. My degree course did little to prepare me for the real world. I thought that taking a master’s degree would change that, and while it was a little more industry relevant, I still felt the market was a big mystery to me. The idea that you can test variables within an economic system by holding other components constant didn’t sit well with me. I am not sure I was consciously mindful of it then, but I saw the world differently. I didn’t think that the markets were efficient. I had a strong belief that the markets were anything but rational. The markets are driven by humans, and if there is something humans are not, it is rational or logical when exposed to stress. RICH MAN’S PANIC I enjoyed studying economic history more than I enjoyed studying economic models. One of the pivotal moments came when studying the rich man’s panic of 1903 and the panic of 1907. Bernard Baruch, a famed Wall Street speculator, made a substantial amount of money by correctly anticipating the consequences of a failed corner of a railroad stock. A corner is when a group of people or a syndicate inflates the price of a stock in order to create a buzz, thus trying to entice more gullible investors to join the bandwagon, and then offloads the stock to the latecomers. Today it would be called a pump and dump. Just think GameStop! What made an impression on me was how Bernard Baruch anticipated the sequence of events. He started to sell short a broad range of popular stocks because he reasoned that the syndicate would have to raise money to keep their ill-fated corner alive. He was right. The general market declined rapidly. The Dow Jones Index fell 49% in a few months, and Baruch profited from it. From then onwards I found it difficult to study economic models. I found them rigid and too theoretical in concept. I felt they made fallible assumptions. They argued that humans always act rationally. But mankind most certainly does not always act rationally. As I write this page, I am looking at my quote monitor. The Dow Jones is called down 500 points. The DAX Index is already down 250 points. “Why is that?” I hear you ask. It is because there is a serious virus called coronavirus spreading through the world. Some 80 people have died already. The market is not so concerned about the 80 people. The market is concerned it is going to get worse. The markets are ALL about perception, sprinkled with economic reality. I don’t understand the fundamentals behind a virus, and I don’t need to. My job is NOT to understand the implications of a virus. My job is to understand the players in the market and what they are feeling. They are scared, and I have spotted their fear. So of course I am short. I am not short the market because I think a virus is going to wreak havoc on the global economy. I am short because I think they think something terrible is about to happen. Whatever happens, my job is to read the sentiment and to keep my own emotions in check. That is essentially what I am going to teach you in this book. I am aligned with reason when it comes to explaining bull markets and bear markets. The health of the underlying economy will drive a market up or down. However, as a day trader I need to have a mental flexibility that is never described or accounted for in economic theory. I also need to know “when to hold, and when to fold,” as Kenny Rodgers sings in ‘The Gambler’. Am I a gambler? If I say yes, you might think there is no difference between me and the guy who visits a casino for a bit of excitement. What if I were to tell you that I make more money than the average professional football player, and I do so not because I am gifted with special abilities to read the markets, but because I have learned to control my emotions? I am not an unemotional sociopath. I feel. I love. I cry. I ache. I mourn. I laugh. I smile. You can be a nice guy and still finish on top. But you do need to learn to think differently than the 99% does, when you are trading. We will get to that soon enough. JPMORGAN CHASE After my graduation I interviewed for many graduate jobs within the banking and finance industry. I didn’t get my dream job, working as a trainee trader, but I did get a good job working for Chase Manhattan Bank, later called JPMorgan Chase. It was an invaluable experience. I arrived with a bagful of enthusiasm. Working for an American investment bank was probably the best thing that could have happened to me. I was able to channel my enthusiasm for the financial markets into my work. I worked with portfolio analysis and performance benchmarking, which meant I was able to observe the financial markets unfold before my eyes every single day. I happened to sit right next to a Bloomberg terminal. I loved that machine. I would often sneak into the office building on Saturdays and Sundays to devour analysis and trading stories, and download data. The great thing about working for an American bank is that there is a very different work ethic to typical European companies. This may have changed in the last 20 years, but when I was working at JPMorgan we were literally allowed to work as many hours of overtime as we wanted. I worked for JPM for close to three years, and in those three years I never had a month where I didn’t do at least 40 hours’ overtime. You got used to working long hours with focus because the job required forensic attention to detail. By the time I left the bank, I was a hardened and seasoned workaholic. I don’t say that with pride, but I don’t think there is any point in hiding the fact that the reason for my success was not due to immense intelligence, but rather my work ethic. I just worked longer hours than the others. I made the sacrifice for what I wanted. My attitude reminds me of the ethos of Navy Seals, the American special forces unit: anything in life worth doing is worth overdoing. Moderation is for cowards. My dream finally did come true, when I walked onto a trading floor for the first time. THE TRADING FLOOR WALKING ONTO A trading floor is a special experience. I vividly remember being interviewed for a trading job after my university graduation. This took place on the trading floor of Handelsbanken, the Scandinavian bank, and the guy who interviewed me was the head of trading. I could tell that he was intensely focused on something else, and I was an inconvenient distraction. I have been in that situation many times in my trading life. Having a big position on in the market and then having to deal with the trivialities of the world outside of trading can be a peculiar experience. Boxing Day 2018 is a great example. I was trading the biggest one-day rally in the history of the Dow Jones Index, while eating Christmas pudding. I had to hide my mobile phones under the dinner table so as not to offend my host, and I had to fake numerous trips to the toilet so I could watch the chart on one phone and the broker platform on another. I arrived at the trading floor of Financial Spreads with a very different attitude to most of my colleagues. As I know many of them will read this book, I owe it to them to explain that I am not accusing them of being lazy. I had lots to learn, including the fact that when the markets are quiet, there really isn’t much for brokers to do. What I found was that people would sit around and read the newspapers or comic books. If the phone didn’t ring, you could hardly force a broker to do anything. I think this was the biggest culture shock I experienced – the contrast between a normal office job and a trading floor. Working on a trading floor is intimidating at first. As the months go by, you become immune to the money changing hands. It is all just numbers on a screen. I once walked in at 6 am to find that a Russian client was on a margin call for $10m. I quickly calculated that it would take me 133 years on my current salary to make $10m. By 7 am he had wired the funds over. This was a private trader. I was in awe. Inspired. There is a unique atmosphere present on a trading floor. When it is busy, it is nothing short of a gigantic melting pot of human emotions. I once saw a colleague of mine kick his PC so hard – repeatedly – that IT engineers had to come and replace it. It is hard to fathom that the financial markets are a complex mechanism if you just look at what is happening on a trading floor. It reminds you more of a local market stall on a busy Saturday morning in any given town anywhere in the world, where one stall owner is trying to out-voice the next. When you witness the raw, uncensored emotions that unfold before your eyes on the trading floor, it is difficult to see how that fits into a finely tuned global economic environment that makes up the very fabric of our modern society and civilisation. Impulse buying, panic selling, holding on to losses, refusing to admit defeat, greed, stupidity, stubbornness, despair, tears, abject depression, exhilaration and excitement are all on display here, and all in quick succession of each other. I worked for Financial Spreads for a year, and was then asked to leave. The same day I was headhunted to City Index, which was owned by ICAP – the biggest US government bond broker in the world. City Index had about 25,000 clients, of which 3,000 were active most days. These clients would trade currencies, commodities, stock indices, individual stocks, options, bonds and anything in between. I must have witnessed tens of millions of trades in my career, executed by thousands of people. Very few, if any, of them stood out, and if they stood out it was for all the wrong reasons. For every success story, I can tell you ten horror stories. NO MEMORY OF THE GREAT TRADERS I recently spoke to a friend of mine, who is the CEO of a trading company in London. I asked him if there were traders who had stood out during his 30 years working on trading floors. He said that over the years he had witnessed many bizarre things, but in terms of good traders, he had seen very few. Here is a man who has spent his entire adult life on trading floors, yet he is incapable of remembering people who did well. We are talking about a percentage of successful traders so infinitesimally small that it makes you wonder why anyone would want to trade in the first place, or if anyone could ever get good at this profession. The conversation with him went as follows. Tom: You have worked in the contract for difference (CFD) industry for 30 years. You must have seen some good traders along the way. Can you tell me about them? CEO: I wish I could. I have seen many people make a lot of money, but very few managed to keep the money. I started in the industry at a time when CFD trading was not a mainstream tool. It was mostly very wealthy people or people who worked in the industry that had CFD accounts. These clients back then often traded as part of an old boys’ club kind of network. It meant they mostly traded specific shares and some commodities. Back then trading was nowhere near as prolific as it is today. Tom: Were they good traders? CEO: No, I would not say they were. We had clients who were well-known personalities in the City, and their personal trading was often atrocious, even though they were hedge fund traders or fund managers. It was almost as if they lost their discipline when trading their own money. I am certain they would not be allowed to trade for their clients in the manner they traded for themselves. Today we have far more smaller traders, but the pattern is remarkably similar between a small trader and a large trader. Almost all clients have more winning trades than losing trades. As such you could argue that they are good traders. However, they tend to lose more, much more, on their losing trades than they win on their winning trades. The ratio is that for every pound they win, they lose about £1.66. Tom: How does a CFD broker make money out of that? CEO: Well, believe it or not, we want our clients to win. I have a network of contacts in the CFD industry. I regularly meet with CEOs of competing companies. Although we are competitors, and we would do anything to outmanoeuvre a competitor, we do have one shared wish. We wish our clients would trade better. We try our best to help them. We give them every tool under the sun. We give them favourable spreads, and we give them news services. We give them sophisticated charting packages. We give them data. We give them analytical tools to measure their performance. In short, we do absolutely everything we can to ensure they have all the tools they need to make money. And then we let them trade. The problem is that most smaller accounts tend to lose within a short space of time. Trust me when I say I wish it was different. I don’t know what more we as brokers can do for our clients. We prefer clients to make money because there is clear evidence that those who trade and win, carry on trading. That is better for business. The truth of the matter is that you can clearly see the difference between a consistently profitable trader and a normal trader. Their approach is very different. Tom: How can you tell whether someone knows what they are doing? CEO: There are a multitude of parameters that we may look at. If I have to narrow it down to the five most important factors, it would be these: 1. Account size. 2. Trade frequency. 3. Ratio of time spent holding winning trades versus losing trades. 4. Adding to winning or adding to losing trades. 5. Trading with a stop-loss. Someone who opens an account with anything less than £100 will, with a very high degree of certainty, lose that money, sadly. Someone who trades everything and anything, i.e., overtrading, will eventually lose their money. Anyone who is unable to hold on to their winners, but holds on to their losing trades, will eventually lose their money. Anyone who adds to their winning trades will catch our attention (positively), but anyone adding to their losing trades will, with near certainty, lose their account deposit at some point. Anyone trading without a stop-loss will follow that path too. We sadly see it all the time. As you can see, as brokers we do everything we can to help people make money, but people are people, which means they will find a way to self-sabotage. CONDITIONS 20 YEARS AGO I keep an eye on all brokers, to make sure I trade with the best and cheapest. Why would I pay 1.5 in spread if I can pay 1 in spread? That is simple economics. I run a business, and I want to spend as little on transaction costs as possible. One of my favourite instruments to trade is the German DAX Index. Today when I trade, I pay a 0.9 point spread in the DAX. However, when I started trading some 20 years ago, the spread intraday in the DAX was 6 to 8 points. I remember vividly trading the Dow intraday. You had to pay an 8-point spread in the Dow for the intraday product. If you wanted to trade the quarterly contract the spread was 16 points. This was at a time when the Dow was trading around 10,000. Today I am trading the Dow with a 1-point spread and the Dow is now trading around 35,000. You are much better off trading in 2020 than you were trading in 1999. It was much harder to make money trading back then. The market has to move significantly less in your favour before you are at breakeven now, compared to 1999. Another major advantage that people who start trading today have is the tools available from the brokers. Look at virtually any trading platform today, and you will see the length brokers go to in order to help you make money. You have access to hundreds of technical studies. You have access to instant news flow. You have the option to be trained through online material and webinars. You have access to Level 2 data for stocks all over the world. You have decent bid-ask spreads. If an institutional trader from 30 years ago saw the tools that you are trading with today, he or she would be green with envy. You have at your disposal every single conceivable analytical tool available from the vast resource pool of technical indicators. You have Bollinger Bands, you have Keltner Channels, you have moving averages. You have tools that I have never even heard of or used myself. Suffice it to say, every broker in the world has spared no expense in their effort to provide you with every opportunity to make as much money as you possibly can out of the markets. But it matters nothing. Most people will fail. The failure rate is astronomical in the trading industry. No one is immune to statistics. NORMAL IS A LOSER There is something inherently wrong with the approach of people who are trading. We have to assume that most people in society are normal, well- adjusted human beings. Their pattern of behaviour, while leaving room for personality, is most likely very similar. From cradle to grave, from morning to night, from one year to the next, the average person is engaged in a remarkably similar pattern: pattern of thought, pattern of action, pattern of hopes and dreams, fears and insecurities. We call that person normal. If normal is the familiar pattern, and if normal is opening an account with a CFD broker and proceeding to lose the money (sooner or later), then normal is simply a representative of everyone else. Everyone who is normal will end up losing. Is that a push too far? Let us look at the evidence. Let us take a look at the norm for a typical CFD trader in the retail trading space. Even though your broker makes all the tools under the sun available to you, no one is immune to the statistics of the financial markets. Unless you have gone through some sort of structured training, or you have been schooled by someone who is walking the path you yourself want to walk, or you give this endeavour some serious thought, you will most likely fail in the financial markets. Look at any broker website in the European Union, and you will see the failure rate. Brokers are obliged by law to post this on the front page of their website. Here are some of the biggest and most well-known CFD brokers in the world, and their failure rates: BROKER FAILURE RATE IG Markets 75% Markets.com 89% CMC Markets 75% Saxo Bank 74% FX PRO 77% Rates correct as of 7 November 2019. I know you like to think you are different. However, in the eyes of the financial markets, you are statistically like everyone else. You can look at the top ten brokers of the world and the statistics do not change. You can look at CMC Markets, you can look at IG Markets, you can look at Gain Capital, or you can look at any one of the top tier or second tier CFD brokers. No one will have a failure rate less than 70%. NORMAL IS NOT GOOD ENOUGH Tools do not make you a top trader. Techniques do not make you a top trader. If you want to be a good trader, if you want to achieve the level of success that you know is possible, you immediately need to stop thinking that the path to riches in trading has anything to do with the tools or techniques you are using. Yes, of course you need a strategy. Yes, you need a plan. Yes, you need to understand the markets. So, what is this book all about, if it is not about tools and strategies? Well, let me address that question from a different perspective. Let me address it from the perspective of the people who work in the industry as brokers and sales traders and as marketing people. Do they trade? I would say it is likely they do not. Yet, traders are taking advice, guidance and training from them; they being guided by people who are no better at trading than they are. It reminds me of Fred Schwed’s book, Where Are the Customers’ Yachts?, in which he says that Wall Street is the only place in the world where people who arrive to work by train and bus give advice to people who arrive by limousine and helicopter (slightly paraphrased for a more modern touch). Traders are being guided by people who can’t trade! WRONG FOCUS When you go to trading shows, read trading magazines or look at the online education materials on broker websites, 100% of the focus is on what I call How To: •How do I scalp? •How do I swing trade? •How do I day trade? •How do I trend follow? •How do I trade the foreign exchange (FX) market? •How do I use Ichimoku charts? •How do I trade with moving average convergence divergence (MACD) or stochastics? This is perfectly normal. The trade shows and magazines are geared towards providing the solutions that most people believe they need in order to make money in the financial markets. The brokers are following the same path. They provide the information that they think traders need and that traders think they need. Newcomers to the industry of trading are often guided by the very people who are likely to set them off on the wrong path. They are led to believe that it is all about technique and strategy – no one is preparing them for the fact that it isn’t strategy that will set them apart from other traders. It is how traders think about their strategy – and their ability to follow the strategy – that will set them apart. Do you not wonder if this is the right path for you? Do you not wonder about the futility of dedicating all your resources to one pursuit, when virtually everyone who walked that path before you has failed? You should. You really should ask yourself what makes you different to the 90% of traders that do not make money. If you are normal – as in you do what everyone else is doing – then you won’t make it. NORMAL WON’T CUT IT The organisers of one of these trade shows invited me to give a talk. This show was in London, and I was told I could talk about whatever I wanted. I decided to give a talk about the disastrous failure rate in the trading industry. My argument is that if 90% of all CFD accounts lose money, the problem is a human problem. I feel I am making a reasonable assumption when I say that everyone opening a CFD account is a normal person with a normal way of thinking. There must be something inherently wrong in the way normal people think and act that makes trading so unsuccessful for them. IT SHOULD BE EASIER THAN EVER TO MAKE MONEY TRADING I mentioned previously how small today’s bid-ask spreads are compared to 20 years ago. Therefore, it should be easier than ever for traders to make money. However, it isn’t. People are still struggling to make money trading. My main premise of this book is to get to the bottom of this conundrum. The approach I have taken is centred around the following facts: 1. It has never been easier to trade. The IT infrastructure is superb for traders. 2. The spreads have never been lower. 3. The margins have never been more favourable. 4. The tools have never been so readily available. 5. The brokers have never done as much for their clients as they do now. 6. The stock indices have never been higher, meaning there is volatility. To reiterate, I assume that people who open trading accounts are normal, well-adjusted human beings – without using this as a slight or an insult – who are perfectly capable of functioning within society. The questions I want to ask, and answer, are these: what does normal behaviour look like? How can I avoid being normal when I trade? If we assume that 80–90% of people trading are normal people, I want to avoid acting like they do. ARE YOU NORMAL? My argument, provocative as it is, asks an essential question: are you thinking like everyone else is thinking and approaching trading like everyone else is approaching trading? If so, you will have a problem. If you think like everyone else, is it so strange that you get the results that everyone else gets? Let us take a look at what normal behaviour is. Normal behaviour is to engage in a never-ending cycle of education, looking for the next new edge. I knew from the moment I read Liar’s Poker that I wanted to be a trader, but I never had any formal training in how a good trader behaves. Why should I? I was always told that a good trader buys low and sells high. But every time I bought low, it always went lower and lower. So what kind of advice was that? And yet this is the advice we listen to when we start. This is the benchmark, and if this is the benchmark, then it is a miracle that it is only 90% that are losing. It should be 100%, because buying low and selling high is a sure recipe for ruin. People will attend weekend courses hoping to learn secrets. People will study and learn to use tools such as candlestick analysis, stochastics, Relative Strength Index (RSI), MACD and moving averages. The list goes on and on. All of this is normal behaviour in a nutshell. EVEN THE BIBLE IS WRONG Even the bible of technical analysis doesn’t do much to help a person on their way, once the initial learning curve is over. The bible of technical analysis was authored by Robert D. Edwards and John Magee. The book is called Technical Analysis of Stock Trends, and it has sold millions of copies since its first printing in 1948. What most readers don’t realise, however, is that Edwards and Magee were not the real creators of modern technical analysis. Rather, it was a little- known technical analyst named Richard W. Schabacker. A brilliant market technician, Schabacker codified almost everything there was to know about technical analysis up to his time – which included such pioneering work as the Dow theory of Charles Dow. Between 1930 and 1937, Schabacker taught several courses to serious Wall Street traders and investors. Unfortunately, he died in 1938 when he was not even 40 years old. Shortly before his death, Schabacker gave a mimeographed copy of his lessons to his brother-in-law, Robert D. Edwards, who rewrote Schabacker’s lessons with the help of his collaborator, John F. Magee, an MIT-trained engineer. As a result, it was not Schabacker who received credit for the original compilation of technical analysis, but Edwards and Magee, whose work became a perennial bestseller. Let me be clear: reading a book like Technical Analysis of Stock Trends is a must, but please don’t think that it will make you a professional, profitable trader, any more than reading a manual on tennis will enable you to compete with Rafa Nadal. I see newcomers make classic mistakes after reading books on technical analysis. They will study indicators such as RSI and stochastics, and they will excitedly declare that a market is ‘overbought’ or ‘oversold’. What they don’t realise is that ‘overbought’ is an emotional expression for a psychological conceptualisation of ‘expensive’. The people reading a stochastics chart are led to believe – through a mathematical manipulation of data – that the market is now expensive, and it should be shorted. The same can be said for ‘oversold’. It is another way for the mind to tell you that the market is cheap, and that there is value associated with it. I’ll give you an example. Yesterday was a particularly bearish day in the Dow Jones Index and the German DAX 40 Index. I was short all day and I had one of my better days, all verified and documented on my Telegram channel. It was 1 October 2019. Towards the end of the day, when the Dow Index was falling even lower, a student of mine contacted me and asked me a very alarming question. The conversation was in Danish, and I have translated it here. “Tom, have you seen the stochastics indicator? It is deeply in ‘oversold’ territory. Do you think it is a good idea to buy now, ahead of the close?” I reply: “Hmm, I am short… maybe you should ask someone else.” He goes on to express his absolute shock that I am short, and a little later he goes on to state that he has bought the Dow at 25,590. Of course, when there is a buyer, there is a seller. However, I am not convinced that buying the Dow Jones Index ten minutes before the close, on a day where it has fallen 400 points, is a good idea. It reminds me of the kind of thinking I would have done 20 years ago. Not today though. If I buy the Dow on a weak day, just before the close, it is to close a short position. I value my sleep too much to carry a position overnight. I said to him: “You had all day to find a short entry. What are you hoping to achieve by being a buyer now? Are you thinking that because it has fallen 400 points, now it is cheap, and maybe just before the close, you may see some buying of these cheap stocks?” I used to think like that too. That was when I was not profitable. The Dow didn’t rally into the close. There was no bounce. I am sure my student didn’t lose a lot. It wasn’t so much his wallet I was concerned about – it was his way of thinking. That is what this book is about. It is about making you think the right way about the market. That is where the 80–90% of losing traders tend to go wrong. CLOSE THE SCHOOL If trading was a school, it would be closed. No school or university could function if 90% of its students failed their exams. We are all pretty much normal people. We fit in and function well within the fabric of modern society. If every person engaged in trading is a normal human being – and I assume they are, meaning they are well-functioning, intelligent, considerate, hard-working – then why is there a 90% failure rate in our industry? That doesn’t make any sense at all. Usually when people work hard at something they will succeed, or they will see some degree of success. That doesn’t appear to be the case with trading. Other professions do not have a 90% failure rate. If you go to the dentist, and you are told there is a 90% chance he will not be able to fix your teeth, you are out of there like a shot. Yet, those are the odds that face a private trader. But it doesn’t have to be like that. As traders, we tend to engage in a never-ending, predictable cycle. We trade well for a while. We are happy. Our discipline weakens. We lose money. We strengthen our resolve, and we get more education. We do well for a while. We lose money. We stop – sometimes for a while, sometimes permanently. Sound familiar? The sad part about this cycle is that everybody has good spells in trading. Everybody has periods when they make money. Everybody has their moments. I am sure you have too. So what happens? What happens is that 99% of people do not know how to lose. The emotions they experience when they lose cause them to act in a manner which is not in their own best interest. Emotions are response driven. Say you hear a funny joke, and you laugh out loud. That is an emotion. When you hear the joke the next time, you don’t laugh. Your mind has become habituated to the joke. When you fall in love with a beautiful man or woman you experience strong emotions, and your inner life is in beautiful turmoil. When you see that person, you just want to express your love for him or her, and be united with them, gaze into their eyes. As time goes by, your loving turmoil is replaced with a sense of calm. You love being around them, but the feelings of passion are less pronounced than they were in the beginning. You have become habituated to the other person. A free solo climber, climbing intimidating rock surfaces without ropes, is faced with severe consequences if they lose their grip. They acclimatise their minds through years of practice, so that their amygdala – the emotional response centre of the mind – is not firing on all cylinders when they are climbing. They are calm. An elite solider is scared to death the first time he is in a combat situation. That is why his first combat situation will be a simulation. And the next one. And the next one. And little by little, his fear is trained out of him, through the use of repetition, breathing awareness and habituation. For every hour you spend on technical analysis, you must set aside at least 25% of that time for what I call internal analysis. You need to know what your weaknesses are. You need to know what your strengths are. You need to know what you are good at, and you need to know what you are not good at. If you don’t spend time trying to improve these things, how will you get better? Very few people, if any, will engage in that level of introspection in order to gain the results they want. If making money trading is your goal, and 99% of people lose, and 99% of people think analysis and strategies are the key to trading profits, you can be 100% sure that strategies and analysis are not the key to trading profits. 43 MILLION TRADES ANALYSED There is a piece of research that makes for very interesting reading. It was the brainchild of an analyst called David Rodriguez, and it is brilliant. Rodriguez worked for a major FX broker, and he attempted to find out why there was such a high failure rate amongst its clients trading currencies. The broker had some 25,000 people who traded FX daily. Rodriguez investigated all the trades executed over a 15-month period. The number of trades was truly staggering. The 25,000 people executed close to 43 million trades. From a statistical point of view, that created a statistically significant and immensely interesting sample space to investigate. Specifically, Rodriguez and his colleagues looked at the number of winning trades. I would like to give you an opportunity now to think about how many trades were winning trades and how many trades were losing trades. You can represent it as a percentage of the overall 43 million trades. If you feel it has any influence on the answer you want to give, I can tell you that most of the trades were executed in Euro Dollar, Sterling Dollar, Dollar Swiss and Dollar Yen. However, the vast majority of the trades were executed in Euro Dollar, where the spread is very tight. Unfortunately, that doesn’t seem to make much of a difference to the outcome. 62% of all the trades by the broker’s clients ended in a profit. That is a little more than six out of ten trades. That’s a good hit rate. A trader with a hit rate of six out of ten should be able to make money from trading. Of course, it does depend greatly on how much he wins when he wins and how much he loses when he loses. Therein lies the problem for the 25,000 people. They were very successful in terms of hit rate. Yet when you look at how much they made on average per trade and how much they lost on average per trade, you soon realise that they had a major problem. When they won, they made about 43 pips. When they lost, they lost about 78 pips. There’s nothing wrong with having a system where you lose more on your losing trades than you win on your winning trades. However, it does require that you have a sufficiently high hit rate in order to absorb the losing trades. A colleague of mine, a professional trader from South Africa who trades at a hedge fund, has a hit rate of about 25%. I tell his story in greater detail later in the book, but let me explain the term hit rate in the context of his hedge fund. When his hedge fund loses on a trade, they lose 1X. When they win, they win as high as 25X. It stands to reason that my friend is immensely profitable even though he doesn’t have a convincing hit rate, at least not from a traditional perspective. What I find particularly interesting is how much bad advice there is in the trading industry. You will often hear traders talk about risk-to-reward ratio, which in itself is fairly innocent, unless the trader takes it literally and applies it on a trade-by-trade basis. When I call out trades in my live TraderTom Telegram group, I will always announce a stop-loss. Always! However, I often get asked if I have a target in mind. The answer is quite often a little sarcastic: “No, my crystal ball is out for repairs,” or if I am particularly grumpy and tired, I will be rude and say, “Sorry amigo, but do I look like a fortune teller to you?” Yes, I know – that isn’t very polite. I’m sorry. Ignoring my blatant inability to be polite when I am faced with the same question for the 450th time, there is a deeper meaning to me not calling targets on my trades. It has a lot to do with risk versus reward. RISK VERSUS REWARD I personally find the whole risk-to-reward concept enormously flawed, but since I am the only one who ever talks about it, I accept that I am probably wrong. Still, hear me out. How on earth do I know what my reward will be? I literally do not know. Even if I pretended to know – say, by using a measured move calculation or a Fibonacci extension – I know myself well enough to know that I will have added to my trade along the way. When it got to my target, I would not close it, because that is my philosophy. I would kick myself if I closed a trade at my target, and then it went even further. I would rather give away some of my open profits than miss out on potentially even more profits. Now I am probably making a big fuss out of nothing, but targets are not for me. I want to see what the market will give me. I am prepared to accept that this may mean I will give away some of my open profits. I have lost count of the number of times I have had a 100-point winner in the Dow, which then turned into a zero. A week before writing this (all documented of course) I had one such winner, which turned into a big fat zero. Some less-than-happy traders confronted me in my live trading room as to why I had not taken my profits. It is difficult to explain, but it is all to do with pain. It gives me much less pain to kiss a 100-point winner goodbye than it does to take my 100 points, only to see the market moving even more in my favour. It is because of this philosophy that I am at times able to make 400–500- point gains, as I did today. It is one or the other. I don’t think you can have the best of both worlds! INTERVIEW WITH CNN In an interview with CNN some years ago, I was asked about the traits of winning traders. In this very candid interview, I highlighted a few points that I felt differentiated the winning traders from the losing traders. It was based upon my experiences from observing millions of trades by retail traders, while I was on the brokerage trading floor. Here are the main differences I identified: 1. TRYING TO FIND THE LOW When the market is trending lower, whether intraday or over a longer time frame, there seems to be a tendency for retail traders to attempt to find the low of the move. Whether that is out of a desire to buy cheap, or because they use ineffective tools, I simply don’t know. What I do know is that this trait is immensely damaging to anyone’s trading account. Winning traders seem to be much more trusting of the prevailing trend. This attitude adjustment may seem trivial, but it literally makes the difference between the winning trader and the losing trader. Over time the losing trader will repeat his distrust in the prevailing trend and will take positions against it. He will do so because from an emotional standpoint it appears as if he is buying a market that is cheap or selling short a market that is expensive. This is emotionally satisfying, like buying toilet paper at a 50% discount from the local supermarket, but the financial markets are not supermarkets. There is no ‘cheap’. There is no ‘expensive’. There is just the prevailing price. The winning trader, however, is not emotionally attached to an idea of ‘cheap’ or ‘expensive’. He is focused on this moment right now, and in this moment right now the market is trending, and he trusts this trend and can unemotionally join this trend without internal discomfort. 2. TRYING TO FIND THE HIGH The opposite also holds true. When the market is trending higher, traders tend to want to find a place to sell short. Although it must be said that people are generally better at jumping on board a market that has already risen than they are at jumping on board with a short position in a market that has already fallen significantly. If the market has moved higher by a significant amount, especially in the very short term, retail traders tend to want to fade the rising prices, i.e., they look to establish short positions. Again, this is probably the result of a distorted view of things being cheap and things being expensive. 3. THINKING EVERY SMALL COUNTER-MOVE AGAINST A TREND IS THE START OF A NEW TREND I have sat on a trading floor through the darkest days of the financial markets. For example, 15 September 2008, when Lehman Brothers was declared bankrupt, the Dow Jones Index fell 4.5%. Throughout that trading day, there were two attempts to rally. Both failed. It was tragic to see how many clients tried to buy the low of the day, only to see the Dow move lower and lower. Whenever there was a single green candle on the 5-minute chart that day, we saw the buy order flow into our position monitors on the trading floor. It seemed as if the clients were possessed by the notion that a low was near, and that they had to be the one buying it. The low didn’t come that day. Nor the next day. This is a common trait amongst traders. They think that every single little counter reaction against the trend is the beginning of a new trend. More fortunes have been lost trying to catch the lows in a falling market than in all wars put together (okay, this is an unsubstantiated statement made for emphasis, but please don’t attempt to catch lows). It seems obvious to me that newcomers and probably also some seasoned traders – profitable or unprofitable – believe that successful trading is all about charts. This belief is a detriment to their accounts, because no one ever took the time to tell them otherwise. No one told them, or thought to tell them, or knew enough to tell them, that actually focusing all your time on your charts is a mistaken strategy. We’ll look at this further in the next chapter. EVERYONE IS A CHART EXPERT I ONCE DECLARED IN an article that you can learn the basics of technical analysis over a weekend. I may have exaggerated a little – but only a little. I know without an inkling of doubt that a chart expert does not equate to a trading expert. I have seen so many of my trading friends build impressive libraries of technical indicators and acquire knowledge about both known and obscure technical indicators. But it didn’t translate into making more money. When it comes to charts, less can be more. Charts can be as simple or as complicated as you want. There seems to be a tendency amongst traders to make charting more complicated than it really needs to be. I have seen many new traders plaster their charts with so many tools that they can barely see the price chart itself. It surprises many people, especially newcomers, when they see my chart screens. There is not a single indicator on them. Not a single one. I might be old fashioned, but I don’t need these extra tools. My job as a trader is to find low-risk trading setups. My approach to trading is not centred around any other tool than price itself. All indicators – more or less – are built from time and price. Therefore, the indicator is a distortion of the reality I am seeing right in front of me. The markets can be range bound, or the markets can trend. Some indicators work well in ranging markets. These usually perform terribly in trending markets. Other indicators work well in trending markets, but are dreadful to use in range-bound markets. As a famous trader friend of mine, Tepid2, once said on the now-defunct trader feed Avid Trader: “Indicators – they all work some of the time, but none of them work all of the time.” I think that many of the 90% of people that lose money trading may very well have excellent chart reading abilities. They can read charts very well, and they understand patterns too. However, I happen to think there is much more to trading than knowing a head and shoulder formation, a bar chart pattern or a Fibonacci ratio. I have seen outstanding traders juggle millions of pounds worth of stock index futures contracts using nothing but a simple ten-minute chart. In fact, I do that myself every single trading day. I truly believe that what separates the 1% from the 99% is how they think when they are in a trade, how they handle their emotions when they trade. That is not to say that there is no merit to learning the craft of chart reading. I know from my own experience that chart reading is an absolute must for my decision making, but that is only a small part of the whole trading picture. The proliferation of gurus selling trading courses is evidence there is a demand to learn the art and craft of trading. I suspect the ‘shortcut’ of a weekend course is a much more appealing proposition than spending that time reading books. If a guru holding a weekend course on trading claims that you will be qualified to trade “like the millionaire professionals” by the Sunday night, then the unsuspecting will select that option. It is perfectly natural to expect a human being to drift down the path of least resistance. Learning any new skill takes time. So when you see an advert saying “learn a new language in 30 days”, you might not believe it consciously, but subconsciously you want to believe it, because people love shortcuts. Similarly, a diet book that promises you will lose 5kg in a year is unlikely to sell as well as one promising you will lose 5kg in two weeks. My philosophy to life is different from so many other people’s. This is the reason I have what so many people dream of. I will choose the path of most resistance, because I know I need to stay clear of the opinion of the 99%. If you think I am conceited, then you are thoroughly mistaken. I have no inflated view of myself. Quite the contrary. I decide carefully what I want, and then I work towards it. This book reflects that ethos. You truly can be a master trader. You truly can live in the house you desire, with the cars you desire in the drive. BUT you must believe me when I say that in order to get what you want, you need to think like the 1%. In fact, you don’t even need to think like the 1%. You just need to not think like the 99%. The following trade is a good example of how mindset trumps technical analysis any day of the week. In this example I short the German DAX 30 Index. I get stopped out for a loss. I kick myself, because my stop-loss gets exceeded by a point or so, only to reverse back in my favour. My stop was too tight. Rather than lose my composure, I dismiss it. Let me pause for a second. Do you know why some athletes let out a shout of frustration when they are not performing well? I thought about it for a while, after I saw Serena Williams shout when she lost an important point in a Wimbledon tennis final. I think they let out a cry because it is a way to reset the mind, to come back into balance and get into the zone again. The act of letting out a cry helps them get rid of the frustration and find their inner peace and balance again. I re-enter a short position at 14,479.80. The screenshot below is from the time of the trade.     AmountOpen PriceCurrent PriceOpen P/L Germany 30Sell 200 12479.812478.5 € 260.00 Wall Street 30Sell 200 27044 27046 −$500.00 The chart at the time of the trade looks as shown in Figure 1. Figure 1 Source: eSignal (esignal.com) The DAX had gapped up. Did you know that only 48% of all gaps get filled on the same trading day? By the third trading day after the gap, 76% of gaps were filled. Why am I telling you this? Don’t believe trading books stating that all gaps get filled. They do not! I short the DAX because the second bar on the chart is an inside bar – from the first ten-minute bar at the open. The third bar closes below the lowest point of the inside bar. Now I have a sell signal, because the first bar’s high is at the same price as a prior high – a double top. I have a stop-loss in place. I have done my job as a trader. I have identified a low-risk entry point, and I have placed my stop-loss. At this point in time, I am at the mercy of the markets. Maybe this will be a great trade. Maybe it won’t. Who knows? No one knows. Before I carry on, I would like to ask YOU a question. It is a question for you to ponder upon. Say you believe in the whole risk-to-reward argument, and you decide that you have a 40-point profit target. You decide upon a 40-point profit target because you risked 20 points. So, you argue that risk-to-reward is 2:1, two units of profit for one unit of risk, which sounds good. It all sounds great, and there is virtually no textbook on trading that would argue against it. But I am arguing against it. I want to ask you some simple questions. If you make 40 points on this short position, and the market continues in your favour, how will you feel? How will you feel if a few hours later you see the market down a further 100 points from your exit? I think the risk-to-reward concept has been designed by an academic who does not understand risk and the mind’s association with risk. I think this academic has created a method to keep his mind at peace, in order to avoid pain. Fifty minutes later the DAX is filling the gap. This is shown in Figure 2. The position is in profit. Figure 2 Source: eSignal (esignal.com) A colleague of mine has followed my trade. The chart is looking good for us. We are in a conversation about the trade. It goes like this: Friend: I am tempted to take my profit. Do you have a target for this trade? Tom: Amigo, I don’t trade with targets. Let’s see what the market will give us. Stop-loss is at breakeven. We can’t lose. Friend: Yes, I know. But yesterday was a poor day of trading. I lost 150 points. I read the market poorly. I had an idea, and the idea didn’t work out. Either way, I lost 150 points. If I close my DAX position right now, I can make up for the lost trade this morning, and I can recover a lot of the points lost yesterday. What do you think? Tom: I think you are trading yesterday’s experience. You haven’t wiped the mind-slate clean. You are not present. You are focused on the past. You are trying to get back to an emotional equilibrium. You are in a state of imbalance because you are unable to shake the loss from yesterday. As a result, you are not judging the trade on its own merit, but on the merit of a past trade. You are not seeing the world as it is. You are seeing it as you are. I understand it is a soothing thought to close the trade. However, we are not trading to break even. We are trading to make money. Can you appreciate that trading is a mind game? It is a game of nerves. My friend was understandably shaken from his loss yesterday. He carried the loss over to the next day. It affected his decision making. Back in 2007 I was invited to the Wimbledon tennis final. My friend was a big name in the media industry, and none other than Ralph Lauren had invited her to the tennis final – with a guest. So, there I was in the VIP tent, and I got to sit next to Luke Donald, who at the time was one of the best golfers in the world. He is a softly spoken man, and very polite. We got talking about Tiger Woods, and I asked him a pretty to-the-point question about competing with Tiger. “Is Tiger Woods a better golfer than you?” I found his answer so incredibly insightful that I never forgot it. He said: I don’t think Tiger is a better golfer than me, if you measure it in how well we putt, or how far we hit the ball, but Tiger Woods does have an amazing ability to forget his mistakes and move on. For example, we can be on the 15th and both make a bad putt. By the time we get to tee up on the 16th, it is as if Tiger has wiped his mind of whatever happened on the 15th, and he is totally in the moment. I, on the other hand, will still deal with the mistake I made on the 15th, and it will affect my performance on the 16th. That is a truly insightful perspective of what really separates the very best in a chosen field. It is the mind, and what it processes at any given moment in time. Is it working with you or against you? COGNITIVE DISSONANCE My friend is having a ping-pong dialogue in his head, arguing for and against taking profits. I am no stranger to that conversation. I may have many years of trading experience, but I still have those thoughts in my head. I am just mindful of them when they arrive. When they do, I focus on the chart and what it is telling me. I don’t look at the profit and loss (P&L). What my friend is experiencing is known as cognitive dissonance. In the field of psychology, cognitive dissonance is the mental discomfort – psychological stress – experienced by an individual who simultaneously holds two contradictory beliefs or ideas in their head. This discomfort is triggered by a situation in which a person’s belief clashes with new evidence contradicting that belief. When confronted with facts that contradict beliefs, ideals, and values, people will try to find a way to resolve the contradiction to reduce their discomfort. The best way for your rational mind to resolve the discomfort of a profitable position is to close it. The best way for the rational mind to resolve the discomfort of a losing position is to let it run. In his 1957 book, A Theory of Cognitive Dissonance, author Leon Festinger proposed that human beings strive for internal psychological consistency to function mentally in the real world. He says that a person who experiences internal inconsistency tends to become psychologically uncomfortable and is motivated to reduce the cognitive dissonance. One way to achieve the goal of reducing the discomfort is by making changes to justify the stressful behaviour, either by adding new unsubstantiated or irrelevant information to the cognition, or by avoiding circumstances and contradictory information likely to increase the magnitude of the cognitive dissonance. In my friend’s case, he is conflicted. He is associating pain with the performance of yesterday. He has an opportunity to eradicate the pain by closing his profitable position right now. The way he justifies this reasoning is by ignoring the information the market is giving him about his position. The market participants agree that the market should be sold short, but instead of acknowledging this, he is ignoring it. From a logical point of view, this all makes sense. From an emotional point of view, this is an inconsistent approach to trading. Our trades from yesterday have no bearing on the markets today. It is a new day. It is a new set of circumstances. Yet to most people’s minds, the two trading days are connected. To our minds we are continuing today what we did yesterday. “Why wouldn’t we be?” we tell ourselves. Are you telling me that you can ‘reset’ your emotions every morning? Are you telling me that you can go to bed at night after a blazing row with your loved ones, and wake up reset and emotionally in equilibrium? I doubt it; at least, not without a conscious effort. It is for this reason that I warm up ahead of the trading day by going through a process. We cover that later in the book. It is, after all, what the book is about. It is a recipe book for methods to avoid the pitfalls that the 90% experience. Now, what is the source of my friend’s turmoil? It is fear. Pure and simple. He is afraid he will lose what he has made on paper. He is desperate to get back to an emotional state where he is at peace. He is no longer trading the charts. He is no longer trading the markets. He is trading his own mental wellbeing. FEAR My friend is fearful. He is afraid that the money he lost yesterday will not be offset by the good trade he has going now. He is afraid that the profits he is currently experiencing will diminish, or in the worst case disappear. He acknowledges that he can’t lose on the trade. The stop-loss is now at breakeven. Unfortunately, that gives him little comfort. I once saw a quote that made me smile: everything you ever wanted lives on the other side of fear. Yet fear is a necessity in our lives. The human brain is a product of millions of years of evolution, and we are hardwired with instincts that helped our ancestors to survive. We need fear to ensure survival in certain situations, but many of the fears that we carry are not appropriate for our trading. Our minds have a primary function, which is to protect us against pain. If you introduce big drastic changes in your life, you are likely going to come face to face with that pain. A clever way to build staying power during change is to introduce that change slowly. Say you set yourself the ambitious target of running a marathon. You achieve this goal by building up your body and mind for the task. Trading big size is exactly the same process. You need to give your mind time to learn to handle the mental anguish that comes from losing when the stakes are bigger. There is no point in comparing yourself with others. Sure, take inspiration from others; but know this is a personal journey, and your job is to achieve an equilibrium mindset, no matter what size you are trading. PHILIPPE PETIT I saw a documentary about Philippe Petit a long time ago. Petit was a French artist who strapped a wire between the two World Trade Center buildings and then walked across it – several times. What struck me about the incredible feat was the preparation. It took Philippe some seven years of physical and mental training to accomplish the feat. Did you think he just set off and hoped for the best? No. In fact his original training height was quite modest compared to the altitudes he would eventually reach. Philippe Petit is a fascinating character; he is someone who has had to deal with fear at a level beyond that which the rest of us have. I have learned a lot about fear and identifying my own shortcomings by studying his approach to his craft. VISUALISATION “Before my high-wire walk across the Seine to the second story of the Eiffel Tower, the seven-hundred-yard-long inclined cable looked so steep, the shadow of fear so real, I worried. Had there been an error in rigging calculations?” How does Petit overcome these doubts? With a simple visualisation exercise. “On the spot I vanquished my anxiety by imagining the best outcome: my victorious last step above a cheering crowd of 250,000.” Added to this, Petit exaggerates his fears. Rather than try to muscle through or outwit fear, he suggests taming it by building it up so that when you are finally faced with your fear, you will be disappointed by how mundane the threat really is: A clever tool in the arsenal to destroy fear: if a nightmare taps you on the shoulder, do not turn around immediately expecting to be scared. Pause and expect more, exaggerate. Be ready to be very afraid, to scream in terror. The more delirious your expectation, the safer you will be when you see that reality is much less horrifying than what you had envisioned. Now turn around. See? It was not that bad – and you’re already smiling. He goes on to say that he has fears like everyone else. In particular, he talks about his dislike of spiders: On the ground I profess to know no fear, but I lie. I will confess, with self-mockery, to arachnophobia and cynophobia [fear of dogs]. Because I see fear as an absence of knowledge, it would be simple for me to conquer such silly terrors. “I am too busy these days,” I’ll say, “but when I decide it’s time to get rid of my aversion to animals with too many legs (or not enough legs —snakes are not my friends, either), I know exactly how to proceed.” I will read science reports, watch documentaries, visit the zoo. I will interview spider-wranglers (is there such a profession?) to discover how these creatures evolved, how they hunt, mate, sleep, and, most importantly, what frightens the hairy, scary beast. Then, like James Bond, I won’t have any problem having a tarantula dance on my forearm. Petit’s walk remains one of the most fabled – and stunning – acts of public art ever. He says there was no why behind the act. To quote his own words: To me, it is really simple. Life should be lived on the edge of life. You have to exercise rebellion, to refuse to tape yourself to rules, to refuse your own success, to refuse to repeat yourself, to see every day, every year, every idea as a true challenge, and then you are going to live your life on a tightrope. THE EGO, AND WONDERFUL FAILURE I am not a fan of clichés. They display a lack of original thought. I am quite cynical towards those who peddle clichés. It doesn’t sit well with me to hear people say that I should run my profits and cut my losses. Yes, but how do I deal with the fear of running my profits? It doesn’t sit well with me when a female friend tells me she is in an abusive relationship, and another friend chirps in and dismissively states that the solution is to “just leave the bastard.” It is a platitude. It is factually true, but it is nonsense, nevertheless. When a solution is obvious, the problem is rarely the only problem. You might as well tell an alcoholic to just stop drinking. There is a reason he is drinking, and there is a reason he is struggling to stop. Does failure exist? I come from a home where you rarely received praise for your achievements. They were expected. The failures, on the other hand, were pointed out – and not in a constructive manner. I had to retrain my mind to stop being afraid of making mistakes. I used to have a favourite saying as a child: “It is not my fault”. Today the buck stops with me every time. It is always my fault. I am good at making mistakes, so that I can learn from them. Failure is a friend in life – if you tell your mind that it is okay to fail. I participate in a radio programme about trading and investments. The focal point of the show is the competition between two other traders and me. The competition is always fierce, and every week we are questioned about the content of our portfolios. My trading style is quite black and white. If I think the market is headed lower, I will buy some put options or some bear certificates, and vice-versa if I am bullish. I learned a long time ago that the best way to shut down a journalist is to be 100% honest. So, when the radio host baits me by saying “Uhm Tom, you got that one wrong, huh?”, the worst thing I can do is to start defending myself. If I start making excuses or argue a defensive stance, I simply pour petrol on that fire. It is such a great metaphor for life. Own up to your errors and be done with it. So, when the radio host is trying to engage in a line of questioning aimed at getting me to defend myself, I always double down in the opposite direction by saying something like, “Oh my lord, I don’t think I could have been more wrong, even if I tried,” or “Oh boy, even a five-year-old could have done better than me.” TRADING MIND UPSIDE-DOWN From my research into the behaviour of our clients during my years at City Index, I concluded that the overwhelming majority had an unhealthy mental thought pattern. They would feel fear at times where there was no reason to be fearful. This would manifest during times in which their positions were making money. However I manipulate the argument, it is still a fear of losing. In this case it is the fear of losing the profits accrued on paper. When the clients were in losing positions, they would be reluctant to realise the loss. It was as if they had the attitude that as long as the position was open, it might still come good. As I see it, they opted to replace fear with hope. They hoped the losing position would come back to breakeven. Going back to the DAX example, my friend hung on to the trade. I did my best to guide him through the pain. He moved his stop-loss down. It meant he had some profits to show for it, if the market moved back up again. In my experience if you can guide a person through a successful trade, where he or she holds on to the trade, you will begin to create the right kind of neuro-associations. The trader will experience the thrill of holding on to a trade. They will experience the joy of locking in more and more profits. My friend was over the moon with the development of the chart. However, it was quite clear that he was constantly looking for reasons to take profit. The thought of leaving money on the table did not sit well with him at all. To his credit he held on to the trade, spurred on by my conviction that the market showed nothing but weakness. We were soon rewarded by a sudden liquidity vacuum. I try not to get excited when the market is giving me a windfall. However, at times even I will have to fist pump the air, even though I am alone in my office. The whole trade sequence is displayed in the time-stamped records in my Telegram channel under 1 October 2019. See Figure 3. Figure 3 Source: eSignal (esignal.com) ELON MUSK I am not a fan of Tesla. This is due to the fact I shorted it and lost big. Yes, I know. What a silly argument, considering Teslas are seemingly good cars. I am a fan of Elon Musk, however. We are bound to make mistakes in life, but mistakes are like fuel for the rocket of improvement. Talking of rockets, how do you think people like Elon Musk handle failure? He is trying to accomplish incredible, life-changing things – things like the electrification of automobiles and the colonisation of space – and he does it while the whole world is watching. For him the possibility of failure is ever present. Not only that, but when he fails it becomes spectacular headline news. Yet Musk just keeps on going and going, doing things that are extremely risky but also extremely important. How does he handle his fear of failure? Does he even fear failure at all, or is he somehow hardwired with resilience again this form of anxiety? Apparently not. Musk has publicly stated he feels fear quite strongly. So how does he keep going despite this terror? There are two main elements to Musk’s ability to overcome his fears. The first is an overwhelming passion for his projects. He admits that SpaceX was an insane venture, but he had a compelling reason for pushing ahead: I had concluded that if something didn’t happen to improve rocket technology, we’d be stuck on earth forever. People sometimes think technology just automatically gets better every year but actually it doesn’t. It only gets better if smart people work like crazy to make it better. By itself, technology, if people don’t work at it, actually will decline. Look at, say, ancient Egypt, where they were able to build these incredible pyramids and then they basically forgot how to build pyramids… There are many such examples in history... entropy is not on your side. Elon Musk was not prepared to sit idly by and watch history repeat itself. The second element is what Musk calls fatalism. Just focusing on why you’re taking a scary risk isn’t always enough to overcome hesitation. It wasn’t for Musk: Something that can be helpful is fatalism, to some degree. If you just accept the probabilities, then that diminishes fear. When starting SpaceX, I thought the odds of success were less than ten percent and I just accepted that actually probably I would just lose everything. But that maybe we would make some progress. He is not the only one to use this approach. Visualising the worst-case scenario can make us appreciate objectively what we are trying to achieve. Facing our fears removes their power over us. Have I digressed too far from the trading journey ahead? I don’t think so. I draw inspiration from many sources, both in and outside of the trading world: Kobe Bryant, Rafa Nadal, Cristiano Ronaldo, Sergio Ramos and Charlie Munger, to name a few. Very different people, yet all obsessed with the journey, the enrichment of their lives and the perfection of their craft. Studying their approach to their work suggests they found the thing they would love to do even if they didn’t get paid for it. I am sure they are businessmen too, and I am sure they keep an eye on the dollars coming in. However, it feels like they perform their craft for the love of it. DO YOU WANT IT BAD? How bad do you want it? Is this journey for you? I don’t know. Only you can answer that. Permit me to ask you a question: what is the alternative? You are reading these pages because you want to trade well. Perhaps you have been in my live trading room, and you have seen what my trading philosophy is doing for me. You want to learn more. I applaud that. Perhaps it is time to acknowledge trading for what it is? It is a great way to expose all your flaws. It is a great way to highlight your strengths. Through my trading and my research, I have uncovered weaknesses in my character. For me, the side benefit of earning a living from trading the financial markets is the character traits it instils in me. I am more patient than ever. I am much more focused and disciplined than I was before. Failure is one of our greatest learning tools. TIMES OF DOUBT Do you really want to trade profitably? I have had to answer that a few times in my career. I have had to make some sacrifices along the way. I have been called out once by a coach who felt my effort was insincere. I recently found myself having dinner with a friend. I have known him for 15 years. I met him when I gave a speech somewhere in the North of England. My friend had asked if he could consult with me while I was in Manchester to give a talk about trading, and naturally I agreed. As we ate, he became very animated. At one point he knocked over a glass of water while expressing his frustration with his trading. It was difficult to really pinpoint what the problem was in his trading, because he never made any specific reference to a problem. It was clear to me that he really was in distress and wanted help, but I was unable to figure out in what capacity my help should come. So, I offered him help in the one area that I felt was appropriate. I offered to go over his trading statements. As I see it, that is the only way I can really help someone. It is a lot of work, but at least I am getting a sense of who he is as a trader. As we said our goodbyes, he told me he would send over his statements. I confirmed, and said I would look forward to hearing from him. As I write this, he has not emailed me. He has not written to me on message apps. Silence. Not a word. If I am offered help in an area where I desperately want to excel, and the help comes from a friend who is an expert in the area, I will respond as soon as I can, if not immediately. As of some four to five days later, I haven’t heard a peep. How badly do you think he wants this? How desperate do you think he is? I question how much he really wants this. I have observed this pattern on several occasions. The student claims to be really keen, but in reality it is mere words. It reminds me of a conversation that the famous trader Ed Seykota had with another brilliant trader and friend. The friend told Ed that he intended to coach a losing trader into a winning trader by teaching him some important pointers that were missing from his trading. Ed Seykota paused for a second, and then said that the friend would fail to teach the student anything. He said that a losing trader is not going to wish to transform himself. That is the sort of thing that only winning traders do. We can all ask for guidance from someone who is better than us. As the saying goes, you only get better by playing a better opponent. I have guided many that were already well on their way to trading with confidence. I merely refined and suggested. Whether I will hear from my friend or not remains unknown. What is known is that many people open trading accounts in the hope of making money. Their effort is disproportional to their expectations, and their results are aligned with their effort. They simply don’t work hard enough. Before I move on to the next topic, I want to warn you: I am a trader who uses charts, but that doesn’t mean that I believe charts are responsible for my profitable trading. I once read that technical analysts are afraid of heights. That is another way of saying that they are unable to let their winners run, because they keep seeing overhead resistance. I have called the next chapter ‘The Curse of Patterns’, because I believe fully that as much as patterns help us, they also make our trading lives difficult. In the search for patterns, we see things that are simply not there. THE CURSE OF PATTERNS IF YOU STRIP away the time and price axis of a chart, you will likely be unable to differentiate between a five-minute chart and an hourly chart. In a sense, that is good news. It means we can perfect our craft and then find a time frame that suits our trading temper. The trader with the ability to focus for long stretches of time will find the one-minute chart and the five- minute chart provide ample opportunity to make money. The trader with time constraints will probably favour a longer time frame such as the hourly chart or the four-hour chart. It means he or she doesn’t have to check the chart so frequently. Charts are far superior to fundamental analysis when it comes to entry points and exit points, and I can use the same tools, irrespective of what time frame I am trading on. Am I opposed to fundamental macroanalysis? I would be a fool if I dismissed the fundamentals. The two should not be in opposing camps. They should walk hand in hand, as they complement each other and make up for each other’s flaws. Now, I would not go so far as to say that chart analysis is the Holy Grail. Yes, I have made a lot of money from trading charts, but it was not my ability to read a chart that made me a wealthy trader. I don’t believe that there is a Holy Grail when it comes to trading, and I certainly don’t believe that chart analysis is the Holy Grail. PATTERNICITY Apophenia is a Latin word that, translated into English, means patternicity. This is a behaviour centred around seeing things that aren’t there; the tendency to perceive meaningful patterns and connections amongst unrelated events. Patternicity is often a harmless diversion. However, it can be used to support a belief that is otherwise lacking in evidence, like a conspiracy theory. Our minds tend to seek out the information that confirms the bias that we have already decided upon. Therefore, to be completely objective in chart analysis is virtually impossible. My early mentor Bryce Gilmore once commented on this fact. He said to me, “Tom, you only see in the markets and on charts what you have trained your eyes to see.” Another perspective of such wisdom was expressed by Anaïs Nin. She said, “We don’t see things as they are, we see them as we are.” “What is the relevance to trading?” I hear you say. I had a friend a long time ago who had made a lot of money trading. Nick was a great trader, right up until 2004. He started reading and believing some writers and contributors on Zero Hedge and he turned bearish on the stock market. He kept shorting. But the market kept going up. He just could not accept that there was no more downside after the bear market of 2000–2003. He didn’t see the market as it was. He saw it as he was. He was negative. He had read that the bear market would continue. He stopped trading what he saw, and he let his opinion cloud his objectivity. Nick no longer trades. I didn’t want to write a book on charts. There are so many books on technical analysis, written by people who I doubt trade full time. I think they tell themselves that because they have a trading account and because they trade from time to time, they are qualified to write books on trading. Although I trade full time, I really don’t think I could add anything new to the world of charting. Charting didn’t make me money. Indicators never made me money. Ratios and bands never filled my bank account. As I am about to post some charts, I want to point out to you that it is to prove a point, rather than to educate you on the merits of technical analysis. THE TREND LINE FANATICAL In the early stages of our chart journey, we come across trend lines. Trend lines are easy to use, and they give the appearance of a great trading strategy, especially when we do it after the fact. Figure 4 shows a naked chart. The diligent chartist begins to draw trend lines. He or she has the full overview of the day. Figure 4 Source: eSignal (esignal.com) Remember, the brain will have as its prime objective – I repeat, PRIME OBJECTIVE – to avoid you experiencing pain. A losing trade equals pain. So, the brain sends a signal to the eyes to ignore the setups that do not work. This selection bias creates a distorted image of the validity of trend lines. You can replace trend lines with any other analytical tool from your charting package, and the bias will remain in place: Fibonacci, Bollinger Bands, Keltner Channels, etc. Your eyes will only see what they want to see. At best they may see the losing trades, but they glance over them, diminishing their significance. The result is predictable. The researcher will end up with a chart that looks like the one in Figure 5. It has a lot of trend line setups that all result in great trades. Figure 5 Source: eSignal (esignal.com) There are no losing trades. Every single trade results in meaningful profits. Such is the power of our subconscious. Cynical traders (people like me) will notice things other traders miss – not because others don’t have the ability to see them, but because they don’t want to. See Figure 6. Figure 6 Source: eSignal (esignal.com) If you are in a research position, and you draw enough of these trend lines after the fact, you’re most likely going to conclude that trend lines are nothing short of a fantastic tool, perhaps the Holy Grail. There is nothing wrong with trend lines, but they will not make you rich. What will make you rich is how you think when you trade. If you think like everyone else, then your results will be like everyone else’s. Don’t you want to make money? Don’t you want to separate yourself from the herd? Then realise that trading profitably has nothing to do with the instrument you use. In order to prove to you how pointless it is to research tools, I would like to introduce you to two of the world’s most esteemed traders, Larry Pesavento and Larry Williams. LARRY PESAVENTO VERSUS LARRY WILLIAMS The two Larrys are both in their senior years. They are both Americans, and incidentally they are friends. Both of them have enjoyed trading careers spanning decades. Both of them have made their living from trading. Larry Pesavento is famous for his use of patterns and Fibonacci ratios. Larry Williams is famous for his pattern recognition setups. Both have written several books on their chosen tools. In a workshop I organised back in 2005, Larry Williams – who was one of the speakers – showed statistics from the S&P 500 Index, which depicted all the major retracements on an hourly chart spanning a decade. As you can imagine, there was virtually every single conceivable percentage retracement on display. What did not stand out, though, was 61.8% or 38.2% – the two prominent Fibonacci ratios. Sure, they were there, but they were surrounded by masses of other percentages. Yes, it turns out the magical growth sequence of Fibonacci does not, after all, rule the market. So how come it works for Larry Pesavento? The answer is simple: it doesn’t have to work all the time to make it a profitable strategy. In Oslo, Norway, in 2016 I gave a talk on Fibonacci ratios. For the talk I had researched all occurrences in which the German DAX Index retraced 78.6% – the square root of 0.618 – and I proved that although the 78.6% retracement had a hit rate of 20%, it could still be a useful strategy. You had to risk very little and go for big pay-outs for it to work. S&P 500 & FIBONACCI The S&P 500 enjoyed an 11% rally during the summer months of 2021. The index rallied from 4,050 to 4,550. Along the way, as you can see on the next chart, there were three significant retracements. The role of the Fibonacci sequence is to enable us to buy into retracements at favourable retracement ratios, such as 38.2% retracement, 61.8% retracement, or even 78.6% retracement. See Figure 7. Figure 7 Source: eSignal (esignal.com) What I am going to show you now is a simple demonstration of the power of hype and selection bias. See Figure 8. Figure 8 Source: eSignal (esignal.com) Fibonacci ratios are one of the best-known tools in the trading arena. There is not a single one of these three major retracements in the S&P 500 Index that is identified by either 38.2%, 61,8% or even 78.6% ratios. In fact, two ratios seem to come up more frequently: 43% retracement and 74% retracement. I put that down to randomness. Yes, such is the power of our belief system. We want to believe there is a magical growth sequence to the way the financial markets expand and contract. We want to believe that there is a universal order to the markets, dictated by a higher deity who created the universe using the mathematical sequence of what we know as Fibonacci. And it works just often enough to keep the believers believing. This is the danger of charts. When we research, we are looking for something to get us in on the long side, so we never miss a rally; or we look for something to make us sell short, so we never miss a short sell. We enter with a bias. This is apophenia in play. Beware! DIVORCE RATES IN SPAIN The definition of ignorance is a lack of knowledge or information. You can be a smart individual but be ignorant in some areas. For example, I am rather ignorant when it comes to, say, soulmates and flat Earth theory. You could argue that I am ignorant because I am not interested, or I don’t believe in it. Fair point. Specifically, on the point of finding your soulmate – the one- and-only whom you will spend eternity with, the person who is perfect for you in every shape or form – well, I don’t believe they are real. You see, as ignorant as I am in the ways of love, I can read statistics, and on that basis, I am supposed to conclude that soulmates have better chances of finding each other in certain countries? I don’t think so! For example, there are certainly not many self-confessed soulmates in Spain or Luxembourg. Did you know that there is a 65% divorce rate in Spain and an 87% divorce rate in Luxembourg? There’s only a 42% divorce rate in the UK. Does that mean that you have a higher chance of finding your soulmate if you live on the British Isles than in Spain? Plenty of people believe that the sun’s heavenly position relative to randomly defined stellar constellations at the time of my birth somehow affects my personality. There are also people who believe that the markets are an equation to be solved, a code to be cracked. All of those people are delusional, or to put it more politely, they are ignorant. THE FRAUD OF THE CANDLESTICK GURU In order to avoid a lawsuit, I have blanked out the name of the central character in the following story. When candlestick charts became a hot topic in the 1990s, one person – who had been instrumental in the propagation of their use – was sitting in a restaurant somewhere in the world with another high-profile trader and me. The central character had at the time published books on the use of candlestick charts. As we sat in the restaurant, I asked him if he believed that some of these patterns had to be identified by different names, when they were practically identical. For example, I argued, the Harami pattern and the Harami Cross pattern are to all intents and purposes identical, except the Harami Cross pattern has no body, while the Harami pattern has one. However, they are both inside bar patterns. It seemed to me like a deliberate attempt to inflate the number of patterns, for purely commercial reasons rather than for legitimate trading reasons. Many of the patterns are near identical but have different names. I asked him if he had a favourite pattern he used, or a selection of preferred patterns he stuck to, and if so, what time frame he traded them on. He answered that he wasn’t trading the patterns. Not only that, but he also conceded that he didn’t trade at all. I don’t know how you feel about that, but it doesn’t sit very well with me. I immediately cut all ties with the gentleman. I felt as if his only mission was to invent as many patterns as he possibly could, in order to fill pages in books and courses, and create alerts on his trading software. Am I arguing that candlestick charts are worthless? No. I just don’t believe that there is statistical relevance to all the patterns. I am not alone. A handful of academic research articles suggest the same. Here is the conclusion from one such article, ‘A Statistical Analysis of the Predictive Power of Japanese Candlesticks’, written by Mohamed Jamaloodeen, Adrian Heinz and Lissa Pollacia, and published in the Journal of International & Interdisciplinary Business Research in June 2018: Japanese Candlesticks is a technique for plotting past price action of a specific underlying such as a stock, index or commodity using open, high, low and close prices. These candlesticks create patterns believed to forecast future price movement. Although the candles’ popularity has increased rapidly over the last decade, there is still little statistical evidence about their effectiveness over a large number of occurrences. In this work, we analyze the predictive power of the Shooting Star and Hammer patterns using over six decades of historical data of the S&P 500 Index. In our studies, we found out that historically these patterns have offered little forecasting reliability when using closing prices. In another work by Piyapas Tharavanij, Vasan Siraprapasiri and Kittichai Rajchamaha, the researchers conclude the following: This article investigates the profitability of candlestick patterns. The holding periods are one, three, five, and ten days. This study tests the predictive power of bullish and bearish candlestick reversal patterns both without technical filtering and with technical filtering (stochastics [%D], Relative Strength Index [RSI], Money Flow Index [MFI]) by applying the skewness adjusted t test and the binomial test. The statistical analysis finds little use of both bullish and bearish candlestick reversal patterns since the mean returns of most patterns are not statistically different from zero. Even the ones with statistically significant returns do have high risks in terms of standard deviations. The binomial test results also indicate that candlestick patterns cannot reliably predict market directions. In addition, this article finds that filtering by %D, RSI, or MFI generally does not increase profitability nor prediction accuracy of candlestick patterns. TRADERS BEWARE Brokers and educators have put the cart before the horse. They make us think that learning as many patterns as we possibly can will increase our chances of trading success. This is simply not true. The more patterns we know, the more we are inclined to talk ourselves out of good positions. There is nothing wrong with technical analysis and patterns, and candle formation and indicators and ratios and bands. Yes, I don’t believe in many of them, because they are subjective and don’t hold up under real scrutiny. But then again, trading is so subjective anyway that we don’t need to be right very much to make a good living from trading. AN OLD FOX TELLS My friend Trevor Neil ran a hedge fund that had a 25% hit rate on their trades. I want to tell you his story here to give you some deeper insight into how some of the best professional traders work and think. I hope you will find it illuminating. It should also serve as a reminder that there are many ways to make money in the market. Your job is not to follow someone, but to find a way that you like, that resonates with you and who you are and what you like to do. The story starts with me asking Trevor a question. I knew that he had been associated with Tom DeMark and his Sequential indicator. Tom DeMark is something of a legend within the technical analysis world. I happen to have met DeMark myself at a Bloomberg lunch many years ago. He seemed like a nice guy, although I had very little to ask him, as I was unfamiliar with his work. You see, his work was only available to those who had a Bloomberg terminal. The Bloomberg terminal at that time was some $25,000 a year. Today, though, Tom DeMark’s work is available on many trading platforms, in case you are interested. I asked Trevor about the Sequential indicator, and his eyes lit up. He told me a story about how he and his friend had decided that there was an edge to be gained from trading the Sequential indicator on a very short-term time frame. They moved to South Africa and started trading South African shares on a one-minute chart. I have never heard of a professional outfit, with significant funds under management, trade on such a short time frame. However, that is not what impressed me most about the story. What impressed me most was how they managed to make money on what other traders would consider an abysmal hit rate. Most people believe that you have to deploy a trading strategy that has a hit rate better than 50%. Trevor told me that their results varied. There were times when they were hot, and there were times when they were not. When they were hot, the hit rate would push 40%. When they were not, the hit rate was down in the mid-20s. Overall, though, they had in their hands a tool that generated about 25–30 winning trades out of every 100 trades placed. They were wildly successful. They traded the fund for a handful of years, then they returned the capital to the investors. They had made their money, and as neither of them were spring chickens, they decided enough was enough. It was time to go home and spend quality time with their families. Had they been younger, they probably would have continued. Now I don’t know about you, but I like the story. It reaffirms the idea that I have about trading. How you think when you trade is much more important than whether your strategy has a hit rate in the 50s or in the 70s or in the 90s. While the story is not conclusive evidence that anyone can make money trading, as long as they have the proper money management rules and the required patience, it is a brilliant anecdote of two traders being able to make money even though – from a conventional point of view – their strategy on paper should not have generated a profit. So, what was the secret? Well, the answer is simple. Although they lost 75 out of 100 trades, those 25 winning trades more than surpassed in profits what the 75 trades generated in losses. Trevor told me that they expected to make 25 times in profit what the risk was. He also told me that when they executed a trade, they expected it to work immediately. So, I grilled him a little bit on that point. “What do you mean you expected it to work immediately?” I said. He said he meant exactly that: when they executed a trade, they expected the trade to begin to work immediately. If they had bought at 50, they would not want it to go to 48. If it went to 48, they would stop themselves out. It meant they had plenty of small losses. Their back-testing had shown that if the strategy was to be traded correctly, it would work immediately. If it didn’t work immediately, the strategy called for the position to be closed. BELIEVE AND ACT When you can act and perform without any fear of consequences and repercussions, you are trading from an ideal state. When you consider how many people lose money overall in trading, you logically have to conclude that achieving this state is not an easy undertaking. It would be foolish to think that this state of mind comes easily or even naturally. It doesn’t. I once sat and traded for a few months with a guy from Germany. He possessed an almost superhuman ability to do nothing. His patience was unrivalled. While we traded together I made it a sport to be as patient as he was. It was fun and, dare I say, somewhat painful. I missed many a good trade, but the ones I took outweighed all the others. You must be patient with yourself. You must be able to let your knowledge settle and mature within you. If you trade small size now, but you want to trade bigger size in the future, then that journey will most likely be anything but linear. It will be a journey of progress and setbacks. It will be a journey of progress and status quo. I can guarantee you that. You have to grow into the trader you dream of becoming. You must be patient with your trade entries. You must be patient with yourself. If you can bring those two qualities to the table, then the rest will solve itself in time. You will grow your trade size at a pace where your mind will not be alarmed or fearful. I discuss this in much greater detail towards the end of the book. Otherwise, I am just like the well-meaning friend who says to my alcoholic friend, “Well, just stop drinking.” Sure, if only it were that easy. Likewise, me saying to you “Just have more patience” is about as helpful as a hog roast at a vegan convention. One macro trader I deeply admire is Greg Coffey, an outstanding London hedge fund trader. In a piece in a newspaper one client described him as “humble and arrogant in equal measures – the perfect trader”. The piece went on to describe that Coffey had an absolute conviction on his trades, to the point of being arrogant, but he was equally quick to be humble when the trades didn’t work out well. Remember this saying: It is not what you know that kills you. It is what you think you know, but which just isn’t so, that kills you. THE NATURE OF THE GAME The game never changes, and it never will. Algorithms won’t change the game. Laws won’t change the game. Because this is an inner game, and you need to spend time – maybe not as much time as you do on charts, but a huge amount of time – contemplating what human qualities you are bringing to the game of trading. Moving in the right direction comes from knowledge of yourself and an understanding of the markets. The game never changes. The players change, of course. We all grow old and die, and we are replaced with fresh blood. Sadly, people don’t change, unless they make an out-of-the-ordinary effort to do so. We have a reptile mind, which is not fond of change. “Hey, if it ain’t broke, why do you want to fix it?” Well, because it is broken. I am not making money how I know I can, so I want to change that. If that means I have to learn to live under a different paradigm, and have a different perspective on fear and hope, so be it. THE ROLE OF CHARTS You can’t create a master painting with just one colour. You don’t create a Michelin-star meal with just one ingredient. And you most certainly do not create a viable business as a trader by only focusing on charts. The role of the chart is to give you a visual representation of the thoughts of other market participants. It enables me to be much more specific in my entry and exit criteria than, say, a fundamental trader. However, it is easy to get seduced by the randomness of charts. Over time, though, it is not your chart reading skills that will decide the number of zeros on your trading account. Controlling your mind is no easy task. Your reflex mind will jump to conclusions before your conscious, reflective mind has had a moment to really consider your response. The sole purpose of this book is to provide you with the right tools to program your mind to be a trader – a profitable one. Our minds are feeble creatures, if left unchecked. Whenever I give a talk about the role of psychology in trading, I always show people the logo of Federal Express, and then I ask them: “Where is the arrow?” In case you didn’t know already, take a look at the FedEx logo – there is an arrow hidden between the ‘E’ and the ‘x’. The coordination between the eyes and the mind is fascinating. The eyes can see one thing, while the reactive impulse mind tells us that we are seeing something else. It is only through observance and training that we become mindful of our tendency to believe what we immediately think we see. Consider the following image. Which square on this chequerboard is darker, A or B? You might be surprised to learn that both squares are exactly the same shade of grey, though it is very likely that your mind told you that square A is darker. Published by MIT professor Edward H. Adelson in 1995, this optical illusion perfectly demonstrates how the mind can misinterpret information passed to it by the eyes. Another example you may have encountered before is a little harder to demonstrate in this book, but I will explain how it played out in the speech I gave – which gave me the impetus to write this book. It is a mind-flexibility exercise. I showed the audience a simple image: a red square. I asked them to call out the colour of the image. “Red!” they shouted in unison. Simple enough, right? I then removed the red square and revealed a yellow one. Same result: “Yellow!” I swapped in a green square. “Green!” they cried. Red. Yellow. Green. So far, so good. The audience didn’t even need to think about it; that is how dominant the automatic response system is. Then we moved onto the trickier bit. I showed the audience an image of the word red written in blue ink, and asked what colour that image was. A lot of them called out “Red!” I showed them yellow written in red ink. Some called out “Red!” but I heard far more shouts of “Yellow!” We repeated this process with a series of colour names written in ink of a different colour. Over time, the audience responses became more consistently accurate. Through a humorous exercise I established that our eyes and minds do not necessarily work in a coordinated manner. Our brain, seeing the word red, wants us to say “red” – even when the answer to the question is “blue”. It is as if we consciously need to stop the brain from jumping to conclusions. This is an important trait in trading, because we often see things that are literally not there. Charts do not work as well in real time as after the fact. Unfortunately, you have to believe and act. If you struggle with that after a few failed trades, then that is your brain trying to protect you against pain. You will begin to second guess your signals, and you will sabotage your own best interests. I have been there. I have done it. And I have the cure. GOOD TRADING GOES AGAINST HUMAN NATURE When I make speeches about trading, in person or on YouTube, I often talk about the concepts of value and price. What is something worth? I think my old car is worth £10,000. The car dealer feels it is worth £8,000. Who do you think is going to win that argument, if I am keen to sell? What something is worth is an emotional, biased statement. Price, on the other hand, is where buyers and sellers meet. It doesn’t make much sense to say that something is worth more. You can anticipate that something will be worth more or less in the future. I mean, that is the essence of the mechanics of my job. Psychology aside, I buy in the hope that whatever I buy will rise in price. Heraclitus, the pre-Socratic Greek philosopher, said: “No man ever steps in the same river twice, for it’s not the same river and he’s not the same man.” That is important to bear in mind as a speculator, because the market changes constantly. Mankind has an ambivalent attitude to change. We want change, because otherwise our lives become mundane and boring; but if the change is thrust upon us, rather than driven by motivation and enthusiasm, then we tend to resent it. The first time I became aware of the importance of mindset in trading was upon reading a book about the trading life of an anonymous trader called Phantom of the Pit. It is a free book. You can find it with my own notes on www.tradertom.com – in the resource section. In the book the mystery trader argues that behaviour modification is the single most important concept in trading. The ability to change one’s mind without causing a mental disequilibrium is the single most important ability for a trader. Running a live Telegram trading channel means I am constantly asked questions – the majority of them from inexperienced traders. One persistent question I get asked is: “Why are you trading against the trend?” When I get asked such a question, I smile, because it is both a naïve and innocent question. It is naïve because any trader can be accused of trading against the trend. It simply depends on the time frame you are looking at. If you are a five- minute candle trader, you don’t care that the trend on the weekly chart is down. You care about the trend of the five-minute chart. Another reason why it is naïve is because the whole construct of technical analysis is fraught with contradictions. Think about it. You are asked to follow the trend; but what happens when you sell a double top? You are betting against the trend. The same can be argued for a double bottom. You are buying a market that is moving down. THIRTY YEARS OF DATA I am a day trader. My speciality is stock indices such as the Dow Jones Index. I looked at the statistics of closing prices in the index over the last 30 years. That equates to roughly 7,500 trading days. I wanted to know how often the Dow Index closed higher for the day and how often it closed lower for the day compared to the previous day’s closing price. I had an idea that, since the Dow Index over the last 30 years had risen from 3,300 to nearly 36,000, you could expect more positive closing prices than negative closing prices. I was wrong in that assumption. Over the last 30 years only 50.4% of all closing prices were higher than the previous day’s closing price. This means the distribution of plus days and minus days in the Dow Index is evenly distributed. The ramifications of this statistic is that day traders like me can’t rely too much on the trend on the higher time frame, because virtually anything can happen down on the five-minute chart. The challenge traders face can be summed up very easily, in a Heraclitus- style explanation. When we shop for a pint of milk, we know that milk is a uniform product. It doesn’t matter where on God’s green earth you shop for a pint of milk. Milk is milk. Hence, if milk costs twice as much in one supermarket as opposed to another supermarket, you can again rightly conclude that a pint of milk is expensive in one supermarket, and it is cheap in the other supermarket. However, a share, or a currency, or a share index, is like a river. It is in constant transformation. The transformation is the result of the interaction of traders and investors. Their action is the result of their opinions about the future. You may agree with their opinions, or you may disagree; but to say that the majority are wrong is counterproductive to efficient money-making in the markets. There are many part-time traders who are incredibly successful in their other careers but struggle when it comes to trading. What we have to do to succeed in the world of trading is significantly different to what we have to do to succeed in the world outside of it. For example, if you go into a supermarket to buy dinner, and you see that there is a special offer on chicken, you will be inclined to take advantage of this offer. If chicken is offered at half price, then you might be thinking that this is a great price, and you will want to buy some supply for the freezer. Our human nature is such that we love a bargain. We love to seek out good offers and take advantage of them. It fills us with a sense of joy to know we have bought something which is cheap. Just yesterday I went shopping and there was an aisle with discounted items. Everything was half price or less. I bought soap and washing liquid and detergent for the next 12 months. As I filled the trolley, I laughed to myself, mostly because I knew that I would go on to write a chapter about this very behaviour. It felt great to save 70% on stuff I knew I would buy anyway at some point during the year. Let’s face it, we can save a lot of money if we shop contrary to the trend. If at all possible, I tend to buy my winter jackets when there is a heatwave outside. That is when the shops want to get rid of these items, to make space for the summer clothes. Conversely, I love to buy my summer clothing when there is six feet of snow outside. I know it is not normal to do that, and maybe that is why I like doing it. I love a bargain. I don’t think I am alone in loving to buy cheap. As I said earlier, the world of trading is diametrically opposed to the world outside trading. The traits I display as a human being outside my world of trading don’t serve me well in the world of trading. This is not just me I am talking about. This is people in general. Our minds struggle to separate the world of trading from the world of general consumer behaviour. Let’s look at the differences. SUPERMARKET BARGAIN When I see something in the supermarket that is cheaper than it was before, or that gives me a discount for buying more than one item, I am attracted to buying it. My action is driven by a subconscious drive towards pleasure. My action is that of a rational consumer who will seek out the cheapest products. The supermarket knows this, and they will tailor their offering to maximise my spending. My behaviour is driven towards maximising my pleasure – within my budget constraint. When I do so, it gives me a sensation of well-being. FINANCIAL MARKET BARGAIN When I see the FTSE Index falling in price during the day, my mind associates falling prices with value and becoming cheap. If I act on the impulse, one of two things will happen: 1. My feeling of value is confirmed. The market begins to rise. 2. My feeling of value is not confirmed. The market continues to fall. My argument is perhaps provocative, but no matter what happens next, I will end up losing – even if I win on the trade. If I buy with no good reason other than my mind sending me an impulse to say the market is cheap, I will lose if the market continues lower. And why would the market not continue lower? That is the premise of technical analysis. Trends persist. The market suffers from inertia, meaning that whatever it is doing now, the odds are above 50% it will continue to do. If I buy, and the market begins to rise, I will eventually lose anyway, because I have now taught my mind that it is okay to stick my hand out and catch the proverbial falling knife. I have created a pattern in my mind that associates buying falling asset prices with pleasure, because I had success with it at some point. As a side note: when I began taking trading very seriously, I would review my trades when the day was over. I would print out the chart and plot my trades onto it. I realised that some eight out of ten trades were impulse trades. I began to become much more conscious of my trades. As I proceeded down that path, I became more and more profitable. The fewer impulse trades I had, the more money I made, and the more satisfaction I derived from my job. SELF-ANALYSIS Through analysis of my trading behaviour – meticulously logging my trades on a chart after the trading day was over – I came to the realisation that I was a prolific value trader. I would repeatedly short rising markets. I would repeatedly buy falling markets. It helps me to remind myself daily that when I am buying, someone else is shorting or getting out of a long position. A significant factor to my trading success, going from being a losing trader to a winning trader, was the realisation that there are no bargains in the financial markets. SUPERMARKET SUBSTITUTES When I am shopping for something in the supermarket, and I discover a product has gone up in price, or a product that used to be on offer is no longer on offer, my mind will associate this with pain. My mind will direct me towards a substitute. This is perfectly rational human behaviour. My sister and I laugh about this phenomenon. She lives in Germany and frequently travels with the airline EasyJet from Berlin. She puts it so eloquently, when she says, “I will get up in the middle of the night for a 5 am flight, if it means I can save myself €25.” I think many of us can recognise this trait. FINANCIAL MARKET SUBSTITUTES If something has gone up in price in the financial markets, then it means there is demand for it. It may seem expensive, but it merely reflects the equilibrium point between buyers and sellers. I struggled with this for years. I argued it was expensive, and this faulty view was compounded by the technical indicators I was using. Indicators like stochastics would suggest a market was overbought or oversold. Those are other words for cheap and expensive. It is for this reason I am no longer trading with any kind of technical indicators. My charts are 100% naked. The perverseness of the financial markets is that it generally makes sense to buy something because it is more expensive today than it was yesterday. DEALING WITH ADVERSITY When I experience difficult situations in my life, I will be patient and work on resolving them. Through my work and my resolve, I hope I will be able to solve the problem. I may even use force on the issue or use my authority to solve the problem. No amount of hard work, resolve or prayer will turn a bad trading position into a good position. Either the market agrees with you or it doesn’t. It doesn’t matter how rich you are; how big and powerful you are. If the market disagrees, it disagrees. The market can only hurt you if you let it hurt you. The market will rally. The market will fall. Whether you are on board or not, making money or not, is inconsequential to the market. It knows nothing about you. When you make money, you make money because you are aligned with the market. The market itself is nothing more than the combined force of all the market players. They, like you, are looking to make money from trading. Unfortunately, we can’t all make money. I came to realise, after years of suffering, that I had to change my relationship – not with the market, but with how I reacted to what the market did. Much of that process was undoing my life values and beliefs when it came to the trading world. In the normal world, when I don’t get my will, I will work hard at convincing the other party to see things my way. I am very persuasive, and I usually get things how I want them. While that may be a trait that helped me in the real world, it is a trait that was detrimental to my trading performance. The market doesn’t care about your position. It doesn’t care if you are long or short or on the side lines. The market has no feelings about you or your position. The essence of my argument is that many of the traits we display as perfectly normal people don’t serve us well in the world of trading. I think all the successful traders I know have gone through a transformation process. Some were gradual. Others talk about a specific situation which acted as a catapult to success. Some became so disgusted with themselves, they decided that they were going to either follow the rules or quit trading altogether. THE INNOCENCE OF OBJECTIVE OBSERVATION A very good friend of mine, Dr David Paul, describes his own transformation in the following story. I have a PhD in mechanical engineering. I have worked for De Beers. I invented a mining drill which made me a fortune. I have had my own mining company. So, it is fair to say that I came into the markets with a lot of confidence, and a lot of money at my disposal. I started investing money in the 1980s. It was easy to make money in the stock market then. All you had to do was buy shares and then sit and wait. While I waited, I started doing programming on the early computers. I eventually created my own share selection software. It was incredibly sophisticated software for its time. On this particular day in question the software called for the market to rise very strongly. So, at the open of trading I phoned my broker and placed a very large buy order. And sure enough, the market did what my software had said it would do. It started moving higher. I was naturally happy that the analysis was correct and that I was making money. I held on because the software predicted the rise would continue, only much more strongly. A short while later, however, the market began to drop. I was naturally a little surprised but knew that it must be just a temporary aberration and a good chance to buy a little more before the market really took off. So, I did. I bought some more. And yet the market continued to drop. And drop. And drop. I began to get a little worried, so I phoned my broker and all my trading friends to see if there was any reason for this deviation. They too were at a loss to explain why the market was down. Their analysis had suggested the market would rally strongly. All the newsletters suggested that we were in the middle of a major wave three in Elliott Wave Analysis terms, and everything pointed to higher prices. I felt somewhat better having spoken to my friends and my broker about the situation, and I was sure that this was just an aberration, so I decided to buy a little bit more at these cheaper price levels. The market bounced for a while, and I felt pretty good about having bought some more at what I thought would be the lows of the day. The market then began to head lower again, and I began to get really concerned, even a little scared. It was quite a big position I had accumulated. Just then my wife walked into my office to ask what I wanted for dinner that night. She must have sensed that I was distracted or in discomfort, and she walked over to my desk and looked at the trading screen. “Is anything the matter, dear?” she asked. She can be so sweet. “No, my love, just working. My software says this market should go up.” I pointed at the screen. “The software has never been wrong, and I have spoken to the brokers and to my friends, and they all say that this market should be going up, but it is going down.” She looked at the screen with the market and said, “Is this the market you are trading in?” “Yes,” I said. “I really don’t understand why it keeps moving lower. I am sure it will move up very soon.” “But it is not moving up right now, is it?” she said. I got a little impatient with her, and I said, “No dear, but what you don’t understand is that the software and the Elliott Wave Count are in agreement, and the market absolutely has to go up.” “Oh well, you are right, I don’t know anything about this software or the Elliott thing, but it just doesn’t seem to be going up right now, does it?” I distinctly remember taking a deep breath. I said to the woman I love but who had now begun to irritate me, “No dear, but just as soon as this passes, it will start to go up. It absolutely has to. I think this is just an AB=CD formation. The software says so. The broker says so. My trading friends say so. The Elliott Count says so. There is no way that all these people and my software could be wrong.” “Ok, I am sorry, you are right; I don’t understand your software or the Elliott thing or what the broker is talking about. All I see is that this market right now is going down, isn’t it?” I stopped staring at the screen for a second, and I looked up at my wife. “Could you please repeat what you just said?” She looked at me puzzled, and said, “Well, I am just saying that right now, right at this moment, right here right now, this market is moving down, isn’t it?” And then it hit me like a thunderbolt. I wasn’t trading the market. I was trading my opinion. I began to laugh, because I felt for the first time that I knew what had to be done to make money in the market. I understood that the very thing I was trying to avoid was the very thing that was killing me right now. I was trying to avoid losing trades at all cost, and now I was in a trade that was losing me – only because I refused to listen to what the market was trying to tell me. I realised in that moment that I had to learn to lose in order to win. It was as simple as that. I wasn’t trading the market. I was reinforcing my ego through the market. I picked up the phone, called my broker and sold out all my long positions. Furthermore, I sold a large number of contracts short as well. And sure enough, the market continued – down and down and down. My trading life changed that day. I no longer paid so much attention to expert theories, and I stopped guessing where the market was going. I started trading the markets. It was a revelation. I started making lots of money. I realised that some of the stuff I had read was outright wrong and detrimental to my trading. For example, we have all read the axiom of ‘buy low and sell high’. I changed that to ‘sell low and cover lower’ and ‘buy high and sell higher’. SURRENDER When I asked David to sum up his experience, he said to me: Look at your own life. You love to surf. You wait for the waves, and you paddle into their energy flow, and you ride the wave. How is that any different to what we do as traders? When you are out there, sitting outside the impact zone, waiting to paddle in, you don’t paddle when there are no waves. You are patient. When the right size wave builds ups, you get ready. You are one with the sea. You roll with its flow. You surrender. To succeed in the markets, we must surrender. Every single individual on planet Earth has a great deal of time, money and value tied up in what we know, and it is unthinkable to even consider surrendering all this perceived knowledge. The purpose of my trading and your trading is not to be proven right and bolster our egos. Our job is to make money. If that means we come to the market with an opinion, and we are proven right, so be it. If it means we have to change our opinion because the market dictates it, so be it. A more spiritual person than I would perhaps express this as “empty your mind and let the market guide you”. THERE IS A LOT LESS TO TRADING THAN MEETS THE EYE The fact is that our complicated human minds have a great deal of trouble processing information that is simple. Unless it is complex to the tenth degree, our minds tend to pass it over. We think that something simple can’t be profitable. What is your aim? The simple answer should be to make money. In the past I was so preoccupied with what should happen. But to make money we must be focused on what is happening right here, right now. When I started writing this book, I wanted to keep it practical. I had no interest in trying to pass myself off as a trader therapist or a psychologist, because I am not. I wanted it to show the true nature of what trading is, written by someone who has skin in the game, and who has both scars and medals to show for it. If the last few pages have been a little too theoretical for your liking, I would like to describe a real-life case study – one that was captured on video (my way of telling you that this is an authentic story) by Round the Clock Trader in July 2019. I want to explain what I mean by going into the market with an open mind and an empty cup. I bought an index after a double bottom. Everything looked pretty good. I was long from 12,808 and I had bought again at 12,818. Then it happened: the index plummeted. My five-minute chart showed three major lows (I call these get out bars, when I am trading against their direction, or add to bars, when I am on the right side of them). I was wrong being long. I got out of my long position and reversed my position to short, relatively early on in the downward spiral of the index. There were some 500 traders attending the event, and what pleased me most about the outcomes was not that I lost on my first trade, or that I won my money back soon after. What pleased me most was that I did not stubbornly hold on to a losing trade, and that I had the mental freedom to move from being long the market to now being short the market. When I started trading, there was no chance in hell I would have done what I did there. I would have held on and held on to that losing position. “I know I am right,” I would have said; except I wasn’t, and I wasn’t making money. The most critical point came when my new short position showed a profit which was equal to what I had lost on the long position. My mind desperately wanted me to bring balance to its emotions. What better way to do that than to offset the loss from the first trade? Well, in the words of my greatest trading hero, Charlie DiFrancesca, “Good trading means combatting the emotions that make us human.” Let’s take a look at how we can do that. FIGHTING MY HUMANNESS WHAT IS NORMAL behaviour amongst retail traders? We know that 80–90% of all retail traders engage in the same self-destructive behavioural pattern. We know that some 90% of traders do not make money consistently trading CFDs or spread betting or in futures markets. It is probably also fair to assume that those 80–90% of traders are intelligent, ambitious, self- motivated human beings, who like to create their own luck and forge their own way in life. I have never met anyone who started trading because they thought it was the same as playing the lottery. Virtually every person I have ever met who was interested in trading and who wanted to learn more about trading has been a self-starter, entrepreneur, or student at an institution of further education. Therefore, it’s a fallacy to say trading attracts the wrong kind of people. It attracts the right kind of people. It attracts those who have a chance of succeeding at it. I think it attracts the kind of people who are not fooled by the get-rich-quick schemes. I doubt many traders buy lottery tickets, purely on account of the odds being rubbish, and traders understanding that all too well. Nevertheless, something is wrong. Something is wrong when 90% of people fail. In the following table I have identified a handful of behavioural patterns that I think are detrimental to traders. The most frequently observed behaviour is the inability to take a loss. What is the reason for not taking a loss? I argue there is one reason we tell ourselves, and then there is another, real reason. The real reason is always the same. Action Conscious Reason Subconscious Reason 1.I am letting my loss runI am hoping Avoid pain 2.I am letting my loss runIndicator/Fib/etc., says soAvoid pain 3.I am taking my profits You can’t go broke taking a profit Avoid pain 4.I am winning, so I am reducing my stake I want to take it easy nowAvoid pain 5.I am losing, so I am increasing my stake I am trying to get back to where I was Get rid of pain 6.I made my points for today, so I stop I am afraid to lose what I madeAvoid pain 7.I am trading without real conviction I am bored/scared of missing out Avoid pain of boredom or pain of missing out Hope features high on the list of reasons. As the saying goes, hope dies last. Our minds seem ill equipped to engage in risk management. Our minds have one primary objective: to protect us against perceived or real pain. During the process of running an open position that is producing a loss, our subconscious mind is telling our conscious mind to keep the position open. It will mask this message as well as it can, in order to protect the ego, which is more fragile than the state of your trading account. If this sounds too airy-fairy, on account of the use of words like ego and subconscious, let’s explore the same argument using a different language. AVOIDING PAIN As long as a losing position is open, there is hope that the position will turn positive. The moment you close the position, and you crystallise the loss, the pain of the loss becomes real. I accept there are many permutations to the situation of handling a losing trade. Some will argue that the very act of closing a losing trade is the point when you can stop agonising over the open loss and open yourself up to other trade options. I personally agree with this argument. When I have a losing position and I no longer believe in it, the worst I can do to myself and my psyche is to begin to hope. I don’t feel free in my thinking and in my market perspective when an open losing position is beaming at me on my open position monitor. When I close the position, I feel free again, and I am opening myself up to taking in market information from an opportunistic frame of mind. However, my primary argument is that the reason we are hoping has little to do with hope itself and everything to do with avoiding pain. How many times did I see clients sit on losing positions for ages? I saw them deposit more money every time their losing position received a margin call. A margin call is when the broker demands more money to keep your position open. They just didn’t want to take the loss. To compound my confusion, how many times did I see the position come good again, and the client close the position as soon as it did? I saw it frequently. They didn’t hold on to the position because they believed in the position. They held on to the position because they could not stand being wrong. The moment they were relieved of their pain of the losing position, they got out – for nothing. They were so relieved to have avoided the pain of being wrong that they completely ignored the fact that the market was now actually agreeing with them. They weren’t trading the financial market. They were trading their emotions, responding to how they felt. When they felt relief that the position had come good again, they now associated a tremendous amount of pain with the thought of having to relive this anxiety once more. As a result of this association, they closed the position. They felt relieved at the thought of not having to go through this anxiety again. If you are taking your profits early under the excuse that ‘you can’t go broke taking a profit’, you are reacting to your mind warning you against future pain. If you are on a winning streak, and you reduce your stake size, you are essentially anticipating the pain of losing some of your gains. You are now rationalising your way to avoid the pain, even though nothing painful has actually happened. I want to reiterate the last paragraph. If you are in doubt whether you are trading from an opportunistic frame of mind or a fear-based frame of mind, then answer this simple question: when you are winning, are you increasing your trading size or decreasing your trading size? You see, the vast majority of traders will decrease their trading size when things are going well, because they are afraid their winning streak will eventually run out. The flip side to that coin is that they might even increase their trading size during a trading slump, so they can win back the lost money. As Greg De Riba, an S&P 500 pit trader of superior quality, said in the movie Floored: “99% still don’t get it – when they win, they start betting less. Bet more!” Perceived pain or real pain matters not to the subconscious. It will be treated with the same response and the same emotions. When the pain is real, i.e., real pain has manifested itself in body and mind because of a trading loss, there is no end to the lengths our ego will go to in its efforts to make the money back. This is the primary driver behind the argument of ‘when wrong, double up’. During a losing streak we tell ourselves that we are ever so close to winning again, so the natural conclusion must be to double up in order to regain what has been lost. The real (subconscious) reason for doubling up on a losing trade is to attempt to get rid of the pain. Now we are not trying to avoid pain; we are dealing with existing pain, and we are trying to get back to that state of equilibrium where we were pain free. ACT WITHOUT FEAR You learn a lot from observing millions of trades. If you want to stand a genuine chance of making money as a trader from the financial markets, I believe with every string of DNA within me, with every fibre in my body, that you need to change the way you think about fear and pain and hope. William Blake said that “He who desires, but acts not, breeds pestilence”. I have worked tirelessly towards being able to act without fear and hesitation. The true measure of your growth as a human being is not what you know, but rather what you do with the things you know. What do I mean by that? Have you ever seen a chart pattern, and your first impulse was to buy or sell short, but then – without warning – the very next thought was one of fear? It was a thought you had no control over. It just exploded into the forefront of your mind. I have experienced that at times in my career. When it happens, I know I need to reset somehow. Maybe I need to meditate. Maybe I need to sleep. Maybe I need to eat or go for a walk. I know that something is blocking me, and I need to resolve it. My free creative mind instructed me to do something, but my fear instinct immediately cautioned me not to follow through, because I might lose. It doesn’t really matter whether you were right not to trade, or whether the position would have lost you money or made you money. Those are afterthoughts (rationalisations or justifications). We can file those under anecdotal evidence, or evidence that has no merit. We all have an uncle who smoked until he was 90 with no negative effects – anecdotal evidence – but that does not justify the argument for smoking. If my free mind argues for a position, and my fear mind argues about the consequences of failing on that trade, then I am essentially arguing with myself. The posh term for this phenomenon is cognitive dissonance. My trades need to flow from a point of freedom of expression. Trades conducted from a perspective of fear or greed will not lead to good decision making. My advice: stop trading and start contemplating. What is going on? When I experience cognitive dissonance, it is for one or both of the following reasons: 1. I have trading fatigue (or physical fatigue – ever heard the saying ‘fatigue makes cowards of us all’?). 2. I haven’t done my preparation well enough. HOW DOES SHE DANCE? Have you ever seen a market that was in freefall, and you were reluctant to sell short because you were afraid you might lose? My basic aim with this book is not to rid you of these fears. Fear will always be part of our lives. My aim is to make you understand why you feel that fear and how to process it, so you can take the trade. I accept that I am a human ruled by emotions. I understand that I can’t escape emotions, and nor should I try to escape them. Rather I want to help you understand your fear, why it is there, and how to become friends with it. Earlier in the book I wrote about Philippe Petit, the man who walked across a wire suspended between the Twin Towers. He is afraid of spiders. Yes, it sounds silly, doesn’t it? His approach to dealing with fear is worth repeating. He would do everything in his power to understand the nature of his fear of spiders. He would study spiders. He would learn everything there was to know about spiders. Through his study he would come to appreciate the nature of his fear. How does that translate into the world of trading? Let’s take a practical example. I am trading the FTSE 100 Index. My stake size is around £300 a point for a starter position. Now I have to find the best entry points and the best exit points. But what do I do if I am afraid? What do I do if I am scared to place my trades because I am not sure what the market is capable of doing? The greater understanding you have of your opponent, the better you are able to understand what she is doing. I use the word opponent here, but really, the market, she is my friend. I want to dance with her. But I am afraid of making a fool of myself. So, I study her moves. I haven’t seen other traders do what I do, so I argue this is a novel way of analysing the markets. Whether it is a new approach or not doesn’t matter. What matters is that I get a sense of what my dancing partner is capable of doing. What can I expect from her price behaviour? Is it erratic? Is it smooth? Observe the chart in Figure 9. Figure 9 Source: eSignal (esignal.com) We are all chart experts after the fact. However, studying past pricing behaviour gives me a strong indication of what I can expect for the trading day. You may see a market that initially rallies, makes a double top, and then declines. Let me show you the chart in Figure 9 from another vantage point – see Figure 10. Figure 10 Source: eSignal (esignal.com) As part of my quest to trade without fear, I break down the chart into its smallest components. I see the first wave up is 24 points. I see the retracement is 9 points down. I see an attempt to make new highs, but it only rallies 6 points. I see a deeper retracement of 12 points. I see an 8- point rally, a 3-point retracement and another 11-point rally. The retracements lower are between 9 and 12 points, with the exception of one move of 17 points. You may argue that this is great (said with sarcasm), if you had known about it before the trading session started. Well, you did. Let me show you the day before, in Figure 11. Figure 11 Source: eSignal (esignal.com) The retracements lower are between 7 and 12 points, with the exception of one move that was 14 points. My approach to a non-fearful trading style is a combination of emotional discipline, mental warm-up, and knowledge of what the market can do. While these two trading days are different in outcome, their behaviour is not altogether different. I would go into the trading day armed with the following knowledge: 1. Deep retracements and outright moves tend to be around 10 points. 2. Small retracements against a strong trend are around 3–7 points. Knowing this, combined with an understanding of basic price patterns, I can develop an entry strategy aimed at risking as little as possible. For example, on the previous chart, after the market has pushed higher for a move of +11, I wait to buy a retracement. I know that most retracements are around 7 to 12 points, with the last three of them being 8, 7 and 10. So now I am looking to buy. Say I buy at the point where the market has retraced −7 points; I may be fearful that the market will move against me. My knowledge of the immediate past suggests that the market is unlikely to move more than −12 points in a retracement. I therefore place my stop-loss at an appropriate distance away, based on the past behaviour. The discipline to wait for the right entry, combined with the knowledge of past price behaviour, will set you apart from the majority of traders. They are unlikely to have done the same level of preparation. Through your preparation (and I admit, I speak for myself now), you are working through the issues your fear mind can throw at you. Your fear mind might say “What if I lose?” If it does, the answer is that if the market moves beyond −12 points your position is probably wrong, and your stop-loss will handle your exit. When I lend a helping hand to struggling traders via my Telegram channel, the first thing I ask them is do they write down their trades? By that I don’t mean write the particular trade entry on a piece of paper. I mean, do they plot their trade entries on a chart once the trading day is over? I have included a couple of examples from my own trading diary to serve as a visual reference guide. See Figures 12 and 13. I use these to warm up in the morning ahead of the trading day. I have selected random files from my old trading days, and I will relive those moments, both the terrible ones – to get me fired up on how not to trade today – as well at the good ones for inspiration. Figure 12 Figure 13 By observing my past behaviour, I am able to reinforce my good points while being mindful of my weak points. I will observe the disastrous consequences of my hasty trading decisions and my impulses. I will observe trades where I didn’t let my profits run. I will in essence torment myself by looking at my bad trades because I know this will act as a positive catalyst. Incidentally, I am not the only one who works like that. I read that Michael Jordan and Cristiano Ronaldo thrive on negative talk about them and their performance. They take that on board, and it acts as fuel to propel them to greater achievements. Unfortunately, no one writes about Tom Hougaard and his trading, so I recreate the situation by putting myself through my past bad trades. NOT ALONE The disastrous, impulsive patterns I saw most frequently on the trading floor fell into two categories: 1. Clients executed a long position in markets that they thought looked cheap. More often than not they bought into established downtrends. 2. Clients executed a short position in markets that they felt had rallied by too much. To them it looked as if the market couldn’t move any higher. I don’t blame you if you think I am making this up. Surely, traders can’t be engaged in this kind of behaviour in an enlightened era like the one we live in, where information flows so freely? To prove my point, I went to the IG Client Sentiment Report from 26 October 2021. IG Markets is a broker that has been around for some time. Their client base is global, and as such their sentiment report represents the trade positions of a large segment of the retail trading community. Before I show you the sentiment report for stock indices, I want to tell you that as I type this, on the day of the sentiment report, stock indices all over the world made fresh new all-time highs. The FTSE 100 Index in the UK traded at levels not seen for years. In the US the Dow Index traded at levels never seen before. So, you would imagine that if my observations were inaccurate, the bias on the sentiment report would call for people being bullish the market. You would be wrong. Sadly, I was right about traders’ behaviour. 71.39% of all Dow Index positions were short positions – on a day when the Dow made fresh new all-time highs. Things were not much better for the DAX Index or the FTSE Index. Symbol Net-Long (%)Net-Short (%) Germany 30 37.04 62.96 FTSE 100 30.60 69.40 US 500 39.85 60.15 Wall Street 28.61 71.39 This is why the 90% lose. We don’t see the market for what it is. We see it as we are. A chart is only as illuminating as our ability to keep out preconceived ideas of the direction of the market. We are not losing money over time because we don’t know enough about technical analysis or the markets as a whole. We lose money because we refuse to accept what is right in front of us. My basic premise is that people: 1. think the wrong way before they get into a trade, and 2. think the wrong way when they are in a trade. It reminds me of the late Mark Douglas, a phenomenal light in the trading industry and an inspiration to thousands of people, when he said that good traders “think differently from everyone else” at the start of his book Trading in the Zone. I have coined my own phrase. I argue that people are fearful when they should be hopeful, and they are hopeful when they should be fearful. I would like to illustrate that by use of an example. Imagine you have bought German DAX Index at 15,510 and the market is now trading up at 15,525. Instead of thinking that the market may be on a tear – and may go on to offer you many more points – you begin to fear that the points you have already earned will be taken away from you. Hence my saying: you should be hopeful in a situation like this, but instead you are fearful. You are afraid that the points will be taken away from you. You are not thinking about how many points this position may end up making you. Your focus is on fear rather than opportunity. The opposite holds true when you are in a losing position. You are now hoping that the market will turn around. Your sole objective is to get rid of your pain, and instead of being afraid that you’re going to lose even more, you now hope that you can reach a position in which you will lose less. Every tick in your favour is celebrated. Every tick against you is ignored. If you want to trade well, you need to turn this on its head. You need to teach your brain to be hopeful (about profits) when it is wrongly fearful (about losing the profits). You need to teach your brain to be fearful (about losses) when it is mistakenly hopeful (about the position turning positive). It starts with being mindful of this behaviour. Perhaps a conversation with a student of mine can further clarify what I am talking about. CONVERSATION WITH A STUDENT In the following conversation, my student and I are discussing a long position I have running in Sterling Dollar. Student: It feels like gambling. Tom: Please explain. Student: Well, I have 40 pips in profit, but you will not let me take the profit. Tom: I won’t stop you from taking the profit, but if you ask for my opinion, you should let the position run. You might want to consider the following scenarios, and then ask yourself how you would feel in each case: 1. Run position and you get stopped out for nothing. 2. Run position and it explodes higher. 3. Close position and it explodes higher. 4. Close position and it reverses. Student: I think it is best to close the position and secure the profits, rather than risk that the market will take the profits away from me. Tom: How would you then feel if the market exploded higher – in your favour? Student: I would be disappointed, but I could always jump back in again. Tom: If you jumped back in, you would have to pay commission again or at least the spread, and you would have missed the explosive move. The only way you would profit from the explosive move is if you were already in the move. Student: Yes, but at least I would be playing for momentum to continue. Tom: That is true, but you are already in a position where the momentum is on your side. Student: I guess I just don’t want to see my profits disappear. And there you have it – in a nutshell. People are hopeful when they are losing money. They are fearful when they are making money. I believe this is how the 90% think. It is the reason why – in a study of 25,000 traders – they won more often than they lost, but they lost 66% more on their average loss than they gained on their average win. When the trader is confronted with a loss, they hope it will turn around. The operative word here is hope. When they are confronted with a profitable position, they are afraid the profit will disappear. The operative word in this scenario is fear. My student naïvely thought he could jump back in again, but he would undoubtedly have had to do so at a worse price than the exit price of his profitable position. So, the trader holds onto the position until a point at which the pain finally becomes too much, then closes the position. Unfortunately, this threshold tends to be further down the road than the threshold of hope. This is what you need to focus on. This is what you need to work on constantly to change your pattern. I will not state whether it will be easy to do or difficult to do. It just is. There is no point in going any further in speculation if you can’t get yourself to do what you must do, even though it feels uncomfortable. You must be aware that in trading we tend to chase hope a lot further down the road of misery than we are prepared to follow the road of opportunity. It is just the way we are put together. You must be aware of this and have a plan for combatting your natural behaviour. However, I must warn you. Your mind is like a muscle. This is not a one-off quick fix any more than doing 100 push-ups once will make you look like Captain America for the rest of your life. Atrophy is not just something that happens to bodies. It also affects our minds. You need to strengthen that mind of yours through repetition. I present my own training regime at the end of the book, although I am actually describing it piece by piece as we move through the book. THE NOT-SO-NORMAL BEHAVIOUR What is not-so-normal behaviour? Well, firstly, I am all too aware of the shortcomings most people display when they are trading: running a loss, cutting short the profitable positions, over-trading, trading for excitement and entertainment. But this is already known to most – if not all – people, so the not-so-normal behaviour goes somewhat beyond that. It is very rare that we ask ourselves why we do what we do. Why do I trade when I do? Why do I take profits when I do? I think it’s time to bring in the words of a relatively unknown trader (but one who was hugely respected by his peers). He was a pit trader at the Chicago Board of Trade (CBOT), and his name was Charlie DiFrancesca, also known as ‘Charlie D’. MY HERO Charlie DiFrancesca arrived at the floor of the CBOT with a dream and a small account. He had a background in competitive college football – American style – but otherwise there was nothing about this guy that would indicate he would go on to become the biggest trader in the US Treasury bond pit in Chicago. He had a rough start. He barely traded in the first six months on the floor. He just stood there and observed. Then one afternoon something clicked, and he traded up a storm for two hours, making himself $5,000. From then onwards there was no stopping Charlie D. He became a legend in the trading pit until his untimely death. In William D. Falloon’s biography of Charlie D., the great trader says: The time you know you’ve become a good trader is that first day you were able to win by holding and adding to a winning position. There are many people here (in the trading pit) that have traded for a long time, and who have never added to a winner. Adding to winning trades is an absolute key trait of the successful trader. It reinforces correct behaviour. It serves as an antidote to the temptation of wanting to take profit. When I am in a profitable position, I have trained my mind to ask, “How can I make my position bigger?” rather than dwelling on the idea of taking profits. Charlie D. goes on to talk about his own mentor, Everett Klipp, who taught him about correct trading: Unfortunately, it’s only human nature to want to cut your winning trades. Say I am long at 6, and the market goes 7 bid, our mind instantly thinks get me out with a profit. That’s human nature. It is also human nature to ride the losses. I am stuck. I won’t close. I will wait. ADDING EPIPHANY In 2007 I met a person who was going to radically change my way of trading. It all came about by chance. I had come back from a lunch break and a colleague of mine returned from a meeting with an educational company. This educational company taught technical analysis and they were pitching their products to my colleague, who happened to be the head of marketing. What you need to know about my colleague is that he was the most obnoxious East End London guy you could possibly imagine. He was brash, obnoxious (I know, I said that twice), and arrogant, and no one could tell him anything he didn’t already know. Yet somehow this educational company had gotten his attention. He spoke glowingly about a gentleman called Dr David Paul, who had taken him through some basic technical analysis. He showed me the technical analysis, and it was basic. Yet there was something about the course material, which I had been given a copy of, that told me that I needed to engage in a conversation with this gentleman. It turned out that Dr David Paul had a two-day trading course coming up in Johannesburg. So a few days later I booked myself onto a flight. It was one of the only times I have ever participated in formal training on the topic of technical analysis. I have mentioned him before, but I’ll describe him a little more now. There is something incredibly humble about Dr David Paul, despite everything he has accomplished. He has a PhD in mechanical engineering. He used his immense abilities to invent a drill for miners in South Africa. This was no ordinary drill. It was the kind that sucks gas out of the ground as it drills, and thus saves lives by more or less eradicating the occurrence of explosions. David Paul spent much of his time investing and trading. He made himself a wealthy man. On the second day of the course David said something that would change my perspective on trading. He said something along the lines of this: “When you are in a winning position, instead of thinking where to get out, why don’t you think about where to get in more?” He basically told me to turn everything upside down. Most traders with a profit will begin to contemplate where to take half the profit. Next, they will begin to contemplate where to take the next half of the profit. David argued that this was what the 90% would do. He didn’t use those exact words, but he did argue that if you want to make money trading, you need to do that which the majority finds difficult to do. The first time you try it, you may fall flat on your face. That is to be expected, but the next time it might be a little easier, and the next time a little easier again. DO WHAT IS HARD David was essentially arguing that when you are in a winning position you should put pressure on your position. The argument for doing so was something he himself had observed when the market really began to trend. I have tried to put a different spin on his words. When you want what you want more than you fear what you want, you will have it. You want profits in your trading. You probably have a good instinct about trading. You probably also realise by now that it is your thinking that causes your problems, rather than your knowledge about the financial markets. If the 90% of traders are engaged with taking half profits and letting the other half run, maybe the right thing to do is to double up on your position, or perhaps conservatively add a little to the position, when everyone else is taking half the profits. At least this is what I read between the lines, as I sat in that hotel conference room in Johannesburg. When the workshop was over I walked across the street and locked myself into my hotel room. I sat down and waited. The Dow Index was trending. I waited for a retracement. Then I waited for a five-minute bar to close above the high of the prior five-minute bar. Then I bought. Ten minutes later I added to my first position. Twenty minutes later I closed at a double top. It was the most satisfying trading moment in my life. A whole new world had opened up to me. Depending on your experience level, you may or may not be able to answer this question: why is it easier to add to a losing position than a winning position? I have wondered about that myself many times. You decide that you want to buy the DAX at 12,325. The market then moves down to 12,315 and you are tempted to add to the position. Why? Why is it easier to add to a losing position than to a winning position? Well, for starters, you would have loved to have bought at 12,315 rather than 12,325 because you would have gotten a better entry price. Therefore, buying again at 12,315 makes sense from an economics point of view. That is plain simple logic. There is a chance that you have a stop-loss in mind, and there is a chance that you have a target in mind. Now you have an opportunity to have the same stop-loss as before, but you have 10 points less risk, and you have more profit potential. You have also created a better average price, so the market has to move fewer points in your favour before you are at breakeven. Simple and logical – something our minds love. However, you will now also have added to your position exposure, and the market has told you that you are wrong, at least right now. It was easy to do the wrong thing because we attach a value to the market. When the market gives an opportunity to increase the value of our trade, it will seem compelling to us. So why is it difficult to add to a winning trade? If I bought at 12,325, and the market is moving in my favour, I am relieved. Now other emotions will enter the consciousness. There will be greed. You want to make more. There will be fear. You want to protect what you have made. When the market reaches 12,345, you will be thinking that if you buy more now, you have increased your average price to 12,335. It means that the market will only have to move 10 points against you before your position will be at breakeven, rather than in profit. The key point here is: what is your mind dwelling on? When we add to a losing position, we decide to dwell on the potential for bigger profits. We decide not to dwell on the fact that the market is telling us we are wrong. We decide not to dwell on the fact we have just doubled our risk. When we add to a winning position, we decide to dwell on the fact that the market may take our profits away, because we have now decreased our average price. We decide not to dwell on the fact that the market is corroborating with us. Put simply, the market disagrees with us, but we have faith that the market is wrong, and we add to a losing position; or the market agrees with us by showing a profit, but we doubt the market is right, so we don’t add to our winning position. It doesn’t quite make sense, does it? And yet, this is what the majority of traders are doing all the time. Adding to a winning position can be uncomfortable to begin with. No one is saying you have to double up on your trading size the first time you add to a winning position. You could add just a little bit. ADDING STRATEGIES There are two ways you can add to your winning trades. You can use a same-size principle, by which you keep adding the same size. Say you buy ten lots to begin with, and then you add ten more lots at a higher price, and so on. That is a risky way of trading. Instead you could use a second principle, by which your first position is the biggest position, and subsequent positions are smaller. So your first position might be ten lots, but the subsequent positions might be five lots. When I trade, I pretty much always use the same-size principle, but I urge you to use the second principle until you are comfortable with adding to winning trades. BUILDING NEW PATHWAYS The purpose of adding to winning trades is at its heart an attempt to fight your normal human behaviour. In the beginning it is not about adding to your profitability. That will come later. The purpose is to stop you from taking half profits. By adding to the winning trade, by thinking, “How can I make more when I am right?” rather than thinking, “Where should I take profit?” you are building a new way of thinking about trading. Do you remember what Mark Douglas said in the opening lines of Trading in the Zone? In trading, consistent winners “think differently from everyone else”. When you start to think, “Where can I add to my winning trades?” you are beginning to think differently. From then onwards, it becomes a matter of habit. You have built a new neurological pathway in your mind, or at least taken meaningful steps in the right direction. CONTROLLING RISK How do you control risk when you add to winning trades? This is a question I am often asked. The answer is the same whether you are adding to a winning or a losing trade: you place a stop-loss. Some who receive this answer will say, “But if I get stopped out on an add- on on a profitable trade, then I will have lost profits from the original trade as well.” Yes, that is true; but isn’t it better to get stopped out of a trade where you have some profits to cushion your loss, rather than having added to a losing trade, where you are now feeling the full force of the loss? At least when you add to a winning trade, the market is currently agreeing with you. I have just bought the Dow at 26,629. My stop-loss is 26,590. The Dow has already rallied from a base of 26,569, so I might be a little late to the party, but that doesn’t bother me. Many a good trade has been missed by those arriving too late to the party. As long as I have a stop-loss in place, I am fine to join a momentum move, even one that has been moving for a while. The Dow prints 26,649, and I buy once more. I am adding to my winning position. Now my stop-loss on the first position I bought has been moved to reflect the fact that I have taken on more risk. My first stop-loss is now at 26,629. The stop-loss on my second position is also 26,629. At this point, two things can happen. Ideally, the market will carry on moving higher, and every point move is now making me twice as much as if I had only one position. The less appealing alternative is that the market moves against me, and I will get stopped out of the first position at breakeven, and I will lose 20 points on the second position. There is no magic to it. It is a philosophy, and it is born out of a desire to not be normal. The normal thing to do is to close half your position and let the other half run. Why would you do that? Why would you have the market agree with you, but you only ride it with half a stake? That is what the 90% are doing, and I don’t want to do what the 90% are doing, no matter how logical it may seem. They are wrong over time, and I want to be right over time! It is such a crucial point I am attempting to get across to you, right here and right now. I don’t know what is going to happen over the course of one trade. Anything can happen. However, I do know what will happen – statistically speaking – over the course of 100 trades. Over the course of one trade, you may win, or you may lose. Over the course of one coin flip, you may get a head or you may get a tail, and you may get five tails in a row, but you will still end up – statistically speaking – with a 50/50 outcome when you throw the coin 100 times. The same applies to trades. You may be on a hot run, and have nothing but winning trades on your screen, but over time it will even itself out. Therefore, it is vitally important you don’t think too much about the outcome of one trade, but rather the outcome of 100 trades. The outcome of one trade is random. The outcome of 100 trades is predictable. It is for this reason that our behaviour needs to be the same for every trade we execute, whether we like it or not. By applying the same correct behaviour to every trade, we are virtually guaranteed to be profitable. What is the correct behaviour? Well, why don’t we observe what everyone else is doing, and then do the opposite of what they are doing? The basic premise is that the majority of people who trade end up losing money. That is our starting point. Now we observe what those people do. I have been doing that for ten years. Here is what I observed: 1. THEY DON’T ADD TO WINNERS They don’t add to winning trades. So, to be profitable, add to winning trades, whether you add a little or you double up. Start slowly, add a little. 2. THEY DON’T USE A STOP-LOSS They don’t like to use a stop-loss, because that would crystallise the pain of the loss. As long as the position is open, there is hope. So, to be profitable over time, use a stop-loss. Use a stop-loss on your first position and on subsequent positions. 3. THEY ADD TO LOSING TRADES We all love a bargain at the local supermarket, don’t we? And by all means, continue to shop for bargains at the local supermarket; but do not do it in the financial markets by buying more, just because you can buy it at a cheaper price than the first time you bought it. While you may get lucky from time to time, this is one of the main traits of losing traders. Remember, we are focused on establishing the behaviour that will ensure we will be profitable over time. 4. THEY TAKE HALF PROFITS This one is going to be tough to argue, so bear with me. I know so many traders – even people who have traded for decades longer than I have – who advocate taking half profits. Their thinking goes along this pathway: I will risk 20 points. I will take half profits at 20 points and move stop-loss on the other half to breakeven. I will take the other half profit at 40 points. It sounds so compelling. You close half the position, so if the market turns around, at least you will have made 20 points on half the position. I can understand the thinking behind it. The problem I have with this strategy is that it never gives you the home- run trades that you need to sustain yourself in this business. You will never be on board the big moves because you have always limited yourself. I have two fundamental arguments against taking half profits: 1. The market agrees with you. Let it ride. 2. Since I don’t believe in the risk-to-reward argument, because no human being can know in advance what their reward will be without limiting themselves, I don’t believe that taking half profits is the right way to trade. RISK TO REWARD Did I just say that I don’t believe in the whole risk-to-reward argument? Yes, that is correct. I do not. I believe in defining my risk. I don’t believe in defining my reward. When I am about to execute a trade, there is only one variable I have meaningful control over: how much money/points/pips will I risk on this trade? Anything else is pure guess work. How much I will make will depend on the market. It will not depend on me, unless I put a limit on my profits. A very wise old trader once told me that losers spend their time thinking how much they will make, while winners spend their time thinking about how much they will lose. The only variable I am in control of, as a point-and-click trader (as opposed to one who uses an algorithm), is how much I can lose on a trade. Observing hundreds of millions of trades over a decade, executed by an army of well-meaning traders doing their best to make a profit, I have come to the conclusion that setting a limit on your profits is not the way forward. If I buy the FTSE 100 Index at 7,240 with a stop-loss at 7,235, and a take- profit target at 7,250, I am sure I will be happy if the FTSE goes to 7,250 and reverses back down again. However, how will I feel if the FTSE moves to 7,260, or 7,270, or higher? Of course, there are exceptions to this rule. I may genuinely want to get out at 7,250 because I feel there is overhead resistance at this area. It may even be an area where I would want to sell short the market. I may also put in a take-profit order at 7,250 because I may not be able to follow the market as closely on this particular trade. But generally, I do not work with targets because a target will limit my profit, particularly on days where the market is in a runaway mode. With this in mind, I would like to show you an example of a decision I made, and how it ended up costing me dearly. HOW NOT TO DO IT The DAX gapped up, as shown in Figure 14. I know from statistics that 48% of all gaps get filled on the same day they occur. Considering that 90% of daily highs and lows occur in the first hour and a half of the trading day, I felt reasonably good about shorting the DAX on the low bar, indicated by the arrow. The stop-loss was close to the high of the day. The risk was 35 DAX points. Figure 14 Source: eSignal (esignal.com) As shown in Figure 15, instead of continuing lower, the DAX Index consolidates and moves higher, and it eventually takes out my stop-loss. I am now at −35 points. Figure 15 Source: eSignal (esignal.com) The previous pattern does suggest higher prices to come. Yes, it looks like a double top sell; but on a gap up day, the odds are higher of continuation than of a reversal. Remember the saying, “In bull markets, resistance is often broken, and in bear markets support rarely holds.” Well, you can replace bull markets with bull trends, and bear markets with bear trends. In Figure 16, I execute a long position on the close of the bar, as it closes above my stop-loss. It is in reality a stop and reverse situation. I am stopped out of my short position, and as a result of it, I am going long. Figure 16 Source: eSignal (esignal.com) The market moves into a consolidation, and eventually breaks higher. I add to my long position, as show in Figure 17. So far everything looks okay. Figure 17 Source: eSignal (esignal.com) Then I make a mistake. I am at this point able to close the position with a profit that exceeds the loss I made earlier. Do you see what I am doing wrong now? I am not trading the chart. I am trading my account. I am trading my state of mind. I am trying to get rid of the pain from my previous trade. You can see this in Figure 18. Figure 18 Source: eSignal (esignal.com) Much to my disappointment, I admit I close my long position for no other reason than being able to offset the prior loss. I talk myself out of the position rather than just moving my stop-loss higher. It is not until my review of my trading day that I really come to realise what I have done. For now the market is not entirely in disagreement with me. For the next two hours the market trades sideways. The longer a market moves from a trending market into a sideways market, the less the prior trend matters. At least that is what I tell myself. Then as the US markets opens the DAX Index moves higher, and I am not on board. You may not yet see the subtle point I am making here, so let me point it out to you. I do not belong to the brigade of traders who believe that “you can’t go broke taking a profit.” I do think you can go broke taking a profit, if it means you never have really big profit days because you are unable to let profits run. Simple as that! Figure 19 shows what happened after my exit. While I don’t insist on perfect trading, I review my trades religiously to pick up on errors creeping into the inner workings of my trading mind. Am I maintaining my discipline? Am I adding to winners? Am I impulsive? Figure 19 Source: eSignal (esignal.com) You may look at the chart and think I did okay. I look at the chart and I wonder why I got out. The pain of having missed out on the rally towards the end of the day was greater than the pleasure from making back what I had lost earlier in the day. PRESSING WINNERS Adding to winners is habitual for me. I have new and experienced traders following me on YouTube and Telegram exclaiming they want to know how I do it. One simple way of doing it is to look over the prior trading days, and come up with a number of points at which you will want to add to your position. For example, you may look at Euro Dollar and conclude you want to add to your position at every 10-pip interval. I went about my approach in a different manner. I think it is best illustrated through the use of a theoretical explanation. I want to trade the FTSE 100 Index, and I am looking for an approach to adding to my winning trades. How do I go about doing that? STEP 1 I need to establish what the historical volatility is in this index. I use a measure called Average True Range (ATR). When using it I carefully differentiate between periods in which I don’t want to trade the product, and those in which I do want to trade the product. For example, the volatility of the FTSE Index on a five-minute chart during the night could be around 4 points, while the volatility on a five-minute chart at the open at 8 am GMT is around 14 points. That is a significant difference. Say for the sake of argument that I have established that the volatility is equal to 10 pips/10 points where I day trade the FTSE Index on the time frame I prefer to trade. We call that value N. N = 10 My stop-loss is 2 × N. STEP 2 Establish how much money you want to risk on a trade. This is a percentage function of your account value. Say you have £10,000 in your trading account, and you decide you want to risk 2% of the account. Hence 2% of £10,000 = £200. STEP 3 Now I establish my trading size unit, which is essentially how big my trading size is. If N = 10 Risk = 2N Monetary Risk = £200 Then my trading size unit will be £200 / 20 = £10 STEP 4 I can then argue that I want to add to my position at every ½N. I think this is where your own research should come into play. However, for the sake of the argument, I will take you through an example, based on the numbers above. EXAMPLE I buy the FTSE Index at 7,500. My stop is 20 points. My risk is £10 per point. My add-on is at every ½N. This means I add at every 5-point increment. The FTSE Index now trades at 7,505. I buy one more unit, meaning I am now buying £10 a point at 7,505. I now have two open positions: Long 7,500 with stop-loss at 7,480. Long at 7,505 with stop-loss at 7,485. As you can quickly gather, this will cause a bigger loss than anticipated if I do not move my stop-loss up on the first position. Before I enter the second position, I have already planned to move my stop- loss up by ½N. I will move the stop-loss up on the first position by 5 points. This means that the stop-losses on the first and second positions are identical. My total risk is now 35 points. As I hope you can see, this way of trading can quickly materialise a larger loss than perhaps you had wanted it to. It is for this reason I urge you to consider variations of this method, such as adding with smaller stake size on the second, third and fourth positions. You may ask, “Why add at all?” Because by adding, I am actively combatting the brain’s proclivity to scaling down risk. Our brains want to take profit. I am doing the opposite. I am adding to my position. REAL-LIFE EXAMPLE The following chart shows the Dow Jones Index on a trend day. I define a trend day as a day when the market opens at the high or the low of the day, and closes at the low or the high of the day. The problem with trend days is that you won’t know it was a trend day until the day is over. So, you have to make an assumption, based around what you see on the chart, about whether you think it is a trend day. I have researched the price action behaviour of the Dow Jones Index over 18 years. I have identified a handful of first hour patterns, which I believe are precursors for trend days. One of those patterns is a gap down after a gap up day, where the gap down is not filled within the first hour. Figure 20 shows a positive Thursday. The trade I want to show you took place on the Friday. Friday is notorious for producing lasting trends, often leading to trend days, especially on Fridays at the beginning or end of the month. Figure 20 Source: eSignal (esignal.com) I have also included a screenshot of my trading monitor. Wall Street 3,000.0 25419.625135.9 kr851,150.00   500.0 25458 25135.9 kr161,500.00   700.0 25455 25135.9 kr224,000.00   350.0 25469 25135.9 kr116,725.00   450.0 25455 25135.9 kr143,775.00   200.0 25441 25135.9 kr61,100.00   300.0 25329 25135.9 kr58,050.00   250.0 25356 25135.9 kr55,250.00   125.0 25258 25135.9 kr15,312.50   125.0 25259 25135.9 kr15,437.50 The top line shows my overall exposure. It states I am short 3,000 in Wall Street. My average entry is 25,419.6. The current price is 25,135.9. The 3,000 means I am short 3,000 Danish kroner per point, which equates to about 500 US dollars per point movement in the Dow. So, for every point the Dow Index drops, I make 3000 kroner, and vice versa. For every point it rallies, I lose 3000 kroner. At the time of the screen shot I am in profit by 851,000 kroner. Below my total exposure, you see each of the entries, which add up to 3,000. If you look at the previous chart, you will see the numbers 1, 2, and 3. Those are points where I am adding to my position. At Point 1 on the chart, I start selling short. I scale into my short position over five entries. Those are the first five entries you see below my total exposure. At Point 2, I add more short positions. I do so because the market is weak, and I am certain a trend day is developing. I add about 25% more to my short position at Point 2. At Point 3, I add about 10% more to my short position As the market moves lower, I add to my positions, as I have been trained to do. I move my stop-loss down as well. What you are unable to see on the chart is that initially the market moved against me. What I am doing here is critical to your understanding of fear. I have been under water on my position, and now I am finally making money. My brain has had to endure pain during the loss period, and I am now being sent signals from my mind to relieve my brain of the pain it felt during the losing period (15 minutes earlier). I counteract this pain by actively doing the very thing that causes me pain. I am embracing the discomfort by compounding it. This is required if I am to actively engage in behaviour that is the opposite of the 90%’s. You will notice that my add-on is not a big position. Yet, it serves to reinforce the right kind of behaviour. The Dow falls strongly. I am in the safe zone now. My core position cannot be threatened. My stops are placed at breakeven. However, I am still prepared to let this trade turn into an insignificant trade (small profit trade) in the hope that it will turn into a significant trade. You must find your own level of risk temperance. Once I was asked “If you keep adding to your trades, when do you take profits?” That is a great question. I use the charts to take profits. If I double bottom on a chart, and I am short, then I might be tempted to take profit. Alternatively – and this is a really good trick – I will place my stop-loss where I would want to get into the market, but in the other direction. For example, in this case, if I am short the Dow Jones Index I might place my stop-loss at the price level where I would turn into a buyer of the index. Although I am 100 points in profit, I am by no means relaxing. I am adding to my position again and again, in smaller increments, in order to reinforce the right behaviour. The trade had the potential to turn into a spectacular trade. It didn’t. The Dow bounced strongly (before falling again), and although I made a profit, it was not the amount you see on the screenshot. That is very important for me to get across to you, because I think it is important that you establish some criteria for how much of your paper profits you are prepared to give away in order to capture the really big days. There are days when I come to work, and I just want to capture 20–30 points, and then be done. Not every day has hundreds of points available in it. Then there are days when the market starts out very strongly or very weakly, and you think to yourself, “This could be a really big day.” I have a philosophy to trading that means I am prepared to sacrifice profits in order to discover how big the profit can get. If you don’t have that philosophy, you will never discover how big the profit can get. If you always think of potential targets, using technical analysis, you are most likely just talking your way out of a good trade. You might be using technical measures to time your exit, but I don’t subscribe to this method. There is a reason for that. When the market is trending, and I am on board the trend with a position, I hope that the market will close that night at its strongest/weakest for the day. It happens on at least 20% of all trading days in stock indices. Yes, I have had plenty of disappointments, but I have had sufficient stellar days to make it part of my philosophy. DAX INDEX – TRADING EXAMPLE Let me show you another example of a trade where I added to my positions. However, this time I will show you what I saw at the time of the trade. See Figure 21. Figure 21 Source: eSignal (esignal.com) I am not on board the first push down. I look at the rebound for an opportunity to short the DAX Index. On the next image you can see my initial position entries highlighted in box 1. DAX finally caves in and resumes its downtrend, as shown in Figure 22. You can see my subsequent short entries in box 2. There are a couple of things I would like you to see here: Figure 22 Source: eSignal (esignal.com) 1. I am not afraid to sell short something that has already fallen in price. This is consistent with what the majority of people do not want to do. 2. I scale into the position in this example, and I add aggressively to my short position once my position is in profit. I urge you to contemplate how you can introduce the element of adding to winners into your trading. I am not interested in rewriting your trading plan. I am not interested in turning you into a copy of me. I am interested in trying to make you understand the value of pain in trading, as a barometer for adding to positions. If it is uncomfortable, then it is probably the right thing to do. I will repeat something I mentioned earlier. I think you should give serious contemplation to the question of why people in general find it easier to add to a losing trade than a winning trade. I don’t ever want to be accused of glorifying trading. It is a risky proposition. Twenty years ago most brokers in Europe didn’t have what we today know as negative balance protection. Today, it is a legal requirement. It means that you can’t lose more money than is available on your trading account. You can still lose a lot more than you anticipate, especially if you add to positions, like I do. As you become better at trading, you will want to trade bigger and bigger size, and the market on a big position doesn’t have to change direction by a lot before you give away a big portion of your open profits. If you want proof of that, here it is. This was a perfectly good-looking DAX position which turned from being very profitable to showing a significant loss. It starts well with a short position at 11,288. I then add to the position as the DAX Index falls. Then the market reverses, and I add a little more at the old top. At the point of the screenshot I am short 4,500 kroner per point, and I am losing 25 points. I close the position shortly after for a loss. 4,500.0 11289.411314.0 kr−110,5100.00 300.011288.311314.0 kr−7,710.00 350.011286.811314.0 kr−9,520.00 400.011285.211314.0 kr−11,520.00 500.011285.011314.0 kr−14,500.00 500.011279.011314.0 kr−17,500.00 500.011274.811314.0 kr−19,600.00 450.011295.211314.0 kr−8,460.00 500.011293.211314.0 kr−10,400.00 500.011292.711314.0 kr−10,650.00 500.011312.711314.0 kr650.00 UNCOMFORTABLE There are no shortcuts in the trading industry, any more than there are shortcuts in, say, professional sports. I expect to get uncomfortable during the trading. At times it feels like the minutes last for hours. My impatience to do something is raging within me. I am battling my own emotions more than I am battling the markets. Finally, when I am in a position, my mind has something to occupy itself with. Be careful what you ask for! Maybe the position is showing a loss, so now I am battling my subconscious mind, which wants the position to run a little longer. My conscious mind has a stop-loss, but my subconscious mind wants to me to remove it. It doesn’t want to lose. It could be the position is going well. Now my subconscious wants me to take my profits. It loves the gratification of a good profit. So, I am battling it whether I am winning or losing on my trades. The key to victory starts with being mindful of the existence of two brains. The ability to anticipate your enemy’s next move is crucial. The subconscious brain is a rather simple beast. It just wants to avoid pain. For the subconscious brain there are two pains in trading. There is the pain of seeing a profit. When it sees a profit, it wants you to close it because then it doesn’t have to deal with the pain of seeing the profit disappear. Then there is the pain of loss. When the subconscious brain sees a loss, it wants you to hold on to the position a little longer and a little longer. Otherwise, it will have to deal with taking the loss. As long as the position is open, there is always hope. In a nutshell, what separates the 10% of winners from the 90% of losers is which brain they are listening to. It took me many years to realise this. I developed a system for my mind, a training program that enabled me to withstand the influences of the emotional subconscious brain on my trading decisions. During the Round the Clock Trader event referred to previously, a guest asked me if I wasn’t afraid that the market would turn back up the moment I went short. Who do you think was really asking that question? It was the part of his mind controlled by fear. Of course, the market might very well turn around. I would lie if I said that had never happened. It probably happens five times out of ten. So, the real question to be asked is this: what would cause you more pain? 1. You sell short and the market reverses back up. 2. You do nothing and the market reverses back up. 3. You sell short and the market continues lower. 4. You do nothing and the market continues lower. OPTION 1 I sell short and the darn market moves against me again. It is annoying, but the stop-loss will take care of my exit. At least I can say that I followed my plan. OPTION 2 I do nothing and the market moves back up. I might be happy, but I have just trained my mind not to follow the plan, and I was rewarded for it. I was rewarded by not selling short, which would have lost me money, and my mind is now congratulating me for my excellent chart reading skills, but for all the wrong reasons. OPTION 3 I sell short, like I am supposed to, and the market follows through to the downside. Instead of clapping my small paws in joy, I am proactive, and I add to my winning trade. I am doing absolutely everything I am meant to do. OPTION 4 I decide not to follow the plan of shorting, and the market moves aggressively lower. I would have made all the lost money back from the first trade, but I do not. I can’t speak for you, but I will tell you how I feel about it. It causes me more emotional pain to miss a move because I didn’t follow through on my plan than when I followed through with my plan. WHAT IS TOO FAR? Another question that came in after the short trade was this: “Were you not concerned that the market had already moved too far? Do you not think you had already missed the boat?” The person who asked this question is most likely the same person who would not buy the DAX because it had already rallied 1% on the day. This is the supermarket analogy all over. We seek out bargains, but we avoid buying items that have risen in price. It is a mental illusion. You can’t say the DAX is too expensive just because it has rallied 1% on the day. We do not want to buy something that is already going up. We would rather wait until it comes down again to buy it, because then it is cheaper. Similarly, we do not want to sell short something that is already going down. We want to wait for it to rise again and sell it when it is higher (more expensive) because it gives us better value. In principle, I don’t disagree with these statements, but here is the flaw: that is what everyone else wants to do, and the majority tend to be wrong. Correction: they don’t tend to be wrong; they are wrong. Sure, they are right 60% of the time, but when they are wrong they are really wrong. How do you know where the top or the bottom is? I have seen a lot of trading systems, but none of them had an acceptable success ratio of predicting tops or bottoms. This is why I say that you should buy strength and you should sell weakness. Buy high, sell higher; sell low, buy back lower. Will I miss the absolute turning points? Yes, I will. Top pickers and bottom pickers soon become cotton pickers. When I am distressed about profits disappearing, I remind myself of the story of a US super trader whose reputation for doing the right thing under pressure is legendary. His name is Paul Tudor Jones. He was once watching the market and, as it had been rising all morning, he had been buying steadily. He was long several hundred contracts showing a good profit. Suddenly the market jolted lower for no apparent reason. Without blinking, he sold out all his long positions, and as the market continued to fall, he started to sell short the market too. One of his colleagues who didn’t know he had commenced shorting the market commented on the fall and said this was a good chance to start buying. The conversation, edited for expletives, went on as follows: “Are you mad?” said Paul. “What do you mean?” said the colleague. “You must be mad. The market has just broken 100 points in 15 minutes, and you are looking to buy it?” “Well, what would you do?” “Let’s put it this way, I am certainly not looking to buy it here.” “Well, would you sell them short here?” “Of course I would!” “But they have come down so far.” “Exactly, that’s the point.” “Right,” said the colleague. “Well just how far would the market have to fall before you started to buy it?” “As long as it is going down, why would I buy it?” “Because it’s so cheap, it’s an absolute bargain. It’s 100 points cheaper than it was 15 minutes ago.” “Forget cheap. Forget expensive. It’s just numbers on a page.” “But I don’t understand. If it kept going down, where would you try and buy it?” “If it kept going down, I’d want to be selling it, not buying it. If it kept going down, I would sell it down to zero.” “And if it was going up?” If it kept going up, I’d buy it to infinity.” I absolutely love this story. Having seen Paul Tudor Jones trade, you sense his energy, his intensity and determination, and his utter conviction in whatever he does. He doesn’t just say, “Sell short.” He shouts, “Sell short!” stamps his feet and swings his hands. I admire his mental agility – flowing from being convinced on the long side to turning the position to the short side. Sadly, this is one trait that is hard to acquire. I know some traders with decades of trading experience who are unable to flip the switch and go from being long to being short. FINDING A LOW Trying to find the low in a stock can be a costly affair. We all make mistakes, but how costly is the mistake going to be? I remember very vividly watching a CNBC show called Mad Money, during the financial crisis in 2008. On the show Jim Cramer received an email from a viewer asking about the health of Bear Stearns. Now I am sure that if Mr Cramer had an opportunity to go back in time he would most certainly amend what he said in that broadcast. He basically shouted at the screen, saying that Bear Stearns was fine. But a few days later Bear Stearns was gone, done and dusted, never to be seen again. You may recall my first brush with meeting clients back in 2001. I gave them the not-so-welcome advice to get the hell out of their Marconi shares. Would you believe it if I told you that history repeated itself in 2007? It is easy to be swayed by a supermarket mentality when we are trading. As I mentioned previously in the book, when we go into a supermarket, we are drawn towards the special offers. When I look at my shopping basket from this weekend, I see things that I wouldn’t normally buy. Of course, I would need these things at some point or another. We all need toilet paper. We all need dishwasher tablets, and we all need hand soap. The reason why they were in my shopping basket this week was because they were on offer. Who can resist a 50% discount? But a 50% discount in a supermarket is not the same thing as a 50% discount in the financial markets. Many clients of City Index, the broker I worked at for more than eight years, came face to face with this reality during the financial crisis from 2007 to 2009. In 2006, after having done very little for years, a stock called Northern Rock went on a tear. It rallied 50% in months. There was no real interest from City Index clients in the stock during the rally phase. However, when it began to slide back down again afterwards, the interest rose. It was as if Northern Rock had the same effect on investors that half- price toilet paper has on shoppers in a supermarket. Northern Rock became quite a lively traded stock. The more Northern Rock fell in price, the more people got interested in the stock. At one point I received a phone call on a Saturday morning at home. At this point Northern Rock had slipped from 1200 pence down to around 500 pence. The person on the other end of the phone was a stranger to me. He had picked up my business card at one of the talks I had given on technical analysis. He apologised for calling me so early on a Saturday morning, but he and his friend had decided to invest in Northern Rock. They had decided to get the opinion of a professional, just to double check whether it was a good idea. Apart from being rather annoyed at being woken up at 7 am on a Saturday by a stranger, I was also annoyed with the question. At this point Northern Rock was in freefall. I roughly said the following to the stranger: Look, I don’t know what is going on with Northern Rock, but there is something horribly wrong. Although the general market is declining too, Northern Rock is declining much more. What I am afraid of is that there is something amiss that we don’t know about, and it has yet to be known to the market. It feels as if someone somewhere knows something is horribly wrong, and they are selling out while they can. I told him that I had many clients who had said exactly what he was saying now, but about Marconi five years earlier. Fortunes were lost by clients who kept buying Marconi, even though it was falling and falling, because they engaged in bargain hunting. It had been horrible to see the losses our most valuable clients endured simply because they did not want to admit they were on the wrong side of a bad share. I said to him: “From a trader’s perspective, you are engaging in a very dangerous activity. If you buy Northern Rock now, it will be very difficult for you to have a meaningful stop-loss. You are essentially trying to catch the falling knife. You talk as if Northern Rock is the only bank in the world worth investing in. “You talk about Northern Rock as if it couldn’t go bust. You talk about it as if the fact that it is 200 years old means that things couldn’t get worse before they get better. You even said it yourself: Northern Rock is too big to fail. It means you are already to some extent aware of the danger here.” I asked him if he remembered Barings Bank. He did. “There is a second reason why I don’t think it’s a good idea you buy Northern Rock,” I continued. “Let’s say you are fortunate enough to witness a turnaround in the fortunes of Northern Rock. You will have trained your mind to think that it is perfectly okay to buy into things that are falling. This works perfectly in a supermarket. Toilet paper has a practical use. Soap has a practical use, so when you are provided with an opportunity to purchase these items at a 50% discount, you should do it. “However, to believe that the financial markets offer discounts akin to what you’re seeing in a supermarket is ludicrous. The financial markets are not a supermarket with special offers.” Eventually Northern Rock went bust. The British government had to guarantee customers’ savings. That didn’t stop panic scenes as people queued up to get their money out. THINKING RIGHT As you read this anecdote, you might think it could never happen to you. Perhaps you are right. I am not going to suggest otherwise, but I would like to ask you a simple question. Imagine you have two investments, Investment A and Investment B. Each investment had equal starting value of $100,000. Investment A is doing well. It is up 50%. Investment B on the other hand is not performing. It is down 50%. You are now in a situation where you need $50,000. What do you do? 1. Close a third of Investment A to raise $50,000? 2. Close investment B to raise $50,000? When I asked this question to a group of investors at a conference in Copenhagen recently, the overwhelming majority opted for option 1. They would close enough of investment A to raise the $50,000. Why do you think that is? Why do you think people close the investment that is doing well? My theory is it all boils doing to how people react to taking a loss. Are they able to take a loss and move on? Or are they so averse to taking a loss because as long as the position is open, there is hope it will come good again? Of course, it is impossible to say exactly how you would react in this situation, but I don’t have to rely on fictitious examples to get an answer. If you recall the chapter where I spoke about the 43 million trades executed by 25,000 traders, you will remember that those traders lost more on their losing trades than they won on their winning trades. Emotionally, a loss is clearly felt much harder than a win. Otherwise, there would be no reason for this anomaly. Human beings postpone making decisions that will cause pain. It is the reason why we let losing trades run. We want the instant gratification, but we want to delay the pain. Hope dies last. As long as the losing position is open, there is hope. THE JUNKIE AND THE CEO I use an analogy to illustrate the concept I have just explained: it is akin to firing the CEO of a successful Fortune 500 company and betting your money on the junkie turning his life around. Crude? Yes. The junkie might turn his life around, but I think the odds of the CEO continuing his successful run are higher than those of the junkie turning a corner for the better. That is why I am arguing that trading is so much more than technical analysis. That is why I am arguing that we need to learn to handle losses a lot better than the general population does, because they handle them very poorly, and as a result they are generally unable to make money from speculation. CONTROL YOUR MIND – CONTROL YOUR FUTURE I am not a masochist. Nothing could be further from the truth. If I do tend to dwell on pain, it is more a reflection of pain’s role in the context of trading profitably. What I’m attempting to do is a difficult endeavour. I’m trying to explain why 90% of all people fail in achieving their hopes and dreams when it comes to trading. When so many people commit the same mistakes over and over, there must be a deeper meaning that has yet to be uncovered. Naturally I’m hoping that by now you will have a much greater understanding of what it is that is going wrong. My own motto is: control your mind – control your future. Doing so requires constant vigilance. You have to own your life. If you don’t own it, you are not the boss. You have to take full responsibility for everything that you do. You must be the master of your own kingdom. You can’t walk through life with your eyes half shut. You have to walk through life with your eyes fully open. You have to know what you are getting into – be prepared. You have to take possession of your life. This is a thought process you have to constantly reaffirm. Our minds tend to drift. There are so many distractions in life, so much superficial noise that doesn’t bring substance but that our brains are attracted to nonetheless. The brain would rather look at Facebook and YouTube than sit in quiet contemplation. The drifter brain needs to be controlled through daily vigilance, whether it be through a mantra or meditation or whatever you decide suits you best. As a famous doctor once said when asked what exercise is best for us humans: “It’s the one you do”. It doesn’t matter whether you meditate or write a diary or do whatever other practice you choose to centre yourself, so long as you do it. There needs to be a regular time in your day where you remind yourself of your purpose, of who you are. The world is full of temptations that distort a healthy self image. The temptations take us away from who we are by telling us that who we are is not enough. But you are enough. Being a good trader really has little to do with tools and charts. It has a lot to do with fighting our humanness. If you really want to trade the markets using leverage, engaging in high-octane speculation, you have to learn to desensitise your normal emotional response mechanism to fear, greed and other delightful human reactions. You have to fight your humanness. DISGUST MANY YEARS AGO, when I was just a young man, I had a girlfriend. She was my first real girlfriend, and I was her first real boyfriend. We were young, and we were very much in love. My girlfriend was a little round bodily, which I found very attractive. She, however, did not like her body image, so she began to diet. She had dieted before, but had always failed to sustain a weight loss plan. Now she was in love, and her motivation shifted into another gear. The weight loss became quite dramatic, and it led me and her family down a path that pains me to write about. Anorexia is a serious psychiatric disorder, but (and forgive me for using a tragic story to illustrate a point about behavioural change) it is an interesting motivational phenomenon. We are hardwired to eat. We need no training to eat. Yet somehow this hardwired pattern is overridden by a social motivation: the desire not to be overweight. This force, this motivation, is so strong in patients with an eating disorder that it proves to be impervious to both medical and psychological treatment. What is the basis for this powerful motivation? It isn’t chanting, and it isn’t positive self-talk. As I understand it, my girlfriend was motivated by love, but more importantly by disgust. She was disgusted by anything that looked and felt fat and overweight. This force was so strong it could disrupt her hardwired pattern of eating food. As humans we are driven forward by forces. Those forces can be born out of a desire to move away from something, or they can be born out of a desire to move towards something. I happen to be a person who is primarily motivated to move away from something. I grew up in a wealthy part of Denmark, and I attended a school for the well-to-do. Then my parents divorced, and I went from living in a big house with an enormous garden to living in a one-bedroom flat, where my father would sleep on a pull-out sofa bed in the living room. I was a young boy at a time when all my school friends wore Levi’s denims and Lacoste shirts. There was no money for that in my life, and it created a sense of inferiority in me. As soon as I was old enough, I started taking afterschool jobs in order to earn money. What did I spend it on? You guessed it. Brand clothes. I also became a prolific hoarder of money, a saver, if you like. I took great pride in depositing my wage cheques in the bank and seeing my account balance grow. I moved away from poverty. In my belief system and in my experience, away-oriented goal setting is a much stronger motivational force than towards-oriented, but I accept that this is an individual preference. You can test for yourself where your preference lies, using a simplistic scenario. What would compel you to lose weight more: a picture of you in perfect shape or a picture of you where you are obese? I asked my circle of friends what they would prefer, and all agreed that they would find the obese picture a stronger motivator than the perfect picture, although a few did comment that they would probably still like to have both. Fair point. I believe that disgust is a much stronger emotion than joy or happiness. We all have reasons to be happy every day, but we tend to forget that. However, disgust is not something we are likely to forget. You won’t forget the rotten milk you drank by mistake, nor will you forget the client of yours who had such repugnant breath that you nearly threw up. Ed Seykota once said that everybody gets what they want from the markets. When I read that, I dismissed it. I wanted to win, but I wasn’t winning, so I clearly wasn’t getting what I wanted. End of story. It annoyed me that he had said that. The thought of never being able to trade profitably consumed me. I had spent so much time studying, researching, testing, formulating plans, calculating ratios that I really didn’t know what more I could do. If you look around in your life, you are likely to be able to find examples of dramatic changes induced by disgust. What gets a person to finally commit to a goal is reaching the point of disgust. I got disgusted with my trading over a long period of time. The pattern was always the same: 1. Trade like a wizard. 2. Become over-confident. 3. Blow up the account. I became so sick of it. Positive intentions, sticky notes with mantras on my trading monitor, and self-help exercises don’t possess nearly the motivational force of physical disgust with oneself. If disgust can turn eating into a behaviour to be avoided, and if disgust can turn an alcoholic’s drinking into a thing of the past, then disgust can also turn you into the trader you would be proud of looking at in the mirror. I am sorry if I have shocked you. Those of you who know me well will probably be taken back by my extreme steps to ensure my pattern of behaviour in the trading arena is exemplary. I am not going back to the rollercoaster ride I was on in my early trading days. I was so disgusted with the amount of money I lost. It was embarrassing. We are most apt to change a pattern once we become truly disgusted by it. Would you continue to do business with someone who violated your trust and stole money from you? No, you’d become so disgusted with such a dishonest character that you would cut all ties with them. Well, that person is you when your own patterns violate your contract with yourself and cause you to lose money consistently. Once you become truly disgusted with your own patterns, you’ll shun them altogether. A trader is losing and continues to lose because he doesn’t want to change. Change is hard work. I began plotting my trades on the chart when the day was over. I put a marker where my entry was and where my exit was. It was horrible. It was like incriminating yourself over and over. I was disgusted with my recklessness. I had to face up to the fact that I was actually an awful trader. I was like the guy who could recite the entire technical analysis syllabus for the Master Technician exam, but I could not stop myself from 1. Overtrading out of boredom. 2. Overtrading out of anger and a desire to get revenge. 3. Impatient trading – jumping the gun. 4. Trading against the trend – trying to catch the low of the day. 5. Fearful trading – by cutting my winners short out of fear the profit would disappear. 6. Constantly averaging in lower and lower – i.e., adding to losing trades. ALCOHOL When you are a successful trader, you make good money. My friend and trader mentor Larry Pesavento instilled in me the passion for passing on. Larry himself is an inspiring trader, but his passion for helping others is equally admirable. One project I support is to help people dealing with alcohol issues. I do so by offering anyone who sincerely desires to quit drinking a book that helped me truly understand the nature of the addiction trap. I developed a drinking problem in the aftermath of a painful breakup. I drank to forget. I was in love. I was a fool. She left me. I started drinking. The problem was that I didn’t seem to be able to stop myself from drinking. This carried on for many months. I could not stop myself from drinking, so I sought out help. I remember vividly standing up at an Alcoholics Anonymous (AA) meeting saying, “My name is Tom Hougaard. I am an alcoholic.” It was horrible, but at the same time it was relieving. I felt like a fraud. I felt there was inconsistency in my life. I was outwardly a success. I had two cars. One was a luxury SUV, the other an Audi R8. I lived in a nice part of town, overlooking the sea. What did I have to be unhappy about? Well, for one, I had no control over myself and my drinking. Standing at an AA meeting is like being stripped naked for the whole world to see. They see your fat ass, your tiny willy, your saggy boobs, your cellulite, your scars, your spots, your pimples, your swellings, your bald head and whatever bodily imperfections you can imagine. It is absolutely everything you don’t want, and you have a hall full of eyes watching you. But by the end of the exercise you realise the truth. You break yourself down so that you can survive, so that you can be reborn as the person that you really want to be. A fresh start. Vanity thrown on the rubbish pile. Clean canvas. Here I am. This is me. The walls are ready to be decorated however you want. Exactly the same model is used to train elite soldiers. They are pushed beyond their breaking point. Then they are put back together again, stronger, wiser and with an unshakable faith in their own strength, their own abilities and their determination to get a job done – no matter what. No one in their right mind enjoys exposing themselves like this. It is why we get defensive. It is why we fight our corner. Our identity is being questioned. Call it ego, call it identity, call it what you want, but no one likes having their intelligence questioned. It is a lot less painful to continue down the known path than to stop, evaluate, and turn around. There is only a slight, nagging pain when you choose to continue down the known path, and you can soothe your inner pain by reminding yourself that you are not alone. There is power in numbers, even when everyone is wrong. But you soon find yourself being disgusted by your own lack of progress, your own inability to stop the behaviour that is troubling you. Attending AA meetings was rock bottom for me. I evaluated. I got honest with myself. The pain was relentless because everything was new, and I felt naked, very alone and exposed. And yet, that is power! There is power in being honest. There is power in standing up and saying to the world and yourself: “This is who I am, and I don’t like it! In fact I hate it. I am embarrassed by it, but it is what it is. It is a clean slate. It is a fresh start. It is like a forest fire. It clears the debris. New growth can start.” I have not touched alcohol for six years and I know I never will. It wasn’t the AA that finally helped me; it was healthy living advocate Jason Vale. I have never met the man, but I want to thank him for setting my life on a good path. I am certain that no one has bought more copies of his book about alcohol dependency than I have. I send them to people all over the world. Jason describes better than anyone the trap of alcohol. Reading his book helped me understand the nature of addiction on an entirely different level, and I found it easy to stop drinking from day one! You may ask what this has to do with trading. Rightly so. The answer is simple: if you have some trading experience, and it is not turning out to be how you want it to be, you have a choice. You can carry on, thinking that things will change. I can tell you they won’t, but you will probably not listen to me. Or you can take my advice. You did after all make it all the way to this section of the book, so maybe there is room for improvement. You can strip yourself naked (metaphorically speaking), and get honest with yourself. You can stop trading, and start reviewing. You can begin to understand what it is you are consistently doing that causes you not to make money trading. Take yourself apart, clean up the process, take on board my guidance for the mental side of trading, put yourself back together again, fund a small account and start with an entirely fresh mindset and approach. THE DRIFTER MIND HOW OUR MINDS work is fascinating. The brain can be our best friend or our worst enemy. When I give talks in public, my own life mantra is written on virtually every PowerPoint page of any presentation I give. Control your mind – control your future. You have to want to do what you do. You can live a life that is authentic to your soul, or you can live the life you think people want you to live. You can be authentic and own your life and take responsibility for everything you do. If you don’t take ownership of your life, you are not the boss. You have to take full responsibility for everything that you do. Why would you live life any other way? Why be subservient? You must be the master of your own kingdom. But brace yourself. You will be forced to make many difficult decisions, and you cannot count on your mind to back you up if your determination wanders a little. You can’t just walk through your life with your eyes half open. You have to know where you are going. You have to take possession of your life. It would be nice if you could rely on your friends and family, but when it comes to your life’s journey, you are on your own. It is your responsibility. Part of that journey, including your trading journey, is to discover your weaknesses. You have to know where your mind lets you down. For the vast majority of people in the world, this will include their mind’s tendency to wander. You see, all of us know what to do. All of us have the knowledge to do what needs to be done, but the path from knowledge to action, where we implement our knowledge, is elusive for many people in many areas of their lives. Your mind will drift. This is unfortunate but perfectly natural. The solution is trivial, and it is powerful. You have to constantly reaffirm your purpose. Whether you meditate or talk to yourself while you brush your teeth in the morning, there needs to be some period in your day when you remember your purpose. There must be a time to remind yourself where you want to go, what you want to do. One thing I can’t always rely on is my ability to act in my own best self- interest. My mind needs constant guidance and direction. I don’t know why that is, but it is. I suspect the majority of the population of the planet is put together like I am. They just haven’t realised it yet, so they drift through life, rather than taking charge. This doesn’t mean they can’t be financially successful, but wouldn’t it be nice to be both financially and spiritually fulfilled? Your job after all is that thing that you do the most, outside of sleeping. I am a professional trader. I cannot afford to go into the trading ring without being 100% mentally prepared. My profession is a mind game like nothing else. If I want to win, I have to focus on what is important now. So Ed Seykota was right, much to my chagrin. I did get what I deserved, because I was only good at one part of the game. I was good at the technical part. I don’t like this metaphor, but being good at the technical part of trading is like being good at putting together a sniper rifle; what good does that do you when you go into combat and you don’t know how to handle yourself? I actively take control of my inner world. I have to give myself enough confidence to reassure myself that I have enough to go out and kick ass in the markets every day. To make that challenge even more real, I post my trades for the world to see. I have never consciously thought about why I do that, until someone recently asked me. I realised that I do it because it keeps me accountable. It keeps me focused. I have been as lost as they come. I tell you that not to inspire you to get lost, nor to evoke sympathy, nor to tell a tale of rags-to-riches, but to make sure you understand that exposing your weaknesses will be a good thing. Your mind is a tool. If you let it delude you into thinking all is well, you will not get the success you want in trading or in life. Losing and failing might be a knock to the ego, but it is rocket fuel for growth. It sounds like I am trying to write a self-help manual for procrastination, a bestselling inspirational book. But I am describing honesty. When you are honest with yourself, in the company of yourself, or on a podium in front of 40 alcoholics, or whatever the setting may be, you just took a step that 99% of the population don’t ever contemplate taking. You already started the journey to winning. So, the journey starts with technical knowledge acquisition and continues indefinitely with the constant evolution of both the technical and mental training. Technical training is part of my day-to-day job, but the mental part needs more dedicated focus, otherwise it gets lost in the noise of the outside world. I need dedicated time to give that brain of mine a workout. I want to show you one of the mental warmup images that I go through before the trading day starts. It gives me the visual evidence I need to act in a manner that is aligned with what I am trying to achieve. This example happened a while ago, but it could happen any day of the week if I don’t mentally prepare myself. Figure 23 tells the tale in all its glory. Figure 23 I short a double top off the open. I am so certain that my research is right. The market will fall. I don’t have a problem with the first short position. I have a problem with the four subsequent ones. I could even forgive myself for the last one, because at least I am shorting weakness. This is unstructured and undisciplined trading. I don’t care how certain I am of something happening. If it isn’t happening, don’t pursue it as if it is. Showing you is so embarrassing! This is part of my preparation. It has been the most useful tool to build mental stamina and discipline. It reminds me of everything that is weak in me. It reminds me of how my mind, if left unchecked and untrained, will go on a rampage to seek excitement and gratification. One of the best ways to increase profits is to use goalsetting and visualisations to align the conscious and subconscious with making profits. I use fear to achieve my goals. I imagine trading a size which even in my mind makes me uncomfortable. I sit quietly in my bed or in my office. The world is quiet, and if it isn’t, I stick a pair of earplugs in my ears. I imagine I am trading, and the market is moving against me. I see myself cut the loss. I imagine I bought the XYZ, and I see it going my way. I feel the brain sending me signals to close the position to crystallise the profit. I see myself doing nothing, as I continue to watch the profit increase and decrease. I see a big profit turn into a small profit. I smile and accept it, and I move on, telling myself it is okay. I place my brain under as much stress as I can with imagined scenarios. I am long and the market is going my way, and a sudden news story breaks the market. I observe my fear shooting through the roof as my P&L turns into a bloodbath. I see myself closing the positions and going in the opposite direction. I see myself not getting unhinged just because the market is moving against me. I cannot guarantee that this approach will work for everyone. Perhaps you think it is brilliant, or at least could be useful after a few personal tweaks. It works for me because I learn visually. I get the message when I see it visually. If you tell me not to trade against the trend, it will not mean any more to me than when a cat meows. But show me a chart with my trades plotted on, with me trading against the trend (better yet, show me repeatedly), and I get the message. This is my therapy. This is like seeing a psychologist every morning. I get fired up. The therapist expands my mind and my horizon. The goal is to remind myself of what behaviour I want to enact. It is about making changes and keeping the changes. So what makes me think this will work for you? Behaviour is patterned. How we think, feel, and act has a pattern to it, and that patterning is what makes us who we are. The sum total of our patterns is our personality. Sometimes our patterns interfere with our goals and dreams in life. They prevent us from being who we want to be or accomplishing what we want to accomplish. We are sometimes our own worst enemy, and we seemingly can’t stop ourselves when we are in the moment. A person can know very well that they have anger issues, and yet be unable to prevent themself from lashing out. Another might have eating issues, and yet can’t exercise the needed restraint in the moment of eating. A trader is fighting the trend all day and his account is suffering, but he can’t stop himself. He is simply incapable of turning his position and trade in the direction of the trend. Only afterwards is he disgusted with himself. The purpose of my warm-up is not to take away everything that is bad in our lives in one swift move. The purpose is not to guarantee I won’t mess up. The purpose is to focus on what I want to achieve or become, while being mindful of the things that will most certainly sabotage my goals. The wonderful part is that I am almost certainly guaranteed success if I avoid the failures. I was guaranteed success with my weight goal if I could cut out all the Coca-Cola I drank. I just had to be mindful of that, and the pounds began to come off. I didn’t have to do anything else. I don’t have to be certain that my trade is going to work out. I just have to be aware that my mind wants to do things that are not in my own best interest. So, I don’t add to my losing trades. That in itself means I just need to be mindful of the one variable I can control. My action in the morning is about changing the patterns that do not serve me. This started by observing another very successful trader and asking myself what was holding me back from becoming him. My technical abilities were just as good as his. I don’t think he was financially much better off than I was, but he was seemingly fearless. How could I become fearless in trading? Did I even want to be fearless? I came to the conclusion that the trader I wanted to become was patient but aggressive when the time was right. It was like Federer playing in the Wimbledon final in 2007: he was patient until just the right moment, and then played with focused aggression. After that it was a question of reminding myself of that goal every day, and several times a day if necessary. That is how habits are built: through repetition. As I grow wiser to the ways of life, I realise that there is a lot of truth to John Lennon’s words, “Life is what happens to you while you’re busy making other plans.” We become so engaged in our day-to-day life, with responsibilities at work and home, that the big picture of our lives stays in the background. Day after day, year after year we busy ourselves with work and routines, only to realise later in life that opportunities have passed us by. So, the first question to address in a change process is: “What do you want to change?” Or, stated otherwise: “How would you like your life to be different?” My answer? I want to dedicate time to trading well, to combat my natural inclinations that stand between me and successful trading. I want to prepare my mind every morning through a series of meditations and visual exercises. To achieve this I will train my mind to act calmly through visualising myself in difficult situations. I will focus on my breath. I will calmly put myself through stressful situations to ensure I would react how I want to react if the circumstances were real. Making changes entails far more than simply engaging in positive thinking or getting positive images in your head. I didn’t want positive images. I wanted a portrait of the dire hell I would reside in if I didn’t change. This may seem like a negative state of being, but it really isn’t. It is immensely positive, albeit a rather tense way of getting what you want. As the saying goes: “The end justifies the means.” I have turned conventional thinking on its head. I do so because I know what compels me more. Roses don’t compel me. Thorns compel me to action. Consider the market itself. It is not so unlike us in its behaviour (because we are the market). It climbs the wall of worry, but it slides down the slope of hope. It might be a Wall Street saying, but it says a whole lot more about humans than it says about the markets. All I have done is used fear and disgust as my protagonist – my major motivator. GETTING BACK IN THE GAME I was surfing in a town outside Biarritz, France, in 1996. I was literally in over my head. The waves were twice as big as anything I had ever handled before. I tried to drop in a few times, but the waves were too fast, and the lip was so steep. Finally, I got myself positioned for a wave, but I was too far into the impact zone, and instead of gliding into the energy path of the wave, it literally knocked me out. I just remember everything going black. Luckily for me someone spotted me and pulled me out of the water. Eight lives left. I was back in the water that afternoon. I was too stupid and ignorant to consider what had happened. Ignorance is bliss. It is only now that I can appreciate my behaviour. Sure, you took a hit, but you are okay. Do you want to sit on the beach and mope all day or do you want to get back in the game? Here’s an example illustrating the importance of getting back in the game. I am writing this the day after a particularly challenging and volatile trading session. It was one of those days that will stick in your my mind for reasons that will shortly become apparent. Over the last week oil has dictated the mood of the stock indices. Naturally, I expected to see the same behaviour on Friday. The Dow started off with a 200-point rally at the open. However, 30 minutes into the trading session, it seemed to lose momentum. Oil on the other hand was in full-blown panic. I started shorting Dow, expecting it to follow oil. In Figure 24, Dow is on the left, and oil is on the right. Both are five-minute charts, and both show the entirety of the trading session from about noon until late evening. Figure 24 I expected the Dow to follow oil, and it did, but not for long. It seemed to pause, as if it suddenly had a mind of its own. By mid-afternoon oil had dropped almost $2 – more than 5% – in little over an hour. The Dow, however, wasn’t moving lower with it. It held. I took my Dow short position off with a loss, and I reversed to long. As soon as I had done that, the Dow dropped 50 points, and oil dropped even lower. I began to wonder if I had simply been too quick to reverse my position, and I decided to close my long position. By now I was convinced the Dow had merely delayed its inevitable fall. I went short again. In hindsight that turned out to be near the low of the day (after the open). Just 15 minutes later the Dow made new highs for the day. I closed my short position and scratched my head. I had gone short at the first low and I had closed at the second high. I had gone long at the second high, and I had closed at the second low. I had gone short at the second low, and I had just stopped myself out at the new highs for the day. I took a moment to reflect. Was I trading with a plan? Was I betting on a relationship between oil and the Dow Index that might not be there anymore? Just then my best trader friend called, and we spoke briefly. I said to him, “What does it mean when the Dow makes new highs on a Friday evening, even though oil is plummeting?” Saying it out loud helped me to get some perspective. It was the last day of the month, which often brings aggressive buying or selling in the market. Remember it was also a Friday, which has a tendency to bring about trend days. I started buying, reluctantly. The market went higher. I bought some more, careful to move the stop-loss up as the markets moved higher. I kept an eye on oil. It was recovering nicely. With 60 minutes to go (and no dinner), the Dow made a new high for the day; and I know from my statistics that you should not short a market that makes new highs for the day in the final hour. By then I began to add more to my position. I was now betting on a classic trend day finish. On those days the market closes right at the high tick of the day. It would have been easy to throw in the towel after the three failed attempts to get on board a move in the market. The effect would have been the same as stopping the game of throwing coins just because you have had three of a kind in a row. I hear about people who stop trading because they have three losing trades in a row. That is a flawed approach if you understand the markets. If you are ill, or you are weighed down by emotional circumstances, then you stop trading. If you are otherwise able, you don’t stop trading just because you have lost three times in a row. As I type this, I look back at my trading before the Friday. I had lost on every other day that week. It is rare, but I had four losing days in a row. I don’t even remember when that last happened. In the movie Floored, the trader Greg Riba puts it so elegantly, albeit in his own way: I swear to god that 99% still don’t get it. When they are winning, they start betting less. Bet more. I mean, if there is one roll that you can make a hundred thousand dollars on, let it ride. If you roll three sixes in a row, let it ride. Let the winners ride. Greg Riba should know. He was said to be one of the best S&P 500 futures pit traders ever. Why do people bet less when they are winning and bet more when they are losing? Fear. TRADING THROUGH A SLUMP I HAVE A FRIEND who was suicidal because of the losses he sustained. He called me to say that he was standing at a railroad bridge. I don’t think it was his intention to end his life. I think he needed someone to talk to. Some would argue that a chapter of this nature does not belong in a trading book. I think people who have lost significant amounts of money will find it reassuring that the focus isn’t one-sided. Either way, while I have plenty of positive memories from my trading career, I also have memories that can only be described as dark. I had a friend called Adam. I no longer know of his whereabouts. He owes me £20,000 – money I doubt I will ever see. Adam was a brilliant trader. Absolutely brilliant. Until it all unravelled for him. Adam and his brother worked on the factory floor for their father’s thriving business. During the 1990s Adam became interested in trading. Over the ensuing years he developed a system for trading stock indices using a 30- minute chart. He told me it was inspired in part by George Taylor’s book The Taylor Trading Technique. It was a simple but very effective strategy. It required Adam to check the charts every 30 minutes, and if the parameters were right he would execute a trade. Otherwise he would leave it alone until the next 30-minute period was up, at which point he would check the charts again. Adam became so adept at trading the 30-minute chart that he soon made much more money trading than he did managing his father’s factory. He decided to sell his share of the factory to his brother and focus all his energy on trading. Adam did well. Really well. I traded with Adam on many occasions in my house or online. He possessed a supernatural patience. I have personally never seen a person stare at a screen from the open of the US market to the close of the US market and not trade once. Yet that was the norm for Adam if there was no signal. Amazing patience. I believe that Adam’s patience and pattern-reading ability made him the supertrader that he was. He lived the life of the supertrader too. He ordered a custom-built house. He travelled first class to exotic holiday destinations with his loving wife and children. However, all supertraders will go through bumpy terrain at some point or another. It is not a question of if it will happen – because it will – but a question of how badly it will affect them when it inevitably does. For Adam the bumpy road caused him to lose everything. His trading account, his wife and his house. I stepped in when Adam was living on the streets in Manchester, suicidal and penniless. I did what I could – but Adam didn’t want my help, and I lost contact with him. It started with a bad loss, and it escalated into a complete blow-out. Adam had seen a pattern on a Friday night, and he had gone maximum short the market. At the close he was well in the money, and he decided to keep the position over the weekend. Unfortunately for Adam, this was the weekend when the American special forces finally captured Saddam Hussein. The financial markets cheered at the good news. I guess naïvely they thought that the Middle East powder keg would settle down once Saddam had been captured. That Sunday night the American markets opened limit up! Limit up is a situation where the market is unable to move any higher until the stock market opens at 9.30 am in New York. Adam was short, but he was unable to close his short position because when the market is limit up you can’t buy, which is what you need to do to close a short position. Adam was awake when the phone call came. It was his futures broker. Adam was informed of his options: deposit more money on the account or risk being closed out once the future market came out of limit up. Adam didn’t have any available capital. It was a long night and a long day until the market finally opened at 2.30 am (Adam lived in the UK). The market opened and stocks soared. The broker liquidated his position because he was in breach of the margin requirement. The account had stood at close to £750,000. Now there was only £400,000 on the account. You may say that £400,000 is also a decent pot of money to trade with, but something short circuited in his mind. He saw the market soar that day, and he saw his position being liquidated. Unfortunately, he also saw how the market came all the way back to his entry point. You see, once the good news had been digested by the market, there was a feeling that this probably wasn’t such great news after all. The Dow Index came all the way back, giving up all the gains for the day. Adam felt the broker had cheated him. He felt as if he had been forced to liquidate. He felt that the broker had acted too hastily. He tried to complain, but his claim was rejected. He then tried to make up for the lost money through trading, but his head wasn’t right. He began to second guess his system and double up on trades. Then his builder demanded payment for his house. Adam had paid a deposit, but now he couldn’t make full and final payment. He lost the deposit and the house. Adam was unable to stop his own downfall. So was his family. He began a pattern of lying and withholding information for his own gain. The last time I heard from Adam was when he cheated me out of a fair sum of money, only to disappear. I haven’t seen him since. Sadly, this is not an isolated story. I have had to cut short a business trip while working in the London because my boss called me back to the office. There was a client in our reception crying his eyes out because he had lost £750,000 trading forex. He was afraid to go home and tell his wife about it. He begged my boss to lend him money so that he could trade again and hopefully make the money back. You may think that this individual lacks the moral fortitude to trade. You may even think less of him because of his apparent lack of dignity. What if I were to tell you that he was a renowned surgeon in a prestigious private London clinic? Education means very little in this industry. It doesn’t matter where you went to school or what your day job is. If you don’t know how to handle a losing trade, and then a winning trade, you will not go very far in this arena. It is for this reason that I tell people to spend less time on technical analysis and more time on self-analysis. Successful trading can mean just making a good living. I got a message from a close friend of mine. He trades full time. He has been doing it for 15 years and, unlike so many other hopefuls, managed to make a success of it. He has made himself a good living over the years. I don’t know many traders who like to talk about what they earn from their trading. When I spoke to my friend about it, he told me he had made about the same as if he had a well-paid managerial job in the City. However, he had no commute, and he had time to be there for his children when they came home from school. To me, my friend is an example of a person who made trading work for him. He had not made himself rich in the process, but he had paid the bills, put food on the table for his family, taken them on holidays, and bought a nice family car. There seems to be an inclination to describe trading as the venue for making untold riches. Yes, the potential is always there, but with bigger reward comes bigger risk. You can’t catch big fish in shallow waters. However, my friend was tiring from the long hours, and he called me to talk. He asked me if I had ever had enough of the endless hours of watching the screens. I immediately responded, “No, and if you feel like that, you have to stop trading and take a break from it all.” We spoke for a while that night on the phone. He told me that now that the kids were older, they wanted to hang out with friends rather than their old dad. His wife worked full time too. It meant he was often alone in the house from early morning until later afternoon, and it began to bother him. I helped him get a few job interviews and he secured himself a job as a broker in London, on account of his in-depth understanding of the markets and his ability to understand what clients are going through in their trading. A fairly innocent story, I am sure you would argue; so why am I telling you about my friend? Well, I am telling you the story for several reasons. The first reason is that trading can be a very lonely business. It has never bothered me, but I have the deepest of sympathy for those who feel lonely while trading. I am not sociable, don’t drink or smoke, can’t stand watching a football match (that excludes me from a lot of male social activities) and prefer my own company; but even I like to pick up the phone from time to time and just shoot the breeze with a friend. When I worked in the City, I would at times stick my head into my boss’s office, who always had a minute to say hi and catch up on life. If you one day decide to make a go of trading full time, you may experience a twinge of sadness that you no longer have the odd chat with a work colleague. I recommend that you take a week or two’s holiday and try full-time trading before you hand in your notice to your boss and begin your full-time online trading job. It will give you a taster of what your day will look like. The second reason I told you the story about my friend is to make sure you realise that a pause from trading is not the end of trading. The markets will always be there. My friend will no doubt be back to trading full-time one day. In the meantime, he is enjoying a new life where he is helping others achieve what they want from trading. The third reason I am telling you this story is because I would love to see you succeed, but I think it is important you understand that trading may not offer you the rainbow you had hoped for. But does it have to? Could it not just offer you a good income, where you are working on your own terms and perhaps doing something that you find immensely interesting? Does it have to result in owning a beachfront property in Barbados? Sure, if you get there, I am happy for you, and you should be proud of yourself. However, if you don’t get there, but you still manage to pay your bills and put money aside for the sweet things in life as if you were the recipient of a monthly pay cheque, then to me you have done what the 99% of the population do not dare to do. They dare not take a chance on their dreams. If you can make a living from it, be it a decent living or a great living, then you really are something out of the ordinary. And trust me when I say that once you understand trading better, you will also come to understand what makes you work optimally in the trading arena, and that is when being a trader gets really fun. Eight months ago, I went through a tough time. It happened during the month of May. I started strongly, and then the wheels started falling off. I was up some £200,000 on the month, and it started to unravel. It started with a loss of £33,000. Often when I have a bad day, I will come roaring back the day after, but I didn’t. I lost another £9,000 the day after. Then came the weekend – not a moment too soon. Monday started where Friday had left off, in spite of all my preparation and introspection over the weekend. I lost another £38,000. Before the week was over, I had lost more than 50% of the gains for the month. More disturbingly, I felt completely lost. I had no idea why I was losing. I wasn’t tired. I was sleeping well. I had no emotional issues that occupied my focus. I was just not performing. I have endured hard times before. Progress has at times been slow. Setbacks have been frequent. Setbacks are always lurking. My goal is to stay in the game until I don’t want to spend all my waking mental energy on the markets. As you can perhaps gather, this is a deeply personal journey for me. It is often a mentally draining journey, where I feel I am not making any progress. What made it worse for me was that a really good friend of mine – also a trader, and probably the best private trader the world has never heard of – was having a great run. We have always been brutally honest with each other. I think therein lies the strength of our friendship. I will tell him point blank, “I am jealous of you. I feel bad that I am jealous of you, because you are my closest friend, and I would give you my last dollar, but right now I am shooting blanks. I am haemorrhaging money.” I told him I had a huge position on. It was literally the biggest position I have ever carried. Each point was worth £4,000. That equates to 400 FTSE futures contracts. I was so certain the FTSE would fall. I have seen the pattern so many times: big fall off the open – two to three bars of five-minute duration of rebound – and then new lows. But it didn’t. Not that day. It rallied. And he was long. I was short. It was immensely painful. It took me to a place I didn’t want to visit. A place of envy, resentment and despair. “You know Tom, you are lucky.” My thoughts were interrupted by my girlfriend. It was as if she knew what I was thinking. “Not everyone has someone who is better than them, and who they stay up at night wondering how to beat. Not everyone is Mozart versus Salieri. You should be happy. So you lost. But what have you gained? Don’t you know that he feels the same as you do? He desperately wants to beat you – for no other reason that you bring out the best in each other.” She carried on: “You know, my old professor Peele, I told you about him… brilliant man. Do you know what made him brilliant? His colleague – Professor Kyle – they were best friends and neither of them would ever acknowledge that they were insanely jealous of each other, yet they were the two most brilliant minds anyone could wish to learn from. You should really count your blessings that you have someone who you so badly want to beat. It is really not a curse. It is a blessing. What do you think would happen if your idols stopped trading?” If they stopped, I thought, who would I beat then? I always loved beating my old high score, and I did today, in size; but she was right. I am not just trading to make money; I am trading to push myself into those places where I am not comfortable. I was once in a restaurant in Porto Cristo, having dinner with my son. I happened to look over my shoulder and I saw Rafa Nadal having a late meal with his friends. It was great to witness a world-famous tennis star just shooting the breeze with his old friends. A few days later we visited his tennis academy. Rafa was training. It was hot as Hell that day. He trained like his life depended on it. He was out there pouring his heart out – in the blazing heat – just to get better. Why do you think he was doing that? It is for the same reason that someone like Matthew McConaughey – during his Oscar acceptance speech in 2014 – said, “There are three things that I need each day: one, I need something to look up to; two, I need something to look forward to; three, I need something to chase.” I am writing this because I think being open about what drives us is healthy. There will come a point in your career as a financial trader where you will go through a slump. When it happens, it might serve you well to step back and think deeply about why you are so drawn to this game. And when it happens, I hope you will turn to these pages. I hope they will remind you why you are doing what you are doing. What my slump taught me was to slow down. If you do not slow down and let the knowledge mature, then you will take a huge loss, which will dent your confidence. Not every trade is the World Cup final. Not every trading session is the final exam of the final year, the culmination of four years of relentless studies. Everyone has setbacks. Kobe. Rafa. Federer. You. Me. And – all slumps end. Slumps are inevitable. You are bearish and the market goes up. You are bullish, the market goes down. It happens to us all. Every one of us. Is there a key to escaping a slump? No. Why should I throw old, worn clichés at you? Why should I tell you to stay calm and work your way through it? Why don’t I just tell you that it is horrible to go through, but it will end – if you persist? I wrote this chapter over several weeks. When I started it, I was not in a slump. Then the slump arrived, and I described it. As I type these words, I have had a fantastic trading morning. Am I out of the slump? Who knows? I do not know what I am doing differently to what I did when the slump set in. I am simply following the process I always follow. I am a process-oriented trader. The markets determine the outcome. I have little control over that. I have faith. I believe that my process will carry me through the highs and the lows of trading. EMBRACING FAILURE THE LATE MARK Douglas argued that successful trading is a question of accepting risk and thinking differently. The Market Wizard trader Ed Seykota put it another way. “A losing trader can do little to transform himself into a winning trader. A losing trader is not going to want to transform himself. That’s the kind of thing winning traders do.” When I read that passage the first time, I was not mature enough to understand its importance. When I started trading for myself, I began to appreciate its depth and wisdom. As I began trading bigger and bigger size, I realised that my journey from a low-stakes trader to a high-stakes trader was not the result of evolution. Sure, I got better the more I traded, but remember this: Practice does not make perfect. It merely makes it permanent. Only through a dedicated approach to practice, with a specific attention to finding your mistakes, will you improve. Otherwise you just are just cementing your unprofitable behaviour. BECOMING A DIFFERENT PERSON Being anxious and fearful is a reflection of an unknown situation. Through exposure – over and over – our minds come to accept the new reality and through that exposure become accustomed to it. You think there is a hack that will all of a sudden take you from trading £10 a point to £100 a point? You think there is some book you can read, or some course you can take, or a pill you can ingest that will take you from being an average-stake trader to a high-stake trader? Well, not quite. But there are certainly ways you can accelerate your progress. It is a question of priority. I am not some hardcore monk with no life and a never-ending commitment to pushing myself into those cold, dark corners where I dance with uncertainty until my emotions are stunted and I essentially become a psychopath with no fear. But I am committed. I want to explore my weaknesses. I am reasonably attuned to my mind and body, and I know that left to my own devices I can quickly spiral into self-destructive behaviour. I had a painful breakup with a loved one, and I turned to food and alcohol. Sure, I think we all do things like that. Even Bridget Jones (I love movies) ate her way through a tub of ice cream in one sitting when she was dumped by the love of her life. But you move on. You get off the sofa. You turn off the TV and throw the ice cream bucket in the bin, and you say, “Okay, so I made a mistake. I will own it.” How you feel about failure will to a very large degree define your growth and the trajectory of virtually every aspect of your life. You may want to close the book and think about that for a while. It is quite frightening how deep that sentence is. A significant part of your success as a trader is correlated to your relationship with failing. If you see failure as the endgame, then you won’t make it as a trader. I have colleagues who will stop trading if they have three losing trades in a row. What kind of attitude is that? You think Kobe Bryant – the absolute superman of basketball – had that attitude? You think during a game he would make three misses and then ask the coach to be replaced by someone else? KOBE BRYANT – THE BIGGEST FAILURE While we are on the topic of Kobe Bryant, I want to tell you a story about him, which I read in a paper – sadly after Kobe passed away in a tragic accident. After the accident, most obituaries focused on Bryant’s amazing achievements and trophies won, but Andy Bull from the Guardian wrote about Kobe Bryant from a different vantage point. The headline of the article sums it up well: “Bryant’s success story began with working to conquer the fear of failure.” It seems Kobe Bryant intuitively knew that, in order to be a great player, he needed to conquer his fear of failing. The article goes on to tell the story of a game in May 1997. It was Kobe’s first season for the LA Lakers, his rookie season. He made four crucial errors inside five minutes, which some say cost his team the game. That night, the story goes, Bryant stayed up shooting hoops privately and alone. He was still at it when the sun came up. I know this feels a little sugar-sweet; it has a David versus Goliath feel to it. But there is more to this than meets the eye. On the surface, it reads that Kobe Bryant was beaten in that game and he followed it with a punishing all-night session. To me the story tells of a man who night-after-night confronted his fear of failure by repeatedly trying. He became used to sometimes failing temporarily, and yet he kept at it. Bull concludes by saying, “He missed more shots than any other player in history. Bryant was willing to encounter failure in every game he played.” It is not the first story I have read about an all-American great, someone who confronted the fear of being wrong, in order to be proven right. Babe Ruth, the American baseball player, held home run records for decades. At the same time, he went by the nickname King of Strikeouts. If the term itself doesn’t give it away, let me explain: a home run is great; a strikeout is the very opposite. I found the story resonated with traders all over the world who seek out systems and strategies aimed at eliminating losing trades. As I write this on a quiet trading day on 1 June 2020, I look over my trading statistics for the month of May. I made a total of 1,513 points. Yet out of the 137 trades I executed, I lost on 66 of them, won on 53 of them, and broke even on 18 of them (where stop-loss was moved to entry point). If I gauged my success according to some of the hyped-up system sellers on the internet who promise a 95% (or better) hit rate on trades, I am an abject failure. I mean, I was less than 50/50 in May. Yet, somehow, I still managed to make a decent return for the month. How do you explain that? The answer is found in the erroneous belief that the more winning trades you have, the better a trader you are. That is plainly and simply wrong. One of the popular clichés in the trading world is that you can’t go broke taking a profit. Oh, hell yes you can. If you are unable to let your profits run, you will never make money trading. While basketball and trading differ on this point, if I were afraid to lose, I would never have had a profitable month. STATISTICS DO NOT MAKE SENSE We know that 90% of traders lose. We also know from the FX trading sample of 25,000 traders that most trading accounts have more winning trades than losing trades. This does not make sense. How can we reconcile those two facts? The answer is found if you read between the lines of the story of Kobe Bryant. If you are in a losing position, you are essentially wrong. However, unlike a shot in a basketball game, where you immediately know when you are right or wrong, in trading there is always the hope that the trade will come back in your favour. Hope is what keeps people in trades long after they should have closed them. As the saying goes, hope dies last. So true, and so detrimental to traders. How do I deal with hope and fear in my trading? I tend to only feel hope when I am in a trade. I hope my position will come good. I hope the market will move in my favour. Fear, however, is felt in more situations. I can feel fear when I am in a trade. But I can also feel fear when I am not in a trade. That is a subtle but important distinction between hope and fear. Hope tends to be reserved for the activity of being in the trade, while fear manifests itself both when I am in a trade and when I am not in a trade. I can be fearful that the market will move ahead without me, or I can be afraid that I have closed my position too soon – which could also rightly be classified as regret. While I intend to write in much more depth about my trading regime at the end of the book, I will describe my approach briefly now. I deal with fear when I am in a trade by having an exit strategy. I have a stop-loss, which defines the size of my loss. I have accepted this loss before I started the trading day. It is part of my trading plan. I will have mentally prepared in the morning, ahead of the trading day. I will have sat quietly, contemplating what I am about to do. I will have subjected my mind to images of me losing. I will have calmed my mind, when it experienced these imagined losses, so as to negotiate away any feelings of anxiety and regret, as well as desires to get revenge and get even. I will have dealt with hope by accepting that my stop-loss will define my exit. Maybe I will win. Maybe I will not win. Before the trading day started I will have gone through mental exercises that saw me enter the market, observe the market move against me, negotiate with my fear brain and the impulse urges it sent to my conscious awareness. By the start of the trading day I will already have seen myself win and lose, add to positions, and patiently wait for the right setup. By the time the bell rings, opening the market for trading, I am mentally warmed up. I am ready to fail without losing my composure. MY COMPETITIVE SON I have a fascination with reading about the lives of high-performance soldiers. I love reading about the trials and tribulations of the SAS and Navy Seals. My son shares this interest. In particular, we are fascinated with the free-diving part of the training. One of the obstacles that these elite warriors have to pass is the 50-metre underwater free-dive. Do you think there is a shortcut to diving 50 metres under water? Take it from someone who has swum 46 metres under water, there is no shortcut. I practised and practised while on holiday with my son. There happened to a 50-metre swimming pool in the complex we were staying at. Being the competitive spirits that both my son and I are, he set out first on our initial attempt. He made it a little less than halfway. Now I had a goal, and I made it almost to the halfway line. I beat him by an inch or two. We spoke about how we could get better, and we agreed that we needed to focus more on our preparation before the swim. So next we sat on the edge of the pool, and we focused on filling our lungs with oxygen and oxygenating our bodies. Gradually we got better and better. Then we realised that if we swam less frantically while underwater, we would expend less oxygen. Our focus shifted to staying calm and taking rhythmic strokes. By the end of the seven-day holiday, I came within a few strokes of 50 metres. My son was a metre or two behind me. Passing this test is one of the major stumbling blocks for aspiring Navy Seals. I am not saying that my son or I are Navy Seal material, but I am saying that there is no way you are going to swim 50 metres under water without relentless practice. We worked on it. Then we evaluated our process. We didn’t actually focus on the outcome at all. We just did everything we could to make the process as efficient as possible. Does that remind you of something? If you have a goal that you want to make X amount of money a day, or a certain amount of pips or points, you might be sabotaging your chances of making a lot of money. You are outcome-oriented. You would benefit immensely from shifting your focus to being process orientated. BEST LOSER WINS THE TIME HAS come to get more specific. We can skirt around the issue forever, or we can decide to get our hands dirty and get down to the business of creating a finely tuned trading mind. What you become in life is dependent on the decisions you make and how you react to decisions made on your behalf. At Stanford University, Steve Jobs, standing at the podium in front of the class of 2005, gave the new graduates their commencement speech – advice on how to live life. It went something like this: Remembering that you’re going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart. Few can walk the walk when money is on the line. The main contributor to not having the life you want is fear. Most play this game called life safely within the boundaries they set while growing up, boundaries built by avoiding pain and anxiety. I am often asked if I know the secret to becoming a good trader. I think many novices believe that I know some really good trading setups. They’re not entirely wrong; yes, I know some great setups, but they still only work – at best – about 70% of the time. I am still wrong 30 times out of 100. I am not where I am in the trading world because of my IQ. I’ll tell you that immediately. I am here because of my relationship with pain. Our brains hate the idea of losing something that is valuable to us. The brain will abandon all rational thought and make some really poor decisions trying to avoid losing something that has value. I am a profitable trader. Is that because I possess superior charting abilities? No. Of course not. There are many brilliant chartists who can’t trade. Is it because I have a superior system? No, there are many great systems but most will still only have a 60% strike rate. Is it because I have friends in high places that feed me insider information? No. Did you not read my book? I am socially reclusive, and I certainly do not have friends in high places. I have no secrets. I have no special abilities, with the possible exception of one. Do you want to know why I am so good at trading? I am exceptionally good at losing. When speculating in financial markets, the best loser wins. Don’t underestimate these four words. Though it may go against the conditioning that life and the modern world have programmed you with, success in financial market speculation is not about being the best, coming first, or winning. Instead, it’s about losing. Your relationship with fear and adversity will to a very high degree define your life. And that’s why I win. I win because I’m really good at losing. In trading, unlike life, it’s the best loser that wins. Do you think a dentist, or a doctor would be in business if they had a 60% win rate? Of course not. But a trader can thrive and prosper on that kind of success rate – as long as they are prepared for it. Most are not. MANY ARE CALLED… Trading attracts many people who shouldn’t be traders. They are led to believe that trading is easy. Maybe a broker is tempting them; I’m sure you’ve seen the broker advertisements where a calm, confident actor knowingly pressing buttons in front of a bedazzling array of screens, then walks away victorious with a confident smirk. If you look at the trading industry, we are led to believe it is all about the tools. Hang on – do you think I can play tennis like Roger Federer just because I have a Wilson Pro tennis racket? It’s an illusion. How do I know? Because, for years, I was an insider working at one of the largest financial market brokers in London. Why do so many people lose? Statistically speaking, it should be impossible for so many people to lose. If the market is random – and most of the time, market movement is indeed random – why do 90% of clients consistently lose a 50:50 bet? The answer is as simple as it is complex. It isn’t the market-beating them. They are beating themselves. I wasn’t always a successful trader either. To become successful, I had to break down the barrier that separates the many from the few, in a business where there is no instruction manual, and where the lesson comes after the test. It didn’t take me long as a broker to notice our clients’ trading behaviour. As a group, traders are predictable. Or, more accurately, their outcome is predictable, because everyone is doing the same thing. I watched thousands of traders execute millions of trades. Their behaviour became predictable, almost as if they were connected together in one hive mind. Week after week, month after month, year in, year out, when they were making a loss they hoped the market would give them back their losses, yet when they were making a profit they feared the market would take it away. They were fearful when they should have been hopeful. They were hopeful when, in fact, they should have been fearful. These human experiences helped make me the trader I am today. Watching them struggle, I realised they were searching in the wrong place. The answer they were so desperate to find is not found in the external. It’s not found in the software, or in any of the tools. Instead, I realised, the answer is to be found inside the self. TUNING MY MIND In the silence of the early morning, I’m in my office, preparing for the day’s trading. It is a minimalistic office. Depending on where I am, there are either two or four screens. That is it. There are no special monitors or water- cooled PCs. My secret ingredient is a couple of files on my hard drive. There is my PowerPoint presentation on one screen. There is a Microsoft Word document on another. The PowerPoint file is my cue. At game time, before I begin to trade, it’s time to become someone else. In the movie Gladiator, why does Maximus Decimus Meridius rub dirt on his hands before combat? It’s a ritual. He must immunise himself before battle, to feel nothing, to become an instrument of death, indestructible, so that he can survive another day. Rubbing dirt on his hands is his ritual of leaving his old self behind. Every day from 5 am until 9 pm, even late into the night, I am battling myself. Trading is a battle of the self. The PowerPoint file contains old trades, mistakes, triumphs, inspirations, and warnings visually arranged to prepare me for the day ahead. I need to become something else; otherwise, I will not make money. This is why trading looks simple when looked at from the outside, but it’s not easy because trading successfully goes counter to virtually every piece of DNA stored in your body. In the 1960s, neuroscientist Paul MacLean proposed the human brain has evolved with three areas of function: the reptile brain, the limbic brain, and the neocortex. So, who’s really in charge when you are trading? It’s your reptile brain, your base self, that’s really in charge. When you are startled, and you react, perhaps you detect a wobble in your stomach, a vibration in the lower back – that’s your reptile mind preparing you for survival, triggering a fight-or-flight response. Will you run, or will you fight? Your subconscious reptile mind has only one function, and that is to protect you. It does this whether you want it to or not. And this is a problem, because to be successful as a trader you need to be very good at losing. This means constant conflict with your built-in subconscious protection system. A system that protected you from death as a caveman guarantees you’ll not survive as a trader – unless you can learn to overcome it. And overcoming it begins with accepting pain. One exercise I use in the morning is closing my eyes and playing out a scenario. I imagine I lose a large amount of money. I will often use an amount that has some significance to me, such as the cost of my last car, or the cost of my son’s college tuition, or the size of a memorable loss. Say for the sake of the argument that I have opted to meditate on losing £78,000. I will see myself losing the amount. I will let it sit there – in my consciousness. I will let it take hold. I will imagine what I will not be able to buy because of the loss. I will make it as emotionally vivid as I can. Now I will turn the table. I will now imagine that I am winning the same amount. I will imagine that I am winning the £78,000. What will happen is that my emotional response system will not allow me to feel a reciprocal sense of joy to the misery I felt earlier. Neurobiology has shown we experience a financial loss 250% more intensely than an equivalent financial gain. After going through this exercise of feeling pain and then not feeling pleasure, I then swap back to feeling the loss again. The purpose of the exercise is to align my feelings of gain and loss. In truth, I don’t really want to feel anything – I have found that if I get overly happy about a win, I tend to get overly sad about a loss. I don’t want that. I am not a dentist who has a win rate of 99.99%. I am a bloody trader, who has to live with being wrong around 50% of the time. It is exhausting to feel joy and pain many times a day. I prefer not to feel anything at all, rather than going through that emotional roller coaster. I win. Move on. I lose. Move on. By adopting this attitude and by warming up my subconscious mind, I am able to flow in and out of winning and losing trades, day in and day out, without it affecting my strategy. Pain is inevitable to some degree in life. Someone lets you down, you feel pain. Someone hurts you emotionally or physically, you feel pain. In life, outside of trading, one way to deal with the pain is to talk to someone. As the saying goes, a problem shared is a problem halved. Why a painful experience feels less potent after we have shared it with a friend I don’t know. Maybe the act of verbalising the disappointment puts the problem into a healthier perspective. Either way, you feel better, and the pain subsides. But when I’m trading, while the majority look to run away and rid themselves of pain, I do the opposite. I run towards it. I embrace it. I don’t want to share my pain. I want to hold on to it. I need it. Whether you are new to trading and speculation, or you have years of experience, you should give this question some serious thought: If you want to be a success in a field where 90% or more fail, how do you think you should approach this task? Trading looks easy on the outside, but in reality it’s much more challenging than people expect – because we are hardwired to do the opposite of what we should be doing. This is why 90 out of every 100 people end up losing. The road to consistency, success, and enlightenment in trading begins in the last place you’d ever think to look. Inside yourself. THE KEY So, here it is. What follows is the key that will unlock the door to your success, the key to breaking down the barrier between the life you want and the life you are leading now. If you want to succeed in an endeavour where 90% are failing, you have two choices. You can study the large 90% losing group and do the opposite of what they do, or you can replicate what the 10% do. If you are not as successful as you want to be, sooner or later you need to change your behaviour. It doesn’t matter if you’ve been trading unsuccessfully for three months or 30 years, you are much closer to success than you realise. The 90% fail because they interpret the pain messages received automatically from our reptile brain without any modification. You need to learn to recode your brain’s messages when pain comes knocking. Instead of reacting and running away, a small group of consistent traders, the 10%, hold fast and run towards the danger – not away from it. The 10% succeed because they have learned to flip the switch. FLIP THE SWITCH This will feel very uncomfortable, but it is a discomfort you must accept and embrace if you want to succeed in the game of financial speculation. It is the reason why trading looks simple but is not easy. The paradox of trading is this: by doing what the 90% cannot do, you will become successful. In other words, I expect to be uncomfortable. I expect my trading to cause me anxiety. I am waiting for it. I can sum it up in a few sentences: 1. I assume I am wrong – until proven otherwise. 2. I expect to be uncomfortable. 3. I add when I am right. 4. I never add when I am wrong. ASSUME YOU ARE WRONG Remember, I’ve watched thousands of traders execute millions of trades, and I noticed when most traders enter into a position they assume they are right. In a business where 90% of people fail, your recoding process begins by flipping that switch. I will assume that I will quickly have to get rid of a losing trade. My confidence in this action is not centred around my ability to select the right setup. That is what the 90% will do. Instead, my confidence is centred around trusting I will get rid of a trade that is not performing. I trust myself to know that if this trade does not work out, there will be another one coming shortly. Do you see how I have flipped the switch on my thinking? I am thinking differently to the 90%. I will assume I am wrong until the market proves me right. Flip the switch! When the 90% of traders execute trades, they experience emotions, which originate from their pain centre. Now it’s only a question of time before their emotionally driven pain threshold centre sends them a false signal, causing them to lose. It is a never-ending rollercoaster ride of disappointment, lost money and pain. When I trade, I assume I am wrong. I enter a trade, and the trade moves in my favour. I am trading my account size or the available profit – I am trading the market because I understand the size of my profit is irrelevant to the market. I know my P&L has no influence on the market. I know that my brain’s automatic pain receptor will kick in causing an inbuilt safety reflex to register pain. I am subject to the same built-in automatic pain receptor as everyone else, but the difference lies in how I handle the pain. Instead of giving in to it, instead of being ruled by my emotional responses, I have flipped the switch. I have trained myself to expect the pain. I am aware of the pain. It is there. It is real, but I accept it. I have encountered it in training over and over. It no longer acts as a debilitating force in my life. I have trained the fear of out my decision making. EXPECT TO BE UNCOMFORTABLE How can you have a good time while you are uncomfortable? Logic will say it is not possible. Well, for starters, I think all humans come alive when we strive. We toil in the garden, we work out, we study for an exam. I think it is perfectly possible to be uncomfortable while enjoying a challenging process. As a trading position grows in profit, instead of giving into the fear it will be taken away from me, I flip the switch, using my mental warm-up, my training exercises and visualisation of trend days where the market just goes higher and higher all day. I flip the switch in my mind from negative mental imagery to positive mental imagery. I see myself riding this monster momentum wave. I see myself being at the forefront of every tick higher. The 90% will focus on what they want to avoid. I focus on what I want to achieve. The 90% give in to their fears. I expect my fears to come in abundance, and I have a plan for counteracting them. I see a different image. And when I am losing? Well, I already expected to lose anyway, so the market disagreeing with my trade will not be associated with pain or fear. I expected it. I have accepted my loss already. I don’t entertain the idea of compounding my mistake by adding to my losing position. I have trained that trait out of my mind. It doesn’t even enter my mind anymore. My mind knows I want to be big when I am right, and I want to be small when I am wrong. Emotions kill trading accounts. It isn’t the lack of knowledge that’s stopping you from winning big. It’s the way you handle yourself when you are in a trade. I spent a decade observing traders lose money. They were intelligent people who often had great hit ratios, but they couldn’t lose well. After reading this far, if you remember only one thing, remember this: in trading, unlike life, the best loser wins. THE IDEAL MINDSET THERE IS AN ideal way to think as a trader. There is an ideal mindset – one that is flexible to the extreme. It does not care about winning. It does not care about losing. It is a carefree state of mind, but it still acts in your best interest. The ideal trading mindset has no fear. If you are alarmed by this statement, then pause for a second. The ideal mindset may have no fear, but the ideal mindset is still acting in your best interest. The ideal mindset might be fearless, but it is not reckless. Fear plays a significant role in explaining why people lose the game of trading. This fear can manifest itself in several ways. It can be the fear of not being in the market and missing a good move. It can be the fear of staying in the market for too long and seeing the open profits disappear. Can you acquire an ideal mindset? Yes. Without a doubt. You may have to grow into it. You may have to begin a period of significant introspection and get to know thyself. I will discuss how to get to know yourself as a trader shortly. The ideal trader mindset does exist, and you can train yourself towards this state of thinking and believing. When you arrive at this state, it means you are able to perceive information from the markets without feeling threatened or fearful. Does it mean you will never lose? No. You will have losing trades just like everyone else. However, the ideal trading mindset is as at peace with losing trades, as it is with winning trades. Neither will impact your ability to unemotionally and dispassionately perceive market information in a non- threatening frame of mind. Your emotional state will stay in balance. Every trader has experienced periods of being in the zone, of being balmed by the soothing feeling of the ideal mindset. It often happens when certain circumstances are present. For me personally, I experience that sense of calm whenever I am trading while on holiday. One story stands out. I was on holiday for 14 days, and I traded every day from my holiday home. I was totally at peace, trading only when the market really spoke to me. Otherwise, I was at the pool relaxing in the sun. When I returned to the trading floor, my boss came out and said, “Someone is on fire!” and clapped. Fourteen days later I had given away all my holiday profits. I remember the story so vividly because it happened to be one of the catalysts that led me to seek a deeper understanding of myself as a trader. HARD-CODED DNA The ideal mindset does exist, but few traders have it consistently. When we do not operate from a frame of mind of the ideal mindset, we are afraid of something. This fear is a manifestation of a lack of trust. We do not trust ourselves to do what we have to do without hesitation, without reservation or internal conflict or argument. Our mind is the problem. Our mind’s core objective is to keep us alive and avoid pain. We are automatically wired to think in a way that keeps us alive. This thought pattern is hard-coded into our DNA. It might keep us alive, but it makes trading difficult. The very thing that keeps us alive is the very thing that makes trading an incredibly difficult proposition, until you have learned how to counter your hard-coding. The issues we face largely fall into two categories: 1. We associate this moment with another moment, whether we are conscious of it or not. 2. We have a mind wired to avoid pain. We have learned to associate in order to benefit from experiences. Association (connecting past moments with the present moment) and pain avoidance do not go hand in hand with trading. Why do I say this? Why do I say that association and pain avoidance are detrimental to profitable trading? I say so because in trading each moment is unique, and anything can happen. Trading is the equivalent of a coin-flip game. Since the win ratio of many professional traders – including myself – is not far from 50/50, the coin-flip analogy is even more appropriate than you might think. If you play a game of heads and tails, you are probably not too concerned about the outcome. Over time it will play itself out quite predictably. You will win 50%. You will lose 50%. If you developed a system where you lost a unit on your losses, and you made 1.5 units on your wins, you have yourself a good business. Trading is just like that in many respects. You don’t judge your system on the merit of one trade. You judge it over many trades. We do so because even a game of heads and tails will show an uneven distribution, even if the outcome over 100 flips is 50/50. As my friend David Paul once said, “There is randomness in the outcome of one, but there is order in the outcome of 100.” He was talking about the coin-flip scenario. I once flipped a coin 100 times, and I wrote down the result on a piece of paper. I witnessed 15 heads in a row. At one point I stopped and looked at the coin, as if to see whether there were obvious flaws to it. There weren’t. If you had 15 losing trades in a row, I imagine your mental state would suffer. If you had 15 winning trades in a row, you may feel invincible. The market will do what the market will do. It doesn’t care about you or your position. It doesn’t care if you are in the market or on the side-lines. If you have 15 winners in a row, it doesn’t care. If you have 15 losers in a row, it doesn’t care. You can’t make the argument that just because you have lost on a trade you are now closer to winning. By doing so, you are doing exactly what we need to learn not to do. Every moment is unique. Just because you had 15 heads in a row does not mean the odds of a head are less on the 16th throw. They are still 50/50. Why? Because there is complete randomness in the outcome of one. That is another way of saying that every moment is unique. However, over time the law of averages will come into play, and over 100 throws, you will experience 50 heads and 50 tails. However, while you may understand this academically, and even logically, there is a good chance you will not understand this emotionally, especially if you just had 15 winners or 15 losers in a row. Therein lies the difference between the trained mind and the untrained mind. I will steadily guide you towards the trained mind, so that you do not succumb to fear. PERCEIVING INFORMATION Information on its own has no power over us. It is our belief system and the energy we give to the information that decide its potency. If you receive an email from an unknown person saying, “You are a dead man,” the chances are your emotional reaction will be very different than if you received an email saying, “Du er en død mand.” The message is the same. One is in English, the other Danish. On its own, the sentence is merely a construct of letters put together. Once it is decoded by the brain, it is assigned an emotional charge. The sentence is meaningless. It is how we interpret the sentence that causes the emotional response. So, imagine a mindset where you can perceive the market information purely from an opportunistic point of view. You are not threatened by the information. You are not thinking, “Oh God, why am I not in this move?” You are not thinking, “Why am I in this move?” You merely observe and decide from a frame of mind that sees opportunities. It does not see threats. The market moves up and down in ticks all day. They form patterns, which we trade on. These ticks up and down are just ticks. If you have a position on, however, these ticks take on a life and meaning of their own. They validate you, or they diminish you. That is not how you want to trade. That is not an ideal mindset. FOCUS AND ATTRACT What we focus on is what we attract. I believe in that, so it is true for me. The fear we experience causes us to focus on the object of our fear so that we end up creating the very experience we’re trying to avoid. I want to give you a simple example of the mind seeking information as a result of what your focus is on. You bought yourself a new car. It is a yellow Volkswagen Beetle. As you drive your new car, you begin to notice other Volkswagen Beetles. You never did that before. Your mind has opened a filter, allowing information about Beetles into your consciousness. What we focus on is what we attract. The trader who has a position on in the market will focus on the price movements (the ticks) that move in his or her favour because they relieve pain and give pleasure. Movements against the position create pain. You might be thinking I am stating the obvious. You are right. My point was not to state the obvious, but to point out that this state of mind is not open to other possibilities. The more fear we experience, the less information the mind will focus on. It will narrow its focus. It will stop you from perceiving alternative options. I run a live trading channel, where I trade in real time. When I trade publicly, one type of scenario I am most proud of is that in which I accept I have misread the market, and I change my position. For example, I may have pushed the short side on the Dow Jones Index, and the market is moving against me. I accept I am wrong. I close my position. I open a trade in the opposite direction. It requires a tremendous amount of self-belief to do this when you are trading big size. What helps me in situations of this type is to recite a mantra I have created: “Focus on the process. Focus on what you can control.” I have developed a belief system that allows me to encourage this kind of flexibility. This kind of mindset is possible for you too. When I set out, I wanted to create a mindset that allowed me to perceive information without fear. That is the ideal mindset. It takes time to create it, but your rewards are directly correlated to your effort. Don’t expect a eureka moment. Expect to get better and better gradually. BELIEFS Our beliefs determine how we react to information. We were born with a clean slate, and our beliefs are taught and adopted. We were taught what to think. We also had experiences that shaped our beliefs. I will get personal for a second. I felt my mother and father abandoned me at a young age. They divorced and I became the object of their fighting. I see now how that shaped my beliefs, which in turn influenced my choices in life and the decisions I made. The moment I was old enough to take charge of my own destiny, I saved up as much money as I could so that I could say goodbye to that toxic environment and leave my home country. How does this relate to trading? Trading gives us unlimited potential to express ourselves. We can open a trading account, and away we go. You are your own boss. There are no rules. There are no limits. Do what you want. You are no longer influenced or guided by your parents. The world is your oyster. You have total freedom to do what you want to do, when you want to do it. We tend not to want to operate under rules. After all, much of our young adulthood is spent rebelling against parents giving us rules. Trading is a rule-free environment. Unfortunately, the result is quite astounding. Traders have free will, and 90% of them will have a belief system that leads them to failure. In order to prosper in trading, we need a combination of being able to operate under trading rules while not feeling we are being held back, because ultimately, we want to experience total freedom. Essentially, what it boils down to is creating a mindset that always acts in your own best interest. It is a mindset that allows you to see opportunities. It knows your weaknesses and what to be mindful of. It allows you to receive information without being threatened by the information. You can operate from a carefree state of mind. I have created a blueprint for a carefree trading mind. I have changed my beliefs about trading. That is the message at the heart of this book – to change how we think, especially how we think about losing. It is to explain my mindset and teach you the mindset. The old way of thinking is still there. It will always be there. It is part of your personality. But the old belief has no charge anymore. It is faded, diffused. Just because you have said goodbye to an old belief does not mean it isn’t still in your memory. I will give you a childish example. We used to believe in Santa Claus. We used to believe if we were good, he would come and visit us to leave us presents. Does it bother you that he is not real? Of course not. You have diffused the emotional charge of being deceived. Your life is no worse off. I have the same sentiment about my old trading beliefs. I am not missing out. I am thriving on a new mindset. I used to think I couldn’t live without a cigarette after a meal. Now I can’t imagine a life where I stick a cigarette in my mouth. I eat every day, and I never have an urge to smoke. Once I could not imagine a life without a smoke. Now I can’t believe I was ever hooked on it. It took me a little more than a week to re-program my mind. The same will happen to you as you apply my blueprint for the ideal trading mindset. My biggest belief I had to overcome in trading was the associations I made when I was confronted with losses. I had to learn how to disassociate losses from feelings of failure or feelings of wanting to extract revenge on the market to create a state of mental equilibrium. Achieving that was a momentous leap for my trading performance. THE BOOK OF TRUTHS I want to move the narrative towards the practical element of creating the right mindset. You can only dance around the fire for so long. Let’s get down to brass tacks. Let’s get specific. I once saw a sign that said, “The best views come after the hardest climbs.” Proverbs have a way of simplifying complex messages, but they are hit- and-run in their nature. They don’t tell you how to do it. How do I climb the mountain? Telling us to “Just Do It” might be well intentioned, but falls disastrously short of a meaningful description of how to climb the damn mountain. In a similar vein, to be told to just “run your profits” and “cut your losses” falls disastrously short of providing a meaningful guide to achieving these noble trading goals. When I started trading, I had the right credentials. On paper I was academically destined to do well. Emotionally, though, I was like everyone else. I was not making money. I should say I wasn’t making meaningful money. I lost more on bad days than I made on good days. Granted I had more good days than bad days, but the bad days would set me back significantly, to the point where I might as well go and get a job. It would have paid better than my trading did. I didn’t question what I brought to the game beyond chart preparation. I showed up. I traded. I studied charts. That was it. I thought that was all there was to it. If it didn’t go well, then I had to do more of it. However, I never looked inwards. Then something happened. I read the research (described earlier in the book) on the 25,000 traders executing 43 million trades, and I thought to myself, I am just like them. They all believed they would be profitable. Practically none of them were. It prompted me to start thinking about trading holistically. I had been obsessed with techniques. I had a belief that more is better when it came to technical analysis. Yet, I was not seeing the results I wanted. It got me thinking about thinking and about what I believed. More importantly, I began to wonder if what I considered to be my beliefs were actually helping me to become a better trader. So far, they had not. Your beliefs create your world. How you see the world is a result of what you believe in. Some beliefs are easy to identify. I believe we should look after the environment, so I make sure I recycle. That is an example of a belief. That was an easy example. How are your beliefs shaping your trading performance? Are you even aware of what your trading beliefs are? Your trading performance is a function of your belief system, and only by dissecting your trading performance are you able to uncover what your belief system is. There is an easy way to discover your trading beliefs. Although I say it is easy, it is also hard work. A friend of mine wanted to improve his surfing, so he hired a friend to video him for a few hours during a surf session. He watched himself surf and he was able to identify his issues. He needed to strengthen his core muscles and he needed to trust his wave selection rather than being half committed, as he often was on many waves. In a similar way, I decided I needed to relive my trades to truly figure out what my problem was. So, I downloaded my trading results into an Excel spreadsheet and went to work. I meticulously went through the trades. I split my trades up into many different categories, with many of them appearing in more than one category. There were trades I held for days. There were trades I held for seconds. There were trades I executed in the mornings. There were trades I executed in the afternoons and evenings. I recommend you read my assessment of my own trading, and you repeat it on your own trading. It is a vital step in understanding who you are and how you interact with the markets. Once you have done that, you will create what I call the Book of Truths. Above all, be honest with yourself, as I was. If you are not honest with yourself, you will not be rewarded with consistency in trading. The courage to be honest with yourself is its own reward. Here goes: 1. I had periods where my win rate exceeded 85%. 2. My average profitable trade was less than my average losing trade. 3. I was a winning trader, but my big losses were seriously denting my overall P&L. 4. I traded well in the first half of the day. 5. I traded well in the first three to four days of the week. 6. I often gave away much of my profit from the morning session when I traded in the afternoon. 7. I often gave away much of my weekly profit on Fridays. 8. I would do very well on range-bound days. 9. I would almost always miss trend days, and I would often fight them. 10. My biggest losses came from fighting trending moves. The breakdown of my performance was incredibly cathartic. I took great pleasure in reviewing my own mistakes, because it felt like I was actually meaningfully moving towards a better version of myself. I took a very time-consuming decision to put all of my trades on the relevant charts. I created a PowerPoint containing every trade to give me visual imagery of my performance. This is the Book of Truths. I will argue that this process stood out as the single most beneficial practical exercise in enhancing my performance. I was, and I am, confronted daily with all my flaws, and I have a visual representation of those flaws. It seems as if the act of portraying a loss in a visual representation is a much more powerful tool for change than merely writing “Don’t trade without a stop-loss” on a Post-It Note and taping it to your screen. I use the PowerPoint file to warm up every morning before trading begins. I am reminded of the things I am good at and the things that tend to be my downfall. It has become an integral part of my process, to ensure I am acting in my own best self-interest. When I started the process of visually recalling my old trades, my old hurts, my old successes, I felt an empowering surge to replicate what I was good at and avoid what I was bad it. I immediately began to trade differently. I immediately saw measurable improvements in my trading. The results were immediate, even if I had to get used to the new way of thinking. I made more money. I became much more trusting of the markets. I trusted that I would be given an opportunity to make money every day. As odd as it sounds, I began to trade less, and I started to make more money. Sure, I wasn’t perfect from day one. I am not perfect today either. In fact, one of my beliefs is don’t insist on perfection in trading. One truth I came face to face with was less is more. There was a clear relationship between the time of the day and my profitability. I was nowhere near as profitable in the afternoons as I was in the mornings. Would I make more money if I just traded mornings? The statistics said yes. My heart said no. I wanted to trade, and I felt (or rather my belief dictated) I had to trade in the afternoons. How else could I call myself a trader if I only traded part time? It was a process of trial and error. This was the immediate benefit from the Book of Truths, but I didn’t stop there. I began to seriously question my motivation for trading. I argue that in a business like trading, where 90% fail to make a positive return on their trading account, the only way to separate yourself from the masses is to acknowledge that your mind is either your best friend or your worst enemy. If you don’t prepare your mind ahead of the game, and you experience adversity during the game, your mind will most likely work against your prime objective. Your prime objective is not to make money. Your prime objective is to follow the strategy you have developed. More importantly, your prime objective is to follow the process you have designed for yourself. If you follow the process, the outcome will take care of itself. I don’t set goals. I just focus on my process. I am a process-oriented trader. I don’t think being overtly goal oriented will help you achieve your goals. Of course, the goal is to win. But a mind subjected to adversity is a mind in stress. A stressed mind needs structure and process. Otherwise, it will succumb to feelings of fear, revenge and desperation, and the decisions it makes will originate from these feelings. Who wants to make decisions about the wellbeing of their financial health based on fear or stress? The mind needs guidance. I read about an American football coach who, during the half-time break, gave specialised talks designed to re-awaken the imagination of the players on his team. One time his team had taken a beating in the first half of the game. During the break in the locker room the coach put on a special video he had prepared. It showed some of the greatest comebacks in football history. The purpose of the video was to give the players a path out of their stressed state. It gave them mental imagery of what was possible. Coupled with the right kind of motivation, encouraging the players to focus on the process, staying present in the moment, waiting for the right opportunity and trusting the process, their minds had gone from being stressed to being prepared. I want to remind you that the first part of my trading life was spent on a trading floor, observing traders – thousands of them – go about their daily lives. I am adamant in my claim that those who were behind at half-time had no mental tools to help themselves, and as a result tended to dig the hole they were in deeper and deeper, as the day wore on. LEAVING THE OLD SELF Remember how Maximus ritualistically rubs dirt on his hands before combat in the movie Gladiator? How, through this symbol of mental preparation, he was leaving his old self behind? Well, I too have to leave my old self behind. I too have to become someone else for the day. Charlie Di Francesca, the legendary bond trader in the pits in Chicago, said that good trading goes against normal human instinct. To succeed you have to get used to being uncomfortable. Trading is a battle of the self. Every morning I have to shed my skin and become someone else. The Book of Truths is key to my transformation. It arouses a desire to do better than the old pattern of behaviour. I am certain that had I not taken the steps to focus on my mental game and confront myself daily with my old behaviour, I would not be where I am today. I argue this to be the case based on my observations of diaries. One of the catalysts for my trading transformation came from tidying up my old office cabinets. I found old trading diaries in which I had meticulously described my trading day. As I read through the diaries, which spanned a decade, I saw how desperate I was to make trading work for me. I saw how day after day I promised myself not to add to losing trades – how I promised myself not to trade well from Monday to Thursday and then lose it all on Friday – how I promised myself I would stick to one setup, and so on. As I read page after page of trials and tribulations (but mostly trials), I realised that the Tom whose words I was reading was in real pain, but he was not transforming. He was repeating the same mistakes day after day. He might have been increasingly technically competent, as his studies took him deeper and deeper into expert territory of technical analysis, but he kept making the same mistakes when his mind became stressed. As I have said before, it was not an epiphany. My change came slowly. It was a gradual realisation that all my chart studies didn’t move me meaningfully towards the goals I wanted to accomplish. Rather, they merely distracted me from the real problem, which was my behaviour when things did not go to plan. Instead of focusing on the process and having tools to get me to operate from a stress-free mind, I succumbed to foolish trading, intending to make back the lost ground. My mind desperately wanted to get rid of the pain of having lost money, and its solution was to chase every movement in the market recklessly. And all I did was dig the hole deeper and deeper. The Book of Truths will give you up-close, face-to-face time with your own shortcomings. It made me realise what my faults were. I also started plotting my good trades. I felt it was necessary not just to remind myself of the behaviour I wanted to avoid. I should also remind myself of the behaviour I wanted to strive towards. The charts I use to prepare for each trading day, to warm up, are my old trades plotted on a chart. That way I can emotionally relive the trades and reinforce the behaviour that is good for me and remind myself what my weak points are. AN EXAMPLE Friday 4 March 2022 was an extremely volatile trading day. A colleague pointed out to me that Brent Oil was soaring. I looked at the chart, shown in Figure 25, and I thought, “Wow, it really is.” Figure 25 I bought the first retracement on this ten-minute chart. Now there is nothing wrong with this entry. I am trading with trend, but as I look back at the trade, I acknowledge that at that precise moment in time I was not trading from an emotionally stable point of view. I was eager to get on board a move, based purely on the opinion of another trader. So, I just bought it without much thought to it. And I had no stop loss in mind. I just put an arbitrary stop loss, for safety. See Figure 26. Figure 26 This is the power of the Book of Truths. I want to remind myself of things like that. I want to remind myself, in the morning, before the trading starts, that Tom Hougaard trades best when he is calm and is not caught up in an emotional whirlpool of excitement and a brain awash with adrenaline and dopamine. I looked at my trading monitor and saw my position losing me money. I reminded myself that, although I got caught up in the emotions of another trader (one that I respect), I am not him. I am me. I closed the trade, and then I waited. I had made an impulsive trade – an emotional trade without a real plan or a real setup. I wasn’t annoyed so much with the losing trade as much as I was annoyed with suddenly being impulsive and acting without truly thinking. I could have spent 30 seconds thinking it through and the outcome would have been very different. I calmed myself down, and I thoroughly analysed the chart, and I decided upon a better entry point. I used my process – the tools that work for me. And then this pattern in Figure 27 showed up. It was late in the day, and I was prepared for a restful evening after a long trading week. I bought Brent, and I held it. Figure 27 The setup is simply a Harmonic Retracement. The first retracement and the second retracement are identical. It gives razor-sharp entries, where it is easy to control your risk. I want to remind myself of the things I do well. I want to remind myself of the things I can be prone to when I am not calm. I want to do that ahead of the open. I accept that I will never be perfect. I will at times still make stupid Brent Oil trades on a Friday afternoon because a friend of mine is telling me of his success; but I like to think that like a missile I will self- coordinate as new data becomes apparent, and I like to think that my mental preparation makes my mistakes short lived. TRUST My review of my trades revealed that I didn’t trust myself or the markets. Profitable trading requires trust. If you don’t believe it can happen, you should not even start. If you don’t trust, then you will not make money. Therefore, before you start trading again, you have to work on your beliefs about yourself and the markets. As I see it, trust falls into two categories. TRUST YOURSELF You have to trust that you already have all the tools you need to make a living from trading. Yes, you need to acquire a certain competence level in the field of technical analysis (or whatever edge you use to make trading decisions). I continue to study technical analysis, and I do so to improve my understanding of the ever-changing nature of the markets I trade, but it is not technical analysis that will make me money. It is trusting that I already have all the skills I need to make money consistently. The reason why I was not more successful in my early trading was not because I didn’t know enough about technical analysis. It was because I thought the only thing I needed was technical analysis. However, that was, and is, simply not true. I had not focused my time and attention on matters outside of technical analysis. My focus was not on the right things. My technical savvy was not matched by an emotional maturity, because I had not spent time working on that side of my game. You need to trust that you already have all that you need. Otherwise, you will not bridge the gap between what you know you can achieve and what you are achieving. You need to believe. The belief comes from doing. I will address that in a moment. TRUST MARKETS The second trust consideration is the trust in the markets. When I go to work in the morning, it would be great if the perfect setup manifested itself before my eyes right at the opening bell. However, it rarely does. I use a five-minute and a ten-minute chart as my primary trading time frame. A typical trading session runs over ten hours for me. That means I will be confronted with a total of 120 candles/bars of five-minute duration. As a result of my review of my trading performance, I came to a realisation. I didn’t trust the market would give me the opportunities I needed to make money. It was a debilitating belief. I set out to prove that I was wrong in that belief by reviewing ten years’ worth of intra-day data from the handful of products that I traded most frequently. Now I wasn’t just studying for the sake of identifying patterns. I studied to prove that the technical analysis setups that served me well would repeat every day. I arrived at a new set of beliefs. I came to believe I can trust the market to give me an opportunity to make money every day. I came to trust the fact that at least two or three of those five-minute candles would produce a great trade entry. I came to trust that the market would give me a perfect entry point, such as a double top in a higher time frame downtrend or a continuation signal. In conclusion, I shaped a new belief around the evidence that I laid bare through my research. I came to accept that I can produce a good living from trading, from waiting for those ideal setups. But those ideal setups don’t necessarily materialise when I want them to, in the time frame I have at my disposal to trade. I need something else beyond trust. Trust is a vital part of the journey to making the markets your playground, but it is not the only component. I needed to work on another part of my behaviour. I would often tire before the afternoon trading session. I would often tire as the week progressed. This led to poor decisions, which can be directly attributed to boredom and impatience. PATIENCE I realised that my patience was my weakness. However, there is more than one kind of patience. For example, a mother teaching her young child to read may experience a sense of impatience, but the mother will remind herself that eventually all children learn how to read. The impatience that a parent may experience is mitigated by the perceived time horizon to reach the end goal. We know our children will learn basic reading skills, as long as we persist. We simply have to maintain our patience as our little ones inch their way towards the desired skill. You can’t argue that patience is a quality directly transferable from parenting to trading. As a parent you can tell yourself you will patiently work towards your child being able to read. However, you can’t say that you will patiently wait for the market to hit your desired entry point, because it might not hit your desired entry point. As a result, you will experience emotions that a parent doesn’t. You will experience a fear that the market will move without you. You will be fearful that the market will not give you an opportunity to jump on board. Without the right kind of conditioning, you will act upon these fear impulses. Had I not gone through all the data I had, I would not have been so assured in my decision to wait for the right setup. I accept my process is thorough, but with that preparation comes significant financial reward. Without a doubt, one of the greatest flaws I saw traders exhibit during my decade on a London trading floor was the idea that it is too late to join the trend. It was a common occurrence during trend days to witness clients continuously try to find the low of the day. On those days our clients lost the most. If the market was rallying, they would either do nothing, or they would try to find a place to sell short. If the market was falling, they would do nothing; but more likely they would try to find the low of the day and buy. Considering the action was so common across such a large group of individuals, I conclude that there is an inherent trading flaw in our thinking which makes us want to go against the trend. I have previously mentioned this supermarket mentality, which compels us to seek value. Another reason this behaviour is commonplace is because of the prolific use of chart indicators that display what is technically known as overbought and oversold price levels. The use of overbought and oversold indicators has a terrible track record in trending markets. To my mind patience is a skillset that can make the difference between being an abject failure or a wizard. I used the word skillset because I believe that patience can be developed. I developed my patience in trading using two methods. Both are practical in nature, but they are very different in their application. One is a proactive exercise. One is a reflective exercise. EXPANDING MY FIELD OF INFORMATION The proactive exercise evolved around the concept of expanding the field of information. I print out the charts of my favourite markets every night, while the trading session is still fresh in my mind. For example, I will print out the DAX Index chart and the FTSE Index chart on both a five-minute chart and a ten-minute chart. The reason I am printing out two time frames is because of perspective. I found that my use of the five-minute chart prompted overtrading. By considering the ten-minute chart I am forcing myself to slow down my decision making. This act of slowing down my time perspective also strengthens my patience. I see things on a ten-minute chart that give me a greater clarity than if I had seen them on a five-minute chart alone. Patience, however, is not a quality that is easy to come by. I am a man in my 50s. Over my lifespan the world has pandered to the impatient. When I was a child, if my family ran out of milk on a Sunday afternoon I would have to wait until Monday morning before I could purchase another bottle. Everything was shut on a Sunday. Forgive me if I sound like a relic. I am really not. I love technological advances. So many wonderful things flow from our advancement of living, but the flipside of the coin is that we as a species have also become impatient. That is important to remember when you set out on a trading journey. Not long ago, I read about a gentleman called Navinder Sarao, a trader who became synonymous with the infamous 2010 flash crash. In the book Flash Crash, by Liam Vaughan, it becomes apparent that some of the primary skills that Navinder possessed were focus and patience. According to the book, Navinder Sarao would hide himself away from the other traders he worked with, so as not to be disturbed. He needed quiet around him to exercise focus and patience. The exercise of printing out the specific charts every day instils in me faith that every day the market will give me an opportunity to make good trades. The exercise is also an opportunity for me to discover new behaviour in the market and continuously train my mind and eyes to spot patterns. I happen to believe that you only see things you have trained your eyes to see. IMAGERY AND BREATHING The second exercise is hard to begin with. Some call this exercise meditation. Some call it visual imagery. I don’t have a name for it, but I know what I want to achieve. I want to calm down my mind. Depending on the mood I am in, I will use one of the following tools to keep my mind trained for the task of being a high-stake day trader. I sit quietly in a comfortable position, and I observe my breath. I breathe in for seven seconds, and I breathe out for 11. I repeat. I will do as much or as little as I need to feel calm coming over me. Sometimes it takes five minutes. Sometimes it takes 15 minutes. The purpose of the exercise is simply to calm my mind. Through the use of breathing exercises I have been able to increase my attention span significantly. I was hesitant at first. I was even hesitant to write about it. It has that taste of a new-age fad. The reality is that calming your mind through breathwork is used extensively by high-performance athletes. I read extensively on the topic of meditation amongst Formula 1 drivers. It was both a surprise and a relief that ultra-competitive sportsmen and women, people I admire and am inspired by, are turning their sight inwards to improve their edge. I have to be upfront with you. I have no formal training in meditation or imagery. I simply trust and let myself be guided by what enters my head. My mental imagery is designed to place myself in physically dangerous situations. I may be face to face with an alligator. I may climb a steep rock face. I may surf a monstrous swell. The exercise is simple. I want to elevate my pulse through imagery. Then I want to consciously focus on my breath and simply accept the situation for what it is. The aim is to confront the imagery and remain calm. Once I am calm, I see myself trading the absolute biggest stake size I am allowed by my broker. I see the market move against me, and I visualise my P&L go deeply into negative. I feel my pulse elevate, and I focus on calming it down. I repeat this process over and over. I see myself riding a trend higher and higher. I see my P&L grow larger and larger. I am waiting for my mind to tell me to take profit. Then I stop the tape and flip the switch. I calm my mind down, and I see myself looking at my P&L dispassionately. I calm my breath until I am able to simply observe my profit grow larger and larger as I trend with the market, higher and higher. The goal is simply to be, to be an unemotional observer of the market. The goal is to act without fear, without hope, without anything but an objective assessment of the price action. ASK FOR HELP I believe that beliefs shape our lives. I believe not all my beliefs are beneficial to the life I want to live. I accept they are there, and as my self- knowledge evolves I address them to the best of my ability. I have come up with this back-to-front idea of how to address my beliefs. It evolves around the old saying, “I will believe it when I see it.” How about turning it on its head to say, “I will see it when I believe it”? This argues that you must believe before you can see. Many of our beliefs have been part of our construct since our formative years. They are not going to go away without a fight. Of course you might decide not to fight them, but to accept them. I call this process Ask for Help. I sit with a blank piece of paper, and I pose a question. It could be, “Why am I afraid to join a down-trend after it already started?” I write down everything that appears in my mind. I sit with my eyes closed and I observe my thoughts. I do not censor myself. I just sit and ask and listen and write down. I may write for 10–20 minutes. What often appears on paper are thoughts straight out of the psych ward. It scares me at times how brutally to the point and honest the answers can be. It can be quite horrifying to read the things the subconscious mind brings up. I don’t judge. I accept. When I am working with my beliefs, fighting those beliefs will not work. I think giving negative energy to a belief will only cause it to fight for its life. The only thing that works is complete acceptance. I accept what is there. I understand it. It allows me to retire it. I diffuse it. If I approach it from a perspective of “I hate this belief”, it will enforce and entrench itself. Say I have a belief about trading that suggests I need to make my money quickly. I need to get in on the move first thing in the morning. If I want to diffuse this belief, because I have strong evidence to suggest it is destructive to my trading account, I will ask for help. I will accept the belief. I will diffuse its negative energy, and I will replace it with positive energy. I will reinforce a new belief such as “I will wait for the first ten- minute bar to complete before I make a decision to trade”. Unfortunately, beliefs do not have the power to dismantle themselves. All beliefs demand expression. Desire and willingness to ask questions from a sincere space, with a sincere mindset, will give you answers. When I use the Ask for Help process, I know it is complete when I can distil my question into a short one-sentence answer. Then I know I have condensed the exercise into its lowest common denominator, and I have diffused whatever belief I had that didn’t serve me. The old memory will always be there, but the context has changed from negative to positive. It is important for me to remind you that money is a by-product of the ideal trading mindset. You are creating a process that will guarantee an optimal mindset for your trading life. The essence of good trading lies squarely in how we think and perceive information about the markets. It has everything to do with how we think and how we live our lives. Today I spoke to a friend of mine. We had not spoken in a while. I consider him a very close friend, and it was a joy to reconnect. As he spoke, I listened intently. You have two ears and one mouth. Use them in that proportion. He was talking animatedly about his trading and how well it was going. In between the stream of sentences, I picked up on a sentence that spoke volumes: “I am still working on increasing my trading size.” I thought long and hard about that sentence, knowing I was going to write this final chapter today. My friend first spoke to me about increasing his trading size back in 2015. Today it is 2022. He has spent seven years talking about increasing his trading size. What does that tell you about his desire to increase his trading size? Do you think there might be a misalignment between what he says he wants, and what he is actually doing to get what he wants? I often tell my children this. Do what you have to do, so that you can do what you want to do. I tell them to make up their minds what they want but think very long and hard about it first. If you say you want something, and then you do nothing about it, then you can be damn certain there is a misalignment between your conscious and your subconscious. When I am faced with a situation like that, I use the Ask for Help exercise, and I always get a brutally honest answer. The most common answer I get is: “Actually you say want it, but you don’t!” The idea of deciding what you want can undo a lifetime of negative energy surrounding your beliefs and your belief system. The power of making up your mind will remove all negative energy surrounding a belief system. I have come to accept that many people do not want to do that. We fall in love with our drama. We cling on to our drama because it validates us and gives us attention. When I am out of sorts, angry, frustrated, I ask questions and work my way backwards. I work my way to the source of the problem. Anger is often a self-defence mechanism. If I am angry, I need to know what the underlying belief for the anger is. So, I ask. I am often told I am very disciplined. This is not true. The word itself is an oxymoron. Discipline implies the use of force and will. My action flows from a love of what I do. I don’t have to apply will to do what I do. Those who are self-disciplined don’t think of themselves as self-disciplined. They are just expressing themselves in harmony with their own dreams and goals and desires. When you watch spiritual movies like The Secret and listen to self-help tapes, you get this sense that the universe is a menu, and you can help yourself to whatever you want. I find that to be one of the most distressing aspects of the self-help industry, be it neurolinguistic programming or Law of Attraction or whatever name the latest fad goes by. I have stood in an auditorium and listened to motivational speakers make their audience shout out whatever grievances are holding them back, and then push the audience towards their private island retreat for untold sums. I never believed in it. I don’t believe anyone ever achieved anything spectacular without putting in a massive amount of effort. I know I put in the effort. I know that everything I do on a daily basis is the result of grit and determination. I am not talented. I am hard working. I am not gifted. I am determined. I am not lucky. I am persistent. TWENTY TRADES My friend Dr David Paul gave me an exercise, which at its heart is designed to strengthen the process of your trading. It is as simple as it is difficult. Your job is to execute 20 trades, as the signals appear. One by one, you take every trade signal as it comes. The purpose of the exercise is not actually to make money. You will probably break even, and that is fine. The purpose of the exercise is to smoke out your internal conflicts and your unresolved emotions. It has at its core the idea that if you can execute 20 trades without any kind of conflict, you are trading from a carefree and fearless frame of mind. This means you are trading from the perspective that: 1. Anything can happen – and you are emotionally detached from the outcome. 2. Every moment is unique – and you are no longer drawing associations between this moment and another moment. You are pain free. 3. There is a random distribution of wins and losses – you accept the outcome as if it were a coin-flip exercise. 4. You don’t have to know what will happen next to make money – so you trust the process, and you focus on controlling the only variable you truly can control, which is how much you want to risk on this trade. The purpose of the exercise is to add energy to your beliefs. Until you can do that without conflict and unresolved thoughts and conflicting energy issues, the negative charge will not dissipate. How do you know when you are successful? When you can trade without any conflicting or competing thoughts. The results are not important during the exercise. This a process exercise. You may have to repeat the 20 trades over and over until you come to a point where you find that you are firing off trades without fear, without hesitation, without connecting this moment with a past moment, and you accept the outcome dispassionately. When you arrive there, you really have arrived! DISASSOCIATION A friend called. She had put up a post on a social media outlet, and her post was very ill received. She endured a torrent of abuse for what was a well- intentioned post. She called me for help. I read her post and the slew of abusive comments. To me, however, they were just words. They were words without energy. I dispassionately read the posts, and then I explained to her what to do. As traders we need to work towards being as dispassionate about our trading as I was about her social media post. The more we work on this, the better we will trade. Some will argue against me. Remember, I am writing this from the perspective of what works for me. How do you do trade dispassionately? How do you disassociate yourself from feeling anything when you are trading? Well, that is what my exercises take care of. If you want to be able to receive information from the market, without feeling threatened, it will not happen by itself. I believe working on what you think and how you respond and evaluate your responses will improve your trading in measures you would struggle to appreciate right now. I once sped down the autobahn doing 186 miles an hour. Yes, it was reckless. Whilst doing it, I wasn’t wondering if there was milk in the fridge or if I had remembered to floss my teeth this morning. I was in the moment. Focused. That is what I want to bring to my trading every day. Every moment is unique. That does not mean we have to act like a formless blob with no memory of the past. There will always be some degree of correspondence. However, just because I was rejected by a girl the first time I invited her for a dance does not mean I will be rejected the next time. But my mind might think so, so I may have an argument with my conscious thinking and my subconscious beliefs. My rational mind might say, “The next girl will say yes to a dance.” My subconscious mind, unbeknownst to me, might say, “No way amigo, give up, she will never dance with you.” If you have a moment of doubt before venturing over to ask the lucky lady, you know you are not aligned. When I experience this in my trading, I will Ask for Help, or I will use imagery to resolve whatever is going on in my head. MIND LOOP My training involves accepting pain and making it part of my existence through habit and repetition, so that my degree of pain tolerance is expanded. I also have to train my mind about expectations, and how to deal with unrealised expectations. This requires a tenacious effort, through journalling, mental imagery, and asking for help. You may quite rightly ask, “Does it work?” I think it does. It has revolutionised my trading. As I type these words, in March 2022, I have not had a losing day since September 2021. That is nearly seven months without a single losing day. I don’t think this should be celebrated. I am not writing this to show off in any shape or form. The intention is to inspire you to take the mental side of trading almost as seriously as the technical side. If I were to describe the beliefs that are the foundation for my trading, they would resemble a flowchart, one where the entire mindset ecosystem forms a loop. My trust (in the markets and in myself) supports my patience. My patience (that a setup will materialise) feeds my confidence. My confidence (that I will win) dictates my inner dialogue. My inner dialogue (what I tell myself while I am trading) supports my process-oriented mindset. The process enables me to stay focused in this moment. I support this loop with my mental exercises. They feed, nourish and sustain the loop. I am a process-oriented trader. I do not believe in goal setting. There are no Post-It Notes on my monitor reminding me how much I want to make today or this month or year. I have no monetary goals or pip/point goals. I will take what the market will give me. I never trade with targets. By being utterly focused on the process as opposed to being outcome oriented, I ensure that I am staying present. When you are present, you don’t connect past moments with this moment or future moments. You are right here, right now. Being present is what some would call mindfulness. I call it focus. I call it concentration. I call it knowing what I want. I want to win. That is my overriding motive for trading – to win. I want to win, but I don’t mind losing. However, I know that if I forget all about winning, and I focus on the process, I will win. It is an idiosyncratic conundrum that for a long time I just could not believe and give into. How can I win if I am not focused on the goal at all times? It took me almost a decade to figure out that process is everything. Don’t focus on the goal. Sure, know what the goal is, but focus on the process. Trust the process. I built my trading life around this mind loop. How does the loop look? I trust. The research underpins the trust. The trust supports the patience. The patience is underpinned by the mental exercises, and it nourishes my confidence. My internal dialogue is driven by a process-oriented mindset, fuelled by my confidence. I focus on what I can control – my mindset, my risk approach – and I let the market do what it wants to do. Whatever it does, does not fuel the fearful side of my mind. That has been trained away. I am not afraid of the market. The only thing I am afraid of is that I do something stupid in the market. As I trust myself, this does not happen. I trust that I have the skills to make money, and I trust that the market will give me opportunities to make money. This trust has been nurtured and strengthened by my intense study of market charts for the time period I desire to trade. The trust is further strengthened by continuous dedication to my vocational skillset. My patience flows from my trust in the market and in myself. I have built an emotional connection between trust and patience. I trust the setups will come, if I am patient. If I am patient, I will win. Winning means more than anything else to me. If I am not patient, I will not win. I will do anything to win. Therefore, the trust overrides any emotional impatience that may arise in my mind, because I trust that if I miss this signal, there will be another one coming. My confidence comes from continuously working on my game. I don’t learn technical analysis once. I learn all the time. Some markets move. Some markets are dead. Some markets require larger stops. Some require you to trade with orders because they move so fast. The markets are forever changing, and I change with them. My inner dialogue stems from the trust and the patience and the confidence. Of course, yours truly has bad trading days. I just don’t let it bother me. I am grounded in this moment. I focus on the process. That is all I can do. I can’t dictate to the market what it must do. I must be like water, and flow. I must flow with the market. I don’t fight the market. I flow with the market. “Just flow,” I tell myself. This is what lies behind the process. I never expect to be comfortable when I am trading. If I am comfortable, I know I am not pushing the boundaries of what I am capable of. I know that to get the best out of myself I need to be a little uncomfortable. I will give you an example. I sold short the Dow Index in my Telegram channel (timestamped for authenticity and verification). I have marked my entry point in Figure 28. Initially, the market moves against me. Then it turns and trends lower. As it trends lower, I am mindful of my mind saying, “Take profit.” That voice used to be much louder. Now I am so focused on the process that the voice is no longer heard. I focus on the process, not on the outcome. Figure 28 However, at one point I have 200 points in profit and the market sits at an old low. I have to accept that there is a real possibility the market will rebound from there, and much of my 200-point profit will disappear. That is being uncomfortable. I accept it and decide to let the position ride. Do you know why I let it ride? Because I know myself well enough to accept that if I took profit, and the market then continued lower, I would feel awful. The pain of seeing a market giving you even more profit when you are not on board is much greater than the pain of seeing some of your paper profit disappear – to me at least! This time it worked. Tomorrow it might not work. I have to trust the process will sustain me over the long run and be less concerned about the outcome of a single event. Remember, there is complete randomness in the outcome of one event, but over hundreds of observations there is no randomness. A trading life is not defined by what we do every now and then, but by what we do over and over. You will never be able to trade without having losing trades. The whole purpose for giving this book the title it has, Best Loser Wins, is to illustrate this point right from the beginning. The one who is best able to lose will win the game of trading. The survey of 25,000 traders executing 43 million FX trades over a 15- month period illustrates this point perfectly. Overall, they had more winning trades than losing trades. Out of those 43 million trades, up to 61% of them were winners, depending on what currency pair they traded. What does that tell you? It tells you that those 25,000 traders have a good grasp on the markets and where to place their trades. It tells you that if they were somehow able to operate with a 1:1 risk-to-reward ratio, they would win 61 out of 100 and lose 39 out of 100. That is a winning formula. That creates a net positive trade flow of 22. That is a business model that has an integral foundation. The problem is that the survey shows that when they win, they win on average 43 pips. When they lose, they lose on average 83 pips. In other words, they lose twice as much (almost) on their losing trade than they make on their winning trades. Let’s say 100 trades are executed. 61 winners at 43 pips = 2,623 pips 39 losers at 83 pips = 3,237 pips What does that tell you? It tells you that they are good at picking winners, but when they are faced with a losing trade, they don’t have the mental discipline to cut the loss. What does that tell you? It tells you that they need to work on their mental game so that they are better equipped to handle losses. Their minds are most likely wired to associate pain with taking a loss. The mind has at its core a mandate to protect you against pain – physical as well as mental pain, perceived pain and real pain. FINAL WORDS Your path to becoming a profitable trader lies not in better understanding the markets, but in better understanding your mind. Your mind and how you operate it will dictate the level of success you have as a trader. I am going to go out on a limb and tell you something about you. People reading this book could have fallen into one of two categories, but I doubt it. I doubt that new traders, who have never traded before, will ever gravitate towards a book like mine. They are more likely to buy books that have titles like Mastering Trading or Trade Your Way to Financial Independence. This kind of book will be 300 pages of technical analysis and most likely not contain a single mention of losing trades. It will contain page after page of perfect chart examples. This book, I speculate, will be read by the people who previously bought the sort of book mentioned above, but have come to the realisation that the gap between where they are now and where they know they can be can only be bridged by a better mindset. The advantage I have in writing this book is that I don’t have to establish my credentials. I have a four-year public track record, timestamped and readily available for anyone to read. I post my broker trades in Excel format on my website and in my Telegram channel daily. There are plenty of bad trades in that track record, I assure you, but somehow I still manage to make money overall, and quite significantly so. Therefore, the focus now needs to be on the actual steps I have taken – and still take – to ensure I stay at the top of my game. That is where you are headed now. I want to finish the book on a note which is important to me. I have described a process that works for me. It is based around my particular beliefs. Those beliefs are the result of my particular life circumstances. I believe that beliefs are defined by one’s own desires and needs. As a result of my desire to be a profitable trader, and my need to create financial stability in my life, I have acquired beliefs that are consistent with this goal. That said, I accept that my way is not the only way. I don’t describe the way. I describe my way. Whatever you decide is right for you is right for you. Trust it. I periodically suffer from verbal diarrhoea on the mental aspect of trading. I post my musings on both www.BestLoserWins.com as well as on my website www.TraderTom.com Have a wonderful journey. With love. Tom Hougaard ABOUT THE AUTHOR TOM HOUGAARD studied economics and finance at two universities in the United Kingdom, and then went on to work for JPMorgan Chase before spending the next ten years in the City of London as a chief market strategist for a CFD broker. He has given thousands of TV and radio interviews on the state of the market and has educated tens of thousands of clients on trading strategies. Since 2009 he has traded for himself. Tom has self-published several works on trading psychology, price action and product knowledge. You can follow Tom’s trading via Telegram and YouTube. You can view his trading results at www.tradertom.com Table of Contents Cover Title Copyright Dedication Contents Dear Markets Preface Introduction Liar’s Poker The Trading Floor Everyone Is a Chart Expert The Curse of Patterns Fighting My Humanness Disgust The Drifter Mind Trading Through a Slump Embracing Failure Best Loser Wins The Ideal Mindset About the Author ================================================================================ SOURCE: eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf ================================================================================ Contents Foreword Preface Acknowledgments Part I: The Basics of Option Greeks Chapter 1: The Basics Contractual Rights and Obligations ETFs, Indexes, and HOLDRs Strategies and At-Expiration Diagrams Chapter 2: Greek Philosophy Price vs. Value: How Traders Use Option-Pricing Models Delta Gamma Theta Vega Rho Where to Find Option Greeks Caveats with Regard to Online Greeks Thinking Greek Notes Chapter 3: Understanding Volatility Historical Volatility Implied Volatility Expected Volatility Implied Volatility and Direction Calculating Volatility Data Volatility Skew Note Chapter 4: Option-Specific Risk and Opportunity Long ATM Call Long OTM Call Long ITM Call Long ATM Put Finding the Right Risk It’s All About Volatility Options and the Fair Game Note Chapter 5: An Introduction to Volatility-Selling Strategies Profit Potential Chapter 6: Put-Call Parity and Synthetics Put-Call Parity Essentials American-Exercise Options Synthetic Stock Synthetic Stock Strategies Theoretical Value and the Interest Rate A Call Is a Put Note Chapter 7: Rho Rho and Interest Rates Rho and Time Considering Rho When Planning Trades Trading Rho Notes Chapter 8: Dividends and Option Pricing Dividend Basics Dividends and Option Pricing Dividends and Early Exercise Inputting Dividend Data into the Pricing Model Part II: Spreads Chapter 9: Vertical Spreads Vertical Spreads Verticals and Volatility The Interrelations of Credit Spreads and Debit Spreads Building a Box Verticals and Beyond Note Chapter 10: Wing Spreads Condors and Butterflies Taking Flight Keys to Success Greeks and Wing Spreads Directional Butterflies Constructing Trades to Maximize Profit The Retail Trader versus the Pro Notes Chapter 11: Calendar and Diagonal Spreads Calendar Spreads Trading Volatility Term Structure Diagonals The Strength of the Calendar Note Part III: Volatility Chapter 12: Delta-Neutral Trading Direction Neutral versus Direction Indifferent Delta Neutral Trading Implied Volatility Conclusions Chapter 13: Delta-Neutral Trading Gamma Scalping Art and Science Gamma, Theta, and Volatility Gamma Hedging Smileys and Frowns Chapter 14: Studying Volatility Charts Nine Volatility Chart Patterns Note Part IV: Advanced Option Trading Chapter 15: Straddles and Strangles Long Straddle Short Straddle Synthetic Straddles Long Strangle Short Strangle Note Chapter 16: Ratio Spreads and Complex Spreads Ratio Spreads How Market Makers Manage Delta-Neutral Positions Trading Skew When Delta Neutral Isn’t Direction Indifferent Managing Multiple-Class Risk Chapter 17: Putting the Greeks into Action Trading Option Greeks Choosing between Strategies Managing Trades The HAPI: The Hope and Pray Index Adjusting About the Author Index Since 1996, Bloomberg Press has published books for financial professionals on investing, economics, and policy affecting investors. Titles are written by leading practitioners and authorities, and have been translated into more than 20 languages. The Bloomberg Financial Series provides both core reference knowledge and actionable information for financial professionals. The books are written by experts familiar with the work flows, challenges, and demands of investment professionals who trade the markets, manage money, and analyze investments in their capacity of growing and protecting wealth, hedging risk, and generating revenue. For a list of available titles, please visit our web site at www.wiley.com/go/bloombergpress . Copyright © 2012 by Dan Passarelli. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. First edition was published in 2008 by Bloomberg Press. Published simultaneously in Canada. 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Library of Congress Cataloging-in-Publication Data : Passarelli, Dan, 1971- Trading options Greeks : how time, volatility, and other pricing factors drive profits / Dan Passarelli. – 2nd ed. p. cm. – (Bloomberg financial series) Includes index. ISBN 978-1-118-13316-3 (cloth); ISBN 978-1-118-22512-7 (ebk); ISBN 978-1-118-26322-8 (ebk); ISBN 978-1-118-23861-5 (ebk) 1. Options (Finance) 2. Stock options. 3. Derivative securities. I. Title. HG6024.A3P36 2012 332.64′53—dc23 2012019462 This book is dedicated to Kathleen, Sam, and Isabel. I wouldn’t trade them for all the money in the world . Disclaimer This book is intended to be educational in nature, both theoretically and practically. It is meant to generally explore the factors that influence option prices so that the reader may gain an understanding of how options work in the real world. This book does not prescribe a specific trading system or method. This book makes no guarantees. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Examples may or may not be based on factual or historical data. In order to simplify the computations, examples may not include commissions, fees, margin, interest, taxes, or other transaction costs. Commissions and other costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax adviser about potential tax consequences. Past performance is not a guarantee of future results. Options involve risks and are not suitable for everyone. While much of this book focuses on the risks involved in option trading, there are market situations and scenarios that involve unique risks that are not discussed. Prior to buying or selling an option, a person should read Characteristics and Risks of Standardized Options (ODD) . Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Chicago, Illinois 60606. Foreword The past several years have brought about a resurgence in market volatility and options volume unlike anything that has been seen since the close of the twentieth century. As markets have become more interdependent, interrelated, and international, the U.S. listed option markets have solidified their place as the most liquid and transparent venue for risk management and hedging activities of the world’s largest economy. Technology, competition, innovation, and reliability have become the hallmarks of the industry, and our customer base has benefited tremendously from this ongoing evolution. However, these advances can be properly tapped only when the users of the product continue to expand their knowledge of the options product and its unique features. Education has always been the driver of growth in our business, and it will be the steward of the next generation of options traders. Dan Passarelli’s new and updated book Trading Option Greeks is a necessity for customers and traders alike to ensure that they possess the knowledge to succeed and attain their objectives in the high-speed, highly technical arena that the options market has become. The retail trader of the past has given way to a new retail trader of the present—one with an increased level of technology, support, capital treatment, and product selection. The impact of the staggering growth in such products as the CBOE Holdings’ VIX options and futures, and the literally dozens of other products tied to it, have made the volatility asset class a new, unique, and permanent pillar of today’s option markets. Dan’s updated book continues his mission of supporting, preparing, and reinforcing the trader’s understanding of pricing, volatility, market terminology, and strategy, in a way that few other books have been able. Using a perspective forged from years as an options market maker, professional trader, and customer, Dan has once again provided a resource for those who wish to know best how the option markets behave today, and how they are likely to continue to behave in the future. It is important to understand not only what happens in the options space, but also why it happens. This book is intended to provide those answers. I wish you all the best in your trading! William J. Brodsky Chairman and CEO Chicago Board Options Exchange Preface I’ve always been fascinated by trading. When I was young, I’d see traders on television, in their brightly colored jackets, shouting on the seemingly chaotic trading floor, and I’d marvel at them. What a wonderful job that must be! These traders seemed to me to be very different from the rest of us. It’s all so very esoteric. It is easy to assume that professional traders have closely kept secrets to their ways of trading—something that secures success in trading for them, but is out of reach for everyone else. In fact, nothing could be further from the truth. If there are any “secrets” of professional traders, this book will expose them. True enough, in years past there have been some barriers to entry to trading success that did indeed make it difficult for nonprofessionals to succeed. For example, commissions, bid-ask spreads, margin requirements, and information flow all favored the professional trader. Now, these barriers are gone. Competition among brokers and exchanges—as well as the ubiquity of information as propagated on the Internet—has torn down those walls. The only barrier left between the Average Joe and the options pro is that of knowledge. Those who have it will succeed; those who do not will fail. To be sure, the knowledge held by successful traders is not that of what will happen in the future; it is the knowledge of how to manage the uncertainty. No matter what our instincts tell us, we do not know what will happen in the future with regard to the market. As Socrates put it, “The only true wisdom is in knowing you know nothing.” The masters of option trading are masters of managing the risk associated with what they don’t know—the risk of uncertainty. As an instructor, I’ve talked to many traders who were new to options who told me, “I made a trade based on what I thought was going to happen. I was right, but my position lost money!” Choosing the right strategy makes all the difference when it comes to mastery of risk management and ultimate trading success. Knowing which option strategy is the right strategy for a given situation comes with knowledge and experience. All option strategies are differentiated by their unique risk characteristics. Some are more sensitive to directional movement of the underlying asset than others; some are more affected by time passing than others. The exact exposure positions have to these market influences determines the success of individual trades and, indeed, the long-term success of the trader who knows how to exploit these risk characteristics. These option-value sensitivities can be controlled when a trader understands the option greeks. Option greeks are metrics used to measure an option’s sensitivity to influences on its price. This book will provide the reader with an understanding of these metrics, to help the reader truly master the risk of uncertainty associated with option trading. Successful traders strive to create option positions with risk-reward profiles that benefit them the most in a given situation. A trader’s objectives will dictate the right strategy for the right situation. Traders can tailor a position to fit a specific forecast with respect to the time horizon; the degree of bullishness, bearishness, neutrality, or volatility in the underlying stock; and the desired amount of leverage. Furthermore, they can exploit opportunities unique to options. They can trade option greeks. This opens the door to many new opportunities. A New Direction Traders, both professional and retail, need ways to act on their forecasts without the constraints of convention. “Get long, or do nothing” is no longer a viable business model for people active in the market. “Up is good; down is bad” is burned into traders’ minds from the beginning of their market education. This concept has its place in the world of investing, but becoming an active trader in the option market requires thinking in a new direction. Market makers and other expert option traders look at the market differently from other traders. One fundamental difference is that these traders trade all four directions: up, down, sideways, and volatile. Trading Strategies Buying stock is a trading strategy that most people understand. In practical terms, traders who buy stock are generally not concerned with the literal ownership stake in a corporation, just the opportunity to profit if the stock rises. Although it’s important for traders to understand that the price of a stock is largely tied to the success or failure of the corporation, it’s essential to keep in mind exactly what the objective tends to be for trading a stock: to profit from changes in its price. A bullish position can also be taken in the options market. The most basic example is buying a call. A bearish position can be taken by trading stock or options, as well. If traders expect the value of a stock they own to fall, they will sell the stock. This eliminates the risk of losses from the stock’s falling. If the traders do not own the stock that they think will decline, they can take a more active stance and short it. The short-seller borrows the stock from a party that owns it and then sells the borrowed shares to another party. The goal of selling stock short is to later repurchase the shares at a lower price before returning the stock to its owner. It is simply reversing the order of “buy low/sell high.” The risk is that the stock rises and shares have to be bought at a higher price than that at which they were sold. Although shorting stock can lead to profits when the market cooperates, in the options market, there are alternative ways to profit from falling prices. The most basic example is buying a put. A trader can use options to take a bullish or bearish position, given a directional forecast. Sideways, nontrending stocks and their antithesis, volatile stocks, can be traded as well. In the later market conditions, profit or loss can be independent of whether the stock rises or falls. Opportunity in option trading is not necessarily black and white—not necessarily up and down. Option trading is nonlinear. Consequently, more opportunities can be exploited by trading options than by trading stock. Option traders must consider the time period in question, the volatility expected during this period, interest rates, and dividends. Along with the stock price, these factors make up the dynamic components of an option’s value. These individual factors can be isolated, measured, and exploited. Incremental changes in any of these elements as measured by option greeks provide opportunity for option traders. Because of these other influences, direction is not the only tradable element of a forecast. Time, volatility, interest rates—these can all be traded using option greeks. These factors and more will all be discussed at great length throughout this book. This Second Edition of Trading Option Greeks This book addresses the complex price behavior of options by discussing option greeks from both a theoretical and a practical standpoint. There is some tactical discussion throughout, although the objective of this book is to provide education to the reader. This book is meant to be less a how-to manual than a how-come tutorial. This informative guide will give the retail trader a look inside the mind of a professional trader. It will help the professional trader better understand the essential concepts of his craft. Even the novice trader will be able to apply these concepts to basic options strategies. Comprehensive knowledge of the greeks can help traders to avoid common pitfalls and increase profit potential. Much of this book is broken down into a discussion of individual strategies. Although the nuances of each specific strategy are not relevant, presenting the material this way allows for a discussion of very specific situations in which greeks come into play. Many of the concepts discussed in a section on one option strategy can be applied to other option strategies. As in the first edition of Trading Option Greeks , Chapter 1 discusses basic option concepts and definitions. It was written to be a review of the basics for the intermediate to advanced trader. For newcomers, it’s essential to understand these concepts before moving forward. A detailed explanation of option greeks begins in Chapter 2. Be sure to leave a bookmark in this chapter, as you will flip to it several times while reading the rest of the book and while studying the market thereafter. Chapter 3 introduces volatility. The same bookmark advice can be applied here, as well. Chapters 4 and 5 explore the minds of option traders. What are the risks they look out for? What are the opportunities they seek? These chapters also discuss direction-neutral and direction-indifferent trading. The remaining chapters take the reader from concept to application, discussing the strategies for nonlinear trading and the tactical considerations of a successful options trader. New material in this edition includes updated examples, with more current price information throughout many of the chapters. More detailed discussions are also included to give the reader a deeper understanding of important topics. For example, Chapter 8 has a more elaborate explanation of the effect of dividends on option prices. Chapter 17 of this edition has new material on strategy selection, position management, and adjusting, not featured in the first edition of the book. Acknowledgments A book like Trading Option Greeks is truly a collaboration of the efforts of many people. In my years as a trader, I had many teachers in the School of Hard Knocks. I have had the support of friends and family during the trials and tribulations throughout my trading career, as well as during the time spent writing this book, both the first edition and now this second edition. Surely, there are hundreds of people whose influences contributed to the creation of this book, but there are a few in particular to whom I’d like to give special thanks. I’d like to give a very special thanks to my mentor and friend from the CBOE’s Options Institute, Jim Bittman. Without his help this book would not have been written. Thanks to Marty Kearney and Joe Troccolo for looking over the manuscript. Their input was invaluable. Thanks to Debra Peters for her help during my career at the Options Institute. Thanks to Steve Fossett and Bob Kirkland for believing in me. Thanks to the staff at Bloomberg Press, especially Stephen Isaacs and Kevin Commins. Thanks to my friends at the Chicago Board Options Exchange, the Options Industry Council, and the CME group. Thanks to John Kmiecik for his diligent content editing. Thanks to those who contribute to sharing option ideas on my website, markettaker.com . Thanks to my wife, Kathleen, who has been more patient and supportive than anyone could reasonably ask for. And thanks, especially, to my students and those of you reading this book. PART I The Basics of Option Greeks CHAPTER 1 The Basics To understand how options work, one needs first to understand what an option is. An option is a contract that gives its owner the right to buy or the right to sell a fixed quantity of an underlying security at a specific price within a certain time constraint. There are two types of options: calls and puts. A call gives the owner of the option the right to buy the underlying security. A put gives the owner of the option the right to sell the underlying security. As in any transaction, there are two parties to an option contract— a buyer and a seller. Contractual Rights and Obligations The option buyer is the party who owns the right inherent in the contract. The buyer is referred to as having a long position and may also be called the holder, or owner, of the option. The right doesn’t last forever. At some point the option will expire. At expiration, the owner may exercise the right or, if the option has no value to the holder, let it expire without exercising it. But he need not hold the option until expiration. Options are transferable—they can be traded intraday in much the same way as stock is traded. Because it’s uncertain what the underlying stock price of the option will be at expiration, much of the time this right has value before it expires. The uncertainty of stock prices, after all, is the raison d’être of the option market. A long position in an option contract, however, is fundamentally different from a long position in a stock. Owning corporate stock affords the shareholder ownership rights, which may include the right to vote in corporate affairs and the right to receive dividends. Owning an option represents strictly the right either to buy the stock or to sell it, depending on whether it’s a call or a put. Option holders do not receive dividends that would be paid to the shareholders of the underlying stock, nor do they have voting rights. The corporation has no knowledge of the parties to the option contract. The contract is created by the buyer and seller of the option and made available by being listed on an exchange. The party to the contract who is referred to as the option seller, also called the option writer, has a short position in the option. Instead of having a right to take a position in the underlying stock, as the buyer does, the seller incurs an obligation to potentially either buy or sell the stock. When a trader who is long an option exercises, a trader with a short position gets assigned . Assignment means the trader with the short option position is called on to fulfill the obligation that was established when the contract was sold. Shorting an option is fundamentally different from shorting a stock. Corporations have a quantifiable number of outstanding shares available for trading, which must be borrowed to create a short position, but establishing a short position in an option does not require borrowing; the contract is simply created. The strategy of shorting stock is implemented statistically far less frequently than simply buying stock, but that is not at all the case with options. For every open long-option contract, there is an open short- option contract—they are equally common. Opening and Closing Traders’ option orders are either opening or closing transactions. When traders with no position in a particular option buy the option, they buy to open. If, in the future, the traders wish to eliminate the position by selling the option they own, the traders enter a sell to close order—they are closing the position. Likewise, if traders with no position in a particular option want to sell an option, thereby creating a short position, the traders execute a sell- to-open transaction. When the traders cover the short position by buying back the option, the traders enter a buy-to-close order. Open Interest and Volume Traders use many types of market data to make trading decisions. Two items that are often studied but sometimes misunderstood are volume and open interest. Volume, as the name implies, is the total number of contracts traded during a time period. Often, volume is stated on a one-day basis, but could be stated per week, month, year, or otherwise. Once a new period (day) begins, volume begins again at zero. Open interest is the number of contracts that have been created and remain outstanding. Open interest is a running total. When an option is first listed, there are no open contracts. If Trader A opens a long position in a newly listed option by buying a one-lot, or one contract, from Trader B, who by selling is also opening a position, a contract is created. One contract traded, so the volume is one. Since both parties opened a position and one contract was created, the open interest in this particular option is one contract as well. If, later that day, Trader B closes his short position by buying one contract from Trader C, who had no position to start with, the volume is now two contracts for that day, but open interest is still one. Only one contract exists; it was traded twice. If the next day, Trader C buys her contract back from Trader A, that day’s volume is one and the open interest is now zero. The Options Clearing Corporation Remember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday for a hamburger today.” Did Popeye ever get paid for those burgers? In a contract, it’s very important for each party to hold up his end of the bargain —especially when there is money at stake. How does a trader know the party on the other side of an option contract will in fact do that? That’s where the Options Clearing Corporation (OCC) comes into play. The OCC ultimately guarantees every options trade. In 2010, that was almost 3.9 billion listed-options contracts. The OCC accomplishes this through many clearing members. Here’s how it works: When Trader X buys an option through a broker, the broker submits the trade information to its clearing firm. The trader on the other side of this transaction, Trader Y, who is probably a market maker, submits the trade to his clearing firm. The two clearing firms (one representing Trader X’s buy, the other representing Trader Y’s sell) each submit the trade information to the OCC, which “matches up” the trade. If Trader Y buys back the option to close the position, how does that affect Trader X if he wants to exercise it? It doesn’t. The OCC, acting as an intermediary, assigns one of its clearing members with a customer that is short the option in question to deliver the stock to Trader X’s clearing firm, which in turn delivers the stock to Trader X. The clearing member then assigns one of its customers who is short the option. The clearing member will assign the trader either randomly or first in, first out. Effectively, the OCC is the ultimate counterparty to both the exercise and the assignment. Standardized Contracts Exchange-listed options contracts are standardized, meaning the terms of the contract, or the contract specifications, conform to a customary structure. Standardization makes the terms of the contracts intuitive to the experienced user. To understand the contract specifications in a typical equity option, consider an example: Buy 1 IBM December 170 call at 5.00 Quantity In this example, one contract is being purchased. More could have been purchased, but not less—options cannot be traded in fractional units. Option Series, Option Class, and Contract Size All calls or puts of the same class, the same expiration month, and the same strike price are called an option series . For example, the IBM December 170 calls are a series. Options series are displayed in an option chain on an online broker’s user interface. An option chain is a full or partial list of the options that are listed on an underlying. Option class means a group of options that represent the same underlying. Here, the option class is denoted by the symbol IBM—the contract represents rights on International Business Machines Corp. (IBM) shares. Buying one contract usually gives the holder the right to buy or to sell 100 shares of the underlying stock. This number is referred to as contract size . Though this is usually the case, there are times when the contract size is something other than 100 shares of a stock. This situation may occur after certain types of stock splits, spin-offs, or stock dividends, for example. In the minority of cases in which the one contract represents rights on something besides 100 shares, there may be more than one class of options listed on a stock. A fairly unusual example was presented by the Ford Motor Company options in the summer of 2000. In June 2000, Ford spun off Visteon Corporation. Then, in August 2000, Ford offered shareholders a choice of converting their shares into (a) new shares of Ford plus $20 cash per share, (b) new Ford stock plus fractional shares with an aggregate value of $20, or (c) new Ford stock plus a combination of more new Ford stock and cash. There were three classes of options listed on Ford after both of these changes: F represented 100 shares of the new Ford stock; XFO represented 100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24; and FOD represented 100 shares of new Ford, 13 shares of Visteon, and $2,001.24. Sometimes these changes can get complicated. If there is ever a question as to what the underlying is for an option class, the authority is the OCC. A lot of time, money, and stress can be saved by calling the OCC at 888- OPTIONS and clarifying the matter. Expiration Month Options expire on the Saturday following the third Friday of the stated month, which in this case is December. The final trading day for an option is commonly the day before expiration—here, the third Friday of December. There are usually at least four months listed for trading on an option class. There may be a total of six months if Long-Term Equity AnticiPation Securities® or LEAPS® are listed on the class. LEAPS can have one year to about two-and-a-half years until expiration. Some underlyings have one-week options called WeeklysSM listed on them. Strike Price The price at which the option holder owns the right to buy or to sell the underlying is called the strike price, or exercise price. In this example, the holder owns the right to buy the stock at $170 per share. There is method to the madness regarding how strike prices are listed. Strike prices are generally listed in $1, $2.50, $5, or $10 increments, depending on the value of the strikes and the liquidity of the options. The relationship of the strike price to the stock price is important in pricing options. For calls, if the stock price is above the strike price, the call is in-the-money (ITM). If the stock and the strike prices are close, the call is at-the-money (ATM). If the stock price is below the strike price the call is out-of-the-money (OTM). This relationship is just the opposite for puts. If the stock price is below the strike price, the put is in-the-money. If the stock price and the strike price are about the same, the put is at-the-money. And, if the stock price is above the put strike, it is out-of-the-money. Option Type There are two types of options: calls and puts. Calls give the holder the right to buy the underlying and the writer the obligation to sell the underlying. Puts give the holder the right to sell the underlying and the writer the obligation to buy the underlying. Premium The price of an option is called its premium. The premium of this option is $5. Like stock prices, option premiums are stated in dollars and cents per share. Since the option represents 100 shares of IBM, the buyer of this option will pay $500 when the transaction occurs. Certain types of spreads may be quoted in fractions of a penny. An option’s premium is made up of two parts: intrinsic value and time value. Intrinsic value is the amount by which the option is in-the-money. For example, if IBM stock were trading at 171.30, this 170-strike call would be in-the-money by 1.30. It has 1.30 of intrinsic value. The remaining 3.70 of its $5 premium would be time value. Options that are out-of-the-money have no intrinsic value. Their values consist only of time premium. Sometimes options have no time value left. Options that consist of only intrinsic value are trading at what traders call parity . Time value is sometimes called premium over parity . Exercise Style One contract specification that is not specifically shown here is the exercise style. There are two main exercise styles: American and European. American-exercise options can be exercised, and therefore assigned, anytime after the contract is entered into until either the trader closes the position or it expires. European-exercise options can be exercised and assigned only at expiration. Exchange-listed equity options are all American-exercise style. Other kinds of options are commonly European exercise. Whether an option is American or European has nothing to with the country in which it’s listed. ETFs, Indexes, and HOLDRs So far, we’ve focused on equity options—options on individual stocks. But investors have other choices for trading securities options. Options on baskets of stocks can be traded, too. This can be accomplished using options on exchange-traded funds (ETFs), index options, or options on holding company depositary receipts (HOLDRs). ETF Options Exchange-traded funds are vehicles that represent ownership in a fund or investment trust. This fund is made up of a basket of an underlying index’s securities—usually equities. The contract specifications of ETF options are similar to those of equity options. Let’s look at an example. One actively traded optionable ETF is the Standard & Poor’s Depositary Receipts (SPDRs or Spiders). Spider shares and options trade under the symbol SPY. Exercising one SPY call gives the exerciser a long position of 100 shares of Spiders at the strike price of the option. Expiration for ETF options typically falls on the same day as for equity options—the Saturday following the third Friday of the month. The last trading day is the Friday before. ETF options are American exercise. Traders of ETFs should be aware of the relationship between the price of the ETF shares and the value of the underlying index. For example, the stated value of the Spiders is about one tenth the stated value of the S&P 500. The PowerShares QQQ ETF, representing the Nasdaq 100, is about one fortieth the stated value of the Nasdaq 100. Index Options Trading options on the Spiders ETF is a convenient way to trade the Standard & Poor’s (S&P) 500. But it’s not the only way. There are other option contracts listed on the S&P 500. The SPX is one of the major ones. The SPX is an index option contract. There are some very important differences between ETF options like SPY and index options like SPX. The first difference is the underlying. The underlying for ETF options is 100 shares of the ETF. The underlying for index options is the numerical value of the index. So if the S&P 500 is at 1303.50, the underlying for SPX options is 1303.50. When an SPX call option is exercised, instead of getting 100 shares of something, the exerciser gets the ITM cash value of the option times $100. Again, with SPX at 1303.50, if a 1300 call is exercised, the exerciser gets $350—that’s 1303.50 minus 1300, times $100. This is called cash settlement . Many index options are European, which means no early exercise. At expiration, any long ITM options in a trader’s inventory result in an account credit; any short ITMs result in a debit of the ITM value times $100. The settlement process for determining whether a European-style index option is in-the-money at expiration is a little different, too. Often, these indexes are a.m. settled. A.m.-settled index options will have actual expiration on the conventional Saturday following the third Friday of the month. But the final trading day is the Thursday before the expiration day. The final settlement value of the index is determined by the opening prices of the components of the index on Friday morning. HOLDR Options Like ETFs, holding company depositary receipts also represent ownership in a basket of stocks. The main difference is that investors owning HOLDRs retain the ownership rights of the individual stocks in the fund, such as the right to vote shares and the right to receive dividends. Options on HOLDRs, for all intents and purposes, function much like options on ETFs. Strategies and At-Expiration Diagrams One of the great strengths of options is that there are so many different ways to use them. There are simple, straightforward strategies like buying a call. And there are complex spreads with creative names like jelly roll, guts, and iron butterfly. A spread is a strategy that involves combining an option with one or more other options or stock. Each component of the spread is referred to as a leg. Each spread has its own unique risk and reward characteristics that make it appropriate for certain market outlooks. Throughout this book, many different spreads will be discussed in depth. For now, it’s important to understand that all spreads are made up of a combination of four basic option positions: buy call, sell call, buy put, and sell put. Understanding complex option strategies requires understanding these basic positions and their common, practical uses. When learning options, it’s helpful to see what the option’s payout is if it is held until expiration. Buy Call Why buy the right to buy the stock when you can simply buy the stock? All option strategies have trade-offs, and the long call is no different. Whether the stock or the call is preferable depends greatly on the trader’s forecast and motivations. Consider a long call example: Buy 1 INTC June 22.50 call at 0.85. In this example, a trader is bullish on Intel (INTC). He believes Intel will rise at least 20 percent, from $22.25 per share to around $27 by June expiration, about two months from now. He is concerned, however, about downside risk and wants to limit his exposure. Instead of buying 100 shares of Intel at $22.25—a total investment of $2,225—the trader buys 1 INTC June 22.50 call at 0.85, for a total of $85. The trader is paying 0.85 for the right to buy 100 shares of Intel at $22.50 per share. If Intel is trading below the strike price of $22.50 at expiration, the call will expire and the total premium of 0.85 will be lost. Why? The trader will not exercise the right to buy the stock at a $22.50 if he can buy it cheaper in the market. Therefore, if Intel is below $22.50 at expiration, this call will expire with no value. However, if the stock is trading above the strike price at expiration, the call can be exercised, in which case the trader may purchase the stock below its trading price. Here, the call has value to the trader. The higher the stock, the more the call is worth. For the trade to be profitable, at expiration the stock must be trading above the trader’s break-even price. The break- even price for a long call is the strike price plus the premium paid—in this example, $23.35 per share. The point here is that if the call is exercised, the effective purchase price of the stock upon exercise is $23.35. The stock is literally bought at the strike price, which is $22.50, but the premium of 0.85 that the trader has paid must be taken into account. Exhibit 1.1 illustrates this example. EXHIBIT 1.1 Long Intel call. Exhibit 1.1 is an at-expiration diagram for the Intel 22.50 call. It shows the profit and loss, or P&(L), of the option if it is held until expiration. The X-axis represents the prices at which INTC could be trading at expiration. The Y-axis represents the associated profit or loss on the position. The at- expiration diagram of any long call position will always have this same hockey-stick shape, regardless of the stock or strike. There is always a limit of loss, represented by the horizontal line, which in this case is drawn at −0.85. And there is always a line extending upward and to the right, which represents effectively a long stock position stemming from the strike. The trade-offs between a long stock position and a long call position are shown in Exhibit 1.2 . EXHIBIT 1.2 Long Intel call vs. long Intel stock. The thin dotted line represents owning 100 shares of Intel at $22.25. Profits are unlimited, but the risk is substantial—the stock can go to zero. Herein lies the trade-off. The long call has unlimited profit potential with limited risk. Whenever an option is purchased, the most that can be lost is the premium paid for the option. But the benefit of reduced risk comes at a cost. If the stock is above the strike at expiration, the call will always underperform the stock by the amount of the premium. Because of this trade-off, conservative traders will sometimes buy a call rather than the associated stock and sometimes buy the stock rather than the call. Buying a call can be considered more conservative when the volatility of the stock is expected to rise. Traders are willing to risk a comparatively small premium when a large price decline is feared possible. Instead, in an interest-bearing vehicle, they harbor the capital that would otherwise have been used to purchase the stock. The cost of this protection is acceptable to the trader if high-enough price advances are anticipated. In terms of percentage, much higher returns and losses are possible with the long call. If the stock is trading at $27 at expiration, as the trader in this example expected, the trader reaps a 429 percent profit on the $0.85 investment ([$27 − 23.35] / $0.85). If Intel is below the strike price at expiration, the trader loses 100 percent. This makes call buying an excellent speculative alternative. Those willing to accept bigger risk can further increase returns by purchasing more calls. In this example, around 26 Intel calls—representing the rights on 2,600 shares—can be purchased at 85 cents for the cost of 100 shares at $22.25. This is the kind of leverage that allows for either a lower cash outlay than buying the stock—reducing risk—or the same cash outlay as buying the stock but with much greater exposure—creating risk in pursuit of higher returns. Sell Call Selling a call creates the obligation to sell the stock at the strike price. Why is a trader willing to accept this obligation? The answer is option premium. If the position is held until expiration without getting assigned, the entire premium represents a profit for the trader. If assignment occurs, the trader will be obliged to sell stock at the strike price. If the trader does not have a long position in the underlying stock (a naked call), a short stock position will be created. Otherwise, if stock is owned (a covered call), that stock is sold. Whether the trader has a profit or a loss depends on the movement of the stock price and how the short call position was constructed. Consider a naked call example: Sell 1 TGT October 50 call at 1.45 In this example, Target Corporation (TGT) is trading at $49.42. A trader, Sam, believes Target will continue to be trading below $50 by October expiration, about two months from now. Sam sells 1 Target two-month 50 call at 1.45, opening a short position in that series. Exhibit 1.3 will help explain the expected payout of this naked call position if it is held until expiration. EXHIBIT 1.3 Naked Target call. If TGT is trading below the exercise price of 50, the call will expire worthless. Sam keeps the 1.45 premium, and the obligation to sell the stock ceases to exist. If Target is trading above the strike price, the call will be in- the-money. The higher the stock is above the strike price, the more intrinsic value the call will have. As a seller, Sam wants the call to have little or no intrinsic value at expiration. If the stock is below the break-even price at expiration, Sam will still have a profit. Here, the break-even price is $51.45 —the strike price plus the call premium. Above the break-even, Sam has a loss. Since stock prices can rise to infinity (although, for the record, I have never seen this happen), the naked call position has unlimited risk of loss. Because a short stock position may be created, a naked call position must be done in a margin account. For retail traders, many brokerage firms require different levels of approval for different types of option strategies. Because the naked call position has unlimited risk, establishing it will generally require the highest level of approval—and a high margin requirement. Another tactical consideration is what Sam’s objective was when he entered the trade. His goal was to profit from the stock’s being below $50 during this two-month period—not to short the stock. Because equity options are American exercise and can be exercised/assigned any time from the moment the call is sold until expiration, a short stock position cannot always be avoided. If assigned, the short stock position will extend Sam’s period of risk—because stock doesn’t expire. Here, he will pay one commission shorting the stock when assignment occurs and one more when he buys back the unwanted position. Many traders choose to close the naked call position before expiration rather than risk assignment. It is important to understand the fundamental difference between buying calls and selling calls. Buying a call option offers limited risk and unlimited reward. Selling a naked call option, however, has limited reward—the call premium—and unlimited risk. This naked call position is not so much bearish as not bullish . If Sam thought the stock was going to zero, he would have chosen a different strategy. Now consider a covered call example: Buy 100 shares TGT at $49.42 Sell 1 TGT October 50 call at 1.45 Unlimited and risk are two words that don’t sit well together with many traders. For that reason, traders often prefer to sell calls as part of a spread. But since spreads are strategies that involve multiple components, they have different risk characteristics from an outright option. Perhaps the most commonly used call-selling spread strategy is the covered call (sometimes called a covered write or a buy-write ). While selling a call naked is a way to take advantage of a “not bullish” forecast, the covered call achieves a different set of objectives. After studying Target Corporation, another trader, Isabel, has a neutral to slightly bullish forecast. With Target at $49.42, she believes the stock will be range-bound between $47 and $51.50 over the next two months, ending with October expiration. Isabel buys 100 shares of Target at $49.42 and sells 1 TGT October 50 call at 1.45. The implications for the covered-call strategy are twofold: Isabel must be content to own the stock at current levels, and—since she sold the right to buy the stock at $50, that is, a 50 call, to another party—she must be willing to sell the stock if the price rises to or through $50 per share. Exhibit 1.4 shows how this covered call performs if it is held until the call expires. EXHIBIT 1.4 Target covered call. The solid kinked line represents the covered call position, and the thin, straight dotted line represents owning the stock outright. At the expiration of the call option, if Target is trading below $50 per share—the strike price —the call expires and Isabel is left with a long position of 100 shares plus $1.45 per share of expired-option premium. Below the strike, the buy-write always outperforms simply owning the stock by the amount of the premium. The call premium provides limited downside protection; the stock Isabel owns can decline $1.45 in value to $47.97 before the trade is a loser. In the unlikely event the stock collapses and becomes worthless, this limited downside protection is not so comforting. Ultimately, Isabel has $47.97 per share at risk. The trade-off comes if Target is above $50 at expiration. Here, assignment will likely occur, in which case the stock will be sold. The call can be assigned before expiration, too, causing the stock to be called away early. Because the covered call involves this obligation to sell the sock at the strike price, upside potential is limited. In this case, Isabel’s profit potential is $2.03. The stock can rise from $49.42 to $50—a $0.58 profit—plus $1.45 of option premium. Isabel does not want the stock to decline too much. Below $47.97, the trade is a loser. If the stock rises too much, the stock is sold prematurely and upside opportunity is lost. Limited reward and unlimited risk. (Technically, the risk is not unlimited—the stock can only go to zero. But if the stock drops from $49.42 to zero in a short time, the risk will certainly feel unlimited.) The covered call strategy is for a neutral to moderately bullish outlook. Sell Put Selling a put has many similarities to the covered call strategy. We’ll discuss the two positions and highlight the likenesses. Chapter 6 will detail the nuts and bolts of why these similarities exist. Consider an example of selling a put: Sell 1 BA January 65 put at 1.20 In this example, trader Sam is neutral to moderately bullish on Boeing (BA) between now and January expiration. He is not bullish enough to buy BA at the current market price of $69.77 per share. But if the shares dropped below $65, he’d gladly scoop some up. Sam sells 1 BA January 65 put at 1.20. The at-expiration diagram in Exhibit 1.5 shows the P&(L) of this trade if it is held until expiration. EXHIBIT 1.5 Boeing short put. At the expiration of this option, if Boeing is above $65, the put expires and Sam retains the premium of $1.20. The obligation to buy stock expires with the option. Below the strike, put owners will be inclined to exercise their option to sell the stock at $65. Therefore, those short the put, as Sam is in this example, can expect assignment. The break-even price for the position is $63.80. That is the strike price minus the option premium. If assigned, this is the effective purchase price of the stock. The obligation to buy at $65 is fulfilled, but the $1.20 premium collected makes the purchase effectively $63.80. Here, again, there is limited profit opportunity ($1.20 if the stock is above the strike price) and seemingly unlimited risk (the risk of potential stock ownership at $63.80) if Boeing is below the strike price. Why would a trader short a put and willingly assume this substantial risk with comparatively limited reward? There are a number of motivations that may warrant the short put strategy. In this example, Sam had the twin goals of profiting from a neutral to moderately bullish outlook on Boeing and buying it if it traded below $65. The short put helps him achieve both objectives. Much like the covered call, if the stock is above the strike at expiration, this trader reaches his maximum profit potential—in this case 1.20. And if the price of Boeing is below the strike at expiration, Sam has ownership of the stock from assignment. Here, a strike price that is lower than the current stock level is used. The stock needs to decline in order for Sam to get assigned and become long the stock. With this strategy, he was able to establish a target price at which he would buy the stock. Why not use a limit order? If the put is assigned, the effective purchase price is $63.80 even if the stock price is above this price. If the put is not assigned, the premium is kept. A consideration every trader must make before entering the short put position is how the purchase of the stock will be financed in the event the put is assigned. Traders hoping to acquire the stock will often hold enough cash in their trading account to secure the purchase of the stock. This is called a cash-secured put . In this example, Sam would hold $6,380 in his account in addition to the $120 of option premium received. This affords him enough free capital to fund the $6,500 purchase of stock the short put dictates. More speculative traders may be willing to buy the stock on margin, in which case the trader will likely need around 50 percent of the stock’s value. Some traders sell puts without the intent of ever owning the stock. They hope to profit from a low-volatility environment. Just as the short call is a not-bullish stance on the underlying, the short put is a not-bearish play. As long as the underlying is above the strike price at expiration, the option premium is all profit. The trader must actively manage the position for fear of being assigned. Buying the put back to close the position eliminates the risk of assignment. Buy Put Buying a put gives the holder the right to sell stock at the strike price. Of course, puts can be a part of a host of different spreads, but this chapter discusses the two most basic and common put-buying strategies: the long put and the protective put. The long put is a way to speculate on a bearish move in the underlying security, and the protective put is a way to protect a long position in the underlying security. Consider a long put example: Buy 1 SPY May 139 put at 2.30 In this example, the Spiders have had a good run up to $140.35. Trader Isabel is looking for a 10 percent correction in SPY between now and the end of May, about three months away. She buys 1 SPY May 139 put at 2.30. This put gives her the right to sell 100 shares of SPY at $139 per share. Exhibit 1.6 shows Isabel’s P&(L) if the put is held until expiration. EXHIBIT 1.6 SPY long put. If SPY is above the strike price of 139 at expiration, the put will expire and the entire premium of 2.30 will be lost. If SPY is below the strike price at expiration, the put will have value. It can be exercised, creating a short position in the Spiders at an effective price of $136.70 per share. This price is found by subtracting the premium paid, 2.30, from the strike price, 139. This is the point at which the position breaks even. If SPY is below $136.70 at expiration, Isabel has a profit. Profits will increase on a tick-for-tick basis, with downward movements in SPY down to zero. The long put has limited risk and substantial reward potential. An alternative for Isabel is to short the ETF at the current price of $140.35. But a short position in the underlying may not be as attractive to her as a long put. The margin requirements for short stock are significantly higher than for a long put. Put buyers must post only the premium of the put —that is the most that can be lost, after all. The margin requirement for short stock reflects unlimited loss potential. Margin requirements aside, risk is a very real consideration for a trader deciding between shorting stock and buying a put. If the trader expects high volatility, he or she may be more inclined to limit upside risk while leveraging downside profit potential by buying a put. In general, traders buy options when they expect volatility to increase and sell them when they expect volatility to decrease. This will be a common theme throughout this book. Consider a protective put example: This is an example of a situation in which volatility is expected to increase. Own 100 shares SPY at 140.35 Buy 1 SPY May139 put at 2.30 Although Isabel bought a put because she was bearish on the Spiders, a different trader, Kathleen, may buy a put for a different reason—she’s bullish but concerned about increasing volatility. In this example, Kathleen has owned 100 shares of Spiders for some time. SPY is currently at $140.35. She is bullish on the market but has concerns about volatility over the next two or three months. She wants to protect her investment. Kathleen buys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and the put at the same time, as a spread, the position would be called a married put.) Kathleen is buying the right to sell the shares she owns at $139. Effectively, it is an insurance policy on this asset. Exhibit 1.7 shows the risk profile of this new position. EXHIBIT 1.7 SPY protective put. The solid kinked line is the protective put (put and stock), and the thin dotted line is the outright position in SPY alone, without the put. The most Kathleen stands to lose with the protective put is $3.65 per share. SPY can decline from $140.35 to $139, creating a loss of $1.35, plus the $2.30 premium spent on the put. If the stock does not fall and the insuring put hence does not come into play, the cost of the put must be recouped to justify its expense. The break-even point is $142.65. This position implies that Kathleen is still bullish on the Spiders. When traders believe a stock or ETF is going to decline, they sell the shares. Instead, Kathleen sacrifices 1.6 percent of her investment up front by purchasing the put for $2.30. She defers the sale of SPY until the period of perceived risk ends. Her motivation is not to sell the ETF; it is to hedge volatility. Once the anticipated volatility is no longer a concern, Kathleen has a choice to make. She can let the option run its course, holding it to expiration, at which point it will either expire or be exercised; or she can sell the option before expiration. If the option is out-of-the-money, it may have residual time value prior to expiration that can be recouped. If it is in- the-money, it will have intrinsic value and maybe time value as well. In this situation, Kathleen can look at this spread as two trades—one that has declined in price, the SPY shares, and one that has risen in price, the put. Losses on the ETF shares are to some degree offset by gains on the put. Measuring Incremental Changes in Factors Affecting Option Prices At-expiration diagrams are very helpful in learning how a particular option strategy works. They show what the option’s price will ultimately be at various prices of the underlying. There is, however, a caveat when using at- expiration diagrams. According to the Options Industry Council, most options are closed before they reach expiration. Traders not planning to hold an option until it expires need to have a way to develop reasonable expectations as to what the option’s price will be given changes that can occur in factors affecting the option’s price. The tool option traders use to aid them in this process is option greeks. CHAPTER 2 Greek Philosophy My wife, Kathleen, is not an options trader. Au contraire. However, she, like just about everyone, uses them from time to time—though without really thinking about it. She was on eBay the other day bidding on a pair of shoes. The bid was $45 with three days left to go. She was concerned about the price rising too much and missing the chance to buy them at what she thought was a good price. She noticed, though, that someone else was selling the same shoes with a buy-it-now price of $49—a good-enough price in her opinion. Kathleen was effectively afforded a call option. She had the opportunity to buy the shoes at (the strike price of) $49, a right she could exercise until the offer expired. The biggest difference between the option in the eBay scenario and the sort of options discussed in this book is transferability. Actual options are tradable—they can be bought and sold. And it is the contract itself that has value—there is one more iteration of pricing. For example, imagine the $49 opportunity was a coupon or certificate that guaranteed the price of $49, which could be passed along from one person to another. And there was the chance that the $49-price guarantee could represent a discount on the price paid for the shoes—maybe a big discount —should the price of the shoes rise in the eBay auction. The certificate guaranteeing the $49 would have value. Anyone planning to buy the shoes would want the safety of knowing they were guaranteed not to pay more than $49 for the shoes. In fact, some people would even consider paying to buy the certificate itself if they thought the price of the shoes might rise significantly. Price vs. Value: How Traders Use Option-Pricing Models Like in the common-life example just discussed, the right to buy or sell an underlying security—that is, an option—can have value, too. The specific value of an option is determined by supply and demand. There are several variables in an option contract, however, that can influence a trader’s willingness to demand (desire to buy) or supply (desire to sell) an option at a given price. For example, a trader would rather own—that is, there would be higher demand for—an option that has more time until expiration than a shorter-dated option, all else held constant. And a trader would rather own a call with a lower strike than a higher strike, all else kept constant, because it would give the right to buy at a lower price. Several elements contribute to the value of an option. It took academics many years to figure out exactly what those elements are. Fischer Black and Myron Scholes together pioneered research in this area at the University of Chicago. Ultimately, their work led to a Nobel Prize for Myron Scholes. Fischer Black died before he could be honored. In 1973, Black and Scholes published a paper called “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy , that introduced the Black-Scholes option-pricing model to the world. The Black-Scholes model values European call options on non-dividend-paying stocks. Here, for the first time, was a widely accepted model illustrating what goes into the pricing of an option. Option prices were no longer wild guesswork. They could now be rationalized. Soon, additional models and alterations to the Black-Scholes model were developed for options on indexes, dividend-paying stocks, bonds, commodities, and other optionable instruments. All the option-pricing models commonly in use today have slightly different means but achieve the same end: the option’s theoretical value. For American-exercise equity options, six inputs are entered into any option-pricing model to generate a theoretical value: stock price, strike price, time until expiration, interest rate, dividends, and volatility. Theoretical value—what a concept! A trader plugs six numbers into a pricing model, and it tells him what the option is worth, right? Well, in practical terms, that’s not exactly how it works. An option is worth what the market bears. Economists call this price discovery. The price of an option is determined by the forces of supply and demand working in a free and open market. Herein lies an important concept for option traders: the difference between price and value. Price can be observed rather easily from any source that offers option quotes (web sites, your broker, quote vendors, and so on). Value is calculated by a pricing model. But, in practice, the theoretical value is really not an output at all. It is already known: the market determines it. The trader rectifies price and value by setting the theoretical value to fall between the bid and the offer of the option by adjusting the inputs to the model. Professional traders often refer to the theoretical value as the fair value of the option. At this point, please note the absence of the mathematical formula for the Black-Scholes model (or any other pricing model, for that matter). Although the foundation of trading option greeks is mathematical, this book will keep the math to a minimum—which is still quite a bit. The focus of this book is on practical applications, not academic theory. It’s about learning to drive the car, not mastering its engineering. The trader has an equation with six inputs equaling one known output. What good is this equation? An option-pricing model helps a trader understand how market forces affect the value of an option. Five of the six inputs are dynamic; the only constant is the strike price of the option in question. If the price of the option changes, it’s because one or more of the five variable inputs has changed. These variables are independent of each other, but they can change in harmony, having either a cumulative or net effect on the option’s value. An option trader needs to be concerned with the relationship of these variables (price, time, volatility, interest). This multidimensional view of asset pricing is unique to option traders. Delta The five figures commonly used by option traders are represented by Greek letters: delta, gamma, theta, vega, rho. The figures are referred to as option greeks. Vega, of course, is not an actual letter of the greek alphabet, but in the options vernacular, it is considered one of the greeks. The greeks are a derivation of an option-pricing model, and each Greek letter represents a specific sensitivity to influences on the option’s value. To understand concepts represented by these five figures, we’ll start with delta, which is defined in four ways: 1. The rate of change of an option value relative to a change in the underlying stock price. 2. The derivative of the graph of an option value in relation to the stock price. 3. The equivalent of underlying shares represented by an option position. 4. The estimate of the likelihood of an option expiring in-the-money. 1 Definition 1 : Delta (Δ) is the rate of change of an option’s value relative to a change in the price of the underlying security. A trader who is bullish on a particular stock may choose to buy a call instead of buying the underlying security. If the price of the stock rises by $1, the trader would expect to profit on the call—but by how much? To answer that question, the trader must consider the delta of the option. Delta is stated as a percentage. If an option has a 50 delta, its price will change by 50 percent of the change of the underlying stock price. Delta is generally written as either a whole number, without the percent sign, or as a decimal. So if an option has a 50 percent delta, this will be indicated as 0.50, or 50. For the most part, we’ll use the former convention in our discussion. Call values increase when the underlying stock price increases and vice versa. Because calls have this positive correlation with the underlying, they have positive deltas. Here is a simplified example of the effect of delta on an option: Consider a $60 stock with a call option that has a 0.50 delta and is trading for 3.00. Considering only the delta, if the stock price increases by $1, the theoretical value of the call will rise by 0.50. That’s 50 percent of the stock price change. The new call value will be 3.50. If the stock price decreases by $1, the 0.50 delta will cause the call to decrease in value by 0.50, from 3.00 to 2.50. Puts have a negative correlation to the underlying. That is, put values decrease when the stock price rises and vice versa. Puts, therefore, have negative deltas. Here is a simplified example of the delta effect on a −0.40- delta put: As the stock rises from $60 to $61, the delta of −0.40 causes the put value to go from $2.25 to $1.85. The put decreases by 40 percent of the stock price increase. If the stock price instead declined by $1, the put value would increase by $0.40, to $2.65. Unfortunately, real life is a bit more complicated than the simplified examples of delta used here. In reality, the value of both the call and the put will likely be higher with the stock at $61 than was shown in these examples. We’ll expand on this concept later when we tackle the topic of gamma. Definition 2 : Delta can also be described another way. Exhibit 2.1 shows the value of a call option with three months to expiration at a variable stock price. As the stock price rises, the call is worth more; as the stock price declines, the call value moves toward zero. Mathematically, for any given point on the graph, the derivative will show the rate of change of the option price. The delta is the first derivative of the graph of the option price relative to the stock price . EXHIBIT 2.1 Call value compared with stock price. Definition 3 : In terms of absolute value (meaning that plus and minus signs are ignored), the delta of an option is between 1.00 and 0. Its price can change in tandem with the stock, as with a 1.00 delta; or it cannot change at all as the stock moves, as with a 0 delta; or anything in between. By definition, stock has a 1.00 delta—it is the underlying security. A $1 rise in the stock yields a $100 profit on a round lot of 100 shares. A call with a 0.60 delta rises by $0.60 with a $1 increase in the stock. The owner of a call representing rights on 100 shares earns $60 for a $1 increase in the underlying. It’s as if the call owner in this example is long 60 shares of the underlying stock. Delta is the option’s equivalent of a position in the underlying shares . A trader who buys five 0.43-delta calls has a position that is effectively long 215 shares—that’s 5 contracts × 0.43 deltas × 100 shares. In option lingo, the trader is long 215 deltas. Likewise, if the trader were short five 0.43-delta calls, the trader would be short 215 deltas. The same principles apply to puts. Being long 10 0.59-delta puts makes the trader short a total of 590 deltas, a position that profits or loses like being short 590 shares of the underlying stock. Conversely, if the trader were short 10 0.59-delta puts, the trader would theoretically make $590 if the stock were to rise $1 and lose $590 if the stock fell by $1—just like being long 590 shares. Definition 4 : The final definition of delta is considered the trader’s definition. It’s mathematically imprecise but is used nonetheless as a general rule of thumb by option traders. A trader would say the delta is a statistical approximation of the likelihood of the option expiring in-the- money . An option with a 0.75 delta would have a 75 percent chance of being in-the-money at expiration under this definition. An option with a 0.20 delta would be thought of having a 20 percent chance of expiring in- the-money. Dynamic Inputs Option deltas are not constants. They are calculated from the dynamic inputs of the pricing model—stock price, time to expiration, volatility, and so on. When these variables change, the changes affect the delta. These changes can be mathematically quantified—they are systematic. Understanding these patterns and other quirks as to how delta behaves can help traders use this tool more effectively. Let’s discuss a few observations about the characteristics of delta. First, call and put deltas are closely related. Exhibit 2.2 is a partial option chain of 70-day calls and puts in Rambus Incorporated (RMBS). The stock was trading at $21.30 when this table was created. In Exhibit 2.2 , the 20 calls have a 0.66 delta. EXHIBIT 2.2 RMBS Option chain with deltas. Notice the deltas of the put-call pairs in this exhibit. As a general rule, the absolute value of the call delta plus the absolute value of the put delta add up to close to 1.00. The reason for this has to do with a mathematical relationship called put-call parity, which is briefly discussed later in this chapter and described in detail in Chapter 6. But with equity options, the put-call pair doesn’t always add up to exactly 1.00. Sometimes the difference is simply due to rounding. But sometimes there are other reasons. For example, the 30-strike calls and puts in Exhibit 2.2 have deltas of 0.14 and −0.89, respectively. The absolute values of the deltas add up to 1.03. Because of the possibility of early exercise of American options, the put delta is a bit higher than the call delta would imply. When puts have a greater chance of early exercise, they begin to act more like short stock and consequently will have a greater delta. Often, dividend-paying stocks will have higher deltas on some in-the-money calls than the put in the pair would imply. As the ex-dividend date—the date the stock begins trading without the dividend—approaches, an in-the-money call can become more apt to be exercised, because traders will want to own stock to capture the dividend. Here, the call begins to act more like long stock, leading to a higher delta. Moneyness and Delta The next observation is the effect of moneyness on the option’s delta. Moneyness describes the degree to which the option is in- or out-of-the- money. As a general rule, options that are in-the-money (ITM) have deltas greater than 0.50. Options that are out-of-the-money (OTM) have deltas less than 0.50. Finally, options that are at-the-money (ATM) have deltas that are about 0.50. The more in-the-money the option is, the closer to 1.00 the delta is. The more out-of-the-money, the closer the delta is to 0. But ATM options are usually not exactly 0.50. For ATMs, both the call and the put deltas are generally systematically a value other than 0.50. Typically, the call has a higher delta than 0.50 and the put has a lower absolute value than 0.50. Incidentally, the call’s theoretical value is generally greater than the put’s when the options are right at-the-money as well. One reason for this disparity between exactly at-the-money calls and puts is the interest rate. The more time until expiration, the more effect the interest rate will have, and, therefore, the higher the call’s theoretical and delta will be relative to the put. Effect of Time on Delta In a close contest, the last few minutes of a football game are often the most exciting—not because the players run faster or knock heads harder but because one strategic element of the game becomes more and more important: time. The team that’s in the lead wants the game clock to run down with no interruption to solidify its position. The team that’s losing uses its precious time-outs strategically. The more playing time left, the less certain defeat is for the losing team. Although mathematically imprecise, the trader’s definition can help us gain insight into how time affects option deltas. The more time left until an option’s expiration, the less certain it is whether the option will be ITM or OTM at expiration. The deltas of both the ITM and the OTM options reflect that uncertainty. The more time left in the life of the option, the closer the deltas tend to gravitate to 0.50. A 0.50 delta represents the greatest level of uncertainty—a coin toss. Exhibit 2.3 shows the deltas of a hypothetical equity call with a strike price of 50 at various stock prices with different times until expiration. All other parameters are held constant. EXHIBIT 2.3 Estimated delta of 50-strike call—impact of time. As shown in Exhibit 2.3 , the more time until expiration, the closer ITMs and OTMs move to 0.50. At expiration, of course, the option is either a 100 delta or a 0 delta; it’s either stock or not. Effect of Volatility on Delta The level of volatility affects option deltas as well. We’ll discuss volatility in more detail in future chapters, but it’s important to address it here as it relates to the concept of delta. Exhibit 2.4 shows how changing the volatility percentage (explained further in Chapter 3), as opposed to the time to expiration, affects option deltas. In this table, the delta of a call with 91 days until expiration is studied. EXHIBIT 2.4 Estimated delta of 50-strike call—impact of volatility. Notice the effect that volatility has on the deltas of this option with the underlying stock at various prices. In this table, at a low volatility with the call deep in- or out-of-the-money, the delta is very large or very small, respectively. At 10 percent volatility with the stock at $58 a share, the delta is 1.00. At that same volatility level with the stock at $42 a share, the delta is 0. But at higher volatility levels, the deltas change. With the stock at $58, a 45 percent volatility gives the 50-strike call a 0.79 delta—much smaller than it was at the low volatility level. With the stock at $42, a 45-percent volatility returns a 0.30 delta for the call. Generally speaking, ITM option deltas are smaller given a higher volatility assumption, and OTM option deltas are bigger with a higher volatility. Effect of Stock Price on Delta An option that is $5 in-the-money on a $20 stock will have a higher delta than an option that is $5 in-the-money on a $200 stock. Proportionately, the former is more in-the-money. Comparing two options that are in-the-money by the same percentage yields similar results. As the stock price changes because the strike price remains stable, the option’s delta will change. This phenomenon is measured by the option’s gamma. Gamma The strike price is the only constant in the pricing model. When the stock price moves relative to this constant, the option in question becomes more in-the-money or out-of-the-money. This means the delta changes. This isolated change is measured by the option’s gamma, sometimes called curvature . Gamma (Γ) is the rate of change of an option’s delta given a change in the price of the underlying security . Gamma is conventionally stated in terms of deltas per dollar move. The simplified examples above under Definition 1 of delta, used to describe the effect of delta, had one important piece of the puzzle missing: gamma. As the stock price moved higher in those examples, the delta would not remain constant. It would change due to the effect of gamma. The following example shows how the delta would change given a 0.04 gamma attributed to the call option. The call in this example starts as a 0.50-delta option. When the stock price increases by $1, the delta increases by the amount of the gamma. In this example, delta increases from 0.50 to 0.54, adding 0.04 deltas. As the stock price continues to rise, the delta continues to move higher. At $62, the call’s delta is 0.58. This increase in delta will affect the value of the call. When the stock price first begins to rise from $60, the option value is increasing at a rate of 50 percent—the call’s delta at that stock price. But by the time the stock is at $61, the option value is increasing at a rate of 54 percent of the stock price. To estimate the theoretical value of the call at $61, we must first estimate the average change in the delta between $60 and $61. The average delta between $60 and $61 is roughly 0.52. It’s difficult to calculate the average delta exactly because gamma is not constant; this is discussed in more detail later in the chapter. A more realistic example of call values in relation to the stock price would be as follows: Each $1 increase in the stock shows an increase in the call value about equal to the average delta value between the two stock prices. If the stock were to decline, the delta would get smaller at a decreasing rate. As the stock price declines from $60 to $59, the option delta decreases from 0.50 to 0.46. There is an average delta of about 0.48 between the two stock prices. At $59 the new theoretical value of the call is 2.52. The gamma continues to affect the option’s delta and thereby its theoretical value as the stock continues its decline to $58 and beyond. Puts work the same way, but because they have a negative delta, when there is a positive stock-price movement the gamma makes the put delta less negative, moving closer to 0. The following example clarifies this. As the stock price rises, this put moves more and more out-of-the-money. Its theoretical value is decreasing by the rate of the changing delta. At $60, the delta is −0.40. As the stock rises to $61, the delta changes to −0.36. The average delta during that move is about −0.38, which is reflected in the change in the value of the put. If the stock price declines and the put moves more toward being in-the- money, the delta becomes more negative—that is, the put acts more like a short stock position. Here, the put value rises by the average delta value between each incremental change in the stock price. These examples illustrate the effect of gamma on an option without discussing the impact on the trader’s position. When traders buy options, they acquire positive gamma. Since gamma causes options to gain value at a faster rate and lose value at a slower rate, (positive) gamma helps the option buyer. A trader buying one call or put in these examples would have +0.04 gamma. Buying 10 of these options would give the trader a +0.4 gamma. When traders sell options, gamma works against them. When options lose value, they move toward zero at a slower rate. When the underlying moves adversely, gamma speeds up losses. Selling options yields a negative gamma position. A trader selling one of the above calls or puts would have −0.04 gamma per option. The effect of gamma is less significant for small moves in the underlying than it is for bigger moves. On proportionately large moves, the delta can change quite a bit, making a big difference in the position’s P&(L). In Exhibit 2.1 , the left side of the diagram showed the call price not increasing at all with advances in the stock—a 0 delta. The right side showed the option advancing in price 1-to-1 with the stock—a 1.00 delta. Between the two extremes, the delta changes. From this diagram another definition for gamma can be inferred: gamma is the second derivative of the graph of the option price relative to the stock price. Put another way, gamma is the first derivative of a graph of the delta relative to the stock price. Exhibit 2.5 illustrates the delta of a call relative to the stock price. EXHIBIT 2.5 Call delta compared with stock price. Not only does the delta change, but it changes at a changing rate. Gamma is not constant. Moneyness, time to expiration, and volatility each have an effect on the gamma of an option. Dynamic Gamma When options are far in-the-money or out-of-the-money, they are either 1.00 delta or 0 delta. At the extremes, small changes in the stock price will not cause the delta to change much. When an option is at-the-money, it’s a different story. Its delta can change very quickly. ITM and OTM options have a low gamma. ATM options have a relatively high gamma. Exhibit 2.6 is an example of how moneyness translates into gamma on QQQ calls. EXHIBIT 2.6 Gamma of QQQ calls with QQQ at $44. With QQQ at $44, 92 days until expiration, and a constant volatility input of 19 percent, the 36- and 54-strike calls are far enough in- and out-of-the- money, respectively, that if the Qs move a small amount in either direction from the current price of $44, the movement won’t change their deltas much at all. The chances of their money status changing between now and expiration would not be significantly different statistically given a small stock price change. They have the smallest gammas in the table. The highest gammas shown here are around the ATM strike prices. (Note that because of factors not yet discussed, the strike that is exactly at-the- money may not have the highest gamma. The highest gamma is likely to occur at a slightly higher strike price.) Exhibit 2.7 shows a graph of the corresponding numbers in Exhibit 2.6 . EXHIBIT 2.7 Option gamma. A decrease in the time to expiration solidifies the likelihood of ITMs or OTMs remaining as such. But an ATM option’s moneyness at expiration remains to the very end uncertain. As expiration draws nearer, the gamma decreases for ITMs and OTMs and increases for the ATM strikes. Exhibit 2.8 shows the same 92-day QQQ calls plotted against 7-day QQQ calls. EXHIBIT 2.8 Gamma as time passes. At seven days until expiration, there is less time for price action in the stock to change the expected moneyness at expiration of ITMs or OTMs. ATM options, however, continue to be in play. Here, the ATM gamma is approaching 0.35. But the strikes below 41 and above 48 have 0 gamma. Similarly-priced securities that tend to experience bigger price swings may have strikes $3 away-from-the-money with seven-day gammas greater than zero. The volatility of the underlying will affect gamma, too. Exhibit 2.9 shows the same 19 percent volatility QQQ calls in contrast with a graph of the gamma if the volatility is doubled. EXHIBIT 2.9 Gamma as volatility changes. Raising the volatility assumption flattens the curve, causing ITM and OTM to have higher gamma while lowering the gamma for ATMs. Short-term ATM options with low volatility have the highest gamma. Lower gamma is found in ATMs when volatility is higher and it is lower for ITMs and OTMs and in longer-dated options. Theta Option prices can be broken down into two parts: intrinsic value and time value. Intrinsic value is easily measurable. It is simply the ITM part of the premium. Time value, or extrinsic value, is what’s left over—the premium paid over parity for the option. All else held constant, the more time left in the life of the option, the more valuable it is—there is more time for the stock to move. And as the useful life of an option decreases, so does its time value. The decline in the value of an option because of the passage of time is called time decay, or erosion. Incremental measurements of time decay are represented by the Greek letter theta (θ). Theta is the rate of change in an option’s price given a unit change in the time to expiration . What exactly is the unit involved here? That depends. Some providers of option greeks will display thetas that represent one day’s worth of time decay. Some will show thetas representing seven days of decay. In the case of a one-day theta, the figure may be based on a seven- day week or on a week counting only trading days. The most common and, arguably, most useful display of this figure is the one-day theta based on the seven-day week. There are, after all, seven days in a week, each day of which can see an occurrence with the potential to cause a revaluation in the stock price (that is, news can come out on Saturday or Sunday). The one- day theta based on a seven-day week will be used throughout this book. Taking the Day Out When the number of days to expiration used in the pricing model declines from, say, 32 days to 31 days, the price of the option decreases by the amount of the theta, all else held constant. But when is the day “taken out”? It is intuitive to think that after the market closes, the model is changed to reflect the passing of one day’s time. But, in fact, this change is logically anticipated and may be priced in early. In the earlier part of the week, option prices can often be observed getting cheaper relative to the stock price sometime in the middle of the day. This is because traders will commonly take the day out of their model during trading hours after the underlying stabilizes following the morning business. On Fridays and sometimes Thursdays, traders will take all or part of the weekend out. Commonly, by Friday afternoon, traders will be using Monday’s days to value their options. When option prices are seen getting cheaper on, say, a Friday, how can one tell whether this is the effect of the market taking the weekend out or a change in some other input, such as volatility? To some degree, it doesn’t matter. Remember, the model is used to reflect what the market is doing, not the other way around. In many cases, it’s logical to presume that small devaluations in option prices intraday can be attributed to the routine of the market taking the day out. Friend or Foe? Theta can be a good thing or a bad thing, depending on the position. Theta hurts long option positions; whereas it helps short option positions. Take an 80-strike call with a theoretical value of 3.16 on a stock at $82 a share. The 32-day 80 call has a theta of 0.03. If a trader owned one of these calls, the trader’s position would theoretically lose 0.03, or $0.03, as the time until expiration change from 32 to 31 days. This trader has a negative theta position. A trader short one of these calls would have an overnight theoretical profit of $0.03 attributed to theta. This trader would have a positive theta. Theta affects put traders as well. Using all the same modeling inputs, the 32-day 80-strike put would have a theta of 0.02. A put holder would theoretically lose $0.02 a day, and a put writer would theoretically make $0.02. Long options carry with them negative theta; short options carry positive theta. A higher theta for the call than for the put of the same strike price is common when an interest rate greater than zero is used in the pricing model. As will be discussed in greater detail in the section on rho, interest causes the time value of the call to be higher than that of the corresponding put. At expiration, there is no time value left in either option. Because the call begins with more time value, its premium must decline at a faster rate than that of the put. Most modeling software will attribute the disparate rates of decline in value all to theta, whereas some modeling interfaces will make clear the distinction between the effect of time decay and the effect of interest on the put-call pair. The Effect of Moneyness and Stock Price on Theta Theta is not a constant. As variables influencing option values change, theta can change, too. One such variable is the option’s moneyness. Exhibit 2.10 shows theoretical values (theos), time values, and thetas for 3-month options on Adobe (ADBE). In this example, Adobe is trading at $31.30 a share with three months until expiration. The more ITM a call or a put gets, the higher its theoretical value. But when studying an option’s time decay, one needs to be concerned only with the option’s time value, because intrinsic value is not subject to time decay. EXHIBIT 2.10 Adobe theos and thetas (Adobe at $31.30). The ATM options shown here have higher time value than ITM or OTM options. Hence, they have more time premium to lose in the same three- month period. ATM options have the highest rate of decay, which is reflected in higher thetas. As the stock price changes, the theta value will change to reflect its change in moneyness. If this were a higher-priced stock, say, 10 times the stock price used in this example, with all other inputs held constant, the option values, and therefore the thetas, would be higher. If this were a stock trading at $313, the 325-strike call would have a theoretical value of 16.39 and a one-day theta of 0.189, given inputs used otherwise identical to those in the Adobe example. The Effects of Volatility and Time on Theta Stock price is not the only factor that affects theta values. Volatility and time to expiration come into play here as well. The volatility input to the pricing model has a direct relationship to option values. The higher the volatility, the higher the value of the option. Higher-valued options decay at a faster rate than lower-valued options—they have to; their time values will both be zero at expiration. All else held constant, the higher the volatility assumption, the higher the theta. The days to expiration have a direct relationship to option values as well. As the number of days to expiration decreases, the rate at which an option decays may change, depending on the relationship of the stock price to the strike price. ATM options tend to decay at a nonlinear rate—that is, they lose value faster as expiration approaches—whereas the time values of ITM and OTM options decay at a steadier rate. Consider a hypothetical stock trading at $70 a share. Exhibit 2.11 shows how the theoretical values of the 75-strike call and the 70-strike call decline with the passage of time, holding all other parameters constant. EXHIBIT 2.11 Rate of decay: ATM vs. OTM. The OTM 75-strike call has a fairly steady rate of time decay over this 26-week period. The ATM 70-strike call, however, begins to lose its value at an increasing rate as expiration draws nearer. The acceleration of premium erosion continues until the option expires. Exhibit 2.12 shows the thetas for this ATM call during the last 10 days before expiration. EXHIBIT 2.12 Theta as expiration approaches. Days to Exp .ATM Theta 10 0.075 9 0.079 8 0.084 7 0.089 6 0.096 5 0.106 4 0.118 3 0.137 2 0.171 1 0.443 Incidentally, in this example, when there is one day to expiration, the theoretical value of this call is about 0.44. The final day before expiration ultimately sees the entire time premium erode. Vega Over the past decade or so, computers have revolutionized option trading. Options traded through an online broker are filled faster than you can say, “Oops! I meant to click on puts.” Now trading is facilitated almost entirely online by professional and retail traders alike. Market and trading information is disseminated worldwide in subseconds, making markets all the more efficient. And the tools now available to the common retail trader are very powerful as well. Many online brokers and other web sites offer high-powered tools like screeners, which allow traders to sift through thousands of options to find those that fit certain parameters. Using a screener to find ATM calls on same-priced stocks—say, stocks trading at $40 a share—can yield a result worth talking about here. One $40 stock can have a 40-strike call trading at around 0.50, while a different $40 stock can have a 40 call with the same time to expiration trading at more like 2.00. Why? The model doesn’t know the name of the company, what industry it’s in, or what its price-to-earnings ratio is. It is a mathematical equation with six inputs. If five of the inputs—the stock price, strike price, time to expiration, interest rate, and dividends—are identical for two different options but they’re trading at different prices, the difference must be the sixth variable, which is volatility. Implied Volatility (IV) and Vega The volatility component of option values is called implied volatility (IV). (For more on implied volatility and how it relates to vega, see Chapter 3.) IV is a percentage, although in practice the percent sign is often omitted. This is the value entered into a pricing model, in conjunction with the other variables, that returns the option’s theoretical value. The higher the volatility input, the higher the theoretical value, holding all other variables constant. The IV level can change and often does—sometimes dramatically. When IV rises or falls, option prices rise and fall in line with it. But by how much? The relationship between changes in IV and changes in an option’s value is measured by the option’s vega. Vega is the rate of change of an option’s theoretical value relative to a change in implied volatility . Specifically, if the IV rises or declines by one percentage point, the theoretical value of the option rises or declines by the amount of the option’s vega, respectively. For example, if a call with a theoretical value of 1.82 has a vega of 0.06 and IV rises one percentage point from, say, 17 percent to 18 percent, the new theoretical value of the call will be 1.88—it would rise by 0.06, the amount of the vega. If, conversely, the IV declines 1 percentage point, from 17 percent to 16 percent, the call value will drop to 1.76—that is, it would decline by the vega. A put with the same expiration month and the same strike on the same underlying will have the same vega value as its corresponding call. In this example, raising or lowering IV by one percentage point would cause the corresponding put value to rise or decline by $0.06, just like the call. An increase in IV and the consequent increase in option value helps the P&(L) of long option positions and hurts short option positions. Buying a call or a put establishes a long vega position. For short options, the opposite is true. Rising IV adversely affects P&(L), whereas falling IV helps. Shorting a call or put establishes a short vega position. The Effect of Moneyness on Vega Like the other greeks, vega is a snapshot that is a function of multiple facets of determinants influencing option value. The stock price’s relationship to the strike price is a major determining factor of an option’s vega. IV affects only the time value portion of an option. Because ATM options have the greatest amount of time value, they will naturally have higher vegas. ITM and OTM options have lower vega values than those of the ATM options. Exhibit 2.13 shows an example of 186-day options on AT&T Inc. (T), their time value, and the corresponding vegas. EXHIBIT 2.13 AT&T theos and vegas (T at $30, 186 days to Expry, 20% IV). Note that the 30-strike calls and puts have the highest time values. This strike boasts the highest vega value, at 0.085. The lower the time premium, the lower the vega—therefore, the less incremental IV changes affect the option. Since higher-priced stocks have higher time premium (in absolute terms, not necessarily in percentage terms) they will have higher vega. Incidentally, if this were a $300 stock instead of a $30 stock, the 186-day ATMs would have a 0.850 vega, if all other model inputs remain the same. The Effect of Implied Volatility on Vega The distribution of vega values among the strike prices shown in Exhibit 2.13 holds for a specific IV level. The vegas in Exhibit 2.13 were calculated using a 20 percent IV. If a different IV were used in the calculation, the relationship of the vegas to one another might change. Exhibit 2.14 shows what the vegas would be at different IV levels. EXHIBIT 2.14 Vega and IV. Note in Exhibit 2.14 that at all three IV levels, the ATM strike maintains a similar vega value. But the vegas of the ITM and OTM options can be significantly different. Lower IV inputs tend to cause ITM and OTM vegas to decline. Higher IV inputs tend to cause vegas to increase for ITMs and OTMs. The Effect of Time on Vega As time passes, there is less time premium in the option that can be affected by changes in IV. Consequently, vega gets smaller as expiration approaches. Exhibit 2.15 shows the decreasing vega of a 50-strike call on a $50 stock with a 25 percent IV as time to expiration decreases. Notice that as the value of this ATM option decreases at its nonlinear rate of decay, the vega decreases in a similar fashion. EXHIBIT 2.15 The effect of time on vega. Rho One of my early jobs in the options business was clerking on the floor of the Chicago Board of Trade in what was called the bond room. On one of my first days on the job, the trader I worked for asked me what his position was in a certain strike. I told him he was long 200 calls and long 300 puts. “I’m long 500 puts?” he asked. “No,” I corrected, “you’re long 200 calls and 300 puts.” At this point, he looked at me like I was from another planet and said, “That’s 500. A put is a call; a call is a put.” That lesson was the beginning of my journey into truly understanding options. Put-Call Parity Put and call values are mathematically bound together by an equation referred to as put-call parity. In its basic form, put-call parity states: where c = call value, PV(x) = present value of the strike price, p = put value, and s = stock price. The put-call parity assumes that options are not exercised before expiration (that is, that they are European style). This version of the put-call parity is for European options on non-dividend-paying stocks. Put-call parity can be modified to reflect the values of options on stocks that pay dividends. In practice, equity-option traders look at the equation in a slightly different way: Traders serious about learning to trade options must know put-call parity backward and forward. Why? First, by algebraically rearranging this equation, it can be inferred that synthetically equivalent positions can be established by simply adding stock to an option. Again, a put is a call; a call is a put. and For example, a long call is synthetically equal to a long stock position plus a long put on the same strike, once interest and dividends are figured in. A synthetic long stock position is created by buying a call and selling a put of the same month and strike. Understanding synthetic relationships is intrinsic to understanding options. A more comprehensive discussion of synthetic relationships and tactical considerations for creating synthetic positions is offered in Chapter 6. Put-call parity also aids in valuing options. If put-call parity shows a difference in the value of the call versus the value of the put with the same strike, there may be an arbitrage opportunity. That translates as “riskless profit.” Buying the call and selling it synthetically (short put and short stock) could allow a profit to be locked in if the prices are disparate. Arbitrageurs tend to hold synthetic put and call prices pretty close together. Generally, only professional traders can capture these types of profit opportunities, by trading big enough positions to make very small profits (a penny or less per contract sometimes) matter. Retail traders may be able to take advantage of a disparity in put and call values to some extent, however, by buying or selling the synthetic as a substitute for the actual option if the position can be established at a better price synthetically. Another reason that a working knowledge of put-call parity is essential is that it helps attain a better understanding of how changes in the interest rate affect option values. The greek rho measures this change. Rho is the rate of change in an option’s value relative to a change in the interest rate. Although some modeling programs may display this number differently, most display a rho for the call and a rho for the put, both illustrating the sensitivity to a one-percentage-point change in the interest rate. When the interest rate rises by one percentage point, the value of the call increases by the amount of its rho and the put decreases by the amount of its rho. Likewise, when the interest rate decrease by one percentage point, the value of the call decreases by its rho and the put increases by its rho. For example, a call with a rho of 0.12 will increase $0.12 in value if the interest rate used in the model is increased by one percentage point. Of course, interest rates usually don’t rise or fall one percentage point in one day. More commonly, rates will have incremental changes of 25 basis points. That means a call with a 0.12 rho will theoretically gain $0.03 given an increase of 0.25 percentage points. Mathematically, this change in option value as a product of a change in the interest rate makes sense when looking at the formula for put-call parity. and But the change makes sense intuitively, too, when a call is considered as a cheaper substitute for owning the stock. For example, compare a $100 stock with a three-month 60-strike call on that same stock. Being so far ITM, there would likely be no time value in the call. If the call can be purchased at parity, which alternative would be a superior investment, the call for $40 or the stock for $100? Certainly, the call would be. It costs less than half as much as the stock but has the same reward potential; and the $60 not spent on the stock can be invested in an interest-bearing account. This interest advantage adds value to the call. Raising the interest rate increases this value, and lowering it decreases the interest component of the value of the call. A similar concept holds for puts. Professional traders often get a short- stock rebate on proceeds from a short-stock sale. This is simply interest earned on the capital received when the stock is shorted. Is it better to pay interest on the price of a put for a position that gives short exposure or to receive interest on the credit from shorting the stock? There is an interest disadvantage to owning the put. Therefore, a rise in interest rates devalues puts. This interest effect becomes evident when comparing ATM call and put prices. For example, with interest at 5 percent, three-month options on an $80 stock that pays a $0.25 dividend before option expiration might look something like this: The ATM call is higher in theoretical value than the ATM put by $0.75. That amount can be justified using put-call parity: (Here, simple interest of $1 is calculated as 80 × 0.05 × [90 / 360] = 1.) Changes in market conditions are kept in line by the put-call parity. For example, if the price of the call rises because of an increase in IV, the price of the put will rise in step. If the interest rate rises by a quarter of a percentage point, from 5 percent to 5.25 percent, the interest calculated for three months on the 80-strike will increase from $1 to $1.05, causing the difference between the call and put price to widen. Another variable that affects the amount of interest and therefore option prices is the time until expiration. The Effect of Time on Rho The more time until expiration, the greater the effect interest rate changes will have on options. In the previous example, a 25-basis-point change in the interest rate on the 80-strike based on a three-month period caused a change of 0.05 to the interest component of put-call parity. That is, 80 × 0.0025 × (90/360) = 0.05. If a longer period were used in the example—say, one year—the effect would be more profound; it will be $0.20: 80 × 0.0025 × (360/360) = 0.20. This concept is evident when the rhos of options with different times to expiration are studied. Exhibit 2.16 shows the rhos of ATM Procter & Gamble Co. (PG) calls with various expiration months. The 750-day Long-Term Equity AnticiPation Securities (LEAPS) have a rho of 0.858. As the number of days until expiration decreases, rho decreases. The 22-day calls have a rho of only 0.015. Rho is usually a fairly insignificant factor in the value of short-term options, but it can come into play much more with long-term option strategies involving LEAPS. EXHIBIT 2.16 The effect of time on rho (Procter & Gamble @ $64.34) Why the Numbers Don’t Don’t Always Add Up There will be many times when studying the rho of options in an option chain will reveal seemingly counterintuitive results. To be sure, the numbers don’t always add up to what appears logical. One reason for this is rounding. Another is that traders are more likely to use simple interest in calculating value, whereas the model uses compound interest. Hard-to- borrow stocks and stocks involved in mergers and acquisitions may have put-call parities that don’t work out right. But another, more common and more significant fly in the ointment is early exercise. Since the interest input in put-call parity is a function of the strike price, it is reasonable to expect that the higher the strike price, the greater the effect of interest on option prices will be. For European options, this is true to a large extent, in terms of aggregate impact of interest on the call and put pair. Strikes below the price where the stock is trading have a higher rho associated with the call relative to the put, whereas strikes above the stock price have a higher rho associated with the put relative to the call. Essentially, the more in-the-money an option is, the higher its rho. But with European options, observing the aggregate of the absolute values of the call and put rhos would show a higher combined rho the higher the strike. With American options, the put can be exercised early. A trader will exercise a put before expiration if the alternative—being short stock and receiving a short stock rebate—is a wiser choice based on the price of the put. Professional traders may own stock as a hedge against a put. They may exercise deep ITM puts (1.00-delta puts) to avoid paying interest on capital charges related to the stock. The potential for early exercise is factored into models that price American options. Here, when puts get deeper in-the- money—that is, more apt to be exercised—the rho decreases. When the strike price is very high relative to the stock price—meaning the put is very deep ITM—and there is little or no time value left to the call or the put, the aggregate put-call rho can be zero. Rho is discussed in greater detail in Chapter 7. THE GREEKS DEFINED Delta (Δ) is: 1. The rate of change in an option’s value relative to a change in the underlying asset price. 2. The derivative of the graph of an option’s value in relation to the underlying asset price. 3. The equivalent of underlying asset represented by an option position. 4. The estimate of the likelihood of an option’s expiring in-the-money. Gamma (Γ) is the rate of change in an option’s delta given a change in the price of the underlying asset. Theta (θ) is the rate of change in an option’s value given a unit change in the time to expiration. Vega is the rate of change in an option’s value relative to a change in implied volatility. Rho (ρ) is the rate of change in an option’s value relative to a change in the interest rate. Where to Find Option Greeks There are many sources from which to obtain greeks. The Internet is an excellent resource. Googling “option greeks” will display links to over four million web pages, many of which have real-time greeks or an option calculator. An option calculator is a simple interface that accepts the input of the six variables to the model and yields a theoretical value and the greeks for a single option. Some web sites devoted to option education, such as MarketTaker.com/option_modeling , have free calculators that can be used for modeling positions and using the greeks. In practice, many of the option-trading platforms commonly in use have sophisticated analytics that involve greeks. Most options-friendly online brokers provide trading platforms that enable traders to conduct comprehensive manipulations of the greeks. For example, traders can look at the greeks for their positions up or down one, two, or three standard deviations. Or they can see what happens to their position greeks if IV or time changes. With many trading platforms, position greeks are updated in real time with changes in the stock price—an invaluable feature for active traders. Caveats with Regard to Online Greeks Often, online greeks are one click away, requiring little effort on the part of the trader. Having greeks calculated automatically online is a quick and convenient way to eyeball greeks for an option. But there is one major problem with online greeks: reliability. For active option traders, greeks are essential. There is no point in using these figures if their accuracy cannot be assured. Experienced traders can often spot these inaccuracies a proverbial mile away. When looking at greeks from an online source that does not require you to enter parameters into a model (as would be the case with professional option-trading platforms), special attention needs to be paid to the relationship of the option’s theoretical values to the bid and offer. One must be cautious if the theoretical value of the option lies outside the bid-ask spread. This scenario can exist for brief periods of time, but arbitrageurs tend to prevent this from occurring routinely. If several options in a chain all have theoretical values below the bid or above the offer, there is probably a problem with one or more of the inputs used in the model. Remember, an option-pricing model is just that: a model. It reflects what is occurring in the market. It doesn’t tell where an option should be trading. The complex changes that occur intraday in the market—taking the day or weekend out, changes in stock price, volatility, and the interest rate—are not always kept current. The user of the model must keep close watch. It’s not reasonable to expect the computer to do the thinking for you. Automatically calculated greeks can be used as a starting point. But before using these figures in the decision-making process, the trader may have to override the parameters that were used in the online calculation to make the theos line up with market prices. Professional traders will ignore online greeks altogether. They will use the greeks that are products of the inputs they entered in their trading software. It comes down to this: if you want something done right, do it yourself. Thinking Greek The challenge of trading option greeks is to adapt to thinking in terms of delta, gamma, theta, vega, and rho. One should develop a feel for how greeks react to changing market conditions. Greeks need to be monitored as closely as and in some cases more closely than the option’s price itself. This greek philosophy forms the foundation of option trading for active traders. It offers a logical way to monitor positions and provides a medium in and of itself to trade. Notes 1 . Please note that definition 4 is not necessarily mathematically accurate. This “trader’s definition” is included in the text because many option traders use delta as a quick rule of thumb for estimating probability without regard to the mathematical shortcomings of doing so. 2 . Note that the interest input in the equation is the interest, in dollars and cents, on the strike. Technically, this would be calculated as compounded interest, but in practice many traders use simple interest as a quick and convenient way to do the calculation. CHAPTER 3 Understanding Volatility Most option strategies involve trading volatility in one way or another. It’s easy to think of trading in terms of direction. But trading volatility? Volatility is an abstract concept; it’s a different animal than the linear trading paradigm used by most conventional market players. As an option trader, it is essential to understand and master volatility. Many traders trade without a solid understanding of volatility and its effect on option prices. These traders are often unhappily surprised when volatility moves against them. They mistake the adverse option price movements that result from volatility for getting ripped off by the market makers or some other market voodoo. Or worse, they surrender to the fact that they simply don’t understand why sometimes these unexpected price movements occur in options. They accept that that’s just the way it is. Part of what gets in the way of a ready understanding of volatility is context. The term volatility can have a few different meanings in the options business. There are three different uses of the word volatility that an option trader must be concerned with: historical volatility, implied volatility, and expected volatility. Historical Volatility Imagine there are two stocks: Stock A and Stock B. Both are trading at around $100 a share. Over the past month, a typical end-of-day net change in the price of Stock A has been up or down $5 to $7. During that same period, a typical daily move in Stock B has been something more like up or down $1 or $2. Stock A has tended to move more than Stock B as a percentage of its price, without regard to direction. Therefore, Stock A is more volatile—in the common usage of the word—than Stock B. In the options vernacular, Stock A has a higher historical volatility than Stock B. Historical volatility (HV) is the annualized standard deviation of daily returns. Also called realized volatility, statistical volatility , or stock volatility , HV is a measure of how volatile the price movement of a security has been during a certain period of time. But exactly how much higher is Stock A’s HV than Stock B’s? In order to objectively compare the volatilities of two stocks, historical volatility must be quantified. HV relates this volatility information in an objective numerical form. The volatility of a stock is expressed in terms of standard deviation. Standard Deviation Although knowing the mathematical formula behind standard deviation is not entirely necessary, understanding the concept is essential. Standard deviation, sometimes represented by the Greek letter sigma (σ), is a mathematical calculation that measures the dispersion of data from a mean value. In this case, the mean is the average stock price over a certain period of time. The farther from the mean the dispersion of occurrences (data) was during the period, the greater the standard deviation. Occurrences, in this context, are usually the closing prices of the stock. Some utilizers of volatility data may use other inputs (a weighted average of high, low, and closing prices, for example) in calculating standard deviation. Close-to-close price data are the most commonly used. The number of occurrences, a function of the time period, used in calculating standard deviation may vary. Many online purveyors of this data use the closing prices from the last 30 consecutive trading days to calculate HV. Weekends and holidays are not factored into the equation since there is no trading, and therefore no volatility, when the market isn’t open. After each day, the oldest price is taken out of the calculation and replaced by the most recent closing price. Using a shorter or longer period can yield different results and can be useful in studying a stock’s volatility. Knowing the number of days used in the calculation is crucial to understanding what the output represents. For example, if the last 5 trading days were extremely volatile, but the 25 days prior to that were comparatively calm, the 5-day standard deviation would be higher than the 30-day standard deviation. Standard deviation is stated as a percentage move in the price of the asset. If a $100 stock has a standard deviation of 15 percent, a one-standard- deviation move in the stock would be either $85 or $115—a 15 percent move in either direction. Standard deviation is used for comparison purposes. A stock with a standard deviation of 15 percent has experienced bigger moves—has been more volatile—during the relevant time period than a stock with a standard deviation of 6 percent. When the frequency of occurrences are graphed, the result is known as a distribution curve. There are many different shapes that a distribution curve can take, depending on the nature of the data being observed. In general, option-pricing models assume that stock prices adhere to a lognormal distribution. The shape of the distribution curve for stock prices has long been the topic of discussion among traders and academics alike. Regardless of what the true shape of the curve is, the concept of standard deviation applies just the same. For the purpose of illustrating standard deviation, a normal distribution is used here. When the graph of data adheres to a normal distribution, the result is a symmetrical bell-shaped curve. Standard deviation can be shown on the bell curve to either side of the mean. Exhibit 3.1 represents a typical bell curve with standard deviation. EXHIBIT 3.1 Standard deviation. Large moves in a security are typically less frequent than small ones. Events that cause big changes in the price of a stock, like a company’s being acquired by another or discovering its chief financial officer cooking the books, are not a daily occurrence. Comparatively smaller price fluctuations that reflect less extreme changes in the value of the corporation are more typically seen day to day. Statistically, the most probable outcome for a price change is found around the midpoint of the curve. What constitutes a large move or a small move, however, is unique to each individual security. For example, a two percent move in an index like the Standard & Poor’s (S&P) 500 may be considered a big one-day move, while a two percent move in a particularly active tech stock may be a daily occurrence. Standard deviation offers a statistical explanation of what constitutes a typical move. In Exhibit 3.1 , the lines to either side of the mean represent one standard deviation. About 68 percent of all occurrences will take place between up one standard deviation and down one standard deviation. Two- and three- standard-deviation values could be shown on the curve as well. About 95 percent of data occur between up and down two standard deviations and about 99.7 percent between up and down three standard deviations. One standard deviation is the relevant figure in determining historical volatility. Standard Deviation and Historical Volatility When standard deviation is used in the context of historical volatility, it is annualized to state what the one-year volatility would be. Historical volatility is the annualized standard deviation of daily returns. This means that if a stock is trading at $100 a share and its historical volatility is 10 percent, then about 68 percent of the occurrences (closing prices) are expected to fall between $90 and $110 during a one-year period (based on recent past performance). Simply put, historical volatility shows how volatile a stock has been based on price movements that have occurred in the past. Although option traders may study HV to make informed decisions as to the value of options traded on a stock, it is not a direct function of option prices. For this, we must look to implied volatility. Implied Volatility Volatility is one of the six inputs of an option-pricing model. Some of the other inputs—strike price, stock price, the number of days until expiration, and the current interest rate—are easily observable. Past dividend policy allows an educated guess as to what the dividend input should be. But where can volatility be found? As discussed in Chapter 2, the output of the pricing model—the option’s theoretical value—in practice is not necessarily an output at all. When option traders use the pricing model, they commonly substitute the actual price at which the option is trading for the theoretical value. A value in the middle of the bid-ask spread is often used. The pricing model can be considered to be a complex algebra equation in which any variable can be solved for. If the theoretical value is known—which it is—it along with the five known inputs can be combined to solve for the unknown volatility. Implied volatility (IV) is the volatility input in a pricing model that, in conjunction with the other inputs, returns the theoretical value of an option matching the market price. For a specific stock price, a given implied volatility will yield a unique option value. Take a stock trading at $44.22 that has the 60-day 45-strike call at a theoretical value of $1.10 with an 18 percent implied volatility level. If the stock price remains constant, but IV rises to 19 percent, the value of the call will rise by its vega, which in this case is about 0.07. The new value of the call will be $1.17. Raising IV another point, to 20 percent, raises the theoretical value by another $0.07, to $1.24. The question is: What would cause implied volatility to change? Supply and Demand: Not Just a Good Idea, It’s the Law! Options are an excellent vehicle for speculation. However, the existence of the options market is better justified by the primary economic purpose of options: as a risk management tool. Hedgers use options to protect their assets from adverse price movements, and when the perception of risk increases, so does demand for this protection. In this context, risk means volatility—the potential for larger moves to the upside and downside. The relative prices of options are driven higher by increased demand for protective options when the market anticipates greater volatility. And option prices are driven lower by greater supply—that is, selling of options—when the market expects lower volatility. Like those of all assets, option prices are subject to the law of supply and demand. When volatility is expected to rise, demand for options is not limited to hedgers. Speculative traders would arguably be more inclined to buy a call than to buy the stock if they are bullish but expect future volatility to be high. Calls require a lower cash outlay. If the stock moves adversely, there is less capital at risk, but still similar profit potential. When volatility is expected to be low, hedging investors are less inclined to pay for protection. They are more likely to sell back the options they may have bought previously to recoup some of the expense. Options are a decaying asset. Investors are more likely to write calls against stagnant stocks to generate income in anticipated low-volatility environments. Speculative traders will implement option-selling strategies, such as short strangles or iron condors, in an attempt to capitalize on stocks they believe won’t move much. The rising supply of options puts downward pressure on option prices. Many traders sum up IV in two words: fear and greed . When option prices rise and fall, not because of changes in the stock price, time to expiration, interest rates, or dividends, but because of pure supply and demand, it is implied volatility that is the varying factor. There are many contributing factors to traders’ willingness to demand or supply options. Anticipation of events such as earnings reports, Federal Reserve announcements, or the release of other news particular to an individual stock can cause anxiety, or fear, in traders and consequently increase demand for options that causes IV to rise. IV can fall when there is complacency in the market or when the anticipated news has been announced and anxiety wanes. “Buy the rumor, sell the news” is often reflected in option implied volatility. When there is little fear of market movement, traders use options to squeeze out more profits—greed. Arbitrageurs, such as market makers who trade delta neutral—a strategy that will be discussed further in Chapters 12 and 13—must be relentlessly conscious of implied volatility. When immediate directional risk is eliminated from a position, IV becomes the traded commodity. Arbitrageurs who focus their efforts on trading volatility (colloquially called vol traders ) tend to think about bids and offers in terms of IV. In the mind of a vol trader, option prices are translated into volatility levels. A trader may look at a particular option and say it is 30 bid at 31 offer. These values do not represent the prices of the options but rather the corresponding implied volatilities. The meaning behind the trader’s remark is that the market is willing to buy implied volatility at 30 percent and sell it at 31 percent. The actual prices of the options themselves are much less relevant to this type of trader. Should HV and IV Be the Same? Most option positions have exposure to volatility in two ways. First, the profitability of the position is usually somewhat dependent on movement (or lack of movement) of the underlying security. This is exposure to HV. Second, profitability can be affected by changes in supply and demand for the options. This is exposure to IV. In general, a long option position benefits when volatility—both historical and implied—increases. A short option position benefits when volatility—historical and implied—decreases. That said, buying options is buying volatility and selling options is selling volatility. The Relationship of HV and IV It’s intuitive that there should exist a direct relationship between the HV and IV. Empirically, this is often the case. Supply and demand for options, based on the market’s expectations for a security’s volatility, determines IV. It is easy to see why IV and HV often act in tandem. But, although HV and IV are related, they are not identical. There are times when IV and HV move in opposite directions. This is not so illogical, if one considers the key difference between the two: HV is calculated from past stock price movements; it is what has happened. IV is ultimately derived from the market’s expectation for future volatility. If a stock typically has an HV of 30 percent and nothing is expected to change, it can be reasonable to expect that in the future the stock will continue to trade at a 30 percent HV. By that logic, assuming that nothing is expected to change, IV should be fairly close to HV. Market conditions do change, however. These changes are often regular and predictable. Earnings reports are released once a quarter in many stocks, Federal Open Market Committee meetings happen regularly, and dates of other special announcements are often disclosed to the public in advance. Although the outcome of these events cannot be predicted, when they will occur often can be. It is around these widely anticipated events that HV-IV divergences often occur. HV-IV Divergence An HV-IV divergence occurs when HV declines and IV rises or vice versa. The classic example is often observed before a company’s quarterly earnings announcement, especially when there is lack of consensus among analysts’ estimates. This scenario often causes HV to remain constant or decline while IV rises. The reason? When there is a great deal of uncertainty as to what the quarterly earnings will be, investors are reluctant to buy or sell the stock until the number is released. When this happens, the stock price movement (volatility) consolidates, causing the calculated HV to decline. IV, however, can rise as traders scramble to buy up options— bidding up their prices. When the news is out, the feared (or hoped for) move in the stock takes place (or doesn’t), and HV and IV tend to converge again. Expected Volatility Whether trading options or stocks, simple or complex strategies, traders must consider volatility. For basic buy-and-hold investors, taking a potential investment’s volatility into account is innate behavior. Do I buy conservative (nonvolatile) stocks or more aggressive (volatile) stocks? Taking into account volatility, based not just on a gut feeling but on hard numbers, can lead to better, more objective trading decisions. Expected Stock Volatility Option traders must have an even greater focus on volatility, as it plays a much bigger role in their profitability—or lack thereof. Because options can create highly leveraged positions, small moves can yield big profits or losses. Option traders must monitor the likelihood of movement in the underlying closely. Estimating what historical volatility (standard deviation) will be in the future can help traders quantify the probability of movement beyond a certain price point. This leads to better decisions about whether to enter a trade, when to adjust a position, and when to exit. There is no way of knowing for certain what the future holds. But option data provide traders with tools to develop expectations for future stock volatility. IV is sometimes interpreted as the market’s estimate of the future volatility of the underlying security. That makes it a ready-made estimation tool, but there are two caveats to bear in mind when using IV to estimate future stock volatility. The first is that the market can be wrong. The market can wrongly price stocks. This mispricing can lead to a correction (up or down) in the prices of those stocks, which can lead to additional volatility, which may not be priced in to the options. Although there are traders and academics believe that the option market is fairly efficient in pricing volatility, there is a room for error. There is the possibility that the option market can be wrong. Another caveat is that volatility is an annualized figure—the annualized standard deviation. Unless the IV of a LEAPS option that has exactly one year until expiration is substituted for the expected volatility of the underlying stock over exactly one year, IV is an incongruent estimation for the future stock volatility. In practice, the IV of an option must be adjusted to represent the period of time desired. There is a common technique for deannualizing IV used by professional traders and retail traders alike. 1 The first step in this process to deannualize IV is to turn it into a one-day figure as opposed to one-year figure. This is accomplished by dividing IV by the square root of the number of trading days in a year. The number many traders use to approximate the number of trading days per year is 256, because its square root is a round number: 16. The formula is For example, a $100 stock that has an at-the-money (ATM) call trading at a 32 percent volatility implies that there is about a 68 percent chance that the underlying stock will be between $68 and $132 in one year’s time— that’s $100 ± ($100 × 0.32). The estimation for the market’s expectation for the volatility of the stock for one day in terms of standard deviation as a percentage of the price of the underlying is computed as follows: In one day’s time, based on an IV of 32 percent, there is a 68 percent chance of the stock’s being within 2 percent of the stock price—that’s between $98 and $102. There may be times when it is helpful for traders to have a volatility estimation for a period of time longer than one day—a week or a month, for example. This can be accomplished by multiplying the one-day volatility by the square root of the number of trading days in the relevant period. The equation is as follows: If the period in question is one month and there are 22 business days remaining in that month, the same $100 stock with the ATM call trading at a 32 percent implied volatility would have a one-month volatility of 9.38 percent. Based on this calculation for one month, it can be estimated that there is a 68 percent chance of the stock’s closing between $90.62 and $109.38 based on an IV of 32 percent. Expected Implied Volatility Although there is a great deal of science that can be applied to calculating expected actual volatility, developing expectations for implied volatility is more of an art. This element of an option’s price provides more risk and more opportunity. There are many traders who make their living distilling direction out of their positions and trading implied volatility. To be successful, a trader must forecast IV. Conceptually, trading IV is much like trading anything else. A trader who thinks a stock is going to rise will buy the stock. A trader who thinks IV is going to rise will buy options. Directional stock traders, however, have many more analysis tools available to them than do vol traders. Stock traders have both technical analysis (TA) and fundamental analysis at their disposal. Technical Analysis There are scores, perhaps hundreds, of technical tools for analyzing stocks, but there are not many that are available for analyzing IV. Technical analysis is the study of market data, such as past prices or volume, which is manipulated in such a way that it better illustrates market activity. TA studies are usually represented graphically on a chart. Developing TA tools for IV is more of a challenge than it is for stocks. One reason is that there is simply a lot more data to manage—for each stock, there may be hundreds of options listed on it. The only practical way of analyzing options from a TA standpoint is to use implied volatility. IV is more useful than raw historical option prices themselves. Information for both IV and HV is available in the form of volatility charts, or vol charts. (Vol charts are discussed in detail in Chapter 14.) Volatility charts are essential for analyzing options because they give more complete information. To get a clear picture of what is going on with the price of an option (the goal of technical analysis for any asset), just observing the option price does not supply enough information for a trader to work with. It’s incomplete. For example, if a call rises in value, why did it rise? What greek contributed to its value increase? Was it delta because the underlying stock rose? Or was it vega because volatility rose? How did time decay factor in? Using a volatility chart in conjunction with a conventional stock chart (and being aware of time decay) tells the whole, complete, story. Another reason historical option prices are not used in TA is the option bid-ask spread. For most stocks, the difference between the bid and the ask is equal to a very small percentage of the stock’s price. Because options are highly leveraged instruments, their bid-ask width can equal a much higher percentage of the price. If a trader uses the last trade to graph an option’s price, it could look as if a very large percentage move has occurred when in fact it has not. For example, if the option trades a small contract size on the bid (0.80), then on the offer (0.90) it would appear that the option rose 12.5 percent in value. This large percentage move is nothing more than market noise. Using volatility data based off the midpoint-of-the-market theoretical value eliminates such noise. Fundamental Analysis Fundamental analysis can have an important role in developing expectations for IV. Fundamental analysis is the study of economic factors that affect the value of an asset in order to determine what it is worth. With stocks, fundamental analysis may include studying income statements, balance sheets, and earnings reports. When the asset being studied is IV, there are fewer hard facts available. This is where the art of analyzing volatility comes into play. Essentially, the goal is to understand the psychology of the market in relation to supply and demand for options. Where is the fear? Where is the complacency? When are news events anticipated? How important are they? Ultimately, the question becomes: what is the potential for movement in the underlying? The greater the chance of stock movement, the more likely it is that IV will rise. When unexpected news is announced, IV can rise quickly. The determination of the fundamental relevance of surprise announcements must be made quickly. Unfortunately, these questions are subjective in nature. They require the trader to apply intuition and experience on a case-by-case basis. But there are a few observations to be made that can help a trader make better- educated decisions about IV. Reversion to the Mean The IVs of the options on many stocks and indexes tend to trade in a range unique to those option classes. This is referred to as the mean—or average —volatility level. Some securities will have smaller mean IV ranges than others. The range being observed should be established for a period long enough to confirm that it is a typical IV for the security, not just a temporary anomaly. Traders should study IV over the most recent 6-month period. When IV has changed significantly during that period, a 12-month study may be necessary. Deviations from this range, either above or below the established mean range, will occur from time to time. When following a breakout from the established range, it is common for IV to revert back to its normal range. This is commonly called reversion to the mean among volatility watchers. The challenge is recognizing when things change and when they stay the same. If the fundamentals of the stock change in such a way as to give the options market reason to believe the stock will now be more or less volatile on an ongoing basis than it typically has been in the recent past, the IV may not revert to the mean. Instead, a new mean volatility level may be established. When considering the likelihood of whether IV will revert to recent levels after it has deviated or find a new range, the time horizon and changes in the marketplace must be taken into account. For example, between 1998 and 2003 the mean volatility level of the SPX was around 20 percent to 30 percent. By the latter half of 2006, the mean IV was in the range of 10 percent to 13 percent. The difference was that between 1998 and 2003 was the buildup of “the tech bubble,” as it was called by the financial media. Market volatility ultimately leveled off in 2003. In a later era, between the fall of 2010 and late summer of 2011 SPX implied volatility settled in to trade mostly between 12 and 20 percent. But in August 2011, as the European debt crisis heated up, a new, more volatile range between 24 and 40 percent reigned for some time. No trader can accurately predict future IV any more than one can predict the future price of a stock. However, with IV there are often recurring patterns that traders can observe, like the ebb and flow of IV often associated with earnings or other regularly scheduled events. But be aware that the IV’s rising before the last 15 earnings reports doesn’t mean it will this time. CBOE Volatility Index ® Often traders look to the implied volatility of the market as a whole for guidance on the IV of individual stocks. Traders use the Chicago Board Options Exchange (CBOE) Volatility Index® , or VIX® , as an indicator of overall market volatility. When people talk about the market, they are talking about a broad-based index covering many stocks on many diverse industries. Usually, they are referring to the S&P 500. Just as the IV of a stock may offer insight about investors’ feelings about that stock’s future volatility, the volatility of options on the S&P 500—SPX options—may tell something about the expected volatility of the market as a whole. VIX is an index published by the Chicago Board Options Exchange that measures the IV of a hypothetical 30-day option on the SPX. A 30-day option on the SPX only truly exists once a month—30 days before expiration. CBOE computes a hypothetical 30-day option by means of a weighted average of the two nearest-term months. When the S&P 500 rises or falls, it is common to see individual stocks rise and fall in sympathy with the index. Most stocks have some degree of market risk. When there is a perception of higher risk in the market as a whole, there can consequently be a perception of higher risk in individual stocks. The rise or fall of the IV of SPX can translate into the IV of individual stocks rising or falling. Implied Volatility and Direction Who’s afraid of falling stock prices? Logically, declining stocks cause concern for investors in general. There is confirmation of that statement in the options market. Just look at IV. With most stocks and indexes, there is an inverse relationship between IV and the underlying price. Exhibit 3.2 shows the SPX plotted against its 30-day IV, or the VIX. EXHIBIT 3.2 SPX vs. 30-day IV (VIX). The heavier line is the SPX, and the lighter line is the VIX. Note that as the price of SPX rises, the VIX tends to decline and vice versa. When the market declines, the demand for options tends to increase. Investors hedge by buying puts. Traders speculate on momentum by buying puts and speculate on a turnaround by buying calls. When the market moves higher, investors tend to sell their protection back and write covered calls or cash- secured puts. Option speculators initiate option-selling strategies. There is less fear when the market is rallying. This inverse relationship of IV to the price of the underlying is not unique to the SPX; it applies to most individual stocks as well. When a stock moves lower, the market usually bids up IV, and when the stock rises, the market tends to offer IV creating downward pressure. Calculating Volatility Data Accurate data are essential for calculating volatility. Many of the volatility data that are readily available are useful, but unfortunately, some are not. HV is a value that is easily calculated from publicly accessible past closing prices of a stock. It’s rather straightforward. Traders can access HV from many sources. Retail traders often have access to HV from their brokerage firm. Trading firms or clearinghouses often provide professional traders with HV data. There are some excellent online resources for HV as well. HV is a calculation with little subjectivity—the numbers add up how they add up. IV, however, can be a bit more ambiguous. It can be calculated different ways to achieve different desired outcomes; it is user-centric. Most of the time, traders consider the theoretical value to be between the bid and the ask prices. On occasion, however, a trader will calculate IV for the bid, the ask, the last trade price, or, sometimes, another value altogether. There may be a valid reason for any of these different methods for calculating IV. For example, if a trader is long volatility and aspires to reduce his position, calculating the IV for the bid shows him what IV level can be sold to liquidate his position. Firms, online data providers, and most options-friendly brokers offer IV data. Past IV data is usually displayed graphically in what is known as a volatility chart or vol chart. Current IV is often displayed along with other data right in the option chain. One note of caution: when the current IV is displayed, however, it should always be scrutinized carefully. Was the bid used in calculating this figure? What about the ask? How long ago was this calculation made? There are many questions that determine the accuracy of a current IV, and rarely are there any answers to support the number. Traders should trust only IV data they knowingly generated themselves using a pricing model. Volatility Skew There are many platforms (software or Web-based) that enable traders to solve for volatility values of multiple options within the same option class. Values of options of the same class are interrelated. Many of the model parameters are shared among the different series within the same class. But IV can be different for different options within the same class. This is referred to as the volatility skew . There are two types of volatility skew: term structure of volatility and vertical skew. Term Structure of Volatility Term structure of volatility—also called monthly skew or horizontal skew —is the relationship among the IVs of options in the same class with the same strike but with different expiration months. IV, again, is often interpreted as the market’s estimate of future volatility. It is reasonable to assume that the market will expect some months to be more volatile than others. Because of this, different expiration cycles can trade at different IVs. For example, if a company involved in a major product-liability lawsuit is expecting a verdict on the case to be announced in two months, the one- month IV may be low, as the stock is not expected to move much until the suit is resolved. The two-month volatility may be much higher, however, reflecting the expectations of a big move in the stock up or down, depending on the outcome. The term structure of volatility also varies with the normal ebb and flow of volatility within the business cycle. In periods of declining volatility, it is common for the month with the least amount of time until expiration, also known as the front month, to trade at a lower volatility than the back months, or months with more time until expiration. Conversely, when volatility is rising, the front month tends to have a higher IV than the back months. Exhibit 3.3 shows historical option prices and their corresponding IVs for 32.5-strike calls on General Motors (GM) during a period of low volatility. EXHIBIT 3.3 GM term structure of volatility. In this example, no major news is expected to be released on GM, and overall market volatility is relatively low. The February 32.5 call has the lowest IV, at 32 percent. Each consecutive month has a higher IV than the previous month. A graduated increasing or decreasing IV for each consecutive expiration cycle is typical of the term structure of volatility. Under normal circumstances, the front month is the most sensitive to changes in IV. There are two reasons for this. First, front-month options are typically the most actively traded. There is more buying and selling pressure. Their IV is subject to more activity. Second, vegas are smaller for options with fewer days until expiration. This means that for the same monetary change in an option’s value, the IV needs to move more for short- term options. Exhibit 3.4 shows the same GM options and their corresponding vegas. EXHIBIT 3.4 GM vegas. If the value of the September 32.5 calls increases by $0.10, IV must rise by 1 percentage point. If the February 32.5 calls increase by $0.10, IV must rise 3 percentage points. As expiration approaches, the vega gets even smaller. With seven days until expiration, the vega would be about 0.014. This means IV would have to change about 7 points to change the call value $0.10. Vertical Skew The second type of skew found in option IV is vertical skew, or strike skew. Vertical skew is the disparity in IV among the strike prices within the same month for an option class. The options on most stocks and indexes experience vertical skew. As a general rule, the IV of downside options— calls and puts with strike prices lower than the at-the-money (ATM) strike —trade at higher IVs than the ATM IV. The IV of upside options—calls and puts with strike prices higher than the ATM strike—typically trade at lower IVs than the ATM IV. The downside is often simply referred to as puts and the upside as calls. The rationale for this lingo is that OTM options (puts on the downside and calls on the upside) are usually more actively traded than the ITM options. By put-call parity, a put can be synthetically created from a call, and a call can be synthetically created from a put simply by adding the appropriate long or short stock position. Exhibit 3.5 shows the vertical skew for 86-day options on Citigroup Inc. (C) on a typical day, with IVs rounded to the nearest tenth. EXHIBIT 3.5 Citigroup vertical skew. Notice the IV of the puts (downside options) is higher than that of the calls (upside options), with the 31 strike’s volatility more than 10 points higher than that of the 38 strike. Also, the difference in IV per unit change in the strike price is higher for the downside options than it is for the upside ones. The difference between the IV of the 31 strike is 2 full points higher than the 32 strike, which is 1.8 points higher than the 33 strike. But the 36 strike’s IV is only 1.1 points higher than the 37 strike, which is also just 1.1 points higher than the 38 strike. This incremental difference in the IV per strike is often referred to as the slope. The puts of most underlyings tend to have a greater slope to their skew than the calls. Many models allow values to be entered for the upside slope and the downside slope that mathematically increase or decrease IVs of each strike incrementally. Some traders believe the slope should be a straight line, while others believe it should be an exponentially sloped line. If the IVs were graphed, the shape of the skew would vary among asset classes. This is sometimes referred to as the volatility smile or sneer, depending on the shape of the IV skew. Although Exhibit 3.5 is a typical paradigm for the slope for stock options, bond options and other commodity options would have differently shaped skews. For example, grain options commonly have calls with higher IVs than the put IVs. Volatility skew is dependent on supply and demand. Greater demand for downside protection may cause the overall IV to rise, but it can cause the IV of puts to rise more relative to the calls or vice versa. There are many traders who make their living trading volatility skew. Note 1 . This technique provides only an estimation of future volatility. CHAPTER 4 Option-Specific Risk and Opportunity New endeavors can be intimidating. The first day at a new job or new school is a challenge. Option trading is no different. When traders first venture into the world of options, they tend to start with what they know— trading direction. Buying stocks is at the heart of the comfort zone for many traders. Buying a call as a substitute for buying a stock is a logical progression. And for the most part, call buying is a pretty straightforward way to take a bullish position in a stock. But it’s not just a bullish position. The greeks come into play with the long call, providing both risk and opportunity. Long ATM Call Kim is a trader who is bullish on the Walt Disney Company (DIS) over the short term. The time horizon of her forecast is three weeks. Instead of buying 100 shares of Disney at $35.10 per share, Kim decides to buy one Disney March 35 call at $1.10. In this example, March options have 44 days until expiration. How can Kim profit from this position? How can she lose? Exhibit 4.1 shows the profit and loss (P&(L)) for the call at different time periods. The top line is when the trade is executed; the middle, dotted line is after three weeks have passed; and the bottom, darker line is at expiration. Kim wants Disney to rise in price, which is evident by looking at the graph for any of the three time horizons. She would anticipate a loss if the stock price declines. These expectations are related to the position’s delta, but that is not the only risk exposure Kim has. As indicated by the three different lines in Exhibit 4.1 , the call loses value over time. This is called theta risk . She has other risk exposure as well. Exhibit 4.2 lists the greeks for the DIS March 35 call. EXHIBIT 4.1 P&(L) of Disney 35 call. EXHIBIT 4.2 Greeks for 35 Disney call. Delta 0.57 Gamma0.166 Theta −0.013 Vega 0.048 Rho 0.023 Kim’s immediate directional exposure is quantified by the delta, which is 0.57. Delta is immediate directional exposure because it’s subject to change by the amount of the gamma. The positive gamma of this position helps Kim by increasing the delta as Disney rises and decreasing it as it falls. Kim, however, has time working against her—theta. At this point, she theoretically loses $0.013 per day. Since her call is close to being at-the- money, she would anticipate her theta becoming more negative as expiration approaches if Disney’s share price remains unchanged. She also has positive vega exposure. A one-percentage-point increase in implied volatility (IV) earns Kim just under $0.05. A one-point decrease costs her about $0.05. With so few days until expiration, the 35-strike call has very little rho exposure. A full one-percentage-point change in the interest rate changes her call’s value by only $0.023. Delta Some of Kim’s risks warrant more concern than others. With this position, delta is of the greatest concern, followed by theta. Kim expects the call to rise in value and accepts the risk of decline. Delta exposure was her main rationale for establishing the position. She expects to hold it for about three weeks. Kim is willing to accept the trade-off of delta exposure for theta, which will cost her three weeks of erosion of option premium. If the anticipated delta move happens sooner than expected, Kim will have less decay. Exhibit 4.3 shows the value of her 35 call at various stock prices over time. The left column is the price of Disney. The top row is the number of days until expiration. EXHIBIT 4.3 Disney 35 call price–time matrix–value. The effect of delta is evident as the stock rises or falls. When the position is established (44 days until expiration), the change in the option price if the stock were to move from $35 to $36 is 0.62 (1.66 − 1.04). Between stock prices of $36 and $37, the option gains 0.78 (2.44 −1.66). If the stock were to decline in value from $35 to $34, the option loses 0.47 (1.04 − 0.57). The option gains value at a faster rate as the stock rises and loses value at a slower rate as the stock falls. This is the effect of gamma. Gamma With this type of position, gamma is an important but secondary consideration. Gamma is most helpful to Kim in developing expectations of what the delta will be as the stock price rises or falls. Exhibit 4.4 shows the delta at various stock prices over time. EXHIBIT 4.4 Disney call price–time matrix–delta. Kim pays attention to gamma only to gauge her delta. Why is this important to her? In this trade, Kim is focused on direction. Knowing how much her call will rise or fall in step with the stock is her main concern. Notice that her delta tends to get bigger as the stock rises and smaller as the stock falls. As time passes, the delta gravitates toward 1.00 or 0, depending on whether the call is in-the-money (ITM) or out-of-the-money (OTM). Theta Option buying is a veritable race against the clock. With each passing day, the option loses theoretical value. Refer back to Exhibit 4.3 . When three weeks pass and the time to expiration decreases from 44 days to 23, what happens to the call value? If the stock price stays around its original level, theta will be responsible for a loss of about 30 percent of the premium. If Disney is at $35 with 23 days to expiration, the call will be worth $0.73. With a big enough move in either direction, however, theta matters much less. With 23 days to expiration and Disney at $39, there is only 0.12 of time value—the premium paid over parity for the option. At that point, it is almost all delta exposure. Similarly, if the Disney stock price falls after three weeks to $33, the call will have only 0.10 of time value. Time decay is the least of Kim’s concerns if the stock makes a big move. Vega After delta and theta, vega is the next most influential contributor to Kim’s profit or peril. With Disney at $35.10, the 1.10 premium for the 35-strike call represents $1 of time value—all of which is vulnerable to changes in IV. The option’s 1.10 value returns an IV of about 19 percent, given the following inputs: Stock: $35.10 Strike: 35 Days to expiration: 44 Interest: 5.25 percent No dividend paid during this period Consequently, the vega is 0.048. What does the 0.048 vega tell Kim? Given the preceding inputs, for each point the IV rises or falls, the option’s value gains or loses about $0.05. Some of the inputs, however, will change. Kim anticipates that Disney will rise in price. She may be right or wrong. Either way, it is unlikely that the stock will remain exactly at $35.10 to option expiration. The only certainty is that time will pass. Both price and time will change Kim’s vega exposure. Exhibit 4.5 shows the changing vega of the 35 call as time and the underlying price change. EXHIBIT 4.5 Disney 35 call price–time matrix–vega. When comparing Exhibit 4.5 to Exhibit 4.3 , it’s easy to see that as the time value of the option declines, so does Kim’s exposure to vega. As time passes, vega gets smaller. And as the call becomes more in- or out-of-the- money, vega gets smaller. Since she plans to hold the position for around three weeks, she is not concerned about small fluctuations in IV in the interim. If indeed the rise in price that Kim anticipates comes to pass, vega becomes even less of a concern. With 23 days to expiration and DIS at $37, the call value is 2.21. The vega is $0.018. If IV decreases as the stock price rises—a common occurrence—the adverse effect of vega will be minimal. Even if IV declines by 5 points, to a historically low IV for DIS, the call loses less than $0.10. That’s less than 5 percent of the new value of the option. If dividend policy changes or the interest rate changes, the value of Kim’s call will be affected as well. Dividends are often fairly predictable. However, a large unexpected dividend payment can have a significant adverse impact on the value of the call. For example, if a surprise $3 dividend were announced, owning the stock would become greatly preferable to owning the call. This preference would be reflected in the call premium. This is a scenario that an experienced trader like Kim will realize is a possibility, although not a probability. Although she knows it can happen, she will not plan for such an event unless she believes it is likely to happen. Possible reasons for such a belief could be rumors or the company’s historically paying an irregular dividend. Rho For all intents and purposes, rho is of no concern to Kim. In recent years, interest rate changes have not been a major issue for option traders. In the Alan Greenspan years of Federal Reserve leadership, changes in the interest rate were usually announced at the regularly scheduled Federal Open Market Committee (FOMC) meetings, with but a few exceptions. Ben Bernanke, likewise, changed interest rates fairly predictably, when he made any rate changes at all. In these more stable periods, if there is no FOMC meeting scheduled during the life of the call, it’s unlikely that rates will change. Even if they do, the rho with 44 days to expiration is only 0.023. This means that if rates change by a whole percentage point—which is four times the most common incremental change—the call value will change by a little more than $0.02. In this case, this is an acceptable risk. With 23 days to expiration, the ATM 35 call has a rho of only 0.011. Tweaking Greeks With this position, some risks are of greater concern than others. Kim may want more exposure to some greeks and less to others. What if she is concerned that her forecasted price increase will take longer than three weeks? She may want less exposure to theta. What if she is particularly concerned about a decline in IV? She may want to decrease her vega. Conversely, she may believe IV will rise and therefore want to increase her vega. Kim has many ways at her disposal to customize her greeks. All of her alternatives come with trade-offs. She can buy more calls, increasing her greek positions in exact proportion. She can buy or sell stock or options against her call, creating a spread. The simplest way to alter her exposure to option greeks is to choose a different call to buy. Instead of buying the ATM call, Kim can buy a call with a different relationship to the current stock price. Long OTM Call Kim can reduce her exposure to theta and vega by buying an OTM call. The trade-off here is that she also reduces her immediate delta exposure. Depending on how much Kim believes Disney will rally, this may or may not be a viable trade-off. Imagine that instead of buying one Disney March 35 call, Kim buys one Disney March 37.50 call, for 0.20. There are a few observations to be made about this alternative position. First, the net premium, and therefore overall risk, is much lower, 0.20 instead of 1.10. From an expiration standpoint, the breakeven at expiration is $37.70 (the strike price plus the call premium). Since Kim plans on exiting the position after about three weeks, the exact break-even point at the expiration of the contract is irrelevant. But the concept is the same: the stock needs to rise significantly. Exhibit 4.6 shows how Kim’s concerns translate into greeks. EXHIBIT 4.6 Greeks for Disney 35 and 37.50 calls. 35 Call37.50 Call Delta 0.57 0.185 Gamma0.1660.119 Theta −0.013−0.007 Vega 0.0480.032 Rho 0.0230.007 This table compares the ATM call with the OTM call. Kim can reduce her theta to half that of the ATM call position by purchasing an OTM. This is certainly a favorable difference. Her vega is lower with the 37.50 call, too. This may or may not be a favorable difference. That depends on Kim’s opinion of IV. On the surface, the disparity in delta appears to be a highly unfavorable trade-off. The delta of the 37.50 call is less than one third of the delta of the 35 call, and the whole motive for entering into this trade is to trade direction! Although this strategy is very delta oriented, its core is more focused on gamma and theta. The gamma of the 37.50 call is about 72 percent that of the 35 call. But the theta of the 37.50 call is about half that of the 35 call. Kim is improving her gamma/theta relationship by buying the OTM, but with the call being so far out-of-the-money and so inexpensive, the theta needs to be taken with a grain of salt. It is ultimately gamma that will make or break this delta play. The price of the option is 0.20—a rather low premium. In order for the call to gain in value, delta has to go to work with help from gamma. At this point, the delta is small, only 0.185. If Kim’s forecast is correct and there is a big move upward, gamma will cause the delta to increase, and therefore also the premium to increase exponentially. The call’s sensitivity to gamma, however, is dynamic. Exhibit 4.7 shows how the gamma of the 37.50 call changes as the stock price moves over time. At any point in time, gamma is highest when the call is ATM. However, so is theta. Kim wants to reap as much benefit from gamma as possible while minimizing her exposure to theta. Ideally, she wants Disney to rally through the strike price—through the high gamma and back to the low theta. After three weeks pass, with 23 days until expiration, if Disney is at $37 a share, the gamma almost doubles, to 0.237. When the call is ATM, the delta increases at its fastest rate. As Disney rises above the strike, the gamma figures in the table begin to decline. EXHIBIT 4.7 Disney 37.50 call price–time matrix–gamma. Gamma helps as the stock price declines, too. Exhibit 4.8 shows the effect of time and gamma on the delta of the 37.50 call. EXHIBIT 4.8 Disney 37.50 call price–time matrix–delta. The effect of gamma is readily observable, as the delta at any point in time is always higher at higher stock prices and lower at lower stock prices. Kim benefits greatly when the delta grows from its initial level of 0.185 to above 0.50—above the point of being at-the-money. If the stock moves lower, gamma helps take away the pain of the price decline by decreasing the delta. While delta, gamma, and theta occupy Kim’s thoughts, it is ultimately dollars and cents that matter. She needs to translate her study of the greeks into cold, hard cash. Exhibit 4.9 shows the theoretical values of the 37.50 call. EXHIBIT 4.9 Disney 37.50 call price–time matrix–value. The sooner the price rise occurs, the better. It means less time for theta to eat away profits. If Kim must hold the position for the entire three weeks, she needs a good pop in the stock to make it worth her while. At a $37 share price, the call is worth about 0.50, assuming all other market influences remain constant. That’s about a 150 percent profit. At $38, Exhibit 4.9 reveals the call value to be 1.04. That’s a 420 percent profit. On one hand, it’s hard for a trader like Kim not to get excited about the prospect of making 420 percent on an 8 percent move in a stock. On the other hand, Kim has to put things in perspective. When the position is established, the call has a 0.185 delta. By the trader’s definition of delta, that means the call is estimated to have about an 18.5 percent chance of expiring in-the-money. More than four out of five times, this position will be trading below the strike at expiration. Although Kim is not likely to hold the position until expiration, this observation tells her something: she’s starting in the hole. She is more likely to lose than to win. She needs to be compensated well for her risk on the winners to make up for the more prevalent losers. Buying OTM calls can be considered more speculative than buying ITM or ATM calls. Unlike what the at-expiration diagrams would lead one to believe, OTM calls are not simply about direction. There’s a bit more to it. They are really about gamma, time, and the magnitude of the stock’s move (volatility). Long OTM calls require a big move in the right direction for gamma to do its job. Long ITM Call Kim also has the alternative to buy an ITM call. Instead of the 35 or 37.50 call, she can buy the 32.50. The 32.50 call shares some of the advantages the 37.50 call has over the 35 call, but its overall greek characteristics make it a very different trade from the two previous alternatives. Exhibit 4.10 shows a comparison of the greeks of the three different calls. EXHIBIT 4.10 Greeks for Disney 32.50, 35, and 37.50 calls. Like the 37.50 call, the 32.50 has a lower gamma, theta, and vega than the ATM 35-strike call. Because the call is ITM, it has a higher delta: 0.862. In this example, Kim can buy the 32.50 call for 3. That’s 0.40 over parity (3 − [35.10 − 32.50] = 0.40). There is not much time value, but more than the 37.50 call has. Thus, theta is of some concern. Ultimately, the ITMs have 0.40 of time value to lose compared with the 0.20 of the OTM calls. Vega is also of some concern, but not as much as in the other alternatives because the vega of the 32.50 is lower than the 35s or the 37.50s. Gamma doesn’t help much as the stock rallies—it will get smaller as the stock price rises. Gamma will, however, slow losses somewhat if the stock declines by decreasing delta at an increasing rate. In this case, the greek of greatest consequence is delta—it is a more purely directional play than the other alternatives discussed. Exhibit 4.11 shows the matrix of the delta of the 32.50 call. EXHIBIT 4.11 Disney 32.50 call price–time matrix–delta. Because the call starts in-the-money and has a relatively low gamma, the delta remains high even if Disney declines significantly. Gamma doesn’t really kick in until the stock retreats enough to bring the call closer to being at-the-money. At that point, the position will have suffered a big loss, and the higher gamma is of little comfort. Kim’s motivation for selecting the ITM call above the ATM and OTM calls would be increased delta exposure. The 0.86 delta makes direction the most important concern right out of the gate. Exhibit 4.12 shows the theoretical values of the 32.50 call. EXHIBIT 4.12 Disney 32.50 call price–time matrix–value. Small directional moves contribute to significant leveraged gains or losses. From share price $35 to $36, the call gains 0.90—from 2.91 to 3.81 —about a 30 percent gain. However, from $35 to $34, the call loses 0.80, or 27 percent. With only 0.40 of time value, the nondirectional greeks (theta, gamma, and vega) are a secondary consideration. If this were a deeper ITM call, the delta would start out even higher, closer to 1.00, and the other relevant greeks would be closer to zero. The deeper ITM a call, the more it acts like the stock and the less its option characteristics (greeks) come into play. Long ATM Put The beauty of the free market is that two people can study all the available information on the same stock and come up with completely different outlooks. First of all, this provides for entertaining television on the business-news channels when the network juxtaposes an outspoken bullish analyst with an equally unreserved bearish analyst. But differing opinions also make for a robust marketplace. Differing opinions are the oil that greases the machine that is price discovery. From a market standpoint, it’s what makes the world go round. It is possible that there is another trader, Mick, in the market studying Disney, who arrives at the conclusion that the stock is overpriced. Mick believes the stock will decline in price over the next three weeks. He decides to buy one Disney March 35 put at 0.80. In this example, March has 44 days to expiration. Mick initiates this long put position to gain downside exposure, but along with his bearish position comes option-specific risk and opportunity. Mick is buying the same month and strike option as Kim did in the first example of this chapter: the March 35 strike. Despite the different directional bias, Mick’s position and Kim’s position share many similarities. Exhibit 4.13 offers a comparison of the greeks of the Disney March 35 call and the Disney March 35 put. EXHIBIT 4.13 Greeks for Disney 35 call and 35 put. Call Put Delta 0.57 −0.444 Gamma0.1660.174 Theta −0.013−0.009 Vega 0.0480.048 Rho 0.023−0.015 The first comparison to note is the contrasting deltas. The put delta is negative, in contrast to the call delta. The absolute value of the put delta is close to 1.00 minus the call delta. The put is just slightly OTM, so its delta is just under 0.50, while that of the call is just over 0.50. The disparate, yet related deltas represent the main difference between these two trades. The difference between the gamma of the 35 put and that of the corresponding call is fairly negligible: 0.174 versus 0.166, respectively. The gamma of this ATM put will enter into the equation in much the same way as the gamma of the ATM call. The put’s negative delta will become more negative as the stock declines, drawing closer to −1.00. It will get less negative as the stock price rises, drawing closer to zero. Gamma is important here, because it helps the delta. Delta, however, still remains the most important greek. Exhibit 4.14 illustrates how the 35 put delta changes as time and price change. EXHIBIT 4.14 Disney 35 put price–time matrix–delta. Since this put is ATM, it starts out with a big enough delta to offer the directional exposure Mick desires. The delta can change, but gamma ensures that it always changes in Mick’s favor. Exhibit 4.15 shows how the value of the 35 put changes with the stock price. EXHIBIT 4.15 Disney 35 put price–time matrix–value. Over time, a decline of only 10 percent in the stock yields high percentage returns. This is due to the leveraged directional nature of this trade—delta. While the other greeks are not of primary concern, they must be monitored. At the onset, the 0.80 premium is all time value and, therefore subject to the influences of time decay and volatility. This is where trading greeks comes into play. Conventional trading wisdom says, “Cut your losses early, and let your profits run.” When trading a stock, that advice is intellectually easy to understand, although psychologically difficult to follow. Buyers of options, especially ATM options, must follow this advice from the standpoint of theta. Options are decaying assets. The time premium will be zero at expiration. ATMs decay at an increasing nonlinear rate. Exiting a long position before getting too close to expiration can cut losses caused by an increasing theta. When to cut those losses, however, will differ from trade to trade, situation to situation, and person to person. When buying options, accepting some loss of premium due to time decay should be part of the trader’s plan. It comes with the territory. In this example, Mick is willing to accept about three weeks of erosion. Mick needs to think about what his put will be worth, not just if the underlying rises or falls but also if it doesn’t move at all. At the time the position is established, the theta is 0.009, just under a penny. If Disney share price is unchanged when three weeks pass, his theta will be higher. Exhibit 4.16 shows how thetas and theoretical values change over time if DIS stock remains at $35.10. EXHIBIT 4.16 Disney 35 put—thetas and theoretical values. Mick needs to be concerned not only about what the theta is now but what it will be when he plans on exiting the position. His plan is to exit the trade in about three weeks, at which point the put theta will be −0.013. If he amortizes his theta over this three-week period, he theoretically loses an average of about 0.01 a day during this time if nothing else changes. The average daily theta is calculated here by subtracting the value of the put at 23 days to expiration from its value when the trade was established to find the loss of premium attributed to time decay, then dividing by the number of days until expiration. Since the theta doesn’t change much over the first three weeks, Mick can eyeball the theta rather easily. As expiration approaches and theta begins to grow more quickly, he’ll need to do the math. At nine days to expiration, the theoretical value of Mick’s put is about 0.35, assuming all other variables are held constant. By that time, he will have lost 0.45 (0.80 − 0.35) due to erosion over the 35-day period he held the position if the stock hasn’t moved. Mick’s average daily theta during that period is about 0.0129 (0.45 ÷ 35). The more time he holds the trade, the greater a concern is theta. Mick must weigh his assessment of the likelihood of the option’s gaining value from delta against the risk of erosion. If he holds the trade for 35 days, he must make 0.0129 on average per day from delta to offset theta losses. If the forecast is not realized within the expected time frame or if the forecast changes, Mick needs to act fast to curtail average daily theta losses. Finding the Right Risk Mick could lower the theta of his position by selecting a put with a greater number of days to expiration. This alternative has its own set of trade-offs: lower gamma and higher vega than the 44-day put. He could also select an ITM put or an OTM put. Like Kim’s call alternatives, the OTM put would have less exposure to time decay, lower vega, lower gamma, and a lower delta. It would have a lower premium, too. It would require a bigger price decline than the ATM put and would be more speculative. The ITM put would also have lower theta, vega, and gamma, but it would have a higher delta. It would take on more of the functionality of a short stock position in much the same way that Kim’s ITM call alternative did for a long stock position. In its very essence, however, an option trade, ITM or otherwise, is still fundamentally different than a stock trade. Stock has a 1.00 delta. The delta of a stock never changes, so it has zero gamma. Stock is not subject to time decay and has no volatility component to its pricing. Even though ITM options have deltas that approach 1.00 and other greeks that are relatively low, they have two important differences from an equity. The first is that the greeks of options are dynamic. The second is the built-in leverage feature of options. The relationship of an option’s strike price to the stock price can change constantly. Options that are ITM now may be OTM tomorrow and vice versa. Greeks that are not in play at the moment may be later. Even if there is no time value in the option now because it is so far away-from-the- money, there is the potential for time premium to become a component of the option’s price if the stock moves closer to the strike price. Gamma, theta, and vega always have the potential to come into play. Since options are leveraged by nature, small moves in the stock can provide big profits or big losses. Options can also curtail big losses if used for hedging. Long option positions can reap triple-digit percentage gains quickly with a favorable move in the underlying. Even though 100 percent of the premium can be lost just as easily, one option contract will have far less nominal exposure than a similar position in the stock. It’s All About Volatility What are Kim and Mick really trading? Volatility. The motivation for buying an option as opposed to buying or shorting the stock is volatility. To some degree, these options have exposure to both flavors of volatility— implied volatility and historical volatility (HV). The positions in each of the examples have positive vega. Their values are influenced, in part, by IV. Over time, IV begins to lose its significance if the option is no longer close to being at-the-money. The main objective of each of these trades is to profit from the volatility of the stock’s price movement, called future stock volatility or future realized volatility. The strategies discussed in this chapter are contingent on volatility being one directional. The bigger the move in the trader’s forecasted direction the better. Volatility in the form of an adverse directional move results in a decline in premium. The gamma in these long option positions makes volatility in the right direction more beneficial and volatility in the wrong direction less costly. This phenomenon is hardly unique to the long call and the long put. Although some basic strategies, such as the ones studied in this chapter, depend on a particular direction, many don’t. Except for interest rate strategies and perhaps some arbitrage strategies, all option trades are volatility trades in one way or another. In general, option strategies can be divided into two groups: volatility-buying strategies and volatility-selling strategies. The following is a breakdown of common option strategies into categories of volatility-buying strategies and volatility-selling strategies: Volatility-Selling Strategies Volatility-Buying Strategies Short Call, Short Put, Covered Call, Covered Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Short Straddle, Short Strangle, Guts, Ratio Call Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars. Long Call, Long Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Long Straddle, Long Strangle, Guts, Back Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars. Long option strategies appear in the volatility-buying group because they have positive gamma and positive vega. Short option strategies appear in the volatility-selling group because of negative gamma and vega. There are some strategies that appear in both groups—for example, the butterfly/condor family, which is typically associated with income generation. These particular volatility strategies are commonly instituted as volatility-selling strategies. However, depending on whether the position is bought or sold and where the stock price is in relation to the strike prices, the position could fall into either group. Some strategies, like the vertical spread family—bull and bear call and put spreads—and risk reversal/collar spreads naturally fall into either category, depending on where the stock is in relation to the strikes. The calendar spread family is unique in that it can have characteristics of each group at the same time. Direction Neutral, Direction Biased, and Direction Indifferent As typically traded, volatility-selling option strategies are direction neutral. This means that the position has the greatest results if the underlying price remains in a range—that is, neutral. Although some option-selling strategies —for example, a naked put—may have a positive or negative delta in the short term, profit potential is decidedly limited. This means that if traders are expecting a big move, they are typically better off with option-buying strategies. Option-buying strategies can be either direction biased or direction indifferent. Direction-biased strategies have been shown throughout this chapter. They are delta trades. Direction-indifferent strategies are those that benefit from increased volatility in the underlying but where the direction of the move is irrelevant to the profitability of the trade. Movement in either direction creates a winner. Are You a Buyer or a Seller? The question is: which is better, selling volatility or buying volatility? I have attended option seminars with instructors (many of whom I regard with great respect) teaching that volatility-selling strategies, or income- generating strategies, are superior to buying options. I also know option gurus that tout the superiority of buying options. The answer to the question of which is better is simple: it’s all a matter of personal preference. When I began trading on the floor of Chicago Board Options Exchange (CBOE) in the 1990s, I quickly became aware of a dichotomy among my market-making peers. Those making markets on the floor of the exchange at that time were divided into two groups: teenie buyers and teenie sellers. Teenie Buyers Before options traded in decimals (dollars and cents) like they do today, the lowest price increment in which an option could be traded was one sixteenth of a dollar—a teenie . Teenie buyers were market makers who would buy back OTM options at one sixteenth to eliminate short positions. They would sometimes even initiate long OTM option positions at a teenie, too. The focus of the teenie-buyer school of thought was the fact that long options have unlimited reward, while short options have unlimited risk. An option purchased so far OTM that it was offered at one sixteenth is unlikely to end up profitable, but it’s an inexpensive lottery ticket. At worst, the trader can only lose a teenie. Teenie buyers felt being short OTM options that could be closed by paying a sixteenth was an unreasonable risk. Teenie Sellers Teenie sellers, however, focused on the fact that options offered at one sixteenth were far enough OTM that they were very likely to expire worthless. This appears to be free money, unless the unexpected occurs, in which case potential losses can be unlimited. Teenie sellers would routinely save themselves $6.25 (one sixteenth of a dollar per contract representing 100 shares) by selling their long OTMs at a teenie to close the position. They sometimes would even initiate short OTM contracts at one sixteenth. These long-option or short-option biases hold for other types of strategies as well. Volatility-selling positions, such as the iron condor, can be constructed to have limited risk. The paradigm for these strategies is they tend to produce winners more often than not. But when the position loses, the trader loses more than he would stand to profit if the trade worked out favorably. Herein lies the issue of preference. Long-option traders would rather trade Babe Ruth–style. For years, Babe Ruth was the record holder for the most home runs. At the same time, he was also the record holder for the most strikeouts. The born fighters that are option buyers accept the fact that they will have more strikeouts, possibly many more strikeouts, than winning trades. But the strategy dictates that the profit on one winner more than makes up for the string of small losers. Short-option traders, conversely, like to have everything cool and copacetic. They like the warm and fuzzy feeling they get from the fact that month after month they tend to generate winners. The occasional loser that nullifies a few months of profits is all part of the game. Options and the Fair Game There may be a statistical advantage to buying stock as opposed to shorting stock, because the market has historically had a positive annualized return over the long run. A statistical advantage to being either an option buyer or an option seller, however, should not exist in the long run, because the option market prices IV. Assuming an overall efficient market for pricing volatility into options, there should be no statistical advantage to systematically buying or selling options. 1 Consider a game consisting of one six-sided die. Each time a one, two, or three is rolled, the house pays the player $1. Each time a four, five, or six is rolled, the house pays zero. What is the most a player would be willing to pay to play this game? If the player paid nothing, the house would be at a tremendous disadvantage, paying $1 50 percent of the time and nothing the other 50 percent of the time. This would not be a fair game from the house’s perspective, as it would collect no money. If the player paid $1, the player would get his dollar back when one, two, or three came up. Otherwise, he would lose his dollar. This is not a fair game from the player’s perspective. The chances of winning this game are 3 out of 6, or 50–50. If this game were played thousands of times, one would expect to receive $1 half the time and receive nothing the other half of the time. The average return per roll one would expect to receive would be $0.50, that’s ($1 × 50 percent + $0 × 50 percent). This becomes a fair game with an entrance fee of $0.50. Now imagine a similar game in which a six-sided die is rolled. This time if a one is rolled, the house pays $1. If any other number is rolled, the house pays nothing. What is a fair price to play this game? The same logic and the same math apply. There is a percent chance of a one coming up and the player receiving $1. And there is a percent chance of each of the other five numbers being rolled and the player receiving nothing. Mathematically, this translates to: percent percent). Fair value for a chance to play this game is about $0.1667 per roll. The fair game concept applies to option prices as well. The price of the game, or in this case the price of the option, is determined by the market in the form of IV. The odds are based on the market’s expectations of future volatility. If buying options offered a superior payout based on the odds of success, the market would put upward pressure on prices until this arbitrage opportunity ceased to exist. It’s the same for selling volatility. If selling were a fundamentally better strategy, the market would depress option prices until selling options no longer produced a way to beat the odds. The options market will always equalize imbalances. Note 1 . This is not to say that unique individual opportunities do not exist for overpriced or underpriced options, only that options are not overpriced or underpriced in general. Thus, neither an option-selling nor option-buying methodology should provide an advantage. CHAPTER 5 An Introduction to Volatility-Selling Strategies Along with death and taxes, there is one other fact of life we can all count on: the time value of all options ultimately going to zero. What an alluring concept! In a business where expected profits can be thwarted by an unexpected turn of events, this is one certainty traders can count on. Like all certainties in the financial world, there is a way to profit from this fact, but it’s not as easy as it sounds. Alas, the potential for profit only exists when there is risk of loss. In order to profit from eroding option premiums, traders must implement option-selling strategies, also known as volatility-selling strategies. These strategies have their own set of inherent risks. Selling volatility means having negative vega—the risk of implied volatility rising. It also means having negative gamma—the risk of the underlying being too volatile. This is the nature of selling volatility. The option-selling trader does not want the underlying stock to move—that is, the trader wants the stock to be less volatile. That is the risk. Profit Potential Profit for the volatility seller is realized in a roundabout sort of way. The reward for low volatility is achieved through time decay. These strategies have positive theta. Just as the volatility-buying strategies covered in Chapter 4 had time working against them, volatility-selling strategies have time working in their favor. The trader is effectively paid to assume the risk of movement. Gamma-Theta Relationship There exists a trade-off between gamma and theta. Long options have positive gamma and negative theta. Short options have negative gamma and positive theta. Positions with greater gamma, whether positive or negative, tend to have greater theta values, negative or positive. Likewise, lower absolute values for gamma tend to go hand in hand with lower absolute values for theta. The gamma-theta relationship is the most important consideration with many types of strategies. Gamma-theta is often the measurement with the greatest influence on the bottom line. Greeks and Income Generation With volatility-selling strategies (sometimes called income-generating strategies), greeks are often overlooked. Traders simply dismiss greeks as unimportant to this kind of trade. There is some logic behind this reasoning. Time decay provides the profit opportunity. In order to let all of time premium erode, the position must be held until expiration. Interim changes in implied volatility are irrelevant if the position is held to term. The gamma-theta loses some significance if the position is held until expiration, too. The position has either passed the break-even point on the at-expiration diagram, or it has not. Incremental daily time decay–related gains are not the ultimate goal. The trader is looking for all the time premium, not portions of it. So why do greeks matter to volatility sellers? Greeks allow traders to be flexible. Consider short-term-momentum stock traders. The traders buy a stock because they believe it will rise over the next month. After one week, if unexpected bearish news is announced causing the stock to break through its support lines, the traders have a decision to make. Short-term speculative traders very often choose to cut their losses and exit the position early rather than risk a larger loss hoping for a recovery. Volatility-selling option traders are often faced with the same dilemma. If the underlying stays in line with the traders’ forecast, there is little to worry about. But if the environment changes, the traders have to react. Knowing the greeks for a position can help traders make better decisions if they plan to close the position before expiration. Naked Call A naked call is when a trader shorts a call without having stock or other options to cover or protect it. Since the call is uncovered, it is one of the riskier trades a trader can make. Recall the at-expiration diagram for the naked call from Chapter 1, Exhibit 1.3 : Naked TGT Call. Theoretically, there is limited reward and unlimited risk. Yet there are times when experienced traders will justify making such a trade. When a stock has been trading in a range and is expected to continue doing so, traders may wait until it is near the top of the channel, where there is resistance, and then short a call. For example, a trader, Brendan, has been studying a chart of Johnson & Johnson (JNJ). Brendan notices that for a few months the stock has trading been in a channel between $60 and $65. As he observes Johnson & Johnson beginning to approach the resistance level of $65 again, he considers selling a call to speculate on the stock not rising above $65. Before selling the call, Brendan consults other technical analysis tools, like ADX/DMI, to confirm that there is no trend present. ADX/DMI is used by some traders as a filter to determine the strength of a trend and whether the stock is overbought or oversold. In this case, the indicator shows no strong trend present. Brendan then performs due diligence. He studies the news. He looks for anything specific that could cause the stock to rally. Is the stock a takeover target? Brendan finds nothing. He then does earnings research to find out when they will be announced, which is not for almost two more months. Next, Brendan pulls up an option chain on his computer. He finds that with the stock trading around $64 per share, the market for the November 65 call (expiring in four weeks) is 0.66 bid at 0.68 offer. Brendan considers when Johnson & Johnson’s earnings report falls. Although recent earnings have seldom been a major concern for Johnson & Johnson, he certainly wants to sell an option expiring before the next earnings report. The November fits the mold. Brendan sells ten of the November 65 calls at the bid price of 0.66. Brendan has a rather straightforward goal. He hopes to see Johnson & Johnson shares remain below $65 between now and expiration. If he is right, he stands to make $660. If he is wrong? Exhibit 5.1 shows how Brendan’s calls hold up if they are held until expiration. EXHIBIT 5.1 Naked Johnson & Johnson call at expiration. Considering the risk/reward of this trade, Brendan is rightfully concerned about a big upward move. If the stock begins to rally, he must be prepared to act fast. Brendan must have an idea in advance of what his pain threshold is. In other words, at what price will he buy back his calls and take a loss if Johnson & Johnson moves adversely? He decides he will buy all 10 of his calls back at 1.10 per contract if the trade goes against him. (1.10 is an arbitrary price used for illustrative purposes. The actual price will vary, based on the situation and the risk tolerance of the trader. More on when to take profits and losses is discussed in future chapters.) He may choose to enter a good-till-canceled (GTC) stop-loss order to buy back his calls. Or he may choose to monitor the stock and enter the order when he sees the calls offered at 1.10—a mental stop order. What Brendan needs to know is: How far can the stock price advance before the calls are at 1.10? Brendan needs to examine the greeks of this trade to help answer this question. Exhibit 5.2 shows the hypothetical greeks for the position in this example. EXHIBIT 5.2 Greeks for short Johnson & Johnson 65 call (per contract). Delta −0.34 Gamma−0.15 Theta 0.02 Vega −0.07 The short call has a negative delta. It also has negative gamma and vega, but it has positive time decay (theta). As Johnson & Johnson ticks higher, the delta increases the nominal value of the call. Although this is not a directional trade per se, delta is a crucial element. It will have a big impact on Brendan’s expectations as to how high the stock can rise before he must take his loss. First, Brendan considers how much the option price can move before he covers. The market now is 0.66 bid at 0.68 offer. To buy back his calls at 1.10, they must be offered at 1.10. The difference between the offer now and the offer price at which Brendan will cover is 0.42 (that’s 1.10 − 0.68). Brendan can use delta to convert the change in the ask prices into a stock price change. To do so, Brendan divides the change in the option price by the delta. The −0.34 delta indicates that if JNJ rises $1.24, the calls should be offered at 1.10. Brendan takes note that the bid-ask spreads are typically 0.01 to 0.03 wide in near-term Johnson & Johnson options trading under 1.00. This is not necessarily the case in other option classes. Less liquid names have wider spreads. If the spreads were wider, Brendan would have more slippage. Slippage is the difference between the assumed trade price and the actual price of the fill as a product of the bid-ask spread. It’s the difference between theory and reality. If the bid-ask spread had a typical width of, say, 0.70, the market would be something more like 0.40 bid at 1.10 offer. In this case, if the stock moved even a few cents higher, Brendan could not buy his calls back at his targeted exit price of 1.10. The tighter markets provide lower transaction costs in the form of lower slippage. Therefore, there is more leeway if the stock moves adversely when there are tighter bid-ask option spreads. But just looking at delta only tells a part of the story. In reality, the delta does not remain constant during the price rise in Johnson & Johnson but instead becomes more negative. Initially, the delta is −0.34 and the gamma is −0.15. After a rise in the stock price, the delta will be more negative by the amount of the gamma. To account for the entire effect of direction, Brendan needs to take both delta and gamma into account. He needs to estimate the average delta based on gamma during the stock price move. The formula for the change in stock price is Taking into account the effect of gamma as well as delta, Johnson & Johnson needs to rise only $1.01, in order for Brendan’s calls to be offered at his stop-loss price of 1.10. While having a predefined price point to cover in the event the underlying rises is important, sometimes traders need to think on their feet. If material news is announced that changes the fundamental outlook for the stock, Brendan will have to adjust his plan. If the news leads Brendan to become bullish on the stock, he should exit the trade at once, taking a small loss now instead of the bigger loss he would expect later. If the trader is uncertain as to whether to hold or close the position, the Would I Do It Now? rule is a useful rule of thumb. Would I Do It Now? Rule To follow this rule, ask yourself, “If I did not already have this position, would I do it now? Would I establish the position at the current market prices, given the current market scenario?” If the answer is no, then the solution is simple: Exit the trade. For example, if after one week material news is released and Johnson & Johnson is trading higher, at $64.50 per share, and the November 65 call is trading at 0.75, Brendan must ask himself, based on the price of the stock and all known information, “If I were not already short the calls, would I short them now at the current price of 0.75, with the stock trading at $64.50?” Brendan’s opinion of the stock is paramount in this decision. If, for example, based on the news that was announced he is now bullish, he would likely not want to sell the calls at 0.75—he only gets $0.09 more in option premium and the stock is 0.50 closer to the strike. If, however, he is not bullish, there is more to consider. Theta can be of great use in decision making in this situation. As the number of days until expiration decreases and the stock approaches $65 (making the option more at-the-money), Brendan’s theta grows more positive. Exhibit 5.3 shows the theta of this trade as the underlying rises over time. EXHIBIT 5.3 Theta of Johnson & Johnson. When the position is first established, positive theta comforts Brendan by showing that with each passing day he gets a little closer to his goal—to have the 65 calls expire out-of-the-money (OTM) and reap a profit of the entire 66-cent premium. Theta becomes truly useful if the position begins to move against him. As Johnson & Johnson rises, the trade gets more precarious. His negative delta increases. His negative gamma increases. His goal becomes more out of reach. In conjunction with delta and gamma, theta helps Brendan decide whether the risk is worth the reward. In the new scenario, with the stock at $64.50, Brendan would collect $18 a day (1.80 × 10 contracts). Is the risk of loss in the short run worth earning $18 a day? With Johnson & Johnson at $64.50, would Brendan now short 10 calls at 0.75 to collect $18 a day, knowing that each day may bring a continued move higher in the stock? The answer to this question depends on Brendan’s assessment of the risk of the underlying continuing its ascent. As time passes, if the stock remains closer to the strike, the daily theta rises, providing more reward. Brendan must consider that as theta—the reward— rises, so does gamma: a risk factor. A small but noteworthy risk is that implied volatility could rise. The negative vega of this position would, then, adversely affect the profitability of this trade. It will make Brendan’s 1.10 cover-point approach faster because it makes the option more expensive. Vega is likely to be of less consequence because it would ultimately take the stock’s rising though the strike price for the trade to be a loser at expiration. Short Naked Puts Another trader, Stacie, has also been studying Johnson & Johnson. Stacie believes Johnson & Johnson is on its way to test the $65 resistance level yet again. She believes it may even break through $65 this time, based on strong fundamentals. Stacie decides to sell naked puts. A naked put is a short put that is not sold in conjunction with stock or another option. With the stock around $64, the market for the November 65 put is 1.75 bid at 1.80. Stacie likes the fact that the 65 puts are slightly in-the-money (ITM) and thus have a higher delta. If her price rise comes sooner than expected, the high delta may allow her to take a profit early. Stacie sells 10 puts at 1.75. In the best-case scenario, Stacie retains the entire 1.75. For that to happen, she will need to hold this position until expiration and the stock will have to rise to be trading above the 65 strike. Logically, Stacie will want to do an at-expiration analysis. Exhibit 5.4 shows Stacie’s naked put trade if she holds it until expiration. EXHIBIT 5.4 Naked Johnson & Johnson put at expiration. While harvesting the entire premium as a profit sounds attractive, if Stacie can take the bulk of her profit early, she’ll be happy to close the position and eliminate her risk—nobody ever went broke taking a profit. Furthermore, she realizes that her outlook may be wrong: Johnson & Johnson may decline. She may have to close the position early—maybe for a profit, maybe for a loss. Stacie also needs to study her greeks. Exhibit 5.5 shows the greeks for this trade. EXHIBIT 5.5 Greeks for short Johnson & Johnson 65 put (per contract). Delta 0.65 Gamma−0.15 Theta 0.02 Vega −0.07 The first item to note is the delta. This position has a directional bias. This bias can work for or against her. With a positive 0.65 delta per contract, this position has a directional sensitivity equivalent to being long around 650 shares of the stock. That’s the delta × 100 shares × 10 contracts. Stacie’s trade is not just a bullish version of Brendan’s. Partly because of the size of the delta, it’s different—specific directional bias aside. First, she will handle her trade differently if it is profitable. For example, if over the next week or so Johnson & Johnson rises $1, positive delta and negative gamma will have a net favorable effect on Stacie’s profitability. Theta is small in comparison and won’t have too much of an effect. Delta/gamma will account for a decrease in the put’s theoretical value of about $0.73. That’s the estimated average delta times the stock move, or [0.65 + (–0.15/2)] × 1.00. Stacie’s actual profit would likely be less than 0.73 because of the bid-ask spread. Stacie must account for the fact that the bid-ask is 0.05 wide (1.75– 1.80). Because Stacie would buy to close this position, she should consider the 0.73 price change relative to the 1.80 offer, not the 1.75 trade price— that is, she factors in a nickel of slippage. Thus, she calculates, that the puts will be offered at 1.07 (that’s 1.80 − 0.73) when the stock is at $65. That is a gain of $0.68. In this scenario, Stacie should consider the Would I Do It Now? rule to guide her decision as to whether to take her profit early or hold the position until expiration. Is she happy being short ten 65 puts at 1.07 with Johnson & Johnson at $65? The premium is lower now. The anticipated move has already occurred, and she still has 28 days left in the option that could allow for the move to reverse itself. If she didn’t have the trade on now, would she sell ten 65 puts at 1.07 with Johnson & Johnson at $65? Based on her original intention, unless she believes strongly now that a breakout through $65 with follow-through momentum is about to take place, she will likely take the money and run. Stacie also must handle this trade differently from Brendan in the event that the trade is a loser. Her trade has a higher delta. An adverse move in the underlying would affect Stacie’s trade more than it would Brendan’s. If Johnson & Johnson declines, she must be conscious in advance of where she will cover. Stacie considers both how much she is willing to lose and what potential stock-price action will cause her to change her forecast. She consults a stock chart of Johnson & Johnson. In this example, we’ll assume there is some resistance developing around $64 in the short term. If this resistance level holds, the trade becomes less attractive. The at-expiration breakeven is $63.25, so the trade can still be a winner if Johnson & Johnson retreats. But Stacie is looking for the stock to approach $65. She will no longer like the risk/reward of this trade if it looks like that price rise won’t occur. She makes the decision that if Johnson & Johnson bounces off the $64 level over the next couple weeks, she will exit the position for fear that her outlook is wrong. If Johnson & Johnson drifts above $64, however, she will ride the trade out. In this example, Stacie is willing to lose 1.00 per contract. Without taking into account theta or vega, that 1.00 loss in the option should occur at a stock price of about $63.28. Theta is somewhat relevant here. It helps Stacie’s potential for profit as time passes. As time passes and as the stock rises, so will theta, helping her even more. If the stock moves lower (against her) theta helps ease the pain somewhat, but the further in-the-money the put, the lower the theta. Vega can be important here for two reasons: first, because of how implied volatility tends to change with market direction, and second, because it can be read as an indication of the market’s expectations. The Double Whammy With the stock around $64, there is a negative vega of about seven cents. As the stock moves lower, away from the strike, the vega gets a bit smaller. However, the market conditions that would lead to a decline in the price of Johnson & Johnson would likely cause implied volatility (IV) to rise. If the stock drops, Stacie would have two things working against her—delta and vega—a double whammy. Stacie needs to watch her vega. Exhibit 5.6 shows the vega of Stacie’s put as it changes with time and direction. EXHIBIT 5.6 Johnson & Johnson 65 put vega. If after one week passes Johnson & Johnson gaps lower to, say, $63.00 a share, the vega will be 0.043 per contract. If IV subsequently rises 5 points as a result of the stock falling, vega will make Stacie’s puts theoretically worth 21.5 cents more per contract. She will lose $215 on vega (that’s 0.043 vega × 5 volatility points × 10 contracts) plus the adverse delta/gamma move. A gap opening will cause her to miss the opportunity to stop herself out at her target price entirely. Even if the stock drifts lower, her targeted stop-loss price will likely come sooner than expected, as the option price will likely increase both by delta/gamma and vega resulting from rising volatility. This can cause her to have to cover sooner, which leaves less room for error. With this trade, increases in IV due to market direction can make it feel as if the delta is greater than it actually is as the market declines. Conversely, IV softening makes it feel as if the delta is smaller than it is as the market rises. The second reason IV has importance for this trade (as for most other strategies) is that it can give some indication of how much the market thinks the stock can move. If IV is higher than normal, the market perceives there to be more risk than usual of future volatility. The question remains: Is the higher premium worth the risk? The answer to this question is subjective. Part of the answer is based on Stacie’s assessment of future volatility. Is the market right? The other part is based on Stacie’s risk tolerance. Is she willing to endure the greater price swings associated with the potentially higher volatility? This can mean getting whipsawed, which is exiting a position after reaching a stop-loss point only to see the market reverse itself. The would-be profitable trade is closed for a loss. Higher volatility can also mean a higher likelihood of getting assigned and acquiring an unwanted long stock position. Cash-Secured Puts There are some situations where higher implied volatility may be a beneficial trade-off. What if Stacie’s motivation for shorting puts was different? What if she would like to own the stock, just not at the current market price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her trading account to secure the purchase of 1,000 shares of Johnson & Johnson if she gets assigned. The $63,250 is the $65 per share she will pay for the stock if she gets assigned, minus the 1.75 premium she received for the put × $100 × 10 contracts. Because the cash required to potentially purchase the stock is secured by cash sitting ready in the account, this is called a cash-secured put. Her effective purchase price if assigned is $63.25—the same as her breakeven at expiration. The idea with this trade is that if Johnson & Johnson is anywhere under $65 per share at expiration, she will buy the stock effectively at $63.25. If assigned, the time premium of the put allows her to buy the stock at a discount compared with where it is priced when the trade is established, $64. The higher the time premium—or the higher the implied volatility—the bigger the discount. This discount, however, is contingent on the stock not moving too much. If it is above $65 at expiration she won’t get assigned and therefore can only profit a maximum of 1.75 per contract. If the stock is below $63.25 at expiration, the time premium no longer represents a discount, in fact, the trade becomes a loser. In a way, Stacie is still selling volatility. Covered Call The problem with selling a naked call is that it has unlimited exposure to upside risk. Because of this, many traders simply avoid trading naked calls. A more common, and some would argue safer, method of selling calls is to sell them covered. A covered call is when calls are sold and stock is purchased on a share- for-share basis to cover the unlimited upside risk of the call. For each call that is sold, 100 shares of the underlying security are bought. Because of the addition of stock to this strategy, covered calls are traded with a different motivation than naked calls. There are clearly many similarities between these two strategies. The main goal for both is to harvest the premium of the call. The theta for the call is the same with or without the stock component. The gamma and vega for the two strategies are the same as well. The only difference is the stock. When stock is added to an option position, the net delta of the position is the only thing affected. Stock has a delta of one, and all its other greeks are zero. The pivotal point for both positions is the strike price. That’s the point the trader wants the stock to be above or below at expiration. With the naked call, the maximum payout is reaped if the stock is below the strike at expiration, and there is unlimited risk above the strike. With the covered call, the maximum payout is reaped if the stock is above the strike at expiration. If the stock is below the strike at expiration, the risk is substantial—the stock can potentially go to zero. Putting It on There are a few important considerations with the covered call, both when putting on, or entering, the position and when taking off, or exiting, the trade. The risk/reward implications of implied volatility are important in the trade-planning process. Do I want to get paid more to assume more potential risk? More speculative traders like the higher premiums. More conservative (investment-oriented) covered-call sellers like the low implied risk of low-IV calls. Ultimately, a main focus of a covered call is the option premium. How fast can it go to zero without the movement hurting me? To determine this, the trader must study both theta and delta. The first step in the process is determining which month and strike call to sell. In this example, Harley-Davidson Motor Company (HOG) is trading at about $69 per share. A trader, Bill, is neutral to slightly bullish on Harley- Davidson over the next three months. Exhibit 5.7 shows a selection of available call options for Harley-Davidson with corresponding deltas and thetas. EXHIBIT 5.7 Harley-Davidson calls. In this example, the May 70 calls have 85 days until expiration and are 2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80 premium would represent a 4 percent profit over this 85-day period (2.80 ÷ 69). That’s an annualized return of about 17 percent ([0.04 / 85)] × 365). Bill considers his alternatives. He can sell the April (57-day) 70 calls at 2.20 or the March (22-day) 70 calls at 0.85. Since there is a different number of days until expiration, Bill needs to compare the trades on an apples-to-apples basis. For this, he will look at theta and implied volatility. Presumably, the March call has a theta advantage over the longer-term choices. The March 70 has a theta of 0.032, while the April 70’s theta is 0.026 and the May 70’s is 0.022. Based on his assessment of theta, Bill would have the inclination to sell the March. If he wants exposure for 90 days, when the March 70 call expires, he can roll into the April 70 call and then the May 70 call (more on this in subsequent chapters). This way Bill can continue to capitalize on the nonlinear rate of decay through May. Next, Bill studies the IV term structure for the Harley-Davidson ATMs and finds the March has about a 19.2 percent IV, the April has a 23.3 percent IV, and the May has a 23 percent IV. March is the cheapest option by IV standards. This is not necessarily a favorable quality for a short candidate. Bill must weigh his assessment of all relevant information and then decide which trade is best. With this type of a strategy, the benefits of the higher theta can outweigh the disadvantages of selling the lower IV. In this case, Bill may actually like selling the lower IV. He may infer that the market believes Harley-Davidson will be less volatile during this period. So far, Bill has been focusing his efforts on the 70 strike calls. If he trades the March 70 covered call, he will have a net delta of 0.588 per contract. That’s the negative 0.412 delta from shorting the call plus the 1.00 delta of the stock. His indifference point if the trade is held until expiration is $70.85. The indifference point is the point at which Bill would be indifferent as to whether he held only the stock or the covered call. This is figured by adding the strike price of $70 to the 0.85 premium. This is the effective sale price of the stock if the call is assigned. If Bill wants more potential for upside profit, he could sell a higher strike. He would have to sell the April or May 75, since the March 75s are a zero bid. This would give him a higher indifference point, and the upside profits would materialize quickly if HOG moved higher, since the covered-call deltas would be higher with the 75 calls. The April 75 covered-call net delta is 0.796 per contract (the stock delta of 1.00 minus the 0.204 delta of the call). The May 75 covered-call delta is 0.751. But Bill is neutral to only slightly bullish. In this case, he’d rather have the higher premium—high theta is more desirable than high delta in this situation. Bill buys 1,000 shares of Harley-Davidson at $69 and sells 10 Harley-Davidson March 70 calls at 0.85. Bill also needs to plan his exit. To exit, he must study two things: an at- expiration diagram and his greeks. Exhibit 5.8 shows the P&(L) at expiration of the Harley-Davidson March 70 covered call. Exhibit 5.9 shows the greeks. EXHIBIT 5.8 Harley-Davidson covered call. EXHIBIT 5.9 Greeks for Harley-Davidson covered call (per contract). Delta 0.591 Gamma−0.121 Theta 0.032 Vega −0.066 Taking It Off If the trade works out perfectly for Bill, 22 days from now Harley-Davidson will be trading right at $70. He’d profit on both delta and theta. If the trade isn’t exactly perfect, but still good, Harley-Davidson will be anywhere above $68.15 in 22 days. It’s the prospect that the trade may not be so good at March expiration that occupies Bill’s thoughts, but a trader has to hope for the best and plan for the worst. If it starts to trend, Bill needs to react. The consequences to the stock’s trending to the upside are not quite so dire, although he might be somewhat frustrated with any lost opportunity above the indifference point. It’s the downside risk that Bill will more vehemently guard against. First, the same IV/vega considerations exist as they did in the previous examples. In the event the trade is closed early, IV/vega may help or hinder profitability. A rise in implied volatility will likely accompany a decline in the stock price. This can bring Bill to his stop-loss sooner. Delta versus theta however, is the major consideration. He will plan his exit price in advance and cover when the planned exit price is reached. There are more moving parts with the covered call than a naked option. If Bill wants to close the position early, he can leg out, meaning close only one leg of the trade (the call or the stock) at a time. If he legs out of the trade, he’s likely to close the call first. The motivation for exiting a trade early is to reduce risk. A naked call is hardly less risky than a covered call. Another tactic Bill can use, and in this case will plan to use, is rolling the call. When the March 70s expire, if Harley-Davidson is still in the same range and his outlook is still the same, he will sell April calls to continue the position. After the April options expire, he’ll plan to sell the Mays. With this in mind, Bill may consider rolling into the Aprils before March expiration. If it is close to expiration and Harley-Davidson is trading lower, theta and delta will both have devalued the calls. At the point when options are close to expiration and far enough OTM to be offered close to zero, say 0.05, the greeks and the pricing model become irrelevant. Bill must consider in absolute terms if it is worth waiting until expiration to make 0.05. If there is a lot of time until expiration, the answer is likely to be no. This is when Bill will be apt to roll into the Aprils. He’ll buy the March 70s for a nickel, a dime, or maybe 0.15 and at the same time sell the Aprils at the bid. This assumes he wants to continue to carry the position. If the roll is entered as a single order, it is called a calendar spread or a time spread. Covered Put The last position in the family of basic volatility-selling strategies is the covered put, sometimes referred to as selling puts and stock. In a covered put, a trader sells both puts and stock on a one-to-one basis. The term covered put is a bit of a misnomer, as the strategy changes from limited risk to unlimited risk when short stock is added to the short put. A naked put can produce only losses until the stock goes to zero—still a substantial loss. Adding short stock means that above the strike gains on the put are limited, while losses on the stock are unlimited. The covered put functions very much like a naked call. In fact, they are synthetically equal. This concept will be addressed further in the next chapter. Let’s looks at another trader, Libby. Libby is an active trader who trades several positions at once. Libby believes the overall market is in a range and will continue as such over the next few weeks. She currently holds a short stock position of 1,000 shares in Harley-Davidson. She is becoming more neutral on the stock and would consider buying in her short if the market dipped. She may consider entering into a covered-put position. There is one caveat: Libby is leaving for a cruise in two weeks and does not want to carry any positions while she is away. She decides she will sell the covered put and actively manage the trade until her vacation. Libby will sell 10 Harley-Davidson March (22-day) 70 puts at 1.85 against her short 1,000 shares of Harley-Davidson, which is trading at $69 per share. She knows that her maximum profit if the stock declines and assignment occurs will be $850. That’s 0.85 × $100 × 10 contracts. Win or lose, she will close the position in two weeks when there are only eight days until expiration. To trade this covered put she needs to watch her greeks. Exhibit 5.10 shows the greeks for the Harley-Davidson 70-strike covered put. EXHIBIT 5.10 Greeks for Harley-Davidson covered put (per contract). Delta −0.419 Gamma−0.106 Theta 0.031 Vega −0.066 Libby is really focusing on theta. It is currently about $0.03 per day but will increase if the put stays close-to-the-money. In two weeks, the time premium will have decayed significantly. A move downward will help, too, as the −0.419 delta indicates. Exhibit 5.11 displays an array of theoretical values of the put at eight days until expiration as the stock price changes. EXHIBIT 5.11 HOG 70 put values at 8 days to expiry. As long as Harley-Davidson stays below the strike price, Libby can look at her put from a premium-over-parity standpoint. Below the strike, the intrinsic value of the put doesn’t matter too much, because losses on intrinsic value are offset by gains on the stock. For Libby, all that really matters is the time value. She sold the puts at 0.85 over parity. If Harley- Davidson is trading at $68 with eight days to go, she can buy her puts back for 0.12 over parity. That’s a 73-cent profit, or $730 on her 10 contracts. This doesn’t account for any changes in the time value that may occur as a result of vega, but vega will be small with Harley-Davidson at $68 and eight days to go. At this point, she would likely close down the whole position—buying the puts and buying the stock—to take a profit on a position that worked out just about exactly as planned. Her risk, though, is to the upside. A big rally in the stock can cause big losses. From a theoretical standpoint, losses are potentially unlimited with this type of trade. If the stock is above the strike, she needs to have a mental stop order in mind and execute the closing order with discipline. Curious Similarities These basic volatility-selling strategies are fairly simple in nature. If the trader believes a stock will not rise above a certain price, the most straightforward way to trade the forecast is to sell a call. Likewise, if the trader believes the stock will not go below a certain price he can sell a put. The covered call and covered put are also ways to generate income on long or short stock positions that have these same price thresholds. In fact, the covered call and covered put have some curious similarities to the naked put and naked call. The similarities between the two pairs of positions are no coincidence. The following chapter sheds light on these similarities. CHAPTER 6 Put-Call Parity and Synthetics In order to understand more complex spread strategies involving two or more options, it is essential to understand the arbitrage relationship of the put-call pair. Puts and calls of the same month and strike on the same underlying have prices that are defined in a mathematical relationship. They also have distinctly related vegas, gammas, thetas, and deltas. This chapter will show how the metrics of these options are interrelated. It will also explore synthetics and the idea that by adding stock to a position, a trader may trade with indifference either a call or a put to the same effect. Put-Call Parity Essentials Before the creation of the Black-Scholes model, option pricing was hardly an exact science. Traders had only a few mathematical tools available to compare the relative prices of options. One such tool, put-call parity, stems from the fact that puts and calls on the same class sharing the same month and strike can have the same functionality when stock is introduced. For example, traders wanting to own a stock with limited risk can buy a married put: long stock and a long put on a share-for-share basis. The traders have infinite profit potential, and the risk of the position is limited below the strike price of the option. Conceptually, long calls have the same risk/reward profile—unlimited profit potential and limited risk below the strike. Exhibit 6.1 is an overview of the at-expiration diagrams of a married put and a long call. EXHIBIT 6.1 Long call vs. long stock + long put (married put). Married puts and long calls sharing the same month and strike on the same security have at-expiration diagrams with the same shape. They have the same volatility value and should trade around the same implied volatility (IV). Strategically, these two positions provide the same service to a trader, but depending on margin requirements, the married put may require more capital to establish, because the trader must buy not just the option but also the stock. The stock component of the married put could be purchased on margin. Buying stock on margin is borrowing capital to finance a stock purchase. This means the trader has to pay interest on these borrowed funds. Even if the stock is purchased without borrowing, there is opportunity cost associated with the cash used to pay for the stock. The capital is tied up. If the trader wants to use funds to buy another asset, he will have to borrow money, which will incur an interest obligation. Furthermore, if the trader doesn’t invest capital in the stock, the capital will rest in an interest-bearing account. The trader forgoes that interest when he buys a stock. However the trader finances the purchase, there is an interest cost associated with the transaction. Both of these positions, the long call and the married put, give a trader exposure to stock price advances above the strike price. The important difference between the two trades is the value of the stock below the strike price—the part of the trade that is not at risk in either the long call or the married put. On this portion of the invested capital, the trader pays interest with the married put (whether actually or in the form of opportunity cost). This interest component is a pricing consideration that adds cost to the married put and not the long call. So if the married put is a more expensive endeavor than the long call because of the interest paid on the investment portion that is below the strike, why would anyone buy a married put? Wouldn’t traders instead buy the less expensive—less capital intensive—long call? Given the additional interest expense, they would rather buy the call. This relates to the concept of arbitrage. Given two effectively identical choices, rational traders will choose to buy the less expensive alternative. The market as a whole would buy the calls, creating demand which would cause upward price pressure on the call. The price of the call would rise until its interest advantage over the married put was gone. In a robust market with many savvy traders, arbitrage opportunities don’t exist for very long. It is possible to mathematically state the equilibrium point toward which the market forces the prices of call and put options by use of the put-call parity. As shown in Chapter 2, the put-call parity states where c is the call premium, PV(x) is the present value of the strike price, p is the put premium and s is the stock price. Another, less academic and more trader-friendly way of stating this equation is where Interest is calculated as Interest = Strike × Interest Rate ×(Days to Expiration/365) 1 The two versions of the put-call parity stated here hold true for European options on non-dividend-paying stocks. Dividends Another difference between call and married-put values is dividends. A call option does not extend to its owner the right to receive a dividend payment. Traders, however, who are long a put and long stock are entitled to a dividend if it is the corporation’s policy to distribute dividends to its shareholders. An adjustment must be made to the put-call parity to account for the possibility of a dividend payment. The equation must be adjusted to account for the absence of dividends paid to call holders. For a dividend-paying stock, the put-call parity states The interest advantage and dividend disadvantage of owning a call is removed from the market by arbitrageurs. Ultimately, that is what is expressed in the put-call parity. It’s a way to measure the point at which the arbitrage opportunity ceases to exist. When interest and dividends are factored in, a long call is an equal position to a long put paired with long stock. In options nomenclature, a long put with long stock is a synthetic long call. Algebraically rearranging the above equation: The interest and dividend variables in this equation are often referred to as the basis. From this equation, other synthetic relationships can be algebraically derived, like the synthetic long put. A synthetic long put is created by buying a call and selling (short) stock. The at-expiration diagrams in Exhibit 6.2 show identical payouts for these two trades. EXHIBIT 6.2 Long put vs. long call + short stock. The concept of synthetics can become more approachable when studied from the perspective of delta as well. Take the 50-strike put and call listed on a $50 stock. A general rule of thumb in the put-call pair is that the call delta plus the put delta equals 1.00 when the signs are ignored. If the 50 put in this example has a −0.45 delta, the 50 call will have a 0.55 delta. By combining the long call (0.55 delta) with short stock (–1.00 delta), we get a synthetic long put with a −0.45 delta, just like the actual put. The directional risk is the same for the synthetic put and the actual put. A synthetic short put can be created by selling a call of the same month and strike and buying stock on a share-for-share basis (i.e., a covered call). This is indicated mathematically by multiplying both sides of the put-call parity equation by −1: The at-expiration diagrams, shown in Exhibit 6.3 , are again conceptually the same. EXHIBIT 6.3 Short put vs. short call + long stock. A short (negative) put is equal to a short (negative) call plus long stock, after the basis adjustment. Consider that if the put is sold instead of buying stock and selling a call, the interest that would otherwise be paid on the cost of the stock up to the strike price is a savings to the put seller. To balance the equation, the interest benefit of the short put must be added to the call side (or subtracted from the put side). It is the same with dividends. The dividend benefit of owning the stock must be subtracted from the call side to make it equal to the short put side (or added to the put side to make it equal the call side). The same delta concept applies here. The short 50-strike put in our example would have a 0.45 delta. The short call would have a −0.55 delta. Buying one hundred shares along with selling the call gives the synthetic short put a net delta of 0.45 (–0.55 + 1.00). Similarly, a synthetic short call can be created by selling a put and selling (short) one hundred shares of stock. Exhibit 6.4 shows a conceptual overview of these two positions at expiration. EXHIBIT 6.4 Short call vs. short put + short stock. Put-call parity can be manipulated as shown here to illustrate the composition of the synthetic short call. Most professional traders earn a short stock rebate on the proceeds they receive when they short stock—an advantage to the short-put–short-stock side of the equation. Additionally, short-stock sellers must pay dividends on the shares they are short—a liability to the married-put seller. To make all things equal, one subtracts interest and adds dividends to the put side of the equation. Comparing Synthetic Calls and Puts The common thread among the synthetic positions explained above is that, for a put-call pair, long options have synthetic equivalents involving long options, and short options have synthetic equivalents involving short options. After accounting for the basis, the four basic synthetic option positions are: Because a call or put position is interchangeable with its synthetic position, an efficient market will ensure that the implied volatility is closely related for both. For example, if a long call has an IV of 25 percent, the corresponding put should have an IV of about 25 percent, because the long put can easily be converted to a synthetic long call and vice versa. The greeks will be similar for synthetically identical positions, too. The long options and their synthetic equivalents will have positive gamma and vega with negative theta. The short options and their synthetics will have negative gamma and vega with positive theta. American-Exercise Options Put-call parity was designed for European-style options. The early exercise possibility of American-style options gums up the works a bit. Because a call (put) and a synthetic call (put) are functionally the same, it is logical to assume that the implied volatility and the greeks for both will be exactly the same. This is not necessarily true with American-style options. However, put-call parity may still be useful with American options when the limitations of the equation are understood. With at-the-money American- exercise options, the differences in the greeks for a put-call pair are subtle. Exhibit 6.5 is a comparison of the greeks for the 50-strike call and the 50- strike put with the underlying at $50 and 66 days until expiration. EXHIBIT 6.5 Greeks for a 50-strike put-call pair on a $50 stock. Call Put Delta 0.5540.457 Gamma0.0750.078 Theta 0.0200.013 Vega 0.0840.084 The examples used earlier in this chapter in describing the deltas of synthetics were predicated on the rule of thumb that the absolute values of call and put deltas add up to 1.00. To be a bit more realistic, consider that because of American exercise, the absolute delta values of put-call pairs don’t always add up to 1.00. In fact, Exhibit 6.5 shows that the call has closer to a 0.554 delta. The put struck at the same price then has a 0.457 delta. By selling 100 shares against the long call, we can create a combined- position delta (call delta plus stock delta) that is very close to the put’s delta. The delta of this synthetic put is −0.446 (0.554 − 1.00). The delta of a put will always be similar to the delta of its corresponding synthetic put. This is also true with call–synthetic-call deltas. This relationship mathematically is This holds true whether the options are in-, at-, or out-of-the-money. For example, with a stock at $54, the 50-put would have a −0.205 delta and the call would have a 0.799 delta. Selling 100 shares against the call to create the synthetic put yields a net delta of −0.201. If long or short stock is added to a call or put to create a synthetic, delta will be the only greek affected. With that in mind, note the other greeks displayed in Exhibit 6.5 —especially theta. Proportionally, the biggest difference in the table is in theta. The disparity is due in part to interest. When the effects of the interest component outweigh the effects of the dividend, the time value of the call can be higher than the time value of the put. Because the call must lose more premium than the put by expiration, the theta of the call must be higher than the theta of the put. American exercise can also cause the option prices in put-call parity to not add up. Deep in-the-money (ITM) puts can trade at parity while the corresponding call still has time value. The put-call equation can be unbalanced. The same applies to calls on dividend-paying stocks as the dividend date approaches. When the date is imminent, calls can trade close to parity while the puts still have time value. The role of dividends will be discussed further in Chapter 8. Synthetic Stock Not only can synthetic calls and puts be derived by manipulation of put-call parity, but synthetic positions for the other security in the equation—stock —can be derived, as well. By isolating stock on one side of the equation, the formula becomes After accounting for interest and dividends, buying a call and selling a put of the same strike and time to expiration creates the equivalent of a long stock position. This is called a synthetic stock position, or a combo. After accounting for the basis, the equation looks conceptually like this: This is easy to appreciate when put-call parity is written out as it is here. It begins to make even more sense when considering at-expiration diagrams and the greeks. Exhibit 6.6 illustrates a long stock position compared with a long call combined with a short put position. EXHIBIT 6.6 Long stock vs. long call + short put. A quick glance at these two strategies demonstrates that they are the same, but think about why. Consider the synthetic stock position if both options are held until expiration. The long call gives the trader the right to buy the stock at the strike price. The short put gives the trader the obligation to buy the stock at the same strike price. It doesn’t matter what the strike price is. As long as the strike is the same for the call and the put, the trader will have a long position in the underlying at the shared strike at expiration when exercise or assignment occurs. The options in this example are 50-strike options. At expiration, the trader can exercise the call to buy the underlying at $50 if the stock is above the strike. If the underlying is below the strike at expiration, he’ll get assigned on the put and buy the stock at $50. If the stock is bought, whether by exercise or assignment, the effective price of the potential stock purchase, however, is not necessarily $50. For example, if the trader bought one 50-strike call at 3.50 and sold one 50-strike put at 1.50, he will effectively purchase the underlying at $52 upon exercise or assignment. Why? The trader paid a net of $2 to get a long position in the stock synthetically (3.50 of call premium debited minus 1.50 of put premium credited). Whether the call or the put is ITM, the effective purchase price of the stock will always be the strike price plus or minus the cost of establishing the synthetic, in this case, $52. The question that begs to be asked is: would the trader rather buy the stock or pay $2 to have the same market exposure as long stock? Arbitrageurs in the market (with the help of the put-call parity) ensure that neither position—long stock or synthetic long stock—is better than the other. For example, assume a stock is trading at $51.54. With 71 days until expiration, 26.35 IV, a 5 percent interest rate, and no dividends, the 50- strike call is theoretically worth 3.50, and the 50-strike put is theoretically worth 1.50. Exhibit 6.7 charts the synthetic stock versus the actual stock when there are 71 days until expiration. EXHIBIT 6.7 Long stock and synthetic long stock with 71 days to expiration. Looking at this exhibit, it appears that being long the actual stock outperforms being long the stock synthetically. If the stock is purchased at $51.54, it need only rise a penny higher to profit (in the theoretical world where traders do not pay commissions on transactions). If the synthetic is purchased for $2, the stock needs to rise $0.46 to break even—an apparent disadvantage. This figure, however, does not include interest. The synthetic stock offers the same risk/reward as actually being long the stock. There is a benefit, from the perspective of interest, to paying only $2 for this exposure rather than $51.54. The interest benefit here is about $0.486. We can find this number by calculating the interest as we did earlier in the chapter. Interest, again, is computed as the strike price times the interest rate times the number of days to expiration divided by the number of days in a year. The formula is as follows: Inputting the numbers from this example: The $0.486 of interest is about equal to the $0.46 disparity between the diagrams of the stock and the synthetic stock with 71 days until expiration. The difference is due mainly to rounding and the early-exercise potential of the American put. In mathematical terms The synthetic long stock is approximately equal to the long stock position when considering the effect of interest. The two lines in Exhibit 6.7 — representing stock and synthetic stock—would converge with each passing day as the calculated interest decreases. This equation works as well for a synthetic short stock position; reversing the signs reveals the synthetic for short stock. Or, in this case, Shorting stock at $51.54 is about equal to selling the 50 call and buying the 50 put for a $2 credit based on the interest of 0.486 computed on the 50 strike. Again, the $0.016 disparity between the calculated interest and the actual difference between the synthetic value and the stock price is a function of rounding and early exercise. More on this in the “Conversions and Reversals” section. Synthetic Stock Strategies Ultimately, when we roll up our sleeves and get down to the nitty-gritty, options trading is less about having another alternative for trading the direction of the underlying than it is about trading the greeks. Different strategies allow traders to exploit different facets of option pricing. Some strategies allow traders to trade volatility. Some focus mainly on theta. Many of the strategies discussed in this section present ways for a trader to distill risk down mostly to interest rate exposure. Conversions and Reversals When calls and puts are combined to create synthetic stock, the main differences are the interest rate and dividends. This is important because the risks associated with interest and dividends can be isolated, and ultimately traded, when synthetic stock is combined with the underlying. There are two ways to combine synthetic stock with its underlying security: a conversion and a reversal. Conversion A conversion is a three-legged position in which a trader is long stock, short a call, and long a put. The options share the same month and strike price. By most metrics, this is a very flat position. A trader with a conversion is long the stock and, at the same time, synthetically short the same stock. Consider this from the perspective of delta. In a conversion, the trader is long 1.00 deltas (the long stock) and short very close to 1.00 deltas (the synthetic short stock). Conversions have net flat deltas. The following is a simple example of a typical conversion and the corresponding deltas of each component. Short one 35-strike call:−0.63 delta Long one 35-strike put:−0.37 delta Long 100 shares: 1.00 delta 0.00 delta The short call contributes a negative delta to the position, in this case, −0.63. The long put also contributes a negative delta, −0.37. The combined delta of the synthetic stock is −1.00 in this example, which is like being short 100 shares of stock. When the third leg of the spread is added, the long 100 shares, it counterbalances the synthetic. The total delta for the conversion is zero. Most of the conversion’s other greeks are pretty flat as well. Gamma, theta, and vega are similar for the call and the put in the conversion, because they have the same expiration month and strike price. Because the trader is selling one option and buying another—a call and a put, respectively—with the same month and strike, the greeks come very close to offsetting each other. For all intents and purposes, the trader is out of the primary risks of the position as measured by greeks when a position is converted. Let’s look at a more detailed example. A trader executes the following trade (for the purposes of this example, we assume the stock pays no dividend and the trade is executed at fair value): Sell one 71-day 50 call at 3.50 Buy one 71-day 50 put at 1.50 Buy 100 shares at $51.54 The trader buys the stock at $51.54 and synthetically sells the stock at $52. The synthetic price is computed as −3.50 + 1.50 − 50. Therefore, the stock is sold synthetically at $0.46 over the actual stock price. Exhibit 6.8 shows the analytics for the conversion. EXHIBIT 6.8 Conversion greeks. This position has very subtle sensitivity to the greeks. The net delta for the spread has a very slightly negative bias. The bias is so small it is negligible to most traders, except professionals trading very large positions. Why does this negative delta bias exist? Mathematically, the synthetic’s delta can be higher with American options than with their European counterparts because of the possibility of early exercise of the put. This anomaly becomes more tangible when we consider the unique directional risk associated with this trade. In this example, the stock is synthetically sold at $0.46 over the price at which the stock is bought. If the stock declines significantly in value before expiration, the put will, at some point, trade at parity while the call loses all its time value. In this scenario, the value of the synthetic stock will be short at effectively the same price as the actual stock price. For example, if the stock declines to $35 per share then the numbers are as follows: or With American options, a put this far in-the-money with less than 71 days until expiry will be all intrinsic value. Interest, in this case, will not factor into the put’s value, because the put can be exercised. By exercising the put, both the long stock leg and the long put leg can be closed for even money, leaving only the theoretically worthless call. The stock-synthetic spread is sold at 0.46 and essentially bought at zero when the put is exercised. If the put is exercised before expiration, the profit potential is 0.46 minus the interest calculated between the trade date and the day the put is exercised. If, however, the conversion is held until expiration, the $0.46 is negated by the $0.486 of interest incurred from holding long stock over the entire 71- day period, hence the trader’s desire to see the stock decline before expiration, and thus the negative bias toward delta. This is, incidentally, why the synthetic price (0.46 over the stock price) does not exactly equal the calculated value of the interest (0.486). The trader can exercise the put early if the stock declines and capitalize on the disparity between the interest calculated when the conversion was traded and the actual interest calculation given the shorter time frame. The model values the synthetic at a little less than the interest value would indicate—in this case $0.46 instead of $0.486. The gamma of this trade is fairly negligible. The theta is slightly positive. Rho is the figure that deserves the most attention. Rho is the change in an option’s price given a change in the interest rate. The −0.090 rho of the conversion indicates that if the interest rate rises one percentage point, the position as a whole loses $0.09. Why? The financing of the position gets more expensive as the interest rate rises. The trader would have to pay more in interest to carry the long stock. In this example, if interest rises by one percentage point, the synthetic stock, which had an effective short price of $0.46 over the price of the long stock before the interest rate increase, will be $0.55 over the price of the long stock afterward. If, however, the interest rate declines by one percentage point, the trader profits $0.09, as the synthetic is repriced by the market to $0.37 over the stock price. The lower the interest rate, the less expensive it is to finance the long stock. This is proven mathematically by put-call parity. Negative rho indicates a bearish position on the interest rate; the trader wants it to go lower. Positive rho is a bullish interest rate position. But a one-percentage-point change in the interest rate in one day is a big and uncommon change. The question is: is rho relevant? That depends on the type of position and the type of trader. A 0.090 rho would lead to a 0.0225 profit-and-loss (P&(L)) change per one lot conversion on a 25-basis- point, or quarter percent, change. That’s just $2.25 per spread. This incremental profit or loss, however, can be relevant to professional traders like market makers. They trade very large positions with the aspiration of making small incremental profits on each trade. A market maker with a 5,000-lot conversion would stand to make or lose $11,250, given a quarter- percentage-point change in interest rate and a 0.090 rho. The Mind of a Market Maker Market makers are among the only traders who can trade conversions and reversals profitably, because of the size of their trades and the fact that they can buy the bid and sell the offer. Market makers often attempt to leg into and out of conversions (and reversals). Given the conversion in this example, a market maker may set out to sell calls and in turn buy stock to hedge the call’s delta risk (this will be covered in Chapters 12 and 17), then buy puts and the rest of the stock to create a balanced conversion: one call to one put to one hundred shares. The trader may try to put on the conversion in the previous example for a total of $0.50 over the price of the long stock instead of the $0.46 it’s worth. He would then try to leg out of the trade for less, say $0.45 over the stock, with the goal of locking in a $0.05 profit per spread on the whole trade. Reversal A reversal, or reverse conversion, is simply the opposite of the conversion: buy call, sell put, and sell (short) stock. A reversal can be executed to close a conversion, or it can be an opening transaction. Using the same stock and options as in the previous example, a trader could establish a reversal as follows: Buy one 71-day 50 call at 3.50 Sell one 71-day 50 put at 1.50 Sell 100 shares at 51.54 The trader establishes a short position in the stock at $51.54 and a long synthetic stock position effectively at $52.00. He buys the stock synthetically at $0.46 over the stock price, again assuming the trade can be executed at fair value. With the reversal, the trader has a bullish position on interest rates, which is indicated by a positive rho. In this example, the rho for this position is 0.090. If interest rates rise one percentage point, the synthetic stock (which the trader is long) gains nine cents in value relative to the stock. The short stock rebate on the short stock leg earns more interest at a higher interest rate. If rates fall one percentage point, the synthetic long stock loses $0.09. The trader earns less interest being short stock given a lower interest rate. With the reversal, the fact that the put can be exercised early is a risk. Since the trader is short the put and short stock, he hopes not to get assigned. If he does, he misses out on the interest he planned on collecting when he put on the reversal for $0.46 over. Pin Risk Conversions and reversals are relatively low-risk trades. Rho and early exercise are relevant to market makers and other arbitrageurs, but they are among the lowest-risk positions they are likely to trade. There is one indirect risk of conversions and reversals that can be of great concern to market makers around expiration: pin risk. Pin risk is the risk of not knowing for certain whether an option will be assigned. To understand this concept, let’s revisit the mind of a market maker. Recall that market makers have two primary functions: 1. Buy the bid or sell the offer. 2. Manage risk. When institutional or retail traders send option orders to an exchange (through a broker), market makers are usually the ones with whom they trade. Customers sell the bid; the market makers buy the bid. Customers buy the offer; the market makers sell the offer. The first and arguably easier function of market makers is accomplished whenever a marketable order is sent to the exchange. Managing risk can get a bit hairy. For example, once the market makers buy April 40 calls, their first instinct is to hedge by selling stock to become delta neutral. Market makers are almost always delta neutral, which mitigates the direction risk. The next step is to mitigate theta, gamma, and vega risk by selling options. The ideal options to sell are the same calls that were bought—that is, get out of the trade. The next best thing is to sell the April 40 puts and sell more stock. In this case, the market makers have established a reversal and thereby have very little risk. If they can lock in the reversal for a small profit, they have done their job. What happens if the market makers still have the reversal in inventory at expiration? If the stock is above the strike price—40, in this case—the puts expire, the market makers exercise the calls, and the short stock is consequently eliminated. The market makers are left with no position, which is good. They’re delta neutral. If the stock is below 40, the calls expire, the puts get assigned, and the short stock is consequently eliminated. Again, no position. But what if the stock is exactly at $40? Should the calls be exercised? Will the puts get assigned? If the puts are assigned, the traders are left with no short stock and should let the calls expire without exercising so as not to have a long delta position after expiration. If the puts are not assigned, they should exercise the calls to get delta flat. It’s also possible that only some of the puts will be assigned. Because they don’t know how many, if any, of the puts will be assigned, the market makers have pin risk. To avoid pin risk, market makers try to eliminate their position if they have conversions or reversals close to expiration. Boxes and Jelly Rolls There are two other uses of synthetic stock positions that form conventional strategies: boxes and rolls. Boxes When long synthetic stock is combined with short synthetic stock on the same underlying within the same expiration cycle but with a different strike price, the resulting position is known as a box. With a box, a trader is synthetically both long and short the stock. The two positions, for all intents and purposes, offset each other directionally. The risk of stock-price movement is almost entirely avoided. A study of the greeks shows that the delta is close to zero. Gamma, theta, vega, and rho are also negligible. Here’s an example of a 60–70 box for April options: Short 1 April 60 call Long 1 April 60 put Long 1 April 70 call Short 1 April 70 put In this example, the trader is synthetically short the 60-strike and, at the same time, synthetically long the 70-strike. Exhibit 6.9 shows the greeks. EXHIBIT 6.9 Box greeks. Aside from the risks associated with early exercise implications, this position is just about totally flat. The near-1.00 delta on the long synthetic stock struck at 60 is offset by the near-negative-1.00 delta of the short synthetic struck at 70. The tiny gammas and thetas of both combos are brought closer to zero when they are spread against each another. Vega is zero. And the bullish interest rate sensitivity of the long combo is nearly all offset by the bearish interest sensitivity of the short combo. The stock can move, time can pass, volatility and interest can change, and there will be very little effect on the trader’s P&(L). The question is: Why would someone trade a box? Market makers accumulate positions in the process of buying bids and selling offers. But they want to eliminate risk. Ideally, they try to be flat the strike —meaning have an equal number of calls and puts at each strike price, whether through a conversion or a reversal. Often, they have a conversion at one strike and a reversal at another. The stock positions for these cancel each other out and the trader is left with only the four option legs—that is, a box. They can eliminate pin risk on both strikes by trading the box as a single trade to close all four legs. Another reason for trading a box has to do with capital. Borrowing and Lending Money The first thing to consider is how this spread is priced. Let’s look at another example of a box, the October 50–60 box. Long 1 October 60 call Short 1 October 60 put Short 1 October 70 call Long 1 October 70 put A trader with this position is synthetically long the stock at $60 and short the stock at $70. That sounds like $10 in the bank. The question is: How much would a trader be willing to pay for the right to $10? And for how much would someone be willing to sell it? At face value, the obvious answer is that the equilibrium point is at $10, but there is one variable that must be factored in: time. In this example, assume that the October call has 90 days until expiration and the interest rate is 6 percent. A rational trader would not pay $10 today for the right to have $10 90 days from now. That would effectively be like loaning the $10 for 90 days and not receiving interest—A losing proposition! The trader on the other side of this box would be happy to enter into the spread for $10. He would have interest-free use of $10 for 90 days. That’s free money! Certainly, there is interest associated with the cost of carrying the $10. In this case, the interest would be $0.15. This $0.15 is discounted from the price of the $10 box. In fact, the combined net value of the options composing the box should be about 9.85 —with differences due mainly to rounding and the early exercise possibility for American options. A trader buying this box—that is, buying the more ITM call and more ITM put—would expect to pay $0.15 below the difference between the strike prices. Fair value for this trade is $9.85. The seller of this box—the trader selling the meatier options and buying the cheaper ones—would concede up to $0.15 on the credit. Jelly Rolls A jelly roll, or simply a roll, is also a spread with four legs and a combination of two synthetic stock trades. In a box, the difference between the synthetics is the strike price; in a roll, it’s the contract month. Here’s an example: Long 1 April 50 call Short 1 April 50 put Short 1 May 50 call Long 1 May 50 put The options in this spread all share the same strike price, but they involve two different months—April and May. In this example, the trader is long synthetic stock in April and short synthetic stock in May. Like the conversion, reversal, and box, this is a mostly flat position. Delta, gamma, theta, vega, and even rho have only small effects on a jelly roll, but like the others, this spread serves a purpose. A trader with a conversion or reversal can roll the option legs of the position into a month with a later expiration. For example, a trader with an April 50 conversion in his inventory (short the 50 call, long the 50 put, long stock) can avoid pin risk as April expiration approaches by trading the roll from the above example. The long April 50 call and short April 50 put cancel out the current option portion of the conversion leaving only the stock. Selling the May 50 calls and buying the May 50 puts reestablishes the conversion a month farther out. Another reason for trading a roll has to do with interest. The roll in this example has positive exposure to rho in April and negative exposure to rho in May. Based on a trader’s expectations of future changes in interest rates, a position can be constructed to exploit opportunities in interest. Theoretical Value and the Interest Rate The main focus of the positions discussed in this chapter is fluctuations in the interest rate. But which interest rate? That of 30-year bonds? That of 10- or 5-year notes? Overnight rates? The federal funds rate? In the theoretical world, the answer to this question is not really that important. Professors simply point to the riskless rate and continue with their lessons. But when putting strategies like these into practice, choosing the right rate makes a big difference. To answer the question of which interest rate, we must consider exactly what the rates represent from the standpoint of an economist. Therefore, we must understand how an economist makes arguments—by making assumptions. Take the story of the priest, the physicist, and the economist stranded on a desert island with nothing to eat except a can of beans. The problem is, the can is sealed. In order to survive, they must figure out how to open the can. The priest decides he will pray for the can to be opened by means of a miracle. He prays for hours, but, alas, the can remains sealed tight. The physicist devises a complex system of wheels and pulleys to pop the top off the can. This crude machine unfortunately fails as well. After watching the lack of success of his fellow strandees, the economist announces that he has the solution: “Assume we have a can opener.” In the spirit of economists’ logic, let’s imagine for a moment a theoretical economic microcosm in which a trader has two trading accounts at the same firm. The assumptions here are that a trader can borrow 100 percent of a stock’s value to finance the purchase of the security and that there are no legal, moral, or other limitations on trading. In one account the trader is long 100 shares, fully leveraged. In the other, the trader is short 100 shares of the same stock, in which case the trader earns a short-stock rebate. In the long run, what is the net result of this trade? Most likely, this trade is a losing proposition for the trader, because the interest rate at which the trader borrows capital is likely to be higher than the interest rate earned on the short-stock proceeds. In this example, interest is the main consideration. But interest matters in the real world, too. Professional traders earn interest on proceeds from short stock and pay interest on funds borrowed. Interest rates may vary slightly from firm to firm and trader to trader. Interest rates are personal. The interest rate a trader should use when pricing options is specific to his or her situation. A trader with no position in a particular stock who is interested in trading a conversion should consider that he will be buying the stock. This implies borrowing funds to open the long stock position. The trader should price his options according to the rate he will pay to borrow funds. Conversely, a trader trading a reversal should consider the fact that he is shorting the stock and will receive interest at the rate of the short-stock rebate. This trader should price his options at the short-stock rate. A Call Is a Put The idea that “a put is a call, a call is a put” is an important one, indeed. It lays the foundation for more advanced spreading strategies. The concepts in this chapter in one way or another enter into every spread strategy that will be discussed in this book from here on out. Note 1 . Note, for simplicity, simple interest is used in the computation. CHAPTER 7 Rho Interest is one of the six inputs of an option-pricing model for American options. Although interest rates can remain constant for long periods, when interest rates do change, call and put values can be positively or negatively affected. Some options are more sensitive to changes in the interest rate than others. To the unaware trader, interest-rate changes can lead to unexpected profits or losses. But interest rates don’t have to be a wild-card risk. They’re one that experienced traders watch closely to avoid unnecessary risk and increase profitability. To monitor the effect of changes in the interest rate, it is important to understand the quiet greek—rho. Rho and Interest Rates Rho is a measurement of the sensitivity of an option’s value to a change in the interest rate. To understand how and why the interest rate is important to the value of an option, recall the formula for put-call parity stated in Chapter 6. Call + Strike − Interest = Put + Stock 1 From this formula, it’s clear that as the interest rate rises, put prices must fall and call prices must rise to keep put-call parity balanced. With a little algebra, the equation can be restated to better illustrate this concept: and If interest rates fall, and Rho helps quantify this relationship. Calls have positive rho, and puts have negative rho. For example, a call with a rho of +0.08 will gain $0.08 with each one-percentage-point rise in interest rates and fall $0.08 with each one-percentage-point fall in interest rates. A put with a rho of −0.08 will lose $0.08 with each one-point rise and gain $0.08 in value with a one- point fall. The effect of changes in the interest variable of put-call parity on call and put values is contingent on three factors: the strike price, the interest rate, and the number of days until expiration. Interest = Strike×Interest Rate×(Days to Expiration/365) 2 Interest, for our purposes, is a function of the strike price. The higher the strike price, the greater the interest and, consequently the more changes in the interest rate will affect the option. The higher the interest rate is, the higher the interest variable will be. Likewise, the more time to expiration, the greater the effect of interest. Rho measures an option’s sensitivity to the end results of these three influences. To understand how changes in interest affect option prices, consider a typical at-the-money (ATM) conversion on a non-dividend-paying stock. Short 1 May 50 call at 1.92 Long 1 May 50 put at 1.63 Long 100 shares at $50 With 43 days until expiration at a 5 percent interest rate, the interest on the 50 strike will be about $0.29. Put-call parity ensures that this $0.29 shows up in option prices. After rearranging the equation, we get In this example, both options are exactly ATM. There is no intrinsic value. Therefore, the difference between the extrinsic values of the call and the put must equal interest. If one option were in-the-money (ITM), the intrinsic value on the left side of the equation would be offset by the Stock − Strike on the right side. Still, it would be the difference in the time value of the call and put that equals the interest variable. This is shown by the fact that the synthetic stock portion of the conversion is short at $50.29 (call − put + strike). This is $0.29 above the stock price. The synthetic stock equals the Stock + Interest, or Certainly, if the interest rate were higher, the interest on the synthetic stock would be a higher number. At a 6 percent interest rate, the effective short price of the synthetic stock would be about $50.35. The call would be valued at about 1.95, and the put would be 1.60—a net of $0.35. A one-percentage-point rise in the interest rate causes the synthetic stock position to be revalued by $0.06—a $0.03 gain in the call value and a $0.03 decline in the put. Therefore, by definition, the call has a +0.03 rho and the put has a −0.03 rho. Rho and Time The time component of interest has a big impact on the magnitude of an option’s rho, because the greater the number of days until expiration, the greater the interest. Long-term options will be more sensitive to changes in the interest rate and, therefore, have a higher rho. Take a stock trading at about $120 per share. The July, October, and January ATM calls have the following rhos with the interest rate at 5.5 percent. Option Rho July (38-day) 120 calls+0.068 October (130-day) 120 calls+0.226 January (221-day) 120 calls+0.385 If interest rates rise 25 basis points, or a quarter of a percentage point, the July calls with only 38 days until expiration will gain very little: only $0.017 (0.068 × 0.25). The October 120 calls with 130 days until expiration gain more: $0.057 (0.226 × 0.25). The January calls that have 221 days until they expire make $0.096 theoretically (0.385 × 0.25). If all else is held constant, the more time to expiration, the higher the option’s rho, and therefore, the more interest will affect the option’s value. Considering Rho When Planning Trades Just having an opinion on a stock is only half the battle in options trading. Choosing the best way to trade a forecast can make all the difference to the success of a trade. Options give traders choices. And one of the choices a trader has is the month in which to trade. When trading LEAPS—Long- Term Equity AnticiPation Securities—delta, gamma, theta, and vega are important, as always, but rho is also a valuable part of the strategy. LEAPS Options buyers have time working against them. With each passing day, theta erodes the value of their assets. Buying a long-term option, or a LEAPS, helps combat erosion because long-term options can decay at a slower rate. In environments where there is interest rate uncertainty, however, LEAPS traders have to think about more than the rate of decay. Consider two traders: Jason and Susanne. Both are bullish on XYZ Corp. (XYZ), which is trading at $59.95 per share. Jason decides to buy a May 60 call at 1.60, and Susanne buys a LEAPS 60 call at 7.60. In this example, May options have 44 days until expiration, and the LEAPS have 639 days. Both of these trades are bullish, but the traders most likely had slightly different ideas about time, volatility, and interest rates when they decided which option to buy. Exhibit 7.1 compares XYZ short-term at-the-money calls with XYZ LEAPS ATM calls. EXHIBIT 7.1 XYZ short-term call vs. LEAPS call. To begin with, it appears that Susanne was allowing quite a bit of time for her forecast to be realized—almost two years. Jason, however, was looking for short-term price appreciation. Concerns about time decay may have been a motivation for Susanne to choose a long-term option—her theta of 0.01 is half Jason’s, which is 0.02. With only 44 days until expiration, the theta of Jason’s May call will begin to rise sharply as expiration draws near. But the trade-off of lower time decay is lower gamma. At the current stock price, Susanne has a higher delta. If the XYZ stock price rises $2, the gamma of the May call will cause Jason’s delta to creep higher than Susanne’s. At $62, the delta for the May 60s would be about 0.78, whereas the LEAPS 60 call delta is about 0.77. This disparity continues as XYZ moves higher. Perhaps Susanne had implied volatility (IV) on her mind as well as time decay. These long-term ATM LEAPS options have vegas more than three times the corresponding May’s. If IV for both the May and the LEAPS is at a yearly low, LEAPS might be a better buy. A one- or two-point rise in volatility if IV reverts to its normal level will benefit the LEAPS call much more than the May. Theta, delta, gamma, and vega are typical considerations with most trades. Because this option is long term, in addition to these typical considerations, Susanne needs to take a good hard look at rho. The LEAPS rho is significantly higher than that of its short-term counterpart. A one- percentage-point change in the interest rate will change Susanne’s P&(L) by $0.64—that’s about 8.5 percent of the value of her option—and she has nearly two years of exposure to interest rate fluctuations. Certainly, when the Federal Reserve Board has great concerns about growth or inflation, rates can rise or fall by more than one percentage point in one year’s time. It is important to understand that, like the other greeks, rho is a snapshot at a particular price, volatility level, interest rate, and moment in time. If interest rates were to fall by one percentage point today, it would cause Susanne’s call to decline in value by $0.64. If that rate drop occurred over the life of the option, it would have a much smaller effect. Why? Rate changes closer to expiration have less of an effect on option values. Assume that on the trade date, when the LEAPS has 639 days until expiration, interest rates fall by 25 basis points. The effect will be a decline in the value of the call of 0.16—one-fourth of the 0.638 rho. If the next rate cut occurs six months later, the rho of the LEAPS will be smaller, because it will have less time until expiration. In this case, after six months, the rho will be only 0.46. Another 25-basis-point drop will hurt the call by $0.115. After another six months, the option will have a 0.26 rho. Another quarter- point cut costs Susanne only $0.065. Any subsequent rate cuts in ensuing months will have almost no effect on the now short-term option value. Pricing in Interest Rate Moves In the same way that volatility can get priced in to an option’s value, so can the interest rate. When interest rates are expected to rise or fall, those expectations can be reflected in the prices of options. Say current interest rates are at 8 percent, but the Fed has announced that the economy is growing at too fast of a pace and that it may raise interest rates at the next Federal Open Market Committee meeting. Analysts expect more rate hikes to follow. The options with expiration dates falling after the date of the expected rate hikes will have higher interest rates priced in. In this situation, the higher interest rates in the longer-dated options will be evident when entering parameters into the model. Take options on Already Been Chewed Bubblegum Corp. (ABC). A trader, Kyle, enters parameters into the model for ABC options and notices that the prices don’t line up. To get the theoretical values of the ATM calls for all the expiration months to sit in the middle of the actual market values, Kyle may have to tinker with the interest rate inputs. Assume the following markets for the ATM 70-strike calls in ABC options: Calls Puts Aug 70 calls1.75–1.851.30–1.40 Sep 70 calls2.65–2.751.75–1.85 Dec 70 calls4.70–4.902.35–2.45 Mar 70 calls6.50–6.702.65–2.75 ABC is at $70 a share, has a 20 percent IV in all months, and pays no dividend. August expiration is one month away. Entering the known inputs for strike price, stock price, time to expiration, volatility, and dividend and using an 8 percent interest rate yields the following theoretical values for ABC options: The theoretical values, in bold type, are those that don’t line up in the middle of the call and put markets. These values are wrong. The call theoretical values are too low, and the put theoretical values are too high. They are the product of an interest rate that is too low being applied to the model. To generate values that are indicative of market prices, Kyle must change the interest input to the pricing model to reflect the market’s expectations of future interest rate changes. Using new values for the interest rate yields the following new values: After recalculating, the theoretical values line up in the middle of the call and put markets. Using higher interest rates for the longer expirations raises the call values and lowers the put values for these months. These interest rates were inferred from, or backed out of, the option-market prices by use of the option-pricing model. In practice, it may take some trial and error to find the correct interest values to use. In times of interest rate uncertainty, rho can be an important factor in determining which strategy to select. When rates are generally expected to continue to rise or fall over time, they are normally priced in to the options, as shown in the previous example. When there is no consensus among analysts and traders, the rates that are priced in may change as economic data are made available. This can cause a revision of option values. In long- term options that have higher rhos, this is a bona fide risk. Short-term options are a safer play in this environment. But as all traders know, risk also implies opportunity. Trading Rho While it’s possible to trade rho, most traders forgo this niche for more dynamic strategies with greater profitability. The effects of rho are often overshadowed by the more profound effects of the other greeks. The opportunity to profit from rho is outweighed by other risks. For most traders, rho is hardly ever even looked at. Because LEAPS have higher rho values than corresponding short-term options, it makes sense that these instruments would be appropriate for interest-rate plays. But even with LEAPS, rho exposure usually pales in comparison with that of delta, theta, and vega. It is not uncommon for the rho of a long-term option to be 5 to 8 percent of the option’s value. For example, Exhibit 7.2 shows a two-year LEAPS on a $70 stock with the following pricing-model inputs and outputs: EXHIBIT 7.2 Long 70-strike LEAPS call. The rho is +0.793, or about 5.8 percent of the call value. That means a 25- basis-point rise in rates contributes to only a 20-cent profit on the call. That’s only about 1.5 percent of the call’s value. On one hand, 1.5 percent is not a very big profit on a trade. On the other hand, if there are more rate rises at following Fed meetings, the trader can expect further gains on rho. Even if the trader is compelled to wait until the next Fed meeting to make another $0.20—or less, as rho will get smaller as time passes—from a second 25-basis-point rate increase, other influences will diminish rho’s significance. If over the six-week period between Fed meetings, the underlying declines by just $0.60, the $0.40 that the trader hoped to make on rho is wiped out by delta loss. With the share price $0.60 lower, the 0.760 delta costs the trade about $0.46. Furthermore, the passing of six weeks (42 days) will lead to a loss of about $0.55 from time decay because of the −0.013 theta. There is also the risk from the fat vegas associated with LEAPS. A 1.5 percent drop in implied volatility completely negates any hopes of rho profits. Aside from the possibility that delta, theta, and vega may get in the way of profits, the bid-ask spread with these long-term options tends to be wider than with their short-term counterparts. If the bid-ask spread is more than $0.40 wide, which is often the case with LEAPS, rho profits are canceled out by this cost of doing business. Buying the offer and selling the bid negative scalps away potential profits. With LEAPS, rho is always a concern. It will contribute to prosperity or peril and needs to be part of the trade plan from forecast to implementation. Buying or selling a LEAPS call or put, however, is not a practical way to speculate on interest rates. To take a position on interest rates in the options market, risk needs to be distilled down to rho. The other greeks need to be spread off. This is accomplished only through the conversions, reversals, and jelly rolls described in Chapter 6. However, the bid-ask can still be a hurdle to trading these strategies for non–market makers. Generally, rho is a greek that for most traders is important to understand but not practical to trade. Notes 1 . Please note, for simplification, dividends are not included. 2 . Note, for simplicity, simple interest is used in the calculation. CHAPTER 8 Dividends and Option Pricing Much of this book studies how to break down and trade certain components of option prices. This chapter examines the role of dividends in the pricing structure. There is no greek symbol that measures an option’s sensitivity to changes in the dividend. And in most cases, dividends are not “traded” by means of options in the same way that volatility, interest, and other option price influences are. Dividends do, though, affect option prices, and therefore a trader’s P&(L), so they deserve attention. There are some instances where dividends provide ample opportunity to the option trader, and there some instances where a change in dividend policy can have desirable, or undesirable, effects on the bottom line. Despite the fact that dividends do not technically involve greeks, they need to be monitored in much the same way as do delta, gamma, theta, vega, and rho. Dividend Basics Let’s start at the beginning. When a company decides to pay a dividend, there are four important dates the trader must be aware of: 1. Declaration date 2. Ex-dividend date 3. Record date 4. Payable date The first date chronologically is the declaration date. This date is when the company formally declares the dividend. It’s when the company lets its shareholders know when and in what amount it will pay the dividend. Active traders, however, may buy and sell the same stock over and over again. How does the corporation know exactly who collects the dividend when it is opening up its coffers? Dividends are paid to shareholders of record who are on the company’s books as owning the stock at the opening of business on another important date: the record date. Anyone long the stock at this moment is entitled to the dividend. Anyone with a short stock position on the opening bell on the record date is required to make payment in the amount of the dividend. Because the process of stock settlement takes time, the important date is actually not the record date. For all intents and purposes, the key date is two days before the record date. This is called the ex-dividend date, or the ex- date. Traders who have earned a dividend by holding a stock in their account on the morning of the ex-date have one more important date they need to know—the date they get paid. The date that the dividend is actually paid is called the payable date. The payable date can be a few weeks after the ex- date. Let’s walk through an example. ABC Corporation announces on March 21 (the declaration date) that it will pay a 25-cent dividend to shareholders of record on April 3 (the record date), payable on April 23 (the payable date). This means market participants wishing to receive the dividend must own the stock on the open on April 1 (the ex-date). In practice, they must buy the stock before the closing bell rings on March 31 in order to have it for the open the next day. This presents a potential quandary. If a trader only needs to have the stock on the open on the ex-date, why not buy the stock just before the close on the day before the ex-date, in this case March 31, and sell it the next morning after the open? Could this be an opportunity for riskless profit? Unfortunately, no. There are a couple of problems with that strategy. First, as far as the riskless part is concerned, stock prices can and often do change overnight. Yesterday’s close and today’s open can sometimes be significantly different. When they are, it is referred to as a gap open. Whenever a stock is held (long or short), there is risk. The second problem with this strategy to earn riskless profit is with the profit part. On the ex- date, the opening stock price reflects the dividend. Say ABC is trading at $50 at the close on March 31. If the market for the stock opens unchanged the next morning—that is, a zero net change on the day on—ABC will be trading at $49.75 ($50 minus the $0.25 dividend). Alas, the quest for riskless profit continues. Dividends and Option Pricing The preceding discussion demonstrated how dividends affect stock traders. There’s one problem: we’re option traders! Option holders or writers do not receive or pay dividends, but that doesn’t mean dividends aren’t relevant to the pricing of these securities. Observe the behavior of a conversion or a reversal before and after an ex-dividend date. Assuming the stock opens unchanged on the ex-date, the relationship of the price of the synthetic stock to the actual stock price will change. Let’s look at an example to explore why. At the close on the day before the ex-date of a stock paying a $0.25 dividend, a trader has an at-the-money (ATM) conversion. The stock is trading right at $50 per share. The 50 puts are worth 2.34, and the 50 calls are worth 2.48. Before the ex-date, the trader is Long 100 shares at $50 Long one 50 put at 2.34 Short one 50 call at 2.48 Here, the trader is long the stock at $50 and short stock synthetically at $50.14—50 + (2.48 − 2.34). The trader is synthetically short $0.14 over the price at which he is long the stock. Assume that the next morning the stock opens unchanged. Since this is the ex-date, that means the stock opens at $49.75—$0.25 lower than the previous day’s close. The theoretical values of the options will change very little. The options will be something like 2.32 for the put and 2.46 for the call. After the ex-date, the trader is Long 100 shares at $49.75 Long one 50 put at 2.32 Short one 50 call at 2.46 Each option is two cents lower. Why? The change in the option prices is due to theta. In this case, it’s $0.02 for each option. The synthetic stock is still short from an effective price of $50.14. With the stock at $49.75, the synthetic short price is now $0.39 over the stock. Incidentally, $0.39 is $0.25 more than the $0.14 difference before the ex-date. Did the trader who held the conversion overnight from before the ex-date to after it make or lose money? Neither. Before the ex-date, he had an asset worth $50 per share (the stock) and he shorted the asset synthetically at $50.14. After the ex-date, he still has assets totaling $50 per share—the stock at $49.75 plus the 0.25 dividend—and he is still synthetically short the stock at $50.14. Before the ex-date, the $0.14 difference between the synthetic and the stock is interest minus the dividend. After the ex-date, the $0.39 difference is all interest. Dividends and Early Exercise As the ex-date approaches, in-the-money (ITM) calls on equity options can often be found trading at parity, regardless of the dividend amount and regardless of how far off expiration is. This seems counterintuitive. What about interest? What about dividends? Normally, these come into play in option valuation. But option models designed for American options take the possibility of early exercise into account. It is possible to exercise American-style calls and exchange them for the underlying stock. This would give traders, now stockholders, the right to the dividend—a right for which they would not be eligible as call holders. Because of the impending dividend, the call becomes an exercise just before the ex-date. For this reason, the call can trade for parity before the ex-date. Let’s look at an example of a reversal on a $70 stock that pays a $0.40 dividend. The options in this reversal have 24 days until expiration, which makes the interest on the 60 strike roughly $0.20, given a 5 percent interest rate. The day before the ex-date, a trader has the following position at the stated prices: Short 100 shares at $70 Long one 60 call at 10.00 Short one 60 put at 0.05 To understand how American calls work just before the ex-date, it is helpful first to consider what happens if the trader holds the position until the ex-date. Making the assumption that the stock is unchanged on the ex- dividend date, it will open at $69.60, lower by the amount of the dividend— in this case, $0.40. The put, being so far out-of-the-money (OTM) as to have a negligible delta, will remain unchanged. But what about the call? With no dividend left in the stock, the put call-parity states In this case, Before the ex-date, the model valued the call at parity. Now it values the same call at $0.25 over parity (9.85 − [69.60 − 60]). Another way to look at this is that the time value of the call is now made up of the interest plus the put premium. Either way, that’s a gain of $0.25 on the call. That sounds good, but because the trader is short stock, if he hasn’t exercised, he will owe the $0.40 dividend—a net loss of $0.15. The new position will be Short 100 shares at $69.60 Owe $0.40 dividend Long one 60 call at 9.85 Short one 60 put at 0.05 At the end of the trading day before the ex-date, this trader must exercise the call to capture the dividend. By doing so, he closes two legs of the trade —the call and the stock. The $10 call premium is forfeited, the stock that is short at $70 is bought at $60 (from the call exercise) for a $10 profit. The transaction leads to neither a profit nor a loss. The purpose of exercising is to avoid the $0.15 loss ($0.25 gain in call time value minus the $0.40 loss in dividends owed). The other way the trader could achieve the same ends is to sell the long call and buy in the short stock. This is tactically undesirable because the trader may have to sell the bid in the call and buy the offer in the stock. Furthermore, when legging a trade in this manner, there is the risk of slippage. If the call is sold first, the stock can move before the trader has a chance to buy it at the necessary price. It is generally better and less risky to exercise the call rather than leg out of the trade. In this transaction, the trader begins with a fairly flat position (short stock/long synthetic stock) and ends with a short put that is significantly out-of-the-money. For all intents and purposes, exercising the call in this trade is like synthetically selling the put. But at what price? In this case, it’s $0.15. This again is the cost benefit of saving $0.40 by avoiding the dividend obligation versus the $0.25 gain in call time value. Exercising the call is effectively like selling the put at 0.15 in this example. If the dividend is lower or the interest is higher, it may not be worth it to the trader to exercise the call to capture the dividend. How do traders know if their calls should be exercised? The traders must do the math before each ex-dividend date in option classes they trade. The traders have to determine if the benefit from exercising—or the price at which the synthetic put is essentially being sold —is more or less than the price at which they can sell the put. The math used here is adopted from put-call parity: This shows the case where the traders can effectively synthetically sell the put (by exercising) for more than the current put value. Tactically, it’s appropriate to use the bid price for the put in this calculation since that is the price at which the put can be sold. In this case, the traders would be inclined to not exercise. It would be theoretically more beneficial to sell the put if the trader is so inclined. Here, the traders, from a valuation perspective, are indifferent as to whether or not to exercise. The question then is simply: do they want to sell the put at this price? Professionals and big retail traders who are long (ITM) calls—whether as part of a reversal, part of another type of spread, or because they are long the calls outright—must do this math the day before each ex-dividend date to maximize profits and minimize losses. Not exercising, or forgetting to exercise, can be a costly mistake. Traders who are short ITM dividend- paying calls, however, can reap the benefits of those sleeping on the job. It works both ways. Traders who are long stock and short calls at parity before the ex-date may stand to benefit if some of the calls do not get assigned. Any shares of long stock remaining on the ex-date will result in the traders receiving dividends. If the dividends that will be received are greater in value than the interest that will subsequently be paid on the long stock, the traders may stand reap an arbitrage profit because of long call holders’ forgetting to exercise. Dividend Plays The day before an ex-dividend date in a stock, option volume can be unusually high. Tens of thousands of contracts sometimes trade in names that usually have average daily volumes of only a couple thousand. This spike in volume often has nothing to do with the market’s opinion on direction after the dividend. The heavy trading has to do with the revaluation of the relationship of exercisable options to the underlying expected to occur on the ex-dividend date. Traders that are long ITM calls and short ITM calls at another strike just before an ex-dividend date have a potential liability and a potential benefit. The potential liability is that they can forget to exercise. This is a liability over which the traders have complete control. The potential benefit is that some of the short calls may not get assigned. If traders on the other side of the short calls (the longs) forget to exercise, the traders that are short the call make out by not having to pay the dividend on short stock. Professionals and big retail traders who have very low transaction costs will sometimes trade ITM call spreads during the afternoon before an ex- dividend date. This consists of buying one call and selling another call with a different strike price. Both calls in the dividend-play strategy are ITM and have corresponding puts with little or no value (to be sure, the put value is less than the dividend minus the interest). The traders trade the spreads, fairly indifferent as to whether they buy or sell the spreads, in hope of skating—or not getting assigned—on some of their short calls. The more they don’t get assigned the better. This usually occurs in options that have high open interest, meaning there are a lot of outstanding contracts already. The more contracts in existence, the better the possibility of someone forgetting to exercise. The greatest volume also tends to occur in the front month. Strange Deltas Because American calls become an exercise possibility when the ex-date is imminent, the deltas can sometimes look odd. When the calls are trading at parity, they have a 1.00 delta. They are a substitute for the stock. They, in fact, will be stock if and when they are exercised just before the ex-date. But if the puts still have some residual time value, they may also have a small delta, of 0.05 or perhaps more. In this unique scenario, the delta of the synthetic can be greater than +1.00 or less than −1.00. It is not uncommon to see the absolute values of the call and put deltas add up to 1.07 or 1.08. When the dividend comes out of the options model on the ex-date, synthetics go back to normal. The delta of the synthetic again approaches 1.00. Because of the out-of-whack deltas, delta-neutral traders need to take extra caution in their analytics when ex- dates are near. A little common sense should override what the computer spits out. Inputting Dividend Data into the Pricing Model Often dividend payments are regular and predictable. With many companies, the dividend remains constant quarter after quarter. Some corporations have a track record of incrementally increasing their dividends every year. Some companies pay dividends in a very irregular fashion, by paying special dividends that are often announced as a surprise to investors. In a truly capitalist society, there are no restrictions and no rules on when, whether, or how corporations pay dividends to their shareholders. Unpredictability of dividends, though, can create problems in options valuation. When a company has a constant, reasonably predictable dividend, there is not a lot of guesswork. Take Exelon Corp. (EXC). From November 2008 to the time of this writing, Exelon has paid a regular quarterly dividend of $0.525. During that period, a trader has needed simply to enter 0.525 into the pricing calculator for all expected future dividends to generate the theoretical value. Based on recent past performance, the trader could feel confident that the computed analytics were reasonably accurate. If the trader believed the company would continue its current dividend policy, there would be little options-related dividend risk—unless things changed. When there is uncertainty about when future dividends will be paid in what amounts, the level of dividend-related risk begins to increase. The more uncertainty, the more risk. Let’s examine an interesting case study: General Electric (GE). For a long time, GE was a company that has had a history of increasing its dividends at fairly regular intervals. In fact, there was more than a 30- year stretch in which GE increased its dividend every year. During most of the first decade of the 2000s, increases in GE’s dividend payments were around one to six cents and tended to occur toward the end of December, after December expiration. The dividends were paid four times per year but not exactly quarterly. For several years, the ex-dates were in February, June, September, and December. Option traders trading GE options had a pretty easy time estimating their future dividend streams, and consequently evaded valuation problems that could result from using wrong dividend data. Traders would simply adjust the dividend data in the model to match their expectations for predictably increasing future dividends in order to achieve an accurate theoretical value. Let’s look back at GE to see how a trader might have done this. The following shows dividend-history data for GE. Ex-DateDividend* 12/27/02$0.19 02/26/03$0.19 06/26/03$0.19 09/25/03$0.19 12/29/03$0.20 02/26/04$0.20 06/24/04$0.20 09/23/04$0.20 12/22/04$0.22 02/24/05$0.22 06/23/05$0.22 09/22/05$0.22 12/22/05$0.25 02/23/06$0.25 06/22/06$0.25 09/21/06$0.25 12/21/06$0.28 02/22/07$0.28 06/21/07$0.28 * These data are taken from the following Web page on GE’s web site: www.ge.com/investors/stock_info/dividend_history.html . At the end of 2006, GE raised its dividend from $0.25 to $0.28. A trader trading GE options at the beginning of 2007 would have logically anticipated the next increase to occur again in the following December unless there was reason to believe otherwise. Options expiring before this anticipated next dividend increase would have the $0.28 dividend priced into their values. Options expiring after December 2007 would have a higher dividend priced into them—possibly an additional three cents to 0.31 (which indeed it was). Calls would be adversely affected by this increase, and puts would be favorably affected. A typical trader would have anticipated those changes. The dividend data a trader pricing GE options would have entered into the model in January 2007 would have looked something like this. Ex-DateDividend* 02/22/07$0.28 06/21/07$0.28 09/20/07$0.28 12/20/07$0.31 02/21/08$0.31 06/19/08$0.31 09/18/08$0.31 * These data are taken from the following Web page on GE’s web site: www.ge.com/investors/stock_info/dividend_history.html . The trader would have entered the anticipated future dividend amount in conjunction with the anticipated ex-dividend date. This trader projection goes out to February 2008, which would aid in valuing options expiring in 2007 as well as the 2008 LEAPS. Because the declaration dates had yet to occur, one could not know with certainty when the dividends would be announced or in what amount. Certainly, there would be some estimation involved for both the dates and the amount. But traders would probably get it pretty close—close enough. Then, something particularly interesting happened. Instead of raising the dividend going into December 2008 as would be a normal pattern, GE kept it the same. As shown, the 12/24/08 ex-dated dividend remained $0.31. Ex-DateDividend* 02/22/07$0.28 06/21/07$0.28 09/20/07$0.28 12/20/07$0.31 02/21/08$0.31 06/19/08$0.31 09/18/08$0.31 12/24/08$0.31 * These data are taken from the following Web page on GE’s web site: www.ge.com/investors/stock_info/dividend_history.html . The dividend stayed at $0.31 until the June 2009 dividend, which held another jolt for traders pricing options. Around this time, GE’s stock price had taken a beating. It fell from around $42 a share in the fall of 2007 ultimately to about $6 in March 2009. GE had its first dividend cut in more than three decades. The dividend with the ex-date of 06/18/09 was $0.10. 12/24/08$0.31 02/19/09$0.31 06/18/09$0.10 09/17/09$0.10 12/23/09$0.10 02/25/10$0.10 06/17/10$0.10 09/16/10$0.12 12/22/10$0.14 02/24/11$0.14 06/16/11$0.15 09/15/11$0.15 Though the company gave warnings in advance, the drastic dividend change had a significant impact on option prices. Call prices were helped by the dividend cut (or anticipated dividend cut) and put prices were hurt. The break in the pattern didn’t stop there. The dividend policy remained $0.10 for five quarters until it rose to $0.12 in September 2010, then to $0.14 in December 2010, then to $0.15 in June 2011. These irregular changes in the historically predictable dividend policy made it tougher for traders to attain accurate valuations. If the incremental changes were bigger, the problem would have been even greater. Good and Bad Dates with Models Using an incorrect date for the ex-date in option pricing can lead to unfavorable results. If the ex-dividend date is not known because it has yet to be declared, it must be estimated and adjusted as need be after it is formally announced. Traders note past dividend history and estimate the expected dividend stream accordingly. Once the dividend is declared, the ex-date is known and can be entered properly into the pricing model. Not executing due diligence to find correct known ex-dates can lead to trouble. Using a bad date in the model can yield dubious theoretical values that can be misleading or worse—especially around the expiration. Say a call is trading at 2.30 the day before the ex-date of a $0.25 dividend, which happens to be thirty days before expiration. The next day, of course, the stock may have moved higher or lower. Assume for illustrative purposes, to compare apples to apples as it were, that the stock is trading at the same price—in this case, $76. If the trader is using the correct date in the model, the option value will adjust to take into account the effect of the dividend expiring, or reaching its ex-date, when the number of days to expiration left changes from 30 to 29. The call trading postdividend will be worth more relative to the same stock price. If the dividend date the trader is using in the model is wrong, say one day later than it should be, the dividend will still be an input of the theoretical value. The calculated value will be too low. It will be wrong. Exhibit 8.1 compares the values of a 30-day call on the ex-date given the right and the wrong dividend. EXHIBIT 8.1 Comparison of 30-day call values At the same stock price of $76 per share, the call is worth $0.13 more after the dividend is taken out of the valuation. Barring any changes in implied volatility (IV) or the interest rate, the market prices of the options should reflect this change. A trader using an ex-date in the model that is farther in the future than the actual ex-date will still have the dividend as part of the generated theoretical value. With the ex-date just one day later, the call would be worth 2.27. The difference in option value is due to the effect of theta—in this case, $0.03. With a bad date, the value of 2.27 would likely be significantly below market price, causing the market value of the option to look more expensive than it actually is. If the trader did not know the date was wrong, he would need to raise IV to make the theoretical value match the market. This option has a vega of 0.08, which translates into a difference of about two IV points for the theoretical values 2.43 and 2.27. The trader would perceive the call to be trading at an IV two points higher than the market indicates. Dividend Size It’s not just the date but also the size of the dividend that matters. When companies change the amount of the dividend, options prices follow in step. In 2004, when Microsoft (MSFT) paid a special dividend of $3 per share, there were unexpected winners and losers in the Microsoft options. Traders who were long calls or short puts were adversely affected by this change in dividend policy. Traders with short calls or long puts benefited. With long- term options, even less anomalous changes in the size of the dividend can have dramatic effects on options values. Let’s study an example of how an unexpected rise in the quarterly dividend of a stock affects a long call position. Extremely Yellow Zebra Corp. (XYZ) has been paying a quarterly dividend of $0.10. After a steady rise in stock price to $61 per share, XYZ declares a dividend payment of $0.50. It is expected that the company will continue to pay $0.50 per quarter. A trader, James, owns the 528-day 60-strike calls, which were trading at 9.80 before the dividend increase was announced. Exhibit 8.2 compares the values of the long-term call using a $0.10 quarterly dividend and using a $0.50 quarterly dividend. EXHIBIT 8.2 Effect of change in quarterly dividend on call value. This $0.40 dividend increase will have a big effect on James’s calls. With 528 days until expiration, there will be six dividends involved. Because James is long the calls, he loses 1.52 per option. If, however, he were short the calls, 1.52 would be his profit on each option. Put traders are affected as well. Another trader, Marty, is long the 60- strike XYZ puts. Before the dividend announcement, Marty was running his values with a $0.10 dividend, giving his puts a value of 5.42. Exhibit 8.3 compares the values of the puts with a $0.10 quarterly dividend and with a $0.50 quarterly dividend. EXHIBIT 8.3 Effect of change in quarterly dividend on put value. When the dividend increase is announced, Marty will benefit. His puts will rise because of the higher dividend by $0.66 (all other parameters held constant). His long-term puts with six quarters of future expected dividends will benefit more than short-term XYZ puts of the same strike would. Of course, if he were short the puts, he would lose this amount. The dividend inputs to a pricing model are best guesses until the dates and amounts are announced by the company. How does one find dividend information? Regularly monitoring the news and press releases on the companies one trades is a good way to stay up to date on dividend information, as well as other company news. Dividend announcements are widely disseminated by the major news services. Most companies also have an investor-relations phone number and section on their web sites where dividend information can be found. PART II Spreads CHAPTER 9 Vertical Spreads Risk—it is the focal point around which all trading revolves. It may seem as if profit should be occupying this seat, as most important to trading options, but without risk, there would be no profit! As traders, we must always look for ways to mitigate, eliminate, preempt, and simply avoid as much risk as possible in our pursuit of success without diluting opportunity. Risk must be controlled. Trading vertical spreads takes us one step further in this quest. The basic strategies discussed in Chapters 4 and 5 have strengths when compared with pure linear trading in the equity markets. But they have weaknesses, too. Consider the covered call, one of the most popular option strategies. A covered call is best used as an augmentation to an investment plan. It can be used to generate income on an investment holding, as an entrance strategy into a stock, or as an exit strategy out of a stock. But from a trading perspective, one can often find better ways to trade such a forecast. If the forecast on a stock is neutral to moderately bullish, accepting the risk of stock ownership is often unwise. There is always the chance that the stock could collapse. In many cases, this is an unreasonable risk to assume. To some extent, we can make the same case for the long call, short put, naked call, and the like. In certain scenarios, each of these basic strategies is accompanied with unwanted risks that serve no beneficial purpose to the trader but can potentially cause harm. In many situations, a vertical spread is a better alternative to these basic spreads. Vertical spreads allow a trader to limit potential directional risk, limit theta and vega risk, free up margin, and generally manage capital more efficiently. Vertical Spreads Vertical spreads involve buying one option and selling another. Both are on the same underlying and expire the same month, and both are either calls or puts. The difference is in the strike prices of the two options. One is higher than the other, hence the name vertical spread . There are four vertical spreads: bull call spread, bear call spread, bear put spread, and bull put spread. These four spreads can be sliced and diced into categories a number of ways: call spreads and put spreads, bull spreads and bear spreads, debit spreads and credit spreads. There is overlap among the four verticals in how and when they are used. The end of this chapter will discuss how the spreads are interrelated. Bull Call Spread A bull call spread is a long call combined with a short call that has a higher strike price. Both calls are on the same underlying and share the same expiration month. Because the purchased call has a lower strike price, it costs more than the call being sold. Establishing the trade results in a debit to the trader’s account. Because of this debit, it’s called a debit spread. Below is an example of a bull call spread on Apple Inc. (AAPL): In this example, Apple is trading around $391. With 40 days until February expiration, the trader buys the 395–405 call spread for a net debit of $4.40, or $440 in actual cash. Or one could simply say the trader paid $4.40 for the 395–405 call. Consider the possible outcomes if the spread is held until expiration. Exhibit 9.1 shows an at-expiration diagram of the bull call spread. EXHIBIT 9.1 AAPL bull call spread. Before discussing the greeks, consider the bull call spread from an at- expiration perspective. Unlike the long call, which has two possible outcomes at expiration—above or below the strike—this spread has three possibilities: below both strikes, between the strikes, or above both strikes. In this example, if Apple is below $395 at expiration, both calls expire worthless. The rights and obligations of the options are gone, as is the cash spent on the trade. In this case, the entire debit of $4.40 is lost. If Apple is between the strikes at expiration, the 405-strike call expires worthless. The trader is long stock at an effective price of $399.40. This is the $395-strike price at which the stock would be purchased if the call is exercised, plus the $4.40 premium spent on the spread. The break-even price of the trade is $399.40. If Apple is above $399.40 at expiration, the trade is profitable; below $399.40, it is a loser. The aptly named bull call spread requires the stock to rise to reach its profit potential. But unlike an outright long call, profits are capped with the spread. If Apple is above $405 at expiration, both calls are in-the-money (ITM). If the 395-strike calls are exercised, the trader buys 100 shares of Apple at $395 and these shares, in turn, would be sold at $405 when the 405-strike calls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40 debit spent on the trade and the net profit is $5.60 per share. There are some other differences between the 395–405 call spread and the outright purchase of the 395 call. The absolute risk is lower. To buy the 395-strike call costs 14.60, versus 4.40 for the spread—a big difference. Because the debit is lower, the margin for the spread is lower at most option-friendly brokers, as well. If we dig a little deeper, we find some other differences between the bull call spread and the outright call. Long options are haunted by the specter of time. Because the spread involves both a long and a short option, the time- decay risk is lower than that associated with owning an option outright. Implied volatility (IV) risk is lower, too. Exhibit 9.2 compares the greeks of the long 395 call with those of the 395–405 call spread. EXHIBIT 9.2 Apple call versus bull call spread (Apple @ $391). 395 Call395–405 Call Delta 0.484 0.100 Gamma0.00970.0001 Theta −0.208−0.014 Vega 0.513 0.020 The positive deltas indicate that both positions are bullish, but the outright call has a higher delta. Some of the 395 call’s directional sensitivity is lost when the 405 call is sold to make a spread. The negative delta of the 405 call somewhat offsets the positive delta of the 395 call. The spread delta is only about 20 percent of the outright call’s delta. But for a trader wanting to focus on trading direction, the smaller delta can be a small sacrifice for the benefit of significantly reduced theta and vega. Theta spread’s risk is about 7 percent that of the outright. The spread’s vega risk is also less than 4 percent that of the outright 395 call. With the bull call spread, a trader can spread off much of the exposure to the unwanted risks and maintain a disproportionately higher greeks in the wanted exposure (delta). These relationships change as the underlying moves higher. Remember, at-the-money (ATM) options have the greatest sensitivity to theta and vega. With Apple sitting at around the long strike, gamma and vega have their greatest positive value, and theta has its most negative value. Exhibit 9.3 shows the spread greeks given other underlying prices. EXHIBIT 9.3 AAPL 395–405 bull call spread. As the stock moves higher toward the 405 strike, the 395 call begins to move away from being at-the-money, and the 405 call moves toward being at-the-money. The at-the-money is the dominant strike when it comes to the characteristics of the spread greeks. Note the greeks position when the underlying is directly between the two strike prices: The long call has ceased to be the dominant influence on these metrics. Both calls influence the analytics pretty evenly. The time-decay risk has been entirely spread off. The volatility risk is mostly spread off. Gamma remains a minimal concern. When the greeks of the two calls balance each other, the result is a directional play. As AAPL continues to move closer to the 405-strike, it becomes the at- the-money option, with the dominant greeks. The gamma, theta, and vega of the 405 call outweigh those of the ITM 395 call. Vega is more negative. Positive theta now benefits the trade. The net gamma of the spread has turned negative. Because of the negative gamma, the delta has become smaller than it was when the stock was at $400. This means that the benefit of subsequent upward moves in the stock begins to wane. Recall that there is a maximum profit threshold with a vertical spread. As the stock rises beyond $405, negative gamma makes the delta smaller and time decay becomes less beneficial. But at this point, the delta has done its work for the trader who bought this spread when the stock was trading around $395. The average delta on a move in the stock from $395 to $405 is about 0.10 in this case. When the stock is at the 405 strike, the characteristics of the trade are much different than they are when the stock is at the 395 strike. Instead of needing movement upward in the direction of the delta to combat the time decay of the long calls, the position can now sit tight at the short strike and reap the benefits of option decay. The key with this spread, and with all vertical spreads, is that the stock needs to move in the direction of the delta to the short strike. Strengths and Limitations There are many instances when a bull call spread is superior to other bullish strategies, such as a long call, and there are times when it isn’t. Traders must consider both price and time. A bull call spread will always be cheaper than the outright call purchase. That’s because the cost of the long-call portion of the spread is partially offset by the premium of the higher-strike short call. Spending less for the same exposure is always a better choice, but the exposure of the vertical is not exactly the same as that of the long call. The most obvious trade-off is the fact that profit is limited. For smaller moves—up to the price of the short strike—vertical spreads tend to be better trades than outright call purchases. Beyond the strike? Not so much. But time is a trade-off, too. There have been countless times that I have talked with new traders who bought a call because they thought the stock was going up. They were right and still lost money. As the adage goes, timing is everything. The more time that passes, the more advantageous the lower-theta vertical spread becomes. When held until expiration, a vertical spread can be a better trade than an outright call in terms of percentage profit. In the previous example, when Apple is at $391 with 40 days until expiration, the 395 call is worth 14.60 and the spread is worth 4.40. If Apple were to rise to be trading at $405 at expiration, the call rises to be worth 10, for a loss of 4.60 on the 14.60 debit paid. The spread also is worth 10. It yields a gain of about 127 percent on the initial $4.40 per share debit. But look at this same trade if the move occurs before expiration. If Apple rallies to $405 after only a couple weeks, the outcome is much different. With four weeks still left until expiration, the 395 call is worth 19.85 with the underlying at $405. That’s a 36 percent gain on the 14.60. The spread is worth 5.70. That’s a 30 percent gain. The vertical spread must be held until expiration to reap the full benefits, which it accomplishes through erosion of the short option. The long-call-only play (with a significantly larger negative theta) is punished severely by time passing. The long call benefits more from a quick move in the underlying. And of course, if the stock were to rise to a price greater than $405, in a short amount of time—the best of both worlds for the outright call—the outright long 395 call would be emphatically superior to the spread. Bear Call Spread The next type of vertical spread is called a bear call spread . A bear call spread is a short call combined with a long call that has a higher strike price. Both calls are on the same underlying and share the same expiration month. In this case, the call being sold is the option of higher value. This call spread results in a net credit when the trade is put on and, therefore, is called a credit spread. The bull call spread and the bear call spread are two sides of the same coin. The difference is that with the bull call spread, one is buying the call spread, and with the bear call spread, one is selling the call spread. An example of a bear call spread can be shown using the same trade used earlier. Here we are selling one AAPL February (40-day) 395 call at 14.60 and buying the 405 call at 10.20. We are selling the 395–405 call at $4.40 per share, or $440. Exhibit 9.4 is an at-expiration diagram of the trade. EXHIBIT 9.4 Apple bear call spread. The same three at-expiration outcomes are possible here as with the bull call spread: the stock can be above both strikes, between both strikes, or below both strikes. If the stock is below both strikes at expiration, both calls will expire worthless. The rights and obligations cease to exist. In this case, the entire credit of $440 is profit. If AAPL is between the two strike prices at expiration, the 395-strike call will be in-the-money. The short call will get assigned and result in a short stock position at expiration. The break-even price falls at $399.40—the short strike plus the $4.40 net premium. This is the price at which the stock will effectively be sold if assignment occurs. If Apple is above both strikes at expiration, it means both calls are in-the- money. Stock is sold at $395 because of assignment and bought back at $405 through exercise. This leads to a loss of $10 per share on the negative scalp. Factoring in the $4.40-per-share credit makes the net loss only $5.60 per share with AAPL above $405 at February expiration. Just as the at-expiration diagram is the same but reversed, the greeks for this call spread will be similar to those in the bull call spread example except for the positive and negative signs. See Exhibit 9.5 . EXHIBIT 9.5 Apple 395–405 bear call spread. A credit spread is commonly traded as an income-generating strategy. The idea is simple: sell the option closer-to-the-money and buy the more out-of- the-money (OTM) option—that is, sell volatility—and profit from nonmovement (above a certain point). In this example, with Apple at $391, a neutral to slightly bearish trader would think about selling this spread at 4.40 in hopes that the stock will remain below $395 until expiration. The best-case scenario is that the stock is below $395 at expiration and both options expire, resulting in a $4.40-per-share profit. The strategy profits as long as Apple is under its break-even price, $399.40, at expiration. But this is not so much a bearish strategy as it is a nonbullish strategy. The maximum gain with a credit spread is the premium received, in this case $4.40 per share. Traders who thought AAPL was going to decline sharply would short it or buy a put. If they thought it would rise sharply, they’d use another strategy. From a greek perspective, when the trade is executed it’s very close to its highest theta price point—the 395 short strike price. This position theoretically collects $0.90 a day with Apple at around $395. As time passes, that theta rises. The key is that the stock remains at around $395 until the short option is just about worthless. The name of the game is sit and wait. Although the delta is negative, traders trading this spread to generate income want the spread to expire worthless so they can pocket the $4.40 per share. If Apple declines, profits will be made on delta, and theta profits will be foregone later. All that matters is the break-even point. Essentially, the idea is to sell a naked call with a maximum potential loss. Sell the 395s and buy the 405s for protection. If the underlying decreases enough in the short term and significant profits from delta materialize, it is logical to consider closing the spread early. But it often makes more sense to close part of the spread. Consider that the 405-strike call is farther out-of-the-money and will lose its value before the 395 call. Say that after two weeks a big downward move occurs. Apple is trading at $325 a share; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at 0.55. At this point, the lion’s share of the profits can be taken early. A trader can do so by closing only the 395 calls. Closing the 395s to eliminate the risk of negative delta and gamma makes sense. But does it make sense to close the 405s for 0.05? Usually not. Recouping this residual value accomplishes little. It makes more sense to leave them in your position in case the stock rebounds. If the stock proves it can move down $70; it can certainly move up $70. Because the majority of the profits were taken on the 395 calls, holding on to the 405s is like getting paid to own calls. In scenarios where a big move occurs and most of the profits can be taken early, it’s often best to hold the long calls, just in case. It’s a win-win situation. Credit and Debit Spread Similarities The credit call spread and the debit call spread appear to be exactly opposite in every respect. Many novice traders perceive credit spreads to be fundamentally different from debit spreads. That is not necessarily so. Closer study reveals that these two are not so different after all. What if Apple’s stock price was higher when the trade was put on? What if the stock was at $405? First, the spread would have had more value. The 395 and 405 calls would both be worth more. A trader could have sold the spread for a $5.65-per-share credit. The at-expiration diagram would look almost the same. See Exhibit 9.6 . EXHIBIT 9.6 Apple bear call spread initiated with Apple at $405. Because the net premium is much higher in this example, the maximum gain is more—it is $5.65 per share. The breakeven is $400.65. The price points on the at-expiration diagram, however, have nothing to do with the greeks. The analytics from Exhibit 9.5 are the same either way. The motivation for a trader selling this call spread, which has both options in-the-money, is different from that for the typical income generator. When the spread is sold in this context, the trader is buying volatility. Long gamma, long vega, negative theta. The trader here has a trade more like the one in the bull call spread example—except that instead of needing a rally, the trader needs a rout. The only difference is that the bull call spread has a bullish delta, and the bear call spread has a bearish delta. Bear Put Spread There is another way to take a bearish stance with vertical spreads: the bear put spread. A bear put spread is a long put plus a short put that has a lower strike price. Both puts are on the same underlying and share the same expiration month. This spread, however, is a debit spread because the more expensive option is being purchased. Imagine that a stock has had a good run-up in price. The chart shows a steady march higher over the past couple of months. A study of technical analysis, though, shows that the run-up may be pausing for breath. An oscillator, such as slow stochastics, in combination with the relative strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing. For traders looking for a small pullback, a bear put spread can be an excellent strategy. The goal is to see the stock drift down to the short strike. So, like the other members of the vertical spread family, strike selection is important. Let’s look at an example of ExxonMobil (XOM). After the stock has rallied over a two-month period to $80.55, a trader believes there will be a short-term temporary pullback to $75. Instead of buying the June 80 puts for 1.75, the trader can buy the 75–80 put spread of the same month for 1.30 because the 75 put can be sold for 0.45. 1 In this example, the June put has 40 days until expiration. Exhibit 9.7 illustrates the payout at expiration. EXHIBIT 9.7 ExxonMobil bear put spread. If the trader is wrong and ExxonMobil is still above 80 at expiry, both puts expire and the 1.30 premium is lost. If ExxonMobil is between the two strikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are OTM and expire. The net effect is short stock at an effective price of $78.70. The effective sale price is found by taking the price at which the short stock is established when the puts are exercised—$80—minus the net 1.30 paid for the spread. This is the spread’s breakeven at expiration. If the trader is right and ExxonMobil is below both strikes at expiration, both puts are ITM, and the result is a 3.70 profit and no position. Why a 3.70 profit? The 80 puts are exercised, making the trader short at $80, and the 75 puts are assigned, so the short is bought back at $75 for a positive stock scalp of $5. Including the 1.30 debit for the spread in the profit and loss (P&(L)), the net profit is $3.70 per share when the stock is below both strikes at expiration. This is a bearish trade. But is the bear put spread necessarily a better trade than buying an outright ATM put? No. The at-expiration diagram makes this clear. Profits are limited to $3.70 per share. This is an important difference. But because in this particular example, the trader expects the stock to retrace only to around $75, the benefits of lower cost and lower theta and vega risk can be well worth the trade-off of limited profit. The trader’s objectives are met more efficiently by buying the spread. The goal is to profit from the delta move down from $80 to $75. Exhibit 9.8 shows the differences between the greeks of the outright put and the spread when the trade is put on with ExxonMobil at $80.55. EXHIBIT 9.8 ExxonMobil put vs. bear put spread (ExxonMobil @ $80.55). 80 Put75–80 Put Delta −0.445−0.300 Gamma+0.080+0.041 Theta −0.018−0.006 Vega +0.110+0.046 As in the call-spread examples discussed previously, the spread delta is smaller than the outright put’s. It appears ironic that the spread with the smaller delta is a better trade in this situation, considering that the intent is to profit from direction. But it is the relative differences in the greeks besides delta that make the spread worthwhile given the trader’s goal. Gamma, theta, and vega are proportionately much smaller than the delta in the spread than in the outright put. While the spread’s delta is two thirds that of the put, its gamma is half, its theta one third, and its vega around 42 percent of the put’s. Retracements such as the one called for by the trader in this example can happen fast, sometimes over the course of a week or two. It’s not necessarily bad if this move occurs quickly. If ExxonMobil drops by $5 right away, the short delta will make the position profitable. Exhibit 9.9 shows how the spread position changes as the stock declines from $80 to $75. EXHIBIT 9.9 75–80 bear put spread as ExxonMobil declines. The delta of this trade remains negative throughout the stock’s descent to $75. Assuming the $5 drop occurs in one day, a delta averaging around −0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36 times $5 times 100). This is still a far cry from the spread’s $3.70 potential profit. Although the stock is at $75, the maximum profit potential has yet to be reached, and it won’t be until expiration. How does the rest of the profit materialize? Time decay. The price the trader wants the stock to reach is $75, but the assumption here is that the move happens very fast. The trade went from being a long- volatility play—long gamma and vega—to a short-vol play: short gamma and vega. The trader wanted movement when the stock was at $80 and wants no movement when the stock is at $75. When the trade changes characteristics by moving from one strike to another, the trader has to reconsider the stock’s outlook. The question is: if I didn’t have this position on, would I want it now? The trader has a choice to make: take the $180 profit—which represents a 138 percent profit on the 1.30 debit—or wait for theta to do its thing. The trader looking for a retracement would likely be inclined to take a profit on the trade. Nobody ever went broke taking a profit. But if the trader thinks the stock will sit tight for the remaining time until expiration, he will be happy with this income-generating position. Although the trade in the last, overly simplistic example did not reap its full at-expiration potential, it was by no means a bad trade. Holding the spread until expiration is not likely to be part of a trader’s plan. Buying the 80 put outright may be a better play if the trader is expecting a fast move. It would have a bigger delta than the spread. Debit and credit spreads can be used as either income generators or as delta plays. When they’re used as delta plays, however, time must be factored in. Bull Put Spread The last of the four vertical spreads is a bull put spread. A bull put spread is a short put with one strike and a long put with a lower strike. Both puts are on the same underlying and in the same expiration cycle. A bull put spread is a credit spread because the more expensive option is being sold, resulting in a net credit when the position is established. Using the same options as in the bear put example: With ExxonMobil at $80.55, the June 80 puts are sold for 1.75 and the June 75 puts are bought at 0.45. The trade is done for a credit of 1.30. Exhibit 9.10 shows the payout of this spread if it is held until expiration. EXHIBIT 9.10 ExxonMobil bull put spread. The sale of this spread generates a 1.30 net credit, which is represented by the maximum profit to the right of the 80 strike. With ExxonMobil above $80 per share at expiration, both options expire OTM and the premium is all profit. Between the two strike prices, the 80 put expires in the money. If the ITM put is still held at expiration, it will be assigned. Upon assignment, the put becomes long stock, profiting with each tick higher up to $80, or losing with each tick lower to $75. If the 80 put is assigned, the effective price of the long stock will be $78.70. The assignment will “hit your sheets” as a buy at $80, but the 1.30 credit lowers the effective net cost to $78.70. If the stock is below $75 at option expiration, both puts will be ITM. This is the worst case scenario, because the higher-struck put was sold. At expiration, the 80 puts would be assigned, the 75 puts exercised. That’s a negative scalp of $5 on the resulting stock. The initial credit lessens the pain by 1.30. The maximum possible loss with ExxonMobil below both strikes at expiration is $3.70 per spread. The spread in this example is the flip side of the bear put spread of the previous example. Instead of buying the spread, as with the bear put, the spread in this case is sold. Exhibit 9.11 shows the analytics for the bull put spread. EXHIBIT 9.11 Greeks for ExxonMobil 75–80 bull put spread. Instead of having a short delta, as with the bear spread, the bull spread is long delta. There is negative theta with positive gamma and vega as XOM approaches the long strike—the 75s, in this case. There is also positive theta with negative gamma and vega around the short strike—the 80s. Exhibit 9.11 shows the characteristics that define the vertical spread. If one didn’t know which particular options were being traded here, this could almost be a table of greeks for either a 75–80 bull put spread or a 75–80 bull call spread. Like the other three verticals, this spread can be a delta play or a theta play. A bullish trader may sell the spread if both puts are in-the-money. Imagine that XOM is trading at around $75. The spread will have a positive 0.364 delta, positive gamma, and negative theta. The spread as a whole is a decaying asset. It needs the underlying to rally to combat time decay. A bullish trader may also sell this spread if XOM is between the two strikes. In this case, with XOM at, say, $77, the delta is +0.388, and all other greeks are negligible. At this particular price point in the underlying, the trader has almost pure leveraged delta exposure. But this trade would be positioned for only a small move, not much above $80. A speculator wanting to trade direction for a small move while eliminating theta and vega risks achieves her objectives very well with a vertical spread. A bullish-to-neutral trader would be inclined to sell this spread if ExxonMobil were around $80 or higher. Day by day, the 1.30 premium would start to come in. With 40 days until expiration, theta would be small, only 0.004. But if the stock remained at $80, this ATM put would begin decaying faster and faster. The objective of trading this spread for a neutral trader is selling future realized volatility—selling gamma to earn theta. A trader can also trade a vertical spread to profit from IV. Verticals and Volatility The IV component of a vertical spread, although small compared with that of an outright call or put, is still important—especially for large traders with low margin and low commissions who can capitalize on small price changes efficiently. Whether it’s a call spread or a put spread, a credit spread or a debit spread, if the underlying is at the short option’s strike, the spread will have a net negative vega. If the underlying is at the long option’s strike, the spread will have positive vega. Because of this characteristic, there are three possible volatility plays with vertical spreads: speculating on IV changes when the underlying remains constant, profiting from IV changes resulting from movement of the underlying, and special volatility situations. Vertical spreads offer a limited-risk way to speculate on volatility changes when the underlying remains fairly constant. But when the intent of a vertical spread is to benefit from vega, one must always consider the delta —it’s the bigger risk. Chapter 13 discusses ways to manage this risk by hedging with stock, a strategy called delta-neutral trading. Non-delta-neutral traders may speculate on vol with vertical spreads by assuming some delta risk. Traders whose forecast is vega bearish will sell the option with the strike closest to where the underlying is trading—that is, the ATM option—and buy an OTM strike. Traders would lean with their directional bias by choosing either a call spread or a put spread. As risk managers, the traders balance the volatility stance being taken against the additional risk of delta. Again, in this scenario, delta can hurt much more than help. In the ExxonMobil bull put spread example, the trader would sell the 80- strike put if ExxonMobil were around $80 a share. In this case, if the stock didn’t move as time passed, theta would benefit from historical volatility being’s low—that is, from little stock movement. At first, the benefit would be only 0.004 per day, speeding up as expiration nears. And if implied volatility decreased, the trader would profit 0.04 for every 1 percent decline in IV. Small directional moves upward help a little. But in the long run, those profits are leveled off by the fact that theta gets smaller as the stock moves higher above $80—more profit on direction, less on time. For the delta player, bull call spreads and bull put spreads have a potential added benefit that stems from the fact that IV tends to decrease as stocks rise and increase when stocks fall. This offers additional opportunity to the bull spread player. With the bull call spread or the bull put spread, the trader gains on positive delta with a rally. Once the underlying comes close to the short option’s strike, vega is negative. If IV declines, as might be anticipated, there is a further benefit of vega profits on top of delta profits. If the underlying declines, the trader loses on delta. But the pain can potentially be slightly lessened by vega profits. Vega will get positive as the underlying approaches the long strike, which will benefit from the firming of IV that often occurs when the stock drops. But this dual benefit is paid for in the volatility skew. In most stocks or indexes, the lower strikes—the ones being bought in a bull spread—have higher IVs than the higher strikes, which are being sold. Then there are special market situations in which vertical spreads that benefit from volatility changes can be traded. Traders can trade vertical spreads to strategically position themselves for an expected volatility change. One example of such a situation is when a stock is rumored to be a takeover target. A natural instinct is to consider buying calls as an inexpensive speculation on a jump in price if the takeover is announced. Unfortunately, the IV of the call is often already bid up by others with the same idea who were quicker on the draw. Buying a call spread consisting of a long ITM call and a short OTM call can eliminate immediate vega risk and still provide wanted directional exposure. Certainly, with this type of trade, the trader risks being wrong in terms of direction, time, and volatility. If and when a takeover bid is announced, it will likely be for a specific price. In this event, the stock price is unlikely to rise above the announced takeover price until either the deal is consummated or a second suitor steps in and offers a higher price to buy the company. If the takeover is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in a very tight range below the takeover price for a long time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will let the trader profit from collapsing IV through negative vega. Say XYZ stock, trading at $52 a share, is a rumored takeover target at $60. When the rumors are first announced, the stock will likely rise, to say $55, with IV rising as well. Buying the 50–60 call spread will give a trader a positive delta and a negligible vega. If the rumors are realized and a cash takeover deal is announced at $60, the trade gains on delta, and the spread will now have negative vega. The negative vega at the 60 strike gains on implied volatility declining, and the stock will sit close to $60, producing the benefits of positive theta. Win, win, win. The Interrelations of Credit Spreads and Debit Spreads Many traders I know specialize in certain niches. Sometimes this is because they find something they know well and are really good at. Sometimes it’s because they have become comfortable and don’t have the desire to try anything new. I’ve seen this strategy specialization sometimes with traders trading credit spreads and debit spreads. I’ve had serial credit spread traders tell me credit spreads are the best trades in the world, much better than debit spreads. Habitual debit spread traders have likewise said their chosen spread is the best. But credit spreads and debit spreads are not so different. In fact, one could argue that they are really the same thing. Conventionally, credit-spread traders have the goal of generating income. The short option is usually ATM or OTM. The long option is more OTM. The traders profit from nonmovement via time decay. Debit-spread traders conventionally are delta-bet traders. They buy the ATM or just out-of-the- money option and look for movement away from or through the long strike to the short strike. The common themes between the two are that the underlying needs to end up around the short strike price and that time has to pass to get the most out of either spread. With either spread, movement in the underlying may be required, depending on the relationship of the underlying price to the strike prices of the options. And certainly, with a credit spread or debit spread, if the underlying is at the short strike, that option will have the most premium. For the trade to reach the maximum profit, it will need to decay. For many retail traders, debit spreads and credit spreads begin to look even more similar when margin is considered. Margin requirements can vary from firm to firm, but verticals in retail accounts at option-friendly brokerage firms are usually margined in such a way that the maximum loss is required to be deposited to hold the position (this assumes Regulation T margining). For all intents and purposes, this can turn the trader’s cash position from a credit into a debit. From a cash perspective, all vertical spreads are spreads that require a debit under these margin requirements. Professional traders and retail traders who are subject to portfolio margining are subject to more liberal margin rules. Although margin is an important concern, what we really care about as traders is risk versus reward. A credit call spread and a debit put spread on the same underlying, with the same expiration month, sharing the same strike prices will also share the same theoretical risk profile. This is because call and put prices are bound together by put-call parity. Building a Box Two traders, Sam and Isabel, share a joint account. They have each been studying Johnson & Johnson (JNJ), which is trading at around $63.35 per share. Sam and Isabel, however, cannot agree on direction. Sam thinks Johnson & Johnson will rise over the next five weeks, and Isabel believes it will decline during that period. Sam decides to buy the January 62.50 −65 call spread (January has 38 days until expiration in this example). Sam can buy this spread for 1.28. His maximum risk is 1.28. This loss occurs if Johnson & Johnson is below $62.50 at expiration, leaving both calls OTM. His maximum gain is 1.22, realized if Johnson & Johnson is above $65 (65–62.50–1.28). With Johnson & Johnson at $63.35, Sam’s delta is long 0.29 and his other greeks are about flat. Isabel decides to buy the January 62.50–65 put spread for a debit of 1.22. Isabel’s biggest potential loss is 1.22, incurred if Johnson & Johnson is above $65 a share at expiration, leaving both puts OTM. Her maximum possible profit is 1.28, realized if the stock is below $62.50 at option expiration. With Johnson & Johnson at $63.35, Isabel has a delta that is short around 0.27 and is nearly flat gamma, theta, and vega. Collectively, if both Sam and Isabel hold their trades until expiration, it’s a zero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel profits. She cancels out Sam’s loss by making 1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount, canceling out Sam’s gains. Between the two strikes, Sam has gains on his 62.50 call and Isabel has gains on her 65 put. The gains on the two options will total 2.50, the combined total spent on the spreads—another draw. EXHIBIT 9.12 Sam’s long call spread in Johnson & Johnson. 62.50–65 Call Spread Delta +0.290 Gamma+0.001 Theta −0.004 Vega +0.006 EXHIBIT 9.13 Isabel’s long put spread in Johnson & Johnson. 62.50–65 Put Spread Delta −0.273 Gamma−0.001 Theta +0.005 Vega −0.006 These two spreads were bought for a combined total of 2.50. The collective position, composed of the four legs of these two spreads, forms a new strategy altogether. The two traders together have created a box. This box, which is empty of both profit and loss, is represented by greeks that almost entirely offset each other. Sam’s positive delta of 0.29 is mostly offset by Isabel’s −0.273 delta. Gamma, theta, and vega will mostly offset each other, too. Chapter 6 described a box as long synthetic stock combined with short synthetic stock having a different strike price but the same expiration month. It can also be defined, however, as two vertical spreads: a bull (bear) call spread plus a bear (bull) put spread with the same strike prices and expiration month. The value of a box equals the present value of the distance between the two strike prices (American-option models will also account for early exercise potential in the box’s value). This 2.50 box, with 38 days until expiration at a 1 percent interest rate, has less than a penny of interest affecting its value. Boxes with more time until expiration will have a higher interest rate component. If there was one year until expiration, the combined value of the two verticals would equal 2.475. This is simply the distance between the strikes minus interest (2.50–[2.50 × 0.01]). Credit spreads are often made up of OTM options. Traders betting against a stock rising through a certain price tend to sell OTM call spreads. For a stock at $50 per share, they might sell the 55 calls and buy the 60 calls. But because of the synthetic relationship that verticals have with one another, the traders could buy an ITM put spread for the same exposure, after accounting for interest. The traders could buy the 60 puts and sell the 55 puts. An ITM call (put) spread is synthetically equal to an OTM put (call) spread. Verticals and Beyond Traders who want to take full advantage of all that options have to offer can do so strategically by trading spreads. Vertical spreads truncate directional risk compared with strategies like the covered call or single-legged option trades. They also reduce option-specific risk, as indicated by their lower gamma, theta, and vega. But lowering risk both in absolute terms and in the greeks has a trade-off compared with buying options: limited profit potential. This trade-off can be beneficial, depending on the trader’s forecast. Debit spreads and credit spreads can be traded interchangeably to achieve the same goals. When a long (short) call spread is combined with a long (short) put spread, the product is a box. Chapter 10 describes other ways vertical spreads can be combined to form positions that achieve different trading objectives. Note 1 . Note that it is customary when discussing the purchase or sale of spreads to state the lower strike first, regardless of which is being bought or sold. In this case, the trader is buying the 75–80 put spread. CHAPTER 10 Wing Spreads Condors and Butterflies The “wing spread” family is a set of option strategies that is very popular, particularly among experienced traders. These strategies make it possible for speculators to accomplish something they could not possibly do by just trading stocks: They provide a means to profit from a truly neutral market in a security. Stocks that don’t move one iota can earn profits month after month for income-generating traders who trade these strategies. These types of spreads have a lot of moving parts and can be intimidating to newcomers. At their heart, though, they are rather straightforward break- even analysis trades that require little complex math to maintain. A simple at-expiration diagram reveals in black and white the range in which the underlying stock must remain in order to have a profitable position. However, applying the greeks and some of the mathematics discussed in previous chapters can help a trader understand these strategies on a deeper level and maximize the chance of success. This chapter will discuss condors and butterflies and how to put them into action most effectively. Taking Flight There are four primary wing spreads: the condor, the iron condor, the butterfly, and the iron butterfly. Each of these spreads involves trading multiple options with three or four strikes prices. We can take these spreads at face value, we can consider each option as an individual component of the spread, or we can view the spreads as being made up of two vertical spreads. Condor A condor is a four-legged option strategy that enables a trader to capitalize on volatility—increased or decreased. Traders can trade long or short iron condors. Long Condor Long one call (put) with strike A; short one call (put) with a higher strike, B; short one call (put) at strike C, which is higher than B; and long one call (put) at strike D, which is higher than C. The distance between strike price A and B is equal to the distance between strike C and strike D. The options are all on the same security, in the same expiration cycle, and either all calls or all puts. Long Condor Example Buy 1 XYZ November 70 call (A) Sell 1 XYZ November 75 call (B) Sell 1 XYZ November 90 call (C) Buy 1 XYZ November 95 call (D) Short Condor Short one call (put) with strike A; long one call (put) with a higher strike, B; long one call (put) with a strike, C, that is higher than B; and short one call (put) with a strike, D, that is higher than C. The options must be on the same security, in the same expiration cycle, and either all calls or all puts. The differences in strike price between the vertical spread of strike prices A and B and the strike prices of the vertical spread of strikes C and D are equal. Short Condor Example Sell 1 XYZ November 70 call (A) Buy 1 XYZ November 75 call (B) Buy 1 XYZ November 90 call (C) Sell 1 XYZ November 95 call (D) Iron Condor An iron condor is similar to a condor, but with a mix of both calls and puts. Essentially, the condor and iron condor are synthetically the same. Short Iron Condor Long one put with strike A; short one put with a higher strike, B; short one call with an even higher strike, C; and long one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put credit spread has the same distance between the strike prices as the call credit spread. Short Iron Condor Example Buy 1 XYZ November 70 put (A) Sell 1 XYZ November 75 put (B) Sell 1 XYZ November 90 call (C) Buy 1 XYZ November 95 call (D) Long Iron Condor Short one put with strike A; long one put with a higher strike, B; long one call with an even higher strike, C; and short one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put debit spread (strikes A and B) has the same distance between the strike prices as the call debit spread (strikes C and D). Long Iron Condor Example Sell 1 XYZ November 70 put (A) Buy 1 XYZ November 75 put (B) Buy 1 XYZ November 90 call (C) Sell 1 XYZ November 95 call (D) Butterflies Butterflies are wing spreads similar to condors, but there are only three strikes involved in the trade—not four. Long Butterfly Long one call (put) with strike A; short two calls (puts) with a higher strike, B; and long one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The difference in price between strikes A and B equals that between strikes B and C. Long Butterfly Example Buy 1 XYZ December 50 call (A) Sell 2 XYZ December 60 call (B) Buy 1 XYZ December 70 call (C) Short Butterfly Short one call (put) with strike A; long two calls (puts) with a higher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike A and strike B has the same distance between the strike prices of the vertical spread made up of the options with strike B and strike C. Short Butterfly Example Sell 1 XYZ December 50 call Buy 2 XYZ December 60 call Sell 1 XYZ December 70 call Iron Butterflies Much like the relationship of the condor to the iron condor, a butterfly has its synthetic equal as well: the iron butterfly. Short Iron Butterfly Long one put with strike A; short one put with a higher strike, B; short one call with strike B; long one call with a strike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal. Short Iron Butterfly Example Buy 1 XYZ December 50 put (A) Sell 1 XYZ December 60 put (B) Sell 1 XYZ December 60 call (B) Buy 1 XYZ December 70 call (C) Long Iron Butterfly Short one put with strike A; long one put with a higher strike, B; long one call with strike B; short one call with a strike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal. The put debit spread has the same distance between the strike prices as the call debit spread. Long Iron Butterfly Example Sell 1 XYZ December 50 put Buy 1 XYZ December 60 put Buy 1 XYZ December 60 call Sell 1 XYZ December 70 call These spreads were defined in terms of both long and short for each strategy. Whether the spread is classified as long or short depends on whether it was established at a credit or a debit. Debit condors or butterflies are considered long spreads. And credit condors or butterflies are considered short spreads. The words long and short mean little, though in terms of the spread as a whole. The important thing is which strikes have long options and which have short options. A call debit spread is synthetically equal to a put credit spread on the same security, with the same expiration month and strike prices. That means a long condor is synthetically equal to a short iron condor, and a long butterfly is synthetically equal to a short iron butterfly, when the same strikes are used. Whichever position is constructed, the best- case scenario is to have debit spreads expire with both options in-the-money (ITM) and credit spreads expire with both options out-of-the-money (OTM). Many retail traders prefer trading these spreads for the purpose of generating income. In this case, a trader would sell the guts, or middle strikes, and buy the wings, or outer strikes. When a trader is short the guts, low realized volatility is usually the objective. For long butterflies and short iron butterflies, the stock needs to be right at the middle strike for the maximum payout. For long condors and short iron condors, the stock needs to be between the short strikes at expiration for maximum payout. In both instances, the wings are bought to limit potential losses of the otherwise naked options. Long Butterfly Example A trader, Kathleen, has been studying United Parcel Service (UPS), which is trading at around $70.65. She believes UPS will trade sideways until July expiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She executes the following legs: Kathleen looks at her trade as two vertical spreads, the 65–70 bull (debit) call spread and the 70–75 bear (credit) call spread. Intuitively, she would want UPS to be at or above $70 at expiration for her bull call spread to have maximum value. But she has the seemingly conflicting goal of also wanting UPS to be at or below $70 to get the most from her 70–75 bear call spread. The ideal price for the stock to be trading at expiration in this example is right at $70 per share—the best of both worlds. The at-expiration diagram, Exhibit 10.1 , shows the profit or loss of all possible outcomes at expiration. EXHIBIT 10.1 UPS 65–70–75 butterfly. If the price of UPS shares declines below $65 at expiration, all these calls will expire. The entire 2.00 spent on the trade will be lost. If UPS is above $65 at expiration, the 65 call will be ITM and will be exercised. The call will profit like a long position in 100 shares of the underlying. The maximum profit is reached if UPS is at $70 at expiration. Kathleen makes a 5.00 profit from $65 to $70 on her 65 calls. But because she paid 2.00 initially for the spread, her net profit at $70 is just 3.00. If UPS is above $70 a share at expiration in this example, the two 70 calls will be assigned. The assignment of one call will offset the long stock acquired by the 65 calls being exercised. Assignment of the other call will create a short position in the underlying. That short position loses as UPS moves higher up to $75 a share, eating away at the 3.00 profit. If UPS is above $75 at expiration, the 75 call can be exercised to buy back the short stock position that resulted from the 70’s being assigned. The loss on the short stock between $70 and $75 will cost Kathleen 5.00, stripping her of her 3.00 profit and giving her a net loss of 2.00 to boot. End result? Above $75 at expiration, she has no position in the underlying and loses 2.00. A butterfly is a break-even analysis trade . This name refers to the idea that the most important considerations in this strategy are the breakeven points. The at-expiration diagram, Exhibit 10.2 , shows the break-even prices for this trade. EXHIBIT 10.2 UPS 65–70–75 butterfly breakevens. If the position is held until expiration and UPS is between $65 and $70 at that time, the 65 calls are exercised, resulting in long stock. The effective purchase price of that stock is $67. That’s the strike price plus the cost of the spread; that’s the lower break-even price. The other break-even is at $73. The net short position of 100 shares resulting from assignment of the 70 call loses more as the stock rises between $70 and $75. The entire 3.00 profit realized at the $70 share price is eroded when the stock reaches $73. Above $73, the trade produces a loss. Kathleen’s trading objective is to profit from UPS trading between $67 and $73 at expiration. The best-case scenario is that it declines only slightly from its price of $70.65 when the trade is established, to $70 per share. Alternatives Kathleen had other alternative positions she could have traded to meet her goals. An iron butterfly with the same strike prices would have shown about the same risk/reward picture, because the two positions are synthetically equivalent. But there may, in some cases, be a slight advantage to trading the iron butterfly over the long butterfly. The iron butterfly uses OTM put options instead of ITM calls, meaning the bid-ask spreads may be tighter. This means giving up less edge to the liquidity providers. She could have also bought a condor or sold an iron condor. With condor- family spreads, there is a lower maximum profit potential but a wider range in which that maximum payout takes place. For example, Kathleen could have executed the following legs to establish an iron condor: Essentially, Kathleen would be selling two credit spreads: the July 60–65 put spread for 0.30 and the July 75–80 call spread for 0.35. Exhibit 10.3 shows the payout at expiration of the UPS July 60–65–75–80 iron condor. EXHIBIT 10.3 UPS 60–65–75–80 iron condor. Although the forecast and trading objectives may be similar to those for the butterfly, the payout diagram reveals some important differences. First, the maximum loss is significantly higher with a condor or iron condor. In this case, the maximum loss is 4.35. This unfortunate situation would occur if UPS were to drop to below $60 or rise above $80 by expiration. Below $60, the call spread expires, netting 0.35. But the put spread is ITM. Kathleen would lose a net of 4.70 on the put spread. The gain on the call spread combined with the loss on the put spread makes the trade a loser of 4.35 if the stock is below $60 at expiration. Above $80, the put spread is worthless, earning 0.30, but the call spread is a loser by 4.65. The gain on the put spread plus the loss on the call spread is a net loser of 4.35. Between $65 and $75, all options expire and the 0.65 credit is all profit. So far, this looks like a pretty lousy alternative to the butterfly. You can lose 4.35 but only make 0.65! Could there be any good reason for making this trade? Maybe. The difference is wiggle room. The breakevens are 2.65 wider in each direction with the iron condor. Exhibit 10.4 shows these prices on the graph. EXHIBIT 10.4 UPS 60–65–75–80 iron condor breakevens. The lower threshold for profit occurs at $64.35 and the upper at $75.65. With condor/iron condors, there can be a greater chance of producing a winning trade because the range is wider than that of the butterfly. This benefit, however, has a trade-off of lower potential profit. There is always a parallel relationship of risk and reward. When risk increases so does reward, and vice versa. This way of thinking should now be ingrained in your DNA. The risk of failure is less, so the payout is less. Because the odds of winning are higher, a trader will accept lower payouts on the trade. Keys to Success No matter which trade is more suitable to Kathleen’s risk tolerance, the overall concept is the same: profit from little directional movement. Before Kathleen found a stock on which to trade her spread, she will have sifted through myriad stocks to find those that she expects to trade in a range. She has a few tools in her trading toolbox to help her find good butterfly and condor candidates. First, Kathleen can use technical analysis as a guide. This is a rather straightforward litmus test: does the stock chart show a trending, volatile stock or a flat, nonvolatile stock? For the condor, a quick glance at the past few months will reveal whether the stock traded between $65 and $75. If it did, it might be a good iron condor candidate. Although this very simplistic approach is often enough for many traders, those who like lots of graphs and numbers can use their favorite analyses to confirm that the stock is trading in a range. Drawing trendlines can help traders to visualize the channel in which a stock has been trading. Knowing support and resistance is also beneficial. The average directional movement index (ADX) or moving average converging/diverging (MACD) indicator can help to show if there is a trend present. If there is, the stock may not be a good candidate. Second, Kathleen can use fundamentals. Kathleen wants stocks with nothing on their agendas. She wants to avoid stocks that have pending events that could cause their share price to move too much. Events to avoid are earnings releases and other major announcements that could have an impact on the stock price. For example, a drug stock that has been trading in a range because it is awaiting Food and Drug Administration (FDA) approval, which is expected to occur over the next month, is not a good candidate for this sort of trade. The last thing to consider is whether the numbers make sense. Kathleen’s iron condor risks 4.35 to make 0.65. Whether this sounds like a good trade depends on Kathleen’s risk tolerance and the general environment of UPS, the industry, and the market as a whole. In some environments, the 0.65/4.35 payout-to-risk ratio makes a lot of sense. For other people, other stocks, and other environments, it doesn’t. Greeks and Wing Spreads Much of this chapter has been spent on how wing spreads perform if held until expiration, and little has been said of option greeks and their role in wing spreads. Greeks do come into play with butterflies and condors but not necessarily the same way they do with other types of option trades. The vegas on these types of spreads are smaller than they are on many other types of strategies. For a typical nonprofessional trader, it’s hard to trade implied volatility with condors or butterflies. The collective commissions on the four legs, as well as margin and capital considerations, put these out of reach for active trading. Professional traders and retail traders subject to portfolio margining are better equipped for volatility trading with these spreads. The true strength of wing spreads, however, is in looking at them as break-even analysis trades much like vertical spreads. The trade is a winner if it is on the correct side of the break-even price. Wing spreads, however, are a combination of two vertical spreads, so there are two break-even prices. One of the verticals is guaranteed to be a winner. The stock can be either higher or lower at expiration—not both. In some cases, both verticals can be winners. Consider an iron condor. Instead of reaping one premium from selling one OTM call credit spread, iron condor sellers double dip by additionally selling an OTM put credit spread. They collect a double credit, but only one of the credit spreads can be a loser at expiration. The trader, however, does have to worry about both directions independently. There are two ways for greeks and volatility analysis to help traders trade wing spreads. One of them involves using delta and theta as tools to trade a directional spread. The other uses implied volatility in strike selection decisions. Directional Butterflies Trading a butterfly can be an excellent way to establish a low-cost, relatively low-risk directional trade when a trader has a specific price target in mind. For example, a trader, Ross, has been studying Walgreen Co. (WAG) and believes it will rise from its current level of $33.50 to $36 per share over the next month. Ross buys a butterfly consisting of all OTM January calls with 31 days until expiration. He executes the following legs: As a directional trade alternative, Ross could have bought just the January 35 call for 1.15. As a cheaper alternative, he could have also bought the 35– 36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only a dime. The benefit of lower cost, however, comes with trade-offs. Exhibit 10.5 compares the bull call spread with a bullish butterfly. EXHIBIT 10.5 Bull call spread vs. bull butterfly (Walgreen Co. at $33.50). The butterfly has lower nominal risk—only 0.10 compared with 0.35 for the call spread. The maximum reward is higher in nominal terms, too—0.90 versus 0.65. The trade-off is what is given up. With both strategies, the goal is to have Walgreen Co. at $36 around expiration. But the bull call spread has more room for error to the upside. If the stock trades a lot higher than expected, the butterfly can end up being a losing trade. Given Ross’s expectations in this example, this might be a risk he is willing to take. He doesn’t expect Walgreen Co. to close right at $36 on the expiration date. It could happen, but it’s unlikely. However, he’d have to be wildly wrong to have the trade be a loser on the upside. It would be a much larger move than expected for the stock to rise significantly above $36. If Ross strongly believes Walgreen Co. can be around $36 at expiration, the cost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As a general rule, directional butterflies work well in trending, low-volatility stocks. When Ross monitors his butterfly, he will want to see the greeks for this position as well. Exhibit 10.6 shows the trade’s analytics with Walgreen Co. at $33.50. EXHIBIT 10.6 Walgreen Co. 35–36–37 butterfly greeks (stock at $33.50, 31 days to expiration). Delta +0.008 Gamma−0.004 Theta +0.001 Vega −0.001 When the trade is first put on, the delta is small—only +0.008. Gamma is slightly negative and theta is very slightly positive. This is important information if Walgreen Co.’s ascent happens sooner than Ross planned. The trade will show just a small profit if the stock jumps to $36 per share right away. Ross’s theoretical gain will be almost unnoticeable. At $36 per share, the position will have its highest theta, which will increase as expiration approaches. Ross will have to wait for time to pass to see the trade reach its full potential. This example shows the interrelation between delta and theta. We know from an at-expiration analysis that if Walgreen Co. moves from $33.50 to $36, the butterfly’s profit will be 0.90 (the spread of $1 minus the 0.10 initial debit). If we distribute the 0.90 profit over the 2.50 move from $33.50 to $36, the butterfly gains about 0.36 per dollar move in Walgreen Co. (0.90/(36 − 33.50). This implies a delta of about 0.36. But the delta, with 31 days until expiration and Walgreen Co. at $33.50, is only 0.008, and because of negative gamma this delta will get even smaller as Walgreen Co. rises. Butterflies, like the vertical spreads of which they are composed, can profit from direction but are never purely directional trades. Time is always a factor. It is theta, working in tandem with delta, that contributes to profit or peril. A bearish butterfly can be constructed as well. One would execute the trade with all OTM puts or all ITM calls. The concept is the same: sell the guts at the strike at which the stock is expected to be trading at expiration, and buy the wings for protection. Constructing Trades to Maximize Profit Many traders who focus on trading iron condors trade exchange-traded funds (ETFs) or indexes. Why? Diversification. Because indexes are made up of many stocks, they usually don’t have big gaps caused by surprise earnings announcements, takeovers, or other company-specific events. But it’s not just selecting the right underlying to trade that is the challenge. A trader also needs to pick the right strike prices. Finding the right strike prices to trade can be something of an art, although science can help, as well. Three Looks at the Condor Strike selection is essential for a successful condor. If strikes are too close together or two far apart, the trade can become much less attractive. Strikes Too Close The QQQs are options on the ETFs that track the Nasdaq 100 (QQQ). They have strikes in $1 increments, giving traders a lot to choose from. With QQQ trading at around $55.95, consider the 54–55–57–58 iron condor. In this example, with 31 days until expiration, the following legs can be executed: In this trade, the maximum profit is 0.63. The maximum risk is 0.37. This isn’t a bad profit-to-loss ratio. The break-even price on the downside is $54.37 and on the upside is $57.63. That’s a $3.26 range—a tight space for a mover like the QQQ to occupy in a month. The ETF can drop about only 2.8 percent or rise 3 percent before the trade becomes a loser. No one needs any fancy math to show that this is likely a losing proposition in the long run. While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit. Strikes Too Far Strikes too far apart can make for impractical trades as well. Exhibit 10.7 shows an options chain for the Dow Jones Industrial Average Index (DJX). These prices are from around 2007 when implied volatility (IV) was historically low, making the OTM options fairly low priced. In this example, DJX is around $135.20 and there are 51 days until expiration. EXHIBIT 10.7 Options chain for DJIA. If the goal is to choose strikes that are far enough apart to be unlikely to come into play, a trader might be tempted to trade the 120–123–142–145 iron condor. With this wingspan, there is certainly a good chance of staying between those strikes—you could drive a proverbial truck through that range. This would be a great trade if it weren’t for the prices one would have to accept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts are 0.25 bid. This means that the put spread would be sold at zero! The maximum risk is 3.00, and the maximum gain is zero. Not a really good risk/reward. The 142–145 call spread isn’t much better: it can be sold for a dime. At the time, again a low-volatility period, many traders probably felt it was unlikely that the DJX will rise 5 percent in a 51-day period. Some traders may have considered trading a similarly priced iron condor (though of course they’d have to require some small credit for the risk). A little over a year later the DJX was trading around 50 percent lower. Traders must always be vigilant of the possibility of volatility, even unexpected volatility and structure their risk/reward accordingly. Most traders would say the risk/reward of this trade isn’t worth it. Strikes too far apart have a greater chance of success, but the payoff just isn’t there. Strikes with High Probabilities of Success So how does a trader find the happy medium of strikes close enough together to provide rich premiums but far enough apart to have a good chance of success? Certainly, there is something to be said for looking at the prices at which a trade can be done and having a subjective feel for whether the underlying is likely to move outside the range of the break- even prices. A little math, however, can help quantify this likelihood and aid in the decision-making process. Recall that IV is read by many traders to be the market’s consensus estimate of future realized volatility in terms of annualized standard deviation. While that is a mouthful to say—or in this case, rather, an eyeful to read—when broken down it is not quite as intimidating as it sounds. Consider a simplified example in which an underlying security is trading at $100 a share and the implied volatility of the at-the-money (ATM) options is 10 percent. That means, from a statistical perspective, that if the expected return for the stock is unchanged, the one-year standard deviations are at $90 and $110. 1 In this case, there is about a 68 percent chance of the stock trading between $90 and $110 one year from now. IV then is useful information to a trader who wants to quantify the chances of an iron condor’s expiring profitable, but there are a few adjustments that need to be made. First, because with an iron condor the idea is to profit from net short option premium, it usually makes more sense to sell shorter-term options to profit from higher rates of time decay. This entails trading condors composed of one- or two-month options. The IV needs to be deannualized and converted to represent the standard deviation of the underlying at expiration. The first step is to compute the one-day standard deviation. This is found by dividing the implied volatility by the square root of the number of trading days in a year, then multiplying by the square root of the number of trading days until expiration. The result is the standard deviation (σ) at the time of expiration stated as a percent. Next, multiply that percentage by the price of the underlying to get the standard deviation in absolute terms. The formula 2 for calculating the shorter-term standard deviation is as follows: This value will be added to or subtracted from the price of the underlying to get the price points at which the approximate standard deviations fall. Consider an example using options on the Standard & Poor’s 500 Index (SPX). With 50 days until expiration, the SPX is at 1241 and the implied volatility is 23.2 percent. To find strike prices that are one standard deviation away from the current index price, we need to enter the values into the equation. We first need to know how many actual trading days are in the 50-day period. There are 35 business days during this particular 50- day period (there is one holiday and seven weekend days). We now have all the data we need to calculate which strikes to sell. The lower standard deviation is 1134.55 (1241 − 106.45) and the upper is 1347.45 (1241 + 106.45). This means there would be about a 68 percent chance of SPX ending up between 1134.55 and 1347.45 at expiration. In this example, to have about a two-thirds chance of success, one would sell the 1135 puts and the 1350 calls as part of the iron condor. Being Selective There is about a two-thirds chance of the underlying staying between the upper and lower standard deviation points and about a one-third chance it won’t. Reasonably good odds. But the maximum loss of an iron condor will be more than the maximum profit potential. In fact, the max-profit-to-max- loss ratio is usually less than 1 to 3. For every $1 that can be made, often $4 or $5 will be at risk. The pricing model determines fair value of an option based on the implied volatility set by the market. Again, many traders consider IV to be the market’s consensus estimate of future realized volatility. Assuming the market is generally right and options are efficiently priced, in the long run, future stock volatility should be about the same as the implied volatility from options prices. That means that if all of your options trades are executed at fair value, you are likely to break even in the long run. The caveat is that whether the options market is efficient or not, retail or institutional traders cannot generally execute trades at fair value. They have to sell the bid (sell below theoretical value) and buy the offer (buy above theoretical value). This gives the trade a statistical disadvantage, called giving up the edge, from an expected return perspective. Even though you are more likely to win than to lose with each individual trade when strikes are sold at the one-standard-deviation point, the edge given up to the market in conjunction with the higher price tag on losers makes the trade a statistical loser in the long run. While this means for certain that the non-market-making trader is at a constant disadvantage, trading condors and butterflies is no different from any other strategy. Giving up the edge is the plight of retail and institutional traders. To profit in the long run, a trader needs to beat the market, which requires careful planning, selectivity, and risk management. Savvy traders trade iron condors with strikes one standard deviation away from the current stock price only when they think there is more than a two- thirds chance of market neutrality. In other words, if you think the market will be less volatile than the prices in the options market imply, sell the iron condor or trade another such premium-selling strategy. As discussed above, this opinion should reflect sound judgment based on some combination of technical analysis, fundamental analysis, volatility analysis, feel, and subjectivity. A Safe Landing for an Iron Condor Although traders can’t control what the market does, they can control how they react to the market. Assume a trader has done due diligence in studying a stock and feels it is a qualified candidate for a neutral strategy. With the stock at $90, a 16.5 percent implied volatility, and 41 days until expiration, the standard deviation is about 5. The trader sells the following iron condor: With the stock at $90, directly between the two short strikes, the trade is direction neutral. The maximum profit is equal to the total premium taken in, which in this case is $800. The maximum loss is $4,200. There is about a two-thirds chance of retaining the $800 at expiration. After one week, the overall market begins trending higher on unexpected bullish economic news. This stock follows suit and is now trading at $93, and concern is mounting that the rally will continue. The value of the spread now is about 1.10 per contract (we ignore slippage from trading on the bid- ask spreads of the four legs of the spread). This means the trade has lost $300 because it would cost $1,100 to buy back what the trader sold for a total of $800. One strategy for managing this trade looking forward is inaction. The philosophy is that sometimes these trades just don’t work out and you take your lumps. The philosophy is that the winners should outweigh the losers over the long term. For some of the more talented and successful traders with a proven track record, this may be a viable strategy, but there are more active options as well. A trader can either close the spread or adjust it. The two sets of data that must be considered in this decision are the prices of the individual options and the greeks for the trade. Exhibit 10.8 shows the new data with the stock at $93. EXHIBIT 10.8 Greeks for iron condor with stock at $93. The trade is no longer neutral, as it was when the underlying was at $90. It now has a delta of −2.54, which is like being short 254 shares of the underlying. Although the more time that passes the better—as indicated by the +0.230 theta—delta is of the utmost concern. The trader has now found himself short a market that he thinks may rally. Closing the entire position is one alternative. To be sure, if you don’t have an opinion on the underlying, you shouldn’t have a position. It’s like making a bet on a sporting event when you don’t really know who you think will win. The spread can also be dismantled piecemeal. First, the 85 puts are valued at $0.07 each. Buying these back is a no-brainer. In the event the stock does retrace, why have the positive delta of that leg working against you when you can eliminate the risk inexpensively now? The 80 puts are worthless, offered at 0.05, presumably. There is no point in trying to sell these. If the market does turn around, they may benefit, resulting in an unexpected profit. The 80 and 85 puts are the least of his worries, though. The concern is a continuing rally. Clearly, the greater risk is in the 95–100 call spread. Closing the call spread for a loss eliminates the possibility of future losses and may be a wise choice, especially if there is great uncertainty. Taking a small loss now of only around $300 is a better trade than risking a total loss of $4,200 when you think there is a strong chance of that total loss occurring. But if the trader is not merely concerned that the stock will rally but truly believes that there is a good chance it will, the most logical action is to position himself for that expected move. Although there are many ways to accomplish this, the simplest way is to buy to close the 95 calls to eliminate the position at that strike. This eliminates the short delta from the 95 calls, leading to a now-positive delta for the position as a whole. The new position after adjusting by buying the 85 puts and the 95 calls is shown in Exhibit 10.9 . EXHIBIT 10.9 Iron condor adjusted to strangle. The result is a long strangle: a long call and a long put of the same month with two different strikes. Strangles will be discussed in subsequent chapters. The 80 puts are far enough out-of-the-money to be fairly irrelevant. Effectively, the position is long ten 100-strike calls. This serves the purpose of changing the negative 2.54 delta into a positive 0.96 delta. The trader now has a bullish position in the stock that he thinks will rally— a much smarter position, given that forecast. The Retail Trader versus the Pro Iron condors are very popular trades among retail traders. These days one can hardly go to a cocktail party and mention the word options without hearing someone tell a story about an iron condor on which he’s made a bundle of money trading. Strangely, no one ever tells stories about trades in which he has lost a bundle of money. Two of the strengths of this strategy that attract retail traders are its limited risk and high probability of success. Another draw of this type of strategy is that the iron condor and the other wing spreads offer something truly unique to the retail trader: a way to profit from stocks that don’t move. In the stock-trading world, the only thing that can be traded is direction— that is, delta. The iron condor is an approachable way for a nonprofessional to dabble in nonlinear trading. The iron condor does a good job in eliminating delta—unless, of course, the stock moves and gamma kicks in. It is efficient in helping income-generating retail traders accomplish their goals. And when a loss occurs, although it can be bigger than the potential profits, it is finite. But professional option traders, who have access to lots of capital and have very low commissions and margin requirements, tend to focus their efforts in other directions: they tend to trade volatility. Although iron condors are well equipped for profiting from theta when the stock cooperates, it is also possible to trade implied volatility with this strategy. The examples of iron condors, condors, iron butterflies, and butterflies presented in this chapter so far have for the most part been from the perspective of the neutral trader: selling the guts and buying the wings. A trader focusing on vega in any of these strategies may do just the opposite —buy the guts and sell the wings—depending on whether the trader is bullish or bearish on volatility. Say a trader, Joe, had a bullish outlook on volatility in Salesforce.com (CRM). Joe could sell the following condor 100 times. In this example, February is 59 days from expiration. Exhibit 10.10 shows the analytics for this trade with CRM at $104.32. EXHIBIT 10.10 Salesforce.com condor ( Salesforce.com at $104.32). As expected with the underlying centered between the two middle strikes, delta and gamma are about flat. As Salesforce.com moves higher or lower, though, gamma and, consequently, delta will change. As the stock moves closer to either of the long strikes, gamma will become more positive, causing the delta to change favorably for Joe. Theta, however, is working against him with Salesforce.com at $104.32, costing $150 a day. In this instance, movement is good. Joe benefits from increased realized volatility. The best-case scenario would be if Salesforce.com moves through either of the long strikes to, or through, either of the short strikes. The prime objective in this example, though, is to profit from a rise in IV. The position has a positive vega. The position makes or loses $400 with every point change in implied volatility. Because of the proportion of theta risk to vega risk, this should be a short-term play. If Joe were looking for a small rise in IV, say five points, the move would have to happen within 13 calendar days, given the vega and theta figures. The vega gain on a rise of five vol points would be $2,000, and the theta loss over 13 calendar days would be $1,950. If there were stock movement associated with the IV increase, that delta/gamma gain would offset some of the havoc that theta wreaked on the option premiums. However, if Joe traded a strategy like a condor as a vol play, he would likely expect a bigger volatility move than the five points discussed here as well as expecting increased realized volatility. A condor bullish vol play works when you expect something to change a stock’s price action in the short term. Examples would be rumors of a new product’s being unveiled, a product recall, a management change, or some other shake-up that leads to greater uncertainty about the company’s future —good or bad. The goal is to profit from a rise in IV, so the trade needs to be put on before the announcement occurs. The motto in option-volatility trading is “Buy the rumor; sell the news.” Usually, by the time the news is out, the increase in IV is already priced into option premiums. As uncertainty decreases, IV decreases as well. Notes 1 . It is important to note that in the real world, interest and expectations for future stock-price movement come into play. For simplicity’s sake, they’ve been excluded here. 2 . This is an approximate formula for estimating standard deviation. Although it is mathematically only an approximation, it is the convention used by many option traders. It is a traders’ short cut. CHAPTER 11 Calendar and Diagonal Spreads Option selling is a niche that attracts many retail and professional traders because it’s possible to profit from the passage of time. Calendar and diagonal spreads are practical strategies to limit risk while profiting from time. But these spreads are unique in many ways. In order to be successful with them, it is important to understand their subtle qualities. Calendar Spreads Definition : A calendar spread, sometimes called a time spread or a horizontal spread , is an option strategy that involves buying one option and selling another option with the same strike price but with a different expiration date. At-expiration diagrams do a calendar-spread trader little good. Why? At the expiration of the short-dated option, the trader is left with another option that may have time value. To estimate what the position will be worth when the short-term option expires, the value of the long-term option must be analyzed using the greeks. This is true of the variants of the calendar— double calendars, diagonals, and double diagonals—as well. This chapter will show how to analyze strategies that involve options with different expirations and discuss how and when to use them. Buying the Calendar The calendar spread and all its variations are commonly associated with income-generating spreads. Using calendar spreads as income generators is popular among retail and professional traders alike. The process involves buying a longer-term at-the-money option and selling a shorter-term at-the- money (ATM) option. The options must be either both calls or both puts. Because this transaction results in a net debit—the longer-term option being purchased has a higher premium than the shorter-term option being sold— this is referred to as buying the calendar. The main intent of buying a calendar spread for income is to profit from the positive net theta of the position. Because the shorter-term ATM option decays at a faster rate than the longer-term ATM option, the net theta is positive. As for most income spreads, the ideal outcome occurs when the underlying is at the short strike (in this case, shared strike) when the shorter-term option expires. At this strike price, the long option has its highest value, while the short option expires without the trader’s getting assigned. As long as the underlying remains close to the strike price, the value of the spread rises as time passes, because the short option decreases in value faster than the long option. For example, a trader, Richard, watches Bed Bath & Beyond Inc. (BBBY) on a regular basis. Richard believes that Bed Bath & Beyond will trade in a range around $57.50 a share (where it is trading now) over the next month. Richard buys the January–February 57.50 call calendar for 0.80. Assuming January has 25 days until expiration and February has 53 days, Richard will execute the following trade: Richard’s best-case scenario occurs when the January calls expire at expiration and the February calls retain much of their value. If Richard created an at-expiration P&(L) diagram for his position, he’d have trouble because of the staggered expiration months. A general representation would look something like Exhibit 11.1 . EXHIBIT 11.1 Bed Bath & Beyond January–February 57.50 calendar. The only point on the diagram that is drawn with definitive accuracy is the maximum loss to the downside at expiration of the January call. The maximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit paid for the spread. If Bed Bath & Beyond is below $57.50 at January expiration, the January 57.50 call expires worthless, and the February 57.50 call may or may not have residual value. If Bed Bath & Beyond declines enough, the February 57.50 call can lose all of its value, even with residual time until expiration. If the stock falls enough, the entire 0.80 debit would be a loss. If Bed Bath & Beyond is above $57.50 at January expiration, the January 57.50 call will be trading at parity. It will be a negative-100-delta option, imitating short stock. If Bed Bath & Beyond is trading high enough, the February 57.50 call will become a positive-100-delta option trading at parity plus the interest calculated on the strike. The February deep-in-the- money option would imitate long stock. At a 2 percent interest rate, interest on the 57.50 strike is about 0.17. Therefore, Richard would essentially have a short stock position from $57.50 from the January 57.50 call and would be essentially long stock from $57.50 plus 0.28 from the February call. The maximum loss to the upside is about 0.63 (0.80 − 0.17). The maximum loss if Bed Bath & Beyond is trading over $57.50 at expiration is only an estimate that assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations. The maximum profit is gained if Bed Bath & Beyond is at $57.50 at expiration. At this price, the February 57.50 call is worth the most it can be worth without having the January 57.50 call assigned and creating negative deltas to the upside. But how much precisely is the maximum profit? Richard would have to know what the February 57.50 call would be worth with Bed Bath & Beyond stock trading at $57.50 at February expiration before he can know the maximum profit potential. Although Richard can’t know for sure at what price the calls will be trading, he can use a pricing model to estimate the call’s value. Exhibit 11.2 shows analytics at January expiration. EXHIBIT 11.2 Bed Bath & Beyond January–February 57.50 call calendar greeks at January expiration. With an unchanged implied volatility of 23 percent, an interest rate of two percent, and no dividend payable before February expiration, the February 57.50 calls would be valued at 1.53 at January expiration. In this best-case scenario, therefore, the spread would go from 0.80, where Richard purchased it, to 1.53, for a gain of 91 percent. At January expiration, with Bed Bath & Beyond at $57.50, the January call would expire; thus, the spread is composed of just the February 57.50 call. Let’s now go back in time and see how Richard figured this trade. Exhibit 11.3 shows the position when the trade is established. EXHIBIT 11.3 Bed Bath & Beyond January–February 57.50 call calendar. A small and steady rise in the stock price with enough time to collect theta is the recipe for success in this trade. As time passes, delta will flatten out if Bed Bath & Beyond is still right at-the-money. The delta of the January call that Richard is short will move closer to exactly −0.50. The February call delta moves toward exactly +0.50. Gamma and theta will both rise if Bed Bath & Beyond stays around the strike. As expiration approaches, there is greater risk if there is movement and greater reward if there is not. Vega is positive because the long-term option with the higher vega is the long leg of the spread. When trading calendars for income, implied volatility (IV) must be considered as a possible threat. Because it is Richard’s objective to profit from Bed Bath & Beyond being at $57.50 at expiration, he will try to avoid vega risk by checking that the implied volatility of the February call is in the lower third of the 12-month range. He will also determine if there are any impending events that could cause IV to change. The less likely IV is to drop, the better. If there is an increase in IV, that may benefit the profitability of the trade. But a rise in IV is not really a desired outcome for two reasons. First, a rise in IV is often more pronounced in the front month than in the months farther out. If this happens, Richard can lose more on the short call than he makes on the long call. Second, a rise in IV can indicate anxiety and therefore a greater possibility for movement in the underlying stock. Richard doesn’t want IV to rock the boat. “Buy low, stay low” is his credo. Rho is positive also. A rise in interest rates benefits the position because the long-term call is helped by the rise more than the short call is hurt. With only a one-month difference between the two options, rho is very small. Overall, rho is inconsequential to this trade. There is something curious to note about this trade: the gamma and the vega. Calendar spreads are the one type of trade where gamma can be negative while vega is positive, and vice versa. While it appears—at least on the surface—that Richard wants higher IV, he certainly wants low realized volatility. Bed Bath & Beyond January–February 57.50 Put Calendar Richard’s position would be similar if he traded the January–February 57.50 put calendar rather than the call calendar. Exhibit 11.4 shows the put calendar. EXHIBIT 11.4 Bed Bath & Beyond January–February 57.50 put calendar. The premium paid for the put spread is 0.75. A huge move in either direction means a loss. It is about the same gamma/theta trade as the 57.50 call calendar. At expiration, with Bed Bath & Beyond at $57.50 and IV unchanged, the value of the February put would be 1.45—a 93 percent gain. The position is almost exactly the same as the call calendar. The biggest difference is that the rho is negative, but that is immaterial to the trade. As with the call spread, being short the front-month option means negative gamma and positive theta; being long the back month means positive vega. Managing an Income-Generating Calendar Let’s say that instead of trading a one-lot calendar, Richard trades it 20 times. His trade in this case is His total cash outlay is $1,600 ($80 times 20). The greeks for this trade, listed in Exhibit 11.5 , are also 20 times the size of those in Exhibit 11.3 . EXHIBIT 11.5 20-Lot Bed Bath & Beyond January–February 57.50 call calendar. Note that Richard has a +0.18 delta. This means he’s long the equivalent of about 18 shares of stock—still pretty flat. A gamma of −0.72 means that if Bed Bath & Beyond moves $1 higher, his delta will be starting to get short; and if it moves $1 lower he will be longer, long 90 deltas. Richard can use the greeks to get a feel for how much the stock can move before negative gamma causes a loss. If Bed Bath & Beyond starts trending in either direction, Richard may need to react. His plan is to cover his deltas to continue the position. Say that after one week Bed Bath & Beyond has dropped $1 to $56.50. Richard will have collected seven days of theta, which will have increased slightly from $18 per day to $20 per day. His average theta during that time is about $19, so Richard’s profit attributed to theta is about $133. With a big-enough move in either direction, Richard’s delta will start working against him. Since he started with a delta of +0.18 on this 20-lot spread and a gamma of −0.72, one might think that his delta would increase to 0.90 with Bed Bath & Beyond a dollar lower (18 − [−0.072 × 1.00]). But because a week has passed, his delta would actually get somewhat more positive. The shorter-term call’s delta will get smaller (closer to zero) at a faster rate compared to the longer-term call because it has less time to expiration. Thus, the positive delta of the long-term option begins to outweigh the negative delta of the short-term option as time passes. In this scenario, Richard would have almost broken even because what would be lost on stock price movement, is made up for by theta gains. Richard can sell about 100 shares of Bed Bath & Beyond to eliminate his immediate directional risk and stem further delta losses. The good news is that if Bed Bath & Beyond declines more after this hedge, the profit from the short stock offsets losses from the long delta. The bad news is that if BBBY rebounds, losses from the short stock offset gains from the long delta. After Richard’s hedge trade is executed, his delta would be zero. His other greeks remain unchanged. The idea is that if Bed Bath & Beyond stays at its new price level of $56.50, he reaps the benefits of theta increasing with time from $18 per day. Richard is accepting the new price level and any profits or losses that have occurred so far. He simply adjusts his directional exposure to a zero delta. Rolling and Earning a “Free” Call Many traders who trade income-generating strategies are conservative. They are happy to sell low IV for the benefits afforded by low realized volatility. This is the problem-avoidance philosophy of trading. Due to risk aversion, it’s common to trade calendar spreads by buying the two-month option and selling the one-month option. This can allow traders to avoid buying the calendar in earnings months, and it also means a shorter time horizon, signifying less time for something unwanted to happen. But there’s another school of thought among time-spread traders. There are some traders who prefer to buy a longer-term option—six months to a year—while selling a one-month option. Why? Because month after month, the trader can roll the short option to the next month. This is a simple tactic that is used by market makers and other professional traders as well as savvy retail traders. Here’s how it works. XYZ stock is trading at $60 per share. A trader has a neutral outlook over the next six months and decides to buy a calendar. Assuming that July has 29 days until expiration and December has 180, the trader will take the following position: The initial debit here is 2.55. The goal is basically the same as for any time spread: collect theta without negative gamma spoiling the party. There is another goal in these trades as well: to roll the spread. At the end of month one, if the best-case scenario occurs and XYZ is sitting at $60 at July expiration, the July 60 call expires. The December 60 call will then be worth 3.60, assuming all else is held constant. The positive theta of the short July call gives full benefits as the option goes from 1.45 to zero. The lower negative theta of the December call doesn’t bite into profits quite as much as the theta of a short-term call would. The profit after month one is 1.05. Profit is derived from the December call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if a short-term, less expensive August 60 call were the long leg of this spread. Rolling the Spread The July–December spread is different from short-term spreads, however. When the Julys expire, the August options will have 29 days until expiration. If volatility is still the same, XYZ is still at $60, and the trader’s forecast is still neutral, the 29-day August 60 calls can be sold for 1.45. The trader can either wait until the Monday after July expiration and then sell the August 60s, or when the Julys are offered at 0.05 or 0.10, he can buy the Julys and sell the Augusts as a spread. In either case, it is called rolling the spread. When the August expires, he can sell the Septembers, and so on. The goal is to get a credit month after month. At some point, the aggregate credit from the call sales each month is greater than the price initially paid for the long leg of the spread, thus eliminating the original net debit. Exhibit 11.6 shows how the monthly credits from selling the one- month calls aggregate over time. EXHIBIT 11.6 A “free” call. After July has expired, 1.45 of premium is earned. After August expiration, the aggregate increases to 2.90. When the September calls, which have 36 days until expiration, are sold, another 1.60 is added to the total premium collected. Over three months—assuming the stock price, volatility, and the other inputs don’t change—this trader collects a total of 4.50. That’s 0.50 more than the price originally paid for the December 60 call leg of the spread. At this point, he effectively owns the December call for free. Of course, this call isn’t really free; it’s earned. It’s paid for with risk and maybe a few sleepless nights. At this point, even if the stock and, consequently, the December call go to zero, the position is still a profitable trade because of the continued month-to-month rolling. This is now a no-lose situation. When the long call of the spread has been paid for by rolling, there are three choices moving forward: sell it, hold it, or continue writing calls against it. If the trader’s opinion calls for the stock to decline, it’s logical to sell the December call and take the residual value as profit. In this case, over three months the trade will have produced 4.50 in premium from the sale of three consecutive one-month calls, which is more than the initial purchase price of the December call. At September expiration, the premium that will be received for selling the December call is all profit, plus 0.50, which is the aggregate premium minus the initial cost of the December call. If the outlook is for the underlying to rise, it makes sense to hold the call. Any appreciation in the value of the call resulting from delta gains as the underlying moves higher is good—$0.50 plus whatever the call can be sold for. If the forecast is for XYZ to remain neutral, it’s logical to continue selling the one-month call. Because the December call has been financed by the aggregate short call premiums already, additional premiums earned by writing calls are profit with “free” protection. As long as the short is closed at its expiration, the risk of loss is eliminated. This is the general nature of rolling calls in a calendar spread. It’s a beautiful plan when it works! The problem is that it is incredibly unlikely that the stock will stay right at $60 per share for five months. It’s almost inevitable that it will move at some point. It’s like a game of Russian roulette. At some point it’s going to be a losing proposition—you just don’t know when. The benefit of rolling is that if the trade works out for a few months in a row, the long call is paid for and the risk of loss is covered by aggregate profits. If we step outside this best-case theoretical world and consider what is really happening on a day-to-day basis, we can gain insight on how to manage this type of trade when things go wrong. Effectively, a long calendar is a typical gamma/theta trade. Negative gamma hurts. Positive theta helps. If we knew which way the stock was going, we would simply buy or sell stock to adjust to get long or short deltas. But, unfortunately, we don’t. Our only tool is to hedge by buying or selling stock as mentioned above to flatten out when gamma causes the position delta to get more positive or negative. 1 The bottom line is that if the effect of gamma creates unwanted long deltas but the theta/gamma is still a desirable position, selling stock flattens out the delta. If the effect of gamma creates unwanted short deltas, buying stock flattens out the delta. Trading Volatility Term Structure There are other reasons for trading calendar spreads besides generating income from theta. If there is skew in the term structure of volatility, which was discussed in Chapter 3, a calendar spread is a way to trade volatility. The tactic is to buy the “cheap” month and sell the “expensive” month. Selling the Front, Buying the Back If for a particular stock, the February ATM calls are trading at 50 volatility and the May ATM calls are trading at 35 volatility, a vol-calendar trader would buy the Mays and sell the Februarys. Sounds simple, right? The devil is in the details. We’ll look at an example and then discuss some common pitfalls with vol-trading calendars. George has been studying the implied volatility of a $164.15 stock. George notices that front-month volatility has been higher than that of the other months for a couple of weeks. There is nothing in the news to indicate immediate risk of extraordinary movement occurring in this example. George sees that he can sell the 22-day July 165 calls at a 45 percent IV and buy the 85-day September 165 calls at a 38 percent IV. George would like to buy the calendar spread, because he believes the July ATM volatility will drop down to around 38, where the September is trading. If he puts on this trade, he will establish the following position: What are George’s risks? Because he would be selling the short-term ATM option, negative gamma could be a problem. The greeks for this trade, shown in Exhibit 11.7 , confirm this. The negative gamma means each dollar of stock price movement causes an adverse change of about 0.09 to delta. The spread’s delta becomes shorter when the stock rises and longer when the stock falls. Because the position’s delta is long 0.369 from the start, some price appreciation may be welcomed in the short term. The stock advance will yield profits but at a diminishing rate, as negative gamma reduces the delta. EXHIBIT 11.7 10-lot July–September 165 call calendar. But just looking at the net position greeks doesn’t tell the whole story. It is important to appreciate the fact that long calendar spreads such as this have long vegas. In this case, the vega is +1.522. But what does this number really mean? This vega figure means that if IV rises or falls in both the July and the September calls by the same amount, the spread makes or loses $152 per vol point. George’s plan, however, is to see the July’s volatility decline to converge with the September’s. He hopes the volatilities of the two months will move independently of each other. To better gauge his risk, he needs to look at the vega of each option. With the stock at $164.15 the vegas are as follows: If George is right and July volatility declines 8 points, from 46 to 38, he will make $1,283 ($1.604 × 100 × 8). There are a couple of things that can go awry. First, instead of the volatilities converging, they can diverge further. Implied volatility is a slave to the whims of the market. If the July IV continues to rise while the September IV stays the same, George loses $160 per vol point. The second thing that can go wrong is the September IV declining along with the July IV. This can lead George into trouble, too. It depends the extent to which the September volatility declines. In this example, the vega of the September leg is about twice that of the July leg. That means that if the July volatility loses eight points while the September volatility declines four points, profits from the July calls will be negated by losses from the September calls. If the September volatility falls even more, the trade is a loser. IV is a common cause of time-spread failure for market makers. When i in the front month rises, the volatility of the back-months sometimes does as well. When this happens, it’s often because market makers who sold front-month options to retail or institutional buyers buy the back-month options to hedge their short-gamma risk. If the market maker buys enough back-month options, he or she will accumulate positive vega. But when the market sells the front-month volatility back to the market makers, the back months drop, too, because market makers no longer need the back months for a hedge. Traders should study historical implied volatility to avoid this pitfall. As is always the case with long vega strategies, there is a risk of a decline in IV. Buying long-term options with implied volatility in the lower third of the 12-month IV range helps improve the chances of success, since the volatility being bought is historically cheap. This can be tricky, however. If a trader looks back on a chart of IV for an option class and sees that over the past six months it has ranged between 20 and 30 but nine months ago it spiked up to, say, 55, there must be a reason. This solitary spike could be just an anomaly. To eliminate the noise from volatility charts, it helps to filter the data. News stories from that time period and historical stock charts will usually tell the story of why volatility spiked. Often, it is a one-time event that led to the spike. Is it reasonable to include this unique situation when trying to get a feel for the typical range of implied volatility? Usually not. This is a judgment call that needs to be made on a case-by-case basis. The ultimate objective of this exercise is to determine: “Is volatility cheap or expensive?” Buying the Front, Selling the Back All trading is based on the principle of “buy low, sell high”—even volatility trading. With time spreads, we can do both at once, but we are not limited to selling the front and buying the back. When short-term options are trading at a lower IV than long-term ones, there may be an opportunity to sell the calendar. If the IV of the front month is 17 and the back-month IV is 25, for example, it could be a wise trade to buy the front and sell the back. But selling time spreads in this manner comes with its own unique set of risks. First, a short calendar’s greeks are the opposite of those of a long calendar. This trade has negative theta with positive gamma. A sideways market hurts this position as negative theta does its damage. Each day of carrying the position is paid for with time decay. The short calendar is also a short-vega trade. At face value, this implies that a drop in IV leads to profit and that the higher the IV sold in the back month, the better. As with buying a calendar, there are some caveats to this logic. If there is an across-the-board decline in IV, the net short vega will lead to a profit. But an across-the-board drop in volatility, in this case, is probably not a realistic expectation. The front month tends to be more sensitive to volatility. It is a common occurrence for the front month to be “cheap” while the back month is “expensive.” The volatilities of the different months can move independently, as they can when one buys a time spread. There are a couple of scenarios that might lead to the back-month volatility’s being higher than the front month. One is high complacency in the short term. When the market collectively sells options in expectation of lackluster trading, it generally prefers to sell the short-term options. Why? Higher theta. Because the trade has less time until expiration, the trade has a shorter period of risk. Because of this, selling pressure can push down IV in the front-month options more than in the back. Again, the front month is more sensitive to changes in implied volatility. Because volatility has peaks and troughs, this can be a smart time to sell a calendar. The focus here is in seeing the “cheap” front month rise back up to normal levels, not so much in seeing the “expensive” back month fall. This trade is certainly not without risk. If the market doesn’t move, the negative theta of the short calendar leads to a slow, painful death for calendar sellers. Another scenario in which the back-month volatility can trade higher than the front is when the market expects higher movement after the expiration of the short-term option but before the expiration of the long-term option. Situations such as the expectation of the resolution of a lawsuit, a product announcement, or some other one-time event down the road are opportunities for the market to expect such movement. This strategy focuses on the back-month vol coming back down to normal levels, not on the front-month vol rising. This can be a more speculative situation for a volatility trade, and more can go wrong. The biggest volatility risk in selling a time spread is that what goes up can continue to go up. The volatility disparity here is created by hedgers and speculators favoring long-term options, hence pushing up the volatility, in anticipation of a big future stock move. As the likely date of the anticipated event draws near, more buyers can be attracted to the market, driving up IV even further. Realized volatility can remain low as investors and traders lie in wait. This scenario is doubly dangerous when volatility rises and the stock doesn’t move. A trader can lose on negative theta and lose on negative vega. A Directional Approach Calendar spreads are often purchased when the outlook for the underlying is neutral. Sell the short-term ATM option; buy the long-term ATM option; collect theta. But with negative gamma, these trades are never really neutral. The delta is constantly changing, becoming more positive or negative. It’s like a rubber band: at times being stretched in either direction but always demanding a pull back to the strike. When the strike price being traded is not ATM, calendar spreads can be strategically traded as directional plays. Buying a calendar, whether using calls or puts, where the strike price is above the current stock price is a bullish strategy. With calls, the positive delta of the long-term out-of-the-money (OTM) call will be greater than the negative delta of the short-term OTM call. For puts, the positive delta of the short-term in-the-money (ITM) put will be greater than the negative delta of the long-term ITM put. Just the opposite applies if the strike price is below the current stock price. The negative delta of the short-term ITM call is greater than the positive delta of the long-term ITM call. The negative delta of the long-term OTM put is greater than the positive delta of the short-term OTM put. When the position starts out with either a positive or negative delta, movement in the direction of the delta is necessary for the trade to be profitable. Negative gamma is also an important strategic consideration. Stock-price movement is needed, but not too much. Buying calendar spreads is like playing outfield in a baseball game. To catch a fly ball, an outfielder must focus on both distance and timing. He must gauge how far the ball will be hit and how long it will take to get there. With calendars, the distance is the strike price—that’s where the stock needs to be—and the time is the expiration day of the short month’s option: that’s when it needs to be at the target price. For example, with Wal-Mart (WMT) at $48.50, a trader, Pete, is looking for a rise to about $50 over the next five or six weeks. Pete buys the August–September call calendar. In this example, August has 39 days until expiration and September has 74 days. Exactly what does 50 cents buy Pete? The stock price sitting below the strike price means a net positive delta. This long time spread also has positive theta and vega. Gamma is negative. Exhibit 11.8 shows the specifics. EXHIBIT 11.8 10-lot Wal-Mart August–September 50 call calendar. The delta of this trade, while positive, is relatively small with 39 days left until August expiration. It’s not rational to expect a quick profit if the stock advances faster than expected. But ultimately, a rise in stock price is the goal. In this example, Wal-Mart needs to rise to $50, and timing is everything. It needs to be at that price in 39 days. In the interim, a move too big and too fast in either direction hurts the trade because of negative gamma. Starting with Wal-Mart at $48.50, delta/gamma problems are worse to the downside. Exhibit 11.9 shows the effects of stock price on delta, gamma, and theta. EXHIBIT 11.9 Stock price movement and greeks. If Wal-Mart moves lower, the delta gets more positive, racking up losses at a higher rate. To add to Pete’s woes, theta becomes less of a benefit as the stock drifts lower. At $47 a share, theta is about flat. With Wal-Mart trading even lower than $47, the positive theta of the August call is overshadowed by the negative theta of the September. Theta can become negative, causing the position to lose value as time passes. A big move to the upside doesn’t help either. If Wal-Mart rises just a bit, the −0.323 gamma only lessens the benefit of the 0.563 delta. But above $50, negative gamma begins to cause the delta to become increasingly negative. Theta begins to wither away at higher stock prices as well. The place to be is right at $50. The delta is flat and theta is highest. As long as Wal-Mart finds its way up to this price by the third Friday of August, life is good for Pete. The In-or-Out Crowd Pete could just as well have traded the Aug–Sep 50 put calendar in this situation. If he’d been bearish, he could have traded either the Aug–Sep 45 call spread or the Aug–Sep 45 put spread. Whether bullish or bearish, as mentioned earlier, the call calendar and the put calendar both function about the same. When deciding which to use, the important consideration is that one of them will be in-the-money and the other will be OTM. Whether you have an ITM spread or an OTM spread has potential implications for the success of the trade. The bid-ask spreads tend to be wider for higher-delta, ITM options. Because of this, it can be more expensive to enter into an ITM calendar. Why? Trading options with wider markets requires conceding more edge. Take the following options series: By buying the May 50 calls at 3.20, a trader gives up 0.10 of theoretical edge (3.20 is 0.10 higher than the theoretical value). Buying the put at 1.00 means buying only 0.05 over theoretical. Because a calendar is a two-legged spread, the double edge given up by trading the wider markets of two in-the-money options can make the out-of- the-money spread a more attractive trade. The issue of wider markets is compounded when rolling the spread. Giving up a nickel or a dime each month can add up, especially on nominally low-priced spreads. It can cut into a high percentage of profits. Early assignment can complicate ITM calendars made up of American options, as dividends and interest can come into play. The short leg of the spread could get assigned before the expiration date as traders exercise calls to capture the dividend. Short ITM puts may get assigned early because of interest. Although assignment is an undesirable outcome for most calendar spread traders, getting assigned on the short leg of the calendar spread may not necessarily create a significantly different trade. If a long put calendar, for example, has a short front-month put that is so deep in-the-money that it is likely to get assigned, it is trading close to a 100 delta. It is effectively a long stock position already. After assignment, when a long stock position is created, the resulting position is long stock with a deep ITM long put—a fairly delta-flat position. Double Calendars Definition : A double calendar spread is the execution of two calendar spreads that have the same months in common but have two different strike prices. Example Sell 1 XYZ February 70 call Buy 1 XYZ March 70 call Sell 1 XYZ February 75 call Buy 1 XYZ March 75 call Double calendars can be traded for many reasons. They can be vega plays. If there is a volatility-time skew, a double calendar is a way to take a position without concentrating delta or gamma/theta risk at a single strike. This spread can also be a gamma/theta play. In that case, there are two strikes, so there are two potential focal points to gravitate to (in the case of a long double calendar) or avoid (in the case of a short double calendar). Selling the two back-month strikes and buying the front-month strikes leads to negative theta and positive gamma. The positive gamma creates favorable deltas when the underlying moves. Positive or negative deltas can be covered by trading the underlying stock. With positive gamma, profits can be racked up by buying the underlying to cover short deltas and subsequently selling the underlying to cover long deltas. Buying the two back-month strikes and selling the front-month strikes creates negative gamma and positive theta, just as in a conventional calendar. But the underlying stock has two target price points to shoot for at expiration to achieve the maximum payout. Often double calendars are traded as IV plays. Many times when they are traded as IV plays, traders trade the lower-strike spread as a put calendar and the higher-strike spread a call calendar. In that case, the spread is sometimes referred to as a strangle swap . Strangles are discussed in Chapter 15. Two Courses of Action Although there may be many motivations for trading a double calendar, there are only two courses of action: buy it or sell it. While, for example, the trader’s goal may be to capture theta, buying a double calendar comes with the baggage of the other greeks. Fully understanding the interrelationship of the greeks is essential to success. Option traders must take a holistic view of their positions. Let’s look at an example of buying a double calendar. In this example, Minnesota Mining & Manufacturing (MMM) has been trading in a range between about $85 and $97 per share. The current price of Minnesota Mining & Manufacturing is $87.90. Economic data indicate no specific reasons to anticipate that Minnesota Mining & Manufacturing will deviate from its recent range over the next month—that is, there is nothing in the news, no earnings anticipated, and the overall market is stable. August IV is higher than October IV by one volatility point, and October implied volatility is in line with 30-day historical volatility. There are 38 days until August expiration, and 101 days until October expiration. The Aug–Oct 85–90 double calendar can be traded at the following prices: Much like a traditional calendar spread, the price points cannot be definitively plotted on a P&(L) diagram. What is known for certain is that at August expiration, the maximum loss is $3,200. While it’s comforting to know that there is limited loss, losing the entire premium that was paid for the spread is an outcome most traders would like to avoid. We also know the maximum gains occur at the strike prices; but not exactly what the maximum profit can be. Exhibit 11.10 provides an alternative picture of the position that is useful in managing the trade on a day-to-day basis. EXHIBIT 11.10 10-lot Minnesota Mining & Manufacturing Aug–Oct 85– 90 double call calendar. These numbers are a good representation of the position’s risk. Knowing that long calendars and long double calendars have maximum losses at the expiration of the short-term option equal to the net premiums paid, the max loss in this example is 3.20. Break-even prices are not relevant to this position because they cannot be determined with any certainty. What is important is to get a feel for how much movement can hurt the position. To make $19 a day in theta, a −0.468 gamma must be accepted. In the long run, $1 of movement is irrelevant. In fact, some movement is favorable because the ideal point for MMM to be at, at August expiration is either $85 or $90. So while small moves are acceptable, big moves are of concern. The negative gamma is an illustration of this warning. The other risk besides direction is vega. A positive 1.471 vega means the calendar makes or loses about $147 with each one-point across-the-board change in implied volatility. Implied volatility is a risk in all calendar trades. Volatility was one of the criteria studied when considering this trade. Recall that the August IV was one point higher than the October and that the October IV was in line with the 30-day historical volatility at inception of the trade. Considering the volatility data is part of the due diligence when considering a calendar or a double calendar. First, the (slightly) more expensive options (August) are being sold, and the cheaper ones are being bought (October). A study of the company reveals no news to lead one to believe that Minnesota Mining & Manufacturing should move at a higher realized volatility than it currently is in this example. Therefore, the front month’s higher IV is not a red flag. Because the volatility of the October option (the month being purchased) is in line with the historical volatility, the trader could feel that he is paying a reasonable price for this volatility. In the end, the trade is evaluated on the underlying stock, realized volatility, and IV. The trade should be executed only after weighing all the available data. Trading is both cerebral and statistical in nature. It’s about gaining a statistically better chance of success by making rational decisions. Diagonals Definition : A diagonal spread is an option strategy that involves buying one option and selling another option with a different strike price and with a different expiration date. Diagonals are another strategy in the time spread family. Diagonals enable a trader to exploit opportunities similar to those exploited by a calendar spread, but because the options in a diagonal spread have two different strike prices, the trade is more focused on delta. The name diagonal comes from the fact that the spread is a combination of a horizontal spread (two different months) and a vertical spread (two different strikes). Say it’s 22 days until January expiration and 50 days until February expiration. Apple Inc. (AAPL) is trading at $405.10. Apple has been in an uptrend heading toward the peak of its six-month range, which is around $420. A trader, John, believes that it will continue to rise and hit $420 again by February expiration. Historical volatility is 28 percent. The February 400 calls are offered at a 32 implied volatility and the January 420 calls are bid on a 29 implied volatility. John executes the following diagonal: Exhibit 11.11 shows the analytics for this trade. EXHIBIT 11.11 Apple January–February 400–420 call diagonal. From the presented data, is this a good trade? The answer to this question is contingent on whether the position John is taking is congruent with his view of direction and volatility and what the market tells him about these elements. John is bullish up to August expiration, and the stock in this example is in an uptrend. Any rationale for bullishness may come from technical or fundamental analysis, but techniques for picking direction, for the most part, are beyond the scope of this book. Buying the lower strike in the February option gives this trade a more positive delta than a straight calendar spread would have. The trader’s delta is 0.255, or the equivalent of about 25.5 shares of Apple. This reflects the trader’s directional view. The volatility is not as easy to decipher. A specific volatility forecast was not stated above, but there are a few relevant bits of information that should be considered, whether or not the trader has a specific view on future volatility. First, the historical volatility is 28 percent. That’s lower than either the January or the February calls. That’s not ideal. In a perfect world, it’s better to buy below historical and sell above. To that point, the February option that John is buying has a higher volatility than the January he is selling. Not so good either. Are these volatility observations deal breakers? A Good Ex-Skews It’s important to take skew into consideration. Because the January calls have a higher strike price than the February calls, it’s logical for them to trade at a lower implied volatility. Is this enough to justify the possibility of selling the lower volatility? Consider first that there is some margin for error. The bid-ask spreads of each of the options has a volatility disparity. In this case, both the January and February calls are 10 cents wide. That means with a January vega of 0.34 the bid-ask is about 0.29 vol points wide. The Februarys have a 0.57 vega. They are about 0.18 vol points wide. That accounts for some of the disparity. Natural vertical skew accounts for the rest of the difference, which is acceptable as long as the skew is not abnormally pronounced. As for other volatility considerations, this diagonal has the rather unorthodox juxtaposition of positive vega and negative gamma seen with other time spreads. The trader is looking for a move upward, but not a big one. As the stock rises and Apple moves closer to the 420 strike, the positive delta will shrink and the negative gamma will increase. In order to continue to enjoy profits as the stock rises, John may have to buy shares of Apple to keep his positive delta. The risk here is that if he buys stock and Apple retraces, he may end up negative scalping stock. In other words, he may sell it back at a lower price than he bought it. Using stock to adjust the delta in a negative-gamma play can be risky business. Gamma scalping is addressed further in Chapter 13. Making the Most of Your Options The trader from the previous example had a time-spread alternative to the diagonal: John could have simply bought a traditional time spread at the 420 strike. Recall that calendars reap the maximum reward when they are at the shared strike price at expiration of the short-term option. Why would he choose one over the other? The diagonal in that example uses a lower-strike call in the February than a straight 420 calendar spread and therefore has a higher delta, but it costs more. Gamma, theta, and vega may be slightly lower with the in-the-money call, depending on how far from the strike price the ITM call is and how much time until expiration it has. These, however, are less relevant differences. The delta of the February 400 call is about 0.57. The February 420 call, however, has only a 0.39 delta. The 0.18 delta difference between the calls means the position delta of the time spread will be only about 0.07 instead of about 0.25 of the diagonal—a big difference. But the trade-off for lower delta is that the February 420 call can be bought for 12.15. That means a lower debit paid—that means less at risk. Conversely, though there is greater risk with the diagonal, the bigger delta provides a bigger payoff if the trader is right. Double Diagonals A double diagonal spread is the simultaneous trading of two diagonal spreads: one call spread and one put spread. The distance between the strikes is the same in both diagonals, and both have the same two expiration months. Usually, the two long-term options are more out-of-the-money than the two shorter-term options. For example Buy 1 XYZ May 70 put Sell 1 XYZ March 75 put Sell 1 XYZ March 85 call Buy 1 XYZ May 90 call Like many option strategies, the double diagonal can be looked at from a number of angles. Certainly, this is a trade composed of two diagonal spreads—the March–May 70–75 put and the March–May 85–90 call. It is also two strangles—buying the May 70–90 strangle and selling the March 75–85 strangle. One insightful way to look at this spread is as an iron condor in which the guts are March options and the wings are May options. Trading a double diagonal like this one, rather than a typically positioned iron condor, can offer a few advantages. The first advantage, of course, is theta. Selling short-term options and buying long-term options helps the trader reap higher rates of decay. Theta is the raison d’être of the iron condor. A second advantage is rolling. If the underlying asset stays in a range for a long period of time, the short strangle can be rolled month after month. There may, in some cases, also be volatility-term-structure discrepancies on which to capitalize. A trader, Paul, is studying JPMorgan (JPM). The current stock price is $49.85. In this example, JPMorgan has been trading in a pretty tight range over the past few months. Paul believes it will continue to do so over the next month. Paul considers the following trade: Paul considers volatility. In this example, the JPMorgan ATM call, the August 50 (which is not shown here), is trading at 22.9 percent implied volatility. This is in line with the 20-day historical volatility, which is 23 percent. The August IV appears to be reasonably in line with the September volatility, after accounting for vertical skew. The IV of the August 52.50 calls is 1.5 points above that of the September 55 calls and the August 47.50 put IV is 1.6 points below the September 45 put IV. It appears that neither month’s volatility is cheap or expensive. Exhibit 11.12 shows the trade’s greeks. EXHIBIT 11.12 10-lot JPMorgan August–September 45–47.50–52.50–55 double diagonal. The analytics of this trade are similar to those of an iron condor. Immediate directional risk is almost nonexistent, as indicated by the delta. But gamma and theta are high, even higher than they would be if this were a straight September iron condor, although not as high as if this were an August iron condor. Vega is positive. Surely, if this were an August or a September iron condor, vega would be negative. In this example, Paul is indifferent as to whether vega is positive or negative because IV is fairly priced in terms of historical volatility and term structure. In fact, to play it close to the vest, Paul probably wants the smallest vega possible, in case of an IV move. Why take on the risk? The motivation for Paul’s double diagonal was purely theta. The volatilities were all in line. And this one-month spread can’t be rolled. If Paul were interested in rolling, he could have purchased longer-term options. But if he is anticipating a sideways market for only the next month and feels that volatility could pick up after that, the one-month play is the way to go. After August expiration, Paul will have three choices: sell his Septembers, hold them, or turn them into a traditional iron condor by selling the September 47.50s and 52.50s. This depends on whether he is indifferent, expects high volatility, or expects low volatility. The Strength of the Calendar Spreads in the calendar-spread family allow traders to take their trading to a higher level of sophistication. More basic strategies, like vertical spreads and wing spreads, provide a practical means for taking positions in direction, realized volatility, and to some extent implied volatility. But because calendar-family spreads involve two expiration months, traders can take positions in the same market variables as with these more basic strategies and also in the volatility spread between different expiration months. Calendar-family spreads are veritable volatility spreads. This is a powerful tool for option traders to have at their disposal. Note 1 . Advanced hedging techniques are discussed in subsequent chapters. PART III Volatility CHAPTER 12 Delta-Neutral Trading Trading Implied Volatility Many of the strategies covered so far have been option-selling strategies. Some had a directional bias; some did not. Most of the strategies did have a primary focus on realized volatility—especially selling it. These short volatility strategies require time. The reward of low stock volatility is theta. In general, most of the strategies previously covered were theta trades in which negative gamma was an unpleasant inconvenience to be dealt with. Moving forward, much of the remainder of this book will involve more in-depth discussions of trading both realized and implied volatility (IV), with a focus on the harmonious, and sometimes disharmonious, relationship between the two types. Much attention will be given to how IV trades in the option market, describing situations in which volatility moves are likely to occur and how to trade them. Direction Neutral versus Direction Indifferent In the world of nonlinear trading, there are two possible nondirectional views of the underlying asset: direction neutral and direction indifferent. Direction neutral means the trader believes the stock will not trend either higher or lower. The trader is neutral in his or her assessment of the future direction of the asset. Short iron condors, long time spreads, and out-of-the- money (OTM) credit spreads are examples of direction-neutral strategies. These strategies generally have deltas close to zero. Because of negative gamma, movement is the bane of the direction-neutral trade. Direction indifferent means the trader may desire movement in the underlying but is indifferent as to whether that movement is up or down. Some direction-indifferent trades are almost completely insulated from directional movement, with a focus on interest or dividends instead. Examples of these types of trades are conversions, reversals, and boxes, which are described in Chapter 6, as well as dividend plays, which are described in Chapter 8. Other direction-indifferent strategies are long option strategies that have positive gamma. In these trades, the focus is on movement, but the direction of that movement is irrelevant. These are plays that are bullish on realized volatility. Yet other direction-indifferent strategies are volatility plays from the perspective of IV. These are trades in which the trader’s intent is to take a bullish or bearish position in IV. Delta Neutral To be truly direction neutral or direction indifferent means to have a delta equal to zero. In other words, there are no immediate gains if the underlying moves incrementally higher or lower. This zero-delta method of trading is called delta-neutral trading . A delta-neutral position can be created from any option position simply by trading stock to flatten out the delta. A very basic example of a delta- neutral trade is a long at-the-money (ATM) call with short stock. Consider a trade in which we buy 20 ATM calls that have a 50 delta and sell stock on a delta-neutral ratio. Buy 20 50-delta calls (long 1,000 deltas) Short 1,000 shares (short 1,000 deltas) In this position, we are long 1,000 deltas from the calls (20 × 50) and short 1,000 deltas from the short sale of stock. The net delta of the position is zero. Therefore, the immediate directional exposure has been eliminated from the trade. But intuitively, there are other opportunities for profit or loss with this trade. The addition of short stock to the calls will affect only the delta, not the other greeks. The long calls have positive gamma, negative theta, and positive vega. Exhibit 12.1 is a simplified representation of the greeks for this trade. EXHIBIT 12.1 20-lot delta-neutral long call. With delta not an immediate concern, the focus here is on gamma, theta, and vega. The +1.15 vega indicates that each one-point change in IV makes or loses $115 for this trade. Yet there is more to the volatility story. Each day that passes costs the trader $50 in time decay. Holding the position for an extended period of time can produce a loser even if IV rises. Gamma is potentially connected to the success of this trade, too. If the underlying moves in either direction, profit from deltas created by positive gamma may offset the losses from theta. In fact, a big enough move in either direction can produce a profitable trade, regardless of what happens to IV. Imagine, for a moment, that this trade is held until expiration. If the stock is below the strike price at this point, the calls expire. The resulting position is short 1,000 shares of stock. If the stock is above the strike price at expiration, the calls can be exercised, creating 2,000 shares of long stock. Because the trade is already short 1,000 shares, the resulting net position is long 1,000 shares (2,000 − 1,000). Clearly, the more the underlying stock moves in either direction the greater the profit potential. The underlying has to move far enough above or below the strike price to allow the beneficial gains from buying or selling stock to cover the option premium lost from time decay. If the trade is held until expiration, the underlying needs to move far enough to cover the entire premium spent on the calls. The solid lines forming a V in Exhibit 12.2 conceptually illustrate the profit or loss for this delta-neutral long call at expiration. EXHIBIT 12.2 Profit-and-loss diagram for delta-neutral long-call trade. Because of gamma, some deltas will be created by movement of the underlying before expiration. Gamma may lead to this being a profitable trade in the short term, depending on time and what happens with IV. The dotted line illustrates the profit or loss of this trade at the point in time when the trade is established. Because the options may still have time value at this point—depending on how far from the strike price the stock is trading —the value of the position, as a whole, is higher than it will be if the calls are trading at parity at expiration. Regardless, the plan is for the stock to make a move in either direction. The bigger the move and the faster it happens, the better. Why Trade Delta Neutral? A few years ago, I was teaching a class on option trading. Before the seminar began, I was talking with one of the students in attendance. I asked him what he hoped to learn in the class. He said that he was really interested in learning how to trade delta neutral. When I asked him why he was interested in that specific area of trading, he replied, “I hear that’s where all the big money is made!” This observation, right or wrong, probably stems from the fact that in the past most of the trading in this esoteric discipline has been executed by professional traders. There are two primary reasons why the pros have dominated this strategy: high commissions and high margin requirements for retail traders. Recently, these two reasons have all but evaporated. First, the ultracompetitive world of online brokers has driven commissions for retail traders down to, in some cases, what some market makers pay. Second, the oppressive margin requirements that retail option traders were subjected to until 2007 have given way to portfolio margining. Portfolio Margining Customer portfolio margining is a method of calculating customer margin in which the margin requirement is based on the “up and down risk” of the portfolio. Before the advent of portfolio margining, retail traders were subject to strategy-based margining, also called Reg. T margining, which in many cases required a significantly higher amount of capital to carry a position than portfolio margining does. With portfolio margining, highly correlated securities can be offset against each other for purposes of calculating margin. For example, SPX options and SPY options—both option classes based on the Standard & Poor’s 500 Index—can be considered together in the margin calculation. A bearish position in one and a bullish position in the other may partially offset the overall risk of the portfolio and therefore can help to reduce the overall margin requirement. With portfolio margining, many strategies are margined in such a way that, from the point of view of this author, they are subject to a much more logical means of risk assessment. Strategy-based margining required traders of some strategies, like a protective put, to deposit significantly more capital than one could possibly lose by holding the position. The old rules require a minimum margin of 50 percent of the stock’s value and up to 100 percent of the put premium. A portfolio-margined protective put may require only a fraction of what it would with strategy-based margining. Even though Reg. T margining is antiquated and sometimes unreasonable, many traders must still abide by these constraints. Not all traders meet the eligibility requirements to qualify for portfolio-based margining. There is a minimum account balance for retail traders to be eligible for this treatment. A broker may also require other criteria to be met for the trader to benefit from this special margining. Ultimately, portfolio margining allows retail traders to be margined similarly to professional traders. There are some traders, both professional and otherwise, who indeed have made “big money,” as the student in my class said, trading delta neutral. But, to be sure, there are successful and unsuccessful traders in many areas of trading. The real motivation for trading delta neutral is to take a position in volatility, both implied and realized. Trading Implied Volatility With a typical option, the sensitivity of delta overshadows that of vega. To try and profit from a rise or fall in IV, one has to trade delta neutral to eliminate immediate directional sensitivity. There are many strategies that can be traded as delta-neutral IV strategies simply by adding stock. Throughout this chapter, I will continue using a single option leg with stock, since it provides a simple yet practical example. It’s important to note that delta-neutral trading does not refer to a specific strategy; it refers to the fact that the trader is indifferent to direction. Direction isn’t being traded, volatility is. Volatility trading is fundamentally different from other types of trading. While stocks can rise to infinity or decline to zero, volatility can’t. Implied volatility, in some situations, can rise to lofty levels of 100, 200, or even higher. But in the long-run, these high levels are not sustainable for most stocks. Furthermore, an IV of zero means that the options have no extrinsic value at all. Now that we have established that the thresholds of volatility are not as high as infinity and not as low as zero, where exactly are they? The limits to how high or low IV can go are not lines in the sand. They are more like tides that ebb and flow, but normally come up only so far onto the beach. The volatility of an individual stock tends to trade within a range that can be unique to that particular stock. This can be observed by studying a chart of recent volatility. When IV deviates from the range, it is typical for it to return to the range. This is called reversion to the mean , which was discussed in Chapter 3. IV can get stretched in either direction like a rubber band but then tends to snap back to its original shape. There are many examples of situations where reversion to the mean enters into trading. In some, volatility temporarily dips below the typical range, and in some, it rises beyond the recent range. One of the most common examples is the rush and the crush. The Rush and the Crush In this situation, volatility rises before and falls after a widely anticipated news announcement, of earnings, for instance, or of a Food and Drug Administration (FDA) approval. In this situation, option buyers rush in and bid up IV. The more uncertainty—the more demand for insurance—the higher vol rises. When the event finally occurs and the move takes place or doesn’t, volatility gets crushed. The crush occurs when volatility falls very sharply—sometimes 10 points, 20 points, or more—in minutes. Traders with large vega positions appreciate the appropriateness of the term crush all too well. Volatility traders also affectionately refer to this sudden drop in IV by saying that volatility has gotten “whacked.” In order to have a feel for whether implied volatility is high or low for a particular stock, you need to know where it’s been. It’s helpful to have an idea of where realized volatility is and has been, too. To be sure, one analysis cannot be entirely separate from the other. Studying both implied and realized volatility and how they relate is essential to seeing the big picture. The Inertia of Volatility Sir Isaac Newton said that an object in motion tends to stay in motion unless acted upon by another force. Volatility acts much the same way. Most stocks tend to trade with a certain measurable amount of daily price fluctuations. This can be observed by looking at the stock’s realized volatility. If there is no outside force—some pivotal event that fundamentally changes how the stock is likely to behave—one would expect the stock to continue trading with the same level of daily price movement. This means IV (the market’s expectation of future stock volatility) should be the same as realized volatility (the calculated past stock volatility). But just as in physics, it seems there is always some friction affecting the course of what is in motion. Corporate earnings, Federal Reserve Board reports, apathy, lulls in the market, armed conflicts, holidays, rumors, and takeovers, among other market happenings all provide a catalyst for volatility changes. Divergences of realized and implied volatility, then, are commonplace. These divergences can create tradable conditions, some of which are more easily exploited than others. To find these opportunities, a trader must conduct a study of volatility. Volatility charts can help a trader visualize the big picture. This historical information offers a comparison of what is happening now in volatility with what has happened in the past. The following examples use a volatility chart to show how two different traders might have traded the rush and crush of an earnings report. Volatility Selling Susie Seller, a volatility trader, studies semiconductor stocks. Exhibit 12.3 shows the volatilities of a $50 chip stock. The circled area shows what happened before and after second-quarter earnings were reported in July. The black line is the IV, and the gray is the 30-day historical. EXHIBIT 12.3 Chip stock volatility before and after earnings reports. Source : Chart courtesy of iVolatility.com In mid-July, Susie did some digging to learn that earnings were to be announced on July 24, after the close. She was careful to observe the classic rush and crush that occurred to varying degrees around the last three earnings announcements, in October, January, and April. In each case, IV firmed up before earnings only to get crushed after the report. In mid-to-late July, she watched as IV climbed to the mid-30s (the rush) just before earnings. As the stock lay in wait for the report, trading came to a proverbial screeching halt, sending realized volatility lower, to about 13 percent. Susie waited for the end of the day just before the report to make her move. Before the closing bell, the stock was at $50. Susie sold 20 one- month 50-strike calls at 2.10 (a 35 volatility) and bought 1,100 shares of the underlying stock at $50 to become delta neutral. Exhibit 12.4 shows Susie’s position. EXHIBIT 12.4 Delta-neutral short ATM call, long stock position. Her delta was just about flat. The delta for the 50 calls was 0.54 per contract. Selling a 20-lot creates 10.80 short deltas for her overall position. After buying 1,100 shares, she was left long 0.20 deltas, about the equivalence of being long 20 shares. Where did her risk lie? Her biggest concern was negative gamma. Without even seeing a chart of the stock’s price, we can see from the volatility chart that this stock can have big moves on earnings. In October, earnings caused a more than 10-point jump in realized volatility, to its highest level during the year shown. Whether the stock rose or fell is irrelevant. Either event means risk for a premium seller. The positive theta looks good on the surface, but in fact, theta provided Susie with no significant benefit. Her plan was “in and out and nobody gets hurt.” She got into the trade right before the earnings announcement and out as soon as implied volatility dropped off. Ideally, she’d like to hold these types of trades for less than a day. The true prize is vega. Susie was looking for about a 10-point drop in IV, which this option class had following the October and January earnings reports. April had a big drop in IV, as well, of about eight or nine points. Ultimately, what Susie is looking for is reversion to the mean. She gauges the normal level of volatility by observing where it is before and after the surges caused by earnings. From early November to mid- to late- December, the stock’s IV bounced around the 25 percent level. In the month of February, the IV was around 25. After the drop-off following April earnings and through much of May, the IV was closer to 20 percent. In June, IV was just above 25. Susie surmised from this chart that when no earnings event is pending, this stock’s options typically trade at about a 25 percent IV. Therefore, anticipating a 10-point decline from 35 was reasonable, given the information available. If Susie gets it right, she stands to make $1,150 from vega (10 points × 1.15 vegas × 100). As we can see from the right side of the volatility chart in Exhibit 12.3 , Susie did get it right. IV collapsed the next morning by just more than ten points. But she didn’t make $1,150; she made less. Why? Realized volatility (gamma). The jump in realized volatility shown on the graph is a function of the fact that the stock rallied $2 the day after earnings. Negative gamma contributed to negative deltas in the face of a rallying market. This negative delta affected some of Susie’s potential vega profits. So what was Susie’s profit? On this trade she made $800. The next morning at the open, she bought back the 50-strike calls at 2.80 (25 IV) and sold the stock at $52. To compute her actual profit, she compared the prices of the spread when entering the trade with the prices of the spread when exiting. Exhibit 12.5 shows the breakdown of the trade. EXHIBIT 12.5 Profit breakdown of delta-neutral trade. After closing the trade, Susie knew for sure what she made or lost. But there are many times when a trader will hold a delta-neutral position for an extended period of time. If Susie hadn’t closed her trade, she would have looked at her marks to see her P&(L) at that point in time. Marks are the prices at which the securities are trading in the actual market, either in real time or at end of day. With most online brokers’ trading platforms or options-trading software, real-time prices are updated dynamically and always at their fingertips. The profit or loss is, then, calculated automatically by comparing the actual prices of the opening transaction with the current marks. What Susie will want to know is why she made $800. Why not more? Why not less, for that matter? When trading delta neutral, especially with more complex trades involving multiple legs, a manual computation of each leg of the spread can be tedious. And to be sure, just looking at the profit or loss on each leg doesn’t provide an explanation. Susie can see where her profits or losses came from by considering the profit or loss for each influence contributing to the option’s value. Exhibit 12.6 shows the breakdown. EXHIBIT 12.6 Profit breakdown by greek. Delta Susie started out long 0.20 deltas. A $2 rise in the stock price yielded a $40 profit attributable to that initial delta. Gamma As the stock rose, the negative delta of the position increased as a result of negative gamma. The delta of the stock remained the same, but the negative delta of the 50 call grew by the amount of the gamma. Deriving an exact P&(L) attributable to gamma is difficult because gamma is a dynamic metric: as the stock price changes, so can the gamma. This calculation assumes that gamma remains constant. Therefore, the gamma calculation here provides only an estimate. The initial position gamma of −1.6 means the delta decreases by 3.2 with a $2 rise in the stock (–1.60 times the $2 rise in the stock price). Susie, then, would multiply −3.2 by $2 to find the loss on −3.2 deltas over a $2 rise. But she wasn’t short 3.2 deltas for the whole $2. She started out with zero deltas attributable to gamma and ended up being 3.2 shorter from gamma over that $2 move. Therefore, if she assumes her negative delta from gamma grew steadily from 0 to −3.2, she can estimate her average delta loss over that move by dividing by 2. Theta Susie held this trade one day. Her total theta contributed 0.75 or $75 to her position. Vega Vega is where Susie made her money on this trade. She was able to buy her call back 10 IV points lower. The initial position vega was −1.15. Multiplying −1.15 by the negative 10-point crush of volatility yields a vega profit of $1,150. Conclusions Studying her position’s P&(L) by observing what happened in her greeks provides Susie with an alternate—and in some ways, better—method to evaluate her trade. The focus of this delta-neutral trade is less on the price at which Susie can buy the calls back to close the position than on the volatility level at which she can buy them back, weighed against the P&(L) from her other risks. Analyzing her position this way gives her much more information than just comparing opening and closing prices. Not only does she get a good estimate of how much she made or lost, but she can understand why as well. The Imprecision of Estimation It is important to notice that the P&(L) found by adding up the P&(L)’s from the greeks is slightly different from the actual P&(L). There are a couple of reasons for this. First, the change in delta resulting from gamma is only an estimate, because gamma changes as the stock price changes. For small moves in the underlying, the gamma change is less significant, but for larger moves, the rate of change of the gamma can be bigger, and it can be nonlinear. For example, as an option moves from being at-the-money (ATM) to being out-of-the-money (OTM), its gamma decreases. But as the option becomes more OTM, its gamma decreases at a slower rate. Another reason that the P&(L) from the greeks is different from the actual P&(L) is that the greeks are derived from the option-pricing model and are therefore theoretical values and do not include slippage. Furthermore, the volatility input in this example is rounded a bit for simplicity. For example, a volatility of 25 actually yielded a theoretical value of 2.796, while the call was bought at 2.80. Because some options trade at minimum price increments of a nickel, and none trade in fractions of a penny, IV is often rounded. Caveat Venditor Reversion to the mean holds the promise of profit in this trade, but Susie also knows that this strategy does not come without risks of loss. The mean to which volatility is expected to revert is not a constant. This benchmark can and does change. In this example, if the company had an unexpectedly terrible quarter, the stock could plunge sharply. In some cases, this would cause IV to find a new, higher level at which to reside. If that had happened here, the trade could have been a big loser. Gamma and vega could both have wreaked havoc. In trading, there is no sure thing, no matter what the chart looks like. Remember, every ship on the bottom of the ocean has a chart! Volatility Buying This same earnings event could have been played entirely differently. A different trader, Bobby Buyer, studied the same volatility chart as Susie. It is shown again here as Exhibit 12.7 . Bobby also thought there would be a rush and crush of IV, but he decided to take a different approach. EXHIBIT 12.7 Chip stock volatility before and after earnings reports. Source : Chart courtesy of iVolatility.com About an hour before the close of business on July 21, just three days before earnings announcements, Bobby saw that he could buy volatility at 30 percent. In Bobby’s opinion, volatility seemed cheap with earnings so close. He believed that IV could rise at least five points over the next three days. Note that we have the benefit of 20/20 hindsight in the example. Near the end of the trading day, the stock was at $49.70. Bobby bought 20 33-day 50-strike calls at 1.75 (30 volatility) and sold short 1,000 shares of the underlying stock at $49.70 to become delta neutral. Exhibit 12.8 shows Bobby’s position. EXHIBIT 12.8 Delta-neutral long call, short stock position. With the stock at $49.70, the calls had +0.51 delta per contract, or +10.2 for the 20-lot. The short sale of 1,000 shares got Bobby as close to delta- neutral as possible without trading an odd lot in the stock. The net position delta was +0.20, or about the equivalent of being long 20 shares of stock. Bobby’s objective in this case is to profit from an increase in implied volatility leading up to earnings. While Susie was looking for reversion to the mean, Bobby hoped for a further divergence. For Bobby, positive gamma looked like a good thing on the surface. However, his plan was to close the position just before earnings were released—before the vol crush and before the potential stock-price move. With realized volatility already starting to drop off at the time the trade was put on, gamma offered little promise of gain. As fate would have it, IV did indeed increase. At the end of the day before the July earnings report, IV was trading at 35 percent. Bobby closed his trade by selling his 20-lot of the 50 calls at 2.10 and buying his 1,000 shares of stock back at $50. Exhibit 12.9 shows the P&(L) for each leg of the spread. EXHIBIT 12.9 Profit breakdown. The calls earned Bobby a total of $700, while the stock lost $300. Of course, with this type of trade, it is not relevant which leg was a winner and which a loser. All that matters is the bottom line. The net P&(L) on the trade was a gain of $400. The gain in this case was mostly a product of IV’s rising. Exhibit 12.10 shows the P&(L) per greek. EXHIBIT 12.10 Profit breakdown by greek. Delta The position began long 0.20 deltas. The 0.30-point rise earned Bobby a 0.06 point gain in delta per contract. Gamma Bobby had an initial gamma of +1.8. We will use 1.8 for estimating the P& (L) in this example, assuming gamma remained constant. A 0.30 rise in the stock price multiplied by the 1.8 gamma means that with the stock at $50, Bobby was long an additional 0.54 deltas. We can estimate that over the course of the 0.30 rise in the stock price, Bobby was long an average of 0.27 (0.54 ÷ 2). His P&(L) due to gamma, therefore, is a gain of about 0.08 (0.27 × 0.30). Theta Bobby held this trade for three days. His total theta cost him 1.92 or $192. Vega The biggest contribution to Bobby’s profit on this trade was made by the spike in IV. He bought 30 volatility and sold 35 volatility. His 1.20 position vega earned him 6.00, or $600. Conclusions The $422 profit is not exact, but the greeks provide a good estimate of the hows and the whys behind it. Whether they are used for forecasting profits or for doing a postmortem evaluation of a trade, consulting the greeks offers information unavailable by just looking at the transaction prices. By thinking about all these individual pricing components, a trader can make better decisions. For example, about two weeks earlier, Bobby could have bought an IV level closer to 26 percent. Being conscious of his theta, however, he decided to wait. The $64-a-day theta would have cost him $896 over 14 days. That’s much more that the $480 he could have made by buying volatility four points lower with his 1.20 vega. Risks of the Trade Like Susie’s trade, Bobby’s play was not without risk. Certainly theta was a concern, but in addition to that was the possibility that IV might not have played out as he planned. First, IV might not have risen enough to cover three days’ worth of theta. It needed to rise, in this case, about 1.6 volatility points for the 1.20 vega to cover the 1.92 theta loss. It might even have dropped. An earlier-than-expected announcement that the earnings numbers were right on target could have spoiled Bobby’s trade. Or the market simply might not have reacted as expected; volatility might not have risen at all, or might have fallen. Remember, IV is a function of the market. It does not always react as one thinks it should. CHAPTER 13 Delta-Neutral Trading Trading Realized Volatility So far, we’ve discussed many option strategies in which realized volatility is an important component of the trade. And while the management of these positions has been the focus of much of the discussion, the ultimate gain or loss for many of these strategies has been from movement in a single direction. For example, with a long call, the higher the stock rallies the better. But increases or decreases in realized volatility do not necessarily have an exclusive relationship with direction. Recall that realized volatility is the annualized standard deviation of daily price movements. Take two similarly priced stocks that have had a net price change of zero over a one-month period. Stock A had small daily price changes during that period, rising $0.10 one day and falling $0.10 the next. Stock B went up or down by $5 each day for a month. In this rather extreme example, Stock B was much more volatile than Stock A, regardless of the fact that the net price change for the period for both stocks was zero. A stock’s volatility—either high or low volatility—can be capitalized on by trading options delta neutral. Simply put, traders buy options delta neutral when they believe a stock will have more movement and sell options delta neutral when they believe a stock will move less. Delta-neutral option sellers profit from low volatility through theta. Every day that passes in which the loss from delta/gamma movement is less than the gain from theta is a winning day. Traders can adjust their deltas by hedging. Delta-neutral option buyers exploit volatility opportunities through a trading technique called gamma scalping. Gamma Scalping Intraday trading is seldom entirely in one direction. A stock may close higher or lower, even sharply higher or lower, on the day, but during the day there is usually not a steady incremental rise or fall in the stock price. A typical intraday stock chart has peaks and troughs all day long. Delta- neutral traders who have gamma don’t remain delta neutral as the underlying price changes, which inevitably it will. Delta-neutral trading is kind of a misnomer. In fact, it is gamma trading in which delta-neutral traders engage. For long-gamma traders, the position delta gets more positive as the underlying moves higher and more negative as the underlying moves lower. An upward move in the underlying increases positive deltas, resulting in exponentially increasing profits. But if the underlying price begins to retrace downward, the gain from deltas can be erased as quickly as it was racked up. To lock in delta gains, a trader can adjust the position to delta neutral again by selling short stock to cover long deltas. If the stock price declines after this adjustment, losses are curtailed thanks to the short stock. In fact, the delta will become negative as the underlying price falls, leading to growing profits. To lock in profits again, the trader buys stock to cover short deltas to once again become delta neutral. The net effect is a stock scalp. Positive gamma causes the delta-neutral trader to sell stock when the price rises and buy when the stock falls. This adds up to a true, realized profit. So positive gamma is a money-making machine, right? Not so fast. As in any business, the profits must be great enough to cover expenses. Theta is the daily cost of running this gamma- scalping business. For example, a trader, Harry, notices that the intraday price swings in a particular stock have been increasing. He takes a bullish position in realized volatility by buying 20 off the 40-strike calls, which have a 50 delta, and selling stock on a delta-neutral ratio. Buy 20 40-strike calls (50 delta) (long 1,000 deltas) Short 1,000 shares at $40 (short 1,000 deltas) The immediate delta of this trade is flat, but as the stock moves up or down, that will change, presenting gamma-scalping opportunities. Gamma scalping is the objective here. The position greeks in Exhibit 13.1 show the relationship of the two forces involved in this trade: gamma and theta. EXHIBIT 13.1 Greeks for 20-lot delta-neutral long call. The relationship of gamma to theta in this sort of trade is paramount to its success. Gamma-scalping plays are not buy-and-hold strategies. This is active trading. These spreads need to be monitored intraday to take advantage of small moves in the underlying security. Harry will sell stock when the underlying rises and buy it when the underlying falls, taking a profit with each stock trade. The goal for each day that passes is to profit enough from positive gamma to cover the day’s theta. But that’s not always as easy as it sounds. Let’s study what happens the first seven days after this hypothetical trade is executed. For the purposes of this example, we assume that gamma remains constant and that the trader is content trading odd lots of stock. Day One The first day proves to be fairly volatile. The stock rallies from $40 to $42 early in the day. This creates a positive position delta of 5.60, or the equivalent of being long about 560 shares. At $42, Harry covers the position delta by selling 560 shares of the underlying stock to become delta neutral again. Later in the day, the market reverses, and the stock drops back down to $40 a share. At this point, the position is short 5.60 deltas. Harry again adjusts the position, buying 560 shares to get flat. The stock then closes right at $40. The net result of these two stock transactions is a gain of $1,070. How? The gamma scalp minus the theta, as shown below. The volatility of day one led to it being a profitable day. Harry scalped 560 shares for a $2 profit, resulting from volatility in the stock. If the stock hadn’t moved as much, the delta would have been smaller, and the dollar amount scalped would have been smaller, leading to an exponentially smaller profit. If there had been more volatility, profits would have been exponentially larger. It would have led to a bigger bite being taken out of the market. Day Two The next day, the market is a bit quieter. There is a $0.40 drop in the price of the stock, at which point the position delta is short 1.12. Harry buys 112 shares at $39.60 to get delta neutral. Following Harry’s purchase, the stock slowly drifts back up and is trading at $40 near the close. Harry decides to cover his deltas and sell 112 shares at $40. It is common to cover all deltas at the end of the day to get back to being delta neutral. Remember, the goal of gamma scalping is to trade volatility, not direction. Starting the next trading day with a delta, either positive or negative, means an often unwanted directional bias and unwanted directional risk. Tidying up deltas at the end of the day to get neutral is called going home flat. Today was not a banner day. Harry did not quite have the opportunity to cover the decay. Day Three On this day, the market trends. First, the stock rises $0.50, at which point Harry sells 140 shares of stock at $40.50 to lock in gains from his delta and to get flat. However, the market continues to rally. At $41 a share, Harry is long another 1.40 deltas and so sells another 140 shares. The rally continues, and at $41.50 he sells another 140 shares to cover the delta. Finally, at the end of the day, the stock closes at $42 a share. Harry sells a final 140 shares to get flat. There was not any literal scalping of stock today. It was all selling. Nonetheless, gamma trading led to a profitable day. As the stock rose from $40 to $40.50, 140 deltas were created from positive gamma. Because the delta was zero at $40 and 140 at $40.50, the estimated average delta is found by dividing 140 in half. This estimated average delta multiplied by the $0.50 gain on the stock equals a $35 profit. The delta was zero after the adjustment made at $40.50, when 140 shares were sold. When the stock reached $41, another $35 was reaped from the average delta of 70 over the $0.50 move. This process was repeated every time the stock rose $0.50 and the delta was covered. Day Four Day four offers a pleasant surprise for Harry. That morning, the stock opens $4 lower. He promptly covers his short delta of 11.2 by buying 1,120 shares of the stock at $38 a share. The stock barely moves the rest of the day and closes at $38. An exponentially larger profit was made because there was $4 worth of gains on the growing delta when the stock gapped open. The whole position delta was covered $4 lower, so both the delta and the dollar amount gained on that delta had a chance to grow. Again, Harry can estimate the average delta over the $4 move to be half of 11.20. Multiplying that by the $4 stock advance gives him his gamma profit of $2,240. After accounting for theta, the net profit is $2,190. Days Five and Six Days five and six are the weekend; the market is closed. Day Seven This is a quiet day after the volatility of the past week. Today, the stock slowly drifts up $0.25 by the end of the day. Harry sells 70 shares of stock at $38.25 to cover long deltas. This day was a loser for Harry, as profits from gamma were not enough to cover his theta. Art and Science Although this was a very simplified example, it was typical of how a profitable week of gamma scalping plays out. This stock had a pretty volatile week, and overall the week was a winner: there were four losing days and three winners. The number of losing days includes the weekends. Weekends and holidays are big hurdles for long-gamma traders because of the theta loss. The biggest contribution to this being a winning week was made by the gap open on day four. Part of the reason was the sheer magnitude of the move, and part was the fact that the deltas weren’t covered too soon, as they had been on day three. In a perfect world, a long-gamma trader will always buy the low of the day and sell the high of the day when covering deltas. This, unfortunately, seldom happens. Long-gamma traders are very often wrong when trading stock to cover deltas. Being wrong can be okay on occasion. In fact, it can even be rewarding. Day three was profitable despite the fact that 140 shares were sold at $40.50, $41, and $41.50. The stock closed at $42; the first three stock trades were losers. Harry sold stock at a lower price than the close. But the position still made money because of his positive gamma. To be sure, Harry would like to have sold all 560 shares at $42 at the end of the day. The day’s profits would have been significantly higher. The problem is that no one knows where the stock will move next. On day three, if the stock had topped out at $40.50 and Harry did not sell stock because he thought it would continue higher, he would have missed an opportunity. Gamma scalping is not an exact science. The art is to pick spots that capture the biggest moves possible without missing opportunities. There are many methods traders have used to decide where to cover deltas when gamma scalping: the daily standard deviation, a fixed percentage of the stock price, a fixed nominal value, covering at a certain time of day, “market feel.” No system appears to be absolutely better than another. This is where it gets personal. Finding what works for you, and what works for the individual stocks you trade, is the art of this science. Gamma, Theta, and Volatility Clearly, more volatile stocks are more profitable for gamma scalping, right? Well . . . maybe. Recall that the higher the implied volatility, the lower the gamma and the higher the theta of at-the-money (ATM) options. In many cases, the more volatile a stock, the higher the implied volatility (IV). That means that a volatile stock might have to move more for a trader to scalp enough stock to cover the higher theta. Let’s look at the gamma-theta relationship from another perspective. In this example, for 0.50 of theta, Harry could buy 2.80 gamma. This relationship is based on an assumed 25 percent implied volatility. If IV were 50 percent, theta for this 20 lot would be higher, and the gamma would be lower. At a volatility of 50, Harry could buy 1.40 gammas for 0.90 of theta. The gamma is more expensive from a theta perspective, but if the stock’s statistical volatility is significantly higher, it may be worth it. Gamma Hedging Knowing that the gamma and theta figures of Exhibit 13.1 are derived from a 25 percent volatility assumption offers a benchmark with which to gauge the potential profitability of gamma trading the options. If the stock’s standard deviation is below 25 percent, it will be difficult to make money being long gamma. If it is above 25 percent, the play becomes easier to trade. There is more scalping opportunity, there are more opportunities for big moves, and there are more likely to be gaps in either direction. The 25 percent volatility input not only determines the option’s theoretical value but also helps determine the ratio of gamma to theta. A 25 percent or higher realized volatility in this case does not guarantee the trade’s success or failure, however. Much of the success of the trade has to do with how well the trader scalps stock. Covering deltas too soon leads to reduced profitability. Covering too late can lead to missed opportunities. Trading stock well is also important to gamma sellers with the opposite trade: sell calls and buy stock delta neutral. In this example, a trader will sell 20 ATM calls and buy stock on a delta-neutral ratio. This is a bearish position in realized volatility. It is the opposite of the trade in the last example. Consider again that 25 percent IV is the benchmark by which to gauge potential profitability. Here, if the stock’s volatility is below 25, the chances of having a profitable trade are increased. Above 25 is a bit more challenging. In this simplified example, a different trader, Mary, plays the role of gamma seller. Over the same seven-day period as before, instead of buying calls, Mary sold a 20 lot. Exhibit 13.2 shows the analytics for the trade. For the purposes of this example, we assume that gamma remains constant and the trader is content trading odd lots of stock. EXHIBIT 13.2 Greeks for 20-lot delta-neutral short call. Day One This was one of the volatile days. The stock rallied from $40 to $42 early in the day and had fallen back down to $40 by the end of the day. Big moves like this are hard to trade as a short-gamma trader. As the stock rose to $42, the negative delta would have been increasing. That means losses were adding up at an increasing rate. The only way to have stopped the hemorrhaging of money as the stock continued to rise would have been to buy stock. Of course, if Mary buys stock and the stock then declines, she has a loser. Let’s assume the best-case scenario. When the stock reached $42 and she had a −560 delta, Mary correctly felt the market was overbought and would retrace. Sometimes, the best trades are the ones you don’t make. On this day, Mary traded no stock. When the stock reached $40 a share at the end of the day, she was back to being delta neutral. Theta makes her a winner today. Because of the way Mary handled her trade, the volatility of day one was not necessarily an impediment to it being profitable. Again, the assumption is that Mary made the right call not to negative scalp the stock. Mary could have decided to hedge her negative gamma when the stock reach $42 and the position delta was at −$560 by buying stock and then selling it at $40. There are a number of techniques for hedging deltas resulting from negative gamma. The objective of hedging deltas is to avoid losses from the stock trending in one direction and creating increasingly adverse deltas but not to overtrade stock and negative scalp. Day Two Recall that this day had a small dip and then recovered to close again at $40. It is more reasonable to assume that on this day there was no negative scalping. A $0.40 decline is a more typical move in a stock and nothing to be afraid of. The 112 delta created by negative gamma when the stock fell wouldn’t be perceived as a major concern by most traders in most situations. It is reasonable to assume Mary would take no action. Today, again, was a winner thanks to theta. Day Three Day three saw the stock price trending. It slowly drifted up $2. There would have been some judgment calls throughout this day. Again, delta-neutral trades are for active traders. Prepare to watch the market much of the day if implementing this kind of strategy. When the stock was at $41 a share, Mary decided to guard against further advances in stock price and hedged her delta. At that point, the position would have had a −2.80 delta. She bought 280 shares at $41. As the day progressed, the market proved Mary to be right. The stock rose to $42 giving the position a delta of −2.80 again. She covered her deltas at the end of the day by buying another 280 shares. Covering the negative deltas to get flat at $41 proved to be a smart move today. It curtailed an exponentially growing delta and let Mary take a smaller loss at $41 and get a fresh start. While the day was a loser, it would have been $280 worse if she had not purchased stock at $41 before the run- up to $42. This is evidenced by the fact that she made a $280 profit on the 280 shares of stock bought at $41, since the stock closed at $42. Day Four Day four offered a rather unpleasant surprise. This was the day that the stock gapped open $4 lower. This is the kind of day short-gamma traders dread. There is, of course, no right way to react to this situation. The stock can recover, heading higher; it can continue lower; or it can have a dead-cat bounce, remaining where it is after the fall. Staring at a quite contrary delta of 11.20, Mary was forced to take action by selling stock. But how much stock was the responsible amount to sell for a pure short-gamma trader not interested in trading direction? Selling 1,120 shares would bring the position back to being delta neutral, but the only way the trade would stay delta neutral would be if the stock stayed right where it was. Hedging is always a difficult call for short-gamma traders. Long-gamma traders are taking a profit on deltas with every stock trade that covers their deltas. Short-gamma traders are always taking a loss on delta. In this case, Mary decided to cover half her deltas by selling 560 shares. The other 560 deltas represent a loss, too; it’s just not locked in. Here, Mary made the conscious decision not to go home flat. On the one hand, she was accepting the risk of the stock continuing its decline. On the other hand, if she had covered the whole delta, she would have been accepting the risk of the stock moving in either direction. Mary felt the stock would regain some of its losses. She decided to lead the stock a little, going into the weekend with a positive delta bias. Days Five and Six Days five and six are the weekend. Day Seven This was the quiet day of the week, and a welcome respite. On this day, the stock rose just $0.25. The rise in price helped a bit. Mary was still long 560 deltas from Friday. Negative gamma took only a small bite out of her profit. The P&(L) can be broken down into the profit attributable to the starting delta of the trade, the estimated loss from gamma, and the gain from theta. Mary ends these seven days of trading worse off than she started. What went wrong? The bottom line is that she sold volatility on an asset that proved to be volatile. A $4 drop in price of a $42 dollar stock was a big move. This stock certainly moved at more than 25 percent volatility. Day four alone made this trade a losing proposition. Could Mary have done anything better? Yes. In a perfect world, she would not have covered her negative deltas on day 3 by buying 280 shares at $41 and another 280 at $42. Had she not, this wouldn’t have been such a bad week. With the stock ending at $38.25, she lost $1,050 on the 280 shares she bought at $42 ($3.75 times 280) and lost $770 on the 280 shares bought at $41 ($2.75 times 280). Then again, if the stock had continued higher, rising beyond $42, those would have been good buys. Mary can’t beat herself up too much for protecting herself in a way that made sense at the time. The stock’s $2 rally is more to blame than the fact that she hedged her deltas. That’s the risk of selling volatility: the stock may prove to be volatile. If the stock had not made such a move, she wouldn’t have faced the dilemma of whether or not to hedge. Conclusions The same stock during the same week was used in both examples. These two traders started out with equal and opposite positions. They might as well have made the trade with each other. And although in this case the vol buyer (Harry) had a pretty good week and the vol seller (Mary) had a not- so-good week, it’s important to notice that the dollar value of the vol buyer’s profit was not the same as the dollar value of the vol seller’s loss. Why? Because each trader hedged his or her position differently. Option trading is not a zero-sum game. Option-selling delta-neutral strategies work well in low-volatility environments. Small moves are acceptable. It’s the big moves that can blow you out of the water. Like long-gamma traders, short-gamma traders have many techniques for covering deltas when the stock moves. It is common to cover partial deltas, as Mary did on day four of the last example. Conversely, if a stock is expected to continue along its trajectory up or down, traders will sometimes overhedge by buying more deltas (stock) than they are short or selling more than they are long, in anticipation of continued price rises. Daily standard deviation derived from implied volatility is a common measure used by short-gamma players to calculate price points at which to enter hedges. Market feel and other indicators are also used by experienced traders when deciding when and how to hedge. Each trader must find what works best for him or her. Smileys and Frowns The trade examples in this chapter have all involved just two components: calls and stock. We will explore delta-neutral strategies in other chapters that involve more moving parts. Regardless of the specific makeup of the position, the P&(L) of each individual leg is not of concern. It is the profitability of the position as a whole that matters. For example, after a volatile move in a stock occurs, a positive-gamma trader like Harry doesn’t care whether the calls or the stock made the profit on the move. The trader would monitor the net delta that was produced—positive or negative—and cover accordingly. The process is the same for a negative-gamma trader. In either case, it is gamma and delta that need to be monitored closely. Gamma can make or break a trade. P&(L) diagrams are helpful tools that offer a visual representation of the effect of gamma on a position. Many option-trading software applications offer P&(L) graphing applications to study the payoff of a position with the days to expiration as an adjustable variable to study the same trade over time. P&(L) diagrams for these delta-neutral positions before the options’ expiration generally take one of two shapes: a smiley or a frown. The shape of the graph depends on whether the position gamma is positive or negative. Exhibit 13.3 shows a typical positive-gamma trade. EXHIBIT 13.3 P&(L) diagram for a positive-gamma delta-neutral position/l. This diagram is representative of the P&L of a delta-neutral positive- gamma trade calculated using the prices at which the trade was executed. With this type of trade, it is intuitive that when the stock price rises or falls, profits increase because of favorably changing deltas. This is represented by the graph’s smiley-face shape. The corners of the graph rise higher as the underlying moves away from the center of the graph. The graph is a two-dimensional snapshot showing that the higher or lower the underlying moves, the greater the profit. But there are other dimensions that are not shown here, such as time and IV. Exhibit 13.4 shows the effects of time on a typical long-gamma trade. EXHIBIT 13.4 The effect of time on P&(L). As time passes, the reduction in profit is reflected by the center point of the graph dipping farther into negative territory. That is the effect of time decay. The long options will have lost value at that future date with the stock still at the same price (all other factors held constant). Still, a move in either direction can lead to a profitable position. Ultimately, at expiration, the payoff takes on a rigid kinked shape. In the delta-neutral long call examples used in this chapter the position becomes net long stock if the calls are in-the-money at expiration or net short stock if they are out-of-the-money and only the short stock remains. Volatility, as well, would move the payoff line vertically. As IV increases, the options become worth more at each stock price, and as IV falls, they are worth less, assuming all other factors are held constant. A delta-neutral short-gamma play would have a P&(L) diagram quite the opposite of the smiley-faced long-gamma graph. Exhibit 13.5 shows what is called the short-gamma frown. EXHIBIT 13.5 Short-gamma frown. At first glance, this doesn’t look like a very good proposition. The highest point on the graph coincides with a profit of zero, and it only gets worse as the price of the underlying rises or falls. This is enough to make any trader frown. But again, this snapshot does not show time or volatility. Exhibit 13.6 shows the payout diagram as time passes. EXHIBIT 13.6 The effect of time on the short-gamma frown. A decrease in value of the options from time decay causes an increase in profitability. This profit potential pinnacles at the center (strike) price at expiration. Rising IV will cause a decline in profitability at each stock price point. Declining IV will raise the payout on the Y axis as profitability increases at each price point. Smileys and frowns are a mere graphical representation of the technique discussed in this chapter: buying and selling realized volatility. These P& (L) diagrams are limited, because they show the payout only of stock-price movement. The profitability of direction-indifferent and direction-neutral trading is also influenced by time and implied volatility. These actively traded strategies are best evaluated on a gamma-theta basis. Long-gamma traders strive each day to scalp enough to cover the day’s theta, while short- gamma traders hope to keep the loss due to adverse movement in the underlying lower than the daily profit from theta. The strategies in this chapter are the same ones traded in Chapter 12. The only difference is the philosophy. Ultimately, both types of volatility are being traded using these and other option strategies. Implied and realized volatility go hand in hand. CHAPTER 14 Studying Volatility Charts Implied and realized volatility are both important to option traders. But equally important is to understand how the two interact. This relationship is best studied by means of a volatility chart. Volatility charts are invaluable tools for volatility traders (and all option traders for that matter) in many ways. First, volatility charts show where implied volatility (IV) is now compared with where it’s been in the past. This helps a trader gauge whether IV is relatively high or relatively low. Vol charts do the same for realized volatility. The realized volatility line on the chart answers three questions: Have the past 30 days been more or less volatile for the stock than usual? What is a typical range for the stock’s volatility? How much volatility did the underlying historically experience in the past around specific recurring events? When IV lines and realized volatility lines are plotted on the same chart, the divergences and convergences of the two spell out the whole volatility story for those who know how to read it. Nine Volatility Chart Patterns Each individual stock and the options listed on it have their own unique realized and implied volatility characteristics. If we studied the vol charts of 1,000 stocks, we’d likely see around 1,000 different volatility patterns. The number of permutations of the relationship of realized to implied volatility is nearly infinite, but for the sake of discussion, we will categorize volatility charts into nine general patterns. 1 1. Realized Volatility Rises, Implied Volatility Rises The first volatility chart pattern is that in which both IV and realized volatility rise. In general, this kind of volatility chart can line up three ways: implied can rise more than realized volatility; realized can rise more than implied; or they can both rise by about the same amount. The chart below shows implied volatility rising at a faster rate than realized vol. The general theme in this case is that the stock’s price movement has been getting more volatile, and the option prices imply even higher volatility in the future. This specific type of volatility chart pattern is commonly seen in active stocks with a lot of news. Stocks du jour, like some Internet stocks during the tech bubble of the late 1990s, story stocks like Apple (AAPL) around the release of the iPhone in 2007, have rising volatilities, with the IV outpacing the realized volatility. Sometimes individual stocks and even broad market indexes and exchange-traded funds (ETFs) see this pattern, when the market is declining rapidly, like in the summer of 2011. A delta-neutral long-volatility position bought at the beginning of May, according to Exhibit 14.1 , would likely have produced a winner. IV took off, and there were sure to be plenty of opportunities to profit from gamma with realized volatility gaining strength through June and July. EXHIBIT 14.1 Realized volatility rises, implied volatility rises. Source : Chart courtesy of iVolatility.com Looking at the right side of the chart, in late July, with IV at around 50 percent and realized vol at around 35 percent, and without the benefit of knowing what the future will bring, it’s harder to make a call on how to trade the volatility. The IV signals that the market is pricing a higher future level of stock volatility into the options. If the market is right, gamma will be good to have. But is the price right? If realized volatility does indeed catch up to implied volatility—that is, if the lines converge at 50 or realized volatility rises above IV—a trader will have a good shot at covering theta. If it doesn’t, gamma will be very expensive in terms of theta, meaning it will be hard to cover the daily theta by scalping gamma intraday. The question is: why is IV so much higher than realized? If important news is expected to be released in the near future, it may be perfectly reasonable for the IV to be higher, even significantly higher, than the stock’s realized volatility. One big move in the stock can produce a nice profit, as long as theta doesn’t have time to work its mischief. But if there is no news in the pipeline, there may be some irrational exuberance—in the words of ex-Fed chairman Alan Greenspan—of option buyers rushing to acquire gamma that is overvalued in terms of theta. In fact, a lack of expectation of news could indicate a potential bearish volatility play: sell volatility with the intent of profiting from daily theta and a decline in IV. This type of play, however, is not for the fainthearted. No one can predict the future. But one thing you can be sure of with this trade: you’re in for a wild ride. The lines on this chart scream volatility. This means that negative-gamma traders had better be good and had better be right! In this situation, hedgers and speculators in the market are buying option volatility of 50 percent, while the stock is moving at 35 percent volatility. Traders putting on a delta-neutral volatility-selling strategy are taking the stance that this stock will not continue increasing in volatility as indicated by option prices; specifically, it will move at less than 50 percent volatility —hopefully a lot less. They are taking the stance that the market’s expectations are wrong. Instead of realized and implied volatility both trending higher, sometimes there is a sharp jump in one or the other. When this happens, it could be an indication of a specific event that has occurred (realized volatility) or news suddenly released of an expected event yet to come (implied volatility). A sharp temporary increase in IV is called a spike, because of its pointy shape on the chart. A one-day surge in realized volatility, on the other hand, is not so much a volatility spike as it is a realized volatility mesa. Realized volatility mesas are shown in Exhibit 14.2 . EXHIBIT 14.2 Volatility mesas. Source : Chart courtesy of iVolatility.com The patterns formed by the gray line in the circled areas of the chart shown below are the result of typical one-day surges in realized volatility. Here, the 30-day realized volatility rose by nearly 20 percentage points, from about 20 percent to about 40 percent, in one day. It remained around the 40 percent level for 30 days and then declined 20 points just as fast as it rose. Was this entire 30-day period unusually volatile? Not necessarily. Realized volatility is calculated by looking at price movements within a certain time frame, in this case, thirty business days. That means that a really big move on one day will remain in the calculation for the entire time. Thirty days after the unusually big move, the calculation for realized volatility will no longer contain that one-day price jump. Realized volatility can then drop significantly. 2. Realized Volatility Rises, Implied Volatility Remains Constant This chart pattern can develop from a few different market conditions. One scenario is a one-time unanticipated move in the underlying that is not expected to affect future volatility. Once the news is priced into the stock, there is no point in hedgers’ buying options for protection or speculators’ buying options for a leveraged bet. What has happened has happened. There are other conditions that can cause this type of pattern to materialize. In Exhibit 14.3 , the IV was trading around 25 for several months, while the realized volatility was lagging. With hindsight, it makes perfect sense that something had to give—either IV needed to fall to meet realized, or realized would rise to meet market expectations. Here, indeed, the latter materialized as realized volatility had a steady rise to and through the 25 level in May. Implied, however remained constant. EXHIBIT 14.3 Realized volatility rises, implied volatility remains constant. Source : Chart courtesy of iVolatility.com Traders who were long volatility going into the May realized-vol rise probably reaped some gamma benefits. But those who got in “too early,” buying in January or February, would have suffered too great of theta losses before gaining any significant profits from gamma. Time decay (theta) can inflict a slow, painful death on an option buyer. By studying this chart in hindsight, it is clear that options were priced too high for a gamma scalper to have a fighting chance of covering the daily theta before the rise in May. This wasn’t necessarily an easy vol-selling trade before the May realized- vol rise, either, depending on the trader’s timing. In early February, realized did in fact rise above implied, making the short volatility trade much less attractive. Traders who sold volatility just before the increase in realized volatility in May likely ended up losing on gamma and not enough theta profits to make up for it. There was no volatility crush like what is often seen following a one-day move leading to sharply higher realized volatility. IV simply remained pretty steady throughout the month of May and well into June. 3. Realized Volatility Rises, Implied Volatility Falls This chart pattern can manifest itself in different ways. In this scenario, the stock is becoming more volatile, and options are becoming cheaper. This may seem an unusual occurrence, but as we can see in Exhibit 14.4 , volatility sometimes plays out this way. This chart shows two different examples of realized vol rising while IV falls. EXHIBIT 14.4 Realized volatility rises, implied volatility falls. Source : Chart courtesy of iVolatility.com The first example, toward the left-hand side of the chart, shows realized volatility trending higher while IV is trending lower. Although fundamentals can often provide logical reasons for these volatility changes, sometimes they just can’t. Both implied and realized volatility are ultimately a function of the market. There is a normal oscillation to both of these figures. When there is no reason to be found for a volatility change, it might be an opportunity. The potential inefficiency of volatility pricing in the options market sometimes creates divergences such as this one that vol traders scour the market in search of. In this first example, after at least three months of IV’s trading marginally higher than realized volatility, the two lines converge and then cross. The point at which these lines meet is an indication that IV may be beginning to get cheap. First, it’s a potentially beneficial opportunity to buy a lower volatility than that at which the stock is actually moving. The gamma/theta ratio would be favorable to gamma scalpers in this case, because the lower cost of options compared with stock fluctuations could lead to gamma profits. Second, with IV at 35 at the first crossover on this chart, IV is dipping down into the lower part of its four-month range. One can make the case that it is getting cheaper from a historical IV standpoint. There is arguably an edge from the perspective of IV to realized volatility and IV to historical IV. This is an example of buying value in the context of volatility. Furthermore, if the actual stock volatility is rising, it’s reasonable to believe that IV may rise, too. In hindsight we see that this did indeed occur in Exhibit 14.4 , despite the fact that realized volatility declined. The example circled on the right-hand side of the chart shows IV declining sharply while realized volatility rises sharply. This is an example of the typical volatility crush as a result of an earnings report. This would probably have been a good trade for long volatility traders—even those buying at the top. A trader buying options delta neutral the day before earnings are announced in this example would likely lose about 10 points of vega but would have a good chance to more than make up for that loss on positive gamma. Realized volatility nearly doubled, from around 28 percent to about 53 percent, in a single day. 4. Realized Volatility Remains Constant, Implied Volatility Rises Exhibit 14.5 shows that the stock is moving at about the same volatility from the beginning of June to the end of July. But during that time, option premiums are rising to higher levels. This is an atypical chart pattern. If this was a period leading up to an anticipated event, like earnings, one would anticipate realized volatility falling as the market entered a wait-and-see mode. But, instead, statistical volatility stays the same. This chart pattern may indicate a potential volatility-selling opportunity. If there is no news or reason for IV to have risen, it may simply be high tide in the normal ebb and flow of volatility. EXHIBIT 14.5 Realized volatility remains constant, implied volatility rises. Source : Chart courtesy of iVolatility.com In this example, the historical volatility oscillates between 20 and 24 for nearly two months (the beginning of June through the end of July) as IV rises from 24 to over 30. The stock price is less volatile than option prices indicate. If there is no news to be dug up on the stock to lead one to believe there is a valid reason for the IV’s trading at such a level, this could be an opportunity to sell IV 5 to 10 points higher than the stock volatility. The goal here is to profit from theta or falling vega or both while not losing much on negative gamma. As time passes, if the stock continues to move at 20 to 23 vol, one would expect IV to fall and converge with realized volatility. 5. Realized Volatility Remains Constant, Implied Volatility Remains Constant This volatility chart pattern shown in Exhibit 14.6 is typical of a boring, run-of-the-mill stock with nothing happening in the news. But in this case, no news might be good news. EXHIBIT 14.6 Realized volatility remains constant, implied volatility remains constant. Source : Chart courtesy of iVolatility.com Again, the gray is realized volatility and the black line is IV. It’s common for IV to trade slightly above or below realized volatility for extended periods of time in certain assets. In this example, the IV has traded in the high teens from late January to late July. During that same time, realized volatility has been in the low teens. This is a prime environment for option sellers. From a gamma/theta standpoint, the odds favor short-volatility traders. The gamma/theta ratio provides an edge, setting the stage for theta profits to outweigh negative- gamma scalping. Selling calls and buying stock delta neutral would be a trade to look at in this situation. But even more basic strategies, such as time spreads and iron condors, are appropriate to consider. This vol-chart pattern, however, is no guarantee of success. When the stock oscillates, delta-neutral traders can negative scalp stock if they are not careful by buying high to cover short deltas and then selling low to cover long deltas. Time-spread and iron condor trades can fail if volatility increases and the increase results from the stock trending in one direction. The advantage of buying IV lower than realized, or selling it above, is statistical in nature. Traders should use a chart of the stock price in conjunction with the volatility chart to get a more complete picture of the stock’s price action. This also helps traders make more informed decisions about when to hedge. 6. Realized Volatility Remains Constant, Implied Volatility Falls Exhibit 14.7 shows two classic implied-realized convergences. From mid- September to early November, realized volatility stayed between 22 and 25. In mid-October the implied was around 33. Within the span of a few days, the implied vol collapsed to converge with the realized at about 22. EXHIBIT 14.7 Realized volatility remains constant, implied volatility falls. Source : Chart courtesy of iVolatility.com There can be many catalysts for such a drop in IV, but there is truly only one reason: arbitrage. Although it is common for a small difference between implied and realized volatility—1 to 3 points—to exist even for extended periods, bigger disparities, like the 7- to 10-point difference here cannot exist for that long without good reason. If, for example, IV always trades significantly above the realized volatility of a particular underlying, all rational market participants will sell options because they have a gamma/theta edge. This, in turn, forces options prices lower until volatility prices come into line and the arbitrage opportunity no longer exists. In Exhibit 14.7 , from mid-March to mid-May a similar convergence took place but over a longer period of time. These situations are often the result of a slow capitulation of market makers who are long volatility. The traders give up on the idea that they will be able to scalp enough gamma to cover theta and consequently lower their offers to advertise their lower prices. 7. Realized Volatility Falls, Implied Volatility Rises This setup shown in Exhibit 14.8 should now be etched into the souls of anyone who has been reading up to this point. It is, of course, the picture of the classic IV rush that is often seen in stocks around earnings time. The more uncertain the earnings, the more pronounced this divergence can be. EXHIBIT 14.8 Realized volatility falls, implied volatility rises. Source : Chart courtesy of iVolatility.com Another classic vol divergence in which IV rises and realized vol falls occurs in a drug or biotech company when a Food and Drug Administration (FDA) decision on one of the company’s new drugs is imminent. This is especially true of smaller firms without big portfolios of drugs. These divergences can produce a huge implied–realized disparity of, in some cases, literally hundreds of volatility points leading up to the announcement. Although rising IV accompanied by falling realized volatility can be one of the most predictable patterns in trading, it is ironically one of the most difficult to trade. When the anticipated news breaks, the stock can and often will make a big directional move, and in that case, IV can and likely will get crushed. Vega and gamma work against each other in these situations, as IV and realized volatility converge. Vol traders will likely gain on one vol and lose on the other, but it’s very difficult to predict which will have a more profound effect. Many traders simply avoid trading earnings events altogether in favor of less erratic opportunities. For most traders, there are easier ways to make money. 8. Realized Volatility Falls, Implied Volatility Remains Constant This volatility shift can be marked by a volatility convergence, divergence, or crossover. Exhibit 14.9 shows the realized volatility falling from around 30 percent to about 23 percent while IV hovers around 25. The crossover here occurs around the middle of February. EXHIBIT 14.9 Realized volatility falls, implied volatility remains constant. Source : Chart courtesy of iVolatility.com The relative size of this volatility change makes the interpretation of the chart difficult. The last half of September saw around a 15 percent decline in realized volatility. The middle of October saw a one-day jump in realized of about 15 points. Historical volatility has had several dynamic moves that were larger and more abrupt than the seven-point decline over this six-week period. This smaller move in realized volatility is not necessarily an indication of a volatility event. It could reflect some complacency in the market. It could indicate a slow period with less trading, or it could simply be a natural contraction in the ebb and flow of volatility causing the calculation of recent stock-price fluctuations to wane. What is important in this interpretation is how the options market is reacting to the change in the volatility of the stock—where the rubber hits the road. The market’s apparent assessment of future volatility is unchanged during this period. When IV rises or falls, vol traders must look to the underlying stock for a reason. The options market reacts to stock volatility, not the other way around. Finding fundamental or technical reasons for surges in volatility is easier than finding specific reasons for a decline in volatility. When volatility falls, it is usually the result of a lack of news, leading to less price action. In this example, probably nothing happened in the market. Consequently, the stock volatility drifted lower. But it fell below the lowest IV level seen for the six- month period leading up to the crossover. It was probably hard to take a confident stance in volatility immediately following the crossover. It is difficult to justify selling volatility when the implied is so cheap compared with its historic levels. And it can be hard to justify buying volatility when the options are priced above the stock volatility. The two-week period before the realized line moved beneath the implied line deserves closer study. With the IV four or five points lower than the realized volatility in late January, traders may have been tempted to buy volatility. In hindsight, this trade might have been profitable, but there was surely no guarantee of this. Success would have been greatly contingent on how the traders managed their deltas, and how well they adapted as realized volatility fell. During the first half of this period, the stock volatility remained above implied. For an experienced delta-neutral trader, scalping gamma was likely easy money. With the oscillations in stock price, the biggest gamma- scalping risk would have been to cover too soon and miss out on opportunities to take bigger profits. Using the one-day standard deviation based on IV (described in Chapter 3) might have produced early covering for long-gamma traders. Why? Because in late January, the standard deviation derived from IV was lower than the actual standard deviation of the stock being traded. In the latter half of the period being studied, the end of February on this chart, using the one- day standard deviation based on IV would have produced scalping that was too late. This would have led to many missed opportunities. Traders entering hedges at regular nominal intervals—every $0.50, for example—would probably have needed to decrease the interval as volatility ebbed. For instance, if in late January they were entering orders every $0.50, by late February they might have had to trade every $0.40. 9. Realized Volatility Falls, Implied Volatility Falls This final volatility-chart permutation incorporates a fall of both realized and IV. The chart in Exhibit 14.10 clearly represents the slow culmination of a highly volatile period. This setup often coincides with news of some scary event’s being resolved—a law suit settled, unpopular upper management leaving, rumors found to be false, a happy ending to political issues domestically or abroad, for example. After a sharp sell-off in IV, from 75 to 55, in late October, marking the end of a period of great uncertainty, the stock volatility began a steady decline, from the low 50s to below 25. IV fell as well, although it remained a bit higher for several months. EXHIBIT 14.10 Realized volatility falls, implied volatility falls. Source : Chart courtesy of iVolatility.com In some situations where an extended period of extreme volatility appears to be coming to an end, there can be some predictability in how IV will react. To be sure, no one knows what the future holds, but when volatility starts to wane because a specific issue that was causing gyrations in the stock price is resolved, it is common, and intuitive, for IV to fall with the stock volatility. This is another type of example of reversion to the mean. There is a potential problem if the high-volatility period lasted for an extended period of time. Sometimes, it’s hard to get a feel for what the mean volatility should be. Or sometimes, because of the event, the stock is fundamentally different—in the case of a spin-off, merger, or other corporate action, for example. When it is difficult or impossible to look back at a stock’s performance over the previous 6 to 12 months and appraise what the normal volatility should be, one can look to the volatility of other stocks in the same industry for some guidance. Stocks that are substitutable for one another typically trade at similar volatilities. From a realized volatility perspective, this is rather intuitive. When one stock within an industry rises or falls, others within the same industry tend to follow. They trade similarly and therefore experience similar volatility patterns. If the stock volatility among names within one industry tends to be similar, it follows that the IV should be, too. Regardless which of the nine patterns discussed here show up, or how the volatilities line up, there is one overriding observation that’s representative of all volatility charts: vol charts are simply graphical representations of realized and implied volatility that help traders better understand the two volatilities’ interaction. But the divergences and convergences in the examples in this chapter have profound meaning to the volatility trader. Combined with a comparison of current and past volatility (both realized and implied), they give traders insight into how cheap or expensive options are. Note 1 . The following examples use charts supplied by iVolatility.com . The gray line is the 30-day realized volatility, and the black line is the implied volatility. PART IV Advanced Option Trading CHAPTER 15 Straddles and Strangles Straddles and strangles are the quintessential volatility strategies. They are the purest ways to buy and sell realized and implied volatility. This chapter discusses straddles and strangles, how they work, when to use them, what to look out for, and the differences between the two. Long Straddle Definition : Buying one call and one put in the same option class, in the same expiration cycle, and with the same strike price. Linearly, the long straddle is the best of both worlds—long a call and a put. If the stock rises, the call enjoys the unlimited potential for profit while the put’s losses are decidedly limited. If the stock falls, the put’s profit potential is bound only by the stock’s falling to zero, while the call’s potential loss is finite. Directionally, this can be a win-win situation—as long as the stock moves enough for one option’s profit to cover the loss on the other. The risk, however, is that this may not happen. Holding two long options means a big penalty can be paid for stagnant stocks. The Basic Long Straddle The long straddle is an option strategy to use when a trader is looking for a big move in a stock but is uncertain which direction it will move. Technically, the Commodity Channel Index (CCI), Bollinger bands, or pennants are some examples of indicators which might signal the possibility of a breakout. Or fundamental data might call for a revaluation of the stock based on an impending catalyst. In either case, a long straddle, is a way for traders to position themselves for the expected move, without regard to direction. In this example, we’ll study a hypothetical $70 stock poised for a breakout. We’ll buy the one-month 70 straddle for 4.25. Exhibit 15.1 shows the payout of the straddle at expiration. EXHIBIT 15.1 At-expiration diagram for a long straddle. At expiration, with the stock at $70, neither the call nor the put is in-the- money. The straddle expires worthless, leaving a loss of 4.25 in its wake from erosion. If, however, the stock is above or below $70, either the call or the put will have at least some value. The farther the stock price moves from the strike price in either direction, the higher the net value of the options. Above $70, the call has value. If the underlying is at $74.25 at expiration, the put will expire worthless, but the call will be worth 4.25—the price initially paid for the straddle. Above this break-even price, the trade is a winner, and the higher, the better. Below $70, the put has value. If the underlying is at $65.75 at expiration, the call expires, and the put is worth 4.25. Below this breakeven, the straddle is a winner, and the lower, the better. Why It Works In this basic example, if the underlying is beyond either of the break-even points at expiration, the trade is a winner. The key to understanding this is the fact that at expiration, the loss on one option is limited—it can only fall to zero—but the profit potential on the other can be unlimited. In practice, most active traders will not hold a straddle until expiration. Even if the trade is not held to term, however, movement is still beneficial —in fact, it is more beneficial, because time decay will not have depleted all the extrinsic value of the options. Movement benefits the long straddle because of positive gamma. But movement is a race against the clock—a race against theta. Theta is the cost of trading the long straddle. Only pay it for as long as necessary. When the stock’s volatility appears poised to ebb, exit the trade. Exhibit 15.2 shows the P&(L) of the straddle both at expiration and at the time the trade was made. EXHIBIT 15.2 Long straddle P&(L) at initiation and expiration. Because this is a short-term at-the-money (ATM) straddle, we will assume for simplicity that it has a delta of zero. 1 When the trade is consummated, movement can only help, as indicated by the dotted line on the exhibit. This is the classic graphic representation of positive gamma— the smiley face. When the stock moves higher, the call gains value at an increasing rate while the put loses value at a decreasing rate. When the stock moves lower, the put gains at an increasing rate while the call loses at a decreasing rate. This is positive gamma. This still may not be an entirely fair representation of how profits are earned. The underlying is not required to move continuously in one direction for traders to reap gamma profits. As described in Chapter 13, traders can scalp gamma by buying and selling stock to offset long or short deltas created by movement in the underlying. When traders scalp gamma, they lock in profits as the stock price oscillates. The potential for gamma scalping is an important motivation for straddle buyers. Gamma scalping a straddle gives traders the chance to profit from a stock that has dynamic price swings. It should be second nature to volatility traders to understand that theta is the trade-off of gamma scalping. The Big V Gamma and theta are not alone in the straddle buyer’s thoughts. Vega is a major consideration for a straddle buyer, as well. In a straddle, there are two long options of the same strike, which means double the vega risk of a single-leg trade at that strike. With no short options in this spread, the implied-volatility exposure is concentrated. For example, if the call has a vega of 0.05, the put’s vega at that same strike will also be about 0.05. This means that buying one straddle gives the trader exposure of around 10 cents per implied volatility (IV) point. If IV rises by one point, the trader makes $10 per one-lot straddle, $20 for two points, and so on. If IV falls one point, the trader loses $10 per straddle, $20 for two points, and so on. Traders who want maximum positive exposure to volatility find it in long straddles. This strategy is a prime example of the marriage of implied and realized volatility. Traders who buy straddles because they are bullish on realized volatility will also have bullish positions in implied volatility—like it or not. With this in mind, traders must take care to buy gamma via a straddle that it is not too expensive in terms of the implied volatility. A winning gamma trade can quickly become a loser because of implied volatility. Likewise, traders buying straddles to speculate on an increase in implied volatility must take the theta risk of the trade very seriously. Time can eat away all a trade’s vega profits and more. Realized and implied exposure go hand in hand. The relationship between gamma and vega depends on, among other things, the time to expiration. Traders have some control over the amount of gamma relative to the amount of vega by choosing which expiration month to trade. The shorter the time until expiration, the higher the gammas and the lower the vegas of ATM options. Gamma traders may be better served by buying short-term contracts that coincide with the period of perceived high stock volatility. If the intent of the straddle is to profit from vega, the choice of the month to trade depends on which month’s volatility is perceived to be too high or too low. If, for example, the front-month IV looks low compared with historical IV, current and historical realized volatility, and the expected future volatility, but the back months’ IVs are higher and more in line with these other metrics, there would be no point in buying the back-month options. In this case, traders would need to buy the month that they think is cheap. Trading the Long Straddle Option trading is all about optimizing the statistical chances of success. A long-straddle trade makes the most sense if traders think they can make money on both implied volatility and gamma. Many traders make the mistake of buying a straddle just before earnings are announced because they anticipate a big move in the stock. Of course, stock-price action is only half the story. The option premium can be extraordinarily expensive just before earnings, because the stock move is priced into the options. This is buying after the rush and before the crush. Although some traders are successful specializing in trading earnings, this is a hard way to make money. Ideally, the best time to buy volatility is before the move is priced in— that is, before everyone else does. This is conceptually the same as buying a stock in anticipation of bullish news. Once news comes out, the stock rallies, and it is often too late to participate in profits. The goal is to get in at the beginning of the trend, not the end—the same goal as in trading volatility. As in analyzing a stock, fundamental and technical tools exist for analyzing volatility—namely, news and volatility charts. For fundamentals, buy the rumor, sell the news applies to the rush and crush of implied volatility. Previous chapters discussed fundamental events that affect volatility; be prepared to act fast when volatility-changing situations present themselves. With charts, the elementary concept of buy low, sell high is obvious, yet profound. Review Chapter 14 for guidance on reading volatility charts. With all trading, getting in is easy. It’s managing the position, deciding when to hedge and when to get out that is the tricky part. This is especially true with the long straddle. Straddles are intended to be actively managed. Instead of waiting for a big linear move to evolve over time, traders can take profits intermittently through gamma scalping. Furthermore, they hold the trade only as long as gamma scalping appears to be a promising opportunity. Legging Out There are many ways to exiting a straddle. In the right circumstances, legging out is the preferred method. Instead of buying and selling stock to lock in profits and maintain delta neutrality, traders can reduce their positions by selling off some of the calls or puts that are part of the straddle. In this technique, when the underlying rises, traders sell as many calls as needed to reduce the delta to zero. As the underlying falls, they sell enough puts to reduce their position to zero delta. As the stock oscillates, they whittle away at the position with each hedging transaction. This serves the dual purpose of taking profits and reducing risk. A trader, Susan, has been studying Acme Brokerage Co. (ABC). Susan has noticed that brokerage stocks have been fairly volatile in recent past. Exhibit 15.3 shows an analysis of Acme’s volatility over the past 30 days. EXHIBIT 15.3 Acme Brokerage Co. volatility. Stock Price Realized VolatilityFront-Month Implied Volatility 30-day high $78.6630-day high 47%30-day high 55% 30-day low $66.9430-day low 36%30-day low 34% Current px $74.80Current vol 36%Current vol 36% During this period, Acme stock ranged more than $11 in price. In this example, Acme’s volatility is a function of interest rate concerns and other macroeconomic issues affecting the brokerage industry as a whole. As the stock price begins to level off in the latter half of the 30-day period, realized volatility begins to ebb. The front month’s IV recedes toward recent lows as well. At this point, both realized and implied volatility converge at 36 percent. Although volatility is at its low for the past month, it is still relatively high for a brokerage stock under normal market conditions. Susan does not believe that the volatility plaguing this stock is over. She believes that an upcoming scheduled Federal Reserve Board announcement will lead to more volatility. She perceives this to be a volatility-buying opportunity. Effectively, she wants to buy volatility on the dip. Susan pays 5.75 for 20 July 75-strike straddles. Exhibit 15.4 shows the analytics of this trade with four weeks until expiration. EXHIBIT 15.4 Analytics for long 20 Acme Brokerage Co. 75-strike straddles. As with any trade, the risk is that the trader is wrong. The risk here is indicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an average of at least $207 a day just to break even against the time decay. And if IV continues to ebb down to a lower, more historically normal, level, she needs to scalp even more to make up for vega losses. Effectively, Susan wants both realized and implied volatility to rise. She paid 36 volatility for the straddle. She wants to be able to sell the options at a higher vol than 36. In the interim, she needs to cover her decay just to break even. But in this case, she thinks the stock will be volatile enough to cover decay and then some. If Acme moves at a volatility greater than 36, her chances of scalping profitably are more favorable than if it moves at less than 36 vol. The following is one possible scenario of what might have happened over two weeks after the trade was made. Week One During the first week, the stock’s volatility tapered off a bit more, but implied volatility stayed firm. After some oscillation, the realized volatility ended the week at 34 percent while IV remained at 36 percent. Susan was able to scalp stock reasonably well, although she still didn’t cover her seven days of theta. Her stock buys and sells netted a gain of $1,100. By the end of week one, the straddle was 5.10 bid. If she had sold the straddle at the market, she would have ended up losing $200. Susan decided to hold her position. Toward the end of week two, there would be the Federal Open Market Committee (FOMC) meeting. Week Two The beginning of the week saw IV rise as the event drew near. By the close on Tuesday, implied volatility for the straddle was 40 percent. But realized volatility continued its decline, which meant Susan was not able to scalp to cover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle was now 5.20 bid, 0.10 higher than it had been on previous Friday. The rising IV made up for most of the theta loss. At this point, Susan could have sold her straddle to scratch her trade. She would have lost $1,100 on the straddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the first week. Susan decided to wait and see what the Fed chairman had to say. By week’s end, the trade had proved to be profitable. After the FOMC meeting, the stock shot up more than $4 and just as quickly fell. It continued to bounce around a bit for the rest of the week. Susan was able to lock in $5,200 from stock scalps. After much gyration over this two-week period, the price of Acme stock incidentally returned to around the same price it had been at when Susan bought her straddle: $74.50. As might have been expected after the announcement, implied volatility softened. By Friday, IV had fallen to 30. Realized volatility was sharply higher as a result of the big moves during the week that were factored into the 30-day calculation. With seven more days of decay and a lower implied volatility, the straddle was 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the position. Her profit for week two was $2,000. What went into Susan’s decision to close her position? Susan had two objectives: to profit from a rise in implied volatility and to profit from a rise in realized volatility. The rise in IV did indeed occur, but not immediately. By Tuesday of the second week, vega profits were overshadowed by theta losses. Gamma was the saving grace with this trade. The bulk of the gain occurred in week two when the Fed announcement was made. Once that event passed, the prospects for covering theta looked less attractive. They were further dimmed by the sharp drop in implied volatility from 40 to 30. In this hypothetical scenario, the trade ended up profitable. This is not always the case. Here the profit was chiefly produced by one or two high- volatility days. Had the stock not been unusually volatile during this time, the trade would have been a certain loser. Even though implied volatility had risen four points by Tuesday of the second week, the trade did not yield a profit. The time decay of holding two options can make long straddles a tough strategy to trade. Short Straddle Definition : Selling one call and one put in the same option class, in the same expiration cycle, and with the same strike price. Just as buying a straddle is a pure way to buy volatility, selling a straddle is a way to short it. When a trader’s forecast calls for lower implied and realized volatility, a straddle generates the highest returns of all volatility- selling strategies. Of course, with high reward necessarily comes high risk. A short straddle is one of the riskiest positions to trade. Let’s look at a one-month 70-strike straddle sold at 4.25. The risk is easily represented graphically by means of a P&(L) diagram. Exhibit 15.5 shows the risk and reward of this short straddle. EXHIBIT 15.5 Short straddle P&(L) at initiation and expiration. If the straddle is held until expiration and the underlying is trading below the strike price, the short put is in-the-money (ITM). The lower the stock, the greater the loss on the +1.00 delta from the put. The trade as a whole will be a loser if the underlying is below the lower of the two break-even points—in this case $65.75. This point is found by subtracting the premium received from the strike. Before expiration, negative gamma adversely affects profits as the underlying falls. The lower the underlying is trading below the strike price, the greater the drain on P&(L) due to the positive delta of the short put. It is the same proposition if the underlying is above $70 at expiration. But in this case, it is the short call that would be in-the-money. The higher the underlying price, the more the −1.00 delta adversely impacts P&(L). If at expiration the underlying is above the higher breakeven, which in this case is $74.25 (the strike plus the premium), the trade is a loser. The higher the underlying, the worse off the trade. Before expiration, negative gamma creates negative deltas as the underlying climbs above the strike, eating away at the potential profit, which is the net premium received. The best-case scenario is that the underlying is right at $70 at the closing bell on expiration Friday. In this situation, neither option is ITM, meaning that the 4.25 premium is all profit. In reaping the maximum profit, both time and price play roles. If the position is closed before expiration, implied volatility enters into the picture as well. It’s important to note that just because neither option is ITM if the underlying is right at $70 at expiration, it doesn’t mean with certainty that neither option will be assigned. Sometimes options that are ATM or even out-of-the-money (OTM) get assigned. This can lead to a pleasant or unpleasant surprise the Monday morning following expiration. The risk of not knowing whether or not you will be assigned—that is, whether or not you have a position in the underlying security—is a risk to be avoided. It is the goal of every trader to remove unnecessary risk from the equation. Buying the call and the put for 0.05 or 0.10 to close the position is a small price to pay when one considers the possibility of waking up Monday morning to find a loss of hundreds of dollars per contract because a position you didn’t even know you owned had moved against you. Most traders avoid this risk, referred to as pin risk, by closing short options before expiration. The Risks with Short Straddles Looking at an at-expiration diagram or even analyzing the gamma/theta relationship of a short straddle may sometimes lead to a false sense of comfort. Sometimes it looks as if short straddles need a pretty big move to lose a lot of money. So why are they definitely among the riskiest strategies to trade? That is a matter of perspective. Option trading is about risk management. Dealing with a proverbial train wreck every once in a while is part of the game. But the big disasters can end one’s trading career in an instant. Because of its potential—albeit sometimes small potential—for a colossal blowup, the short straddle is, indeed, one of the riskiest positions one can trade. That said, it has a place in the arsenal of option strategies for speculative traders. Trading the Short Straddle A short straddle is a trade for highly speculative traders who think a security will trade within a defined range and that implied volatility is too high. While a long straddle needs to be actively traded, a short straddle needs to be actively monitored to guard against negative gamma. As adverse deltas get bigger because of stock price movement, traders have to be on alert, ready to neutralize directional risk by offsetting the delta with stock or by legging out of the options. To be sure, with a short straddle, every stock trade locks in a loss with the intent of stemming future losses. The ideal situation is that the straddle is held until expiration and expires with the underlying right at $70 with no negative-gamma scalping. Short-straddle traders must take a longer-term view of their positions than long-straddle traders. Often with short straddles, it is ultimately time that provides the payout. While long straddle traders would be inclined to watch gamma and theta very closely to see how much movement is required to cover each day’s erosion, short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game. There are some situations that are exceptions to this long-term focus. For example, when implied volatility gets to be extremely high for a particular option class relative to both the underlying stock’s volatility and the historical implied volatility, one may want to sell a straddle to profit from a fall in IV. This can lead to leveraged short-term profits if implied volatility does, indeed, decline. Because of the fact that there are two short options involved, these straddles administer a concentrated dose of negative vega. For those willing to bet big on a decline in implied volatility, a short straddle is an eager croupier. These trades are delta neutral and double the vega of a single-leg trade. But they’re double the gamma, too. As with the long straddle, realized and implied volatility levels are both important to watch. Short-Straddle Example For this example, a trader, John, has been watching Federal XYZ Corp. (XYZ) for a year. During the 12 months that John has followed XYZ, its front-month implied volatility has typically traded at around 20 percent, and its realized volatility has fluctuated between 15 and 20 percent. The past 30 days, however, have been a bit more volatile. Exhibit 15.6 shows XYZ’s recent volatility. EXHIBIT 15.6 XYZ volatility. Stock Price Realized VolatilityFront-Month Implied Volatility 30-day high $111.7130-day high 26%30-day high 30% 30-day low $102.0530-day low 21%30-day low 24% Current px $104.75Current vol 22%Current vol 26% The stock volatility has begun to ease, trading now at a 22 volatility compared with the 30-day high of 26, but still not down to the usual 15-to- 20 range. The stock, in this scenario, has traded in a channel. It currently lies in the lower half of its recent range. Although the current front-month implied volatility is in the lower half of its 30-day range, it’s historically high compared with the 20 percent level that John has been used to seeing, and it’s still four points above the realized volatility. John believes that the conditions that led to the recent surge in volatility are no longer present. His forecast is for the stock volatility to continue to ease and for implied volatility to continue its downtrend as well and revert to its long-term mean over the next week or two. John sells 10 September 105 straddles at 5.40. Exhibit 15.7 shows the greeks for this trade. EXHIBIT 15.7 Greeks for short XYZ straddle. The goal here is for implied volatility to fall to around 20. If it does, John makes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will outpace gamma losses. The following is a two-week examination of one possible outcome for John’s trade. Week One The first week in this example was a profitable one, but it came with challenges. John paid for his winnings with a few sleepless nights. On the Monday following his entry into the trade, the stock rose to $106. While John collected a weekend’s worth of time decay, the $1.25 jump in stock price ate into some of those profits and naturally made him uneasy about the future. At this point, John was sitting on a profit, but his position delta began to grow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75 stock, a move of $1.25—or just over 1 percent—is not out of the ordinary, but it put John on his guard. He decided to wait and see what happened before hedging. The following day, the rally continued. The stock was at $107.30 by noon. His delta was around −3. In the face of an increasingly negative delta, John weighed his alternatives: He could buy back some of his calls to offset his delta, which would have the added benefit of reducing his gamma as well. He could buy stock to flatten out. Lastly, he could simply do nothing and wait. John felt the stock was overbought and might retrace. He also still believed volatility would fall. He decided to be patient and enter a stop order to buy all of his deltas at $107.50 in case the stock continued trending up. The XYZ shares closed at $107.45 that day. This time inaction proved to be the best action. The stock did retrace. Week one ended with Federal XYZ back down around $105.50. The IV of the straddle was at 23. The straddle finished up week one offered at $4.10. Week Two The future was looking bright at the start of week two until Wednesday. Wednesday morning saw XYZ gap open to $109. When you have a short straddle, a $3.50 gap move in the underlying tends to instantly give you a sinking feeling in the pit of your stomach. But the damage was truly not that bad. The offer in the straddle was 4.75, so the position was still a winner if John bought it back at this point. Gamma/delta hurt. Theta helped. A characteristic that enters into this trade is volatility’s changing as a result of movement in the stock price. Despite the fact that the stock gapped $3.50 higher, implied volatility fell by 1 percent, to 22. This volatility reaction to the underlying’s rise in price is very common in many equity and index options. John decided to close the trade. Nobody ever went broke taking a profit. The trade in this example was profitable. Of course, this will not always be the case. Sometimes short straddles will be losers—sometimes big ones. Big moves and rising implied volatility can be perilous to short straddles and their writers. If the XYZ stock in the previous example had gapped up to $115—which is not an unreasonable possibility—John’s trade would have been ugly. Synthetic Straddles Straddles are the pet strategy of certain professional traders who specialize in trading volatility. In fact, in the mind of many of these traders, a straddle is all there is. Any single-legged trade can be turned into a straddle synthetically simply by adding stock. Chapter 6 discussed put-call parity and showed that, for all intents and purposes, a put is a call and a call is a put. For the most part, the greeks of the options in the put-call pair are essentially the same. The delta is the only real difference. And, of course, that can be easily corrected. As a matter of perspective, one can make the case that buying two calls is essentially the same as buying a call and a put, once stock enters into the equation. Take a non-dividend-paying stock trading at $40 a share. With 60 days until expiration, a 25 volatility, and a 4 percent interest rate, the greeks of the 40-strike calls and puts of the straddle are as follows: Essentially, the same position can be created by buying one leg of the spread synthetically. For example, in addition to buying one 40 call, another 40 call can be purchased along with shorting 100 shares of stock to create a 40 put synthetically. Combined, the long call and the synthetic long put (long call plus short stock) creates a synthetic straddle. A long synthetic straddle could have similarly been constructed with a long put and a long synthetic call (long put plus long stock). Furthermore, a short synthetic straddle could be created by selling an option with its synthetic pair. Notice the similarities between the greeks of the two positions. The synthetic straddle functions about the same as a conventional straddle. Because the delta and gamma are nearly the same, the up-and-down risk is nearly the same. Time and volatility likewise affect the two trades about the same. The only real difference is that the synthetic straddle might require a bit more cash up front, because it requires buying or shorting the stock. In practice, straddles will typically be traded in accounts with retail portfolio margining or professional margin requirements (which can be similar to retail portfolio margining). So the cost of the long stock or margin for short stock is comparatively small. Long Strangle Definition : Buying one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typical long strangles involve an OTM call and an OTM put. A strangle in which an ITM call and an ITM put are purchased is called a long guts strangle. A long strangle is similar to a long straddle in many ways. They both require buying a call and a put on the same class in the same expiration month. They are both buying volatility. There are, however, some functional differences. These differences stem from the fact that the options have different strike prices. Because there is distance between the strike prices, from an at-expiration perspective, the underlying must move more for the trade to show a profit. Exhibit 15.8 illustrates the payout of options as part of a long strangle on a $70 stock. The graph is much like that of Exhibit 15.1 , which shows the payout of a long straddle. But the net cost here is only 1.00, compared with 4.25 for the straddle with the same time and volatility inputs. The cost is lower because this trade consists of OTM options instead of ATM options. The breakdown is as follows: EXHIBIT 15.8 Long strangle at-expiration diagram. The underlying has a bit farther to go by expiration for the trade to have value. If the underlying is above $75 at expiration, the call is ITM and has value. If the underlying is below $65 at expiration, the put is ITM and has value. If the underlying is between the two strike prices at expiration both options expire and the 1.00 premium is lost. An important difference between a straddle and a strangle is that if a strangle is held until expiration, its break-even points are farther apart than those of a comparable straddle. The 70-strike straddle in Exhibit 15.1 had a lower breakeven of $65.75 and an upper break-even of $74.25. The comparable strangle in this example has break-even prices of $64 and $76. But what if the strangle is not held until expiration? Then the trade’s greeks must be analyzed. Intuitively, two OTM options (or ITM ones, for that matter) will have lower gamma, theta, and vega than two comparable ATM options. This has a two-handed implication when comparing straddles and strangles. On the one hand, from a realized volatility perspective, lower gamma means the underlying must move more than it would have to for a straddle to produce the same dollar gain per spread, even intraday. But on the other hand, lower theta means the underlying doesn’t have to move as much to cover decay. A lower nominal profit but a higher percentage profit is generally reaped by strangles as compared with straddles. A long strangle composed of two OTM options will also give positive exposure to implied volatility but, again, not as much as an ATM straddle would. Positive vega really kicks in when the underlying is close to one of the strike prices. This is important when anticipating changes in the stock price and in IV. Say a trader expects implied volatility to rise as a result of higher stock volatility. As the stock rises or falls, the strangle will move toward the price point that offers the highest vega (the strike). With a straddle, the stock will be moving away from the point with the highest vega. If the stock doesn’t move as anticipated, the lower theta and vega of the strangle compared with the ATM straddle have a less adverse effect on P&L. Long-Strangle Example Let’s return to Susan, who earlier in this chapter bought a straddle on Acme Brokerage Co. (ABC). Acme currently trades at $74.80 a share with current realized volatility at 36 percent. The stock’s volatility range for the past month was between 36 and 47. The implied volatility of the four-week options is 36 percent. The range over the past month for the IV of the front month has been between 34 and 55. As in the long-straddle example earlier in this chapter, there is a great deal of uncertainty in brokerage stocks revolving around interest rates, credit- default problems, and other economic issues. An FOMC meeting is expected in about one week’s time about whose possible actions analysts’ estimates vary greatly, from a cut of 50 basis points to no cut at all. Add a pending earnings release to the docket, and Susan thinks Acme may move quite a bit. In this case, however, instead of buying the 75-strike straddle, Susan pays 2.35 for 20 one-month 70–80 strangles. Exhibit 15.9 compares the greeks of the long ATM straddle with those of the long strangle. EXHIBIT 15.9 Long straddle versus long strangle. The cost of the strangle, at 2.35, is about 40 percent of the cost of the straddle. Of course, with two long options in each trade, both have positive gamma and vega and negative theta, but the exposure to each metric is less with the strangle. Assuming the same stock-price action, a strangle would enjoy profits from movement and losses from lack of movement that were similar to those of a straddle—just nominally less extreme. For example, if Acme stock rallies $5, from $74.80 to $79.80, the gamma of the 75 straddle will grow the delta favorably, generating a gain of 1.50, or about 25 percent. The 70–80 strangle will make 1.15 from the curvature of the delta–almost a 50 percent gain. With the straddle and especially the strangle, there is one more detail to factor in when considering potential P&L: IV changes due to stock price movement. IV is likely to fall as the stock rallies and rise as the stock declines. The profits of both the long straddle and the long strangle would likely be adversely affected by IV changes as the stock rose toward $79.80. And because the stock would be moving away from the straddle strike and toward one of the strangle strikes, the vegas would tend to become more similar for the two trades. The straddle in this example would have a vega of 2.66, while the strangle’s vega would be 2.67 with the underlying at $79.80 per share. Short Strangle Definition : Selling one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typically, an OTM call and an OTM put are sold. A strangle in which an ITM call and an ITM put are sold is called a short guts strangle. A short strangle is a volatility-selling strategy, like the short straddle. But with the short strangle, the strikes are farther apart, leaving more room for error. With these types of strategies, movement is the enemy. Wiggle room is the important difference between the short-strangle and short-straddle strategies. Of course, the trade-off for a higher chance of success is lower option premium. Exhibit 15.10 shows the at-expiration diagram of a short strangle sold at 1.00, using the same options as in the diagram for the long strangle. EXHIBIT 15.10 Short strangle at-expiration diagram. Note that if the underlying is between the two strike prices, the maximum gain of 1.00 is harvested. With the stock below $65 at expiration, the short put is ITM, with a +1.00 delta. If the stock price is below the lower breakeven of $64 (the put strike minus the premium), the trade is a loser. The lower the stock, the bigger the loss. If the underlying is above $75, the short call is ITM, with a −1.00 delta. If the stock is above the upper breakeven of $76 (the call strike plus the premium), the trade is a loser. The higher the stock, the bigger the loss. Intuitively, the signs of the greeks of this strangle should be similar to those of a short straddle—negative gamma and vega, positive theta. That means that increased realized volatility hurts. Rising IV hurts. And time heals all wounds—unless, of course, the wounds caused by gamma are greater than the net premium received. This brings us to an important philosophical perspective that emphasizes the differences between long straddles and strangles and their short counterparts. Losses from rising vega are temporary; the time value of all options will be zero at expiration. But gamma losses can be permanent and profound. These short strategies have limited profit potential and unlimited loss potential. Although short-term profits (or losses) can result from IV changes, the real goal here is to capture theta. Short-Strangle Example Let’s revisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this example, with an implied volatility of 26 percent and a stock volatility of 22. Both implied and realized volatility are higher than has been typical during the past twelve months. John wants to sell volatility. In this example, he believes the stock price will remain in a fairly tight range, causing realized volatility to revert to its normal level, in this case between 15 and 20 percent. He does everything possible to ensure success. This includes scanning the news headlines on XYZ and its financials for a reason not to sell volatility. Playing devil’s advocate with oneself can uncover unforeseen yet valid reasons to avoid making bad trades. John also notes the recent price range, which has been between $111.71 and $102.05 over the past month. Once John commits to an outlook on the stock, he wants to set himself up for maximum gain if he’s right and, for that matter, to maximize his chances of being right. In this case, he decides to sell a strangle to give himself as much margin for error as possible. He sells 10 three-week 100–110 strangles at 1.80. Exhibit 15.11 compares the greeks of this strangle with those of the 105 straddle. EXHIBIT 15.11 Short straddle vs. short strangle. As expected, the strangle’s greeks are comparable to the straddle’s but of less magnitude. If John’s intention were to capture a drop in IV, he’d be better off selling the bigger vega of the straddle. Here, though, he wants to see the premium at zero at expiration, so the strangle serves his purposes better. What he is most concerned about are the breakevens—in this case, 98.20 and 111.8. The straddle has closer break-even points, of $99.60 and $110.40. Despite the fact that in this case, John is not really trading the greeks or IV per se, they still play an important role in his trade. First, he can use theta to plan the best strangle to trade. In this case, he sells the three-week strangle because it has the highest theta of the available months. The second month strangle has a −0.71 theta, and the third month has a −0.58 theta. With strangles, because the options are OTM, this disparity in theta among the tradable months may not always be the case. But for this trade, if he is still bearish on realized volatility after expiration, John can sell the next month when these options expire. Certainly, he will monitor his risk by watching delta and gamma. These are his best measures of directional exposure. He will consider implied volatility in the decision-making process, too. An implied volatility significantly higher than the realized volatility can be a red flag that the market expects something to happen, but there’s a bigger payoff if there is no significant volatility. An IV significantly lower than the realized can indicate the risk of selling options too cheaply: the premium received is not high enough, based on how much the stock has been moving. Ideally, the IV should be above the realized volatility by between 2 and 20 percent, perhaps more for highly speculative traders. Limiting Risk The trouble with short straddles and strangles is that every once in a while the stock unexpectedly reacts violently, moving by three or more standard deviations. This occurs when there is a takeover, an extreme political event, a legal action, or some other extraordinary incident. These events can be guarded against by buying farther OTM options for protection. Essentially, instead of selling a straddle or a strangle, one sells an iron butterfly or iron condor. Then, when disaster strikes, it’s not a complete catastrophe. How Cheap Is Too Cheap? At some point, the absolute premium simply is not worth the risk of the trade. For example, it would be unwise to sell a two-month 45–55 strangle for 0.10 no matter what the realized volatility was. With the knowledge that there is always a chance for a big move, it’s hard to justify risking dollars to make a dime. Note 1 . This depends on interest, dividends, and time to expiration. The delta will likely not be exactly zero. CHAPTER 16 Ratio Spreads and Complex Spreads The purpose of spreading is to reduce risk. Buying one contract and selling another can reduce some or all of a trade’s risks, as measured by the greeks, compared with simply holding an outright option. But creative traders have the ability to exercise great control over their greeks risk. They can practically eliminate risk in some greeks, while retaining risks in just the desired greeks. To do so, traders may have to use more complex, and less conventional spreads. These spreads often involve buying or selling options in quantities other than one-to-one ratios. Ratio Spreads The simplest versions of these strategies used by retail traders, institutional traders, proprietary traders, and others are referred to as ratio spreads . In ratio spreads, options are bought and sold in quantities based on a ratio. For example, a 1:3 spread is when one option is bought (or sold) and three are sold (or bought)—a ratio of one to three. This kind of ratio spread would be called a “one-by-three.” However, some option positions can get a lot more complicated. Market makers and other professional traders manage a complex inventory of long and short options. These types of strategies go way beyond simple at- expiration diagrams. This chapter will discuss the two most common types of ratio spreads—backspreads and ratio vertical spreads—and also the delta-neutral position management of market makers and other professional traders. Backspreads Definition : An option strategy consisting of more long options than short options having the same expiration month. Typically, the trader is long calls (or puts) in one series of options and short a fewer number of calls (or puts) in another series with the same expiration month in the same option class. Some traders, such as market makers, refer generically to any delta-neutral long-gamma position as a backspread. Shades of Gray In its simplest form, trading a backspread is trading a one-by-two call or put spread and holding it until expiration in hopes that the underlying stock’s price will make a big move, particularly in the more favorable direction. But holding a backspread to expiration as described has its challenges. Let’s look at a hypothetical example of a backspread held to term and its at- expiration diagram. With the stock at $71 and one month until March expiration: In this example, there is a credit of 3.20 from the sale of the 70 call and a debit of 1.10 for each of the two 75 calls. This yields a total net credit of 1.00 (3.20 − 1.10 − 1.10). Let’s consider how this trade performs if it is held until expiration. If the stock falls below $70 at expiration, all the calls expire and the 1.00 credit is all profit. If the stock is between $70 and $75 at expiration, the 70 call is in-the-money (ITM) and the −1.00 delta starts racking up losses above the breakeven of $71 (the strike plus the credit). At $75 a share this trade suffers its maximum potential loss of $4. If the stock is above $75 at expiration, the 75 calls are ITM. The net delta of +1.00, resulting from the +2.00 deltas of the 75 calls along with the −1.00 delta of the 70 call, makes money as the stock rises. To the upside, the trade is profitable once the stock is at a high enough price for the gain on the two 75 calls to make up for the loss on the 70 call. In this case, the breakeven is $79 (the $4 maximum potential loss plus the strike price of 75). While it’s good to understand this at-expiration view of this trade, this diagram is a bit misleading. What does the trader of this spread want to have happen? If the trader is bearish, he could find a better way to trade his view than this, which limits his gains to 1.00—he could buy a put. If the trader believes the stock will make a volatile move in either direction, the backspread offers a decidedly limited opportunity to the downside. A straddle or strangle might be a better choice. And if the trader is bullish, he would have to be very bullish for this trade to make sense. The underlying needs to rise above $79 just to break even. If instead he just bought 2 of the 75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the breakeven would be $77.20 instead of $79, and profits at expiration would rack up twice as fast above the breakeven, since the trader is net long two calls instead of one. Why would a trader ever choose to trade a backspread? EXHIBIT 16.1 Backspread at expiration. The backspread is a complex spread that can be fully appreciated only when one has a thorough knowledge of options. Instead of waiting patiently until expiration, an experienced backspreader is more likely to gamma scalp intermittent opportunities. This requires trading a large enough position to make scalping worthwhile. It also requires appropriate margining (either professional-level margin requirements or retail portfolio margining). For example, this 1:2 contract backspread has a delta of −0.02 and a gamma of +0.05. Fewer than 10 deltas could be scalped if the stock moves up and down by one point. It becomes a more practical trade as the position size increases. Of course, more practical doesn’t necessarily guarantee it will be more profitable. The market must cooperate! Backspread Example Let’s say a 20:40 contract backspread is traded. (Note : In trader lingo this is still called a one-by-two; it is just traded 20 times.) The spread price is still 1.00 credit per contract; in this case, that’s $2,000. But with this type of trade, the spread price is not the best measure of risk or reward, as it is with some other kinds of spreads. Risk and reward are best measured by delta, gamma, theta, and vega. Exhibit 16.2 shows this trade’s greeks. EXHIBIT 16.2 Greeks for 20:40 backspread with the underlying at $71. Backspreads are volatility plays. This spread has a +1.07 vega with the stock at $71. It is, therefore, a bullish implied volatility (IV) play. The IV of the long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much as with any other volatility trade, traders would compare current implied volatility with realized volatility and the implied volatility of recent past and consider any catalysts that might affect stock volatility. The objective is to buy an IV that is lower than the expected future stock volatility, based on all available data. The focus of traders of this backspread is not the dollar credit earned. They are more interested in buying a 30 volatility—that’s the focus. But the 75 calls’ IV is not the only volatility figure to consider. The short options, the 70s, have implied volatility of 32 percent. Because of their lower strike, the IV is naturally higher for the 70 calls. This is vertical skew and is described in Chapter 3. The phenomenon of lower strikes in the same option class and with the same expiration month having higher IV is very common, although it is not always the case. Backspreads usually involve trading vertical skew. In this spread, traders are buying a 30 volatility and selling a 32 volatility. In trading the skew, the traders are capturing two volatility points of what some traders would call edge by buying the lower volatility and selling the higher. Based on the greeks in Exhibit 16.2 , the goal of this trade appears fairly straightforward: to profit from gamma scalping and rising IV. But, sadly, what appears to be straightforward is not. Exhibit 16.3 shows the greeks of this trade at various underlying stock prices. EXHIBIT 16.3 70–75 backspread greeks at various stock prices. Notice how the greeks change with the stock price. As the stock price moves lower through the short strike, the 70 strike calls become the more relevant options, outweighing the influence of the 75s. Gamma and vega become negative, and theta becomes positive. If the stock price falls low enough, this backspread becomes a very different position than it was with the stock price at $71. Instead of profiting from higher implied and realized volatility, the spread needs a lower level of both to profit. This has important implications. First, gamma traders must approach the backspread a little differently than they would most spreads. The backspread traders must keep in mind the dynamic greeks of the position. With a trade like a long straddle, in which there are no short options, traders scalping gamma simply buy to cover short deltas as the stock falls and sell to cover long deltas as the stock rises. The only risks are that the stock may not move enough to cover theta or that the traders may cover deltas too soon to maximize profits. With the backspread, the changing gamma adds one more element of risk. In this example, buying stock to flatten out delta as the stock falls can sometimes be a premature move. Traders who buy stock may end up with more long deltas than they bargained for if the stock falls into negative- gamma territory. Exhibit 16.3 shows that with the stock at $68, the delta for this trade is −2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the stock subsequently falls to $62 a share, instead of being short 1.46 deltas, as the figure indicates, they will be long 1.04 because of the 250 shares they bought. These long deltas start to hurt as the stock continues lower. Backspreaders must therefore anticipate stock movements to avoid overhedging. The traders in this example may decide to lean short if the stock shows signs of weakness. Leaning short means that if the delta is −2.50 at $68 a share, the traders may decide to underhedge by buying just 100 or 200 shares. If the stock continues to fall and negative gamma kicks in, this gives the traders some cushion to the downside. The short delta of the position moves closer to being flat as the stock falls. Because there is a long strike and a short strike in this delta-neutral position, trading ratio spreads is like trading a long and a short volatility position at the same time. Trading backspreads is not an exact science. The stock has just as good a chance of rising as it does of falling, and if it does rise and the traders have underhedged at $68, they will not participate in all the gains they would have if they had fully hedged by buying 250 shares of stock. If trading were easy, everyone would do it! Backspreaders must also be conscious of the volatility of each leg of the spread. There is an inherent advantage in this example to buying the lower volatility of the 75 calls and selling the higher volatility of the 70 calls. But there is also implied risk. Equity prices and IV tend to have an inverse relationship. When stock prices fall—especially if the drop happens quickly —IV will often rise. When stock prices rise, IV often falls. In this backspread example, as the stock price falls to or through the short strike, vega becomes negative in the face of a potentially rising IV. As the stock price rises into positive vega turf, there is the risk of IV’s declining. A dynamic volatility forecast should be part of a backspread-trading plan. One of the volatility questions traders face in this example is whether the two- point volatility skew between the two strike prices is enough to compensate for the potential adverse vega move as the stock price changes. Put backspreads have the opposite skew/volatility issues. Buying two lower-strike puts against one higher-strike put means the skew is the other direction—buying the higher IV and selling the lower. The put backspread would have long gamma/vega to the downside and short gamma/vega to the upside. But if the vega firms up as the stock falls into positive-vega territory, it would be in the trader’s favor. As the stock rises, leading to negative vega, there is the potential for vega profits if IV indeed falls. There are a lot of things to consider when trading a backspread. A good trader needs to think about them all before putting on the trade. Ratio Vertical Spreads Definition : An option strategy consisting of more short options than long options having the same expiration month. Typically, the trader is short calls (or puts) in one series of options and long a fewer number of calls (or puts) in another series in the same expiration month on the same option class. A ratio vertical spread, like a backspread, involves options struck at two different prices—one long strike and one short. That means that it is a volatility strategy that may be long or short gamma or vega depending on where the underlying price is at the time. The ratio vertical spread is effectively the opposite of a backspread. Let’s study a ratio vertical using the same options as those used in the backspread example. With the stock at $71 and one month until March expiration: In this case, we are buying one ITM call and selling two OTM calls. The relationship of the stock price to the strike price is not relevant to whether this spread is considered a ratio vertical spread. Certainly, all these options could be ITM or OTM at the time the trade is initiated. It is also not important whether the trade is done for a debit or a credit. If the stock price, time to expiration, volatility, or number of contracts in the ratio were different, this could just as easily been a credit ratio vertical. Exhibit 16.4 illustrates the payout of this strategy if both legs of the 1:2 contract are still open at expiration. EXHIBIT 16.4 Short ratio spread at expiration. This strategy is a mirror image of the backspread discussed previously in this chapter. With limited risk to the downside, the maximum loss to the trade is the initial debit of 1 if the stock is below $70 at expiration and all the calls expire. There is a maximum profit potential of 4 if the stock is at the short strike at expiration. There is unlimited loss potential, since a short net delta is created on the upside, as one short 75 call is covered by the long 70 call, and one is naked. The breakevens are at $71 and $79. Low Volatility With the stock at $71, gamma and vega are both negative. Just as the backspread was a long volatility play at this underlying price, this ratio vertical is a short-vol play here. As in trading a short straddle, the name of the game is low volatility—meaning both implied and realized. This strategy may require some gamma hedging. But as with other short volatility delta-neutral trades, the fewer the negative scalps, the greater the potential profit. Delta covering should be implemented in situations where it looks as if the stock will trend deep into negative-gamma territory. Murphy’s Law of trading dictates that delta covering will likely be wrong at least as often as it is right. Ratio Vertical Example Let’s examine a trade of 20 contracts by 40 contracts. Exhibit 16.5 shows the greeks for this ratio vertical. EXHIBIT 16.5 Short ratio vertical spread greeks. Before we get down to the nitty-gritty of the mechanics and management of this trade—the how—let’s first look at the motivations for putting the trade on—the why. For the cost of 1.00 per spread, this trader gets a leveraged position if the stock rises moderately. The profits max out with the stock at the short-strike target price—$75—at expiration. Another possible profit engine is IV. Because of negative vega, there is the chance of taking a quick profit if IV falls in the interim. But short-term losses are possible, too. IV can rise, or negative gamma can hurt the trader. Ultimately, having naked calls makes this trade not very bullish. A big move north can really hurt. Basically, this is a delta-neutral-type short-volatility play that wins the most if the stock is at $75 at expiration. One would think about making this trade if the mechanics fit the forecast. If this trader were a more bullish than indicated by the profit and loss diagram, a more-balanced bull call spread would be a better strategy, eliminating the unlimited upside risk. If upside risk were acceptable, this trader could get more aggressive by trading the spread one-by-three. That would result in a credit of 0.05 per spread. There would then be no ultimate risk below $70 but rather a 0.05 gain. With double the naked calls, however, there would be double punishment if the stock rallied strongly beyond the upside breakeven. Ultimately, mastering options is not about mastering specific strategies. It’s about having a thorough enough understanding of the instrument to be flexible enough to tailor a position around a forecast. It’s about minimizing the unwanted risks and optimizing exposure to the intended risks. Still, there always exists a trade-off in that where there is the potential for profit, there is the possibility of loss—you can always be wrong. Recalling the at-expiration diagram and examining the greeks, the best- case scenario is intuitive: the stock at $75 at expiration. The biggest theta would be right at that strike. But that strike price is also the center of the biggest negative gamma. It is important to guard against upward movement into negative delta territory, as well as movement lower where the position has a slightly positive delta. Exhibit 16.6 shows what happens to the greeks of this trade as the stock price moves. EXHIBIT 16.6 Ratio vertical spread at various prices for the underlying. As the stock begins to rise from $71 a share, negative deltas grow fast in the short term. Careful trend monitoring is necessary to guard against a rally. The key, however, is not in knowing what will happen but in skillfully hedging against the unknown. The talented option trader is a disciplined risk manager, not a clairvoyant. One of the risks that the trader willingly accepted when placing this trade was short gamma. But when the stock moves and deltas are created, decisions have to be made. Did the catalyst(s)—if any—that contributed to the rise in stock price change the outlook for volatility? If not, the decision is simply whether or not to hedge by buying stock. However, if it appears that volatility is on the rise, it is not just a delta decision. A trader may consider buying some of the short options back to reduce volatility exposure. In this example, if the stock rises and it’s feared that volatility may increase, a good choice may be to buy back some of the short 75-strike calls. This has the advantage of reducing delta (buy enough deltas to flatten out) and reducing gamma and vega. Of course, the downside to this strategy is that in purchasing the calls, a loss is likely to be locked in. Unless a lot of time has passed or implied volatility has dropped sharply, the calls will probably be bought at a higher price than they were sold. If the stock makes a violent move upward, a loss will be incurred. Whether this loss is locked in by closing all or part of the position, the account will still be down in value. The decision to buy the calls back at a loss is based on looking forward. Nothing good can come of looking back. How Market Makers Manage Delta-Neutral Positions While market makers are not position traders per se, they are expert position managers. For the most part, market makers make their living by buying the bid and selling the offer. In general, they don’t act; they react. Most of their trades are initiated by taking the other side of what other people want to do and then managing the risk of the positions they accumulate. The business of a market maker is much like that of a casino. A casino takes the other side of people’s bets and, in the long run, has a statistical (theoretical) edge. For market makers, because theoretical value resides in the middle of the bid and the ask, these accommodating trades lead to a theoretical profit—that is, the market maker buys below theoretical value and sells above. Actual profit—cold, hard cash you can take to the bank— is, however, dependent on sound management of the positions that are accumulated. My career as a market maker was on the floor of the Chicago Board Options Exchange (CBOE) from 1998 to 2005. Because, over all, the trades I made had a theoretical edge, I hoped to trade as many contracts as possible on my markets without getting too long or too short in any option series or any of my greeks. As a result of reacting to order flow, market makers can accumulate a large number of open option series for each class they trade, resulting in a single position. For example, Exhibit 16.7 shows a position I had in Ford Motor Co. (F) options as a market maker. EXHIBIT 16.7 Market-maker position in Ford Motor Co. options. With all the open strikes, this position is seemingly complex. There is not a specific name for this type of “spread.” The position was accumulated over a long period of time by initiating trades via other traders selling options to me at prices I wanted to buy them—my bid—and buying options from me at prices I wanted to sell them—my offer. Upon making an option trade, I needed to hedge directional risk immediately. I usually did so by offsetting my option trades by taking the opposite delta position in the stock —especially on big-delta trades. Through this process of providing liquidity to the market, I built up option-centric risk. To manage this risk I needed to watch my other greeks. To be sure, trying to draw a P&L diagram of this position would be a fruitless endeavor. Exhibit 16.8 shows the risk of this trade in its most distilled form. EXHIBIT 16.8 Analytics for market-maker position in Ford Motor Co. (stock at $15.72). Delta +1,075 Gamma−10,191 Theta +1,708 Vega +7,171 Rho −33,137 The +1,075 delta shows comparatively small directional risk relative to the −10,191 gamma. Much of the daily task of position management would be to carefully guard against movement by delta hedging when necessary to earn the $1,708 per day theta. Much of the negative gamma/positive theta comes from the combined 1,006 short January 15 calls and puts. (Note that because this position is traded delta neutral, the net long or short options at each strike is what matters, not whether the options are calls or puts. Remember that in delta- neutral trading, a put is a call, and a call is a put.) The positive vega stems from the fact that the position is long 1,927 January 2003 20-strike options. Although this position has a lot going on, it can be broken down many ways. Having long LEAPS options and short front-month options gives this position the feel of a time spread. One way to think of where most of the gamma risk is coming from is to bear in mind that the 15 strike is synthetically short 503 straddles (1,006 options ÷ two). But this position overall is not like a straddle. There are more strikes involved—a lot more. There is more short gamma to the downside if the price of Ford falls toward $12.50. To the upside, the 17.50 strike is long a combined total of 439 options. Looking at just the 15 and 17.50 strikes, we can see something that looks more like a ratio spread: 1,006:439. If the stock were at $17.50, the gamma would be around +5,000. With the stock at $15.72, there is realized volatility risk of F rallying, but with gamma changing from negative to positive as the stock rallies, the risk of movement decreases quickly. The 20 strike is short 871 options which brings the position back to negative-gamma territory. Having alternating long and short strikes, sometimes called a butterflied position, is a handy way for market makers to reduce risk. A position is perfectly butterflied if it has alternating long and short strikes with the same number of contracts. Through Your Longs to Your Shorts With market-maker-type positions consisting of many strikes, the greatest profit is gained if the underlying security moves through the longs to the shorts. This provides kind of a win-win scenario for greeks traders. In this situation, traders get the benefit of long gamma as the stock moves higher or lower through the long strike. They also reap the benefits of theta when the stock sits at the short strike. Trading Flat Most market makers like to trade flat—that is, profit from the bid-ask spread and strive to lower exposure to direction, time, volatility, and interest as much as possible. But market makers are at the mercy of customer orders, or paper, as it’s known in the industry. If someone sells, say, the March 75 calls to a market maker at the bid, the best-case scenario is that moments later someone else buys the same number of the same calls—the March 75s, in this case—from that same market maker at the offer. This is locking in a profit. Unfortunately, this scenario seldom plays out this way. In my seven years as a market maker, I can count on one hand the number of times the option gods smiled upon me in such a way as to allow me to immediately scalp an option. Sometimes, the same option will not trade again for a week or longer. Very low-volume options trade “by appointment only.” A market maker trading illiquid options may hold the position until it expires, having no chance to get out at a reasonable price, often taking a loss on the trade. More typically, if a market maker buys an option, he must sell a different option to lessen the overall position risk. The skills these traders master are to lower bids and offers on options when they are long gamma and/or vega and to raise bids and offers on options when they are short gamma and/or vega. This raising and lowering of markets is done to manage risk. Effectively, this is your standard high school economics supply-and- demand curves in living color. When the market demands (buys) all the options that are supplied (offered) at a certain price, the price rises. When the market supplies (sells) all the options demanded (bid) at a price level, the price falls. The catalyst of supply and demand is the market maker and his risk tolerance. But instead of the supply and demand for individual options, it is supply and demand for gamma, theta, and vega. This is trading option greeks. Hedging the Risk Delta is the easiest risk for floor traders to eliminate quickly. It becomes second nature for veteran floor traders to immediately hedge nearly every trade with the underlying. Remember, these liquidity providers are in the business of buying option bids and selling option offers, not speculating on direction. The next hurdle is to trade out of the option-centric risk. This means that if the market maker is long gamma, he needs to sell options; if he’s short gamma, he needs to buy some. Same with theta and vega. Market makers move their bids and offers to avoid being saddled with too much gamma, theta, and vega risk. Experienced floor traders are good at managing option risk by not biting off more than they can chew. They strive to never buy or sell more options than they can spread off by selling or buying other options. This breed of trader specializes in trading the spread and managing risk, not in predicting the future. They’re market makers, not market takers. Trading Skew There are some trading strategies for which market makers have a natural propensity that stems from their daily activity of maintaining their positions. While money managers who manage equity funds get to know the fundamentals of the stocks they trade very well, options market makers know the volatility of the option classes they trade. When they adjust their markets in reacting to order flow, it’s, mechanically, implied volatility that they are raising or lowering to change theoretical values. They watch this figure very carefully and trade its subtle changes. A characteristic of options that many market makers and some other active professional traders observe and trade is the volatility skew. Savvy traders watch the implied volatility of the strikes above the at-the-money (ATM)—referred to as calls , for simplicity—compared with the strikes below the ATM, referred to as puts . In most stocks, there typically exists a “normal” volatility skew inherent to options on that stock. When this skew gets out of line, there may be an opportunity. Say for a particular option class, the call that is 10 percent OTM typically trades about four volatility points lower than the put that is 10 percent OTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher, say, nine points above where the calls are offered—for instance, the puts are bid at 32 volatility bid while the calls are offered at 23 vol—a trader can speculate on the skew reverting back to its normal relationship by selling the puts, buying the calls, and hedging the delta by selling the right amount of stock. This position—long a call, short a put with a different strike, and short stock on a delta-neutral ratio—is called a risk reversal. The motive for risk reversals is to capture vega as the skew realigns itself. But there are many risk factors that require careful attention. First, as in other positions consisting of both long and short strikes, the gamma, theta, and vega of the position will vary from positive to negative depending on the price of the underlying. Risk-reversal traders must be prepared to trade long gamma (and battle time decay) when the stock rallies closer to the long-call strike and trade short gamma (and assume the risk of possible increased realized volatility) when the stock moves closer to the short-put strike. As for vega, being short implied volatility on the downside and long on the upside is inherently a potentially bad position whichever way the stock moves. Why? As equities decline in price, the implied volatility of their options tends to rise. But the downside is where the risk reversal has its short vega. Furthermore, as equities rally, their IV tends to fall. That means the long vega of the upside hurts as well. When Delta Neutral Isn’t Direction Indifferent Many dynamic-volatility option positions, such as the risk reversal, have vega risk from potential IV changes resulting from the stock’s moving. This is indirectly a directional risk. While having a delta-neutral position hedges against the rather straightforward directional risk of the position delta, this hidden risk of stock movement is left unhedged. In some circumstances, a delta-lean can help abate some of the vega risk of stock-price movement. Say an option position has fairly flat greeks at the current stock price. Say that given the way this particular position is set up, if the stock rises, the position is still fairly flat, but if the stock falls, short lower-strike options will lead to negative gamma and vega. One way to partially hedge this position is to lean short deltas—that is, instead of maintaining a totally flat delta, have a slightly short delta. That way, if the stock falls, the trade profits some on the short stock to partially offset some of the anticipated vega losses. The trade-off of this hedge is that if the stock rises, the trade loses on the short delta. Delta leans are more of an art than a science and should be used as a hedge only by experienced vol traders. They should be one part of a well- orchestrated plan to trade the delta, gamma, theta, and vega of a position. And, to be sure, a delta lean should be entered into a model for simulation purposes before executing the trade to study the up-and-down risk of the position. If the lean reduces the overall risk of the position, it should be implemented. But if it creates a situation where there is an anticipated loss if the stock moves in either direction and there is little hope of profiting from the other greeks, the lean is not the answer—closing the position is. Managing Multiple-Class Risk Most traders hold option positions in more than one option class. As an aside, I recommend doing so, capital and experience permitting. In my experience, having positions in multiple classes psychologically allows for a certain level of detachment from each individual position. Most traders can make better decisions if they don’t have all their eggs in one basket. But holding a portfolio of option positions requires one more layer of risk management. The trader is concerned about the delta, gamma, theta, vega, and rho not only of each individual option class but also of the portfolio as a whole. The trader’s portfolio is actually one big position with a lot of moving parts. To keep it running like a well-oiled machine requires monitoring and maintaining each part to make sure they are working together. To have the individual trades work in harmony with one another, it is important to keep a well-balanced series of strategies. Option trading requires diversification, just like conventional linear stock trading or investing. Diversification of the option portfolio is easily measured by studying the portfolio greeks. By looking at the net greeks of the portfolio, the trader can get some idea of exposure to overall risk in terms of delta, gamma, theta, vega, and rho. CHAPTER 17 Putting the Greeks into Action This book was intended to arm the reader with the knowledge of the greeks needed to make better trading decisions. As the preface stated, this book is not so much a how-to guide as a how-come tutorial. It is step one in a three- step learning process: Step One: Study . First, aspiring option traders must learn as much as possible from books such as this one and from other sources, such as articles, both in print and online, and from classes both in person and online. After completing this book, the reader should have a solid base of knowledge of the greeks. Step Two: Paper Trade . A truly deep understanding requires practice, practice, and more practice! Fortunately, much of this practice can be done without having real money on the line. Paper trading—or simulated trading—in which one trades real markets but with fake money is step two in the learning process. I highly recommend paper trading to kick the tires on various types of strategies and to see how they might work differently in reality than you thought they would in theory. Step Three: Showtime ! Even the most comprehensive academic study or windfall success with paper profits doesn’t give one a true feel for how options work in the real world. There are some lessons that must be learned from the black and the blue. When there’s real money on the line, you will trade differently—at least in the beginning. It’s human nature to be cautious with wealth. This is not a bad thing. But emotions should not override sound judgment. Start small—one or two lots per trade—until you can make rational decisions based on what you have learned, keeping emotions in check. This simple three-step process can take years of diligent work to get it right. But relax. Getting rich quick is truly a poor motivation for trading options. Option trading is a beautiful thing! It’s about winning. It’s about beating the market. It’s about being smart. Don’t get me wrong—wealth can be a nice by-product. I’ve seen many people who have made a lot of money trading options, but it takes hard work. For every successful option trader I’ve met, I’ve met many more who weren’t willing to put in the effort, who brashly thought this is easy, and failed miserably. Trading Option Greeks Traders must take into account all their collective knowledge and experience with each and every trade. Now that you’re armed with knowledge of the greeks, use it! The greeks come in handy in many ways. Choosing between Strategies A very important use of the greeks is found in selecting the best strategy for a given situation. Consider a simple bullish thesis on a stock. There are plenty of bullish option strategies. But given a bullish forecast, which option strategy should a trader choose? The answer is specific to each unique opportunity. Trading is situational. Example 1 Imagine a trader, Arlo, is studying the following chart of Agilent Technologies Inc. (A). See Exhibit 17.1 . EXHIBIT 17.1 Agilent Technologies Inc. daily candles. Source : Chart courtesy of Livevol® Pro ( www.livevol.com ) The stock has been in an uptrend for six weeks or so. Close-to-close volatility hasn’t increased much. But intraday volatility has increased greatly as indicated by the larger candles over the past 10 or so trading sessions. Earnings is coming up in a week in this example, however implied volatility has not risen much. It is still “cheap” relative to historical volatility and past implied volatility. Arlo is bullish. But how does he play it? He needs to use what he knows about the greeks to guide his decision. Arlo doesn’t want to hold the trade through earnings, so it will be a short- term trade. Thus, theta is not much of a concern. The low-priced volatility guides his strategy selection in terms of vega. Arlo certainly wouldn’t want a short-vega trade. Not with the prospect of implied volatility potential rising going into earnings. In fact, he’d actually want a big positive vega position. That rules out a naked/cash-secured put, put credit spread and the likes. He can probably rule out vertical spreads all together. He doesn’t need to spread off theta. He doesn’t want to spread off vega. Positive gamma is attractive for this sort of trade. He wouldn’t want to spread that off either. Plus, the inherent time component of spreads won’t work well here. As discussed in Chapter 9, the bulk of vertical spreads profits (or losses) take time to come to fruition. The deltas of a call spread are smaller than an outright call. Profits would come from both delta and theta, if the stock rises to the short strike and positive theta kicks in. The best way for Arlo to play this opportunity is by buying a call. It gives him all the greeks attributes he wants (comparatively big positive delta, gamma and vega) and the detriment (negative theta) is not a major issue. He’d then select among in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) calls and the various available expiration cycles. In this case, because positive gamma is attractive and theta is not an issue, he’d lean toward a front month (in this case, three week) option. The front month also benefits him in terms of vega. Though the vegas are smaller for short-term options, if there is a rise in implied volatility leading up to earnings, the front month will likely rise much more than the rest. Thus, the trader has a possibility for profits from vega. Example 2 A trader, Luke, is studying the following chart for United States Steel Corp. (X). See Exhibit 17.2 . EXHIBIT 17.2 United States Steel Corp. daily candles. Source : Chart courtesy of Livevol® Pro ( www.livevol.com ) This stock is in a steady uptrend, which Luke thinks will continue. Earnings are out and there are no other expected volatility events on the horizon. Luke thinks that over the next few weeks, United States Steel can go from its current price of around $31 a share to about $34. Volatility is midpriced in this example—not cheap, not expensive. This scenario is different than the previous one. Luke plans to potentially hold this trade for a few weeks. So, for Luke, theta is an important concern. He cares somewhat about volatility, too. He doesn’t necessarily want to be long it in case it falls; he doesn’t want to be short it in case it rises. He’d like to spread it off; the lower the vega, the better (positive or negative). Luke really just wants delta play that he can hold for a few weeks without all the other greeks getting in the way. For this trade, Luke would likely want to trade a debit call spread with the long call somewhat ITM and the short call at the $34 strike. This way, Luke can start off with nearly no theta or vega. He’ll retain some delta, which will enable the spread to profit if United States Steel rises and as it approaches the 34 strike, positive theta will kick in. This spread is superior to a pure long call because of its optimized greeks. It’s superior to an OTM bull put spread in its vega position and will likely produce a higher profit with the strikes structured as such too, as it would have a bigger delta. Integrating greeks into the process of selecting an option strategy must come natural to a trader. For any given scenario, there is one position that best exploits the opportunity. In any option position, traders need to find the optimal greeks position. Managing Trades Once the trade is on, the greeks come in handy for trade management. The most important rule of trading is Know Thy Risk . Knowing your risk means knowing the influences that expose your position to profit or peril in both absolute and incremental terms. At-expiration diagrams reveal, in no uncertain terms, what the bottom-line risk points are when the option expires. These tools are especially helpful with simple short-option strategies and some long-option strategies. Then traders need the greeks. After all, that’s what greeks are: measurements of option risk. The greeks give insight into a trade’s exposure to the other pricing factors. Traders must know the greeks of every trade they make. And they must always know the net-portfolio greeks at all times. These pricing factors ultimately determine the success or failure of each trade, each portfolio, and eventually each trader. Furthermore, always—and I do mean always—traders must know their up and down risk, that is, the directional risk of the market moving up or down certain benchmark intervals. By definition, moves of three standard deviations or more are very infrequent. But they happen. In this business anything can happen. Take the “flash crash of 2010 in which the Dow Jones Industrial Average plunged more than 1,000 points in “a flash.” In my trading career, I’ve seen some surprises. Traders have to plan for the worst. It’s not too hard to tell your significant other, “Sorry I’m late, but I hit unexpected traffic. I just couldn’t plan for it.” But to say, “Sorry, I lost our life savings, and the kids’ college fund, and our house because the market made an unexpected move. I couldn’t plan for it,” won’t go over so well. The fact is, you can plan for it. And as an option trader, you have to. The bottom line is, expect the unexpected because the unexpected will sometimes happen. Traders must use the greeks and up and down risk, instead of relying on other common indicators, such as the HAPI. The HAPI: The Hope and Pray Index So you bought a call spread. At the opening bell the next morning, you find that the market for the underlying has moved lower—a lot lower. You have a loss on your hands. What do you do? Keep a positive attitude? Wear your lucky shirt? Pray to the options gods? When traders finds themselves hoping and praying—I swear I’ll never do that again if I can just get out of this position!—it is probably time for them to take their losses and move on to the next trade. The Hope and Pray Index is a contraindicator. Typically, the higher it is, the worse the trade. There are two numbers a trader can control: the entry price and the exit price. All of the other flashing green and red numbers on the screen are out of the trader’s control. Savvy traders observe what the market does and make decisions on whether and when to enter a position and when to exit. Traders who think about their positions in terms of probability make better decisions at both of these critical moments. In entering a trade, traders must consider their forecast, their assessment of the statistical likelihood of success, the potential payout and loss, and their own tolerance for risk. Having considered these criteria helps the traders stay the course and avoid knee-jerk reactions when the market moves in the wrong direction. Trading is easy when positions make money. It is how traders deal with adverse positions that separates good traders from bad. Good traders are good at losing money. They take losses quickly and let profits run. Accepting, before entering the trade, the statistical nature of trading can help traders trade their positions with less emotion. It then becomes a matter of competent management of those positions based on their knowledge of the factors affecting option values: the greeks. Learning to think in terms of probability is among the most difficult challenges for a new options trader. Chapter 5 discussed my Would I Do It Now? Rule, in which a trader asks himself: if I didn’t currently have this position, would I put it on now at current market prices? This rule is a handy technique to help traders filter out the noise in their heads that clouds judgment and to help them to make rational decisions on whether to hold a position, close it out or adjust it. Adjusting Sometimes the position a trader starts off with is not the position he or she should have at present. Sometimes positions need to be changed, or adjusted, to reflect current market conditions. Adjusting is very important to option traders. To be good at adjusting, traders need to use the greeks. Imagine a trader makes the following trade in Halliburton Company (HAL) when the stock is trading $36.85. Sell 10 February 35–36–38–39 iron condors at 0.45 February has 10 days until expiration in this example. The greeks for this trade are as follows: Delta: −6.80 Gamma: −119.20 Theta: +21.90 Vega: −12.82 The trader has a neutral outlook, which can be inferred by the near-flat delta. But what if the underlying stock begins to rise? Gamma starts kicking in. The trader can end up with a short-biased delta that loses exponentially if the stock continues to climb. If Halliburton rises (or falls for that matter) the trader needs to recalibrate his outlook. Surely, if the trader becomes bullish based on recent market activity, he’d want to close the trade. If the trader is bearish, he’d probably let the negative delta go in hopes of making back what was lost from negative gamma. But what if the trader is still neutral? A neutral trader needs a position that has greeks which reflect that outlook. The trader would want to get delta back towards zero. Further, depending on how much the stock rises, theta could start to lose its benefit. If Halliburton approaches one of the long strikes, theta could move toward zero, negating the benefit of this sort of trade all together. If after the stock rises, the trader is still neutral at the new underlying price level, he’d likely adjust to get delta and theta back to desired territory. A common adjustment in this scenario is to roll the call-credit-spread legs of the iron condor up to higher strikes. The trader would buy ten 38 calls and sell ten 39 calls to close the credit spread. Then the trader would buy 10 of the 39 calls as sell 10 of the 40 calls to establish an adjusted position that is short a 10 lot of the February 35–36–39–40 iron condor. This, of course, is just one possible adjustment a trader can make. But the common theme among all adjustments is that the trader’s greeks must reflect the trader’s outlook. The position greeks best describe what the position is—that is, how it profits or loses. When the market changes it affects the dynamic greeks of a position. If the market changes enough to make a trader’s position greeks no longer represent his outlook, the trader must adjust the position (adjust the greeks) to put it back in line with expectations. In option trading there are an infinite number of uses for the greeks. From finding trades, to planning execution, to managing and adjusting them, to planning exits; the greeks are truly a trader’s best resource. They help traders see potential and actual position risk. They help traders project potential and actual trade profitability too. Without the greeks, a trader is at a disadvantage in every aspect of option trading. Use the greeks on each and every trade, and exploit trades to their greatest potential. I wish you good luck ! For me, trading option greeks has been a labor of love through the good trades and the bad. To succeed in the long run at greeks trading—or any endeavor, for that matter—requires enjoying the process. Trading option greeks can be both challenging and rewarding. And remember, although option trading is highly statistical and intellectual in nature, a little luck never hurt! That said, good luck trading! About the Author Dan Passarelli is an author, trader, and former member of the Chicago Board Options Exchange (CBOE) and CME Group. Dan has written two books on options trading—Trading Option Greeks and The Market Taker’s Edge . He is also the founder and CEO of Market Taker Mentoring, a leading options education firm that provides personalized, one-on-one mentoring for option traders and online classes. The company web site is www.markettaker.com . Dan began his trading career on the floor of the CBOE as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (now part of CME Group). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisers, money managers, and market makers. In addition to his work with the CBOE, he has taught options strategies at the Options Industry Council (OIC), the International Securities Exchange (ISE), CME Group, the Philadelphia Stock Exchange, and many leading options-based brokerage firms. Dan has been seen on FOX Business News and other business television programs. Dan also contributes to financial publications such as TheStreet.com , SFO.com , and the CBOE blog. Dan can be reached at his web site, MarketTaker.com , or by e-mail: dan@markettaker.com . He can be followed on Twitter at twitter.com/Dan_Passarelli . Index American-exercise options Arbitrageurs At-the-money (ATM) Backspreads Bear call spread Bear put spread Bernanke, Ben Black, Fischer Black-Scholes option-pricing model Boxes building Bull call spread strengths and limitations Bull put spread Butterflies long alternatives example short iron long short Buy-to-close order Calendar spreads buying “free” call, rolling and earning rolling the spread income-generating, managing strength of trading volatility term structure buying the front, selling the back directional approach double calendars ITM or OTM selling the front, buying the back Calls buying covered entering exiting long ATM delta gamma rho theta tweaking greeks vega long ITM long OTM selling Cash settlement Chicago Board Options Exchange (CBOE) Volatility Index® Condors iron long short long short strikes safe landing selectiveness too close too far with high probability of success Contractual rights and obligations open interest and volume opening and closing Options Clearing Corporation (OCC) standardized contracts exercise style expiration month option series, option class, and contract size option type premium quantity strike price Credit call spread Debit call spread Delta dynamic inputs effect of stock price on effect of time on effect of volatility on moneyness and Delta-neutral trading art and science direction neutral vs. direction indifferent gamma, theta, and volatility gamma scalping implied volatility, trading selling portfolio margining realized volatility, trading reasons for smileys and frowns Diagonal spreads double Dividends basics and early exercise dividend plays strange deltas and option pricing pricing model, inputting data into dates, good and bad dividend size Estimation, imprecision of European-exercise options Exchange-traded fund (ETF) options Exercise style Expected volatility CBOE Volatility Index® implied stock Expiration month Ford Motor Company Fundamental analysis Gamma dynamic scalping Greeks adjusting defined delta dynamic inputs effect of stock price on effect of time on effect of volatility on moneyness and gamma dynamic HAPI: Hope and Pray Index managing trades online, caveats with regard to price vs. value rho counterintuitive results effect of time on put-call parity strategies, choosing between theta effect of moneyness and stock price on effects of volatility and time on positive or negative taking the day out trading vega effect of implied volatility on effect of moneyness on effect of time on implied volatility (IV) and where to find Greenspan, Alan HOLDR options Implied volatility (IV) trading selling and vega In-the-money (ITM) Index options Interest, open Interest rate moves, pricing in Intrinsic value Jelly rolls Long-Term Equity AnticiPation Securities® (LEAPS®) Open interest Option, definition of Option class Option prices, measuring incremental changes in factors affecting Option series Options Clearing Corporation (OCC) Out-of-the-money (OTM) Parity, definition of Pin risk borrowing and lending money boxes jelly rolls Premium Price discovery Price vs. value Pricing model, inputting data into dates, good and bad dividend size “The Pricing of Options and Corporate Liabilities” (Black & Scholes) Put-call parity American exercise options essentials dividends synthetic calls and puts, comparing synthetic stock strategies theoretical value and interest rate Puts buying cash-secured long ATM married selling Ratio spreads and complex spreads delta-neutral positions, management by market makers through longs to shorts risk, hedging trading flat multiple-class risk ratio spreads backspreads vertical skew, trading Realized volatility trading Reversion to the mean Rho counterintuitive results effect of time on and interest rates in planning trades interest rate moves, pricing in LEAPS put-call parity and time trading Risk and opportunity, option-specific finding the right risk long ATM call delta gamma rho theta tweaking greeks vega long ATM put long ITM call long OTM call options and the fair game volatility buying and selling direction neutral, direction biased, and direction indifferent Scholes, Myron Sell-to-open transaction Skew term structure trading vertical Spreads calendar buying “free” call, rolling and earning income-generating, managing strength of trading volatility term structure diagonal double ratio and complex delta-neutral positions, management by market makers multiple-class risk ratio skew, trading vertical bear call bear put box, building bull call bull put credit and debit, interrelations of credit and debit, similarities in and volatility wing butterflies condors greeks and keys to success retail trader vs. pro trades, constructing to maximize profit Standard deviation and historical volatility Standard & Poor’s Depositary Receipts (SPDRs or Spiders) Straddles long basic trading short risks with trading synthetic Strangles long example short premium risk, limiting Strategies and At-Expiration Diagrams buy call buy put factors affecting option prices, measuring incremental changes in sell call sell put Strike price Supply and demand Synthetic stock strategies conversion market makers pin risk reversal Technical analysis Teenie buyers Teenie sellers Theta effect of moneyness and stock price on effects of volatility and time on positive or negative risk taking the day out Time value Trading strategies Value Vega effect of implied volatility on effect of moneyness on effect of time on implied volatility (IV) and Vertical spreads bear call bear put box, building bull call bull put credit and debit interrelations of similarities in and volatility Volatility buying and selling teenie buyers teenie sellers calculating data direction neutral, direction biased, and direction indifferent expected CBOE Volatility Index® implied stock historical (HV) standard deviation implied (IV) and direction HV-IV divergence inertia relationship of HV and IV selling supply and demand realized trading skew term structure vertical vertical spreads and Volatility charts, studying patterns implied and realized volatility rise realized volatility falls, implied volatility falls realized volatility falls, implied volatility remains constant realized volatility falls, implied volatility rises realized volatility remains constant, implied volatility falls realized volatility remains constant, implied volatility remains constant realized volatility remains constant, implied volatility rises realized volatility rises, implied volatility falls realized volatility rises, implied volatility remains constant Volatility-selling strategies profit potential covered call covered put gamma-theta relationship greeks and income generation naked call short naked puts similarities Would I Do It Now? Rule Volume WeeklysSM Wing spreads butterflies directional long short iron condors iron long short greeks and keys to success retail trader vs. pro trades, constructing to maximize profit Would I Do It Now? Rule