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February 2008

Volume 2, No. 2

FIBONACCIPIVOT POINTS:A twist on the

floor-trader technique p. 8

MANAGING OPTION RISKwith the Greeks p. 30

COMMITMENTSOF TRADERS:

COT extremesstrategy test p. 22

Large specs vs.hedgers p. 44

STOCKS VS.LEAPS p. 28

OPTIONSSTRATEGY

comparison p. 16

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2/532 February 2008 FUTURES & OPTIONS TRADER

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Trading Strategies

Fibonacci pivot points . . . . . . . . . . . . . . . . .8This intraday system tweaks the standard

pivot-point formulas with Fibonacci ratios

to improve its odds of success.

By Lee Leibfarth

Exploiting the fear factor . . . . . . . . . . . . .16Whats the best way to profit from a

high-volatility forecast? Comparing the

performance of covered calls, different

option spreads, and LEAPS shines some

light on the subject.

By Tristan Yates

Futures Trading System Lab

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

Options Trading System Lab

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

Trading Basics

Fighting the options battle

with the Greeks . . . . . . . . . . . . . . . . . . . . . .30The major options Greeks (delta, gamma,

theta, and vega) can help you anticipate

market risk and manage trades better.

By Dan Passarelli

Deciphering stock

option symbols . . . . . . . . . . . . . . . . . . . . . .34Learn how to interpret stock-option symbols.

By Chris Peters

CONTENTS

continued on p. 4

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Futures Snapshot . . . . . . . . . . . . . . . . . . . .38Momentum, volatility, and volume

statistics for futures.

Options Radar . . . . . . . . . . . . . . . . . . . . . . .39Notable volatility and volume in the

options market.

News

CME not content to stand pat . . . . . . . . .40The Chicago Mercantile Exchange has

admitted to negotiations with the New York

Mercantile Exchange about a possible

acquisition.

SEC agrees with CBOEin rights battle . . . . . . . . . . . . . . . . . . . . . . .40The Securities and Exchange Commission

agreed with the Chicago Board Options

Exchange that the Chicago Board of

Trades purchase by the Chicago Mercantile

Exchange eliminated the existence of CBOE

rights holders at the CBOT.

CBOT integration of electronic

products complete . . . . . . . . . . . . . . . . . . .41The Chicago Board of Trades electronically

traded products have moved to the Chicago

Mercantile Exchanges Globex platform.

Options Watch:

Top Nasdaq 100 components . . . . . . . . . . .42Tracking bid-ask spreads on the top

15 Nasdaq 100 stock options.

Futures & Options Calendar . . . . . . . . . . . .43

Futures Fundamentals . . . . . . . . . . . . . .44This list highlights extremes in sentiment

from the weekly Commitment of Traders(COT) report.

Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

New Products and Services . . . . . . . . . . . . .45

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . .46References and definitions.

Options Trade Journal. . . . . . . . . . . . . . .50Trading the Feds rate cut with a put spread.

Have a question about something youve seen

in Futures & Options Trader?

Submit your editorial queries or comments to [email protected].

Looking for an advertiser?

Click on the company name below for a direct link to the ad

in this months issue ofFutures & Options Trader.

CBOE

eSignal

E*TRADE FINANCIAL

New York Traders Expo

OptionsMentoring

OptionVue

Risk Management Conference

RS of Houston

TradeStation

Zecco

CONTENTS

4 February 2008 FUTURES & OPTIONS TRADER

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Editor-in-chief: Mark Etzkorn

[email protected]

Managing editor: Molly Flynn

[email protected]

Senior editor: David Bukey

[email protected]

Contributing editors:Jeff Ponczak

[email protected],

Keith Schap

Associate editor: Chris Peters

[email protected]

Editorial assistant and

Webmaster: Kesha Green

[email protected]

Art director: Laura Coyle

[email protected]

President: Phil Dorman

[email protected]

Publisher,

Ad sales East Coast and Midwest:

Bob Dorman

[email protected]

Ad sales

West Coast and Southwest only:

Allison Ellis

[email protected]

Classified ad sales: Mark Seger

[email protected]

Volume 2, Issue 2. Futures & Options Traderis pub-lished monthly by TechInfo, Inc., 161 N. Clark Street,Suite 4915, Chicago, IL 60601. Copyright 2007TechInfo, Inc. All rights reserved. Information in thispublication may not be stored or reproduced in anyform without written permission from the publisher.

The information in Futures & Options Tradermagazineis intended for educational purposes only. It is notmeant to recommend, promote or in any way imply theeffectiveness of any trading system, strategy orapproach. Traders are advised to do their ownresearch and testing to determine the validity of a trad-ing idea. Trading and investing carry a high level ofrisk. Past performance does not guarantee futureresults.

For all subscriber services:www.futuresandoptionstrader.com

A publication ofActive Trader

CONTRIBUTORSCONTRIBUTORS

Lee Leibfarth ([email protected]) is an independ-

ent futures trader, trading system researcher, and programmer. He

is president and founder of PowerZone Trading, a company that

provides a range of services for traders. His articles on technical

analysis and market technology have been featured in a variety of

publications. He is the author of the recently published Make Money Trading How to Build a Winning Trading Business (Marketplace Books, 2007).

Dan Passarelli , author of the bookTrading Option Greeks

(Bloomberg, 2008), started his trading career on the floor of the

Chicago Board Options Exchange (CBOE) as an equity options

market maker. He also traded agricultural options and futures on

the floor of the Chicago Board of Trade (CBOT). In 2005, Passarelli

joined CBOE Options Institute and began teaching both basic and advanced

trading concepts to retail traders, brokers, institutional traders, financial plan-

ners and advisors, money managers, and market makers. In addition to his work

with the CBOE, he taught options strategies at the Options Industry Council

(OIC). Passarelli has been featured on television and radio and has written

numerous articles in the financial press.

Tristan Yates researches and writes about enhanced indexing strategies

using derivatives for publications including Futures & Options Trader,

SeekingAlpha, Investopedia , and Traders Journal. His articles are distributed

through Yahoo! Finance, Forbes, Kiplinger, and MSN Money. He received his

MBA from INSEAD in Singapore, lives in Bethesda, MD, and is working on a

book on enhanced indexing for the Wiley Trading Series.

Volker Knapp has been a trader, system developer, and

researcher for more than 20 years. His diverse background

encompasses positions such as German National Hockey team

player, coach of the Malaysian National Hockey team, and presi-

dent of VTAD (the German branch of the International

Federation of Technical Analysts). In 2001 he became a partner in

Wealth-Lab Inc. (http://www.wealth-lab.com), which he is still running.

Jim Graham ([email protected]) is the product man-

ager for OptionVue Systems and a registered investment advisor

for OptionVue Research.

Steve Lentz ([email protected]) is executive vice president of

OptionVue Research, a risk-management consulting company. He also heads

education and research programs for OptionVue Systems, including one-on-one

mentoring for intermediate and advanced traders.

6 February 2008 FUTURES & OPTIONS TRADER

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Support and resistance is

one of the most basic

technical analysis con-

cepts: When price drops

to support, buyers tend to enter the

market as sellers exit; when price

climbs to resistance, sellers tend to

appear as buyers exit. But when

price moves beyond either level, it

may continue trending higher or

lower.Although the idea is fairly sim-

ple, support and resistance levels

can be difficult to find and often

become clear only in hindsight.

One way around this dilemma is to

calculate pivot points supposed

support and resistance levels based

on yesterdays daily range and

closing price.

The idea behind pivot points is

compelling. Standard pivot pointsuse yesterdays trading activity to

help define todays market direc-

tion. Who wouldnt want to identi-

fy todays potential support and

resistance levels before the markets

open? Despite their popularity,

however, pivot points are some-

what arbitrary, and few analysts

focus on their performance or why

these specific values are so impor-

tant.

8 February 2008 FUTURES & OPTIONS TRADER

TRADING STRATEGIES

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

BY LEE LEIBFARTH

FIGURE 1 FIBONACCI PIVOT POINTS

Pivot points are a series of horizontal lines intended to represent differentlevels of support (S1 and S2) and resistance (R1 and R2).

Source: TradeStation

Strategy snapshot

Strategy: Fibonacci pivot points.

Market: E-Mini S&P 500 (ES).

Logic: Combining Fibonacci numbers and pivot points in an intraday

system. Exploit countertrend moves when price is near the

central pivot, and capture trending markets on a breakout above

resistance (R2) or below support (S2).

Money Profit targets and stop-losses defined by Fibonacci ratios reduce

management: risk and increase profit potential.

Timing: Enter trades between 9:30 a.m. and 1:00 p.m. ET. Exit the

position at 4:00 p.m. if a stop has not been reached.

Only triggers one trade per day.

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The following discussion compares

two different types of intraday pivot-

point strategies designed to capture

both countertrend and breakout

moves. The first strategy uses stan-

dard pivot points, while the second

strategy uses pivot points based on

Fibonacci levels with the goal of

defining more accurate support and

resistance levels and boosting the

techniques reward-to-risk ratio.The system is tested on the E-Mini

S&P 500 futures (ES) but it can be

applied to other stock-index futures.

Standard vs. Fibonacci

pivot points

To calculate pivot points, start with

the central pivot, which is the average

of yesterdays high, low, and close. In

theory, price should trade around the

central pivot. The next step is to iden-tify two resistance levels above it (R1

and R2) and two support levels below

it (S1 and S2). For more details, see

Pivot points.

Figure 1 shows Fibonacci pivot

points as a series of horizontal lines

applied to an E-Mini S&P 500 chart.

Fibonacci pivot points calculate sup-

port and resistance levels based on

Fibonacci ratios, a technique that typ-

ically shortens the distance betweeneach point. Because 24-hour markets

tend to have large price swings,

Fibonacci pivots tighten entry and

exit points.

The first Fibonacci ratio divides a

number from the Fibonacci series by

the next consecutive number to form

0.618, often referred to in mathematics

as the golden ratio conjugate. The

second ratio divides a number in the

continued on p. 10

TABLE 1 FIBONACCI PIVOT POINT FORMULAS

Tweaking the standard formulas shortens the distance between the two support

and resistance levels, a technique that boosts the systems reward-to-risk ratio.

R2 = pivot + ((yesterdays high yesterdays low) * 0.618)

R1 = pivot + ((yesterdays high yesterdays low) * 0.382)

Pivot = (yesterdays high + yesterdays low + yesterdays close) / 3

S1 = pivot - ((yesterdays high yesterdays low) * 0.382)

S2 = pivot - ((yesterdays high yesterdays low) * 0.618)

Pivot points

Pivot points are calculations some traders use to determine supposed support

and resistance levels derived from the high, low, and closing prices of the previ-

ous price bar. The pivot point value is added to and subtracted from the previous

bars reference points to determine support and resistance levels for future trad-

ing. The pivot point (PP) formula is:

1. PP = (H + L + C)/3

2. First resistance level (R1) = (PP*2) - L

3. Second resistance level (R2) = PP + (H - L)

4. First support level (S1) = (PP*2) - H

5. Second support level (S2) = PP - (H + L)

A typical pivot point application is to cover any short positions and go long at

either of the two support levels, or sell any long positions and go short at the pro-

jected resistance levels. Pivot points are often attributed to a tradition passed

down among floor traders. Like any tool, pivot points should be tested to verify

their potential before trading.

FUTURES & OPTIONS TRADER February 2008 9

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TRADING STRATEGIES continued

series by the second consecutive

number, equaling 0.382. (For more

details about the Fibonacci series,

see Key concepts.)

Fibonacci traders measure the

distance between two extremes

and then divide it by Fibonacci

ratios (0.618 or 0.382) to find

retracement levels, or points where

the market could reverse. For

example, if price fell sharply from

a recent high of 100, it may

rebound after it drops near 61.8; or

if price rallied from a recent low of100, it may lose momentum

around 138.2.

Table 1 shows the revised formu-

las for Fibonacci pivot points,

which are based on the same con-

cept. The central pivot doesnt

change, but the support and resist-

ance formulas multiply yesterdays

range by Fibonacci retracement

values (0.618 or 0.382).

Defining session times

Pivot points are attributed to a floor-

trader tradition that evolved before

stocks and futures traded electronical-

ly. Back then markets had well-

defined trading hours, so identifying

daily ranges was easy. Today, howev-

er, traders can access markets virtual-

ly around the clock, which makes it

more difficult to select the beginning

and ending times that define the ses-sions range and the resulting pivot-

point values.

Although U.S. stock index futures

tend to be most volatile when the cash

market is open (9:30 a.m. to 4 p.m.

ET), trading during off-peak hours is

now more important than ever.

Picking specific time periods is subjec-

tive, so to eliminate any ambiguity

this system uses both the pit and elec-

tronic sessions in a 24-hour trading

FIGURE 2 COUNTERTREND TRADE EXAMPLE

After the E-Mini S&P 500 climbed to R1, the system sold short around 10 a.m. ET

on Dec. 19, 2007. The market then fell to the pivot (1,462.00) and the system

captured gains.

Source: TradeStation

FIGURE 3 STANDARD PIVOTS MISS A TRADE

The distance between the standard pivot points was larger on Dec. 19, so

Figure 2s short trade wasnt triggered.

Source: eSignal

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day. The beginning and end of the

day varies in 24-hour markets such

as the E-Mini S&P 500, depending

on your location. Therefore, the

days range will likely change, and

pivot-point values may differ even

though U.S. and Australian traders

apply the same formulas.

A sessions highs and lows must

reflect realistic turning points from

yesterday. In this case the daily

range will begin at 12 a.m. and end

at 11:59 p.m. ET, a period chosen

because the price action betweenmidnight and 9:30 a.m., when the

U.S. stock market opens, can tell

you more about the markets tone

than yesterdays price action.

In addition, the system enters

trades only between 9:30 a.m. to 1

p.m. ET (when the futures are most

active) and any open positions are

closed at 4 p.m. The system enters

only one trade per day and doesnt

trade unless certain rules are met.

Countertrend rules:

From S1 to R1

The strategy triggers trades two ways

based on prices proximity to the cen-

tral pivot. In general, the closer price

is to the central pivot, the more likely

it is to revert back to that level, while

as price climbs above resistance or

below support, it is more likely to

trend in that direction and away fromthe central pivot.

Both patterns stem from the basic

tenets of support and resistance:

Resistance acts as a price ceiling

and support acts as a price floor,

unless the market breaks beyond

either level.

The first set of trade rules tries to

exploit price moves between S1 and

R1. In this range, price will often trade

continued on p. 12

FIGURE 4 BREAKOUT TRADE EXAMPLE

The system went long after the E-Mini S&P 500 rose above R2 on Nov. 23, 2007

and exited at the 4 p.m. close.

Source: TradeStation

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12/5312 February 2008 FUTURES & OPTIONS TRADER

around the central pivot, creating a zone

bordered by R1 (top) and S1 (bottom). To

capture gains if price returns to the central

pivot point, go long if price drops to S1 or

sell short if price rises to R1. A protective

stop-loss is placed at the outer support or

resistance levels (S2 or R2), while the system

exits at the central pivot point.

Fibonacci pivot points provide better exits

than the standard formulas because profit

targets will always be larger than stop-loss

amounts. In other words, the distance from

P to S1 or R1 is bigger than the distance between the first and second support or

resistance levels, which isnt true with stan-

dard pivots. This means you always risk less

than you could earn a positive risk-to-

reward ratio. The countertrend rules are:

1. Enter long if price drops

to S1.

2. Enter short if price rises to R1.

3. Exit position with a limit

when price returns to thecentral pivot.

4. Exit position with a stop

when price falls to S2 (long

trades) or climbs to R2 (short

trades).

Figure 2 shows the Fibonacci pivot system

sold short when price climbed from the cen-

tral pivot to R1 (1,472.25) around 10 a.m. ET

on Dec. 19, 2007. The E-Mini S&P 500 fell to

the pivot (1,462.00) and the system capturedgains, although a protective stop-loss order

was placed at R2 (1,478.25).

Figure 3 shows standard pivot points on

the same day. By contrast, no trades were

triggered, because price failed to hit R1

(1,477.08) before dropping again. When

comparing Figures 2 and 3, notice the dis-

tance between the first and second support

and resistance levels is bigger with standard

pivots, which means the standard system

risks more than its Fibonacci counterpart.

TRADING STRATEGIES continued

TradeStation Code

This code can be copied from http://www.activetradermag.com/code.htm

// ================================

// FibPivot Strategy (Version 1.0)

// By: Lee Leibfarth

// 12-30-07

//

// TARGET: 5-Minute ES

// ================================

variables:

TradeSwitch(false),

Pivot(0),

R1(0),

R2(0),

S1(0),

S2(0),

PrevHigh(0),

PrevLow(0),

PrevClosed(0);

If date date[1] then begin

TradeSwitch = true;

PrevHigh = highd(1);

PrevLow = lowd(1);

PrevClosed = closed(1);

Pivot = (PrevHigh + PrevLow + PrevClosed )/3;

R1 = Pivot + (PrevHigh - PrevLow) * .382;S1 = Pivot - (PrevHigh - PrevLow) * .382;

R2 = Pivot + (PrevHigh - PrevLow) * .618;

S2 = Pivot - (PrevHigh - PrevLow) * .618;

end;

if TradeSwitch and time > 930 and time < 1300 and marketposition = 0 then begin

if c < R1 then sellshort ("SellShort_R1") next bar at R1 limit;

if c > S1 then buy ("Buy_S1") next bar at S1 limit;

if c > R1 and c < R2 then buy ("Buy_R2") next bar at R2 stop;

if c < S1 and c > S2 then sellshort ("SellShort_S2") next bar at S2 stop;

end;

if marketposition = 1 then begin

sell from entry ("Buy_S1") next bar at Pivot limit;

sell from entry ("Buy_S1") next bar at S2 stop;

sell from entry ("Buy_R2") next bar at Pivot stop;

TradeSwitch = false;

end;

if marketposition = -1 then begin

buytocover from entry ("SellShort_R1") next bar at Pivot limit;

buytocover from entry ("SellShort_R1") next bar at R2 stop;

buytocover from entry ("SellShort_S2") next bar at Pivot stop;

TradeSwitch = false;

end;

if time >= 1600 then begin

sell next bar at market;

buytocover next bar at market;

end;

setexitonclose;

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13/53FUTURES & OPTIONS TRADER February 2008 13

Breakout rules:

Above R2 and below S2

The second set of rules tries to capture

breakouts beyond initial support andresistance levels (S1 and R1). The goal

is to catch a significant trend as price

breaks above R2 or below S2. These

trades are typically triggered after a

small-range or consolidation day

when the current pivot points are

close together.

The breakout rules are:

1. Enter long if price climbs to R2.

2. Enter short if price drops to S2.3. Exit position with a stop if price

falls back to R1 (long trades) or

advances to S1 (short trades).

4. Or exit position at 4 p.m.

Figure 4 shows a long breakout

trade example of the E-Mini S&P 500

rallying above R2 on Nov. 23, 2007.

Note that price traded below the R2

level at 9:30 a.m. to trigger a long sig-

TABLE 2 BACK-TEST RESULTS

The Fibonacci pivots outperformed the standard formulas. The return on capital is twice as large, the average profit is

58 percent bigger, and the profit factor is higher.

Standard Fibonacci Standard Fibonacci

Total net profit $6,060.00 $12,902.50 Profit factor 1.28 1.57

Gross profit $27,567.50 $35,600.00 Gross loss $21,507.50 $22,697.50

Total number of trades 149 201 Percent profitable 51.68% 47.26%

Winning trades 77 95 Losing trades 72 106

Avg. profit $40.67 $64.19 Ratio avg. win / avg. loss 1.2 1.75Avg. winner $358.02 $374.74 Avg. loser $298.72 $214.13

Largest winning trade $1,502.50 $1,852.50 Largest losing trade $1,097.50 $947.50

Largest winning trade as Largest losing trade as

percentage of gross profit 5.45% 5.20% percentage of gross loss 5.10% 4.17%

Max. consecutive Max. consecutive

winning trades 5 6 losing trades 7 6

Avg. bars in winning trades 46.06 37.75 Avg. bars in losing trades 36.5 23.41

Avg. bars in total trades 41.44 30.18 Account size required $4,080.00 $2,952.50

Total commission $1,490.00 $2,010.00 Percent of time in market 6.09% 6.20%

Return on initial capital 6.06% 12.90% Annual rate of return 5.97% 12.32%

Buy-and-hold return 3.54% 3.32% Return on account 148.53% 437.00%

Standard deviation

Avg. monthly return $505.00 $1,075.21 of monthly return $1,631 $1,409

6 days, 23 hrs, 7 days,

Longest flat period 30 min. 20 min.

Source: TradeStation

continued on p. 14

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14/5314 February 2008 FUTURES & OPTIONS TRADER

nal. The system exited with a profit at 4

p.m. ET.

Test results

The system was tested on five-minute

bars in the E-Mini S&P 500 futures

from Jan. 2, 2007 to Dec. 27, 2007. (The

bar interval isnt important, because

the strategys signals are based on yes-

terdays range and closing price.) The

system tested one contract and includ-

ed $10 round-trip commissions.Table 2 compares back-tested results

of the standard-pivot and Fibonacci-

pivot systems (blue text represents

improved performance). The Fibonacci

pivots beat the standard formulas: The

return on capital was twice as large

(12.9 percent vs. 6.06 percent), the aver-

age profit was 58 percent bigger ($64.19

vs. $40.67), and the profit factor was

higher (1.57 vs. 1.28). The Fibonacci

strategy improved most of the otherperformance statistics, including the

average winner and average loser, and

it also increased the number of trades

without increasing the systems expo-

sure.

Other considerations

This strategy probably benefited from

the increased market volatility in the

last half of 2007. Volatile markets

widen the pivot point levels, so youcan expect larger net profits under

these conditions. Additional volatility

will increase both average winning and

losing trades. On the other hand, less

volatile markets will hurt this strate-

gys overall profitability. Its average

profit may drop because smaller daily

ranges lead to smaller profit and loss targets, even though

the percentage of profitable trades and profit factor may

change.

Finally, because this is an intraday strategy, it will likely

have a smaller profit expectancy than a longer-term system,

but it will compensate by generating more trades.

For information on the author see p. 6.

TRADING STRATEGIES continued

Related readingLee Leibfarth articles

Sharpening a countertrend strategy,Active Trader, October 2007.

Designing a trading system involves more than just creating profitable signals.

You also need to consider how to size your trades.

Intraday hybrid strategy,Active Trader, July 2007.

Because simple trend-following methods can fall flat during choppy markets,

this breakout system adjusts its exits to fit different market environments.

Forecasting techniques,Active Trader, October 2006.

Predicting probable market action is a challenging task, but a handful of calcula-

tions make it possible to measure the reliability and improve the accuracy

of price forecasts.

Other articles

Trader Interview: Tom DeMark, Futures & Options Trader, April 2007.

Market legend Tom Demark explains why the tools he created with a calculator

and printed charts more than 30 years ago are still valid today.

Tom DeMark: Market immersion,Active Trader, July 2007.

In this second installment, DeMark discusses volume tools, Fibonacci, and

following your nose in the markets.

Tom DeMark,Active Trader, August 2007.

Continuing our discussion with Tom DeMark, the analyst, author, and strategy

designer discusses retracements, price projections, and enhancements to his

signature trend reversal techniques.

The Fibonacci swing filter,Active Trader, February 2005.

One way to filter market noise and focus on tradable price moves is to gauge

price swings in terms of retracement percentages. This approach creates an

adaptive trading system that adjusts to the markets behavior.

Pivot points and candlesticks, Currency Trader, February 2005.Augmenting pivot point analysis with candlestick formations helps determine

potential turning points in the forex market.

You can purchase and download past articles at

http://www.activetradermag.com/purchase_articles.htm

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Its difficult to recall a new year with so much pes-simism. In the first week of January, the S&P 500 fell5.45 percent, wiping out all of 2007s meager returns.

For option sellers, though, fear is good for business it often prompts traders to hedge their positions, increas-ing potential profits. But selling uncovered, or naked,options is too risky for many traders, so they prefer to cre-ate an options spread or enter a covered call.

Successful option traders build positions to exploit cur-rent market conditions. For example, if you have a slightly bullish forecast, you could put on a debit spread by pur-chasing a call and selling a cheaper call to offset its cost. Or,

you could buy the underlying and sell a call against it (acovered call). But which strategy should you choose?

Comparing four types of option spreads that consist of a

short call and a long call (or its equivalent) for protectionwill help answer this question. If you can gauge which posi-tions tend to perform best in bearish, high-volatility mar-kets, you can profit while others panic.

Neutral to bullish strategiesTable 1 compares four similar strategies: covered call,bullcall spread,calendar call spread, and a diagonal spreadthatuses Long-term AnticiPation Securities, or LEAPS (see

16 February 2008 FUTURES & OPTIONS TRADER

TRADING STRATEGIES

Exploiting the fear factorTesting shows comparable option strategies can fare much differently dependingon the market environment.

TABLE 1 COMPARING OPTIONS STRATEGIES

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

BY TRISTAN YATES

Covered call futures Bull call spread Calendar call spread Diagonal LEAPS spread

Components Long future + short Long front-month ITM Long next-month ATM Long 12-month ITM call +

front-month, ATM call. call + short same-month, call + short front-month, short front-month, ATM call.

ATM call. ATM call.

Criteria: Futures contract is Long call is ITM When the short call Long LEAPS call is ITM by

unhedged with by 5 percent. expires, sell the long 5 percent. Buy back short

5-percent margin. call to exit. call and sell more calls in

successive months.

Worst-case Market drops to Market drops below Market drops to Market drops below

scenario*: zero. long strike. zero. long strike.Best-case Market closes at short Market closes at Market closes at Market closes at

scenario*: strike and call expires short strike. shared strike. short strike.

worthless.

Max. gain*: Call strike underlying Strike-price difference Long calls cost Long calls cost

price (at entry) + call spreads cost. spreads cost. spreads cost.

premium collected.

Max loss*: Underyling price Spreads cost. Spreads cost. Spreads cost.

(at entry) - calls cost.

Note: All positions include: 1) long-term neutral or bullish market bias, and 2) the same short, front-month ATM call.

* At first expiration

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What are LEAPS?). Each position

sells a front-month, at-the-money(ATM) call to profit from time decay.The difference lies in the long compo-nents that are intended to limit losses.Covered calls use a long position inthe underlying, while the threespreads use long calls with differentstrike prices or expirations.

All four strategies are either neutralor bullish. They will lose value if theunderlying drops sharply, but theymay perform well otherwise. The

short call offsets short-term downsidelosses somewhat, while (with theexception of the covered call) the longcomponent is also long volatility.

Despite their similarities, thespreads arent identical because theirlong components hedge risk different-ly and have different leverage. Tocompare the strategies, the followingstudy uses historical data from theS&P 500 index (SPX) and the CBOEvolatility index (VIX) from January

1990 to December 2007. The analysisexcludes slippage and commissions.(To gauge S&P 500 futures perform-ance, the test used 5-percent initialmargin.)

Performance estimates

November index options expired onNov. 16, 2007 when the S&P 500 trad-ed at 1,458.74 and the VIX at 25.49.Given these numbers, you could havesold an ATM December call for $53.94

about 3.7 percent of the indexsvalue.Table 2 shows the four strategies

initial costs on Nov. 16, 2007 and esti-mates each positions performance ifthe S&P 500 index gains 5 percent,drops 5 percent, or stays flat by Dec.21 expiration.

Covered call futures and the bullcall spread should outperform diago-nals and calendars. The first twostrategies will gain the most ground if

FUTURES & OPTIONS TRADER February 2008 17

continued on p. 18

TABLE 2 PERFORMANCE ESTIMATES

If the S&P 500 goes nowhere between Nov. 16 and Dec. 21, the calendar call

spread could double in value. But the diagonal LEAPS spread is a good bet for

more conservative traders.

The S&P 500 closed at 1,458.74 on Nov. 16, and the VIX closed at 25.49.

Strategy Covered Bull Calendar Diagonal

call futures call spread call spread LEAPS spread

Long S&P 500 Dec. Jan. Dec. 2008

futures 1,350 call 1,450 call 1,400 call

Short Dec. Dec. Dec. Dec.

1,450 call 1,450 call 1,450 call 1,450 call

Initial cost

Long 72.94 128.60 73.50 242.88

Short -53.94 -53.94 -53.94 -53.94

Debit 72.94 74.66 19.56 188.94

5% gain

Long 192.52 181.68 100.54 273.75

Short -81.68 -81.68 -81.68 -81.68Payoff 110.84 100.00 18.87 192.07

% return 52.0% 33.9% -3.5% 1.7%

Flat

Long 119.58 108.74 50.05 221.73

Short -8.74 -8.74 -8.74 -8.74

Payoff 110.84 100.00 41.31 212.99

% return 52.0% 33.9% 111.2% 12.7%

5% drop

Long 46.65 35.80 18.49 174.53

Short 0.00 0.00 0.00 0.00

Payoff 46.65 35.80 18.49 174.53

% return -36.0% -52.0% -74.8% -28.1%

Notes: 5% cost of capital used. DITM call for BCS has +4.5% vol. skew. LEAP

vol. is fixed at 27%.

For futures covered call, short call premium may not be immediately applied to

initial margin to create debit spread.

What are LEAPS?

Long-term AnticiPation Securities, or LEAPS, are longer-term options contracts

that expire up to two years and eight months in the future. They are no different

from regular puts and calls, and give the owner the right to buy or sell 100 shares

of stock at any time. But instead of expiration months, they have expiration years

(e.g., January 2008 LEAPS expire on Jan. 19, 2008).

All LEAPS are divided into three cycles that determine when they are listed.

Cycle 1 LEAPS are listed after May equity options expire, cycle 2 are listed after

the June expiration period, and cycle 3 are listed after the July period, three cal-

endar years in advance (i.e., 2010 LEAPS begin listing in 2007, 2011 LEAPS in

2008, etc.) As of Aug. 14, you can buy LEAPS on the S&P 500 index that expire

on Jan. 16, 2010 24 months from now.In theory, LEAPS behave the same as regular options. In practice, however,

new LEAPS have low thetas and deltas in the first few months. This means time

decay is reduced, but changes in the underlying market dont affect the options

price as much, at least initially.

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18/5318 February 2008 FUTURES & OPTIONS TRADER

TRADING STRATEGIES continued

the underlying closes above the short strike at expiration.The covered call should gain 52 percent regardless ofwhether the market climbs or goes nowhere. And the bullcall spread should gain 33.9 percent in either scenario.

One difference is that a futures contract can lose morethan its initial margin requirement. Therefore, the bull callspread risks less (at the expense of profitability). However, both positions are highly leveraged and can lose a greatdeal even if the underlying falls slightly.

By contrast, the calendar call spread will gain the mostground if the S&P remains flat (111.2 percent), while itshould lose only 3.5 percent if the S&P 500 climbs 5 percent.If, however, volatility drops, the calendar could lose value,because it has additional vega risk.

Table 2s estimates show the diagonal LEAPS spreadshould be the most stable position, but it is also the most

expensive. For instance, the diagonal may gain modestly inflat and rallying markets, and it should lose less than theothers if the S&P 500 drops. However, the diagonal LEAPSspread costs more than twice as much as the bull callspread (188.94 vs. 74.66, respectively).

LEAPS are less vulnerable to changes in price andvolatility, but their cost reduces leverage and capital effi-ciency. For example, if the S&P 500 goes nowhere, the diag-onal LEAPS spread will likely gain just 12 percent.

Actual performanceFigure 1 shows a daily S&P 500 chart and highlights the

December 1,450 strike. The S&P 500 climbed 1.7 percent to1,484.46 from Nov. 16 to Dec. 21 expiration. The shortDecember 1,450 call moved in-the-money (ITM) and was

exercised.Table 3 lists each strategys actual

returns; all four positions posted gainsduring this period. Covered callfutures gained 52 percent and the bullcall spread gained 33.9 percent, respec-tively, matching Table 2s flat-marketestimates.

The calendar call spread should

have gained at least 60 percent, but itclimbed just 6.2 percent. The reason:Implied volatility fell 7 points from25.49 percent to 18.47 percent. But if IVhad risen, the calendars vega expo-sure would have boosted perform-ance.

The LEAPS diagonal spreadclimbed 8.6 percent from Nov. 16 toDec. 21 expiration. But most traderswould buy back the ITM short call justbefore it expired and then sell anotherone.

TABLE 3 RESULTS: NOVEMBER TO DECEMBER 2007

Covered call futures and the bull call spread gained at least 33.9 percent, match-

ing Table 2s flat-market estimates. The diagonal LEAPS spread climbed 8.6 per-

cent, while the calendar call spread gained just 6.2 percent because IV dropped.

S&P 500 index traded at 1484.46 on Dec. 21, 2007,

when SPX options expired.

Strategy Covered Bull Calendar Diagonal

call futures call spread call spread LEAPS spread

Long S&P 500 Dec. Jan. Dec. 2008

futures 1,350 call 1,450 call 1,400 call

Short Dec. Dec. Dec. Dec.

1,450 call 1,450 call 1,450 call 1,450 call

Actual result

Long 145.30 134.46 55.24 239.56

Short -34.46 -34.46 -34.46 -34.46

Payoff 110.84 100.00 20.78 205.10

% return 52.0% 33.9% 6.2% 8.6%

FIGURE 1 S&P 500 BETWEEN EXPIRATIONS

The S&P 500 climbed 1.7 percent from Nov. 16 to Dec. 21

when the short 1,450 call expired at a profit of 19.48. All

four strategies gained ground during this period.

Source: eSignal

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Historical results

Table 4 lists the four positions month-ly statistics since January 1990. LikeTables 2 and 3, the methodology does-

nt use actual options prices, butderives them from the S&P 500s andVIXs daily historical values.

The calendar call spread gained anaverage 21.1 percent per month, rep-resenting Table 4s highest risk-adjust-ed returns. Its standard deviation isslightly higher than the bull callspreads and covered call futures(52.2 percent vs. 45 percent, respec-tively). However, the calendar spreadhas much larger potential profits,

which compensates for its vega risk.The diagonal LEAPS spread has

one of the best return-risk ratios(average/standard deviation),although its average gain (4.1 per-cent) is the lowest. LEAPS spreadsoffer plenty of stability, becauseshort-term losses can be erased bythe markets long-term uptrend.However, LEAPS arent the mosteffective way to use capital.

The bull call spread and covered

call futures are risky. Although bothpositions posted the biggest mediangains in Table 4, they sometimes suf-fer large losses of 100 percent ormore.

Also, the bull call spreads ITMcall is expensive. ITM calls on theS&P 500 tend to have bigger IVs thantheir ATM counterparts, a phenome-non called volatility skew. Theadded expense reduces the spreadslong-term profitability.

Year-by-year performance

Tables 5 and 6 break down the fourstrategies monthly performance byyear. Table 5 compares covered callfutures to bull call spreads and Table6 compares calendar calls to diago-nal LEAPS. The tables last row listseach strategys average monthlygains or losses.

The calendar call spread gainedan average 21.1 percent per month,

TABLE 4 HISTORICAL RESULTS

The calendar call spread gained an average 21.1 percent per month and

posted the largest risk-adjusted returns.

Average Median StDev Min Max Return/risk

Covered

call futures 17.2% 28.3% 45.3% -236.7% 98.2% 0.38

Bull

call spread 11.5% 31.6% 45.5% -100.0% 53.4% 0.25

Calendar

call spread 21.1% 17.6% 52.2% -68.6% 162.8% 0.40

Diagonal

LEAPS spread 4.1% 4.9% 10.4% -48.8% 31.0% 0.40

Note: 3.5% cost of capital used to incorporate dividends, 10% volatility premium

for bull call spread, 25% average long-term volatility for 365 day + 1 month LEAP

assumed for all environments.

TABLE 5 COVERED CALLS VS. BULL CALL SPREADS

Covered call futures and the bull call spread were extremely volatile. The covered

call lost more than its initial margin in at least one month during six of the 18 years

analyzed.

continued on p. 20

Covered call futures Bull call spread

Average Worst Best StDev Average Worst Best StDev

1990 14.6% -142.3% 65.8% 60.5% 5.7% -100.0% 50.4% 57.5%

1991 21.0% -62.2% 58.5% 40.5% 14.8% -94.2% 48.6% 51.4%

1992 18.4% -20.1% 36.2% 20.2% 16.5% -31.4% 38.8% 27.6%

1993 17.0% -25.0% 29.3% 16.8% 18.5% -36.0% 33.0% 21.4%

1994 1.3% -59.7% 43.9% 38.3% -4.3% -88.5% 43.1% 49.3%

1995 25.1% 16.9% 28.8% 3.3% 28.9% 17.9% 32.8% 4.0%

1996 23.5% -62.4% 42.5% 29.9% 22.0% -88.7% 42.2% 38.8%

1997 27.7% -67.8% 77.3% 44.4% 14.5% -100.0% 52.2% 56.6%

1998 28.1% -236.7% 98.2% 87.1% 27.2% -100.0% 53.4% 44.4%

1999 32.9% -17.8% 62.0% 29.9% 16.7% -48.3% 49.5% 42.3%

2000 3.8% -109.0% 66.1% 54.6% -13.4% -100.0% 50.4% 60.2%

2001 0.3% -139.0% 73.8% 77.9% -9.9% -100.0% 51.8% 70.3%

2002 -14.0% -148.4% 89.4% 81.2% -24.7% -100.0% 53.1% 69.6%

2003 39.9% 8.9% 66.0% 16.7% 30.5% -32.3% 50.4% 25.5%

2004 21.8% -38.0% 39.8% 23.0% 20.9% -57.8% 40.7% 30.4%

2005 11.4% -22.4% 32.8% 20.7% 10.6% -34.7% 36.0% 26.8%

2006 21.1% -37.6% 34.7% 18.8% 23.5% -51.1% 37.6% 23.7%

2007 15.3% -48.6% 51.9% 33.6% 8.9% -83.2% 46.4% 43.1%

Avg: 17.2% -67.3% 55.4% 38.7% 11.5% -68.2% 45.0% 41.3%

Note: 1990 is a partial year as only 11 months of SPX/VIX data were available.

8/8/2019 FOT200802

20/5320 February 2008 FUTURES & OPTIONS TRADER

and outperformed the others in sevenof the last eight years. The calendar

even gained ground during the 2000-2002 downturn when the bull callspread lost an average 25 percent permonth. Table 7 shows calendars beatthe others during 11 of the past 18years.

The diagonal LEAPS call risked less.Although it gained just 4.2 percent onaverage, it lost less than 10 percent amonth in the past five years. Thesetypes of lower-risk strategies allow youto reinvest capital at a quicker pace, so

they can often compound just as quick-ly as higher-risk ones.

By contrast, covered call futures andthe bull call spread were extremelyvolatile. Covered call futures gained anaverage 17.2 percent per month, but thestrategy lost more than 100 percent ofits initial margin in at least one monthduring six of the 18 years analyzed.

A bull call spread cant lose morethan it costs, but its returns are also sig-nificantly lower than the covered calls.

It gained an average 11.5 percent, butits average worst monthly move was -68.2 percent.

The volatility effect

All 215 months were then divided intothree levels of volatility: high, medium,

and low. The categories were as follows:

High volatility = VIX >= 22

Medium volatility = VIX < 22 and VIX > 14

Low volatility = VIX

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21/53FUTURES & OPTIONS TRADER February 2008 21

was high. The same trend appeared intwo of the three other positions.

When volatility spiked, the bull callspread gained 10 percent, but 100-per-cent losses were more common. Andcovered call futures lost 237 percentwhen the S&P 500 index dropped 14percent in the summer of 1998.

By contrast, the calendar call wasstill relatively profitable in highlyvolatile markets. Admittedly, itsworst monthly move was -63 percent,about four times larger than its aver-age gain (16.2 percent). But calendars

still might earn up to 100 percent (ormore) if the S&P 500 trades sidewaysand volatility remains high.

The LEAPS diagonal spread isprobably the most profitable strategyfor high-volatility markets. LEAPSdiagonals are riskier when the VIXclimbs, but its return/risk ratio (0.53)is the largest. The LEAPS time valueand ITM strike helps you hedgeagainst market drops.

Finding the right strategyIts a good idea to avoid bull callspreads and covered call futures inhighly volatile markets. When theVIX is high, calendar call spreads tendto gain more ground with less risk. Inaddition, diagonal LEAPS spreadsmay be appropriate if you preferlower leverage. The bottom line is youshould sell fewer calls to keep risk ata tolerable level.

However, there is one important

caveat. Historically, the best time tosell options was in January 2003 the best-performing year since 1990.But the S&P 500 didnt rebound untilApril 2003, and the VIX did notdecline significantly until 2004.

For information on the author see p. 6.

For a spreadsheet containing theformulas used here, visit

http://www.futuresandoptionstrader.combetween Feb. 5 and Feb. 29.

Related readingTristan Yates articles

Long-term diagonal call spreads, Futures & Options Trader, November 2007.

This detailed look at diagonal spreads shows how to trade them with a long-term

perspective.

Rolling leaps calls, Futures & Options Trader, September 2007.

Holding LEAPS calls instead of the underlying shares can pay off but only if you

know when to roll them forward.

Other articles

Managing covered calls,Active Trader, February 2008.

Roll out, roll down, roll up, or do nothing? You have several options when trading

covered calls.

Another look at double diagonal spreads, Options Trader, March 2007.

This position combines bullish and bearish diagonal spreads and is quite flexible if

youre willing to adjust its components.

Calendar spreads surrounding earnings news, Options Trader, March 2007.

More versatile than you might think, these calendar spreads profit from changes involatility rather than the time decay.

Death, Taxes, and time decay, Options Trader, March 2006.

Markets that go nowhere can be frustrating, but call calendar and diagonal spreads

can generate respectable profits in these situations by taking advantage of time

decay.

Controlling risk with spreads, Options Trader, July 2005.

Tired of fighting time decay and volatility fluctuations? Heres a look at an option

spread trade that was a much lower-risk alternative to an outright purchase.

You can purchase and download past articles at

http://www.activetradermag.com/purchase_articles.htm

TABLE 8 VOLATILITY VIEW

When volatility spikes, the futures covered call and bull call spread become

extremely dangerous, while the LEAPS diagonal is probably the most

profitable strategy.

Average Worst Best StDev Return/risk

Covered call futures

High vol 23.2% -236.7% 98.2% 65.9% 0.35

Med vol 15.4% -142.3% 48.3% 39.8% 0.39

Low vol 13.7% -62.4% 29.3% 22.0% 0.62

Bull call spread

High vol 10.1% -100.0% 53.4% 56.9% 0.18

Med vol 10.6% -100.0% 45.0% 46.7% 0.23

Low vol 14.2% -88.7% 33.1% 28.5% 0.50

Calendar call spread

High vol 16.2% -63.3% 123.2% 55.5% 0.29

Med vol 20.8% -68.6% 162.8% 54.8% 0.38

Low vol 26.3% -44.9% 139.0% 44.5% 0.59

Diagonal LEAPS spread

High vol 8.0% -48.8% 31.0% 15.0% 0.53

Med vol 3.1% -30.1% 13.7% 8.6% 0.37

Low vol 1.0% -3.4% 6.9% 4.3% 0.24

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Market: Futures.

System concept: The Com-

mitment of Traders (COT) re-port released every Friday bythe Commodity Futures TradingCommission (CFTC) details thepositions of different types oftraders in all traded futures con-tracts.

The COT data measures openinterest the outstanding(unclosed) positions in any mar-ket that meets the CFTCsminimum reporting limits, bro-

ken down into the following cat-egories of traders:

Commercial traders (thoseinvolved in the production orconsumption of the commodi-ties in which they trade, suchas oil refineries or agribusi-nesses).

Large non-commercials (commoditytrading advisors, hedge funds andother professional large specula-

tors), also referred to as largespecs.

Non-reportable positions (smallspeculators), also referred to assmall specs (i.e., the public).

The report shows the overall (net)long or short position for each groupin each market, as well as the individ-ual long and short position numbers.For example, the commercial tradershort open interest in crude oil would

be subtracted from the long open inter-est to determine the net long or shortcommercial trader position in crudeoil. (For more information on the COTreport and related trading techniques,see Related reading.)

One popular idea about the COT report is the positionsof the commercial traders are especially worth watching because these traders are believed to be the most in theknow about the supply and demand situation in theirmarkets. However, rather than taking positions to profitfrom price fluctuations, commercial traders are typicallyinvolved in hedging their exposure in the cash commodity

market or locking in prices. As a result, they are mostlycountertrend traders, buying as prices fall and selling intorallies.

This system is based on the idea that an extreme long orshort commercial position indicates a market reversal. Todetermine what qualifies as extreme, the current COTreading is compared to a certain number of past readings.

FUTURES TRADING SYSTEM LAB

22 February 2008 FUTURES & OPTIONS TRADER

COT extreme-position system

The system was profitable, but its equity growth was rather jagged.

FIGURE 2 EQUITY CURVE

Source: Wealth-Lab Pro 5.0

The exits, which were based exclusively on the COT data, were more timely than the entries.

FIGURE 1 SAMPLE TRADES

Source: Wealth-Lab Pro 5.0

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These extremes are used only to exitpositions.

To enter trades the system reliesmostly on price-based indicators,resulting in a trend-following systemwith a countertrend exit technique based on the COT data. However,COT data is also used to filter entrysignals: the commercial traders should be net short (below zero) for longtrades and net long (above zero) forshort trades.

Strategy rules:

Buy tomorrow at the market when:1. Todays net commercialposition is below zero.

2. The 13-day exponentialmoving average (EMA) ofclosing prices crosses abovethe 39-day EMA of closingprices.

3. The 14-day averagedirectional movement index(ADX) is above 15.

Short tomorrow at the market when:

1. Today's net commercialposition is above zero.

2. The 13-day EMA of closingprices crosses below the39-day EMA of closing prices.

3. The 14-day ADX is above 15.

Exit long position tomorrow at the market when the netcommercial position is less than or equal to the 100-daylowest net commercial position.

Cover short position tomorrow at the market when thenet commercial position is greater than or equal to the 100-day highest net commercial position.

Alternately, exit long or short position with a protective5-percent stop-loss order.

(See Key concepts for information about EMAs and theADX.)

FUTURES & OPTIONS TRADER February 2008 23

LEGEND

Avg. hold time The average holding period for alltrades.

Avg. hold time (losers) The average holding time forlosing trades.

Avg. hold time (winners) The average holding time forwinning trades.

Avg. loss (losers) The average loss for losing trades.

Avg. profit/loss The average profit/loss for all trades.

Avg. profit (winners) The average profit for winningtrades.

Avg. return The average percentage for the period.

Best return Best return for the period.

Exposure The area of the equity curve exposed to longor short positions, as opposed to cash.

Longest flat period Longest period (in days) betweentwo equity highs.

Max consec. profitable The largest number of consecu-tive profitable periods.

Max consec. unprofitable The largest number of con-

secutive unprofitable periods.

Max consec. win/loss The maximum number of con-secutive winning and losing trades.

Max. DD Largest percentage decline in equity.

Net profit Profit at end of test period, less commission.

No. trades Number of trades generated by the system.

Payoff ratio Average profit of winning trades divided byaverage loss of losing trades.

Percentage profitable periods The percentage of peri-ods that were profitable.

Profit factor Gross profit divided by gross loss.

Recovery factor Net profit divided by max. drawdown.

Reward/risk The ratio of the net profit to maximumdrawdown.

Sharpe ratio Average return divided by standard devia-tion of returns (annualized).

Win/loss The percentage of trades that were profitable.

Worst return Worst return for the period.

PERIODIC RETURNS

Percentage Max Max

Avg. Sharpe Best Worst profitable consec. consec.

return ratio return return periods profitable unprofitable

Monthly 0.56% 0.10 20.72% -10.45% 44.17 4 4

Quarterly 1.58% 0.09 24.64% -11.35% 55.00 3 3

Annually 6.13% 0.10 23.18% -9.57% 50.00 2 2

continued on p. 24

STRATEGY SUMMARY

Profitability Trade statistics

Net profit: $712,460.50 No. trades: 334

Net profit: 71.25% Win/loss: 49.40%

Profit factor: 1.25 Avg. profit/loss: 1.10%

Payoff ratio: 1.54 Avg. hold time (days): 32.60

Recovery factor: 3.32 Avg. profit (winners): 6.67%

Exposure: 8.33% Avg. hold time (winners): 43.98

Total commission $5,288

Drawdown Avg. loss (losers): -4.33%

Max. DD: -20.17% Avg. hold time (losers): 21.48

Longest flat period: 591 days Max consec. win/loss: 8/7

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Figure 1 shows examples of extremecommercial positions in the Japaneseyen (top pane). In both cases, price bot-toms very near the systems exitpoints.

Money management: Risk 1 per-cent of account equity per position.

Starting equity: $1,000,000. Deduct$8 commission and one tick of slippage

per trade.

Test data: The system was tested onthe Futures & Options Trader StandardFutures Portfolio, which contains thefollowing 20 futures contracts: Britishpound (BP), soybean oil (BO), corn (C),crude oil (CL), cotton #2 (CT), E-MiniNasdaq 100 (NQ), E-Mini S&P 500

(ES), 5-year T-note (FV), euro (EC), gold(GC), Japanese yen (JY), coffee (KC),

wheat (W), live cattle (LC), lean hogs(LH), natural gas (NG), sugar #11 (SB),silver (SI), Swiss franc (SF), and T-Bonds (US). Data source: ratio-adjusteddata from Pinnacle Data Corp.(http://www.pinnacledata.com).

Test period: January 1998 throughDecember 2007.

Test results: The system was prof-itable (71.3 percent total return), but the

equity curve (Figure 2) is not veryappealing. The system was inconsis-

tent, with winning streaks abruptly interrupted by losingperiods.

The systems long and short sides ended up more or lessequally profitable, but short trades were the real profit gen-erator for most of the test period. Because of renewedupswings in the commodity market (especially preciousmetals and some of the grains), the long side began drivingprofits more recently.

Drawdowns (Figure 3) were neither excessive (-20.2 per-cent) nor too prolonged (591 days), at least for a long-term

FUTURES TRADING SYSTEM LAB continued

The deepest drawdown was just a little more than -20 percent.

FIGURE 3 DRAWDOWN

Source: Wealth-Lab Pro 5.0

The system was inconsistent from year to year.

FIGURE 4 ANNUAL RETURNS

Source: Wealth-Lab Pro 5.0

24 February 2008 FUTURES & OPTIONS TRADER

TABLE 1: PARAMETER OPTIMIZATION RESULTS

Look-back Net Reward/

(days) profit Max DD Trades risk

100 71.25% -20.17% 334 3.53

125 64.29% -22.50% 322 2.86

150 114.01% -27.66% 311 4.12

175 117.89% -28.89% 304 4.08

200 124.56% -30.31% 294 4.11

continued on p. 26

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100% annua lized return over the last three years. He inc ludes a step -by-step guide on employing this strategy,

including how to identify potential trading opportunities and how to construct this straddle and strangle

approach. Len also gives some insights into the current market and an overview of other proven strategies.

Steve Lentz

Mento r and Direc tor of Educ ationSteve Lentz is a we ll-esta b lished op tions ed uc a tor and

trad er who has lec tured a ll ove r the United Sta tes, Asia andAustralia on beha lf of the CBOEs Op tions Institute, the

Op tions Ind ustry Counc il and the ASX. Steve is c onsta ntlydeve lop ing new stra teg ies and wa ys to use o p tions as pa rt

of a c om prehensive and p rofitab le trad ing ap proac h.

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FUTURES TRADING SYSTEM LAB continued

trend-following system. The system has a solid gain-to-pain ratio, as reflected by ratio net profit to maximumdrawdown.

Of the 334 trades, almost half (49.4 percent) were winners a slightly higher-than-expected win rate for a trend-fol-lowing system. The average profit of 1.1 percent certainly

could have been larger, but the systems market exposurewas low at 8.3 percent (along with an average holding peri-od of 33 days). The system is not particularly active, mak-ing a little more than 30 trades per year on average.

The annual returns (Figure 4) were inconsistent: a prof-itable year or two was followed by a losing year or two,although all the annual losses (except for the first) weresmaller than the smallest annual gain.

Finally, Figure 5 shows 75 percent of profits were gener-ated by just five markets an unhealthy concentration thatshould be taken into consideration.

Optimization: What happens if the look-back period exit

parameter is altered? For example, trader Larry Williamssuggests referencing even longer-term COT readings. Table1 shows the performance results look progressively betteras the look-back period increases. After doubling the look-back period, the net profit percent jumped 75 percent andthe reward-to-risk ratio rose from 3.5 to 4.1.

Bottom line: Although the test shows trading based onthe positions of commercial traders is a viable idea, thisstrategy had much room for improvement.

COT data can be used several ways. Trader Steve Briesedeveloped the COT Index a stochastic-like formula that

measures the current net position of a group to the range ofpast values over a given look-back period. Trader FloydUpperman uses a proprietary method for calculating thenormal distribution of COT values for each group.

Larry Williams also combines standard open interestwith COT values. These are all potential ideas for furtherresearch.

Volker Knapp of Wealth-Lab

Five markets (out of 20 in the portfolio) were responsible

for three quarters of the systems profit.

FIGURE 5 PROFIT DISTRIBUTION

Source: Proprietary calculations

For information on the authorsee p. 6.

Futures Lab strategies are tested on a portfolio basis (unless otherwise noted)

using Wealth-Lab Inc.s testing platform. If you have a system youd like to see

tested, please send the trading and money-management rules to

[email protected].

Disclaimer: The Futures Lab is intended for educational purposes only to

provide a perspective on different market concepts. It is not meant to rec-

ommend or promote any trading system or approach. Traders are advised

to do their own research and testing to determine the validity of a trading

idea. Past performance does not guarantee future results; historical testing

may not reflect a systems behavior in real-time trading.

Related reading

Interview: Larry Williams looks inside futures

Active Trader, January 2006.Larry Williams discusses the twists he puts on the COTreport in his latest book.

Interview: Floyd Upperman: Digging into COT data

Active Trader, February 2006.Its not just a matter of hedgers vs. speculators. Anengineer turned trader discusses ways to make sense ofthe futures Commitment of Traders report.

Straddling the COT report

Futures & Options Trader, September 2007.Tracking shifts in large-trader sentiment can signal tradeopportunities. This long straddle was triggered by anextreme reading in the S&P 500 futures.

Cracking the COT code

Futures & Options Trader, July 2007.

While data from the COT report has been used in conjunc-tion with other indicators, this strategy relies exclusively onthe numbers found in the COT.

All traders, big and small: The Commitment of

Traders report

Active Trader, March 2003.A COT primer for beginning traders or those unfamiliarwith the report.

Note: The Larry Williams and Floyd Upperman interviewsare also part of the discounted article collection, TheActive TraderInterviews Vol. 3

You can purchase and download past articles at

http://www.activetradermag.com/purchase_articles.htm .

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OPTIONS TRADING SYSTEM LAB

Market: Options on large-cap stocks.This technique could also be applied toexchange-traded funds (ETFs) with liq-uid options contracts.

System concept: A stock option con-trols 100 shares of stock with less capitalthan buying stock outright. This type ofleverage is typically associated with theoptions, futures, and currency markets,but stock traders can also use leverage bybuying stock on margin and borrowingup to half its initial cost.

This system compares buying large-cap stock on margin to buying calls.Which strategy offers the best combina-

tion of leverage and expected profit?Instead of testing regular calls, the sys-tem uses Long-term Equity AnticiPationSecurities (LEAPS), which dont expirefor at least 12 months. Some LEAPSdont expire for up to three years, behavelike underlying stock, and dont initiallylose much time value. Ideally, LEAPScalls can lower cost, reduce risk, and per-form roughly the same as stock. The main difference is thatLEAPS dont pay dividends and lack voting rights. Also,LEAPS expire, stocks dont.

Previous Option Labs have analyzed how specific options

positions (vertical spreads, covered calls, butterflies, etc.)have performed in the last few years. By contrast, thisOptions Lab measures the same long-term bullish strategy,but focuses on these two different ways to use leverage.

Buying stocks on margin is pretty straightforward. Thesystem started with roughly $20,000 for each of the sevenstocks tested on Sept. 4, 2001, boughtmultiples of 100 shares of seven large-cap stocks, and held them until Dec. 31,2007. The total account began with$75,610 in capital, and since the shareswere bought with 50-percent initial mar-

gin, the system initially controlled$151,220 of stock.

The LEAPS position contains one at-the-money (ATM) LEAPS call for each100 shares of stock. If, for example, thesystem buys 800 shares of Intel Corp.(INTC), it also purchases 8 LEAPS callssimultaneously. To minimize time decay,all LEAPS calls were sold every year inthe first week of September when theyare converted to standard options. Atthat point, the system buys a new LEAPScall in the furthest expiration month.

Figure 1 compares the potential gains and losses of one ofthe long stock positions (red line) to the equivalent LEAPScall position long 8 Intel January 2009 calls at a $20 strike(blue line). Both positions are represented as if they were

both entered on Sept. 1, 2006. The different lines representeach strategys performance at various stock prices by Sept.4, 2007. Notice the underlying stocks risk line is straight,while the LEAPS calls risk line is curved.

The LEAPS position outperforms margined stock only ifthe stock is quite volatile in the following year. For example,

The LEAPS position (blue line) outperforms margined stock only if the

underlying stock is quite volatile in the following year.

FIGURE 1 LEAPS VS. MARGINED STOCK

28 February 2008 FUTURES & OPTIONS TRADER

The stock vs. LEAPS showdown

Although the LEAPS calls (red line) gained the most ground, the margined stock

method (blue line) outperformed for long stretches, which underscores the

LEAPS calls need for increased volatility.

FIGURE 2 PERFORMANCE STOCK VS. LEAPS

Source: OptionVue

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Intel traded at $19.88 on Sept. 1, 2006, and buying INTC onmargin leads to larger gains and smaller losses if Intel tradesbetween $10 and $24 during this period. But if the underly-ing drops below $10 or jumps above $24, the LEAPSapproach will perform better.

Trade rules:

Margined stock:1. Buy as many shares of each stock with $20,000,

rounded to the nearest 100 shares, on Sept. 4, 2001.Use 50-percent initial margin.

LEAPS calls:

1. Buy one ATM LEAPS call in the furthest availableexpiration month for each 100 shares of underlyingstock held.

2. Sell the LEAPS calls one year later in the first week ofSeptember. Then replace those ATM LEAPS by buying one call in the furthest available expirationmonth for each 100 shares of underlying stock held.

Test details:

Dividends were not included. Margin interest expense was ignored. Daily closing prices were used. Trades were executed

at the bid and ask, when possible. Otherwise,theoretical prices were used.

Commissions were $5 plus $1 per option trade,$8 per stock trade.

Test data: The system was tested on the following stocksand their options: Apple Inc. (AAPL), Citigroup (C), GeneralElectric (GE), Intel (INTC), Johnson and Johnson (JNJ),Microsoft (MSFT), and Wal-Mart (WMT).

Test period: Aug. 31, 2001 to Dec. 31, 2007.

Test results: Figure 2 compares both strategies perform-

ance in the last six and a half years. The margined stockapproach gained $201,036 (266 percent), while the LEAPSstrategy earned $132,796 (306 percent). In dollar terms, buy-ing stock beat the LEAPS method, but it lagged the LEAPScalls in percentage terms, because LEAPS required less capi-tal.

If you study Figure 2, however, you will notice that buy-ing stock outperformed the LEAPS calls for long stretches,which underscores the LEAPS calls need for increasedvolatility. Despite these differences, a large portion of thegains from both systems was because of a single stock Apple Inc., which rallied 133.5 percent in 2007.

Bottom line: LEAPS calls have a clear advantage only ifthe underlying moves sharply (up or down). If the marketsplummet, you will lose less with a LEAPS call than withmargined stock, and there are no margin calls to worryabout. Also, if the markets spike, the LEAPS approach will

beat margined stock. But if your forecast lies in betweenthese extremes, buying stock on margin is prudent.

For stocks, margin interest expense was not included, butcould be $4,000 to $6,000 per year. The system assumed a30-percent maintenance margin, and there would have beenno margin calls during this test period. For LEAPS, the testrequired an additional $13,000 in capital at one point, butwould also have been able to reinvest excess capital at therisk-free interest rate during most other portions of the testperiod. Finally, minimal commissions were included, butlarger fees and bad fills will likely affect performance.

Steve Lentz and Jim Graham of OptionVue

STRATEGY SUMMARY

Stock LEAPS

margin (50%) strategy

Starting capital ($) 75,610 43,000

Net gain ($): 201,036 132,796

Percentage return (%): 266 309

Annualized return (%): 42.0 48.8

No. of trades: 7 49

Winning/losing trades: 2/5 20/29

Win/loss (%): 29 41

Avg. trade ($): 28,719.43 2,710.12

Largest winning trade ($): 215,984.00 74,354.00

Largest losing trade ($): -8,436.00 -6,226.00

Avg. profit (winners): 110,094.00 9,640.35

Avg. profit (losers): 3,830.40 -2,069.34

Avg. hold time (winners): 2,309 304

Avg. hold time (losers): 2,309 348

Max. consec. win/loss : 2/5 6/9

FUTURES & OPTIONS TRADER February 2008 29

Option System Analysis strategies are tested using OptionVues

BackTrader module (unless otherwise noted).

If you have a trading idea or strategy that youd like to see tested,please send the trading and money-management rules [email protected].

LEGEND:

Net gain Gain at end of test period, less commission.

Percentage return Gain or loss on a percentage basis.

Annualized return Gain or loss on an annualized percentage

basis.

No. of trades Number of trades generated by the system.

Winning/losing trades Number of winners/losers generated

by the system.

Win/loss (%) The percentage of trades that were profitable.

Avg. trade The average profit for all trades.Largest winning trade Biggest individual profit generated

by the system.

Largest losing trade Biggest individual loss generated by

the system.

Avg. profit (winners) The average profit for winning trades.

Avg. loss (losers) The average loss for losing trades.

Avg. hold time (winners) The average holding time for winning

trades.

Avg. hold time (losers) The average holding time for losing trades.

Max consec. win/loss The maximum number of consecutive

winning and losing trades.

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Options trading is a battle few people sur-vive. If you dont understand the risks

(and there are several), youll run intotrouble fast. Successful traders deter-

mine the risks of every trade with precision. They under-stand not only the markets intricacies, but also the bestway to profit from a forecast with the least amount ofrisk.

This may sound obvious, but understanding optionrisk is more difficult than it seems. Options are complexinstruments that are influenced by several variables.When measuring option risk and reward, some tradersfocus on the options potential values at expiration.Although this is an important consideration, prior to

expiration three main factors govern the price of anoption: the direction of the underlying instrument, thetime to expiration, and volatility.

It is essential to understand how each of these variablescan affect an options price. And the best way to measurethese risks is to study the major optionGreeks delta, gamma, theta, andvega.

Absolute risk and reward

First, it is helpful to consider anoptions absolute risk. When you

buy an option your risk is limited tothe premium you paid for it, whileyour potential reward can be unlimit-ed. When you sell an option, risk andreward are reversed: Your potentialreward is limited to the premium youreceived, while your risk can be unlim-ited.

Suppose a stock trades at $50 andyou buy an at-the-money (ATM) calloption with a strike price of 50. Figure1 shows the calls possible gains andlosses at expiration. The long call cant

lose more than its premium ($2), but if the underlying stockrises the call gains value.

Figure 1 only tells part of the story, however. Althoughthe distance between the underlying instrument and an

30 February 2008 FUTURES & OPTIONS TRADER

TRADING BASICS

Fighting the options battlewith the Greeks

Paying attention to options Greeks is vital for nearly any options trader. Tracking an options delta,gamma, theta, and vega might save your neck in todays volatile market.

FIGURE 2 OPTION GREEKS

When a stock traded at $36.95 on Jan. 7, its February 35 call had a delta of

0.72. If the stock gains $1, the calls value will rise by $0.72, but if the stockdrops $1, the calls value will drop by $0.72.

Source: OptionsHouse

FIGURE 1 LONG CALL RISK PROFILE

This chart shows only the ATM calls absolute risk and

reward at expiration the effects of time (theta) and implied

volatility (vega) are ignored.

BY DAN PASSARELLI

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options strike is important, absoluterisk tends to be relevant only if theoption is held until expiration.

Meanwhile, two other variables arecritical: an options time to expirationand implied volatility (IV).

Meet the Greeks

The option Greeks are measures thatdescribe aspects of an options behav-ior. The four most common Greeks are:

Delta: The rate of change ofan options value relative to achange in the underlying

instruments price.Gamma: The rate of changeof an options delta relativeto a change in the underlyinginstruments price.Theta: The rate of change ofan options value relative to time.Vega: The rate of change of anoptions value relative to achange in IV.

Figure 2 shows call option priceswith Greeks (highlighted in yellow) on

a stock trading at $36.95 on Jan. 7.Delta is in the first Greeks column.Call options have positive deltas and

put options have negative deltas. Letsexamine delta by measuring howFigure 2s near-the-money February 35call might move if the stock climbs ordrops $1.

The 35-strike call has a delta of 0.72,meaning that if the underlying rises$1, the calls value will rise $0.72. Thatmeans, all else held constant, you canexpect the calls bid and offer prices(2.49 and 2.53) to each climb 0.72. If,conversely, the stock falls $1, the

February 35 calls price will decline$0.72.Figure 2s next column shows

gamma, which represents the deltaschange as the stock price changes (i.e.,deltas acceleration or deceleration).Again, with all other factors remainingconstant, if the stock climbs $1 the 35-strike calls delta would rise from 0.72to 0.814 an increase of 0.094, whichis the gamma value. If, however, thestock falls $1, the February 35 calls

FUTURES & OPTIONS TRADER February 2008 31

continued on p. 32

FIGURE 3 INDIVIDUAL AND TOTAL GREEKS

To measure the Greeks for a multi-option position, simply add the same-type Greeks together.

Source: OptionsHouse

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TRADING BASICS continued

FIGURE 4 DIRECTIONAL RISK PORTFOLIO

When these stocks rally, the total options position should gain ground (and vice versa). But gains accumulate faster than losses.

Source: OptionsHouse

delta would decrease by the gamma (0.094), falling from0.72 to 0.626.

The third Greeks column in Figure 2 lists theta, or timedecay. Theta measures how much an options value willdecrease as each day passes. The February 35 calls theta is0.014, which means the call will lose $0.14 as one day pass-es, assuming price and volatility remain constant.

Figure 2s last Greeks column is vega, which is theoptions response to IV changes. The February 35 call has anIV of 28 percent and a vega of 0.043. If IV rises one percent-age point to 29, the calls value will increase by $0.043, allelse equal; if IV falls one percentage point to 27, the calls

value will drop by $0.043 as a result of vega.

The Greeks go to battleEach Greek helps you fight a different market foe. Forinstance, delta measures your option positions directionalexposure. If you are strongly bullish, you would likely wantan option position with a larger delta than you would if youare only moderately bullish, because the value of higher-delta calls will increase more if the underlying rallies. Thetrade-off is they also face greater losses if the stock falls.

In short, delta is a measure of how aggressive a positionis from a directional perspective. Calls have positive deltasbecause they benefit from underlying price increases, while

puts have negative deltas because they benefit from under-lying price declines.

Gamma can help or hurt you depending on whether anoption position is long or short. Buying options yields pos-itive gamma, which creates more favorable deltas as theunderlying price moves. As the stock price rises, a longcalls delta will increase, racking up profits faster. As thestock price drops, a long calls delta will decrease, easingthe pain of loss.

Short options, however, have negative gamma workingagainst them. For example, if the underlyings price rises, ashort calls delta becomes increasingly negative and losses

can mount; if the underlying falls, a short calls deltashrinks, so profits accumulate at a slower pace.Traders who buy options are hurt by the passage of time

as the value of their options decreases. By contrast, traderswho sell options benefit from time decay because their shortoptions decrease in value as time passes. Theta helpstraders estimate how much time is helping or hurting theirposition.

Vega measures a positions exposure to positive or nega-tive IV. Long options have positive vega. Conversely, shortoptions have negative vega. When implied volatility rises,option holders benefit and option sellers are hurt. Thereverse is true when IV falls.

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Calculating position GreeksIn addition to tracking the Greeks on individual options,you should calculate their totals on a portfolio basis.Measuring Greeks for a position with multiple options is

fairly easy simply add the values of each type of Greek.Figure 3 shows a sample stock portfolio Bed Bath and

Beyond (BBBY), Baidu.com Inc., (BIDU), Crocs Inc. (CROX),and Dryships Inc. (DRYS), among other symbols. The figureshows the corresponding risk in terms of delta, gamma,theta, and vega. Here, the individual options Greeks are broken down so you can see how underlying direction,time, and volatility might affect these trades.

Each Greeks total portfolio value is shown in Figure 3sfirst row, which indicates how the overall position might beaffected if direction, time, or volatility rise or fall across the board. These total Greeks values represent the portfolios

market risk.For example, Figure 3s position delta shows its direc-

tional exposure, which has the biggest effect on most trades.Its total delta (-257) shows how much this hypothetical posi-tion will lose as the underlying securities move higher inunison. The portfolio loses $257 if the underlying stocks allrise by $1 and gains $257 if they all fall by $1. (Because ofgamma, however, deltas will change as the underlyingstock prices move.)

Figure 4 shows how the same options portfolio wouldfare if all its underlying stocks gain or lose 5, 10, 20, or 50percent (i.e., directional risk). In this portfolio, some options

are bullish and some are bearish, but the overall position isbullish. For instance, if the stocks rise 5 percent, the overallposition could gain $5,496. The higher the stocks rise, thegreater the profit.

If all stocks in the portfolio fall significantly by equalamounts, the overall position loses ground. The more theunderlying prices decline, the greater the loss (althoughgains accumulate faster than losses).

Living to trade another dayRisk is unavoidable, but recognizing and understanding therisks you face as an options trader can help make this

enemy easier to fight. Studying Greeks can help you seewhat is at risk and to what degree. Once you know the var-ious risks associated with delta, gamma, theta, and vega,you can react to threats as markets change.

Delta is helpful in assessing directional risk, but deltaschange. To gain a clearer picture of directional risk, study aportfolios total delta, especially for big moves. This givesyou a sense of how much a stock needs to move to reach aprofit target. It also reveals how much a stock can moveagainst you before you must take a loss. Knowing your riskhelps you live to trade another day.

For information on the author see p. 6.

Related readingDan Passarelli articles

Trading against the pros

Options Trader, November 2006.

Understanding how market makers manage risk may help

you get better fills.

Calendar spreads: Taking time out of the market

Options Trader, February 2006.

Trading time spreads offers a way to take advantage of

time decay and volatility changes while limiting risk.

Other articles

The theta-vega relationship

Futures and Options Trader, January 2008.

Focusing on these option Greeks can help you avoid

missteps when trading calendar spreads.

Swing with the market: Vega and rho

Options Trader, February 2007.Vega and rho are lesser-known Greeks, but they measure

the effect of two critical option-pricing components: implied

volatility and interest rates.

Know your theta

Options Trader, January 2007.

Time eats away at every options position, so it pays to

know how time decay affects option prices.

Get on the fast track wit