trading methods - Long Option or Synthetic Option

One thought that crosses my mind when trading is that the 5 percent of the time that I am directional in my trading, Which long option strategy is the best in terms of practical risk and reward? Many of you are probably scratching your heads right now thinking that I might be off my rocker. For those of you who are novices there is 2 ways to construct a risk graph that looks like a long call option. The first is by buying a call option and the second is by creating what is known as a synthetic long option. This is done by buying the underlying and also buying a put for protection.

For example purposes lets say we are interested in a long strategy in the S&P 500. At the money calls and puts are each trading for 15 points. I can create the same risk graph by either buying the at-the-money call or by buying the futures and buying an at-the-money put. Does these two positions offer the same risk and reward. Lets examine the entry of each.

S&P = 900 and 900 calls and puts are both 14.50 bid and 15 ask each

• Example 1
  Long 1 S&P 900 call at 15 points
  Cost - $7500 + 1 commission
• Example 2
  Long Futures at 900 + Long 1 S&P 900 put at 15 points
  Cost - $7500 + 2 commissions

Example 1 looks like the logical choice because we only have 1 commission versus paying an additional commission for example 2. Why then do professional traders sometimes take a synthetic approach to trading rather than simply buying the call of the put. Well if the trader intends to hold the position and look for a big increase in his favor, the synthetic will in most cases, be the better strategy in the long run. Lets look once again at the example to find out why.

S&P is now at 925.	900 calls are bid 25 and ask 26
	900 puts are bid 1 and ask 1.15

In example 1 we can exit the trade buy selling the 900 calls for a price of 25 therefore capturing a profit of $5000 (12,500 - 7500)

In example 2 we can exit the futures side for a profit of $12,500 plus exit the put side by selling for 1 point and incurring a $7000 loss, thereby netting us a profit of $5500.

Example 2 now looks better due to less slippage and in this case, some time premium left over in the puts. Remember that volatility can play an important role in determining which strategy is more practical. Just some food for thought.

Good trading!

The Risk of Trading - trading methods

Directional Risk is the most common risk in the eyes of any trader. There are many different factors that affect supply and demand, therefore affecting the outcome of any trader who invests on one side of the market. In the stock market, an upward move is normally what most traders like to see. That’s because 90% of all traders that have stock are long the market.

However, a decline in the price of a stock can hurt the stock trader’s portfolio. This is referred to as downside risk. When you are long a stock, the downside risk is limited to the price that the stock is. This means that if Trader A purchased 100 shares of XYZ for $100 per share, his directional downside risk is limited to $100. If Trader B also purchased 100 shares of XYZ, but for $50, his directional downside risk is limited to just $50.

What about futures traders? Long and short futures traders have directional risk, but because futures trading is a zero sum game, both long and short traders have equal directional risk -- both upside for short sellers and downside for buyers. Let’s get back to our stock traders above. Which has more directional risk, Trader A or Trader B? Trader B has 1/2 the directional risk when compared to trader A. Is there any way Trader B can have the same risk as Trader A even though both traders bought at different price levels? Yes he can. Here’s how:

• Portfolio Risk is determined by taking the number of trades in one account and analyzing the total risk of the entire portfolio. Trader B can have the same risk above as Trader A if he/she were to buy 200 shares of XYZ at $50. Many traders think that buying more shares at cheaper prices lowers their risk while increasing their rewards. This is all too common in the marketplace. The trader who puts too much money on one trade can open himself up to a greater drawdown. It pays to not only research your trades, but to diversify your account, not only in different trades, but different sectors as well. While we may have a long bias in the Bond market, we may elect not to take a long biased trade in the T-Notes due to too much directional exposure in debt instruments that correlate together.


• Volatility Risk can be described by how much or little an asset or derivative that is being traded moves. It makes no sense to trade in a volatile market that could risk a margin call and wipe you out of a potentially good trade. The margin requirements are there for a reason. If the historical volatility on an asset or derivative were to double, so could the margin to trade it. This helps take the risk out of the brokerage firms’ hands and puts it into your hands. Volatility risk for an options trader is different however, according to his/her trade. If the trader is long volatility, any trade that dramatically rises or falls is good for the trader. Traders who are short volatility are looking for a collapse in volatility, or dull market conditions. In each case, the volatility traders are looking to gain by market momentum, or lack of it. Any trader short volatility in a market collapse could certainly lose his entire portfolio. What about the long volatility trader? Where does his/her risk come from?


• Theta risk is for long options traders only. Theta risk is how much option’s premium is lost while holding a long position. Option sellers do not have theta risk, but they have volatility risk. As for the option buyers, the theta risk is determined by how much or how little was paid for the option they hold. Obviously, the less paid for the option, the less theta risk is involved.

We are continually teaching our students how to limit risk while still being able to realize a good reward. We concentrate on strategies that are not only non-directional, or have a directional bias, but other things as well. We try to develop strategies that are not only delta neutral, but theta and vega neutral as well. This type of strategy can consistently crank out good yields while limiting your exposure.

We try to develop strategies that are not only delta neutral, but theta and vega neutral as well. This type of strategy can consistently crank out good yields while limiting your exposure.

trade volatility

Volatility Skews Explained

Volatility is probably the most confusion issue that options traders deal with. If that is the case, than the volatility skew is like rocket science to most traders. I want to explain volatility skewing and how a trader can take advantage of this useful information.

As you may realise, volatility is a major factor to the overall price and value of an option. As volatility rises and falls, so does the price of options. Statistical volatility is related to the past ranges of the underlying, as determined through a calculation using a standard deviation in options prices that is averaged. Most people use 21-30 days of data. Implied volatility is calculated using an option pricing model, and takes in to effect the strike price, asset price, volatility, days to expiration, and the risk free interest rate at that time. The result of implied and statistical volatility can greatly differ at times.

Volatility skewing occurs when options of the same underlying have different implied volatility levels. This skewing occurs through supply and demand mostly. This occurs mostly on in the money options as well as out of the money options. In the money options generally have a higher skew due to options price movement, while out of the money options command a higher volatility due to demand for the cheaper option from most traders. This basically means that some option strikes are trading at a higher than normal price when compared to the entire option series. If a trader were to plot volatility on a graph, it would look similar to this.

The graph above is actually taken from recent information in the soybean market. As of this article, Soybeans have a high volatility and a high volatility skew. Notice that the 625 strike has an implied volatility of 30, and that the 850 strike has an implied volatility of a 50. This means that the 850 calls are priced 66% higher than they should be when comparing them to the implied volatility of the 725 strike.

So how can a trader benefit from this information. "Buy Low and Sell High" is a phrase that makes complete sence to volatility traders. If you are spreading options in a market that has a high volatility skew, than make sure the options you are buying are on the low side of the skew and the options that you are selling are on the high side of the skew. By doing this you are further reducing your risk, if you are spreading options at a 1 to 1 ratio. If you are ratio spreading or back spreading, your risk reward may be different, but can vastly improve by researching volatility before entering a trade.

CNBC Ticker

CNBC Ticker Tape Terminology

I know that not everyone that trades is not a full-time trader, therefore not everyone owns a real-time software package. I do know that from time to time, everyone in this business sits down in front of the tube and turns on CNBC. For some of us, reading the Ticker Tape at the bottom of the screen is second nature. For the novice, understanding the numbers can be confusing at times, so I am going to attempt to piece the puzzle together for you.

First, there are two ticker tapes running on CNBC before, during, and after market hours. The top ticker tape, which is displayed in white, represents the NYSE stocks and is quoted in real-time. The bottom ticker tape, shown in blue, is the AMEX and NASDAQ stocks delayed 15 minutes. AMEX symbols are posted in four letters and NASDAQ trades on the bottom ticker use a five letter symbol.

Before the market opens and after the market closes, you can see all the settlement prices for every stock in alphbetical order. During the market, stock symbols are displayed as they are traded. About every minute the market summary will appear in the top ticker which gives you current broad market averages such as DJIA and other averages, ups, downs, tick, volume, etc.

Let's take a look at IBM 3 different ways to show you what the translation means:

IBM 120 1/2	- This means that 100 shares of IBM traded at 120 1/2
10sIBM 120 1/2	- This means that 1000 shares of IBM traded at 120 1/2
10.000s IBM 120 1/2	- This means that 10,000 shares of IBM traded at 120 1/2

Obviously this can vary from time to time as does everything in this business. But for now, the novice can now gain a better understanding of how to read the ticker tape.

Good Luck and Good Trading!

The Dow and E mini Contracts

The Dow and E mini Contracts -- Are they worth Trading?

There has been a lot of hype about the new Dow and Mini S&P Futures and Options contracts that have hit the exchanges over the last few weeks. Questions have been pouring into the office about these products and we feel it is necessary to explain them in detail:

** The S&P Mini contract was introduced on September 9, 1997 as an alternative to trading the big S&P contact. This is an electronic traded product using computers. Also referred to as the E Mini, it is 1/10 the size of the S&P — $50 per full point. The contract trades in 1/4 point increments and the margin is about $2,200. You need a lot of movement to make any money trading E-Mini. Commissions are a factor as well, as most brokerage firms charge the same commission as they do for any future or option trade. As far as order types, the E Mini trades like Globex products, which means most firms do not take stops. However, if they do take stops and its not filled after 1 full point, then it becomes a limit. This leaves a bad taste in my mouth knowing that if I call in a sell stop at 950, it could be filled below 949. Options are traded on this product, but it is hard to get a bid/offer from a broker on any strikes.

** The Dow contract was introduced the first week of Oc-tober. It is an open outcry market unlike the E Mini. This future moves at $10 per point, meaning if the Dow climbed 50 points in one day, a long future would have gained $500. The commissions should be the same as any futures contract at your firm. This market also has options, which are easier to get than the E Mini contract. Margin on this futures contract is about $3,300.

I think if I was considering using these products as an options trader, I would lean toward the Dow contracts for two reasons. First, I like the open outcry system of getting bid/offers to have an idea of what I am going to pay for a trade. Secondly, if the commissions are the same, it looks as if I get about twice the reward potential using the Dow product than the E Mini — when looking at the movement of both.

I must mention OPTIONETICS does not trade any new products until they have been on the market at least 60 to 90 days. With the S&P splitting at the end of October, there could be a shift away from these new products and back to the old reliable one. Only time will tell!

Why I won't trade new markets -- just yet...

In an earlier article I mentioned the Dow Futures and the E mini S&P as well as my hesitations to trade these products during the early stages of their infancy. Looking at what happened last Thursday, I am glad I wrote that article. Let's first revist the Dow contract and then talk about last Thursday.

The Dow contract was introduced the first week of October. It is an open outcry market unlike the E Mini. This future moves at $10 per point, meaning if the Dow climbed 50 points in one day, a long future would have gained $500. The commissions should be the same as any futures contract at your firm. This market also has options, which are easier to get than the E Mini contract. Margin on this futures contract is about $3,300.

Now look at last Thursdays action on Wall Street. Hong Kong's stock market went into a freefall of historic proportions last Thursday, with panic selling set off by rising interest rates and regional instability. The blue-chip Hang Seng index plummeted 1211.47 points, or 10.4% -- its largest one-day point loss in more than seven years -- to reach a 19-month low of 10426.30. The decline affected the US markets, as well as world markets abroad.

Anyone who was long Dow Futures going into Thursday morning got hammered. Why? Even thought the Dow opened down over 100 points, the Dow Futures opened down 3 1/4, or the equivelant of 325 points. The Dow limit is 3 1/2. Due to thin market trading of this contract and high volatility, many small traders headed for the exit doors only to be greeted by bad fills. Also think of the high slippage as well.

Once again, I write this to tell you that we do not trade any new markets for at least 60-90 days. I have friends who are traders in the pits begging me to give them business. This alone tells me not to. Just another lesson about illiquidity and the effect it can have on you if you trade markets with low volume. Good trading! -- Tom

S&P trader

Cause and Effect for the S@P 500 Split -- Who did it help?

Well if you actively trade the S&P 500 futures than you already know by now that the contract size has been cut in half. What does this mean? What are the details of this change and how does it affect the S&P trader? I will attempt to answer that in this weeks article.

For any open positions after October 31, 1997 the exchange will double market participants' open positions and will halve the underlying value and performance bond requirements. The underlying value of the contract will be reduced from $462,125 to $231,062 at recent index levels of 925.00. The action will not affect the price level of the S&P 500 stock index, the U.S. equity benchmark. The minimum price increment (tick) for futures and options contracts will increase from 0.05 to 0.10 index points. This change in tick size will have the effect of maintaining the value of one tick at $25.

What does this trader think? Well, Im not too excited about this, since I trade S&P futures and options on a regular basis. Firstly, I don't beleive the remarks by the exchange that this will "help the investor" by reducing risk and volatility. Most directional traders will just double up on their positions and have the exact same risk as before. What about all those new traders that will be able to finally trade the S&P at half the margin as before. After the recent turbulance, margins have doubled, and after the split, are nearly the same as they were a month ago. I don't expect to see any new traders enter the S&P soon.

So who benefits? Brokers @ Clearing firms just got a big revenue increase due to the increase in volume from all areas, whether institutional, large speculator, or small trader. The second entity that will ultimately benefit will be the exchange in the area of exchange fees. I don't see either of these two groups cutting fees at all to "help the trader" as they say that this split will do. What about the floor trader? Well they got a big paycheck as well. Although the contract split in half, the tick value did not split -- in fact the tick value increased to 10 cents from 5. Talk about a raise!

Hmm... Knowing all this I think the best thing to do now is to buy a seat on the CME. Its just one "upstairs" traders opinion. Good trading!

hedging strategies

Are High Returns Achievable using Hedged Strategies?

As a Delta Neutral Trader, I’m often asked if achieving returns of 100-300% are realistic while trading an account delta neutral. After completing one of the Optionetics 2-day workshops., one might wonder if trades that are hedged would attain returns that money managers would envy.

While most of the trades that I take are dull and boring, they do have the ability to reap great rewards when looking at the capital at risk. I normally do not have more than 20-25% of my trading capital working at one time. Let’s take a look at an example using the WealthWire Futures Account for 1997

WealthWire Futures - Real Time Account
Account Start at 1997 - $10,000 (Beginning Balance)
Number of Trades taken - 44 Trades
Average Number of Days in Trade - 15 Days

Average Cost of Each Trade - $300
Account Balance to Date - $17,010 (After Commissions)
Return on Investment - 280%
Return on Account - 70%

Notice that the Return on the WealthWire Futures account stands at 70 percent. This average is quite above that of the S&P, which is currently up just over 20 percent for the year. However, when looking more closely, the Return on Investment is up 280 percent for the year. Return on Investment is the return on the cost of trade. If one trade cost $300 to enter, and was exited for a $300 profit, the Return on Investment for that particular trade would be 100 percent.

As you can see, it is possible to achieve a high rate of return while risking very little on your account. Optionetics strategies allow this with both directional and non-directional trades. I know this is true, because I do it every day. Good trading!

trading methods

article : trading methods - Shorting the Box

Important Note: For Information Purposes Only. Consult your CPA or Tax Attorney for individual tax advice.

How can you protect a long stock position to prevent drawdowns? One particular way that I avoid drawdowns on long-term securities is with a method known as "Shorting the Box." This method of trading will allow a trader to hedge long term securities without selling the actual stock. It also does not involve buying or selling any options, therefore, eliminating the possibility of time value. Shorting the box involves selling securities against the ones you already own. For example, if you own 100 shares of IBM and you wanted to short the box, you would instruct your broker to sell short 100 shares of IBM. The broker would loan you the stock from the firms inventory, or sell short the stock on the exchange for you, while you continued to hold your IBM stock. Most people who want protection on their securities will buy puts as disaster insurance in case of a possible collapse of the securities that they currently hold. When shorting the box, the short stock will lose one dollar for every dollar made from the long stock held, and vice versa. As you can see, when you short the box, you have locked your gains, until you close out one side of the trade. What is the benefit of shorting the box? The biggest reason for shorting the box is to delay paying taxes against securities that you have made a tidy profit on. Let's assume you bought 100 shares of IBM at $50 per share, and the current price is $120. If you sell the IBM stock at $120 per share, you will have realized a $70 taxable profit. You may feel that next year your income may be lower allowing you to sell the stock and allowing you to fall into a smaller tax bracket. Yet if you wait, the market may correct itself, causing a decline in the price of IBM. By shorting the box, you have not closed a position, but now have 2 positions open. The profit is now locked but the trade will remain open until you close out one or more sides of the trade. You could leave the trade open as long as you like. Closing the trade out is done one of 2 ways. You can either leg out of the trade, legging out the short side first and then closing out the long side; or you can tell the broker to deliver the shares you own to cover the short.

The biggest misconception with shorting the box involves the long-term gain of stocks. Most people who first learn about shorting the box think to themselves, " I can short the box against that Netscape stock I bought 3 months ago at 20, and lock the profits in for a year, at which time I will close the position out and take the long- term capital gain tax against the trade." The IRS has taken this strategy into account and has set up rules regarding this which states the following:

"If you held property substantially identical to the property sold short 1 year or less on the date of the short sale, or if you acquire property substantially identical to the property sold short after the short sale, then:
1. Your gain, if any, when you close the short sale is a short-term capital gain; and
2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first."
IRS Publication 550

Notice here that this last quote taken from the IRS specifically states that you cannot short the box, and close the trade out to avoid the short-term capital gain on the stock. An example would be that if you held a long stock position for 50 weeks, you cannot short the box and close out the position 2 weeks later as a long- term capital gain. As a matter of fact, if you do short the box- - even with only 2 weeks remaining before the trade becomes a long-term stock- - the holding period is cancelled out and starts over the day you cover the short position of the trade. Traders beware that you cannot short the box to avoid short-term capital gains.