Trading Options to Win Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Trading series features books by traders who have survived the market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics Whether a novice trader, professional, or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future For a list of available titles, please visit our Web site at www.WileyFinance.com Trading Options to Win Profitable Strategies and Tactics for Any Trader S A JOHNSTON John Wiley & Sons, Inc Copyright © 2003 by S A Johnston All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada Designations used by companies to distinguish their products are often claimed as trademarks In all instances where John Wiley & Sons, Inc is aware of a claim, the product names appear in initial capital or all capital letters Readers, however, should contact the appropriate companies for more complete information regarding trademarks and registration No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: permcoordinator@wiley.com Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.Wiley.com Library of Congress Cataloging-in-Publication Data: Johnston, S A Trading options to win : profitable strategies and tactics for any trader / S A Johnston p cm ISBN 0-471-22685-8 (alk paper) Stock options I Title HG6042 J64 2003 332.64′5—dc21 2002153117 Printed in the United States of America 10 Contents Preface vii CHAPTER Making Money with Money CHAPTER On the Trail of a Method: Risk, Leverage, and Markets 22 CHAPTER Profitability 101: Expectation and Options 45 CHAPTER Just the Facts, Ma’am: Avoiding Moonshine, Morons, and Myths 71 No Hammer, No House: The Tools of the Trader 89 CHAPTER CHAPTER Thomas More’s Revenge: A Strategy for All Seasons 100 CHAPTER Apocalypse Never: The Uses of Defense 122 CHAPTER Don’t Just Stand There, Do Something: The Straddle 146 v vi CHAPTER Contents Don’t Just Do Something, Stand There: The Strangle 168 CHAPTER 10 Hi-Yo, Yogi! Riding the Bear 188 CHAPTER 11 The King of Strategies: The Martian Ratio-Spread 207 CHAPTER 12 Every Once in a While: The Picador 226 CHAPTER 13 Pay Me after Lunch: The Endplay 238 CHAPTER 14 Filling in the Cracks: Ideas, Understanding, and Winning 252 APPENDIX A Studies of Historical Gross Movement in Selected Markets, 1990–2002 263 APPENDIX B Distribution of Contract Highs and Lows in Selected Markets, 1980–2002 280 Index 297 Preface here are thousands of books about trading Some books approach trading as an exercise in mathematics and focus on effective ways to turn the mathematics of the marketplace into a profit-generation machine Some approach trading as an exercise in psychology and tactics, attempting to generate profit from a correct understanding and appreciation of what the other traders in the market are doing Some are catalogues of strategies Some apply economic, statistical, or logical principles to trading in the marketplace Some are practical guides to the minutiae of markets This book either fits into none of those categories or is a mixture of all of them with several other topics included I’m not sure which What it is, at bottom, is my understanding of the whats, hows, and whys of earning a trading profit, acquired over 30 years of trading in all sorts of markets (all sorts— remind me to tell you sometime about the great caviar-for-condoms caper) I didn’t become a steadily profitable trader until I came to understand some of the assumptions and conditions that underlie markets and to figure out certain practical and usually effective ways to combat the assorted risks that markets present; in short, to learn to deal effectively with the nature of the beast This book is informal, because I’m an informal guy There’s almost nothing I like better than talking with other traders about trading, and so the text is written in a generally conversational style We will crunch a few numbers on occasion, to clarify various topics and as an aid in looking at practical examples of trading, but there are no formal mathematical demonstrations at all in this book for two very good reasons First, a number of fine analysts and remarkable scholars have published extensive compilations of the mathematics involved in quantitative analysis, numerical methods, and risk and price modeling, and there’s no point whatever in even attempting to replicate their efforts A motto of mine is, “Always go to the best source available,” which is usually the original author Who wants to read a rewrite of someone else’s work, anyway, particularly a very good original work? Can you even imagine Hamlet as rewritten by, say, Danielle Steele? Ghastly thought T vii viii Preface Second, a whole lot of people (possibly including you) find formal mathematics either mind-numbingly boring, or impenetrable, or both Cards on the table, I want you to turn the next page, not fall asleep or use the book to stoke up your barbecue To this end, I figure that, in addition to providing what I believe to be useful and in the best cases profitable information, the text had darned well better be entertaining too This book is for traders, particularly retail traders That’s easy to say but tricky to accomplish, because the level of experience varies greatly among any group of traders This is not a primer I’m assuming first of all that you trade in some market, and that your principal interest is to look at ways to improve the profitability of your trading In addition, I’m assuming that you are moderately familiar with what a futures market is and with its basic workings, and that you are at least comfortable with the idea of options, even if you believe you’ve never traded an option in your life You have dealt in options, of course; you very likely deal in them implicitly every single day of your life but we’ll get into that subject a little later Don’t believe it? Care to bet against it? Read on, and save your money If you know the difference between a put and a call, and know what a premium, a striking price, and an expiration date are, you’ll have no difficulty with the text If you’re a sophisticated and experienced trader in futures and options markets, you’ll doubtless find some of the text to be elementary, even possibly annoyingly so Sorry about that, but this result happens to be a condition of contest when writing for a wide (I sincerely hope!) audience about the subject of trading Frankly, I think that any trader, no matter how sophisticated, will find a number of worthwhile ideas inside but there’s only one way to find out, isn’t there? Few books are the product of any single person’s thoughts and efforts, and most certainly this one is not It literally would not even have been written without the encouragement of Alex McCallum of INO, and without his introduction to my generous (and patient!) editors, Pamela van Giessen and Lara Murphy, at John Wiley & Sons I also owe a considerable debt to Jay Shartsis and Bob McKenna at R F Lafferty & Co., for the enormous amount of practical advice they’ve offered, and explained, over the years Many traders, including especially David H Murray, Elaine Long Knuth, Janet diGregorio, John Anderson, and Mark Kelly were kind enough to read my original drafts, offer a variety of valuable suggestions, and point out and correct several instances where I had driven neatly off a literary cliff Dan Reinhart, a marvelous statistician (among his other considerable talents), was gracious enough to check over the analyses in the text and correct several that I had fluffed Thank you, Danimal Preface ix Even though my principal business is the design of computer systems, I’m an absolute idiot when the subject is graphics, and I’m fortunate to have a very talented friend to bail me out of my fumblethumbedness The tables and figures in the text were produced by the ultimate sweetheart, Lee Fleming, one of the masterminds behind InfoPulse LLC (www.infopulsellc.com), of Norwalk, Connecticut My long-time futures broker, Ken Margherio at REFCO, Inc., has contributed mightily to this little effort by applying his 30-plus years of experience to helping refine some of the strategies discussed in the later chapters Mark Kinoff, a local trader at the Chicago Board of Trade, offered several creative ideas about useful tactics in interest rate markets The noted currency analyst and author, Barbara Rockefeller, was extremely generous, both in offering constructive criticism and in introducing me to a bunch of folks who could, and did, clarify a number of points I also want to thank Ed Rittershausen for taking his time to make several excellent and practical suggestions In theory at least, we learn from our mistakes I know for a certainty I’ve learned much more from my errors in trading than from my successes Books about trading or investing that focus on the author’s successes, usually with at least an implied “Hey, look how wonderful this method (or this author) is!”, exasperate me no end Look, I already know how to win; what I want to know is how not to lose Consistent with this view, the examples of actual or hypothetical trades throughout the text are generally negative examples— demonstrating what to if a trade goes awry, how to deal with unanticipated risk, and even, occasionally, how to turn a loss back into a profit After all, if a trade goes well, it goes well, we bank the profit, and there’s little more to be said about it, right? There just isn’t much value in yammering on about a wonderful trade I made last year or last month, and I want to provide as much value to you as I can manage I’m just a trader, a part-time trader at that I realize that there are numerous ways to profit in trading Unfortunately, there are a much larger number of ways to lose Many of these losing methods are superficially appealing and seem to offer an advantage to traders, but turn out ultimately to be only expensive illusions Larry McMillan, the inestimable author of, among his other works, Options as a Strategic Investment (New York Institute of Finance 1993), states on page 467 of the third edition, “There are certain investors who will enter positions only when the historical percentages are on their side.” He is exactly right, as usual, and his statement applies with equal validity to traders as well as investors I’m one of those traders and, by George, I will have an advantage Whether the advantage is historical, statistical, or 292 TRADING OPTIONS TO WIN CBT Soybean Meal (SM) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec F Hi Lo 4 2 3 1 1 3 H Hi Lo 0 2 3 0 2 K Hi Lo 0 4 2 0 2 1 N Hi Lo 0 1 2 1 1 Q Hi Lo 0 1 1 2 2 1 U Hi Lo 0 1 0 1 4 4 1 V Hi Lo 0 1 3 1 2 Z Hi Lo 2 2 1 2 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec CBT Soybeans (S) F Hi Lo 3 2 1 2 0 2 H Hi Lo 2 5 1 3 1 0 2 0 K Hi Lo 1 0 2 0 N Hi Lo 1 0 4 0 0 Q Hi Lo 0 0 2 0 U Hi Lo 1 0 3 2 X Hi Lo 0 2 0 3 0 293 Contract Highs and Lows in Selected Markets, 1980–2002 NYBOT Sugar #11 (SB) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec H Hi Lo 0 0 1 2 K Hi Lo 1 4 0 1 N Hi Lo 1 2 3 0 1 1 V Hi Lo 2 2 2 1 2 5 CME/IMM Swiss Franc (SF) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec H Hi Lo 2 2 2 1 2 1 1 M Hi Lo 2 1 1 2 3 U Hi Lo 2 0 2 0 4 Z Hi Lo 10 1 1 0 3 2 CBT U.S Treasury 10-Year Notes (TY) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec H Hi Lo 2 5 1 1 1 1 M Hi Lo 1 4 3 1 U Hi Lo 0 2 1 3 2 Z Hi Lo 3 0 1 0 3 294 TRADING OPTIONS TO WIN CBT U.S Treasury 30-Year Bonds (US) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec H Hi Lo 1 2 0 0 2 1 M Hi Lo 1 1 1 2 1 U Hi Lo 1 1 2 1 1 7 Z Hi Lo 4 1 0 1 2 NYMEX RFG II Unleaded Gasoline (HU) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec F Hi Lo 0 2 0 1 2 G Hi Lo 0 1 1 2 0 0 2 0 H Hi Lo 4 0 1 1 2 0 0 2 0 J Hi Lo 2 0 2 1 0 2 0 K Hi Lo 2 2 0 1 1 2 0 M Hi Lo 1 0 3 2 0 N Hi Lo 2 0 1 0 3 0 Q Hi Lo 3 2 0 1 2 1 0 U Hi Lo 3 2 0 1 0 V Hi Lo 1 1 2 1 0 2 0 X Hi Lo 1 0 2 0 Z Hi Lo 1 1 2 0 2 0 295 Contract Highs and Lows in Selected Markets, 1980–2002 CBT Soft Red Winter Wheat (W) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec H Hi Lo 5 1 2 0 0 0 K Hi Lo 2 10 0 0 0 N Hi Lo 2 1 2 1 8 0 U Hi Lo 2 1 1 0 3 1 Z Hi Lo 2 1 3 0 2 4 KCBT Hard Red Winter Wheat (KW) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec H Hi Lo 3 3 0 1 1 K Hi Lo 1 3 4 4 0 1 0 N Hi Lo 2 0 2 1 U Hi Lo 1 1 3 5 3 1 Z Hi Lo 2 1 2 2 Index Illustration and table page references are italic accidental counterparty risk, 30 actual market value, 58 advantage, gambling and, Against the Gods: The Remarkable Story of Risk, 236 agricultural markets, 113 analysis, of seasonal trades, 101–102 analysts, 90–91 arbitrage, 46, 83, 139–141 Arthur Andersen, 42 asset allocation, capacity risk and, 32–33 asset profitability curve, 47, 48 at-the-money (ATM) straddle, 148–149, 150–151 Australian dollar distribution study of, 282 historical gross movement study of, 265 Bachelier, Louis, 66–67 banking, 16–20 bank runs, 19 Barrymore, Ethel, 262 Baruch, Bernard, 210–211 basket products, 38 bear markets vs bull markets, 226 preconditions for entering, 191–192 strategies for, 188–206 bearish put spread, 228 Beat the Dealer, 238 Bernstein, Peter, 236 betting, proposition, 3–4 bid-ask risk, 24 bid-ask spread, 8, 9, 48 Black, Fischer, 35 Black Monday, 14–15, 18, 82–83 Black-Scholes-Merton model, 73 Bohl, Bernie, 97 bond indenture, 39, 40 bond markets, 32, 39 information risk and, 27 bookie, bookie strategy, 253 bookmakers, definition of, bookmaking, 7–16 counterparty risk and, 10–12 vs gambling, 9–10 British pound distribution study of, 282 historical gross movement study of, 265 brokers, 30–31 Brown, Robert, 66 Brownian motion, 66 bull market causes of, 226–227 parabolic, 229–231 runaway, 226–237 strategies for, 207–225 vs bear markets, 226 calendar spread, 140 call option, 48–49, 77 Canadian dollar distribution study of, 282 historical gross movement study of, 266 roll-out defense and, 133 297 298 capacity risk, 31–34 banking and, 18 capital and, 49–50 definition of, 15 “gambler’s ruin,” 32 leverage and, 15–16 reduction of, 33–34, 74–75 capital capacity risk and, 49–50 efficient use of, 32 management of, 92–93 protecting, 123 capital usage per trade, 114 Caplan, David, 96, 146 Capra, Frank, 19 cattle, feeder distribution study of, 286 historical gross movement study of, 269 cattle, live distribution study of, 288 historical gross movement study of, 271 Chicago Board Options Exchange (CBOE), 14–15 as bookmaker, Chicago Board of Trade (CBOT), 224 Chicago Mercantile Exchange (CME), 15, 146 PC-SPAN®, 92 SPAN® and, 35–36 Citibank, 20 cocoa ride-the-bear strategy in, 194–197 distribution study of, 283 historical gross movement study of, 266 coffee distribution study of, 283 historical gross movement study of, 267 risk period of, 119 seasonal sell study of, 120 statistical volatility of, 60 suicide season of, 156 Consolidated Chaos, 259–260 contest risk, 49 Index illustration of, 45, 46 margin trading and, 35 reduction of, 48–51 slippage and, 23 straddle and, 168 trading and, 23–24 copper distribution study of, 283 historical gross movement study of, 267 statistical volatility of, 60 corn distribution study of, 284 historical gross movement study of, 268 risk periods of, 119 corrections, 101 cotton distribution study of, 284 historical gross movement study of, 268 counterparty risk accidental, 30 banking and, 17–20 bookmaking and, 10–12 brokers and, 30–31 definition of, fraud, 30–31 insurance and, 11–12 Internet and, 30–31 trading and, 29–31 countertrend moves, 101 coupons, as options, 77 Cox-Ross-Rubenstein model, 108 criteria for endplay trades, 244–245 for non-seasonal trades, 109–113 for ratio-spread application, 213–214 for riding the bear, 191–192 for roll-out or flip defense, 134 for straddles, 173–174 crude oil, 103, 209, 246 distribution study of, 285 historical gross movement study of, 269 cumulative normal density function, 53 Index currencies, national, 83 currency markets, 113, 227 data analysis, tools for, 91–92 databases, 90 debit put spread, 228 decimalization of prices, defense bear market strategies, 202–203 bull market strategies, 223 delta/gamma-neutral, 140 diagonal, 140 endplay strategies, 246–247 flip, 133–139 hedge, 123–132 market conditions and, 138 mini-bull strategies, 233–234 move-the-goalpost, 141–143 parabolic bull market strategies, 229–231 ratio-spread, 218–220, 223 roll-out, 133–139 runaway bull market strategies, 235–236 spread trading, 139–141 straddle, 160–164 strangle, 168, 171–189 types of, 123 deferred bid-ask spread, delta, 60, 62–63 delta/gamma-neutral defense, 140 derivatives, 34 diagonal defense, 140 Diamonds, 38 Disraeli, Benjamin, 39 distribution curves, 51–53, 52, 53 distribution study, market highs and lows, 280–281, 282–295 diversification, of trading positions, 50 Dow Jones Industrial Average, 14 Dunbar, Nicholas, 117 electronic trading, El Toro Grande, 227–231 endplay strategy, 238–251 preconditions for, 244–245 299 energy markets endplay strategy in, 241–244 event risk in, 106 Enron, 43 entry conditions See preconditions event risk, 40–43 banking and, 18–20 bookmaking and, 12–15 energy markets and, 106 gambling and, 5–7 governmental, 38–40 non-seasonal trading and, 115–116 regulations and, 12 self-induced, 19–20 stock markets and, 82, 258 exchanges counterparty risk and, 10–11 event risk and, 14 fraud and, 11 expectation approximating, 51–54 calculation of, 46 definition of, 45, 46 examples of, 55, 56, 107 model of, 51–54 options and, 45–70 risk and, 115 expectation tables, values of, 54, 55, 56 expiration dates, 28 experts, 93–94 trading and, 87–88 fadeaway strategy, 252 fair value, 57, 58 Federal Reserve, 15 purpose of, 19 Federal Reserve Regulation T, 92–93 financial media, 27 flexibility, trading and, 47–48 flip defense, 133–139 preconditions for, 134 Fly-By-Night Trading Partners, 259 Food and Drug Administration (FDA), 157 forecasting, 100 forex markets, 83, 215 300 forum.ino.com, 210 fraud in banking, 17–18 in insurance, 11 trading and, 30–31 free market, definition of, 36–37 futures, single-stock, 38 futures contracts, late-in-life, 80 futures markets capital requirements of, 35 event risk and, 41–43 governmental risk and, 39–40 information risk and, 27 leverage in, 32, 35–36 myths about, 85–87 purpose of, 86 symmetry of, 37, 38 futures options, bid-ask spreads in, 48 futures trading, SPAN® and, 35–36, 37 “gambler’s ruin,” 32 gambling, 3–7, 9–10 event risk and, 5–6 games, 1–2 game theory, trading and, 24, 86 gasoline, unleaded distribution study of, 294 expectation of writing, 107 historical gross movement study of, 278 seasonal buy study of, 103 GLOBEX®, 83 goalpost defense See move-thegoalpost defense gold, 83, 119 distribution study of, 286 good will, risk and, governmental event risk, 38–40 heating oil, 58, 246 distribution study of, 287 historical gross movement study of, 270 non-seasonal strategy and, 117–118 hedge, 123–132 definition of, 123 principles of, 128, 129 Index historical databases, 90 historical gross movement, studies of, 263–264, 265–279 historical volatility (HV), 55 hogs, live/lean distribution study of, 288 historical gross movement study of, 272 statistical volatility of, 61 hype, 64–70 illiquidity See liquidity implied volatility (IV), 58–63 delta and, 60, 62–63 inflation of, 220–222 indenture, 39, 40 indexes, safety of, 82 inflation risk, 40 information current, 90–91 effects on trading of, 25–26 evaluation of, 25 historical, 90 impact of, 256–257 requirements, 90–99 information risk, 24–28 hard data and, 27 non-seasonal trades and, 111 options trading and, 71–88 reduction of, 26–27 initial risks, 46–47 insurance companies as bookmakers, 7, reinsurance of risk by, 14 securitization of risk by, 14 insurance counterparty risk and, 11–12 event risks of, 13–14 fraud and, 11 profit possibilities of, 9–10 spread and, interest-rate markets, 113, 226–227 interest rates, 76 interest rate spread, 17 interim dollar risk, 115–116 Internet as information source, 91 Index 301 as training source, 96–97 use of, 30–31 Inventing Money, 117 investing, vs trading, 22 It’s a Wonderful Life, 19 loss limit, risk and, 29 lumber distribution study of, 289 historical gross movement study of, 272 Japanese yen, 83–84 distribution study of, 287 historical gross movement study of, 271 seasonal buy study of, 181 margin definition of, 35 minimum, 50 margin account, 34–35 margining policy, 50 margin requirement, 33–34, 204 setting, 50–51 margin traders, contest risk and, 35 market definition of, 190 conditions, defense and, 138 discontinuities, 73–74 equilibrium, 161 market makers, 8, 9, 224 market report, straddle and, 162–164 markets asymmetry of, 36–38 futures, 188–206 governmental event risk and, 38–40 leverage and, 34–36 minimum value of, 189 movement of, 152–154, 153 news vacuums and, 239–240 orange juice, 152–154, 153 retail, 23 seasonal tendencies of, 101 selecting, 34–36 strangle and, 176–178 volatility, 55–64 market value, 58 Martian ratio-spread strategy See bull market strategies McDonough, William, 33 McMillan, Larry, 57, 67, 78, 96, 146, 221 McMillan on Options, 96 media, financial, 27 Merrill Lynch, 14 Merton, Robert, 35, 73 methodology subjectivity of, 72 technical, 89 knowledge risk, 28–29, 108 late-in-life futures contracts, 80 LEAPS, 33, 96 Lehrer, Tom, 72 leverage availability of, 34–36, 37 capacity risk and, 15–16, 31–32 calculating, 34 markets and, 32 maximizing, 33 liquidity, 8, 17, 19, 48, 136 bid-ask spreads and, 48 bond options and, 41 content risk and, 23, 24 Long-Term Capital Management and, 33 straddles and, 150 loans default and, 16–17 “five Cs” of, 17–18 as options, 76–77 sovereign, 20 lognormal distribution curve, 52–54, 53, 57–58 lognormal model, application of, 108 long position notice period, 80–81 Long-Term Capital Management (LTCM), 33, 73, 83–84, 117 loss external factors and, 5–6 gambling and, 4–5 illustration of, 45, 46 probability of, self-induced, 5–6 302 methodology, (cont.) of trading, 89–99 Microsoft Corporation, 39 mini-bull market, 231–234 minimum value, 189 models bear markets and, 203–206 failure risk of, 75, 113 future price distribution, 72, 73 market discontinuities and, 73–74 myths about, 72–76 purpose of, 73 money, 2–3 gambling and, 3–7 moneylending, “five Cs” of, 17–18 money supply, event risk and, 18–19 Moore, Stephen, 91 Moore Research, Inc., 91 move-the-goalpost defense examples of, 142–143 types of, 141 movement, studies of, 263–264, 265–279 myths about models, 72–76 about options, 76–78 about unlimited risk, 78–80 about wealth creation, 85–87 naked options, risks of, 78–80 Natenberg, Sheldon, 78, 96, 186 national currencies, 83 natural gas distribution study of, 289 historical gross movement study of, 272 margin requirements and, 243–244 seasonal sell study of, 177 networking, 93–94 New York Federal Reserve Bank, 33 New York Stock Exchange (NYSE), as bookmaker, news vacuums, 239–240 non-seasonal strategy, 102–121, 171–189 example of, 102–106 model failure risk and, 113 volatility and, 116 Index non-seasonal tendency, 102 non-seasonal trades criteria for, 109–113 examples of, 265–279 exiting, 117 normal distribution, expectation and, 51–52, 52 NYMEX energy markets, 119 oats distribution study of, 290 historical gross margin study of, 274 offensive strategies, spread, 139–141 one-tick rule, 242 opportunities, evaluation of, 255 option, definition of, 76 option prices, time and, 97 Optionetics, 98 Option Pricing and Volatility, 186 options expiration dates of, 28 flexibility and, 47–48 hedging with, 125–127 loans as, 76–77 myths about, 76–78 naked, 78–80 types of, 76–78 Options as a Strategic Investment, 67, 96 options exchanges, market maker functions and, options markets, risk reduction and, 41 option strikes, ratio spreads and, 216–218 options trading evaluation of, 45–70 profit possibilities in, Options Volatility and Pricing, 96 option-writing strategies, 100–145 orange juice distribution study of, 290 gross movement of, 153 historical gross movement study of, 273 May 1, 2002 snapshot of, 159 straddle and, 158–160, 159 303 Index orders changing, 154–155 ratio-spread and, 224 overvaluation, 207 PC-SPAN®, 92–93 perceived advantage, gambling and, perceived risks, in bookmaking, 10 performance bond, futures markets and, 35 permanent strangle, 182–186, 252 Philip Morris, 42–43 physical futures markets bear markets and, 188–206 shortages and, 227–231 Picador strategy, 227–231 Pinnacle Data, 90 Pit Bull, 87 Poincaré, Jules–Henri, 66 policyholders, as gamblers, 10 portfolio insurance model, 73 portfolio margining, 35–36, 92–93 position size, 144–145 preconditions for bear market strategies, 194–195 for endplay strategies, 244–248 for mini-bull market strategies, 231–234 for parabolic bull market strategies, 229 for ratio-spread strategies, 213–214 price, movement of, 157–158 prices, information and, 256–257 price discovery, 189, 190–191 price distribution model, application of, 54–55 price inelasticity of demand, gasoline and, 105 pricing models of, 51–54 volatility of, 238–239 profit bookmaking and, gambling and, 4–5, illustration of, 45, 46 principles of, 21 spread and, 7, profitability discipline and, 122 strategies for, 146–167 threats to, 197–199 profitability curve, 47–48, 48 profit expectation gambling and, risk and, 5–6 proposition betting, 3–4 pure assets, 47–48 put spread, 228 QQQs, 38 quadratic models, 108 randomness, options and, 256–258 ratio-spread strategy bull markets and, 208–210 mini-bull markets and, 232–233 parabolic bull markets and, 229–230 preconditions for, 213–214 recommendations, for training, 94–97 REFCO, Inc., 90, 224 Regulation T, 34, 92–93 regulatory risk, 12 banking and, 18 definition of, 14 reinsurance, definition of, 14 replacement cost, as counterparty risk, 11 retail markets, pricing in, 23 return on capital (ROC), 70 margin requirements and, 114 non-seasonal trades and, 114–115 strangle and, 172–173 R F Lafferty & Co., 146 risk accidental counterparty, 30 avoidance of, 21, 32–33 in banking, 16–20 bid-ask, 24 capacity, 15–16, 31–34, 74–75 collateralization of, 16–17 contest, 23–24 counterparty, 6–7, 10–12, 17–20, 29–31 event, 5–7, 12–15, 18–19, 40–43 304 risk, (cont.) endplay strategies and, 240–241 gambling and, 5–7 governmental, 38–40 good will and, hedging and, 123–132 inflation, 40 information, 24–28, 71–88 insurance against, 9–10 interim dollar, 115–116 knowledge, 28–29 loss limit and, 27 mini-bull markets and, 235 model failure, 113 myth of unlimited, 78–80 options and, 258 perceived, 10 position and, 79 reduction, 41, 48–51 regulatory, 12, 18 reinsurance and, 14 self-induced, 19–20 securitization of, 14 slippage, 24 SPAN® and, 35–36, 37 structural, 40 taxation, 40 trading, 22–44, 46–47 unlimited, 78–80 volatility and, 121 weather, 40–41 wiggle, 29, 115–116 ROC See return on capital Rockefeller, Barbara, 215 roll-out defense, 133–139 vs flip defense, 138 preconditions for, 134 roll-out strategy, 193–194 Roth, Harrison, 33–34, 96 Rothschild, Baron Edmond de, 211 Rubenstein, Mark, 73 Rubenstein-Leland model, 73 runaway bull market defense in, 235–236 See also bull market runaway parabolic market, 227–231 Index seasonal analysis, straddle and, 155–157 seasonal buy study, 103 seasonal sell study, 120 seasonal trade, example of, 102–108, 103 serial months, 192, 193–194 Salomon Smith Barney, 90 Samuelson, Paul, 66–67 Scholes, Myron, 35, 73 Schwartz, Marty, 22, 87 securitization, 14 selling short, 38 Shartsis, Jay, 146 short-dated options, theta and, 108 short positions, 81 silver, 126, 222–223 distribution study of, 291 historical gross movement study of, 270, 274 single-stock futures, 38, 92–93 skill, definition of, slippage, 24 definition of, 23 sovereign loans, 20 soybean meal distribution study of, 292 historical gross movement study of, 275 soybean oil distribution study of, 291 historical gross movement study of, 275 soybeans distribution study of, 292 historical gross movement study of, 276 risk periods of, 119 SPAN® (Standard Portfolio Analysis of Risk®), 35–36 bear markets and, 204 SPDRs, 38 specialists, 8, sports bookmaking, 8, counterparty risks and, 10 event risk and, 13 305 Index spread, 139–141 bookmaking and, bid-ask, 8, deferred bid-ask, definition of, 139 insurance companies and, interest rate, 17 spreadsheets, 91–92 square root of time calculation, 67 Standard & Poor’s 500 Index (S&P 500), 15 Standard Portfolio Analysis of Risk® See SPAN® statistical volatility (SV), 55–64 calculating, 57 illustrations of, 60, 61, 62 step-in strangle, 179–182 straddle, 146–167, 168–171, 170, 263 ATM December markets and, 169, 170 defense of, 160–164 definition of, 147 preconditions for, 173–174 strangle, 168, 171–189, 239–293 permanent, 183–186, 252 strategy bookie, 253 bear market, 189–206 bull market, 207–225 defensive, 122–145 endplay, 238–251 evaluation of, 254 fadeaway, 252 flip defense, 134 gambling, 3–4 hedge, 127–128 Martian ratio-spread, 209–225 move-the-goalpost, 141–142 non-seasonal, 102–121, 171–189 parabolic bull market, 229–231 permanent strangle, 182–186 Picador, 227–231 ratio-spread, 208–210 roll-out defense, 134, 193–194 seasonally based, 101–121 straddle, 146–167 strangle, 168, 171–189 “Voice From the Tomb, The,” 101 stock indexes, naked put options and, 82 stock markets, asymmetry and, 82 event risk and, 41–43, 258 governmental risk and, 39 information risk and, 27 leverage and, 32 myths about, 85–87 stock options, long-term, 33–34 structural risk, 40 sub-event, 5–6 sugar distribution study of, 293 historical gross movement study of, 276 suicide seasonal, 118–119 straddle and, 155–157 SV (statistical volatility) , 55–64 calculating, 57 illustrations of, 60, 61, 62 Swiss franc distribution study of, 293 historical gross movement study of, 277 statistical volatility of, 62 taxation risk, 40 technical methodology, 89 theoretical fair value, 57, 58 theta, 108, 164, 190 Thorp, Edward O., 238 time, 97–98 time premiums, 201 time spread, 140 time-spread defense, 246 time value of money, 76 timing, 117 bull markets and, 207 defense and, 143–144 mini-bull markets and, 232–233 Toro poco markets See mini-bull market Trade Like a Bookie, 96 306 trade, definition of, 22 trading “at the market,” 23 experts and, 87–88 flexibility and, 47–48 fraud in, 30–31 as game playing, hype and, 64–70 information risk and, 24–28, 71–88 initial risks of, 46–47 vs investing, 22 mechanical errors in, 30 methodology, 22–44 principles of, 21 risk profile of, 22–44 risk reduction and, 46–47, 48–51 risk events and, 14–15 success factors of, 43–44 tools for, 89–99 time and, training and, 94–97 training, 94–97 Treasury markets bonds, statistical volatility of, 61 10-Year Notes, distribution study of, 293 10-Year Notes, historical gross movement study of, 277 30-Year Bonds, distribution study of, 294 30-Year Bonds, historical gross movement study of, 278 trigger event, 192, 199 Index unleaded gasoline distribution study of, 294 expectation of writing, 107 historical gross movement study of, 278 seasonal buy study of, 103 “Voice From the Tomb, The,” 101 volatility, 55–64, 60, 61, 62 bear markets and, 204 bull markets and, 209 calculating, 57 causes of, 238–239 implied (IV), 58–63 profit opportunities and, 59 straddle and, 154–157 strangle and, 175–178 wagering games, rules of, 1–2 wealth creation, myths about, 85–87 Whaley quadratic model, 108 wiggle risk, 29, 115–116 wheat distribution study of, 279 historical gross movement study of, 279 Wriston, Walter, 20 WorldCom, 43 ... Certain people apparently cannot resist an opportunity to attempt to swindle other people, and large profitable companies seem to be an irresistible target for these lowlifes Another major part... infrequent profit well out of proportion to his stake, his capital The high-skill gambler attempts to earn a profit generally proportionate to his capital over a healthy majority of (usually varied) propositions... Cataloging-in-Publication Data: Johnston, S A Trading options to win : profitable strategies and tactics for any trader / S A Johnston p cm ISBN 0-471-22685-8 (alk paper) Stock options I Title