OPTIONS ON FUTURES

Prepared by Salomon Smith Barney

(January 2001) As we progress through the year, implied volatility levels for many option markets remain rich. For example, coffee and sugar option volatilities are trading above their 75th percentiles. Coffee prices continue to trend downward, while sugar has staged a sharp rebound towards 9 cents, after basing in the 5-cent area during February-March 2000. Cocoa prices remain in a sustained downtrend with implied volatility above its 90th percentile. High option volatility for these contracts may be a function of low price levels for the respective commodities. In fact, if prices were to rally, we would see significant advances in terms of percentage price moves. In such a scenario, option-writing strategies, including spreads and covered writes, would have good appeal.

Grain and oilseed implied volatilities have begun their seasonal rise, after making their lows during the winter. In the second half of last year, these markets had experienced a sharp decline from that summer's July peak. Seasonal trends call for a peak in implied volatility in July/August. We still recommend long combinations to take advantage of potential weather problems this summer. Historically, option-writing strategies have been attractive during the fall.

The dollar has remained strong against most currencies, but has started to show some signs of weakness, particularly against the EuroFX. Recent EuroFX strength may be setting the stage for a more significant dollar correction later in the year. With implied option volatility relatively rich, EuroFX bull spreads appear most attractive.

Implied volatility in the energy complex has remained in a high-level trading range, after declining from a spike in the winter of 1998. Option volatility levels for crude oil, gasoline, heating oil and natural gas are currently around the 75th percentiles. With crude prices trading at the upper end of OPEC's $22-28 target range, a sustained advance from that range seems unlikely. Looking for a price correction to the current rally and given the rich premium levels, bear spreads look attractive.

Metals markets have not been able to sustain rallies. Gold rallied into early February, but spent the following period trading lower. Silver and copper traded in depressed and narrow ranges. Option premiums reflect the recent action in these markets, with volatility running below long-term medians in both silver and copper. Volatilities for gold options remain relatively high. We recommend bull spreads on gold options and favor buying calls on silver and copper options.

Large price declines were the story in NASDAQ stocks in early 2000. Weakness was also evident in the rest of the equity markets, although it was not as pronounced. Option implied volatility spiked to a new high for the year during the week of April 10, when the S&P 500 made its recent low, doubling the January volatility levels. In stocks, volatility remains directional, increasing when prices trade sharply lower. Volatility levels are back to long-term averages.

In the Treasury market, the news of note has been the move from the 30-year T-bond to the 10-year T-note as the benchmark. Daily volume in the 30-year bond options is still about 50% higher than for the 10-year T-note. Yet, open interest, which has been about 50% higher for the 30-year T-bond than for the 10-year T-note in the early part of this year, is currently about equal. This year, the CBOT introduced 10-year agency debt options. We favor buying volatility in the interest rate contracts, where volatilities are running about average levels.

January 2001

Carmen Kneopffler and Paul Fine

Salomon Smith Barney

388 Greenwich Street, New York, New York

212-723-5444

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