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Financial Option Markets
Bonds Rally Strongly At The End Of April
On Surprising Weak Economic Reports
After holding their long-term support near 107, bonds jumped over 2 full points on the last 2 days of April, when economic reports indicated slower growth with no dramatic inflation, adding stability to the bond market.
We had previously recommended taking profits on our bearish bond put spreads; April's economic data confirmed the likelihood that interest rates have seen a top for the time being. With the first quarter employment coming in lower than expected and the durable goods orders down, the bonds rallied as fears of tightening eased. The June Fed funds contract, which anticipates Fed actions, is now indicating about a 50% anticipation for a Fed tightening at the May 20th FOMC meeting, versus 75% last week. "Retail sales--the trend will be more moderate in coming months...Industrial production-- gains will remain robust before fading...Building activity will lose vigor and may well decline in 1998...No sustained pickup in inflation in the offing...disinflation will remain the theme for the next two years...Interest rates...will be considerably lower twelve months from now." Industry Forecast, the Jerome Levy Economic Institute, April 21.
Our NOPS in the bond market are working very well in this environment, with the outlook for interest rates now more neutral.
We recommend "wide" NOPS in the December bonds now. In the December bonds, sell the 116 call and 100 put at about $900. The likelihood of the futures being in the predicted range of 100-116 at option expiration is 91%; margin is about $800, with return on margin over 100% if this range holds until option expiration in 28 weeks. The daily effect of time decay is $8.13. Adjust this trade on closes above 112 or below 104, basis December.
Put Ratio Credit Spreads Recommended;
Bond Strength Bullish For Stocks
We recommended these put ratio credit spreads mid-April in the S&P market to take advantage of high option premium for out of the money puts and the bullish technical pattern.
We now continue to recommend the put ratio credit spread of buying (1) June 700 put and selling (1) 690 put and (2) 670 puts for a credit of about 200 points ($1,000). Margin is about, $1,500 with a return on margin almost 70% in 7 weeks until the option expiration. Use the following risk plan on this trade: on a decline below the lows at 758 in the June S&P, close both short 670 puts, holding the bear put spread. Use one position per $10,000 of excess account margin. This position has a statistical probability of profit of over 90% at expiration, based on futures volatility; that is the likelihood of the futures being above the break-even level (below 665, more than 10% and 12,000 points below current levels).
To collect even more premium, we also recommend the slightly more aggressive put ratio spread of buying (1) June 730 put and selling (1) 720 put and (2) 700 puts for a credit of about $2,000. Margin is about $4000, with return on margin more than 50% in 7 weeks. We will use the same risk plan on this trade: on a decline below the lows at 758 in the June S&P, close both short 700 puts, holding the remaining bear put spread.
Yen Continues In Major Downtrend;
Use Bearish Free Option Position
The yen started the mouth of April with a dramatic rise, then proceeded to sell off again to new lows, continuing the major downtrend. The G-7 meeting provided no support to stop the slide in the yen and fundamentals are also too weak to expect any significant rally in this currency."The G-7 pretty much left the yen to its own devices and without a voice of concern over their trade deficit few should be interested in being long yen," The Hightower Report, April 28.
In the December Japanese Yen, we recommend the free option position of buying the 80 put and selling the 78 put and 87 call for about even money. This position has a potential of $2500 (less fees and commissions); the likelihood of the futures being in the range of profit below 87 at option expiration is 91%. The margin is about $900. We would recommend risking $300 as your "stop-out" point or a. close above 84 in the December Japanese Yen."
September Copper At Top Of Trading Range;
Signs Of Economic Slowdown May Limit
Upside Potential "Wide" Neutrals Are Recommended
The copper market continued in its trading range. We will maintain our "neutral" stance until the market "tells us" that it has established a new direction.
In September copper, we recommend the neutral option position of selling the 118 call and 98 put for about $750. The likelihood of the futures being in the predicted range of 98-118 at option expiration is 66%; margin is about $750, with return on margin about 100%, if this range holds until option expiration in 17 weeks, The daily effect of time decay is $7.64. We would adjust this position on closes below 102 or above 114 in September copper.
Seasonal Pullbacks Plus Fundamentally Bullish
Market Equals Good Opportunities To Initiate
Bullish Strategies In Major Trend
The grains underwent normal seasonal consolidation and volatility during April, with underlying bullish supply/demand fundamentals providing support.
July soybeans again reached their previous highs, with new-crop beans holding in spite of continuing pressure from potential for new-crop production. Any new problems would be very bullish for November beans.
Corn is finding support at the bottom of its two-month trading range with continuous strong demand evident. "...the corn market should experience a period of extreme tightness as supplies dwindle into summer..." C.I.S. Price Perceptions.
Wheat was the star of the month, rallying dramatically in the new- crop contracts as freezes, strong demand, and planting problems drove this market higher, benefitting our bullish option backspread strategies recommended before the rally. "...It appears the market made a mistake...It focused on production when it should have been dwelling on world demand trends." C.I.S. Price Perceptions.
"...Demand is getting greater every day. China takes large chunks of that arable land and places apartment buildings on them for the new batch of one million two hundred thousand people. You are looking at the beginnings of the greatest bull markets in the history of the world..." Bob McGovern's Commodity Futures Spreads, April 26.
We've seen the "explosive" potential in grain markets with these fundamentals in years past, and we recommend using pullbacks to initiate the following bullish strategies:
We recommend free option position in November soybeans of buying the November beans $8.00 call and selling the $9.00 call and $6.00 put at near even money and which has a profit potential of nearly $5,000 on a margin of about $800. The probability of being in the profit zone above the short put at $6.00 is 78%. With about 6 months until the option expiration, this will give plenty of time to take advantage of a potential major move in the bean market. We will close this position on a move below $6.75 in November beans, below the important lows in early February.
In December com, we recommend the free option position of buying the $3.00 call and selling the $3.40 call and $2.50 put at near even money. This trade has a profit potential of about $2,000 (less fees and commissions) and has over 6 months until option expiration. The probability of being above $2.50 at expiration is 75%. The margin on this trade is about $400. We would close this trade on a move below $2.60 in December corn.
We also recommend the bullish option backspread in December corn, described in this month's "Option Strategy Corner."
Pushing To New Highs,
Long-Term Options Remain Very Cheap
The sugar market pushed to new highs in April, continuing the uptrend that started in January. Option volatility in the March 1998 contract is almost 30% lower than the July, and these options are near historic lows. We recommend purchasing the March 1998 sugar 11-cent call at about $500. Our objective will be to turn this into a free trade by selling a 14-cent call at the same price on a rally.
The Option Backspread
The "option backspread" is a strategy that takes advantage of both a directional move in the futures market and an increase in option volatility, which often accompanies a large market move. The potential profit on this position is unlimited, as you are long more options than short.
This position is often used by professional traders to take advantage of the increase in volatility for out-of-the-money options (premium disparity), that often occurs in accelerated market moves, which substantially increases the value of the multiple options that you own. (The "backspread" is the opposite of a "ratio spread," which is best used to take advantage of high option premium and premium disparity in a market that has already made a large move.)
When option volatility reaches historically low levels, we find that the market is often consolidating for a major move. The problem is in determining the exact timing. The backspread allows us to initiate a position that will take advantage of a move in the futures market and benefit from increasing volatility, while still being able to keep the potential loss very low. This is because the option we sell will provide protection if the market doesn't move within our expected time parameters.
The option backspread is initiated by purchasing 2 options and selling 1 option that is closer to the money. We normally attempt to initiate this at close to even money, or at a credit when possible. (When initiated at a credit, the position can even be profitable if the market moves against you.)
The best conditions for entering the "option backspread" are:
1. Low option volatility. (We have often discussed how low option volatility often occurs before large market moves.)
2. Likelihood of a large move in either direction (seasonal markets such as the grains, softs, and cattle provide some of the best opportunities).
3. A market where option volatility is subject to increase when trends occur, such as in the grains in the spring-summer time periods.
4. Markets where premium disparity (greater increase in volatility for the out-of-the-money options) occurs; out-of-the-money options in the grains, coffee, sugar, and S&P 500 often increase in value between 50-200% in big moves--this would greatly increase the value of the multiple options purchased!
5. Three months or more to option expiration (many of the positions we have recently recommended have more than 6 months to expiration). This allows enough time for the market to move. Also, our computer projection for loss in 60-90 days (the best time frame to reevaluate this strategy) is usually low--the cattle backspread recommended here has a computer projected maximum loss of less than $150 (plus commissions and fees) in this time period.
In summary, the benefits of the "option backspread" position when initiated under the circumstances recommended include: unlimited profit potential; ability to take advantage of both price and volatility increase, limited loss potential (in fact, the position can be profitable even if the market fails to move as expected, if option volatility increases).
Our current recommended option backspread positions are:
1. December Live Cattle--Buy (2) 66 puts, and sell (1) 70 put at about even money. Margin is about $200. Cattle meets every one of the criteria listed for the best backspreads--implied option volatility is at 3-year lows; it has risen during this time period from 50-100% in each of the last 3 years; and, with cattle near one-year highs, a decline from these levels would be very beneficial for the backspread, as cattle volatility rises even more on declines! (OptionVue analysis confirms that cattle volatility increases substantially on declines, in fact even more than the S&P 500.) Our analysts say this is caused by producers buying of puts to protect profits. We will close this trade if the market fails to make a move within about 90 days.
2. December Corn--Buy (2) 300 calls, and sell (1) 260 call for even money or better. Margin is about $200. Despite bullish supply/demand fundamentals, corn has pulled back due to good planting progress so far. However, with growing demand, any change from these "ideal" conditions could again put upward pressure on new-crop corn. Our maximum recommended hold time for this trade will be until about mid-July, leading into a time of normal seasonal rises in volatility in this market.
3. December Cotton--Buy (2) 80 calls. and sell (1) 75 call at about even money. Margin is about $300. With implied volatility near 3- year lows, and possibilities for a rally based on technicals and fundamentals, this market is well suited to the backspread strategy. From Bob McGovern's Commodity Futures Spreads, April 26: "I expect the new-crop December cotton to be a short acreage crop, since many planting intentions are to plant soybeans on cotton land this year. I expect the crop to be late. I feel the Mississippi Delta will be subject to flooding this year, and the cotton crop may have to be replanted. December cotton is at the low end of its price range also." Besides problems in domestic plantings, "Talk of less acres planted in China this year is still valid and may help support a more robust market later this year." The Hightower Report, April 29. We would be able to hold this trade until about the end of July to benefit from a possible rise in cotton.
4. September British Pound--Buy (2) 166 calls and sell (1) 162 call at about even money. Margin is about $400. We have been recommending our bullish backspread in the British Pound in anticipation of strength in the UK currency due to an expected interest rate hike after the election on May 1. After the uncertainty of the election is removed, and some intentions regarding policy are made clear, the pound may continue to gain versus the dollar. Steve Merry, CTA at OIO, anticipates an announcement of a rate hike shortly after the election, and the bullish potential for the pound: "The British Building Societies (portfolio mortgage lenders), are being converted into banks. This should inject large amounts of liquidity into the economy, which will further support the Bank of England's request that the government hikes rates to control inflation."
On a rise in the pound to the 170 level, with a 3% gain in volatility, the computer prediction is that this trade would gain about $1400, with unlimited profit potential on further rises in price.
May, 1997
Opportunities In Options
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