Prepared by
Opportunities In Options

The month of June was a good example of the advantage of diversifying among different strategies in diverse market groups. In the bonds, our neutral option position strategies continued to work well as we followed the lead of the market to take a slightly more bullish stance. Trades in the currencies worked well as we recommended a calendar spread to take advantage of the overvalued, expiring yen options early in the month, and then also recommended neutral option positions in the Swiss Franc and British Pound. We recommended long positions in the Canadian Dollar before the recent breakout from the downtrend. In the metals, we have been on the sidelines, awaiting further developments in these very oversold markets. In the grains, the extreme moves were very challenging to bullish positions for us and the entire industry, and proved that following a disciplined plan for risk control is very important in trading. In the coffee market, we used ratio spreads to collect premium as the market came off the highs. Cocoa moved up quickly, and we recommended adjustments to stay in a bullish position there. In sugar, we have continued to add to bullish long-term positions.

“Too Far, Too Fast,” And Too Many Bulls

Take Advantage Of High Option Prices

By Selling Call Premium; For Possible Market Downturn

We Recommend Calendar Spreads

After seeing the dramatic rally from the April lows in the stock indexes, we want to look for opportunities to sell very rich call option premium to those who think that “it's just going to keep on going.” That may be true for the long term, but the recent rally in the stock indexes from the April lows is approaching levels of appreciation that have only been achieved twice in over 10 years. We decided to look back to other periods of time during the 15-year bull market when we had rapid price appreciation from intermediate lows; specifically, we wanted to know what the largest percentage gain was in the time from the April lows to the expiration of July options. This is a 68-day period, or roughly equivalent to measuring the quarterly rate-of-change. Other than the dramatic move into equities after the major low in 1982, the highest rate of percentage appreciation during this amount of time was 25.34% achieved in 1991 (closing basis, cash S&P). If the cash index were to achieve this level by July expiration, this would take us up to about 925, equivalent to about 930-935 in the futures. In short, we do not expect the September S&P futures to exceed 935 before the July option expiration. Also, if the market were to reach for these higher levels soon, it would also encounter resistance from the top of the rising trend channel which has contained the rally from the April lows. Additionally, the market sentiment has recently achieved very high levels, which usually leads to at least an extended consolidation (which has already started) or pullback in the market. Recent readings from Market Vane showed an incredible 80% bullish reading (at least a 5-year high), and our own Equity Sentiment Composite has just made new highs.

Our suggested strategies to take advantage of high option premium and downside potential:

1. In the July S&P, we recommend the call option credit spread of buying the July 950 call and selling the July 940 call for a credit of at least 100 points or better. For risk control, we would close this trade if the value of the spread triples. Margin is about $3000. These options expire on July 18th.

2. In the July S&P, we recommend selling calls at 950 or above to collect premium of 100 points or more. We recommend closing these short calls if the premium triples. Margin is about $5000.

3. Paul Forchione, one of our top option strategists, has suggested using calendar spreads in the S&P, using accelerated time decay and higher volatility in the front months to take advantage of a potential correction from these extended levels. The market has seen meaningful corrections in July during the last two years.

We recommend buying the August S&P 850 put and selling the July S&P 855 put for a cost of about $3000. Since these options are both indexed to the September S&P, there is no additional margin. On a market drop of 30 points at July expiration, with a 2% rise in volatility, this trade shows a profit potential of more than $3500. After the expiration of the July options, we can either hold the August puts if a downtrend has started, or sell further out-of-the-money puts to collect premium. We recommend closing the trade if the market trades above 930 SPU, which would result in a loss of about half the premium, with volatility near recent levels.

We also recommend the calendar spread of buying the September S&P 500 850 put and selling the August S&P 850 put at a cost of about $3000. This position would make somewhat less on an equal move down at the July expiration, but gives us more time flexibility, has profit potential if the market stays flat until August expiration, and less drawdown if the market trades to 930, our recommended stop point.

With the extreme volatility in the S&P, the market must be evaluated at the time the trade is being considered, to see if the strike prices are appropriate. In this market (as in all others), we recommend following a disciplined plan of risk control.

Bonds Consolidating After Rally;

With Important Economic Reports Due,

We Recommend“Wide” December Neutral Positions

In early June, bonds broke out of their short-term trading range, and we began to adjust our neutral option positions to a more bullish stance. The market followed through on the breakout as the outlook for financial futures remained positive. After the second leg of the rally from the April lows to the highs in June, bonds faced concerns about some foreign liquidation of U.S. debt, and the market used the news to start a normal pullback in the uptrend. With the FOMC meeting and many important economic reports due before the Independence Day weekend, we recommend “wide” neutral option positions, which are easier to manage if the market makes a larger move than expected. We can then sell more premium after this period of potentially heightened volatility. With the strong likelihood for unchanged monetary policy from the Fed, a strong move is only likely to occur if there is a large surprise in one of the major indicators.

In the December bonds, we recommend the neutral option position of selling the 118 call and 104 put at about $600. The likelihood of the futures being in the predicted range of 104-118 at option expiration is 82%; margin is about $600, with return on margin about 100% if this range holds until option expiration in 20 weeks. The daily effect of time decay is $7.74. We recommend adjusting this trade on closes above 115 (above 6-month highs) or below 109 (below the low of the wide-range breakout day), basis December. Upon confirmation of the bullish trend with trades above 112-16, we recommend selling an additional 106 put for each 2 positions. This will require about $800 in additional margin.

Swiss Franc Sideways Action Great For

Neutral Option Positions In December.

Canadian Dollar Makes Strong Bullish

Breakout From Downtrend; Strategies Recommended

The Swiss Franc started June with a sharp drop, and it spent the month consolidating near the middle of its 5-month trading range. This has been very beneficial to our neutral option positions. The balanced outlook for the Swiss Franc continues; while this currency has benefitted from some capital inflows as concerns have grown about the European Monetary Union, the Swiss National Bank has stated that they will strive to prevent any rise in the currency. Even though the currency has wound itself up in a tight coiling pattern in the last few weeks, as of yet there is no fundamental evidence that a break from this very tight range should lead to any major price moves. Until we see evidence that a larger move is taking place, we recommend neutral option positions in the December Swiss Franc.

In the December Swiss Franc, we recommend the neutral option position of selling the 77 call and 65 put at about $800. The likelihood of the futures being in the predicted range between 65 and 77 at option expiration is 80%; margin is about $600, with return on margin over 100% if this range holds until option expiration in 23 weeks. The daily effect of time decay is $8.74. We would recommend adjusting this trade on closes above 7400 (5-month highs) or below 6800 (100 points below contract lows), basis December.

In the Canadian Dollar, it had been declining for several weeks during June, challenging the strong support at the April lows; we didn't have to wait long for the market to fulfill our expectations for a bullish breakout (spurred by tightening by the Bank of Canada) from the potential bottoming pattern in this currency. The timing of the rate hike by the BOC was somewhat of a surprise, but it has already fostered speculation that another rate hike will eventually follow. Since we have the potential for a larger intermediate-term move in this market, the next target for this currency may be the highs near 7400 in May. Our recommended positions in the Canadian Dollar will take advantage of further rises in this currency and option volatility. We recommend buying the September Canadian Dollar 7300 call at about $450-500. As a stop-out point, risk half the premium or to a close below 7190 in the September contract (below the April 1997 contract lows in September futures). This option has about 10 weeks to expiration. Our objective will be to turn this into a free trade on a rally. We also recommend the synthetic futures strategy of buying the September 73 call and selling the 72 put at a cost of about $200. Margin is about $600. We also recommend risking this trade to a close below 7190 CDU.

In the December British Pound, the market has broken out of its trading range; we would recommend adjusting existing neutral positions in the December pound by selling additional 156 puts to give these positions a slightly bullish orientation. As an adjustment point, we would adjust these puts on closes below 162 BPZ.

December Cotton's Bullish Potential Confirmed With Breakout.

Volatility Is Just Starting To Rise From 3-Year Lows;

We Recommend Bullish Positions

December cotton spent June in a consolidation pattern, building up energy for the dramatic breakout at the end of the month, on the widest range day in several months when the market moved above 3-month highs; we reached our “trigger point” to take more aggressive bullish positions in this market. Fundamentals and technicals support the case for higher prices to come. This activity should also lead to higher volatility, which will benefit our recommended trades. “USDA assessment of the U.S. cotton situation for 1997/98: Early outlook points to smaller cotton crop...prospects are for reduced U.S. cotton acreage...total demand for U.S. cotton is also expected to rise, with both domestic mill use and exports projected to expand...with the U.S. cotton harvest still several months away, the crop remains vulnerable to weather and insects.” Futures World News, June 26. “...increasing weather fears, slow crop progress and ideas that the USDA will cut planted acreage estimates on Monday (June 30) supported the rally...Too much rain in the Delta and Texas with not enough sun has slowed crop development in the U.S. and scorching temperatures in the cotton regions of major importer China added to the buying support.” The Hightower Report, June 24.

We recommend the free option position in December cotton of buying the 78 call, and selling the 82 call and 73 put (below contract lows) at a slight debit. Margin is about $800. This trade has a profit potential of $2000 (less costs). The probability of being above the strike price of the short put at option expiration in 19 weeks is 81%. We recommend closing the put on a close below the June lows at 7465 (basis December).

For free trade potential, we also recommend buying the December cotton 80 call at about $900. With option volatility just rising from 3- year lows, this option is well priced. Our objective will be to turn this into a free trade by selling a higher strike call at the same price on a rally. Recommended risk is half the premium or a close below 7465 CTZ.

For existing option backspreads in December cotton, our recommendation is to close the short 75 call and (1) of the long calls, thus being able to hold the remaining bullish 79 or 80 call position longer towards option expiration. On further rallies in cotton, this position will take better advantage of the move. Also consider selling a 73 put at this time (as in the free option position), and selling further out-of- the-money calls now or upon a continuation of the rally. We recommend closing any bullish positions on closes below the June lows at 7465.

Wait For Market Confirmation

Before Initiating New Positions

The grains spent the month of June extending their declines, as the markets continued to assume that there will be enough supply to fill current demand and that high yields in the new crop will take the pressure off of a tight carryover situation. In corn and wheat, violations of support in June had us stand aside and we recommend waiting for the market to show us that there is new buying interest; wait for closes above 250 in December corn and above 370 in December wheat. In soybeans, the market broke to new lows after the June 30th Stocks and Plantings report; even though we are in areas of major long-term support, we recommend waiting for fundamental and technical developments that justify new market positions. The July-August time period will be critical for this market.

Technicals And Fundamentals Support

Long-Term Bullish Outlook. Volatility Remains

Favorable For Initiating Bullish Option Positions

March sugar began the month of June with a strong jump to new highs and has been consolidating in a new high range. March sugar also continues to gain in relative strength versus the nearby contracts, showing the positive implications for long-term prices. “The big picture fundamentals for the sugar market are shifting to a much improved price outlook for the 1997/98 crop year. A world production deficit is anticipated for the first time in four years. A steady rise in world consumption combined with stagnant world production has created the outlook for a deficit...With the strongest El Nino pattern since 1982, normal weather is not something traders should count on.” CRB Futures Market Service. Even though normal pullbacks are likely to occur, these will be likely to provide good buying opportunities; we recommend our bullish long-term strategies.

We recommend purchasing the very reasonably priced March 1998 sugar 1150 call at about $450. This option is very close to the money and has almost 8 months until option expiration. Our objective will be to turn this into a free trade by selling a higher strike call at the same price on a rally.

Also, in March sugar, we recommend the bullish option backspread strategy of buying (3) 11 calls, and selling (1) 950 call at a cost of about $100. With option volatility near 3-year lows and a bullish technical trend, more speculative interest would be likely to raise the volatility in sugar options (which has been 5% higher within the last six months). Margin is about $500. We would recommend initiating this trade for a few more weeks and evaluating the trade in October.

July, 1997Opportunities In Options

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