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Opportunities In Options

Trading Backspreads And The Potential Effects

Of El Nino On The Markets

In our General Comments last month, we discussed that the combination of low volatility in many of the option markets combined with the potential for big moves in the underlying futures markets was making option buying strategies more advisable now. This began to occur in September with breakouts to six month highs in silver and heating oil, and to three month highs in gold and crude oil. We made timely bullish recommendations in these markets in the hotline just before these moves occurred, which now allow many of these positions to be adjusted into “Free Trades.”

Gold and silver may be just at the very beginning of a long-term change of trend, so we will continue to recommend the best option positions to take advantage of this move. the metals tend to remain in long term trends for 5 years or more; if this move is real, entering with long term positions after only the current one-week move is certainly not too late; however for money management reasons, we are recommending entering 1/2 of your intended positions now, and the other 1/2 on a pullback.

Option volatility remained near three year lows in our favorite premium selling market (Treasury bonds). However, we recommended both neutral positions and credit spreads that were successful in the S&P 500, where option premium is at three year highs.

The grains, cotton, coffee and orange juice have been very subdued even in light of the El Nino threat. What's even more surprising to me is that option volatility is at the low end of the range in soybeans, corn, wheat, cotton and coffee, reflecting the traders' belief that there will be little damage or crop problems. The fact is that we know that El Nino is already occurring by the warming of the oceans' waters, and we have already had several storms caused by this effect. What is not clear yet is the damage (if any) that will occur. With the futures in the grains near five-year lows and cotton and soybeans off by about 50% from recent highs; and option volatility also near the low end of the range in al of these markets, we particularly like option buying strategies that can work well if either price or volatility rises (and do really well if both occurs!)

We have recommended several backspreads in the March contract month that are particularly suited for these circumstances. They provide the advantages of having the right amount of time, as December through February should have most of the weather changes; backspreads will benefit from increases in option volatility; and if the markets are not affected and do not move, premium losses are generally much lower than other bullish positions. (In fact, if you do the backspread at a credit, you can sometimes profit if the market moves against your predicted direction!)

Our favorite backspread right now is coffee, where volatility has dropped about 50% from previous levels, and the futures tend to be very volatile, even without potential El Nino problems.

In our May Opportunities In Options newsletter, the backspread was featured in the Option Strategy Corner. We discussed the benefits of the option backspread, and the best conditions for initiating this position.

Bonds Reverse After Breakout;

This Is Favorable For Inter-Market Spreads

In Notes Versus Bonds

Bonds started September continuing their August consolidation, then managed a sharp rally that led to a test of the August highs. The market retreated on strong durable goods numbers, but most new data has been neutral to positive. The bullish Payroll report ignited a huge rally, which turned into a potentially negative reversal; another trading example of “buy the rumor, sell the fact.” After having discounted a lot of good news with their rally, bonds will need more supportive news to significantly exceed the highs. Until more bullish fundamentals or technicals emerge to drive bonds to significantly higher levels, our trades in ten-year notes versus bonds can take advantage of the present trading area. Currently, T-notes are at wide discounts to bonds. This spread is known as the NOB spread (notes over bonds). We recommend taking advantage of “buying the NOB spread” in the options market, and also using a calendar spread in the NOB.

For a calendar spread in ten-year note versus bond options, we recommend buying the March ten-year note 114 call, and selling the December bond 120 call at about even money. Margin is about $1000. This spread takes advantage of the greater time decay expected to affect the December bond options. If the December bond options expire worthless in 6 weeks, we will then have a free call position in the ten-year notes. We recommend a risk of about $300.

For a credit spread in notes versus bonds, we recommend buying the March ten-year note 114 call, and selling the March bond 122 call for a credit of about $300. Margin is about $1000. Based on previous relationships at historic highs, if bonds were to reach their all-time highs, we would expect the level of the note option to be in-the-money. When bonds reached their all-time highs above 122 in 1993, ten-year notes traded above 117; when bonds challenged those highs again in January of 1996 (with short-term rates close to current levels), ten-year notes were above 115. In either case, if bonds were to reach their all-time highs, we would expect the level of the note option to be in-the-money. For this trade to lose money at expiration, bonds would have to move above all-time highs, and the spread between bonds and notes would have to widen to over 8 full points, which would be an all-time new historical disparity. We recommend a risk of $300 as a stop-out point.

We would not recommend these trades if December bonds are trading above the recent highs at 118-18. This area can also be used as an alternate stop-out point for the above trades.

Volatility Remains Near Multi-Year Highs;

Take Advantage Of Time Decay With

Neutral Credit Spreads In October Contract

The S&P 500 has been trading in a range since the August highs, and option volatility is at very high levels. This scenario is beneficial for the credit spread strategy, a tactic that can be used to collect premium in out-of-the-money calls and puts, while having defined risk exposure in the event of a major move. Even though the S&P is likely to remain very volatile with wide-ranging days, it may take a significant event to break it out from its current range bounded by resistance from 980-985, and support from 905-920. Money flow and a favorable rate environment are supportive, while slowing corporate earnings and the potential for an exodus of foreign capital (if the dollar weakens) remain a major concern.

In the October S&P options, (with December S&P trading near 960), we recommend using credit spreads to collect premium on both sides of the market. On the call side, on rallies, buy the 1010 call, and sell the 1000 call for a credit of about 100 points ($500). On the put side, on market declines, buy the 900 put and sell the 910 put for a credit of about 100 points ($500). These options have about 2-3 weeks to expire and are indexed to the December S&P contract. Full margin is $5000. If both sides are initiated at recommended prices, return on margin is about 20% in 2-3 weeks. For risk control, if both sides are initiated (with 200 points collected), we recommend closing the trade if one side of the trade goes to a 400-point premium. If only one side is initiated, we recommend closing the trade if the premium triples. The reason we specify a stop using the premium is that time decay has such a dramatic effect on the trade, and a fixed market point will not accurately reflect this variable. In other words, the closer to expiration that we are, we can get closer to the short strikes without hitting the risk control point.

Silver Leads The Way With A Strong Breakout

And Gold Follows Suit, Moving To 3-Month Highs

After spending most of September continuing its basing pattern, gold broke through short-term resistance and also moved above a 5-month downtrend line. Inflation fears were re-ignited when the very strong durable goods number reported by the Commerce Department created new concerns that the economic expansion is even stronger than previously estimated. With commercial interests at bullish levels, and sentiment at multi-year lows, this market could continue to move higher. Recent breakouts above 335 basis December gold are decidedly bullish. Importantly, the XAU index (Philadelphia Gold and Silver mining index), has started to break through the important 1996-1997 downtrend line; this index is often considered to be a leading indicator for the gold market, because the earnings of many of these companies are directly related to the gold price (depending on how much forward hedging they have done). This index recently moved up 10% in just three days, and is up over 25% from its July lows. An equivalent move in gold itself would take December gold above $380; other estimates for rally potential from the weekly charts are for a move to the $360-370 level. Considering the above, and the potential for these markets to begin longer-term moves, we think that this is an excellent time to take initial bullish positions in the gold market. We had recommended bullish call purchases in our hotline, and continue to recommend well-priced calls in April and June gold.

In gold, we recommend the April gold 350 call at about $400, or the June gold 350 call at about $550. These options have 23 and 32 weeks to expiration. We recommend a risk of half the premium, or to a close below 321, basis December gold. Our intent will be to turn these into Free Trades by selling calls at higher strikes on a rally.

Silver briefly penetrated the bottom of its rising trend channel in the middle of the month, then moved back up with a strong break through resistance at the last two highs at 485 and 486 SIZ, quickly moving above $5.00. Our previously recommended call spreads are now well positioned to take advantage of a continuing move, and can now also benefit from our strategy to roll up the long calls to collect premium. “The traders at the COMEX are already watching the amount of open interest in the contract and the amount of stocks in the warehouse as there would appear to be a shortage if enough longs took delivery.” The Hightower Report.

For new trades in silver, especially on a pullback to the breakout area near 500 SIZ, we recommend the July silver call spread of buying the July 550 call, and selling the 625 call for a cost of about 15 cents ($750) or better. We recommend a risk of half the premium, or a close below 450, basis December (below the September lows). These options have over 8 months until expiration. Our intent will be to roll up the long call on a rally to collect the original premium spent.

Excellent Backspread Opportunities

In Puts And Calls; Option Volatility Is Low

And Futures Can Make A Large Move

After challenging historic highs in May, coffee retreated sharply to lows in July, and has been trading sideways in about a 50-cent range. Fundamental arguments could support a move either way; rising stocks and good production could send the market plunging through important support, whereas weather concerns and export retention schemes by producers could be bullish. With option volatility down about 50% from summer highs, and a market that has the potential for large, dramatic moves, we can recommend option backspreads here as a strategy that has very good profit potential, as the futures are likely to make a big move soon: “Coffee traders continue to be on pins and needles with the fundamentals a potpourri of good and bad news. The start of the 1997-98 season officially begins next month and there is much uncertainty about crop prospects...the true size of the Brazilian 1997-98 crop remains a mystery...should the market indeed be small as Brazilian sources have argued all year, then the market will have to continue to reckon with extreme volatility and high prices.– Merrill Lynch & Co.

In March coffee calls, we recommend the call option backspread of buying (2) 190 calls, and selling (1) 160 call for even money or better. The margin is about $700. OptionVue analysis shows that if the market rallies 40 cents in 60 days, and volatility rises 10% (a very reasonable expectation on a rally), profit potential is over $1500. If March coffee rallies over previous highs (above 205), profit potential would approach $5000. Additional rises in volatility would increase the profit potential. We recommend a risk of $500 a your stop-out point.

In March coffee puts, we recommend the put option backspread of buying (3) 125 puts, and selling (1) 150 put for a credit of about $1000. Margin is about $1000. Computer analysis shows that with a drop to the 120 level within the 2-month trading period, profit potential is over $2000, and with a drop near the $1.00 level, profit potential exceeds $10,000. This is with no change in volatility. We recommend risking $500 as a stop- out point. For both of these trades, we recommend a trade period of 2 months, or late November, adequate time for the market to make a move.

Volatility Skewing Is Favorable

For Put Backspreads

In mid-September, sugar finally succumbed to its overbought condition, moving down quickly to an important support area between 1100-1140, basis March. The market was pressured by “... active speculative selling, fears of high deliveries against the expiring October contract, and expectations for a large European crop.” CRB Futures Market Service, September 26. However, after the correction ran its course, the bulls found support from El Nino concerns affecting the upcoming harvest in Cuba and production in Indonesia. The current pricing of the options and the market action makes the use of backspreads in both directions a favorable strategy in this market. Current strategies in the call options are well positioned if the market finds support and resumes the previous uptrend. We can also take advantage of the potential for a larger move down by using the put backspread strategy. The positive skewing of these put options (with out-of-the-money puts at lower volatility than the at-the- money) makes this a very favorable situation for doing put backspreads, because if the market drops, the puts should trade at progressively higher volatility levels. The put strategy is also complementary to long positions, as it covers the downside potential in this market.

In May sugar, we recommend the put option backspread of buying (3) May 1100 puts, and selling (1) May 1200 put for about even money. The margin is about $250. Our recommended holding period is until December, at which time the positions should be evaluated if no major move has occurred. OptionVue analysis estimates that on a 200 point downmove in sugar within 90 days, this trade would make over $2000, assuming no rises in volatility (rises in option volatility should benefit the trade even more). If the market were to stay unchanged for 90 days, losses are estimated at less than $200 (plus commissions and fees), and should be less if the market prices were to rise significantly from current levels. The risk/reward potential for this trade is very favorable.

We recommend the call backspread position in May sugar, which is at favorable entry levels. We recommend buying (3) May 1250 calls, and selling (1) 1100 call, for about even money. The margin is about $250.

Fundamentals Improving And Call Options

Well Priced For Long-Term Trades;

We Recommend Using Pullbacks

To Initiate Positions In March

Soybean oil continued its bullish pattern and made higher lows and higher highs during September. The weekly chart has penetrated the 40-week moving average, and stochastics are on a buy signal; the monthly chart is overdue for a bottom, having recently challenged the uptrend line from the 1986 and 1992 lows. Fundamentals continue to improve, with strong domestic usage of soyoil, and mounting concerns over the production of palm oil. “...drought, forest fires, and sever smog in Indonesia has provided uncertainty for future palm oil yields and production. Palm oil was up the 50-point limit twice last week...much uncertainty for future yields and production. December futures are up nearly 20% since mid-September. Palm oil exports in the world are about twice the size of total world soybean oil exports. Disruptions could support increased soybean oil usage.” CRB Futures Market Service, September 26. In the seasonal analysis from Moore Research, the 5-year seasonal average shows a distinct bullish trend starting in early October. Finally, according to an option evaluation strategy developed by Paul Forchione, one of our top option strategists, soybean oil options are good candidates for buying, when considering historical volatility in the futures and options.

In March soybean oil, we recommend using pullbacks to about the 2400 level to establish positions in March soybean 2400 calls at about 100-120 points ($600-720). After a valid bullish breakout, most markets will return to the breakout level before continuing the trend. We recommend a risk of half the premium. These options have almost 5 months until expiration.

October 1997 Opportunities In Options

Financial Plaza

300 Esplanada Drive, Ste. 200, Oxnard, California

OPTIONS - Ira Epstein & Company
Opportunities In Options
The Spread Trader
Consensus National Futures and Financial On Line Index

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