THE OPTION STRATEGIST · THE OPTION STRATEGIST Published by McMillan Analysis Corporation P.O. Box 1323, Morristown, NJ, 07962-1323 CUSTOMER SERVICE: 1-800-724-1817

THE OPTION STRATEGISTPublished by McMillan Analysis CorporationP.O. Box 1323, Morristown, NJ, 07962-1323

CUSTOMER SERVICE: [email protected]

Dear New Subscriber:

Enclosed is a packet of materials that is designed to help you use and understand "The OptionStrategist Newsletter.”

PHILOSOPHY: Recommendations will generally be of two types, strategic or speculative. Strategic recommendationsare spreads, neutral in nature, designed to take advantage of a perceived "edge" in the market place. For example, if certain options are too expensive, a spread would be designed to sell those options (tocapture their overpriced nature), and that sale would be hedged with the purchase of other options. Speculative strategies normally involve option buying. These recommendations would be based ontechnical analysis or option trading patterns such as increased volume or a significant change in theput-call ratio (see glossary).

New trading recommendations will be highlighted in yellow. Thus, you can quickly scan thenewsletter to see the new recommendations.

NEWSLETTER FORMAT: While the format of the newsletter can vary, it generally includes the following sections:

1. Stock market commentary based on various technical indicators including put-callratios, breadth, sentiment, price action, momentum, volatility and volatility derivatives.

2. Featured articles, often of educational or informative value, that were either originallypublished throughout the week or published that Friday.

3. Specific trading recommendations based on various indicator. Each recommendationincludes follow-up action, trading stops and position analysis.

4. Specific follow-up recommendations to all pertinent model portfolio positions.

There are some other information pieces designed to give you background on our products andphilosophy:

• "The Oscillator" – an explanation of our advance-decline oscillator, along with adescription of the charts you will see in our publications.

http://www.OptionStrategist.com

• "Some Random Thoughts On Option Trading" – trading philosophy.

• "Which Option To Buy?" – thoughts on choosing the proper option for your strategy.

• "Put-Call Ratios" – a brief explanation of this important technical indicator.

• “When Is Trading Stock Superior To Buying Options?” - call buying vs. owningstock.

• “Position Delta” - how to construct positions that are neutral to the market.

• “Measuring And Trading Volatility” - basic principles of volatility trading

• "Option Glossary” – a glossary of option terms is also included for new subscribers. This should be of use to less experienced traders who might not be familiarwith some of the terms used in the newsletter. While we attempt to give clearexplanations of all recommendations and ideas, it might be useful to have thisglossary available as well.

The model portfolio positions, except for those in the “Covered Write/Naked Put Sale” category, aregeared for the risk that a portfolio of approximately $100,000 should be taking. For example, eachoutright call or put speculative buy risks about $1,500. The “Covered Write/Naked Put Sale” positionsare sized for another portfolio of $100,000 if using margin, or $200,000 if operating on cash.

Please let us know if there are any questions you have, or any ways in which you feel service could beenhanced.

President, McMillan Analysis Corp.

Table of Contents

The Oscillator 1

Charts Used in The Option Strategist 2

Some Random Thoughts on Option Trading 3-4

Which Option to Buy 5-6

Put Call Ratios 7-8

When Is Trading Stock Superior To Buying Options? 9-11

Position Delta 12-13

Measuring And Trading Volatility 14-16

Option Glossary 17-20

Figure 4

THE OSCILLATOR

We occasionally make OEX recommendations, based upon our short-term overbought/oversold oscillator. If theoscillator rises to +200 or higher, the market is overbought. We then look to short the market (i.e., buy OEX puts)when it subsequently falls back below +180. Conversely, if the oscillator is below -200, then the market is oversold,and we will buy calls when it eventually rises back above -180.

The oscillator is calculated with the following formula:

Today's Oscillator = 90% of Yesterday's Oscillator + 10% of (Today's Advances - Today's Declines)

For example, if the oscillator stood at 100 yesterday, and today there were 1200 advances and 900 declines,then the today's oscillator number would be calculated as 120:

Today's Oscillator = 0.9 * 100 + 0.1 * (1200 – 900) = 90 + 30 = 120

The “Stocks Only” Oscillator

In the fall of 2001, several analysts were toutingthe fact that the NYSE advance-decline wasmaking new all-time highs. At the time, we hada bearish opinion on the market, and I couldscarcely believe that was true. But it was! Sureenough, even though the stock market had beenstruggling since the end of the tech boom rally inearly 2000, the NYSE advance-decline line wasindeed making new highs.

We have access to another good set of stocks,though – all stocks with listed options. That is,all optionable stocks. There is a large set of suchstocks, so we created our own advances anddeclines (and our own advance-decline line),using that set of stocks. It was remarkablydifferent. Figure 1 shows how much the “Stocksonly” cumulative advance-decline line haddiffered from the NYSE cumulative advance-decline line.

This was mostly due to decimalization, for reasons that are too detailed to explain in this short piece.

However, because of this, we also compute a “stocks only” oscillator each day. Furthermore, we monitor both the“stocks only” and the NYSE-based oscillators as potential market indicators and as measures of market breadth.

Buy and Sell Signals

A Buy Signal is generated when the oscillator drops into oversold territory and them emerges from it. A Sell Signalis generated when the oscillator climbs into overbought territory and them falls from it.

For the NYSE oscillator: a Buy Signal is generated when it falls below –200 and then later rises above –180. A Sell Signal is generated when it rises above +200 and then later falls below +180.

For the “Socks Only” oscillator: a Buy Signal is generated when it falls below –400 and then later rises above–180. A Sell Signal is generated when it rises above +140 and then later falls below +120.

1

CHARTS USED IN THE OPTION STRATEGIST

The chart on the right is one of IBM. Ourprice charts are always daily charts, unlessspecifically noted otherwise. The stocksymbol is on the upper left (for futurescharts the symbol begins with '@' and forindices it begins with '$'). Then, readingfrom left to right across the top, we havethe price information for the rightmost databar on the price chart. This wouldnormally be the most current date. Theprice information is high, low, and close,for the date shown. In this IBM chart, thatdate is Monday, January 22nd (960122),and on that day IBM had a high of 103f,a low of 101d, and a close of 102¼. Therightmost number on the top is the "volume cut-off" figure — the maximum daily volume graphedalong the bottom of the chart. For IBM, this is 6,000,000 (6 million) shares. Look at the bottom ofthe chart. You see that the stock volume is shown, but some of the volume lines have a circle on thetop. That circle represents the 6,000,000-share figure. Larger volumes are not graphed, for theywould interfere with the chart of prices, which is the most important data.

Finally, the daily price bars are shown in the middle of the chart. On this IBM chart, we havesurrounded the price bars with the "modified Bollinger Bands". These are similar to regularBollinger Bands, but we use a shorter volatility period, and draw the bands at 3- and 4-standarddeviations. Bollinger Bands, invented by John Bollinger (P. O. Box 3358, Manhattan Beach, CA,90266) are a dynamic way of denoting overbought- oversold areas. They are dynamic because theyare based on the volatility of the stock — note how the bands shrink and expand (they are not alwaysequidistant from each other).

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SOME RANDOM THOUGHTS ON OPTION TRADINGReprinted from the 11/26/93 issue of "The Option Strategist"

I was recently asked what guidelines I generally follow in myoption trading. This is actually a rather thought-provokingquestion, especially when it regards something one doesalmost every day. In our feature articles, many useful generalstrategies have been given, but not assembled all in oneplace. After giving the matter some thought, it seemed likeit might be beneficial to list some of the "rules" that wefollow, either consciously or sub-consciously after all theseyears. For the novice, they may be eye-opening; for theexperienced option trader, they may serve as a reminder. These guidelines are not the path to easy riches, or somesuch hype, but following these guidelines will generally keepyou out of trouble, increase your efficiency of capital, andhopefully improve your chances of making money withoptions. They are not presented in any particular order.

Trade in accordance with your comfort level and psych-ological identity. If you are not comfortable sellingnaked options, then don't; even though suchstrategies are nicely profitable for some traders, theyshould not be used if they cause you sleeplessnights. If hedged positions drive you crazy becauseyou know you'll have a losing side as well as awinning side, then perhaps you should trade optionsmore as a speculator — forming opinions and actingon them accordingly. The important thing to realizeis that it is much easier to make money if you are "intune" with your strategies, whatever they may be. No one strategy is right for all traders due to theirindividual risk and reward characteristics, andaccompanying psychological demands.

Always use a model. The biggest mistake that option tradersmake is failing to check the fair value of the optionbefore it is bought or sold. It may seem like anuisance — especially if you or your broker don'thave real-time evaluation capability — but this is thebasis of all strategic investments. You need to knowwhether you're getting a bargain or paying too muchfor the option.

Don't always use options -- the underlying may be better (ifoptions are overpriced or markets are too wide). This is related to the previous rule. Sometimes it'sbetter to trade the underlying stock or futurescontract rather than the options, especially if you'relooking for a quick trade. Over a short time period,an overpriced option may significantly underperformthe movement by the underlying instrument.

Buying an in-the-money call is often better than buying theunderlying instrument; buying an in-the-money put is usually better than shorting the underlying(if the underlying is stock). An in-the-moneyoption has a high delta, meaning that it movesnearly point-for-point with the underlying stock orfutures contract. Furthermore, the option's pricecontains only a small amount of time valuepremium — the "wasting" part of the option asset. Thus, the profit potential is very similar to that ofthe underlying instrument. Finally, the risk islimited by the fact that one cannot lose more thanthe price he paid for the option, while one hasmuch larger risk when owning or shorting theunderlying instrument.

Don't buy out-of-the-money options unless they're reallycheap. This is really a corollary of the above rule,but it's important enough to state separately. Obviously, you can't tell if the option is "cheap"unless you use a model. If the out-of-the-moneyoption is expensive, then revert to the previousrule and buy the in-the-money option.

Don't buy more time than you need. The longer-termoptions often appear, to the naked eye, to be betterbuys. For example, suppose XYZ is 50, the Jan50 call costs 2, and the Feb 50 call costs 2¾. Onemight feel that the Feb 50 is the better buy, evenif both have the same implied volatility (i.e.,neither one is more expensive than the other). This could be a mistake, especially if you'relooking for a short-term trade. The excess timevalue premium that one pays for the February call,and the resultant lower delta that it has, bothcombine to limit the profits of the Feb 50 call vis-a-vis the Jan 50 call. On the other hand, if you'relooking for the stock or futures contract to moveon fundamentals — perhaps better earnings or acrop yield — then you need to buy more timebecause you don't know for sure when theimproving fundamentals will reflect themselves inthe price of the underlying.

Know what strategies are equivalent and use theoptimum one at all times. Equivalent strategieshave the same profit potential. For example,owning a call is equivalent to owning both a putand the underlying instrument. However, thecapital requirements of two equivalent strategies

3McMillan Analysis Corporation

(and their concomitant rates of return) canvary widely. The purchase of the call willonly cost a fraction of the amount needed topurchase the put and the underlying stock,for example. However, the call purchasehas a much larger probability of losing100% of that investment.

Naked put selling is equivalent to covered call writing, butis generally a better strategy. We've mentioned thisoften before, but it bears repeating because so manyoption traders don't follow this rule, or don't believeit. Both strategies — naked put selling and coveredcall writing — have limited upside profit potentialand large downside risk. However, the naked putsale involves less of an investment in terms ofcollateral required, has a lower commission cost,and allows one to earn interest on his collateralwhile the position is in place. For these reasons,naked put selling is the better strategy of the two.

The option positions that are equivalent to long stock (orlong futures) and to short stock (or short futures)are perhaps the most important ones. Buying a calland selling a put, both with the same terms (strikeprice and expiration date) produces a position that isequivalent to being long the underlying instrument. Similarly, buying a put and selling a call with thesame terms is equivalent to being short theunderlying instrument. The next three rules dealwith these equivalences.

The equivalent option strategy may be better than owning the underlying stock itself. If one buys acall and sells a (naked) put, his investment is smallerthan that required to own the stock, and the"investment" may be in the form of interest-earningcollateral.

The equivalent option strategy is better than selling stock short, and of course is the only way tocompletely short an index. The option strategy notonly has the advantage mentioned above, but doesnot require a plus tick to establish the short position. It theoretically might be possible to short an entireindex by shorting every stock in the index, but thatwould be almost impossible because of the uptickrequirement.

The equivalent option strategy is mandatory knowledge forfutures traders, for it allows one to extricatehimself from a position that is locked limitagainst him. When futures are locked limit, theoptions will generally still be trading. The pricesof the options provide a price discoverymechanism, in that one can see where the futureswould be trading were they not locked at the limit. Furthermore, one can take an equivalent optionposition opposite to his (losing) futures position,and effectively close out the position at the currentloss without risking further limit moves onsucceeding days.

Naked combo selling in indices is usually less trouble thanselling combos in individual futures or equityoptions. Selling both puts and calls is anattractive strategy to many option traders, sincethe benefits of the wasting asset are on your side. Unfortunately, large or sudden moves by theunderlying instrument can create some nastysurprises for the option writer. One way tocounter this is to concentrate the option selling inindex options. The broader the index, the lesslikely it is to experience a gap opening. Therecannot be a takeover attempt on an index nor canan individual earnings report, for example, causethe index to move a great distance as it can for astock. For the index to gap, many of the stocksthat comprise the index would have to gap as well;that might be possible in a very narrow-basedindex, but is quite unlikely in a broad-based one. These statements generally apply to U.S. indices;indices on foreign markets (JPN or FSX, forexample) gap virtually every day since the actualtrading in those markets is occurring while theU.S. markets are closed.

Trade all markets. There are strategic option opportunitiesin all markets — equities, indices, and futures. Toignore one or two of these just doesn't make sense. The same principles of option evaluation neededto construct a statistically attractive strategy applyequally well to all three markets. Furthermore,there are often inter-market hedges that areextremely reliable, but in order to take advantageof them, one has to trade all of the markets.

Trade in accordance with your comfort level and psych-ological identity. This is the first and last ruleand, ultimately, the most important one.


WHICH OPTION TO BUY?

Reprinted from The Option Strategist newsletter, October 28, 1999. Copyright McMillan Analysis Corp.

There are various trading strategies – some short-term, some long-term (even buy and hold). If onedecides to use an option to implement a trading strategy, the time horizon of the strategy itself oftendictates the general category of option which should be bought – in-the-money vs. out-of-the-money,

near-term vs. long-term, etc. This statement is true whether one is referring to stock, index, or futuresoptions.

In this article, we’ll lay out the basic types of option purchases that are dictated by the trading strategy beingapplied to the underlying. The general rule is this: the shorter-term the strategy, the higher the delta shouldbe of the instrument being used to trade the strategy.

Day Trading

For example, day trading has become a popular endeavor – at least if we are to believe the media reports. Statistics have been produced which indicate that most of these day traders lose money. In fact, there areprofitable day traders – it’s just more and harder work than many are willing to invest. Many day tradershave attempted to use options in their strategies. These day traders apparently are attracted by the leverageavailable from options, but they often lose money via option trading as well.

What many of these option-oriented day traders fail to realize is that, for day-trading purposes, theinstrument with the highest possible delta should be used. That instrument is the underlying, for it has adelta of 1.0. That is, day-trading is hard enough, without complicating it trying to use options. So, if you’reusing a day-trading system based on S&P futures, you are most likely only complicating things if you tryto trade it via S&P or $OEX options – trade the futures instead. For stock traders, this is equally true. Ifyou’re day-trading Microsoft (MSFT), trade the stock, not an option.

What makes options difficult in such a short-term situation is their relatively wide bid-asked spread, ascompared to that of the underlying instrument itself. Plus, since a day trader is only looking to capture asmall part of the underlying’s daily move, an at-the-money or out-of-the-money option just won’t respondwell enough to those movements. That is, if the delta is too low, there just isn’t enough room for the optionday-trader to make money.

If a day trader insists on using options, a short-term, in-the-money should be bought, for it has the largestdelta available – hopefully something approaching .90 or higher. This option will respond quickly to smallmovement by the underlying stock, index, or futures contract.

Note that when we say “high delta”, we are actually referring to the absolute value of the delta. That is,when buying calls we want to use ones with a delta of 0.90 or higher. But, if your strategy calls for shortingthe underlying – thus, buying a put if you are trading options – then the put’s delta should be –0.90 or less. That is, put deltas range from 0 down to –1.0, so a “large delta” for a put means that the absolute value ofthe delta is large.

Short-term Trading

Moving on to a somewhat longer-term oriented strategy, suppose you have one in which you expect to holdthe underlying for approximately a week or two. In this case – just as with day-trading – a high delta is


desirable. However, now that the holding period is more than a day, it may be appropriate to buy an option– as opposed to merely trading the underlying – because it lessens the risk of a surprisingly large downsidemove. Still, it is the short-term, in-the-money option that should be bought, for it has the largest delta andwill thus respond most closely to the movement in the underlying stock. Such an option has a very highdelta – usually in excess of 0.80. Part of the reason that the high-delta options make sense in such situationsis that one is fairly certain of the timing of day-trading or very short-term trading systems. When the systembeing used for selection of which stock, index, or futures to trade has a high degree of timing accuracy, thenthe high-delta option is called for.

Intermediate-term Trading

As the time horizon of one’s trading strategy lengthens, it is appropriate to use an option with a lesser delta. This generally means that the timing of the selection process is less exact. One good example is using put-call ratios to select what to trade. While the track record of put-call ratios as a contrarian indicator is good,the timing of the forthcoming move is not exact, because it often takes time for an extreme in sentiment toreflect itself in a change of direction by the underlying.

Hence, for a strategy such as this, we want to use something with a smaller delta – figuring that we will limitour risk by using such an option, knowing that large moves are possible since the position is going to be heldfor several weeks – perhaps even a couple of months or more. Therefore, an at-the-money option can beused in such situations.

Long-Term Trading

If one’s strategy is even longer-term, an option with a lower delta can be considered. Such strategies wouldgenerally have only vague timing qualities – such as selecting a futures contract to buy, based on the generalfundamental outlook for the commodity. In the extreme, it would even apply to “buy and hold” strategies.

Generally, I don’t espouse buying out-of-the-money options in any event, but for very long-term strategies,one might consider something slightly out of the money. Or at least a fairly, long-term, at-the-money option. In either case, that option will have a lower delta as compared to the options that have been recommendedfor the other strategies mentioned above. In a similar manner, LEAPS options might be appropriate for stockstrategies of this type.

Summary

The estimated holding period of a system’s trades, and the exactness of the timing of the strategy, shoulddictate what type of option purchase is best used for that system: from very high delta options for short-term, exact timing strategies to low delta options for long-term, inexact timing strategies. If the options areextremely overpriced, though, it may be wiser to buy slightly deeper-in-the-money options than indicatedabove. Finally, note that this advice is for option buyers – if one is attempting an option spread, straddle,strangle or premium selling strategy, different option deltas and time horizons might be more appropriate.


PUT-CALL RATIOS

Put-call ratios are useful, sentiment-based, indicators. The put-call ratio is simply the volume of allputs that traded on a given day divided by the volume of calls that traded on that day. The ratio canbe calculated for an individual stock, index, or futures underlying contract, or can be aggregated – for

example, we often refer to the equity-only put-call ratio, which is the sum of all equity put options dividedby all equity call options on any given day. Once the ratios are calculated, a moving average is generallyused to smooth them out. We prefer the 21-day moving average for that purpose, although it is certainlyacceptable to use moving averages of other lengths.

The chart on the right above is a sample one – of IBM. Buy and sell points are marked on the chart. Notethat buy signals occur when the ratio is “too high” (i.e., near the top of the chart) and sell signals occur whenthe ratio is “too low” (near the bottom of the chart). The chart on the left above is that of IBM commonstock, with the put-call ratio buy and sell signals marked on it. You can see that, in general, the signals aregood ones. In reality, we couple technical analysis – using support and resistance levels – with the signalsgenerated by the put-call ratios. The combining of the two methods normally produces better-timed entryand exit points in our trades.

A dollar-weighted put-call ratio is constructed by using not only the volume of the various options, but theirprice as well. The two are multiplied together, and the total of that product for all put options is divided bythe total of that product for all call options. That computation is the daily weighted put- call ratio. As withthe “standard” put-call ratio, this weighted ratio can be computed for individual stocks, futures, or indices,or for aggregated groups of options. Formally stated, the weighted put-call ratio can be writtenmathematically as shown in the box below. What this weighted ratio attempts to show, which the “standard”ratio does not, is how much money put buyers are spending.

(put price V put volume)Dollar Weighted Put-call Ratio = i

(call price V call volume)

i

where the summation over i means that the product is summed over alloptions belonging to this entity – whether it be an individual stock, or a groupsuch as “all equity options”.

j

j


The thinking is that it is more important to know how much total money is being spent on puts versus calls,than merely to know the volume. This point has some validity. For example, a person who is merelyhedging his position perhaps is not really all that bearish, but just wants to buy some puts as insurance. Hemight buy fairly deep out-of-the-money puts. Thus, his dollars would be spent on rather low-priced puts. On the other hand, a truly bearish speculator would most likely buy a put with a higher delta – somethingthat is at-the-money, or perhaps slightly in-the-money. Thus, this “true” bearishness would perhaps resultin a higher expenditure in terms of dollars.

The main difference between the “normal” and weighted ratios is that the weighted put-call ratio generates more extreme readings – especially at major turning points. That is, during bullish periods theweighted reading can dip down to 0.20 or below on a given day, even pushing the 21-day moving averagedown to those minimal levels at times. The “standard” put-call ratio rarely gets that low, especially whereequity options are concerned. Furthermore, during extreme bearishness, the weighted ratio will easily riseabove 2.00 on individual days, and the 21-day average can rise to nearly 2.00 as well. Again, those kindsof numbers are generally unheard of for the “standard” ratio.

As an example, let’s look at the big picture, via the equity-only charts. The two charts below show the“normal” ratio (on the left) and the “weighted” ratio (on the right). The buy and sell signals are marked onthe charts. For these charts, the major buy and sell signals occur at relatively the same points in time.

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Figure 5

When Is Trading Stock Superior To Buying Options?

Reprinted from The Option Strategist newsletter, August 23, 2013.

The common perception among option traders is that option buying is the “best” approach to a speculativesituation because of the great leverage that the calls or puts provide. But in many cases, ranging fromextremely short-term holding periods to ones of more moderate length, where limited stock moves are likely,

one may be better served by trading the underlying entity than by buying options. In this article, we’ll try to answerthe question of which is better, an option position or a stock position. It turns out that the answer may be dependenton what one’s objectives are. Also, we’ll reconstruct some trading from past recommendations to see the optionvs. stock results.

Call Buying vs. Owning Stock

The graph on the right (Figure 1) shows the profit graph of a simple call purchase vs. the purchase of the underlyingstock. The same graph would apply if the underlying were futures or an ETF, or anything else.

This is the profit graph of a Sept 100 call,bought when the stock was at 100, with amonth remaining until expiration. The thickred line is the dollars of profit or loss in thestock. The straight black lines are theoption’s profit or loss at expiration. Thecurved lines are the option’s profit or loss attwo dates prior to expiration: 9/01/2013(pink line) and 9/10/2013 (blue line).

The “dollar breakeven” price is equal to thestrike (100) minus the cost of the call (4.60)minus commissions.

Above the “dollar breakeven” price, thestock purchase makes more dollars than thepurchase of one (100-share) option does. Below the “dollar breakeven” price – shadedin black – the option loses fewer dollars than the stock purchase does. So, over a wide range of prices, the stockpurchase of 100 shares makes more money than the purchase of one call does.

“Wait!,” you shout. The investments are completely different. Yes, they might be, but we’ll get to that in a minute. Are there some traders who don’t really care about Return On Investment, but are rather just trying to make as manydollars as possible? Yes, there are. These types of investors would generally be ones trading stocks with highleverage. This would include accounts trading on portfolio margin, or professional traders who are working forbroker-dealers. Broker-dealers can trade their own capital with leverage of 6-to-1. Portfolio margin is similar, inthat one only has to advance 15% of the stock price. As we found out during the Financial Crisis of 2008, someprofessional traders were trading with much greater leverage than that.

Almost anyone in this situation is most likely interested in profit dollars. The returns will take care of themselvesbecause of the leverage. When I first became a proprietary trader, in 1980, one of the veterans told me that hewasn’t interested in comparing the expected returns of positions, but rather was just interested in making money.


That statement is still true for many highly-leveraged accounts.

This type of trader would likely view Figure 1 and determine that the red line is where he wants his money. Thered line is the highest dollar profit line if the stock rises, or even if it falls slightly. The only time the option has abetter dollar return (actually, a smaller dollar loss) is if the stock falls rather sharply. Traders operating with highleverage are usually fairly quick to take losses, so they would likely not even still be long if this theoretical 100-dollar stock dropped to 95.

Figure 2 shows the same data, but the Y-axis is now graphed as Return on Investment, rather than dollars of profitand loss, assuming that the stock and the option are purchased for cash.

Figure 2 shows why many speculators buy options– for the large returns available because theinvestment is so much smaller in the option. Thecolored lines in Figure 2 (which are brieflydescribed in the enclosed box) are the same asFigure 1 – red for the stock, black for the option atexpiration, pink for the option results on Sept 1st,and blue for the option results on Sept 10th.

The black line (option rates of return at expiration)crosses the red line at a gain of about 4.8%. (theoption cost 4.60). Above that point, the optionoffers a greater rate of return than the stock does. The other colored lines (blue and pink) cross overthe stock (red) line at even lower stock prices. Ofcourse, if the stock falls, the percentage losses onthe option are much greater than the percentagelosses on the cash stock holding.

What we can’t see from either of these charts is theprobability of the stock being at any of those points. Without getting overly technical, suffice it to saythat since stocks generally adhere to a lognormaldistribution, there is the greatest chance that thestock will be little changed at the end of a month. Hence the extremely high returns for the option in Figure 2 are rare. Unfortunately, too many option traders areenvisioning those extremely superior returns when they buy the option, when in fact it is “pie in the sky.”

Another thing not shown in the above charts is what a change in implied volatility might do, but I don’t feel thatis really pertinent to our analysis. If volatility increases, that benefits the option trader, in theory (setting aside thefact that usually it’s a stock price decline that is the cause for an increase in implied volatility). Conversely, adecline in implied volatility hurts the option buyer. The stock holder is not affected by a change in the option’simplied volatility, except perhaps for the residual effect of the stock itself potentially becoming more volatile. Thatfact doesn’t change the stock’s returns at any price, but if the stock becomes more volatile, that makes the moredistant stock prices more likely to be attained.

–—––

Would any other type of trader be favoring Figure 1 over Figure 2? I would think that anyone who has a trading

Figure 6


system that holds for relatively short periods of time might be more inclined to view Figure 1 favorably – especiallyif he is trading stock with leverage. The reason I say this, is because in a fairly short period of time, the big risesin stock price are less likely to occur.

When I first began publishing Daily Volume Alerts in 1994, the original research on the methodology had beenbased on stock price movements. I have always felt that if one has a profitable stock trading methodology, he couldtranslate it to an option buying methodology, merely by using high-delta options (delta of 0.85 and above for optionspositions that are likely to be held for two weeks or less) as a substitute for stock. But most retail subscribers arenot interested in high-delta options (for example, with the stock at 100, buying the 90 or 95 strike, instead of the100 strike). So, in order to actually sell subscriptions, options with smaller deltas were often recommended.

In the modern markets, with striking price distances having shrunk to 1.0 or 2.5 points in many cases, the problemisn’t as great as it was. Even so, the 0.85-delta option is still likely to be several strikes in-the-money, and that isnot attractive to many speculators.

In conclusion, one might find it a better approach to use the underlying stock or a synthetic version of stock. A longcall plus a short put is synthetic long stock, for example. Or one could use a “split-strike” approach: long an at-the-money call plus short an out-of-the-money put. This would reduce time value premium expense, while stillpreserving upside profit potential.


POSITION DELTA

All strategy recommendations made by "The Option Strategist" are approximately neutral to the market. That is, theywill not initially make or lose much money as the underlying instrument changes in price. When room permits, a graphwill be used to display how the delta of the position is expected to change as the stock moves up or down in price.

The delta of an option is the amount the option changes in price for a 1-point move in the underlying security. However,the term "delta" may also refer to the exposure that a entire option position has with respect to movement in theunderlying common stock. This second usage of the term "delta" is sometimes referred to as the equivalent stockposition (ESP), or as the equivalent futures position (EFP). To differentiate between the two terms, the delta of theoption is generally referred to as "option delta" while the ESP or EFP is called "position delta". The position delta canbe computed according to the following simple equation:

Position delta = option's delta × shares per option × option quantity.

Shares per option is generally 100 for most stock options, except those affected by a previous stock dividend or stocksplit. For futures options, the term "shares per option" would be replaced by "shares per contract", which is always 1. By summing the above calculations for each item in a position, or even in an entire option portfolio, one can approximatehow much market exposure the entire option position has.

As a means of demonstrating the usage of position delta, the Archer Daniels Midland (symbol:ADM) straddlerecommendation in the first issue will be used as an example. The position is simple enough that the concepts can bedemonstrated without getting overly complicated.

When ADM was at 30, the recommendation was made to buy 10 Mar 30 calls and to buy 12 Mar 30 puts. The initialrecommendation was made at the following prices and deltas:

Option Option Delta Position Delta

Long 10 ADM Mar 30 calls 0.56 +560 sharesLong 12 ADM Mar 30 puts !0.44 !528 shares

Net position delta: + 32 shares

Note that puts have a negative delta, indicating that they move in the opposite direction from the underlying security. The total position delta of this straddle is equivalent to being long only 32 shares of ADM -- almost nothing -- and hencethe position is nearly delta neutral (a position is delta neutral if the position delta is zero).

Since the position is a long straddle (with a couple of extra puts), the delta grows larger as the stock rises and becomesnegative as the stock falls, thereby meaning that the position no longer remains neutral as the stock moves away fromthe striking price. The strategist who is managing the above position knows that his delta will change in this manner,but he should be aware, in advance, of how much change there will be in his position delta so that he can planappropriate follow-up action. There are mathematical ways to quantify this change in delta, but a simple way is to


calculate the position deltas for various stock prices in advance. It is this type of calculation that is presented,graphically, with each strategy recommendation made by this publication.

In order to see how to best use these graphs of position delta, again consider the ADM example. The two previousgraphs show the initial situation. The one on the left shows the profit potential of the position, while the one on the rightshows how the delta is expected to change as the stock price changes over the two weeks after the recommendation wasmade. The overall position was destined to become long 500 shares with ADM at 32½, and to become short 500 sharesif ADM fell to 27¾. If the stock rose even farther, to over 39, the position would be long over 900 shares. On the otherhand, a massive drop in stock price to below 21 would have made the position delta short over 1100 shares. All of theseobservations are readily discerned from the graph on the right above.

In order to avoid having too much market exposure, part of the recommended follow-up action was to place an orderto sell short 500 ADM at 32½, should the stock rise that far. In fact, ADM did trade at that price, and 500 shares weresold. How did that sale affect the position? The graphs below display the situation after ADM has moved to 32½ and500 shares have been sold. The graph on the left below shows the profit picture of the new ADM position, includingthe sale of the 500 shares. Note that the new graph shows the effect of the sale of stock: the upside potential is lessened(although it could still be substantial) and the downside potential is increased. The strategist has locked in some moneyby having sold the 500 shares. Another observation can be made: the loss near 30 seems over the short-term is worsethan was projected in the above graph. That is due to two things. First, the projected "14-day" profit line is being drawnthree weeks later in time, and time decay takes its biggest toll near the striking price. Second, the market price of ADMoptions has gotten even cheaper, so the new graph on the next page takes into effect the current market pricing of theoptions. The profit and delta projections used by "The Option Strategist" will always be based on the current marketpricing of the options, unless otherwise stated. Part of the initial reason for buying this straddle was that the options werecheap compared with the historic volatility of the underlying stock. Now they are even cheaper, even though the stockjumped over 10% in just three weeks!

The graph on the right below shows the projected position delta of the current position, including the sale of the 500shares of ADM. Note that it still has the characteristics of a straddle -- getting longer as the stock rises and shorter asthe stock falls -- but now the maximum position delta attained will be near 500 shares on the upside, while the positioncould become delta short 1700 shares on the downside. Moreover, the strategist can plan further follow-up action, suchas covering the 500 shares should ADM fall back to 30 (see graph), for that is where the current position would be shortthe equivalent of 500 shares of ADM. Covering the short sale at that point would return the straddle to a neutralposition.

In summary, the strategist should be aware of how his position delta changes over time and with changes in the priceof the underlying security. It is not necessary to be so aware of position delta in a speculative, option buying situation. Of course, the follow-up recommendations that are made will be based, at least partially, on these projections ofposition delta.

13www.OptionStrategist.com

Measuring And Trading Volatility

Reprinted from a composition of several articles in The Option Strategist newsletter, as excerpted from the 4th

edition of the book, Options As A Strategic Investment, by Lawrence G. McMillan, President, McMillan AnalysisCorp.

The one thing that ties all option strategies together and allows one to make comparative decisions is volatility. In fact, volatility is the most important concept in option trading. Oh, sure – if you’re a great picker of stocks, thenyou might be able to get by without considering volatility. Even then, though, you’d be operating without fullconsideration of the main factor influencing option prices and strategy. For the rest of us, it is mandatory that weconsider volatility carefully before deciding what strategy to use.

The information to be presented here is not overly theoretical. All of the concepts should be able to be understoodby most option traders. Whether or not one chooses to actually “trade volatility”, it is nevertheless important foran option trader to understand the concepts that underlie the basic principles of volatility trading.

Why Trade “The Market”?

The “game” of stock market predicting holds appeal for many because one who can do it seems powerful andintelligent. Everyone has his favorite indicators, analysis techniques, or “black box” trading systems. But can themarket really be predicted? And if it can’t, what does that say about the time spent trying to predict it? Theanswers to these questions are not clear, and even if one were to prove that the market can’t be predicted, mosttraders would refuse to believe it anyway. In fact, there may be more than one way to “predict” the market, so ina certain sense one has to qualify exactly what he is talking about before it can be determined if the market can bepredicted or not.

The astute option trader knows that market prediction falls into two categories: 1) the prediction of the short-termmovement of prices, and 2) the prediction of volatility of the underlying. These are not independent predictions. For example, anyone who is using a “target” is trying to predict both. That’s pretty hard. Not only do you haveto be right about the direction of prices, but you also have to be able to predict how volatile the underlying is goingto be so that you can set a reasonable target. In certain cases, the first prediction can be made with some degreeof accuracy, but the second one is extremely difficult.

Nearly every trader uses something to aid him in determining what to buy and when to buy it. Many of thesetechniques, especially if they are refined to a trading system, seem worthwhile. In that sense, it appears that themarket can be predicted. However, this type of predicting usually involves a lot of work, including not only theinitial selection of the position, but money management in determining position size, risk management in placingand watching (trailing) stops, etc. Thus, it’s not easy.

To make matters even worse, most mathematical studies have shown that the market can’t really be predicted. They tend to imply that anyone who is outperforming an index fund is merely “hot” – has hit a stream of winners. Can this possibly be true? Consider this example. Have you ever gone to Las Vegas and had a winning day? How about a weekend? What about a week? You might be able to answer “yes” to all of those, even though youknow for a certainty that the casino odds are mathematically stacked against you. What if the question wereextended to your lifetime – are you ahead of the casinos for your entire life? This answer is most certainly “no”if you have played for any reasonably long period of time.

Mathematicians have tended to believe that outperforming the broad stock market is just about the same as beatingthe casinos in Las Vegas – possible in the short term, but virtually impossible in the long term. Thus, whenmathematicians say that the stock market can’t be predicted, they are talking about consistently beating the “index”– say, the S&P 500 – over a long period of time.

Those with an opposing viewpoint, however, say that the market can be beat. That the “game” is more like poker– where a good player can be a consistent winner through money management techniques – than like casino


gambling, where the odds are fixed. It would be impossible to get everyone to agree for sure on who is right. There’s some credibility in both viewpoints, but just as it’s very hard to be a good poker player, so it is difficultto beat the market consistently with directional strategies. Moreover, even the best directional traders know thatthere are large swings or drawdowns in one’s net worth during the year. Thus, the consistency of returns is generally erratic for the directional trader.

This inconsistency of returns, the amount of work required, and a necessity to have sufficient capital and to manageit well are all things that can lead to the demise of a directional trader. As such, short-term directional tradingprobably is not really a “comfortable” trading strategy for most traders – and if one is trading a strategy that he isnot comfortable with, he is eventually going to lose money doing it.

So, is there a better alternative? Or should one just pack it in, buy some index funds and forget it? As an optionstrategist, one should most certainly feel that there’s something better than buying the index fund. The alternativeof volatility trading really offers significant advantages in terms of the things that make directional trading difficult. So if one finds that he is able to handle the rigors of directional trading, then stick with that approach. He mightwant to add some volatility trading to your arsenal, though, just to be safe. However, if one finds that directionaltrading is just too time-consuming, or he has trouble utilizing stops properly, or is constantly getting whipsawed,then it’s time to concentrate more heavily on volatility trading, preferably in the form of straddle buying.

There was an extremely interesting comment in an article on chaos theory, that has some application to volatilitytrading. I don’t expect most readers to be familiar with that chaos theory of mathematics/physics. However,anyone should be able to grasp the general theory, which states that a small change in a seemingly irrelevant placecan have great affects – perhaps even chaotic ones – later on in time. It applies to many areas of nature and somehave tried to apply it to the stock market as well, especially after the crash of ‘87 which didn’t seem predictableby any “standard” branch of mathematics, but did seem possible under chaos theory.

In the article, it was pointed out that some systems just can’t be predicted. Chaos theory also aids in determiningthat fact as well. For example, chaos theory provides some evidence that earthquakes cannot be predicted. Is thisa useful piece of information, or just some irrelevant trivia? In fact, it is quite useful and important. The articlequotes mathematical physicist Henrik Jensen as saying, “It’s pretty important if you can say you will never be ableto predict earthquakes. Instead you should concentrate on building quality houses.”

I thought that comment was very apropos to the stock market. If chaos theory says that we can’t predict the stockmarket – and many say that it does – then perhaps we should stop trying to do so and instead should concentrateon building quality strategies. Such a strategy would certainly be volatility trading – especially straddle buyingwhen implied volatility is low.

Volatility Trading Overview

Volatility trading first attracted mathematically oriented traders who noticed that the market’s prediction offorthcoming volatility – i.e., implied volatility – was substantially out of line with what one might reasonablyexpect should happen. Moreover, many of these traders (market makers, arbitrageurs, and others) had found greatdifficulties with keeping a “delta neutral” position neutral. Seeking a better way to trade without having a marketopinion on the underlying security, they turned to volatility trading. This is not to suggest that volatility tradingeliminates all market risk – turning it all into volatility risk, for example. But it does suggest that a certain segmentof the option trading population can handle the risk of volatility with more deference and aplomb than they canhandle price risk.

Simply stated, it seems like a much easier task to predict volatility that to predict prices. That is said,notwithstanding the great bull market of the ‘90's in which every investor who strongly participated certainly feelsthat he understands how to predict prices. Remember not to confuse brains with a bull market. Consider the chartin Figure 1 (below-right):


This seems like it might be a good stock to trade: buy itnear the lows and sell it near the highs, perhaps evenselling it short near the highs and covering when it laterdeclines. It appears to have been in a trading range fora long time, so that after each purchase or sale, it returnsat least to the mid-point of its trading range andsometimes even continues on to the other side of therange. There is no scale on the chart, but that doesn’tchange the fact that it appears to be a tradeable entity. Infact, this is a chart of implied volatility of the options ofa major US corporation. It really doesn’t matter whichone (it’s IBM) for the implied volatility chart of nearlyevery stock, index, or futures contract has a similarpattern – a trading range. The only times that impliedvolatility will totally break out of it’s “normal” range isif something material happens to change thefundamentals of the way the stock moves – a takeover bid, for example, or perhaps a major acquisition or otherdilution of the stock.

So, many traders observed this pattern and have become adherents of trying to predict volatility. Notice that if oneis able to isolate volatility, he doesn’t care where the stock price goes – he is just concerned with buying volatilitynear the bottom of the range and selling it when it gets back to the middle or high of the range, or vice versa. Inreal life, it is nearly impossible for a public customer to be able to isolate volatility so specifically – he will haveto pay some attention to the stock price, but he still is able to establish positions in which the direction of the stockprice is irrelevant to the outcome of the position. This quality is appealing to many investors – who have repeatedlyfound it difficult to predict stock prices. Moreover, an approach such as this should work in both bull and bearmarkets.

Despite the neutral stance, there is risk in volatility trading. For example, if one decides to “buy” volatility, he willgenerally be buying options. Thus, he is at risk of time decay and he also has a risk that volatility might decreasewhile the position is in place. On the other hand, if one decided to sell options as his initial position (becausevolatility was “too high”)_then he faces other risks: there is the risk that volatility could increase and thus causelosses, and if the options are naked options, there is the risk that the underlying instrument could move sharply –a gap move – and cause large losses. For this latter reason, we generally prefer to trade volatility from the long sideor as a spread – not with naked options.

Volatility trading has an appeal to a great number of individuals. Just remember that, for you personally to engagein a strategy, you must find that it appeals to your personal philosophy of trading. To try to use a strategy whichyou find uncomfortable will only lead to losses and frustration. So, if this somewhat neutral approach to optiontrading sounds interesting to you, then we should talk.

Figure 1


OPTION GLOSSARY

The following is a list of terms that will appear in the newsletter with some frequency.

Assignment: the process by which a seller (or writer) of an option is notified that he is being required tofulfill his obligation to sell stock (call assignment) or buy stock (put assignment).

Backspread: any spread in which in-the-money options are sold and a greater quantity of out-of-the-moneyoptions are bought. In a more general sense, it may refer to any strategy that makes money when themarket becomes volatile.

Bear spread: a spread which makes money if the underlying stock or future declines in price. Typicallyconstructed by buying puts at one strike and selling a like number of puts with a lower strike.

Break-even Point: the point at which a strategy or position would neither make nor lose money (generally,at the option's expiration date).

Bull spread: a spread which makes money if the underlying stock or future rises in price. Typically, onewould buy calls at a certain strike and sell the same number of calls at a higher strike.

Calendar spread: a spread in which one sells options at one strike and buys options at a longer maturitywith the same striking price. In a neutral calendar spread, one would not necessarily buy and sellthe same quantity of options. The spread may be constructed with either puts or calls, but they arenot mixed; that is, if one buys calls, he also sells calls to complete the spread -- puts would not beinvolved in that case.

Cash-based: an option or future that settles for cash at its expiration date, rather than being converted intostock or a physical commodity.

Closing transaction: a trade that reduces an investor's position. Closing buy transactions reduce one's shortposition, and closing sell trades reduce an existing long position.

Collateral: the loan value of marginable securities; generally used to finance the writing of naked options.

Contrarian: one who thinks that the popular opinion of the masses is wrong, and will therefore go againstthat opinion. If everyone is bullish, the contrarian will interpret that as a sell signal.

Cover: 1) to buy back an option that was written; 2) to sell an option against an existing position in theunderlying stock or futures.

Covered option: a written option is considered covered if the investor has an offsetting position in theunderlying security. Written calls are covered by long stock; written puts are covered by short stock.

Covered write: typically meant to denote the strategy in which one is long the stock or future and is shortan equal number of calls.

Credit: money received in an account. When a spread is done "at a credit", the dollars from the options soldare greater than the cost of the options purchased.

Debit: money expended from an account. A debit spread requires an outlay of dollars to establish.

Delta: the amount by which an option's price will change if the underlying security moves one point in price. See also 'position delta'.

Discount: an option is trading at a discount if it is selling for less than its intrinsic value. Example: XYZis 55, the Jan 50 call is 4½ : this is a ½ point discount, since the intrinsic value is 55 ! 50 = 5.

Early exercise or assignment: the exercise or assignment of an option before its expiration date. Notallowed for certain options, which are known as European options.


Equity: see collateral.

Equity options: options which have common stock as their underlying security.

Equivalent positions: two strategies are equivalent if they have the same profit picture at expiration. Selling naked puts is equivalent to writing covered calls; buying stock and puts is equivalent tobuying calls.

European exercise: a feature of some options which means that they are only allowed to be exercised atexpiration, but not before. Therefore, there can be no early assignment of a European option. Manyindex options have this feature.

Exercise: to invoke the holder's right to buy stock (calls) or sell stock (puts).

Expected return: a mathematical estimate of the return that can be made from a position. It is technicallythe return which an investor might expect to make if he were to make exactly the same investmentmany times throughout history. If one consistently invests in positions with high expected returns,he should, on average, outperform those who don't.

Expiration date: the date on which an option contract becomes void. For equity and index options, it isthe Saturday after the third Friday of the expiration month. For futures options, each one is different.However, most commodity-based futures options expire in the month before the future expires.

Fair Value: a term used to describe the theoretical worth of an option or futures contract; determinedgenerally by a mathematical model, with volatility sometimes being a subjective variable.

Futures: a standardized contract calling for the delivery of a specified quantity of a commodity at a specifieddate in the future. In some cases, the contract is cash-based, meaning that no actually commodityis delivered; rather the contract is settled for cash.

Futures options: options which have futures contracts as their underlying security.

Gamma: the amount by which the delta will change when the underlying stock moves by one point. Seedelta.

Historical Volatility: a measure of the volatility of the underlying stock or futures contract, determined byusing historical price data.

Implied Volatility: a measure of the volatility of the underlying stock or futures contract. It is determinedby using prices currently existing in the market at the time, rather than using historical data pricechanges.

Index future or option: a future or option whose underlying entity is an index. Most index futures andoptions are cash-based, meaning they settle for cash at their expiration, rather than for shares of theindex itself.

In-the-money: a term describing any option that has intrinsic value. A call is in-the-money if the stock orfuture is trading higher than the striking price; a put is in-the-money if the stock is trading lower thanthe striking price.

Inter-market spread: a spread involving contracts on two different markets, generally referring to futurescontracts. For example, one might be long Deutschmark futures and short Yen futures as a hedge.

Intra-market spread: a spread involving different contracts on the same underlying commodity. Example:long July soybeans, short May soybeans.

Intrinsic value: the amount by which an option is in-the-money; it is never a negative number. For calls,the difference between the stock or futures price and the striking price; for puts, the differencebetween the striking price and the stock or futures price.


Limit Order: an order to buy or sell at a specific price. A limit buy order is placed below the current marketprice; a limit sell order is placed above the current market price.

Margin: the investment required by a brokerage firm. Long options must be paid for in full. Futurescontracts and naked options are margined. In this sense, one is not borrowing money from thebroker. Rather the margin is a deposit of collateral against potential losses from the position.

Moving average: an average of closing prices over a specific time period, which could be hourly, daily,weekly, or even monthly. A 200-day moving average of a stock price is sometimes considered tobe significant support or resistance.

Naked option: a written option is considered to be naked, or uncovered, if the investor does not have anoffsetting position in the underlying stock or futures. See covered option.

Neutral: describing a position that does not have exposure to a certain factor of the marketplace. Forexample, delta neutral means that the position is not affected by short-term market movements;gamma neutral means that the position will not be affected by even larger market movements; veganeutral means the position is not affected by changes in implied volatility.

Opening Transaction: a trade which adds to the net position of an investor; an opening buy adds more longoptions or futures, while an opening sell adds more short stock or futures.

Open Interest: the net total of outstanding open futures or options contracts that have been purchased. Notethat for every opening buy, there is an opening sell as well, but the open interest only counts oneside, not both.

Out-of-the-money: describing an option with no current intrinsic value. For calls, when the stock or futureis below the strike; for puts when the stock or future is above the strike.

Parity: describing an in-the-money option trading for its intrinsic value. Also used as a point of reference --an option is sometimes said to be trading at a specific distance "over parity" or "under parity". Anoption trading under parity is trading at a discount.

Profit Graph: a graphical representation of the profit potential of a position. Usually, the stock or futureprice is plotted on the horizontal axis, while the dollars of profit or loss are plotted on the verticalaxis. Results may be plotted at any point in time. Generally, in The Option Strategist, profit graphswill show results projected two weeks hence, as well as projected results at expiration of the nearest-term option in the position.

Position delta: a measure of the exposure of an entire option position to market movement. It is computedby summing the following for every option in the position: quantity × delta × shares per option.

Premium: another word for price, when speaking of an option.

Put-call Ratio: a measure of option trading volume that is sometimes used as a contrarian technical indicatorto predict forthcoming market movements. The ratio is computed by dividing trading volume of putsby the trading volume of calls. It may be used in a specific case, such as options on gold futures, forexample. It may also be used in a broader sense by dividing the total volume of all puts trading onequities on all exchanges by all calls traded. If the ratio gets too high, that indicates too many peopleare buying puts. Since this is a contrarian indicator, that would be a buy signal. Conversely, if toomany calls are being bought, the ratio will be too low, and that is generally a sell signal.

Ratio spread: a spread in which the number of options sold is larger than the number purchased. Hencethe strategy involves naked options. See also backspread.

Resistance: a term in technical analysis indicating a price area higher that the current stock price where anabundance of supply exists. Therefore the stock or future may have trouble rising through theresistance price.


Roll: to close an option and re-establish a similar position in another option on the same underlying security. To roll a long call, one would sell the call he owns, and buy another call, generally with either ahigher strike or a longer time to expiration, or both.

Skewing: a term referring to volatilities of options at different striking prices on the same underlyingsecurity. If the implied volatilities are different at each strike, there is said to be volatility skewing.

Spread: for options, any option position having both long options and short options of the same type (putor call) on the same underlying stock or futures contract. For futures, any position involving bothlong and short futures either with different months on the same commodity, or on two relatedcommodities.

Stop order: an order which becomes a market order when the stock or future trades at the price specifiedon the stop order. Buy stop orders are placed above the current market price; sell stop orders areplaced below the current market price.

Straddle: any position involving both puts and calls on the same side of the market, with the same strikingprice. For example, a long straddle involves buying both puts and calls with the same striking price.

Support: a term in technical analysis indicating a price area lower than the current price of the stock orfuture, where demand is thought to exist. Thus a stock or futures contract would stop decliningwhen it reached a support area.

Technical Analysis: the method of predicting future price movements based on observations of historicalprice movements; applies to either stocks or futures.

Theoretical Value: the price of an option or spread as computed by a mathematical model. See also fairvalue.

Uncovered option: see naked option.

Underlying security: a broad term used to denote the stock, index, or futures contract which underlies aparticular series of options.

Vega: a term to describe the amount by which an option's price will change for a 1 percent change in thevolatility of the underlying security.

Volatility: a measure of the amount by which an underlying security is expected to fluctuate in a givenperiod of time. See also skewing.

Volume: the amount of trading of a stock, option, or future. Excessive trading volume in an equity optionmay portend a move in price by the underlying stock. If one can spot unusually heavy trading incalls, that may be a buy signal for the underlying stock.

Write: to sell an option. The investor who sells is called the writer.

McMillan Analysis CorporationP.O. Box 1323, Morristown, NJ, 07962-1323

Customer Service: [email protected]

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