From the December 01, 2005 issue of Futures Magazine • Subscribe!

A sideways and directional proposition

Survival of the fittest is a concept that definitely applies to markets. The theory of evolution states that it is not the strongest, but the most adaptive beings that ultimately survive. The fittest could be categorized as the more adaptive.

The more adaptive you are, the better you can master your zone. Your zone is where you feel comfortable with your trading, without fear or overconfidence; where you stay completely focused on the opportunity flow; where you have a belief system that is strong enough not to be shaken by market uncertainty. So to become adaptive to the marketplace, you have to learn to accept, understand and use the conditions the market presents from its perspective. The perspective of the market can be described as having two types of movements: sideways and directional.

Therefore, a risk study should have a proposition for the sideways market and one for the directional market. Simplicity is highly useful when approaching both propositions because the concept of trading simultaneously both sideways and directional markets can become confusing. The idea behind the concept is to be neutral to market movements without an opinion of whether the market is going up, down or sideways. The trading approach is from a risk management perspective rather than from a technical perspective.

Before we get into the model, here are definitions of the important concepts behind it:

Market risk. This represents the level of uncertainty of market movements. It is minimized when indexed. In this model the S&P 500 index is used as the instrument traded. By using the S&P, which is the market risk benchmark itself, the beta is neutralized to one.

Time value. The variable of time is factored into the price of the option. It is calculated as the value of borrowing money, given an interest rate, for the remaining life of the option.

Volatility value. This is the market range and speed of movement. It is defined as the level of risk. Therefore, when it is factored into the price of the option, it is going to reflect market conditions. VIX is the measure of the implied volatility on the S&P. When the VIX is high, options are expensive, as more risk is implied in the price.

Option straddle. In this strategy the investor buys or sells both a call and put with the same strike price and expiration date.

Asian options. This also could be called average options. An Asian option is a strategy that consists of a group of European options of consecutive strikes purchased or sold simultaneously. By definition, the average of their combined cost, and their combined exposure, is a risk assessment on itself and is useful for creating risk profiles with supplemental value.

The distribution of the cost among different strikes, built in the Asian option, works like supplemental insurance as the market moves in one direction or the other. European options are a better fit for the Asian average because they can only be executed at the end of its life, and thus add some peace of mind for the option trader.

An example of a long Asian call will be a simultaneous purchase of calls at 1200, 1205, 1210 and 1215 strikes. As the S&P rallies, profits at expiration and 25 days out converge.

Asian straddle. In this strategy the investor buys or sells both an Asian call and an Asian put at the same expiration date. Examples of Asian straddles are:

Short Asian Call:

Short 1225 SPX Call

Short 1220 SPX Call

Short 1215 SPX Call

Short Asian Put:

Short 1215 SPX Put

Short 1210 SPX Put

Short 1205 SPX Put

The straddle is a strategy for a sideways market. By writing the naked Asian straddle, the premium collected is kept to generate credits in the trading account. A performance bond requirement of approximately $20,000 is needed for each naked SPX written, for only one side. The margin required on the example above is about $60,000 because only one side of the 1215 price will be affected, the other will expire worthless. This is the sideways part of the hedge.

For the directional element of the strategy proposed, we can look to the trend following strategy otherwise known as the Turtle Trading System. The Turtle System is one of the more consistent and profitable systems for directional trading across all markets.

One thing that makes that system so powerful is a money management element. The system adjusts trading size as the position moves in one direction. As momentum builds up, new contracts are added in to capitalize on the move, and as the market is quiet, the position is kept small to minimize the whipsaw. This logic is used as the directional part of the hedge proposition.

For every SPX contract, two E-mini contracts are needed to hedge proportionally. Every option strike price constitutes a price level to manage the risk of the hedge system. As a strike price is reached, a buy or sell order should be entered to balance the portfolio, adding or removing E-mini contracts to keep the balance. The hedge is constructed gradually, keeping in perspective support and resistance levels to confirm the direction building on the hedged portfolio.

Consider an example. It is June 20, 2005, and the SPX just closed at 1216.10. There is a potential for a strong move given the low volatility on the market. So, we short an Asian straddle, collecting a premium for a credit in the account of $7,272. There is a margin requirement of about $60,000.

Short Asian Call:

Short 1225 SPX July 05 Call @ $1.011

Short 1220 SPX July 05 Call @ $1.239

Short 1215 SPX July 05 Call @ $1.497

Short Asian Put:

Short 1215 SPX July 05 Put @ $1.379

Short 1210 SPX July 05 Put @ $1.166

Short 1205 SPX July 05 Put @ $ 980

If the market closed between 1185 and 1245 on the July 15 expiration, we would be able to maintain a profit. But our goal is not to be subject of market uncertainties and we follow the plan. We have a $7,272 credit to compensate for market sideways whipsaws; therefore, we establish a directional position to hedge the sideways position. Based on the analysis, we decide to be short at the close at 1216.10.

The bias is discretionary at this point. So, the next move is to short two June E-mini contracts at 1216.10. The margin requirement for this trade is about $8,000, which is covered by our credit. On June 21, the SPX closes at 1213.61. The trade has moved slightly in the favor of our directional bias.

At this point, we let things ride. The inside day action gives us confirmation that the market is set for a volatility jump. On June 22, the SPX closes at 1213.88. Obviously, the market tricked us. We placed a short stop above 1218.00 and took it. We then go long two contracts at 1218. Unfortunately, at the close the set up becomes very bearish and we switch to the short side again.

Here are our trades so far:

Long 2 ESN5 @ 1218.00 - 1216.10 = $190 Loss closing previous directional position

Long 2 ESN5 @ 1218.00 to open the new directional hedge

Short 2 ESN5 @ 1213.88 -1218.00 = $412 Loss closing previous directional position

Short 2 ESN5 @ 1213.88 to open the new directional hedge

Margin Requirement $8,000

On June 23, the SPX closes at 1200.73. At 1210, we have the next strike for adding to the directional position. This level is also a support technical level, which is confirmation of scaling in the directional position. So we sell two contracts at 1210. At 1205, the technical setup is not so clear that we want to add more positions, but we have to hedge the put we sold before regardless of technical levels. Besides, the trade is a confirmation of the awaited volatility peak: we sell two more contracts at 1205.

Because of the level of the close and because we have a volatility setup for a continuation day, we expect to close the trade in the next support level at 1195.

Here are the additional trades:

Short 2 ESN5 @ 1210 to add to the directional hedge

Short 2 ESN5 @ 1205 to add to the directional hedge

Margin Requirement $16,000

Next comes June 24, and the SPX closes at 1191.53. True to our strategy, we close all positions around the 1195 area, given that it represents a support level and that the trade has worked favorably for us.

Here is how it played out:

Long 6 ESN5 @ 1195 for $ 4,388 Profit

Long 1225 SPX July 05 Call @ $329 for $682 Profit

Long 1220 SPX July 05 Call @ $411 for $828 Profit

Long 1215 SPX July 05 Call @ $513 for $984 Profit

Long 1215 SPX July 05 Put @ $2.722 for $1,343 Loss

Long 1210 SPX July 05 Put @ $2.381 for $1,215 Loss

Long 1205 SPX July 05 Put @ $2.069 for $1,089 Loss

Previous whipsaw losses of $602

Total Balance: $2,633 Profit

Total Margin Required $85,000

The concept of hedging a sideways with a directional market is a proposition with a high level of risk if not done with discipline. But this is no different than any other trading system. Plus, this strategy offers an alternative that stands on a risk perspective, and it also adapts to market conditions as they change. Keeping a mind set to profit from a directional move on a sideways setup may meet market conditions better than a stand alone directional or sideways method.

Octavio Riano is a market timing system developer and an S&P derivatives trader with Carlin Financial Group. E-mail: octriano@bellsouth.net.

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