Profit Each Month-or Walk Out on the Bill

What we really would like to do when we ride the bear is to stay right on his back, to turn a profit for several months in succession while a market puts in an extended bottom. Suppose we’d be required by the lack of liquidity or the complete non-existence of the next month’s options to move our second,third, nth option write to the options 2 or 3 months away for each successive write.

We’d almost surely earn a larger premium on the successive writes, but the premium, equally surely, would be net lower on a per-month basis and we’d have to contend with yet another condition.When a bear market in physical goods exists, supplies are by definition too ample for the existing market demand. The price of each successive regular month futures contract will reflect this excess in the cost of interest,and of storing and insuring the goods for another 60 or 90 days or so, the well-known carrying charge.

These successive months’ prices will be higher than the nearby regular month contract, and this price structure may force us to make a decision whether to change the striking price of the next puts we write.Serial month options are offset against the next regular month’s futures.January and February options in cocoa, for example, are matched off against the March futures, just as are the March options. Liquid serial month options give us a sizeable opportunity advantage.

If we would want to continue the trade while the underlying market keeps scraping along its bottom, their
availability will have removed one variable from our decision-making process, namely, the striking price of the next options we’ll write. If we begin riding the bear by writing the January puts in cocoa or coffee, say, then when or just before the January options expire, our decision process is very simple—do it again or call it a day.

We usually won’t have to examine which strike to write; the same strike we originally wrote will ordinarily be the one we’ll want for the next write. Naturally, wanting and getting are not the same thing at all, and we may be required by market conditions to write a different strike, but whichever strike best meets our entry criteria will be all right with us.Liquid serial month options also, beneficially, make defending our position easier should a defense become desirable.

A hedge defense isn’t possible when riding the bear because we have deliberately written a strike very close to the market price. A spread defense, creating a calendar time spread by purchasing puts in a further out month with the same striking price as the ones we wrote, presents more complications than it’s worth, and usually restricts our future range of profitability far too tightly.The usual defense in this strategy is a roll-out; buy back what we originally sold and then write some number of puts in the next month, or possibly two months, out.

When we can and when the option premiums justify it, we’ll prefer to roll out-and-down to a lower strike while the bear market piddles along near its bottoms. Our ability to do so will depend on the amount of life left in the puts we originally wrote and the comparative premiums of the two options at the time we decide to examine defensive possibilities.On the Bear’s Back—A Real-World Trade:For a practical example of riding the bear, we can look at a trade conducted over several months in the 1999–2000 cocoa market.

Your favorite author managed the trade fairly well from November through August (I’d give myself about 65 or 70 marks out of 100, no more). At the time, I was just fooling with developing the ride-the-bear strategy, and if I had known then what I know now . . . well, never mind. On November 12, 1998, NYBOT March 2000 cocoa, a 10 metric ton (tonne) contract, closed at 1648.

The contract began a steady and protracted decline on continuing good supply news until the market reached 984 on May 28, 1999. In the next month, it bounced back to 1226 on June 21, then resumed its price erosion. The market broke 1000 again on August 18, and gave up another $150/tonne through early November.At the time, I was involved in a non-seasonal trade, writing NYBOT cocoa calls, which, as we see above, was certainly a profitable idea over the preceding period.

Then, reading over the newswires on November 12, I saw the story about Ivorians threatening to burn cocoa stocks. I hadn’t analyzed the ride-the-bear strategy thoroughly at that point, but was willing to experiment a little bit, so I wrote a few February 2000 800-strike puts for $35/tonne, thus stepping into a strangle along the lines discussed in the previous chapter. As things turned out, I was too early, but only slightly. The market wasn’t quite sold out. February 2000 cocoa options on NYBOT offset against the March 2000 futures (ticker: CCH), and expire on the first Friday in January.