Suitability—Round Up the Suspects

The inflation of options’ IVs can theoretically occur in any market, from azuki beans to wheat, and probably in stamps, baseball cards, and Ming porcelain,too, but not all markets offer opportunities for Martian ratio-spreads.In some markets, call premiums can become wildly out of line relative to that market, but still not reach the quite high levels required for this style of ratio-spreading.

Currencies and interest-rate bull markets, for example, typically will feature their call IVs below 20% even in a strong bull market, and while the WOOM and WTBOOM options’ premiums will surely have risen,they won’t likely be anywhere near the levels we want to see before employing this strategy.I rarely trade stock-index markets, but I’d guess that in the late 1990s these markets offered some excellent Martian ratio-spread opportunities.(Once I acquire that historical database of option prices, I’m definitely going to hunt around for such occurrences).

These markets, after all, could hardly have been much more bullish than they actually were, and SVs and the call options’ IVs probably had some hefty spikes on occasion. Nonetheless, index futures probably are only rarely good candidates.McMillan and other writers have commented on a long-lasting overvaluation in the call option IVs and premiums in certain markets, naming coffee, soybeans, and gold as prime examples.

I don’t really believe in a sort of long-term collective market psyche, but in these markets the evidence is incontrovertible.When the bull threatens to rumble, these markets’ call premiums go absolutely bazoo. Natural gas, too. These are all excellent candidates for us, the “A” list so to speak, and these markets, along with silver occasionally,have offered the vast majority of the ratio-spreads I’ve entered in the past few years.

You might be tempted to think that NYMEX crude oil and heating oil would be markets to watch here also, and I would too. Maybe they are. I’ve never yet found a really good possibility in either of these, but who’s to say I haven’t just missed one when it was present? So, I’ll keep looking, and perhaps a good, disciplined ratio-spread will turn up one day. Right around the time the bombs start falling on Iraq, as a guess.

I wouldn’t doubt for a minute that CBOT corn had some dandy ratiospread possibilities in 1995 when the market topped $5.00. Unfortunately, I wasn’t looking for them then, and, barring some enormous weather disaster,the Congress has seen to it that giant bull markets in corn and other grains and oilseeds probably will be rare for several years.

An example of lower than possibly expected IVs may be seen in the 2002 grain crops, seriously damaged by heat and drought, yet whose volatilities haven’t spiked sharply enough to allow creation of a good Martian-style trade. Curiously, the CBOT oats market may become an exception to this situation, because some large fraction of the crop each year comes from Canada, Sweden, and Finland,which nations are (mostly) beyond the depredations of Congress, and this year’s Canadian harvest is beset by all sorts of problems.

A bad crop next year, too, and . . . who knows?The various metals markets are half-yes, half-no NYMEX/COMEX gold and silver offer us excellent ratio-spreads from time to time. NYMEX/COMEX copper might at some point, but opportunities here have been nonexistent for the last few years. The NYBOT platinum and palladium markets certainly meet the preconditions for ratio-spreading every so often, but their options are completely impossible to trade for the careful and practical trader.

I can’t see even trying to ratio-spread these two markets.I haven’t seen any ratio-spread opportunities in the CME meat markets,either, although other opportunities abound for option trading on these floors. This brings us to the softs markets, what we used to call “exotics” 30 years ago. Aside from NYBOT coffee (one of my favorites), CME lumber,NYBOT cocoa, and frozen concentrated orange juice will very likely present good opportunities from time to time and are very much worth keeping an eye on.

The options markets in lumber and OJ are thinly traded as a rule,and our contest risk, particularly our slippage, will generally be higher than we want to see, but an opportunity is an opportunity, and not to be ignored out of hand.One important point needs to be clearer than perhaps I’ve made it so far.

While many traders consider a rip-snorting bull market as necessary for the sharply rising IVs we want to observe as the initial setup for a good ratiospread,this is not the case. We distinctly do not require a long-lasting runaway bull market such as NYMEX natural gas in late 2000 or COMEX gold in late 1979. Any circumstance that sends SV higher and also causes WOOM call option premiums to rise apace is definitely good enough for our purposes.