Filling Out the Deposit Slip—Preconditions for the Endplay

So much for negativity. The preconditions for a good endplay trade are remarkably straightforward and easily met, and here they are:

1. Option expiration must be no more than two day sessions away when we write the options, whether using the one-sided approach or the strangle, and the less time remaining, the better for us.

2. The IVs of the nearby options in this market must be high. If the market has natively very high absolute volatility (natural gas, coffee, etc.), we still prefer that the present IV be in the upper half of its 6-month range.If the market has only middling-highish native volatility (cocoa, soybeans, crude oil, etc.), we insist that the IVs be near the top end of their 6-month range.

3. In the strangle approach to endplays, ROC net of costs should be at least 3% of double the initial SPAN margin requirement. In the onesided approach, net ROC should be at least 2% of double initial SPAN requirement.

4. If the market can be strongly affected by overnight weather developments, and one or more such developments are even possible in the next 2–3 days, do not use the endplay strategy at this time in this market. This strategy is completely dependent on our being very confident that there exists a short-term news/event vacuum in our selected market.

5. If there is any supply/demand news pending in a market in the next 2–3 days, or better still 4–5 days, do not use the endplay strategy. The endplay strategy works best when the trade is entered a day or two after a scheduled supply/demand report or other significant information has reached the market, and the news/event vacuum is now present.

6. Don’t be greedy. Attempting to make 8–10% or more, while possible,gives away the structural advantage of the trade. Select the strike(s) of the endplay as far away from the current market as possible, consistent with the goals for ROC.

Condition 1 is part of the definition of the strategy. Don’t adapt it by extending the trade to three or four days, because more time until expiration means more possibility of external events intruding on the trade. Condition 2 is likewise vital, particularly for the strangle approach. If option IVs are low, strangle-style endplays will need to be defended much more often than we’d like, which defeats the purpose of the trade. Sure, we’ll defend if necessary,
but, once again, we do not want to seek out trades that we are more likely to have to defend.

Lower IVs are acceptable in the one-sided approach,as long as you’ve a reasonable measure of confidence that your view of the market’s direction over a day or two isn’t considerably off the mark. Use non-seasonal reasoning here: you don’t need to be right to make a profit,merely not significantly wrong.Conditions 3 is included because a considerable number of traders consider a 2–3% return on a trade to be not worth their while.

Two or three per cent over a year? I agree completely. But, 2 or 3 per cent over 1 or 2 days?How greedy are these traders, anyway? If we were able to find enough trades yielding 2% over 2 days, consecutively throughout a year’s time, we’d be staring at a 1,161% total ROC at the end of the year. Maybe I’m missing something here, but that’s certainly enough for me. Condition 6 applies here, too.

As in other option writing strategies, keep the strikes of the written options as far from the current market price as feasible, the more so given the modest ROC requirement.Condition 4 is somewhat amorphous, but still easily implemented.For example, the natural gas market is notoriously affected by certain weather conditions—an extended nationwide heat wave in the summer,prolonged cold as we saw in the winter of 2000–2001, or the advent of a hurricane near the production areas in the Gulf of Mexico.

If any of these exist,or might come to exist within 48 hours, don’t enter an endplay trade. If they don’t, then go ahead. Condition 5 is really the key to this strategy. In an endplay, the occurrence of new news is either outright evil, in the straddle approach, or halfway risky, in the one-sided approach. The less likely that new information will appear in the marketplace over the 1–2-day term of the trade, the more likely the trade is to succeed.

Markets that have regularly scheduled weekly or monthly releases of supply/demand data are considerably more likely than other markets to be good candidates for endplays. This is why the NYMEX energy markets tend to offer more opportunities to apply this strategy.

For crude oil, heating oil,and gasoline, the major weekly reports and their times of release are wellknown and, even more importantly, well trusted by the market participants.By mid-morning every Wednesday, the market has digested the weekly API and DOE supply/demand figures, and if the current month options expire on that Thursday or Friday, we have the potential for a good endplay trade.