January 2006Volume 2, No. 1

• MAX ANSBACHER ON SHORTING OPTIONSThe Options Trader interview

• CALL WRITING FOR STOCK INVESTORS:Low-cost portfolio insurance

• THE OPTION SELLING ALTERNATIVE:Covered combos

• STRATEGY ANALYSIS:Option volume trade signals

• TRADE DIARY: S&P bear call spread

2 January 2006 • OPTIONS TRADER

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . .4

Options NewsConsidering the options for the future(s) . . . . . . . . . . . . . . . . . . . . . . .6Although an SEC-CFTC merger is highly unlikely, a multi-asset class exchange might not be too far off.

CBOE, ISE keep rolling . . . . . . . . . . . . . . . . .6The Chicago Board Options Exchange and the International Securities Exchange bothhad good news in December that had nothing to do with trading volume.

Options Trader Interview . . . . . . . . . . . .8Max Ansbacher: The options sellerMoney manager Max Ansbacher describes thenuances of selling options and how thisapproach has helped him outperform the marketsince 1995.By David Bukey

Trading Strategies . . . . . . . . . . . . . . . . . .14The out-of-the-money advantageA put-buying strategy to cope with a nervous stock market.By Keith Schap

Options Strategy Lab . . . . . . . . . . . . . . .18Trading on unusual call activity

New Products/Events . . . . . . . . . . . . . . .19

Trading Basics . . . . . . . . . . . . . . . . . . . . . .20The option-selling alternativeComparing three short option techniques —uncovered puts, covered calls, and coveredcombos — shows ways to gain an edge whenbuying or selling the underlying instrument.By Bill Ryan

Options Trade Journal . . . . . . . . . . . . . .24S&P 500 bear call spreadPutting on a bear call spread in S&P 500options.

Key Concepts . . . . . . . . . . . . . . . . . . . . . . .26

Options Expiration Calendar . . . . . . .28

CONTENTS

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8 January 2006 • OPTIONS TRADER

In the early 70s Max Ansbacher was a successfulattorney working for Colgate Palmolive when listedoptions were introduced by the Chicago BoardOptions Exchange (CBOE). When his broker sug-

gested selling some covered calls on stocks he owned, hewas surprised when the calls all made money as theyexpired worthless.

The only problem was Ansbacher’s stock was plummet-ing at the same time because he began selling options at theoutset of the 1973-74 bear market. But once he started sell-ing uncovered calls, he was hooked.

“It was a money machine for two reasons,” he says.“Option prices were probably five times higher than theyare now. And it was also a bear market, so if you sell over-priced calls, how can you go wrong?”

After his initial success, Ansbacher began researchingoptions but couldn’t find relevant books on the subject. At thetime, option trading books focused on the over-the-countermarket, so Ansbacher wrote the first book on listed options —The New Options Market, originally published in 1975.

Ansbacher then left his 15-year law career to work as abroker at Bear Stearns for the next 20 years. Meanwhile, hecontinued to write options and wrote two more books —How to Profit from the Coming Bull Market (Prentice Hall,1981) and The New Stock-Index Market (Walker & Co., 1983).

He also developed the Ansbacher Index, a market senti-ment indicator that compares the prices of out-of-the-money (OTM) puts and OTM calls on the S&P 100 (OEX)and S&P 500 indices (see “The Ansbacher Index,” ActiveTrader, February 2002). It is a contrarian indicator designedto supplement the put-call ratio, which tracks only optionvolume.

Ansbacher launched his own option-trading fund,Ansbacher Investment Management, in 1995. The fund

now manages more than $171 million and has been prof-itable nine of the past 10 years, including a 94.93-percentgain in 1997, the largest net return of any CommodityTrading Advisor that year.

While Ansbacher has refined his approach over the yearsand is quick to recognize the risk of selling naked options,he maintains that premium sellers have a market edge invarious market conditions.

OT: You began selling calls in the early 70s and have con-tinued to sell options throughout your career. Do you stilladvise against buying options? MA: Options are much less expensive than 30 years ago. Iwrote in The New Options Market that you can’t make moneybuying options. Today you could if you happened to beright. However, option writers make money for some verysolid reasons.

OT: Which are?MA: They have capital and are entitled to a return like anybusiness. A businessman has capital and puts it at risk inhopes of making a profit. Option writers provide a financialproduct to the world because when you short an option,you’re creating it.

OT: Was it easier to find overpriced options at the begin-ning of exchange-traded options in the 70s than it is now?MA: Absolutely.

OT: Why?MA: Options started out at very high prices because somany brokers recommended their clients buy calls insteadof stocks.

There was quite a bull market going into that 1973-74

OPTIONS TRADER INTERVIEW

Max Ansbacher:The options seller

Max Ansbacher has been selling options for more than 30 years

and runs a multi-million-dollar option fund with an impressive track

record. We spoke with him about his market experience and why he

thinks his fund’s option-selling strategy continues to have an edge.

BY DAVID BUKEY

OPTIONS TRADER • January 2006 9

period. Brokers said “You can buy AvonProducts for $130 or you can buy a callfor $10. If the stock goes up a lot, you’llmake just as much money on the call asyou would in the stock. If it goes down,your call will only lose $10, the stockcould lose $130.” Pretty easy decision —buy the option. (Laughs.) Of course, nowwe know they should be worth muchless than they were then.

OT: What’s your fund’s strategy?MA: We sell options on the S&P 500 andalso on 10-year and 30-year U.S. treas-ury futures.

OT: Why those markets?MA: First, we needed a macroeconomicindex for liquidity, which is very impor-tant to us since our fund [now managesmore than $171 million]. The market makers inthose markets can step up and buy 1,500 or3,000 options at a time. Also, the S&P 500 is notnearly as volatile as the individual stocks thatmake it up. When you buy an index, it auto-matically takes out a lot of the volatility.

OT: Do you trade options on S&P futuresrather than index options themselves, and if so,why?MA: Yes. The margins are lower, and you don’twant to get a margin call if something gets a lit-tle bit out of whack.

OT: Is it fair to say that your strategy is basi-cally selling volatility? MA: I don’t know if we’re selling volatility. Welike to think we’re selling time value.

OT: Do you take a market direction or are yousolely focused on taking premium out of themarket?MA: We’re a market-neutral fund. And ourresults have had very little volatility over thelast three years (see Figures 1 and 2).

OT: So it’s not as simple as selling more puts in an uptrendor selling more calls in a downtrend?MA: If identifying an uptrend or downtrend were that easy,then we could trade S&P futures and do very well, right?

OT: So how do you find overpriced options?MA: That’s an interesting question. You assume we do find

continued on p. 10

Ansbacher outperformed the CSFB/Tremont Hedge Fund Index in eight of thepast 10 years, including each of the past three years. His outstanding gain in1997 (94.93 percent) made him the top-performing CTA that year.

FIGURE 1 — YEARLY PERFORMANCE — 1995 TO 2005

Source: www.AnsbacherUSA.com; www.hedgeindex.com

A $1,000 investment in Ansbacher’s option-selling fund in May 1994would have returned $9,580.76 within 10 years — nearly three timesas much as the S&P 500.

FIGURE 2 — ANSBACHER VS. S&P 500

Source: www.AnsbacherUSA.com

10 January 2006 • OPTIONS TRADER

overpriced options. But that’s not oneof the most important things. We wantto be in the market all the time. We’relooking for a certain delta, so we’reusually in the near-month contract orthe next one out.

OT: So your time frame is less thaneight weeks?MA: Right. This isn’t always the case,though.

OT: Are you looking for strike pricesthat are a certain percentage aboveand below the current price?MA: No. If the market’s extremelyvolatile, you might want to be 15 per-centage points out of the money. Butif the market’s flat as a pancake, theVIX would drop, and you couldn’t getany money for those. Second, youwouldn’t need to sell options that farout of the money. In the last year or so,it’s been a rather non-volatile market.So you don’t have to sell strike pricesso far out.

OT: Many traders compare a market’simplied volatility and its statistical, orhistorical, volatility and then tradebased on extreme divergences —buying historical lows and sellingunusual highs. What do you think ofthis approach?MA: We look at the differencebetween implied and actual volatility.As you may know, the implied is sig-nificantly above actual [volatility lev-els], especially in S&P puts. This iswhere we have our edge.

For example, if the Black-Scholespricing model shows S&P optionsshould cost $3, but they cost $3.75, that$0.75 is what option buyers are willingto pay. It’s also the profit margin thatoption writers insist on before they sellthem. Our strategy is inherently prof-itable because options are priced high-er than they theoretically should be,

OPTIONS TRADER INTERVIEW continued

The Ansbacher Index

T he Ansbacher Index (AI) is an indicator based on the prices of indexoptions designed to gauge the sentiment of options traders. AI read-ings can be used to measure the current level of bullish/bearish

sentiment, forecast the future direction of the stock market, and decidewhether to use long or short option strategies. Extreme AI readings indicatepotential reversals of the current price trend.

The AI offers a different way to measure market sentiment by comparingthe prices of calls and puts rather than the number of calls and puts (as doesthe put-call ratio). The indicator compares Standard & Poor’s 100 Index (OEX)call prices to put prices — specifically, the price of a call approximately 40 pointsabove the current OEX price divided by the price of a put the same amountbelow the OEX price.

When traders become optimistic, they will tend to aggressively bid for calls,especially out-of-the money calls. This demand for calls can drive the price ofcalls relative to puts to extreme levels — an indication of the bullish senti-ment. On the other hand, if the majority of traders are pessimistic, they willpurchase puts. The price of puts will climb relative to the price of calls, areflection of bearish sentiment.

Interpreting the indexThe higher the price of the put compared to the price of the call, the lower theAI will be. For example, if a put were 2 and the call were 1, the index wouldbe 0.5. If the put and call were equal, the index would be 1.0, and if the putwere 1 and the call 2, the index would be 2.0.

At first glance, a 1.0 reading would seem to be the theoretical neutral levelfor the index. However, in the real world the neutral level ranges between0.70 to 0.90 because many stock owners are natural buyers of puts (to hedgetheir positions). Also, many investors sell calls against their portfolio toincrease their yields.

These two factors account for the downward shift in AI readings. As aresult, an index reading less than 0.70 is regarded as bullish for the stockmarket, with the degree of bullishness climbing as the value of the indexdecreases. An index level greater than 0.90 is bearish, with the level of bear-ishness increasing as the index moves higher. Thus, the more people are will-ing to pay for puts (which is a way of indicating they are bearish), the lower(more bullish) the index reading.

As its levels imply, the AI is a contrarian sentiment indicator. The basis of con-trarian theory is that when most people are very bullish the stock market is likelyto go down, and when most participants are very bearish the market is likely togo up. When traders or investors are extremely bullish, they already have pur-chased all the stock and call options they are likely to buy. Therefore, there is nolonger future potential buying power and there is little demand left to push priceshigher. If the market turns down, the amount of selling will rise, as many of theseinvestors will change their opinions and liquidate positions, intensifying the down-turn. The opposite is true when most investors and traders are very bearish.

While extreme AI readings are rare, they provide a qualitative perspectiveto the current sentiment of options players. For example, if the market is in adowntrend and AI readings are hovering near 0.70 (despite the reading beingon the lower side of neutral), you can conclude that options traders are morebullish than one would expect given the market’s bearish condition.

— Excerpted from “The Ansbacher Index,” Active Trader, February 2002. You can

purchase past articles at www.activetradermag.com/purchase_articles.htm and down-

load them to your computer.

OPTIONS TRADER • January 2006 11

especially puts.

OT: Nassim Nicholas Taleb, author ofFooled by Randomness, takes theopposite approach. He buys OTMoptions instead of selling them,because he argues it’s better to paysmall amounts waiting for an inevitablerare event — and reaping its largereward — instead of taking in premiumand exposing yourself to such anevent. What do you think about this?MA: The problem is you lose moneywhile you wait. And that can be a veryserious problem. You might have towait 10 years before you get an eventlike that. And you may have lost half,or more than half. How many puts canyou afford to be long?

OT: Can your strategy be profitable inall markets — up, down, and side-ways?MA: We’re going to struggle if themarket suddenly spikes up or down.But we could make money in eitherbear or bull markets. And it’s prettyobvious that we’re going to profit in aflat market.

OT: What percentage of your soldoptions expires worthless?MA: We don’t really let any optionsexpire worthless. We buy them backaround $0.40. At least 75 percent of ourtrades are successful. But our [individ-ual] losers may be as big — if not larg-er — than our gains.

OT: Do you set stop-loss points?MA: Yes, we enter a good-till-can-celled stop-loss order for every optionwe’re short.

OT: How do you determine your stop-loss?MA: It’s a certain ratio of the option’sprice. If we only have a few options onone side of the market, we [loosen]

those stops. We wouldn’t want to getstopped out on the side that didn’thave much short option value. If wehave a lot, we’ll [tighten] them. Also,as we get closer to expiration, we wantto tighten stops because the gammaincreases as expiration approaches.

OT: Do you ever buy options or createany spreads to protect positions?MA: No. We experimented with acredit spread program, but in myopinion, we spent so much moneybuying the further-out options, it was-n’t worthwhile.

OT: So instead you might tighten thestops a little more?MA: Exactly. That is our defensemechanism. Normally, we don’t hedgewith the futures, and we’re not buyingother options. I’m aware of all theseother strategies, but we don’t do that. Ibelieve in the principle of Occam’sRazor — when there’s more than onesolution to the problem, the simpleone is usually the best.

If an option’s getting in trouble, wejust buy it back. It’s called the turtledefense — you pull in your head andwait for the storm to blow over.

OT: Could you describe a previoustrade?MA: We sold May 1,195 puts and 1,050calls when the S&P 500 traded at1,129.49 on April 14, 2004 (see Figure 3).The calls lost most of their value as theS&P dropped nearly three percent overthe next four weeks, and we boughtthem back at $0.40 each. Although theputs got stopped out the next week, theoverall position gained ground.

OT: How helpful is the Ansbacherindex (the ratio between prices ofnear-month OTM calls and puts)? Howoften do you track it?

continued on p. 12

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MA: It’s not that formal anymore. I measure it wheneverI’m interested.

OT: So it isn’t necessarily a trade signal?MA: No. But it gives you an idea [of market sentiment]. It’sa way to come up with a number expressing the differentprices of puts vs. calls for equally out-of-the-money strikeprices. So if the S&P 500 is 1,200, look at the 1,280 calls andthe 1,120 puts that expire in about two months and dividethe call price by the put price. In the S&P 500, the puts arealmost always worth more than the calls. They vary from 50percent more to three times as much.

OT: Has the Ansbacher Index’s historical extremesmatched prior highs or lows in the market?MA: It’s a very bearish sign when the calls are nearly asexpensive as the puts (a value of 1). If you didn’t know, you’dthink it’s a neutral market. However, it shows tremendousoptimism in the market. Everybody’s long — a good time tostart selling calls.

OT: Did the index signal the market peak in 2000?MA: Yes, and also in 1997. [But as a shorter-term signal] itdoesn’t work any better than other sentiment indicators.

OT: Does it work better than the put-call ratio?MA: How well does that work? You can say they’re helpful,

but when you’re actually trackingthem, what’s extreme? With hind-sight, you can always pinpoint thehigh, but does that mean you can useit in real-time?

OT: Why was 1997 such an extraor-dinary year for your fund?MA: After the big drop in October, theVIX went way up and we were able totake in a lot of money. I also started1997 with a lot of option value leftover from the year before.

But we’re never going to see a yearlike that again because of ourenhanced risk-management program.That’s the trade-off we made [in2002]. We wanted lower volatility inour results, so we’re never going tohave those outsized profits again.

OT: What type of changes did youmake in 2002, and why?

MA: In the past, this was really a one-man firm, and ourclients were almost entirely high net-worth individuals.Many of them wanted us to make as much money as wecould, and if we had a big monthly loss, they weren’t tooupset as long as we made it up in a couple of months. Weusually did.

In 2002, however, I decided to enter the institutional mar-ket, and they probably never want to see more than a six-percent loss in any given month. So I hired another princi-pal (Khan Noorpuri, the firm’s bond trader) and dramaticallyimproved our risk-management program. [In addition toplacing stop-losses on all trades], we don’t sell nearly asmany options as we’re entitled to under the margin rules.

OT: You had a 5.51-percent loss in 2000 and gained just2.3 percent in 2002. How were those market conditions dif-ferent from other profitable years?MA: 2000 was a tough year for a lot of people. As I men-tioned, we have problems when the market makes big spikesup and down. In 2002 the bear market was ending. The mar-ket would shoot up before plunging again, and so forth.

But if the VIX falls too low, then we really can’t makemuch money. That’s probably why we weren’t doing aswell this year. The implied volatility is so low now, we justcan’t take in very much money. Our actual returns throughthe end of November were 9.4 percent.�

OPTIONS TRADER INTERVIEW continued

Ansbacher sold both calls and puts on the S&P 500 on April 14, 2004. Hebought back the calls for a $2.55 profit on May 12; the puts got stopped out aweek later. But the overall position was profitable.

FIGURE 3 — SELLING OPTIONS ON THE S&P 500

Source: www.AnsbacherUSA.com